Money is one-half of virtually every economic transaction. Therefore, it is the single most important factor in any modern economy. By extension, banks, being the conduits by which money enters the economy, are crucial to prosperity and stability. Banking can be broken down into two basic categories: commercial banks and central banks.
Commercial banks are profit-seeking, more-or-less private companies. They accept deposits and make loans to their customers. Central banks are the creations of government, do not seek profits, and have, as their key mission, the centralized control of the supplies of money and credit in the economy. Central banks also hold a monopoly on the issue of legal currency for the country in question and serve as a "lender of last resort" (they bail out financial institutions when the economy goes sour). The Federal Reserve in the United States, the Bank of England, the Bank of Japan, and the Reserve Bank of New Zealand are all central banks.
It has often been said that the twentieth century was the "century of socialism." It is no coincidence, therefore, that the past century also saw central banking become the norm world-wide, even in those few countries that retained some significant vestiges of a free market. The reason why this cannot be called a coincidence is that central banks are, in fact, instruments of central planning. That is, they are manifestations of a collectivist mentality. The only possible "justification" for creating a central bank is the belief that free markets just don't work when it comes to monetary issues. That is errant nonsense. There is no more reason to collectivise banking than there is to collectivise the production of food or automobiles or personal computers. This has been borne out in the research of economists such as Lawrence H. White, George A. Selgin, Kevin Dowd, and myself, among others. There is now a large body of work that strongly supports the theoretical desirability and historical success of laissez-faire banking.
One should be aware that the most common motivation for establishing a central bank has been to provide funds for the national government. Originally, this took the form of direct loans to the government. These days the object is often achieved by having the central bank purchase government securities (bonds). The state Treasury thus has more funds to spend on various government programs. Such purchases also bring about an increase in the reserves held by commercial banks, which allows those banks to grant additional loans to their customers. Since the loans appear as increases in the customers' bank accounts, the money supply rises—think of the money supply as being composed principally of cash plus deposit accounts.
Economists commonly refer to this sequence of events as the "monetisation of debt." Politically, it is by far the most popular way to finance state expenditures. There are only two other options: raise taxes or have the government sell more of its bonds to the public.
And neither of those is consistently feasible. Moreover, most citizens never realize that this monetisation of the state's debt is a kind of implicit taxation. That is, the increase in the money supply that is involved usually causes price inflation. And if prices are generally rising, then the purchasing power of people's incomes falls. In short, a 10% increase in the price level has the same basic effect on individuals' real incomes as does a 10% rise in income taxes. Best of all—to the politicians in power—is the fact that some scapegoat can often successfully be blamed for the price inflation, such as the manufacturers of imported goods, farmers, labour unions, or OPEC.
Not only do central banks burden us with inflation, they also bedevil us with the ups and downs of business cycles. In an attempt to please voters by boosting production and reducing unemployment, central banks are chronically guilty of driving market interest > rates too low, that is, below the rate that reflects how much people are saving. This is accomplished by expanding the supply of money, since increases in money push interest rates down—at least for a short while. These actions affect the structure of production in a systematic way. Longer-term, more capital-intensive projects appear more profitable than before, so entrepreneurs invest in that direction. Initially, all looks well and good, and the economy seems robust. However later, when the resources needed to complete the projects are not forthcoming (because there is too little saving), the expected profits turn into losses. Projects are liquidated, production declines, and unemployment rises.
Not surprisingly, there is then political pressure for the central bank to "do something to help," and the whole sequence starts over again. Ultimately, there is only one solution: the elimination of all centralized control over money and banking.
Certain economists have come to recognise the inescapable damage done by central banks. Milton Friedman, once a defender of central banking, has stated that "in my opinion, no major institution in the United States has so poor a record of performance over so long a period….as the Federal Reserve" and that Congress should "abolish the money-creating powers of the Federal Reserve." Economists of the Austrian School have long favored true competition in banking. For example, in 1978 Friedrich Hayek argued for what he called the denationalisation of money and banking (that is, for free or laissez-faire banking) and declared that "what we now need is a Free Money Movement comparable to the Free Trade Movement of the 19th century."
I could not agree more. As long as we have central banks, inflation and periodic crises will remain the order of the day. The temptations are simply too great to resist.
Moreover, as long as money remains a tool of the state, that tool will continue to serve
the state as a well-spring of income redistribution, social engineering, and military adventurism. A laissez-faire approach to money and banking is thus more than merely conducive to efficiency and stability. It is likely to prove to be a necessary precondition for prosperity, justice, and peace.
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