Skip to main content

Free Banking and the Rationale for Central Banks

If free banking is so great and has worked in the past, why then did central banks develop?  Free bankers answer this question by arguing that central banks generate seignorage revenue for governments, thus central banks exist for a fiscal reason.  Although this may be the case for some developing economies, central banks generate relatively little income in economies with sophisticated tax-raising bureaucracies.
The mainstream and dominant view is that central banks exist to stabilise the financial system, which is prone to episodic crises.  Central banks are believed to stabilise the economy by providing liquidity to individual institutions as well as the system as a whole.  As central banks can essentially print money, they are able to create such liquidity almost ex nihilo.  The problem with this view is that historical banking systems were relatively stable even without a central bank.  In addition, the ongoing financial crisis occurred despite (and maybe because of) the existence of sophisticated central banks.

The other explanation as to why central banks (and the gold standard) emerged has been put forward by the late Earl Thompson of UCLA and Charlie Hickson.  Thompson and Hickson suggests that central banks operating under a gold standard were a vital institution which ensured the survivability of democracies.  As democracies are overly appeasing in the face of an external threat, a central bank with a national currency which could expand the money supply in a defensive emergency was necessary for the long-term survivability of democratic nations.  You can read their argument in full by clicking here


Popular posts from this blog

The Failure of Herstatt Bank

As an undergraduate, I was taught about the failure of Herstatt Bank in 1974 and Herstatt risk. This bank was only the 35th largest bank in Germany at the time so why would anyone be interested in studying its failure? Herstatt failed because of its involvement in risky foreign exchange business. When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received dollars due to them because of time-zone differences - this is known as settlement risk. The cross-jurisdictional implications of its failure resulted in the Bank for International Settlements setting up the Basel Committee on Banking Supervision and Herstatt's failure was a key reason for the establishment of real-time gross settlements systems, which ensures that payments between two banks are executed in real time. The Bank of England's Ben Norman has an interesting post on Herstatt over at the Bank's new blog ( Bank Underground ). As well as giving an excellent overview of

Boom and Bust: A Global History of Financial Bubbles

Boom and Bust: A Global History of Financial Bubbles, co-authored with my colleague Will Quinn , is forthcoming in August. It is published by Cambridge University Press and is available for pre-order at Amazon , Barnes and Noble , Waterstones and Cambridge University Press . 

The Great Depression

Marginal Revolution University has a great video on the Great Depression.