Is a Central Bank Necessary?

Posted on 26. Sep, 2011 by in Blog

Ladies and Gentlemen in Pawnland!

I found a very interesting read this morning while playing catch up from our Symposium and my weekly travels around the Caribbean. This article poses some very interesting thought provoking issues that should be looked at. I hope you enjoy the read and we should be getting back to our regular newsletters now that our Historic Pawn Symposium has completed and we are starting on our second one. More to follow and we hope you enjoy the read! Jerry Whitehead

Is A Central Bank Necessary?

By Paul Nathan   
Sep 23 2011 3:08PM
   

In last week’s article I concluded: “It is time to debate and resolve whether we as a nation want a bank of last resort or not. Our decision will determine the future of the Federal Reserve and perhaps the future of the financial system and economy we live in.” The following is a continuation of that discussion.

The idea of a central bank has been around longer than this country. Our first bank, The Bank of North America, was chartered for five years. Sponsored by Alexander Hamilton despite Thomas Jefferson’s objections, it was in operation from 1781-1785. The Second Bank of North America (1816-1836) had no less than James Madison’s signature on its charter. Both banks eventually closed.

During the operating gap between the two banks, the country saw hyper-inflation as the Treasury issued fiat notes to finance the war of 1812. (Note that it does not require the existence of a Federal Reserve System to create inflation.) During this period we had bank runs, and specie payments were suspended by all banks. So this argument we are having now about the validity of our central bank is not a new one, it is an argument which we have had many times throughout our history.

The question of whether we should have a central bank and what form it should take is as old as the Bank of England, established in 1694. Banks in general have had a spotty record of performance throughout most of history. During the gold standard there were periods where 50% of banks, which were privately owned, failed. But then so did state chartered banks, and even nationally chartered banks. Banks in general have always been a source of concern and debate.

In my book, The New Gold Standard, there is a chapter entitled, “Are the Fiat and Gold Standards Converging?” In it I suggest we may be moving toward a hybrid system utilizing parts of both standards. If in the next few years the Fed pulls off a non-inflationary return to stability, we will be looking at a stronger Fed, not a weaker one as many are predicting today. But what kind of Fed should that be, if it should be at all?

I am for a return to the gold standard. But I am also keenly aware that a gold standard will not prevent panics, recessions, or monetary crises. The Fed has an important role as lender of last resort, precisely because these crises are possible, no matter what kind of monetary system exists. It has the ability to prevent a systemic breakdown. It can work in conjunction with the Treasury to take extraordinary action if necessary, to preserve and protect the financial system and the economy.

The way back to limited government and a sound monetary system is by eventually eliminating the Board of Governors of the Fed. Instead of the Fed setting interest rates and increasing or decreasing the money supply, let the market perform that function. However, until we return to a much smaller government, and eliminate much of its spending and intervention into the economy, the central bank should preserve its function as a lender of last resort.

Think of this last resort function as the net under a tight rope walker. You don’t need a safety net if you are only ten feet in the air, but you better have one if you are balancing on a thin rope 100 feet above the hard ground. Under a fiat standard, you are a hundred feet in the air. In today’s world of high leverage it is only prudent to have a safety net. But because reserve requirements are much higher under a gold standard, leverage is much less than the permissive leverage of a fiat standard. With decreased leverage comes decreased danger. With increased leverage comes increased danger.  Under a gold standard, a bank of last resort is not a requirement.  Under a fiat standard a bank of last resort is an insurance policy.

It is also important to realize that some things just go together—such as fixed exchange rates under a gold standard and floating exchange rates under a fiat standard. You cannot mix and match these things. The two systems have different natures and require different institutions. The same is true of the need for a central bank. Having one, is necessary in today’s world of high leverage to protect against a fatal fall, but not needed under the low leverage typical of a gold standard. This is something Europe is beginning to rethink, as they are now considering what amounts to a European Union style Treasury and Fed.

The key to any successful Fed intervention taken to prevent systemic damage is to neither create victims nor protect victims. Any intervention should isolate the problem, neutralize it, and leave everything as it was before the operation. A bank of last resort’s attempt to save the system should never amount to a bail out. The options should either be loans with collateral (with reasonable expectations they will be paid back), or an organized liquidation with all the top officers of the corporation removed whenever this kind of action is necessary.

The liquidation of hundreds of banks during the eighties should be enough of a template to see how this should be done. The Resolution Trust Corporation is an excellent example of forced liquidations where heads of failing banks lost their jobs, yet no taxpayer or customer monies were ever lost. FDIC, is another, in which banks are liquidated and paid for by the member banks. No taxpayer money has ever been needed. Hundreds of banks have failed over the last few decades, yet none have resulted in the ruin of innocent victims, nor came at the expense of citizens.  This is a constructive service government can provide in times of stress.

We need to redefine the duties of the Fed and move in a measured way toward a Fed that increases reserve requirements, removes itself from the interest rate market, and limits the increase in money supply, permanently. Only then will we see stability in the value of the dollar, and market originated interest rates. This would provide a neutral monetary environment for the economy to operate within. Then the Fed’s job would be monitoring the economy for distortions or anomalies that may arise to threaten the system as a whole.

I can live with a central bank that has defined, limited, powers. Or I can live without one in a much freer society where government doesn’t intervene into the economy. But, it would be a mistake simply to outlaw the Fed while we are still on this ultra-leveraged tight rope. It makes more sense to cut back its power as we strive to cut back economic government intervention in general.  We can start by removing the dual mandate that charges the Fed with the contradictory obligations of both price stability and full employment.

A lot of people out there right now believe the best way to rectify our past mistakes is for the economy to collapse. They argue for the elimination of the Fed to “hasten the inevitable”. This is totally unnecessary, and I would argue immoral. I have never accepted the proposition that allowing a total breakdown of the monetary system is a moral obligation. On the contrary, if you can save innocent victims of government intervention, I believe you should.

I am all for market forces resolving problems. But government does have a role: it is to get out of the way gracefully. Gracefully means having and following a plan. The plan should be to back out of the economy the same way they moved into it. Year by year, we must reduce the intrusive intervention of government. Only then will we return to a free society where the responsibility of living is on the shoulders of individuals, rather than the mandate of governments. The de-evolution of the Fed’s powers to a more limited and defined bank of last resort is one way to achieve this.

By Paul Nathan

Jerry Whitehead 

Pawnshop Consulting Group, Inc.

954-540-3697

www.pawnshopconsultinggroup.com

www.pawnsymposium.com

jerry@pawnshopconsultinggroup.com

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