A few days ago, RBI Governor Shaktikanta Das received an A+ rating in The Global Finance Central Banker Report. It was the top mark that acknowledged how well he’s handled affairs at the central bank. And it’s a big deal because only two other central bankers got an A+ rating.

But that got us thinking about something — the utility of these central banks.

So in today’s Finshots, we decided to explore this a little more. But please remember that we’re trying to summarize decades of debate into about 1000 words. So strap in.

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The Story

Central banks have 3 goals — keep prices stable, grow the economy steadily, and ensure financial stability by monitoring banks so that they don’t do anything foolhardy.

They’re quite crucial cogs in the ecosystem.

Or are they? Do we really need these central banks?

Yeah, we know it’s a pretty controversial question. And yes, it sounds crazy to even think about it. After all, who on earth will take on the role of fighting inflation and managing the money supply, right?

But hear us out. Some people argue that central bankers haven’t made the economy stable. They’ve made it messier.

Just look at the global financial crisis of 2008. While everyone warned central bankers about a bubble, they continued to keep interest rates low and promote credit. They loved the fact that the economy was growing.

But they simply had no clue what was in store. Here’s the first sentence of the Bank of England's Financial Stability Report that was published immediately before the financial crisis: ‘The UK financial system remains highly resilient.” And then, “So it would seem that there is a good deal to welcome in the greater dispersion of risk made possible by modern instruments, markets and institutions.”

Those instruments were the same ones that caused panic when bad things happened soon after.

The worst part?

Central banks have even propagated moral hazard.

It's a situation when banks adopt aggressive practices because they know that even if things go south, the central bank will step in to save them. They know that they’re too big to fail. Basically, it’s capitalism when things are going well. But they know that socialism will step in to bail them out when things go wrong.

And this isn’t a one off situation of a central bank messing up. Immediately after the pandemic, they failed to gauge inflation. They even issued apologies for that. And history is replete with such mishaps, where the bankers at the top who're trying to play god get it all wrong — whether it’s in dealing with the oil crisis of the 1970s or the Great Depression of 1929. Central banks are often the ones who shoot the economy in the foot.

So yeah, the problem seems to be that the few leading the central banks have too much power. And humans, as we know, aren’t infallible. We make really stupid judgment calls at times.

Anyway, now that we’ve sort of established that central banks are often the culprits, there's the all important question —  do we have an alternative system?

Maybe. And the answer lies in history. In Scotland’s history, to be exact.

Let’s start with Financial Stability

See, in the 18th century, Scotland did not have a central bank. It didn’t have a privileged bank at the top of the ladder that would control money. Instead, there first came a Bank of Scotland that could conduct banking and currency business. And then came a rival bank called the Royal Bank of Scotland too. The government did not interfere in any of their affairs. It was a free market.

And if you’re a staunch proponent of the free market, then you know that competition is often the best regulator. That’s what happened in Scotland. Banks started popping up. Each bank could issue currency if they wanted to lend money to people.

But isn’t that reckless when you’re dealing with public money, you ask?

Well, apparently not. And this is how it worked.

Let’s take 2 banks and call them A and B. Now in the course of everyday business, Bank A might get notes of Bank B. Some customers might deposit it or pay for a service using Bank B’s currency.

But Bank A doesn’t have much use for this. It only issues and deals with its own currency. So, at the end of the day, it’ll hand over these notes back to Bank B. It might do it directly or indirectly through an entity that exists just to keep tabs on these dues. It’s all recorded.

But wait? How does it ensure discipline?

So here’s how the American economist George Selgin described it using the analogy of a chain gang.

In a chain gang, the prisoners are chained to one another, but none has to be chained to anything else. That’s because none of them can run away without being tripped up by the others, and because it’s practically impossible for them to coordinate their steps so as to all run away at once, as any of you who has ever been in a three-legged race can imagine.
…were any one Scottish bank [to get] too aggressive in its lending, it would essentially be trying to run ahead of the other banks. But unless all the banks were somehow acting in unison, the aggressive bank would find more of its notes presented to it at settlement time, without itself receiving a like value of other banks’ notes, and it would have to have, or get hold of, reserves to cover its net dues to the rest of the system, or else it would default. In short, no Scottish bank could afford to be too generous in its lending if it wished to avoid being ‘tripped up’ by losing reserves to other banks in the system

Or put simply, imagine that Bank A issues 100 notes and Bank B issues only 50. If Bank B somehow gets hold of all of Bank A’s notes and hands it over, it expects to get an equivalent number of notes back. To keep the system in balance. But since Bank B never issued 100 notes in the first place, Bank A has to dip into reserves of gold or silver to fulfil this obligation.

It’s screwed!

And this actually happened in reality. Back in the day, the Ayr Bank in Scotland tried to get too smart for its own good. It got aggressive in its lending. And then had to dip into reserves to settle dues. The bank failed.

The end result?

It became a teachable moment for other banks. They knew they couldn't get too cocky with lending practices. And for nearly 100 years, the financial system was extremely stable.

Meanwhile, in neighbouring England, things were in stark contrast. The central bank became the pied piper of credit. It issued currency, expanded money supply, and eventually created an inflationary environment. And when it realized this — always too late — it would turn the credit tap off and hurt businesses. An economic crisis would emerge. This boom and bust occurred like clockwork.

Now you could argue that the sample size is too small. It’s just the experience of two countries on which we’re pegging this argument.

Well, something similar played out in the US and Canada too in the early 1900s. The American government interfered in banking and created an economic crisis. Canada’s authorities gave a free rein and everything was as smooth as butter.

So yeah, it does seem as if too much power in the hands of one entity was the problem.

But wait…what about Inflation?

Okay. So back in the day, money supply was linked to reserves. You needed to have certain gold or silver backing it. But not anymore. Central banks print money willy-nilly. And that excess money supply gets quite problematic. It gets into people's hands, they spend it, and inflation rises. That’s one theory.

Now it might be quite hard to go back to a reserve-based system. Even though some economists advocate for that. So maybe, as Milton Friedman suggested in 1994, just choose a stable base of money as the reserve instead. A set sum of money that's kept aside. And then let free banking do its job. This group of small banks will then basically self-regulate money supply because they know what will happen if one gets too ambitious. And this will ensure that overall spending in the economy is stable at all times too.

Or even better, Friedman thinks we should just get a computer to handle money supply and increase it by a bit every now and then. That way, there are rules in place and there's no human discretion. And then, maybe we won’t need a central bank.

Still sounds crazy, doesn't it?

Now we’re not saying they’re right. We’re not even saying that the current system is perfect. It’s just that since we always talk about how crucial central banks are, it’s worth pondering over the counterarguments too. No?

Until then…

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