Central Banks as Sources of Financial Instability

Article excerpt

The present financial crisis has set in bold relief the Jekyll and Hyde nature of contemporary central banks. It has made apparent both our utter dependence on such banks as instruments for assuring the continuous flow of credit in the aftermath of a financial bust and the same institutions' capacity to fuel the financial booms that make severe busts possible in the first place.

Yet theoretical treatments of central banking place almost exclusive emphasis on its stabilizing capacity--that is, on central banks' role in managing the growth of national monetary aggregates and in supplying last-resort loans to troubled financial (and sometimes nonfinancial) firms in times of financial distress. This one-sided treatment of central banking reflects both the normative nature of much theoretical work on the subject--that is, its tendency to focus on ideal rather than actual central-bank conduct--mad the (usually tacit) assumption that however much central banks might depart in practice from ideal, financially stabilizing policies, they at least succeed in limiting the amplitude of booms and busts, compared to what would occur in the absence of centralized monetary control.

I propose to challenge this conventional treatment of central banking by arguing that central banks are fundamentally destabilizing--that financial systems are more unstable with them than they would be without them. To make this argument, I must delve into the history of central banking and explain both why governments favored the establishment of destabilizing institutions in the first place and why there is the modern tendency to regard central banks as sources of financial stability. I hope to show that the modern view of central banks as sources of monetary stability is in essence a historical myth.

The Origins of Central Banking

An objective understanding of the macroeconomic and financial consequences of central banking requires, first of all, a value-free definition of the term central bank--that is, a definition that does not presuppose any particular sort of conduct, whether beneficial or malign. Common textbook definitions of central banks as institutions devoted to combating inflation, dampening business cycles, and serving as lenders of last resort must thus be rejected both because they involve a tacit counterfactual whose validity is open to doubt and because they are flagrantly inconsistent with the actual conduct of many real-world central banks.

So what, really, is a central bank? It is fundamentally a bank that possesses a national monopoly or something approaching a national monopoly of the right to issue circulating paper currency. Although outright monopolies are most common today, in a few instances--for example, in the United Kingdom, Ireland, and China-other (commercial) banks also enjoy highly circumscribed currency-issuing privileges.

The privilege of issuing paper currency was not always so limited, however. On the contrary, it was once enjoyed by practically all banks, which depended on it as a means of extending credit when the custom of transferring deposits by means of checks was not yet developed. Although the earliest central banks began as "public" banks that typically enjoyed a monopoly of the banking business of their sponsoring governments only, while sharing with other banks at least to a limited extent the right to issue currency, they gradually acquired currency monopolies as well. Indeed, the transition to central banking in its modern guise tended to follow public banks' consolidation of currency-issuing privileges, for reasons to be made clear in due course.

Nevertheless, the first steps toward modern currency monopolies long predated modern notions of central banking with their emphasis on central banks' stabilizing role. Instead, the public banks that later became full-fledged central banks were established solely for the purpose of catering to their sponsoring governments' fiscal needs--by managing their deposits, administering their debt, and, especially, accommodating their short-run credit needs. …