Central Banks as Sources of Financial Instability

George Selgin has written an interesting piece here, explaining why the institution of central banking is inherently destabilizing (relative to an institution of free-banking). I have a lot of sympathy for what he has to say here, although I do have some reservations. (Thanks to Prof J for sending this to me).

Selgin begins by describing how a free-banking systems works. Competitive banks issue paper liabilities made redeemable on demand for specie (historically, these paper notes also constituted senior claims against the bank’s assets in the event of bankruptcy; i.e., they were backed beyond the available specie held in reserve). Banks would create these notes whenever they wanted to make a money loan. The money loan would be extended against sufficient collateral (hence, the paper issued by the bank was backed, at least in part, by the collateral backing its loan portfolio).

Question: what prevents individual banks from “over-issuing” the paper money that they can evidently create “out of thin air?” Answer: the principle of adverse clearing. What is this? As banknotes circulate, a portion are redeemed for specie (either directly by people, as when you or I visit an ATM, or by other banks who have received deposits consisting of other banks’ notes. This continual flow of redemptions is what keeps the supply of credit in check: banks that issue too many notes will have trouble honoring their redemption obligations, leading to bankruptcy.

I have some sympathy for this argument, but I wonder whether it is entirely correct. One might note that Microsoft shares are not made redeemable on demand for anything (although they are backed by capital). What prevents Microsoft, or any other company for that matter, from “overissuing” its debt obligations? There is no principle of adverse clearing at work here.

A central bank is defined by Selgin as an agency that has monopoly control over the supply of small denomination paper notes. As Selgin rightly notes, the monopoly was usually conferred by resource-hungry sovereigns. Private banks would deposit their specie with the central bank, and issue liabilities (checkable deposits) redeemable in central bank money (rather than specie). Or something like this…practices likely varied across space and time. In any case, the point is that the central bank is no longer subject to the force of adverse clearing.

If I understand his argument correctly, all I think he is saying is that the central bank is now in control of the object of redemption (specie in free-banking). There is very little economic discipline on how a central bank manages the base money supply. It can overissue, leading all banks who make their liabilities redeemable in central bank money, to overissue as well. A credit bust inevitably follows the resulting boom in credit.

Well, I suppose. On the other hand, an independent central bank might choose to keep the supply of base money in check. What is the difference now between bank liabilities made redeemable in specie or central bank paper? In fact, the latter might be superior in that it frees the specie from its role as idle reserves…the gold and silver can now be used for other purposes.

Of course, central banks have behaved badly in the past. But this has almost always been because of pressure from the fiscal authority. Even a free-banking system is not free from the grabbing (and destabilizing) hand of the state.

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