Monetary Policy

Bernanke: Less Than Candid About Central Banking


"Free banking" advocate George Selgin critiques Fed Chair Ben Bernanke's recent lecture about central banking, which Bernanke delivered at George Washington University Monday. (Part two happening today.)

The highlights: 

like any central banker, and unlike better academic economists, Bernanke consistently portrays inflation, business cycles, financial crises, and asset price "bubbles" as things that happen because…well, the point is that there is generally no "because." These things just happen; central banks, on the other hand, exist to prevent them from happening, or to "mitigate" them once they happen, or perhaps (as in the case of "bubbles") to simply tolerate them, because they can't do any better than that. That central banks' own policies might actually cause inflation, or contribute to the business cycle, or trigger crises, or blow-up asset bubbles–these are possibilities to which every economist worth his or her salt attaches some importance, if not overwhelming importance. But they are also possibilities that every true-blue central banker avoids like so many landmines….

In describing the historical origins of central banking, for instance, Bernanke makes no mention at all of the fiscal purpose of all of the earliest central banks–that is, of the fact that they were set up, not to combat inflation or crises or cycles but to provide financial relief to their sponsoring governments in return for monopoly privileges….

By ignoring the true origins of early central banks, and of the Bank of England in particular, and simply asserting that the (immaculately conceived) Bank gradually figured-out its "true" purpose, especially by discovering that it could save the British economy now and then by serving as a Lender of Last Resort, Bernanke is able to overlook the important possibility that central banks' monopoly privileges–and their monopoly of paper currency especially–may have been a contributing cause of 19th-century financial instability. Why this is likely to be the case is something I've explained elsewhere. More to the point, it is something that Walter Bagehot was perfectly clear about in his famous 1873 work, Lombard Street. Bernanke, in typical central-bank-apologist fashion, refers to Bagehot's work, but only to recite Bagehot's rules for last-resort lending. He thus allows all those innocent GWU students to suppose (as was surely his intent) that Bagehot considered central banking a jolly good thing. In fact, as anyone who actually reads Bagehot will see, he emphatically considered central banking–or what he called England's "one-reserve system" of banking–a very bad thing, best avoided in favor of a "natural" system, like Scotland's, in which numerous competing banks of issue are each responsible for maintaining their own cash reserves.

one wish[es] that some clever GWU student had interrupted him to observe that Canada and Scotland, despite also lacking central banks, each had far fewer crises than either the U.S. or England. Hearing Bernanke you would never guess that U.S. banks were generally denied the ability to branch, or that state chartered banks were prevented by a prohibitive federal tax from issuing their own notes, or that National banks found it increasingly difficult to issue their own notes owing to the high cost of government securities required (originally for fiscal reasons) as backing for their notes. Certainly you would not realize that economic historians have long recognized how these regulations played a crucial part in pre-Fed U.S. financial instability. No: you would be left to assume that U.S. crises just…happened, or rather, that they happened "because" there was no central bank around to put a stop to them.

Was the Fed a historically inevitable and needed response to national financial fluctuations, or were there other possible solutions? Bernanke avoids this point; Selgin addresses it.

Bernanke…overlook[s]….the historically important "asset currency" reform movement that anticipated the post-1907 turn toward a central-bank based monetary reform. Instead of calling for yet more government intervention in the monetary system the earlier movement proposed a number of deregulatory solutions to periodic financial crises, including the repeal of Civil-War era currency-backing requirements and the dismantlement of barriers to nationwide branch banking. Canada's experience suggested that this deregulatory program might have worked very well. Unfortunately concerted opposition to branch banking, by both established "independent" bankers and Wall Street (which gained lots of correspondent business thanks to other banks' inability to have branches there) blocked this avenue of reform. Instead of mentioning any of this, Bernanke refers only to the alternative of relying upon private clearinghouses to handle panics, which he says "just wasn't sufficient." True enough. But the Fed, first of all (as Bernanke himself goes on to admit, and as Friedman and Schwartz argue at length), turned out be be even more inadequate a solution than the clearinghouses had been….

Selgin mocks Bernanke's resort to the It's A Wonderful Life theory of bank failures, and how he  

never mentions the fact that Canada had no bank failures at all during the 1930s, despite having had no central bank until 1935, and no deposit insurance until many decades later. And although Bernanke shows a chart depicting high U.S. bank failure rates in the years prior to the Fed's establishment, he cuts it off so that no one can observe how those failure rates increased after 1914. Finally, Bernanke suggests that the Fed, acting in accordance with his theory, only offers last-resort aid to solvent ("Jimmy Stewart") banks, leaving others to fail, whereas…the record shows that, after the sorry experience of the Great Depression (when it let poor Jimmy fend for himself), the Fed went on to employ its last resort lending powers, not to rescue solvent banks (which for the most part no longer needed any help from it), but to bail out manifestly insolvent ones. All of these "overlooked" facts suggest that there is something not quite right about the suggestion that bank failure rates are highest when there is neither a central bank nor deposit insurance. But why complicate things?….who wants to spoil the plot of "It's a Wonderful Life?"

Selgin then takes on Bernanke's weak attacks on the gold standard (one wonders why he even feels obligated to mention it now; feeling hot breath on your neck, Ben? The guilty flee when no man pursueth….) and wraps up with:

 I myself chuckled at hearing Bernanke say, matter of factly, that "The Fed was established in 1914, and for while life was not so bad," as if the Fed did a dandy job until 1930 or so. No mention of the high inflation before 1921–as high as 40%, on an annualized basis, during some quarters; no mention of the record numbers of bank failures throughout the 1914-1930 period; no mention of the sharp recession of 1920-21; and no mention of any possible contribution by the Fed to the stock market boom (or "bubble," as Bernanke would have it) of the 1920s….

My November 2009 Reason feature on anti-Fed sentiment, and a November 2006 Reason roundtable about Bernanke taking the helm at the Fed, starring Milton Friedman and Ron Paul, among others.