Well, if you're looking for criticism, let's start with this: As someone who has almost certainly spent much more time around economists than you have, I think both of your explanations for the unpopularity of free banking are very bad. On the second point, self-interest has little influence on individuals' politics. This is a robust result in political science across a large range of policies, and so should be the default when discussing why others have the politics they do. Unless you have very good evidence, rather than weak conjecture, you should assume that people's salaries do not determine their political opinions. Your conjecture makes little sense anyway, since under free banking economists would be hired by private banks instead of the Federal Reserve, while getting paid nicely to help shape the economy, and only a small portion of economists work for the Fed anyway. So there's a reasonable case to be made that self-interest would encourage economists to support rather than reject free banking.
For your first criticism, I think you're starting from entirely the wrong assumption. Your argument seems to be, "economists naturally distrust the government except for here, where status quo bias prevents them from doing so."
More reasonably, I think, is that you are simply wrong about what most economists believe. The average economist is a moderate Democrat. They support many, many government monopolies when they think there is a market failure to correct. They support the regulation of natural monopolies, they support antitrust commissions to tell us whether a market is too concentrated, they support the EPA, etc.
Most economists are quite supportive of centralization in the face of market failure, and there is at least one market failure argument with regard to free banking that is quite obvious: you might get too many currencies, the constant exchange of which would cause a large deadweight loss. And that's not just the exchange rates, that's employees now tasked with manning money exchange booths all over town, time wasted going to such vendors, people holding more than the optimal amount of money, etc. Indeed, some people will tell you this is exactly what happened when Switzerland tried free banking. Heck, there's currently a quote regarding that case on the wikipedia page for free banking.
There are good arguments in response to that, and responses to other criticisms of free banking. But your post pretends that such arguments don't even exist. I can find several more.
Not to mention other reasons the typical economist might not spend too much time looking into free banking: Free banking is largely the product of Austrian economists, an unpopular group whose main idea separating them from the mainstream, their business cycle theory, is considered by most economists totally wrong. So a first pass at free banking might see it as an attempt to fix a problem that is incorrectly identified to begin with.
In short: far, far too much confidence on display here. That's what politics does to us, and I'd recommend reading a lot more before continuing your series. As a start, read the references in Selgin and White's papers, you're sure to find some genuine criticisms there.
(Disclaimer: I have no strong opinions on free banking. I think it might be worth a try, that it's a shame we can't run this experiment, and that it's also a shame our historical data isn't good enough to settle the question. I have a Master's in econ from GMU.)
No, people don't vote in their own self-interests. But in this case economists would constitute a special interest group supporting a policy that increases their own income and status. Or do you think that whenever a special interest group requests subsidies and attempts to restrict its competition, self-interest isn' the primary motivator? Now, of course they won't be thinking any sinister or malevolent thoughts; I'm sure as well that economists genuinely think that central banking is the best alternative. But why would they think that? Why isn't Greg Mankiw a strident free banker? Self-interest must be a primary motivator here--not the only motivator, but I'll eat my hat if it isn't playing a significant role.
The average economists supports various interventions in the economy for valid economic reasons he would have no trouble explaining. I know, as I'm sure do most economists, valid economic arguments against free markets whenever there are problems with externalities, information asymmetries, natural monopolies, etc, which might well justify things like the EPA and a single-payer universal health care system, public utilities, etc. But Professor Mankiw of Harvard doesn't seem to think that there's any similar argument for central banking.
Arguments against central banking go back to people like Adam Smith and Walter Bagehot, who preceded the Austrians.
You're right; it especially needs a conclusion. Coming out with new articles as fast as possible (at least one a day) will take precedence over editing but I'll try to find the time. My writing should improve with practice, which is one of my goals for doing this.
If they're worth writing, they're worth writing well. If it helps your writing process to write one article per day, then do so but save them as drafts, and give yourself a week or two to come back to them and clean them up with a fresh eye.
This isn't an area I'm an expert in, but here are some thoughts.
And let us note that “the benefits of a system of fiat money” seems insignificantly different from “the benefits of central banking” because that’s pretty much what a system of fiat money is.
That isn't true. Historically, a central bank generally consisted of a very large deposit of precious metal and currency consisted of promissory notes that could be exchanged for that metal under certain circumstances.
And free banking can have fiat currency too: think Bitcoin.
And I can’t for the light of me see how “the possiblity of short-run monetary nonneutrality” (due to sticky prices and/or imperfect information about prices) should be sufficient to move economists from their normal support of decentralized competitive markets to support for a government-backed monopoly tasked with central planning, or even how it should move economists in that direction at all
You can't? I mean, I'm not saying there isn't a debate to be had, but this is basically monetary policy since Keynes, no?. How motivated is your confusion here?
It also seems weird to criticize economists for not being curious about this when what your quoting from Mankiw is basically saying "we don't know ! It's a really good question!". Isn't that exactly the attitude we want from scientists?
We love decentralized competitive markets so much that we even call them “perfect.” Any deviation from this perfection is labeled “inefficient” and “failure” and economists quickly design a correction intended to push the system back towards perfection with minimal interference.
One could plausibly make the case for central banking as an infrastructure project with similar justifications as centralized highway construction. Being able to deal in a common currency almost certainly reduces transaction costs.
Finally, I wonder if there is any way that a government that collects taxes doesn't end up acting as a defacto central banker. Like, there is a strong sense in which "fiat currency" is backed since that is how the government collects taxes. No matter the monetary environment there is a tax policy that is essentially equivalent to a monetary policy. In a competitive currency market the government is still going to price assets and take them. And if the government is worried about banks not lending enough they can always just raise taxes on whatever uncredited assets are in the vault. That's a lot more expensive and invasive than a central bank, though.
Fiat money is money that is money because the government said it is money and that it is valuable and, usually, is money that no one else is allowed to compete with. Bitcoin is certainly not fiat money.
You can't? I mean, I'm not saying there isn't a debate to be had, but this is basically monetary policy since Keynes, no?. How motivated is your confusion here?
It's a complete non-sequitur, even if it is a standard non-sequitur. We'll get to it eventually.
It also seems weird to criticize economists for not being curious about this when what your quoting from Mankiw is basically saying "we don't know ! It's a really good question!". Isn't that exactly the attitude we want from scientists?
It looks like a lack of curiosity when they casually hold beliefs they can't support with the evidence (Mankiw, if no one else, should oppose central banking because he has stated he has no reason for supporting it) and because economists simply don't talk or ask very much about why they think central banking is a good idea, even though it is so weird and different from the way economists normally do things.
Fiat money is money that is money because the government said it is money and that it is valuable and, usually, is money that no one else is allowed to compete with. Bitcoin is certainly not fiat money.
This is just semantics but since we're talking about the semantics of something a real person actually said it would be useful to understand what that person means by the word.
Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money.
-Gregory Mankiw, "Principles of Economics". Bitcoin has no intrinsic value.
It's a complete non-sequitur, even if it is a standard non-sequitur. We'll get to it eventually.
No. Look. It might be wrong. I'm not equipped to fully evaluate the claim. But it isn't a non-sequitur because makes total sense that you might be able to encourage consumption and hiring by increasing the money supply and by increasing the rate of inflation.
It looks like a lack of curiosity when they casually hold beliefs they can't support with the evidence (Mankiw, if no one else, should oppose central banking because he has stated he has no reason for supporting it) and because economists simply don't talk or ask very much about why they think central banking is a good idea, even though it is so weird and different from the way economists normally do things.
Huh? Mankiw clearly has some notions about why it is a good idea even if he doesn't have a fully developed theory. He certainly doesn't appear to have more evidence against the belief than he has for it (which is, you know, the actual Bayesian requirement for disbelief).
The other thing is, Mankiw, and the field of economics in general is in the business of giving concrete and immediate advice to the public. That kind of activity tends to involve working within the status quo along plausible lines of reform. Most economists are focused on narrow areas of policy not trying to rethink the global economy from the ground up (though, of course there are those that do which is why the idea of free banking is in no way a new idea). Dismantling central social institutions, with the destablization that entails, is going to have to clear a higher bar of evidence before it gets seriously discussed.
even though it is so weird and different from the way economists normally do things.
You're just going to end up playing reference class tennis with this point. The extent to which it is "so weird and different" is clearly disputable.
Also, the self-interest argument proves far too much. Consider:
Second of all, there is the obvious problem of self-interest. Central economic planning like in the Soviet Union raises the income and status of economists, and strokes their ego. It lets them work cushy, secure high-paying high-status jobs where they get to do what they enjoy and feel like they are Gods in charge of the economy entirely. They can flatter themselves that they are controlling things and fixing the world while pulling in a nice income doing the work that they like.
Economists were far more supportive of general central economic planning than the evidence ever supported. A lot of very, very smart, talented, sincere economists worked for decades to make communism work, and it was a terrible failure. if self-interest as I described it didn't play a very important role in motivating economists to support central planning, then...what did, exactly? Not the evidence, that's for sure.
You're signalling a ton of confidence about a politically loaded topic and claiming that self-serving bias is keeping a mainstream academic field, of which you are an amateur, from seeing the truth about a central question in their field.
Take the outside view about yourself for a minute.
Anyway, economics in the Soviet Union barely resembled Western economics and Marxian Political Economy really shouldn't be considered a part of the economic establishment you're critiquing. To the extent there were talented Soviet economists trying to make an impossibly flawed system succeed is poor evidence of self-interest bias. But that really isn't the point: the point is that economists generally minimize the roll of policy-making relative to other opinion-makers. You can say they're just following the evidence in those cases but then you're getting awfully close to "they're following the evidence when they agree with me and are biased when they don't agree with me".
I am not a professional economist, but this one seems relatively obvious to me: There are self-amplifying effects relating to monetary velocity especially in a fractional reserve banking system (which dates back to goldsmiths), e.g. people try to hold money, velocity goes down, the price of money goes up, people can't pay back debts, debt is destroyed, in a fractional system this decreases the money supply further, etc. Velocity of trade is a public good and commons problem because if I refuse to trade with you, e.g. I don't buy your apple for money, I only lose the part of the gains from trade which would've gone to me, but you lose the portion of gains from trade that would've gone to the apple store, and then the farmer loses the gains from trade with the apple store, and can't buy a tractor, etc. Money is a tool in the first place for allowing trades like this, and in the presence of sticky prices and nominally-anchored contracts and debts, decreases in the money supply can cause your economy to lurch some of the way toward its state if cash had never been invented, which is bad. If you regard money as a tool to create velocity of trade, and systemic velocity of trade as a public good, the rationale for central banking seems relatively clear: It is to create the public good of money with a predictable price path, or in the Sumner version, create a predictable level trajectory for nominal GDP.
It's possible one could transition to a system of free banking now that we have much more fluid markets, but step one would be to outlaw fractional reserve lending and require banks to create bonds or bond-equivalents when depositor money is invested in them, rather than allowing banks to falsely claim that depositor money is always available on-demand in which case black swan bank runs can blow up the system, requiring an FDIC. You have to get rid of the public good rationale for an FDIC before transitioning to a system of private insurance on bank bonds where the price signals of insurance cost will exist. You will recall that it was the problem of runs on banks (and the subsequent fractional-reserve money supply decrease and deflation) which originally led economists to think central banking was better than the alternative. Even so, it's not obvious to me that self-amplifying velocity effects couldn't be awful (price of money goes up, people want to hold more of it) even in the absence of fractional reserve lending.
Maybe this is just another entire field of academia that you've personally outperformed in a single hour of thinking about it (teasing), but why do you think that Greg Mankiw didn't say this?
Greg Mankiw is strong evidence by authority for your claims. When a major authority in a field says "We don't know what's going on here, and nobody has really tried to find out," it sets off my atrophied grad student reflexes, and I start thinking "dissertation topic!" However were I still looking for a dissertation topic, the next thing I would do would be to spend a few hours in the library, a few hours with Google, and a few hours talking to folks in my department (not necessarily in that order) to see whether Mankiw was correct or not.
As reliable as Mankiw is, he's still just one economist; and my prior that economists as a group don't simply ignore obvious questions like this one is pretty strong. Show me ten respected economists from a diverse array of schools of economic thought that agree with Mankiw that there really hasn't been a lot of research or thought on this topic, and then I update further.
In addition to providing Harvard with the services of a professional economist, Mankiw also provides TV shows with a media personality, and political campaigns with consulting. He is good at all 3 jobs, but they do sometimes entail different things. Consequently "Mankiw said X" and "Mankiw said X in an article intended for publication in an academic journal" provide very different levels of evidence.
I dunno. It's not out of reach for my model of variance within macroeconomists. I'd be more hesitant if asking Cowen and Sumner produced the same 'nobody knows' response.
Scott Sumner is aware of free banking and seems somewhat supportive of it. Same for Lars Christensen. Alex Tabarrok is critical of the Fed and Cowen in response is critical of the anti-Fed case. (But note that the anti-Fed case is not the same as the case FOR free banking--I don't know Tabarrok's actual policy preference.) I can't find any Krugman mentions of free banking but he has offered arguments for a central bank. David Andolfatto, VP of the St. Louis Fed, has said that he sees some merit in free banking arguments but finds some of its modern proponents focusing on weak criticisms of the Fed. He even claims that he invited George Selgin to give a lecture on free banking to that Fed branch. Vera Smith, a Hayek student, claimed that central banking won out due to political motives and historical accident rather than sound economic theory. Keynes, in a passage that isn't quite about free banking, offered a criticism of bank incentives that suggests banks suffer a problem of liquidity preferences that central banks do not, and this can be read as an argument for central banking. (His argument is similar to yours about bank runs.) Brad DeLong included on a course syllabus a 1974 paper on free banking which argued that there was enormous variation in success in free banking in the U.S., with massive hyperinflation in some areas and stable currency in others. I don't know DeLong's actual position on the topic, but "the data suggests that free banking is unreliable" wouldn't surprise me. Of course the footnotes in that paper refer to other papers on central banking, and searching citation will find other research on free banking v. central banking, some of it negative. One of these papers, Whaples', surveyed economic historians and found they near universally agree that the free banking period in the U.S. didn't hurt the economy.
So, yes, I'd say Mankiw's opinion is within the range of normal economist variation. Obviously there are many professional economists who think there are sound market failure arguments in favor of a central bank or that the history of free banking shows a failure rather than success; Mankiw can only be saying that he finds their judgments inadequate, not that they don't exist. Otherwise, he's ignorant. And obviously one can't say that almost the entire economics profession has completely ignored the question. It's still an ongoing debate even among employees of the Fed.
Your research was not comprehensive. Check transaction costs. Economics of trade. Fixed v floating rate regimes. Optimal currency areas. Monetary policy and problems of insufficient demand. Relative financial stability of gov borrowing in own vs other currencies and cliff effects.
Um, what does any of that have to do with anything? Where's the market failure that justifies central banking the way economists can offer for any other intervention they support?
Benjamin, one thing clear from your post and the following comments is that your confidence greatly exceeds your expertise. It's a common human failing, we all suffer from it, at least in the fields we are not experts in. I am as guilty as anyone. But this does not mean your should inflict your overconfidence on this forum. You tried one post, and it was not well received. This should be your clue that you picked a wrong audience to sharpen your skills on. If you have a blog, link it here and post the rest of the sequence there, for those interested, and improve your knowledge of the subject and your writing before posting more here.
Central banks are much older than fiat money. They weren't originally set up for purely macroeconomic reasons, but also for political reasons. Governments need to borrow, and that means they need institutions to help manage the flow of capital. Even if in the long run they have enough income, need liquid assets to meet funding needs -- hence, promissory notes and paper money. Having a government-organized bank helps manage this too.
Some examples: The Bank of England dates to the War of the Triple Alliance in the 1690s, when William III needed to raise money. Likewise, the Second Bank of the United States was set up in response to a Federal funding crisis during the War of 1812. The Bank of France was set up by Napoleon.
Governments can borrow or issue paper money without a central bank -- the US did from the 1830s until 1914 -- but it has inconveniences. For example, the government has to make payments, and that means there has to be some interface between the treasury and the banking system. Having the government put its treasury in assorted commercial banks was felt to be corrupting -- too easy for treasury officials to collude with the pet banks.
Howdy.
This is what I intend to be the start of a sequence on economics. Almost two years ago while reading through Greg Mankiw’s macroeconomics textbook, I noticed the bizarre manner in which Mankiw’s analysis of banking simply presumed central banking, with free market banking entirely ignored. I looked around for an explanation of why the economics is done that way, and after realizing that there isn’t one, I decided to write a book about why economists support central banking and what banking regime the evidence actually supports.
Writing a book is slow and difficult, and I finally realized recently, even though my dad told me this from the beginning, that it would be much smarter to write out my thoughts in shorter articles and get immediate feedback on them, which is what I intend to do here.
I decided to try this on LessWrong because I really liked reading the sequences here and think there should be one on economics, and because the feedback I’ll get here is probably the best I could hope to get on the Internet anywhere.
I know there’s a community norm against discussing politics here, but this sequence is really supposed to be about the economics, not politics, although it is the curse of economics that it’s really hard to talk about what economics does and doesn’t say without inadvertently refuting half a dozen political ideologies in the process. For me my opinions about the desirability of central banking simply fell out of doing the economics, in much the same way that atheism ought to be a natural consequence of reaching a certain level of rationality. In any case, the sequence will mostly be about history, economics, and economists. Most of the articles individually won’t have anything to do with politics. And if my sequence is ignored because of its political connotations, or if the introduction of a bit of political discussion into LessWrong starts destroying the community here, I’ll go elsewhere.
My name is Benjamin Lyons. I’m a self-taught 20 year-old American currently serving as a volunteer soldier in the Israeli Defense Force, where I am a proud senior vice supply closet manager at an army-themed summer camp for the worst teenagers in the Middle East. Yes, I’m entirely self-taught in economics, so you’re free to be entirely skeptical of anything I have to say and you probably should be. However, the economics and history I’ll present in this sequence will be entirely orthodox mainstream stuff. I’ll differ from the mainstream in the conclusions I draw and don’t draw from the economics, not the economics itself. If there’s any exceptions I’ll highlight them.
Well, this might turn out to be a disaster but the whole point of doing this for me is to get a lot better at writing and to turn my thoughts and arguments into something that can become a book in a manner much faster than just trying to write a book.
I don’t know what kind of posting schedule I’ll be able to maintain. I’d like to do one per day but that may be impossible, especially in the army. Nevertheless that’s what I’ll shoot for.
I’m trying to become stronger quickly, so I definitely am looking for fierce criticism here. That sort of thing has never bothered me on a personal level, and I know I can count on the people at LessWrong to criticize what needs criticizing and to complement and encourage what deserves complements and encouragement.
It's funny.
I went to business school, studied some economics, even did well enough in a monetary policy competition to meet Bernanke.
And I can't once recall having a conversation like the one you've just initiated. Even if your arguments end up invalid... I'm interested to see what you have to say.
I should start off by mentioning I'm as big a fan of free banking as the next libertarian (perhaps more; I've even gone far enough to pick a favorite economics professor specializing in free banking).
I know there’s a community norm against discussing politics here, but this sequence is really supposed to be about the economics, not politics, although it is the curse of economics that it’s really hard to talk about what economics does and doesn’t say without inadvertently refuting half a dozen political ideologies in the process.
I don't see an easy way to discuss the content of the beliefs without it being a normal political discussion, which I don't think is a good fit for LW. What seems more appropriate for LessWrong is the process that they use to reach those beliefs- but I don't think there's anything interesting going on besides normal political / self-serving close-mindedness. From my point of view, whether or not banking is centralized is an obviously political question about where power is stored, and progressives want the power centralized, and mainstream academic economics is progressive economics, so they recommend the power be centralized, and this looks like run of the mill motivated cognition.
For calibration: do you think the question of whether green house gas emissions cause climate change is a political question?
Edit: to clarify this question is directed to the writer the post I'm responding to and is not meant to solicit responses from all readers. It's a post rather than a PM because I think the answer impacts the interpretation of the above post.
For calibration: do you think the question of whether green house gas emissions cause climate change is a political question?
I think discussions of it here would probably be, yes. I suspect it would be possible to have a discussion that wasn't, but it would be much easier to do about some narrow subquestion, which would probably not be easy to identify.
The primary reason why I suspect that is I think most people don't have the relevant backgrounds to comment on it, and the people who do have relevant backgrounds will have relevant backgrounds about different parts. The impression I get is that people who know a lot about simulations and dynamical systems (like myself) think that climate change modeling is mostly worthless on a technical level (i.e. by different choices of fudge factors they could get about any result they wanted from their models, and the current results are what seems reasonable to the culture of climate scientists), but I don't know enough about climate science to know how significant a role the models play in their whole argument.
I'll also point out that the primary discussion of a scientific subject (other than cognitive or decision science) here that comes to mind- the QM sequence- was, if I recall correctly, explicitly a question that is political in some parts of the world.
I’m a self-taught 20 year-old American currently serving as a volunteer soldier in the Israeli Defense Force, where I am a proud senior vice supply closet manager at an army-themed summer camp for the worst teenagers in the Middle East.
Gadna, I presume?
Dammit why do you know what that is.
:D
My sister was a Gadna instructor. She got all the crazy Russian kids who would fill their canteens with Vodka.
I get drafted in a few weeks. If you have a day off, I think LW Israel is meeting on July 4th, you should join us!
Are you American? A volunteer or aliyah? I have plans for the 4th but at the very least I'd like to warn you to stay the hell away from the Education Corps (it's so embarrassing just writing that).
Yes, we're meeting. The Google Group we used for organizing is: https://groups.google.com/forum/#!forum/lesswrong-tel-aviv
Should do a meetup post...
If anyone would have developed a thorough, persuasive answer to the question of why economists support central banking, it would be Greg Mankiw.
This sort of lead-up to the fallacy (A->B) -> (notA->notB) is too transparent. I would suggest just cutting out the fallacy and letting the claim that economists don't have a theoretical reason to prefer central banking develop more naturally over the next paragraph or three.
Now, and this might be presumptuous, but there is an obvious explanation for why economists would be entirely uncurious about central banking and be perfectly content with that state of affairs.
I think it is definitely too presumptuous. First of all you're asserting at least one property of economists that you haven't even tested (uncuriousness) rather than a property of the economics literature which you've at least started to search (doesn't have any well-known theoretical proofs that central banks are a good idea). Also your second argument is at least 2 experiments removed from having a leg to stand on.
The problem is I don't know how to show the absence of arguments for central banking, so a quote by someone as authoritative as Mankiw is really useful, even though it certainly isn't logical proof.
I think it is definitely too presumptuous. First of all you're asserting at least one property of economists that you haven't even tested (uncuriousness) rather than a property of the economics literature which you've at least started to search (doesn't have any well-known theoretical proofs that central banks are a good idea). Also your second argument is at least 2 experiments removed from having a leg to stand on.
What is the difference exactly between the economists and their literature? I mean, if they should be asking a question, and I can't find the answer to the question in the literature and I can't even find the question itself anywhere, and I can't even find anyone pointing out how weird it is that the question isn't asked, what should I conclude other than a lack of curiosity?
Economists are pretty comfortable asserting self-interest as an explanation for anything where it possibly could be an explanation in the absence of disconfirming evidence, because we're that confident in the generality and power of self-interest as a motivator. You would need to do the experiment proving that it isn't self-interest--if the subject were anything other than central banking.
Here's something I find mysterious: How is it possible for the central bank to set interest rates? Shouldn't banks find some way to drag their feet about lending if the rates are too low (or add fees, perhaps) and lower barriers for borrowers if the rates are too high?
Just by controlling incentives. As I understand it the Federal Reserve bank has three tools: the discount rate (the rate at which it loans money to banks), the reserve requirement (how what percentage of a bank's loans have to be covered by cash on hand) and buying and selling government bonds which correspondingly increase or decrease the money supply. At least that's the deal with the federal reserve. I can't say about Europe
So you're a bank and some one comes in for a loan (representing the marginal loan): Let's say your cash on hand is right at the reserve requirement. If the requirement is lowered, you can issue loans where you couldn't before. If the requirement is raised, you can't issue loans where you could before. As a bank you can borrow money from other banks or from the fed to cover that reserve requirement. But that money is going to cost you. If the interest rate between banks and the discount rate are high, you're going to have to charge more on loans. If they're lowered you can charge less.
When rates zero out and banks still won't lend the central bank can buy government bonds (using money that wasn't there before). Money get's devalued, but since wages and prices are sticky that money is worth more to employers and consumers than it is to the bank- increasing the bank's incentive to lend. The Fed can also sell back bonds which takes money out of the bank, making it more expensive for banks to get money to loan...
There are so-called "liquidity trap scenarios" where banks just want to hang onto the cash and traditional monetary tools are supposed to stop working. But banks can still be influenced by anticipated inflation-- if banks think the Fed is about to buy a whole round of new assets, inflating the money supply, devaluing the cash they have on hand, they'll be looking to lend that money before it loses value. Scott Sumner argues, pretty convincingly, that all monetary policy really is/ought to be about anticipated money supply.
(This is probably oversimplified, I'm not an economist.)
This might be misleading.
Open market operations (where the Federal Reserve directly buys and sells securities) are the primary means of monetary policy. Borrowing directly from the Fed leads to increased regulatory attention and public skepticism, and so banks avoid doing so except in emergencies. (The discount rate is higher than the rate at which banks lend to each other: If they won't lend to you then something is wrong). This means the discount rate is relatively unimportant in interest rate targeting outside of emergencies. I don't understand reserve requirements, but I'm told it's seen as a fickle way of influencing rates. So buying and selling bonds by the Federal Reserve isn't the last resort, but rather the favored means of influencing interest rates.
"Set" is an problematic verb here.
Sometimes, the Federal Reserve does lend directly to banks, at a rate the Fed can set exactly. But this rate is higher than the market rate, and banks avoid borrowing from the Fed unless they're in trouble and no one else will lend them money. Outside of this situation, the Federal Reserve, (and any other modern central bank), can't force banks to lend or borrow at a particular rate.
Instead of setting rates by fiat, the Fed will buy and sell bonds and other assets, (printing new money if neccesary) on a public market used by banks to lend to one another. If the Fed wants to lower interest rates, it will buy bonds at higher prices (which means lower yields, which are good for the borrower). By selling bonds to the Fed at higher prices (i.e. getting newly printed money for cheap), a bank can usually lend more at lower interest rates than before. Since banks are competing, no individual bank could really refuse to lower their lending rates unless other banks were also not lowering their rates.
In this way, the Fed can try to influence interests rates without creating incentives for banks to just hoard the money.
Confusingly, the market rate the Federal Reserve is trying to influence is called the "Federal Funds Rate", while the rate the Fed can set directly is called the "discount rate".
I suspect it has to be with being insured. Also, at some point they do drag their feet, or at least have been accoused of such as of late.
I used to be a straight up anarcho-fucking-capitalists. Since then I've reformed piece by piece by the sheer weight of evidence for market failures without legalistic 'centralised' intervention:
The latest thing: 'The largest producers and sellers of eggs labelled 'free range' – Pace Farm, Farm Pride, Manning Valley, Woolworths and Coles – declare the highest stocking densities' . It would be comical if it weren't cruelty.
LET'S HOLD OFF ON PROPOSING SOLUTIONS
To all of the people who have offered explanations for why free banking might not be such a great idea and possible rationales for central banking,
Whoa there, cowboy! I haven't even started explaining any economics yet. This introduction was only intended to explain how weird and problematic the unique treatment economists afford central banking is. Free banking is only offered as an alternative because it is the natural starting place and is the salient and obvious alternative--that's just how economics works, except in banking for some reason.
There are in fact all kinds of arguments for central banking, just nobody seems to be able to turn them into the format economists usually require. We'll get to them in time. Yes, I'm merely a self-taught 20 year-old but I've also spent 2 years reading my butt off about this stuff. I know a fair bit more than might be obvious from the introduction.
So apparently this introductory article was really unclear about a lot of things. That's my failure as a writer and hopefully I'll get better. But we haven't even learned any economics yet, so let's hold off on proposing those solutions.
The multi-part articles are not good format for this website.
This may sound ironically, because we have the Sequences, etc. But when you read them, each article in the Sequences has its own point. If often references previous articles. But it does not rely on the future articles to provide its value.
Perhaps the second part will give some additional information. But it does not exist yet. The votes and the comments are about the first part.
When I think about it, the style you used here (and some other people used it in the past too), is the style typically used for books. The first chapter presents a big mystery, to make the reader interested. Then slowly we move to the solution. Like this:
The problem is that the first part does not provide information, only a question. Even at the second, third, and fourth part, the question is still not answered.
This would be the Sequences style:
It's almost the same as the previous, but the introduction is removed. And suddenly each article has its own point. The first article speaks about A. Not about "A as a prerequisite for some future X". Just: about A. Etc. The advantage is that each article can be enjoyed and discussed as it comes.
So here's a few reasons why the community here will find my sequence interesting (if I can become a better writer fast enough),
I can't do an experiment proving that free banking beats central banking, but I do think I can show that if you actually work through the economics then you can see that free banking wins outright (which isn't the same as a defense of free banking because there might be something else better than both free and central banking). This is another example of when Bayes beats Science.
So if I'm right about all this, then you will all get to see some pretty huge intellectual blind spots and biases revealed in real time. This won't be learning about past scientific mistakes and corrections; this will be participating in it.
Economics itself is really interesting and important. Optimization, coordination, rationality (and coordination problems and irrationality), etc. These are all the bread and butter of economics, and of great interest to the community here as well. The sequences, at least those parts that deal with optimizing and rational behavior, are implicitly and explicitly full of economics and economic concepts.
Hey, it's better than the Discussion page being nothing but a bunch of [Link]'s and [Meetup: Wherever]'s.
If the question is indeed as unstudied and unconsidered as Mankiw claims, you'd probably achieve more by publishing in an economics journal or on an economics blog, rather than LessWrong.
So let me try to clarify a few things here.
This sequence is in no way intended to be a defense of free banking. It's intended to teach a sufficient amount of economics such that, among other things, disagreeing with central banking falls out of it, in much the same way that teaching a sufficient amount of rationality should produce atheism as a side effect. If people say at the end of the sequence, "Geez, I sure learned a lot of economics, and incidentally I no longer think central banking is a swell idea," I would take that a sign of success, and if they said the opposite I would take it as a sign of failure. But if people said at the end, "Now I think free banking is swell," I would not take that as a sign of success, and if people said at the end, "I still don't think free banking is swell," I would not take that as a sign of failure. Thinking central banking is a bad idea simply doesn't imply that free banking is a good idea.
When I say that economists have no explanation for central banking, this isn't supposed to say that there aren't any intellectual reasons economists support central banking or that individual economists don't have their own rationales. But these don't take the form of arguments that justify other entities like the FDA or other regulations like Pigovian taxes. Nor does central banking look like an targeted minimally intrusive intervention that addresses the various specific issues with free banking. This is because it isn't, of course. If you had never heard of central banking, and then you noticed those various problems in the banking market, would central banking really be the best idea you would come up with to solve those problems?
Saying that someone is motivated by self-interest doesn't mean they are motivated by impure thoughts. That's not how the algorithm feels from the inside. It is my hypothesis that self-interest has dramatically lowered the intellectual standards of economists relative to central banking. That looks bad from the outside, but from the inside it feels normal and that's just how things are. That's why economists can be satisfied with their own weak individual rationalizations, like, say, the deadweight loss from dealing with too many different currencies, which would never in a million years persuade economists of central banking if they weren't already persuaded of central banking and/or had lowered intellectual standards for some reason. But they're not thinking bad thoughts, and I'll never use self-interest as an ad hominem against economists who support central banking.
As far as politics goes, the truth of the matter is that I didn't make up my mind about the merits of central banking until after months of research and thought. The project was the result of genuine curiosity about just why economists treat banking so much differently from other industries after I was shocked by the way Mankiw completely glossed over free banking in his textbook. The problem wasn't that he supported central banking. The problem is that's not how economists do things. I was just trying to find the answer to that question, and ended up destroying my own confidence in central banking. I'm not a libertarian nor an Austrian economist, and most of the articles in this sequence should be pure economics. Now, I might use examples from politics when doing so is really convenient--the disasters of price controls make the function and role of prices so very clear--but if even that turns out to be a problem, I'll find different examples.
Actually it sounds to me like you don't yet know sufficient economics to be sure that "disagreeing with central banking falls out of it." Mankiw seems to be saying that he doesn't know sufficient economics to be sure that "disagreeing with central banking falls out of it", and he doesn't think anyone else does either.
There is (maybe) an interesting topic here, but don't presume your conclusion. What if you learn sufficient economics and realize that "agreeing with central banking falls out of it" instead?
Economists love decentralized competitive markets. There’s nothing an economist likes to see more than some decentralized entrepreneurs starting businesses with well-defined property rights, competing with each other to serve the interests of others in order to serve their own interests, coordinated through decentralized prices which transmit information about relative scarcities, with success determined by profits and failure by loss. We love decentralized competitive markets so much that we even call them “perfect.” Any deviation from this perfection is labeled “inefficient” and “failure” and economists quickly design a correction intended to push the system back towards perfection with minimal interference.
Now let’s look at central banking and try to predict whether economists would love or hate it. To what extent does central banking approach economists’ vision of perfection?
Is the bank decentralized? Nope, it has “central” in the name for crying out loud.
Competitive? Central banks are monopolies by law. Competing with a central bank is a crime.
Private actors serving the public good through self-interest? No, central banking uses government-employed technocrats whose motives are apparently supposed to be public-spiritedness in the manner of politicians and government bureaucrats.
Success determined by profits and failure by loss? The central bank is not a profit-maximizing entity and in any case has the explicit backing of the government in case it runs into trouble, a support central banks the world over have repeatedly had to turn to in crisis.
Coordination through decentralized profits? On the contrary, the central bank is the entity that is supposed to be doing the coordinating, these days on a global level, when economists are convinced that in every other industry centralized planning runs into insurmountable information and incentives problems at a scale far below what central banks these days are expected to manage.
So what do you predict? Are economists supportive of central banking or not?
That’s right, economists support central banking over competitive decentralized banking near-unanimously. The only university of any significance that might have an economics department a majority of whom support free market banking would be George Mason University. There are also a couple of very small colleges with an “Austrian” economics program that are also most likely supportive of a free market in banking and oppose central banking. Otherwise, economists spend quite a lot of time and effort both staffing and running central banks, gathering data and developing theories, trying to learn what mistakes central banks made in the past and how to avoid them in the future, arguing over what central banks should be doing in the present and what they should be prepared for in the future, etc. Support for a banking system that doesn’t include a central bank is a minority fringe view.
That...
...Is not what anyone would expect, if they knew what economists generally think about decentralized competitive markets versus government-supported monopolies tasked with managing the macroeconomy before they knew how near-unanimously supportive economists are of central banking. So what’s going on?
Not all industries are identical, and banking is unique among all the different kinds of markets since it has a unique relationship with a unique good, money. So while you shouldn’t expect economists to support central banking, you also shouldn’t be too surprised by their support if they have a good explanation for why they do.
And of course economists will have a good explanation for their support for central banking. Central banking isn’t new--if you date the beginning of economics at 1776, when Adam Smith published The Wealth of Nations, then centrally banking pre-dates economics--so they’ve had plenty of time to think about it. Economists have been working and theorizing for central banks for centuries, so they’re familiar with central banking and the many ways it differs from the “perfect” arrangement economists are usually so fond of. Plus central banking is simply something that should clash so strongly with their normal intuitions--seriously? A government-protected monopoly centrally managing the macroeconomy--that every new generation of student economists would stridently demand explanations from their professors. Finally, centrally banking is really important, and it is something economists have responsibility for in a way that isn’t true of any other institution. Getting the right answer on central banking versus some other banking regime is one of the most important things that economists could do.
So let’s ask Greg Mankiw, professor and chairman of the economics department at Harvard University, where among other things, he teaches introductory economics, just why it is economists support central banking. Mankiw is the author of a very popular macroeconomics textbook for undergraduates. He’s smart, well-read, and a very popular and successful educator. If anyone would have developed a thorough, persuasive answer to the question of why economists support central banking, it would be Greg Mankiw.
“The economics profession does not have a good answer.”
Oh. Uh--
“We economists have rigorous and fundamental theory to explain why we have environmental regulation (externalities) and to explain why we have antitrust laws (market power), but there is no consensus about what market failure calls for the existence of a central bank. “
Okay, well “no consensus” isn’t so bad. It must be a hard topic. But economists must be hotly debating all kinds of answers--
“The answer has something to do with the benefits of a system of fiat money. And it has something to do with the possibility of short-run monetary nonneutrality (due to sticky prices and/or imperfect information about prices). But the precise combination of elements that would yield a satisfying answer is still elusive.”
Wait, so nobody has an answer?
And let us note that “the benefits of a system of fiat money” seems insignificantly different from “the benefits of central banking” because that’s pretty much what a system of fiat money is. And I can’t for the light of me see how “the possiblity of short-run monetary nonneutrality” should be sufficient to move economists from their normal support of decentralized competitive markets to support for a government-backed monopoly tasked with central planning, or even how it should move economists in that direction at all, and Mankiw doesn’t explain or even link to someone else’s suggestion.
Please, Professor Mankiw, if you don’t know the answer just tell us who does--
“If anyone has a good answer, let me know, or publish it in the American Economic Review.”
...
Okay, is it just me, or does it kind of sound like Greg Mankiw, professor and chairman of the department of economics at Harvard University, perhaps the most popular economics educator in the United States, not only not know the answer, but he doesn’t even know of anyone in the economics profession who has ever offered a good answer.
It’s almost as if Mankiw has never heard a reason why economists should support central banking (at least, one that doesn’t beg the question--“the benefits of a system of fiat money” explains nothing). He also--professor and chairman of the department of economics at Harvard--doesn’t think that any other economist ever has come up with a good reason, even one that he hasn’t personally heard.
And he doesn’t even seem particularly concerned about what is essentially the most important question in monetary theory.
....
I did my own search, and I can confirm that Mankiw isn’t simply lazy or ignorant. The economics profession really doesn’t have a good answer to this incredibly important question. They do have an explanation for why they don’t support unregulated banking: banking regimes that lacked central banks suffered financial crises and recessions--for example, the repeated financial crises of postbellum America that led to the demand for banking reform which culminated in the creation of the Federal Reserve system.
This is a weak argument, however. It doesn’t even work as a strike against a free market in banking because banking regimes like that of postbellum America were heavily regulated despite the lack of a central bank. Lightly regulated banking regimes like Canada and Scotland did at different times in history did a better job of avoiding and weathering financial crises and recessions than did America’s and and Britain’s over the same period of time. Furthermore, banking regimes that include central banks have also suffered from financial crises and recessions. We’re still feeling the effects of one today. So if the occurrence financial crises and recessions were arguments against the system that preceded, then they are just as equally arguments against the current system, the system of central banking.
So the one argument economists have is an incredibly weak argument against a free market in banking, and it is an argument against central banking.
And economists really don’t seem to care about this. It is something they are simply not curious about. They don’t write about it, not even things like “Boy, It Sure is Weird that We All Just Accept Central Banking.” When you study any other industry in economics, first you learn about how it works in the “natural” unregulated state, and then you decide if regulations are desirable and what those regulations might look like and what consequences they will have. When it comes to banking, the textbooks start with a central bank. Free market banking is completely ignored. If any justification is offered, it is a brief version of “the past system had a lot of crises” argument that cuts just as strongly against central banking.
Now, and this might be presumptuous, but there is an obvious explanation for why economists would be entirely uncurious about central banking and be perfectly content with that state of affairs.
First of all, people are naturally uncurious about things. Hopefully scientists are more curious, at least about the subject matter of their own science, but in remember that central banking pre-dates economics. Central banking is what economists are used to. This is more of a barrier than it might seem. It is well known in economics that people are entirely comfortable with markets in things that they are used to and extremely skeptical and suspicious of markets in things that they are not, even when they work by the exact same principles--look at the resistance and apathy towards prediction markets for an example. There is something of a joke in economics to the effect that if the market for sandwiches had always been controlled in a top-down manner, then calls to open the market to free competition would be met with cries of “But where will the sandwiches come from?” and things to that effect. People have a very hard time imagining how markets they aren’t used to will work. This should be doubly true of a free market in banking, which doesn’t have a great number of historical examples, and those examples (Scotland, Canada, Australia) aren’t very well known. Just as importantly, banking is a particularly, perhaps uniquely, abstract and difficult industry to understand. If there was every a set of problems economists would be tempted to run from, it would be the economics of banking.
Second of all, there is the obvious problem of self-interest. Central banking raises the income and status of economists, and strokes their ego. It lets them work cushy, secure high-paying high-status jobs where they get to do what they enjoy and feel like they are in charge of the economy to some extent. They can flatter themselves that they are controlling things and fixing the world while pulling in a nice income doing the work that they like.
Given those two points, it’s not that surprising anymore that economists support central banking, don’t have any reasons for supporting central banking over a free market in banking, and aren’t very bothered by this.
To see if that explanation holds up...
...And to find out for ourselves what kind of banking regime, central banking or other, is actually justified by the economics...
We’ll start exploring from the beginning: just why do economists generally support decentralized competitive markets over government-backed monopolies? Why should economists have to be persuaded of the merits central banking from the more obvious position of free market banking, the opposite of the status quo? That is where we’ll begin.