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Debunking the Myths About Central Banks

Posted by Gonzalo Schwarz
March 1, 2013

By GERALD P. O’DRISCOLL JR.

Myths govern modern central banking. Like many myths, they contain an element of truth that has been distorted by exaggeration and misapplication. This year marks the 100th anniversary of the U.S. Federal Reserve System—an appropriate time for some long-overdue myth-busting.

The first myth is that central banks are intrinsically necessary for market economies. History and theory belie this.

The Federal Reserve was not founded until 1913, and it had no monetary role. The U.S. operated under a gold standard and had no need for a central bank to control the money supply. A gold, or any commodity, standard places a natural limitation on money creation, which is the resource cost of extracting the commodity. It is only with fiat (paper) money that central banks are necessary to control the money supply.

The Bank of Canada was not founded until 1935. The Canadian banking system survived the Great Depression with no major bank failures. By contrast, thousands of U.S banks failed, despite the existence of the Federal Reserve. These large-scale failures were ended by FDR’s bank holiday, not by any Fed contribution to banking stability.

The second myth is that central banks are needed as a lender of last resort—that is, to supply liquidity in times of financial stress when short-term lending freezes up. The Federal Reserve’s lending in the aftermath of Lehman’s collapse in 2008 is the new textbook example of this function. But this argument has the causality exactly backwards.

Walter Bagehot, the eminent 19th-century British economic journalist, coined the phrase “lender of last resort” in his classic book, “Lombard Street.” He recognized this was an essential function for the Bank of England.

However, the context is often dropped. Bagehot knew that a central bank inevitably resulted in a concentration of reserves within that institution, making it the lender of last resort. But he did not believe that a central bank was inevitable or desirable.

For Bagehot, “the natural system” was the one “which would have sprung up if Government had let banking alone.” There would have been “many banks of equal or not altogether unequal size.” He described this as “the many reserve system,” in which each bank held reserves for itself, which he believed would have meant a stronger banking system. In modern parlance, Bagehot’s celebrated “lender of last resort” is a second-best solution—second to a world of competitive banks and no central bank. …

Continue reading at online.wsj.com…