Saturday, August 13, 2011

Central Banking is Not Central Planning

On the excellent Free Banking blog, Kurt Schuler argues that central banking is a form of central planning.

I think this is fundamentally mistaken.

He says:

Central banks are government monopolies that consciously try to steer the economy. If that is not central planning, nothing is.

That is one way to characterize central banking, and that characterization certainly sounds like central planning, but really,  it is nothing like comprehensive central planning of the economy.

Comprehensive central planning of the economy is the central direction of the production and consumption of all goods services.   How many cars do we want this year?   How much steel is needed to produce those cars?   How much iron ore is needed to produce the steel?   And how many cups of coffee will the miners get in their snack bar?    How many new coffee machines will be needed in that snack bar?

Trying to do this for every good and service all the time for millions of people producing and consuming is really, really hard.   Perhaps impossible is not too strong of a word, though that really means impossible to do very well at all, much less do better than a competitive market system.

Central banking is very different.   It does involve having a monopoly over a very important good--base money.    Early on, governments sold that monopoly to private firms, but later either explicitly nationalized the central banks, or regulated and "taxed" them to a point where any private elements are just window dressing.    Schuler is correct to treat central banking as a government monopoly over the provision of base money.

Schuler's error is to identify this monopoly on the provision of an important good with comprehensive central planning.    Yes, a monopolist must determine how much of its product to produce and what price to charge.   The central bank must determine what quantity of base money to produce and what interest rate to pay (or charge) on reserve balances.    But that is nothing like determining how much of each and every good is to be produced while making sure that the resources needed to produce them are properly delivered to the correct places at the correct times.

Suppose electric power was produced as a government monopoly.   That is certainly realistic.    The inefficiency of multiple sets of transmission lines provides a plausible rationale.    The government power monopoly would need to determine some pricing scheme and how much power to generate.   And, of course, these decisions would have implications for the overall level of economic activity.     Not enough capacity, and blackouts disrupt economic activity.   Too much capacity, and the higher rates needed to pay for it deter economic activity.  

It is hard to conceive of an electric utility centrally directing the economy, but it isn't impossible.   Ration electricity to all firms based upon a comprehensive plan for what they should be doing.    Any firm that produces the wrong amount and sends it to the wrong place is cut off.   Sure, there could be leakage.  Not every economic activity requires electric power.   But the point is that there is no need for an electric utility to worry about that.   It just needs to worry about the demand for electricity and the cost of producing it, not exactly what everyone using electricity is doing with it.

A more direct way to see that central banking is not the same thing as central planning is to suppose that the monopoly is extended, so that the central bank monopolizes all credit.   Every business that borrows must borrow directly borrow from the central bank.     Even then, this doesn't involve central planning of the economy.    The central bank would have to determine what interest rates to charge and the amount of credit to provide for each user.  

We could imagine the central bank developing a comprehensive plan of all economic activity, and only providing loans to firms that carried out their parts in the plan.   But it wouldn't have to do it that way.   It could just make loans and set interest rates on those loans based upon the particular business plans.    The central bank wouldn't have to try to undertake the impossible task of determining whether all the plans of all the borrowers are consistent with one another, much less create an allocation of final outputs or production methods that the central bank finds desirable.

What this central bank as monopoly lender would need to do is make sure that the total amount it was lending matched the total amount that it can borrow.    If we imagine a central bank that doesn't create money, this is straightforward.    The monopoly would have to pay interest to depositors and charge interest to borrowers.   It must simply pay and charge interest rates so that the two match.   Bringing them closer together allows for more borrowing and lending.   Setting them further apart, involves less borrowing and lending.    

Certainly, the activity of the credit monopolist would have an impact on overall economic activity.    Credit is an important economic institution.   If the monopolist paid too little, there would be too few funds to lend.   If they charge too much, valuable projects would not be completed.   And, of course, judging whether particular firms and households will be able to pay back their loans is no easy task.    If the monopolist made loans for unsuccessful projects, resources would be wasted.  

When central banks were first started, no one had the intention of consciously steering the economy.    It was about sharing the benefits of borrowing at a zero nominal interest rate between the government and the private owners of the central bank.    People are willing to hold hand-to-hand currency even though it pays a zero nominal interest rate.   That means, that someone can borrow at a zero nominal interest rate.   Free banking allows competing private banks to do this, and presumably compete away any net benefit to the banks (rents)--providing some kind of service to those using the currency.   Central banking prevents this competition.   Today, the benefits (or rents) go to the government.    

With a gold coin standard, the paper money issued by the central bank is just one form of hand-to-hand currency.    As long as central bankers are committed to maintaining redeemability, they cannot have too grandiose a vision of steering the whole economy.      The whole point of the rent seeking activity was to borrow at zero interest, and so, the interest rate paid by the central bank is fixed.   All that is left is to limit the quantity of currency issued to the amount people want to hold.   With a gold standard, the price level depends on the world supply and demand for gold.  

However, from the days of Henry Thornton, economists have understood that the policies of a central bank can have very significant impacts on its economy in the short run--even with the constraint of maintaining redeemability.   Further, during period of suspension, there is a large element of "steering," especially if the resumption of payments is to be deferred, for example, until after a war ends.   And finally, central banks can manage their total gold reserves, temporarily offsetting the impact of changes in the gold balance of payments, and conceiving having a significant impact on the world supply and demand for gold.   Collectively, they can impact the world supply and demand for gold, and so, the long history of international monetary institutions.

And, of course, redeemability in precious metals is now gone.

Still, the task of the central bank remains the same.   Adjust the quantity of base money (and its yield, if it wants to pay interest on reserves) to the quantity demanded--to the amount that banks and other firms and households want to hold.    Because base money serves as the medium of exchange (along with various sorts of bank deposits,) this is no easy task.    And because money is a very important good, errors by the central bank will have economy-wide impacts.

And with the price of currency and reserve balances no longer tied to gold by redeemability, some alternative is necessary.    If this is left up to the central bank to determine as it sees fit, then the money price level is left in its hands.    From the perspective of most people, determining the long run value of the price level (and its rate of change) could be described as "steering the economy."

Still, this is nothing like comprehensive economic planning.   Suppose the central bank didn't just monopolize the issue of hand-to-hand currency, but also all checkable deposits.   Further, suppose it quit issuing hand-to-hand currency.   Then, the central bank developed a comprehensive plan for the entire economy and only allowed sellers to deposit checks if the buyers had spent the funds according to the plan.   (Hand-to-hand currency has to go because how then could the central bank use its control over money to specifically limit money payments according to its central plan?)

If a central bank is bound to some kind of rule for a nominal value--for inflation, the price level, GDP,  growth of GDP, some broader measure of the quantity of money, an exchange rate--then its role is to adjust the quantity (and yield) of its liabilities to the demand to hold them.   Because its mistakes have economy-wide impacts, avoiding those errors could be described as "steering the economy," but it would be similar to the national electricity monopoly with delusions of grandeur.   It is nothing like comprehensive planning of the economy.

If a central bank is left free to determine nominal values on the fly, then it does truly steer that aspect of the economy.    Still, its ability to manipulate any of the real aspects of the economy in any conscious way is very limited.    What particular combination of goods are produced, how they are produced, and even the total volume of production and employment, would not be "steered" by the central bank in the long run.

Central banking is nothing like comprehensive central planning.

P.S.   The Fed's huge holdings of mortgaged backed securities today is hard to explain except as an effort to channel credit into the housing market.    Directing credit towards particular industries could be a step on the path towards comprehensive planning.   But it isn't.    It is really just the usual piecemeal intervention in a competitive market economy.


  1. The Fed's huge holdings of mortgaged backed securities today is hard to explain except as an effort to channel credit into the housing market. Really? I suppose it could be construed that way. It could also be a way of repairing very weak balance sheets. No? In essence the Fed has relieved the banks of questionable assets with no corresponding relief for the parties responsible for the liabilities.

  2. All the mortgage backed securities held by the Fed are already guaranteed by the Treasury.

    I don't understand the part about the parties responsible for the liabilities.

    If you mean the banks' liabilities, then they banks are still responsible for those, but they now have a very safe asset (reserve balances at the Fed) rather than a risky one (mortgage backed securities.)

    And while it is true that government guaranteed mortgage backed securities are more risky than reserve balances at the Fed, there isn't that much difference.

    And, more importantly, the banks that were holding the mortgage backed securities that aren't guaranteed by the Treasury are still stuck with them. The Fed didn't buy those.

  3. Mayor Bill, (or is it ex-Mayor?)
    OK. Maybe I'm dumb as a stump. (Feel free to be blunt.) If the securities are already guaranteed by the Treasury, why purchase them in the first place? Regarding the liabilities part: Surely, some of those mortgages are still being repaid by the borrowers. No? Wouldn't it make more sense to address the distressed borrowers equally?

  4. I agree that purchasing government guaranteed mortgage backed securities is pointless, but it seems like some of those on the FOMC don't agree and think they are directing credit to where it is most needed.

    And it is me that was being a blockhead. It was the homeowner's liabilities that worry you.

    My view on that is to end the recession first, and then let's see.

  5. Bill, in case you missed it on the commentary to Kurt's blog, I wrote there that I think your argument against comparing central banking to central planning "goes to far": "After all, we condemn central planning because we believe that it is no substitute for using market-determined relative prices to guide the use of resources. The "central planning" of money differs from the central planning of any other good because (1) the profit motive alone ceases to be a reliable guide to optimal money creation and (2) suboptimal money creation introduces "noise" into the price system, and so undermines somewhat the working of that system, and hence its advantages relative to central planning. You don't get these problems when the state monopolizes, say, electricity-generation or automobile production."

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