The evolution of the banking system, as I previously described it, was “ideal-typical.” The description’s purpose was to get at the essence of how monetary institutions work. Clearly, the circumstances of time and place affected the development of historical banking systems such that they differed from how they looked in the story. Nevertheless, this simplified analysis conveys important lessons about the economic mechanisms at work. Furthermore, the theoretical description does have historical evidence supporting it. In many times and places, so-called “free banking systems”—monetary arrangements where there are no special legal restrictions on banking—did arise, and worked well.
But in other times and places, banking systems didn’t grow up this way. The heavy hand of the state is something we cannot afford to ignore if we want to understand money and banking, especially in the United States. Today, in almost all developed economies, there are numerous legal restrictions specifically on money, banking, and finance. Although they are promulgated as solving various “market failures” in the monetary system, in reality they exist due to political constraints, not economic ones. Oftentimes these entail ongoing supervision and regulation by government departments and agencies. Among these organizations, one looms large: the central bank.
Central banks are ubiquitous in the developed world. They are the primary entity responsible for managing a country’s fiat money supply, and they frequently have various regulatory roles as well. The US central bank, the Federal Reserve (“Fed”), greatly expanded the scale and scope of its authority in the 21st century, beginning with the 2008 financial crisis. Following the economic turmoil caused by the Covid-19 pandemic in early 2020, the Fed intervened swiftly and decisively in financial markets, often in ways that set worrying new precedents. Many believed central banks had to grow each of these times, to stave off the dangers of future crises. But politics follows a logic of its own, and central banks are indisputably political entities. Unless kept within careful bounds, public procedures often don’t translate into public welfare.
But where did central banks come from? How did they come to be in the first place? In the free banking story, it’s not obvious when they would arise, or even if there was a need for them. Historically, central banks tend to have rather unsavory origins. Whenever governments intervene in monetary affairs, their motivations are usually fiscal. That is, governments regulate monetary systems primarily to raise revenue, not improve the systems’ functioning. In ancient times, the state monopolized the mint and debased the coinage. More recently, the state created a privileged bank to extend loans to the state at favorable rates. In return, the state restricted competition for the privileged bank by enacting legal disadvantages against other banks. The establishment of the Bank of England in 1694 is perhaps the best known, but by no means only, example of this dynamic at work. (Interestingly, the Fed does not have this kind of origin story. More on that later.) These privileges could include a grant of legal tender status to the bank’s notes, restrictions on branching and operations for the non-privileged banks, as well as others. These competitive restrictions helped the privileged bank to make extraordinary profits, which they “earned” by granting the government credit on terms more generous than it could receive elsewhere.
Over time, these privileged banks, which were established as private, for-profit companies, came to acquire significant power over the nation’s money stock. Especially as reserves in the banking system became increasingly concentrated at the privileged bank, the bank’s normal operations in the course of business could have large, and often unintended, effects on overall financial conditions. Gradually, the privileged bank acquired additional powers that were supposed to be wielded for reasons of public welfare, rather than private profitability. As these powers accumulated, the privileged bank became an increasingly public institution, until it culminated in what we’ve got now: a true central bank, whose job is not to earn profits, but manage the money supply, as well as engage in other regulatory activities.
The Fed is a notable exception to the above, although the contrasts don’t make much of a difference in the end. The Fed was created in 1913, not as a central bank, but as a formalization of the interbank clearing system that existed under the then-National Banking System (1863-1913). The Fed’s job wasn’t to conduct monetary policy. It was supposed to provide limited banking and clearing services to member banks of the National Banking System, in order to correct some of that system’s problems. These flaws, well-known at the time, resulted in periodic banking panics throughout the late 19th century.
Many proponents of the Federal Reserve Act denied the Fed would be anything like a central bank. Americans knew what central banks were, and they didn’t like them. Central banks were viewed as incompatible with limited government, and Americans’ suspicion of them is why the Fed initially had such a restricted mandate. Unsurprisingly, those restrictions didn’t last long. Once the US entered World War I, the Fed began experimenting with proto-monetary policy in order to help finance the war. And when the war ended, the Fed didn’t stop tinkering. Gradually its powers grew until it, too, became a full-fledged central bank. Plus ça change.
Many economists have tried to justify central banks on efficiency grounds. These economists argue that, although the motivations behind the creation of central banks are rarely pure, there are nonetheless real problems in the banking system that central banks are uniquely positioned to solve. For example, Charles Goodhart argues that central banks are a natural outgrowth of banking systems. If left to themselves, banking systems are hampered by a mix of incentive and information problems that render them perpetually unstable. For example, depositors can only imperfectly monitor banks, meaning banks will always have better information about the quality of their balance sheets than depositors. This information mismatch might result in rational, yet pointless and costly, bank runs. As another example, the clearinghouses that govern parts of the banking system might need an impartial arbiter to get them to “play nice” with each other. Whatever the mechanism, this view of central banking tries to rescue a public interest story from the jaws of political realism.
It’s a valiant attempt, but it doesn’t work. The less encumbered by politically-motivated restrictions a banking system was, the less likely it fell prey to the problems listed by the pro-central bankers. The “need” for a central bank is due to economists inaccurately projecting onto historical banking systems their contemporary monetary-macroeconomic paradigms, not any fatal flaw in these systems. Furthermore, the belief amongst today’s economists that the central banking era is more economically stable than in previous eras has several blind spots. Neither theory nor history show we need a central bank to guarantee optimal economic performance.
While central banks don’t help (and may even hinder) economic stability, they’re still the dominant monetary institution in wealthy countries. Given this, we’d better understand how they work. Next time, we’ll go over the various tools central banks have at their disposal, with special emphasis on their traditional “money management” role. As we’ll see, their impressive arsenal hasn’t enabled them to improve over past arrangements.