Uneasy Money

In the last few weeks I wrote two posts arguing that, despite the attempts of some to identify them, central banking is not the same as central planning.  In my first post, I explained that central planning originally referred to attempts to allocate the resources available to society in accord with a pre-determined unitary “rational” plan rather than allow resources to be allocated according to the decisions of individuals advancing their own self-interest through market transactions.  In my second, I showed that Hayek in both The Road to Serfdom andThe Constitution of Liberty explicitly denied that central banking was a form of central planning.

Central planning in this sense is much different from what a central banker, even under the most expansive view of his responsibilities, is trying to do.  Obviously a central banker is engaged in planning, in the sense that a central banker is trying to act in a rational way calculated to achieve his purposes.  The ambiguity in the meaning of planning has long been recognized, and dismissed by critics of central planning.  Only planning designed to override the voluntary decisions and plans of private individuals and business, compelling them to conform to the central plan rather than to their own preferred courses of action, is planning of the objectionable type.  So just because a central banker has a centralized role in the banking system, and seeks to achieve his goals in a rational, planned, non-random way, does not establish ipso facto that his planning is necessarily objectionable in the same way that planning by a central planner is objectionable, inasmuch as central bankers typically do not aim to achieve any particular allocation of society’s resources.  Rather the goal of the central banker is to create the macroeconomic conditions in which people can succeed in executing their own economic plans to buy and sell, save and invest, produce and consume.

As usual, Hayek made the point about as well as it can be made.  Rather than clutter up this post which is already too long with that quote, I am going to put an extended quotation from The Road to Serfdom in a follow-up post to this one.

Obviously, there can be disputes about whether central banks adopt policies likely to achieve their stated goals generally summarized as a stable general level of prices and a high level of economic activity and employment.  But it is an abuse of language to say that by trying to create those conditions, conditions that increase the chances that individuals and businesses can fulfill their own plans for economic activity, central banks are doing anything even comparable to what central planners were trying to do.

My earlier posts elicited some lively comments on this blog and on some other blogs.  For example, Kurt Schuler at freebanking.org, believes that it is self-evident that central banking is a form of central planning, despite acknowledging that the nexus between central planning and central banking was not identified until the contributions of Larry White (1984) and George Selgin (1988), a remarkable statement inasmuch as the two seminal figures, Mises and Hayek, in the debates about central planning in the 1920s and 1930s, were both monetary theorists of note who supposedly missed the obvious connection between central banking and the theory of central planning that they had developed.  That huge historical gap is elided when Schuler asks rhetorically:

Central planning failed as a comprehensive economic system; why should we expect central planning limited to particular fields of economic activity to do better?

This question is less devastating to central banking than Schuler imagines;  most economists, including most of those accepting the general argument against central planning, concede that there may be times when markets do not function as efficiently as they normally do, say, because property rights to scarce resources cannot be defined or enforced, or because of informational asymmetries, or because some markets are inherently uncompetitive.  In such cases, the informational shortcomings of central direction are offset by market imperfections, so that it is at least possible for regulation or intervention to improve the outcome.  One may agree or disagree whether intervention does indeed improve the outcome, but the case for intervention cannot be dismissed simply by invoking the argument against central planning. 

But even to frame it in this way mischaracterizes the argument against central planning, for what that argument says is that the very attempt to allocate resources by way of a central plan is irrational, the central planner lacking any rational basis for comparing the costs and benefits of the alternative allocations of resources that he is considering.  With no functioning price system to provide a way of evaluating the resources used in those alternatives, the planner is unable to make a rational choice between alternatives.  On the other hand, when there is a functioning — even an imperfectly functioning — price system, the valuations reflected in those prices provide at least some basis, however imperfect, for choosing between alternative uses of resources for competing ends and alternatives means of achieving the same end.  But the more that central planning supplants market decisions, the more tenuous the connection between “prices” and valuations and costs. 

So even though there is an argument that central direction of a single sector in a functioning market economy is inefficient, the argument is an order of magnitude weaker than the argument against central planning of the whole economy.  The argument about a single sector is at least potentially rebuttable in the face of a strong reason to suspect market failure.  The argument against central direction of the entire economy is not rebuttable even in the presence of market failure.  And it is a clear conceptual error to treat the two sorts of arguments as if they were equivalent.

Schuler goes on to assert: 

Central banks are government monopolies that consciously try to steer the economy. If that is not central planning, nothing is.

Central banks are government monopolies, but their monopoly power is not unlimited inasmuch as the vast majority of all money in the economy is created by private banks in the form of deposits.  Now it is true that banks have to make their deposits convertible into government money, but in the US reserve requirements are now very low, so the government is now extracting only a very modest rent from its monopoly.  As for steering the economy, the Fed does indeed try to do so, but only in the sense that it tries (not always successfully) to create stable economic conditions.  It does not aim to achieve any particular allocation of resources.  The Fed tries to steer the economy in the way that a captain tries to steer his boat toward a destination chosen not by him, but by the passengers.  The objective of the captain is to choose a route that is safe, economical, pleasant, and speedy.  His decisions may not always be correct, but his objective is not to override the wishes of his passengers but to find the most satisfying route for their journey. 

Finally, Schuler, referring to my post quoting from both The Road to Serfdom and The Constitution of Liberty documenting that Hayek held that the conduct of monetary policy by a central bank was not planning in a sense incompatible with a market economy, concludes with this statement:

And by the way, it will not do to cite the younger Hayek in support of central banking when the older Hayek in Denationalisation of Money wrote about “the obvious corollary that the abolition of the government issue of money should involve also the disappearance of central banks as we know them” [page 105].

I will just note in passing that “the younger Hayek” was 62 years old when he published The Constitution of Liberty from which I quoted, so his remarks can hardly be dismissed as an intemperate youthful outburst.  But leave that point aside.  Schuler omits the rest of the passage from Denationalization of Money in which Hayek wrote the following:

The need for such an institution [i.e., a central bank] is, however, entirely due to the commercial banks incurring liabilities payable on demand in a unit of currency which some other bank has the sole right to issue, thus in effect creating money redeemable in terms of another money.  This, as we shall have still to consider, is indeed the chief cause of the instability of the existing credit system, and through it of the wide fluctuations in all economic activity.  Without the central bank’s (or the government’s) monopoly of issuing money, and the legal tender provisions of the law, there would be no justification whatever for the banks to rely for their solvency on the cash to be provided by another body.  The ‘one reserve system’, as Walter Bagehot called it, is an inseparable accompaniment of the monopoly of issue but unnecessary and undesirable without it.

So Hayek’s dismissal of central banking was crucially and explicitly dependent on an argument that private competitive banks would issue their own currencies defined in terms of units of their choosing not redeemable in terms of any outside asset not under the control of the issuing bank.  In my book, Free Banking and Monetary Reform (p. 176), I explained that Hayek’s argument overlooked the network effects (though I didn’t use the term, which was then only just beginning to be used by economists) associated with using a money denominated in a unit already widely accepted as money.  This implies that there are powerful market forces leading banks not to try to compete by offering a different monetary standard from that already in use, but to make their monies “compatible” with the existing monetary standard by making their own monies convertible into a money already widely accepted as such.  To my knowledge, most advocates of free banking have not followed Hayek in supposing that, under a free-banking regime, banks would compete by issuing inconvertible monies defined in terms of some standard of their own choosing.  So unless Schuler wants to defend the older Hayek’s dubious premise in Denationalization of Money, he can hardly rely on the authority of the older Hayek to dismiss the younger Hayek’s acceptance of central banking as being fully consistent with a market economy.