Hayek Lecture 2016: Price Stability and Financial Stability without Central Banks

thank you mark thanks to the Institute of Economic Affairs for the honor of being able to to give the Hayek lecture this year and I'm particularly touched to have had to have the opportunity to do so at the time that IEA is also celebrating its anniversary this to me is the whether intentional or not makes it all the more of an honor to be speaking to you tonight and and thanks to all of you for coming I'm really looking forward to this when I was a young boy my brother I have a twin brother by the way fraternal twin brother he and I would play a game with my father called the five line game I don't know if this was a game anyone else played but we did and this game worked as follows you we would scribble five lines on a piece of paper any any kinds of lines or curves what have you and my father had we would tell my father that he had to make out of these lines incorporating all of them a picture of something like an elephant or dog and the idea was that the picture had to look like the thing we wanted it to look like the lines had to all be used and they don't have and they should not look odd and my father was excellent at this game what does that got to do with this talk well I was I had that the five line game came to mind when I finally got around to taking a good look at the title that to Philip I think it assigned to to my talk and found myself saying to myself how the heck am I going to turn that into a good lecture and so I struggled with it it was too late to change the title Philip told me I said you know I can talk about some of this I can I think I can make it work but I've got to cheat a little bit so I'm going to tell you about financial stability without central bank's sure enough but I'm also going to tell you about financial stability without price stability because I don't believe the price stability as it's normally understood as a stable price level or stable absolutely stable greater than nation is in fact a desirable thing so I'm going to explain to you how we can have stability financial stability macroeconomic stability if you like without central banks and also without a stable price level though with a price level that behaves in a certain systematic fashion as for financial stability without a central bank well it's actually rather easy to explain that that is possible because history shows that it is possible most close to where we are today history has given us a good example in the Scottish banking system that flourished from roughly the later part of the 18th century until the middle of the 19th century when British legislature started to really interfere with it and ruin it turning it into the disaster that it has become in recent times the Scottish system unlike the English system did not involve the establishment of any privileged bank of in issue what we would later later come to be known as a central bank by the way this happened as a result of a sort of malign neglect if you will the Bank of Scotland had received the first Charter to do a banking and currency business there but it was owing to the suspicion on the part of the Parliament that this was a Jacobite institution that they allowed the Royal Bank of Charter of Scotland to be established as a rival bank and that opened the floodgates to what ultimately became a system of numerous banks of issue and it was because there were many banks of issue very free from any sort of government regulation that Scotland and uh ended up with a notoriously stable financial system and the stability was ultimately due to the pressure that the competing banks of issue exerted upon one another by actively presenting the notes that they received in the course of a business day from rival banks for collection either directly to the banks that had issued them or indirectly through a clearing house where clerks as in this picture would would figure out what banks owed what to which other banks this this mechanism created a discipline that was not unlike the discipline one finds in a chain gang right in a chain gang the prisoners are linked to each other but they don't have to be links to anything else the fact is that none of them can run away without being tripped up by the others and it's impossible practically for them to coordinate their steps so as to run away all at once as any of you who's ever been in a three-legged race can imagine now what's the analogy well the analogy is that if any one bank should be too aggressive in its lending of credit to generous it will run ahead of or try fine it will essentially be trying to run ahead of the other banks but unless the other banks are acting in unison with it it will find more profits items presented to it after settlement at the end of the day and it will have to fork over the necessary reserves to cover its net dues to the rest of the system and that means that no bank can be too generous without finding itself punished by a loss of its reserves to other banks in the system in fact up early in the history of the Scottish system we had a very good example of how this discipline worked in the failure the notorious failure of known to some of you at least of the air bank the formal name of which was Douglas Heron and company this was a bank set up around 1770 which immediately proceeded to land extremely generously with the explicit aim of becoming the biggest Scottish bank of issue and doing so very quickly well as the theory would predict the air bank proceeded to start owing money to its less aggressive rivals it tried to put off the inevitable not by contracting its lending not by rethinking its strategy for success but by borrowing in London to cover its gold losses and this of course it could only do to a certain point finally it collapsed famously bringing down some smaller Scottish banks with it but the others stood pat carefully not getting themselves involved and the result of this failure of what had in fact become in assets Scottish Scotland's biggest bank Scotland enjoyed almost a century of complete economic stability and financial stability afterwards the air bank was a good example of why too big to fail is a bad idea because by letting this big bank fail Scotland bought itself and in a long period of stability because other banks didn't dare to try but the air bank had tried again now a more subtle advantage of this chain gang discipline in the competitive banking system has to do with how it stabilizes the total amount of spending in the system as I explained before the banks can't individually try to be too generous in their lending but they can't be collectively too generous either because at some point usually very quickly one of them is going to feel the pinch that's going to make it stop it Gress aggressively lending and that will of course force the other banks to stop as well the the overall discipline that this imparts on the system can be summed up in this diagram and I'm not going to show you a lot of graphs and math or anything like that so don't panic what this shows is the total reserves in the Scottish banking system mainly consisting primatene Scotland the total sum of which will be reflecting what's been acquired in the course of trade with other nations and so we'll assume a given amount of reserves just a straight fixed amount straight line the demand for reserves by the Kabang collectively is a function of the amount of notes mainly notes and some checks that are being exchanged every day which in turn reflects the total amount of spending going on in the Scottish economy does that make sense to everybody and as you can see of course when no one spends anything of course the banks don't need any reserves for settlement because there's no settlement going on so we start at zero as we have spending increase and spending here's represented as the sum of the quantity of money in the Scottish economy and its velocity and velocity is just how many times each unit of money gets spent in a period of time so as that value increases the demand for reserves increases but not proportionately so the line curves up but the argument doesn't depend on the curve it just depends on this positive slope if that's easy enough to believe right but then that means that there's a certain point where the supply of reserves is equal to the demand and the system will tend to stabilize at that level of spending now that doesn't mean that the banks can't and and aren't indeed inclined to adjust hum how big they are how many notes they issue because if the velocity of money which is a sort of backward measure of how much people hold if that declines that people are holding on the bank notes more and spending them less the banks will issue a little more because the the achieving reserve supply demand equilibrium allows them to do that and vice versa if the people are spending more aggressively the banks at better lend a little less so you have this situation where spending is kept very stable why is this interesting it's interesting because there's a whole slew of economists today who style themselves market monetarists who've been arguing that if we only could get central banks to maintain stable levels of spending then we'd have financial stability my point being that in the Scottish system this was a tendency that was 10 this was a tendency inherent in the nature of competitive currency just to drive home that point Fedwire handles most of the large-scale settlements on and clearing transactions in the u.s. today it's a Federal Reserve clearing system and here you see in the jagged line the most jagged one you see what's happened to the total amount of payments through Fedwire right over time over the course of the subprime boom and as you can see there's a very close correlation between the boom and payments rising and the bust and payments collapsing imagine that instead we'd had a system at work a competitive system without the Fed that tended to maintain a stable equilibrium of spending relative to reserves we'd have kept to that straight line that I've drawn into the picture or something closer to it and we'd have had a much nicer time alright enough about Scotland let's talk about England first of all I want to remind everyone that the early central banks including the Bank of England they weren't set up for the purpose of achieving greater financial stability they were set up for fiscal reasons particularly in the case of the Bank of England to help pay for the war with France the law establishing the Bank of England was an act that was primarily a revenue measure and so it shouldn't surprise us if these institutions these privileged institutions and the Bank of England again in particular should actually have a destabilizing consequence instead of participating in chain-gang like competitive regulatory process a privileged central bank is more like a Pied Piper that can lead all the other banks in a general expansion or in a general contraction why is that it's because when one bank has special privileges in the case of the Bank of England those privileges amounted at first to something like a monopoly within the London area of currency eventually they expanded to become a complete monopoly of currency in all of England when that those privileges exist the less privileged banks will find that it's convenient for them to treat the notes and other claims against the privileged bank as if they were reserves rather than in this historical context gold itself so the tendency was for the other English banks to actually send all their golds to the Bank of England in exchange for Bank of England notes or for other claims against the Bank of England and then they would use the Bank of England notes to make their own payments to their customers because they couldn't issue currency themselves here's what happens when you do that this is the same picture as before starting with the equilibrium with gold being the only reserve now imagine the gold all gets shipped to a central bank the Bank of England and it heaps its own IOUs on top of this gold treating the gold as reserves as a basis for its own expansion and now the total sum of reserves is no longer equal to the available gold it's equal to the amount of IOUs that the central bank chooses to create and so it can by choosing to put more io u--'s into existence it can allow a general expansion by all the other banks that have access to these as it where paper reserves and the system can be encouraged to expand now if that makes sense allow me to explain why England had lots of crises and more so than Scotland when the Bank of England whether there were the the amount of spending in England would clearly depend on how generous the Bank of England was in credit creation if it created more credits it made more a paper reserves available to other English banks and led them all in a general expansion which would raise total spending but that would tend to raise prices to write more economics MV equals py where P is the price level and Y is the output of the economy the tendency would be for more spending to raise prices in the world of the gold standard or any kind of specie standard gold or silver if prices in England went up relative to prices elsewhere in the world eventually a tendency first described by David Hume another Scot would kick in and the tendency was for gold to now starts to leave England and to go to places where prices weren't so high because in gold terms goods were cheaper to buy in those other places and that was essentially the basis for the classic if you like 19th century late 18th century English financial boom-bust cycle excessive expansion by the Bank of England leading to corresponding expansion by the whole English banking system to rising prices to the beginnings of an outflow of gold from the Bank of England which would cause the Bank of England to suddenly contract credit in order to save its own reserves and avoid going bankrupt and that would plunge the economy into a crisis the point is not simply that England was exposed to crises of these of this type again and again but that Scotland even though it was operating on the same British pound unit escaped those crises it was notoriously free from crises that were afflicting England time and again and the difference was that prints between the banking systems of the two country at least no one's been able to identify any other reason why Scotland should have escaped trouble this cartoon is for appeared at the time of the panic of 1825 a major English panic and as you can see it illustrates the point that Scotland doesn't seem to be troubled by these panics as similar cartoons might have been drawn for other episodes in 19th century Scottish banking history now this fellow you've probably heard of or you know about his book or both this is Walter Paget and Walter Paget's very important because he plays a somewhat tragic part in the story of central banking and of financial instability Badgett wrote Lombard streets in 1875 and most people understand Lombard streets to have been the book that drove home the necessity of the Bank of England serving as a lender of last resort during crises specifically when faced with an external drain of specie of gold or silver the bank was to lend heavily to any solvent firm and high interest rates now Badgett and this is the tragic part has been understood now by a general generations of central bankers as having positively recommended central banks because if you can't have a lender of last resort how are you going to prevent crises in fact Lombard streets is quite explicit in saying that what was really behind the crises in England was the monopoly of the Bank of England which allowed it to acquire all the gold and to centralize the reserves and it was this system of a centralized reserves at the Bank of England that was the ultimates problem as far as Badgett was concerned and he argued that if England had could have it would have been best off never creating a monopoly Bank of issue and never having the centralization of reserves that took place because it had done so and he what he says is I'm offering this lender of last resort advice instead of advising that we get rid of the Bank of England only because I don't think anyone will listen to me if I make that later recommendation we are as stuck with the Bank of England as we are with the British monarchy we just have to figure out a way to make them do as little harm as possible so the sad thing in the tragic outcome of a misunderstanding of badger which is still being perpetuated by central bankers everywhere is that he has been read as recommending central banks to us and of saying that they are desirable these are some passages from Badgett that you can read on your own if you like that basically are among those there are several places in the book where he is very clear that the best system is a system with competing independent banks holding their own cash reserves and not the system with a central bank holding all the gold in the country now I want to say a little bit about another comparison I've talked about the difference between England and Scotland I want to talk about America now and the difference between the United States monetary experience and the experience of Canada it's important that I do so because after all we had financial crises in the United States but we didn't create a central bank until we established the Fed in 1914 but of course while I do believe like Badgett that central banks are inherently destabilizing that doesn't mean that you can't have instability financial and economic instability without a central bank in the United States is a good example of how that can happen it happened in particular after the Civil War because of some very badly misguided financial interventions that took place in connection with the Civil War and by the way the common theme here is when government stant with their monetary systems to achieve fiscal ends stability goes out the window during the civil war we did a number of things most of them ultimately harmful one of which was to create a new system of banks the national banks and we still have national banks today and to empower them to issue notes under the requirement that the notes be backed by US government securities here you can see if you look closely at this note it says this note is secured by bonds of the United States deposited with the treasurer blah blah blah well the idea was simple we had a war to pay for if the bank's the new banks could all be forced to back their notes with u.s. securities this would generate revenue to help pay for the war oh and it might make the currency safe so long as the bonds hold their value which was a dubious assumption at the time of the war but not afterwards the problem though with this setup is that it tied the total supply of currency to the available supply of government debt after the Civil War we started to retire the debt there was less and less secure there was less fewer and fewer bonds available to secure national banknotes state banks have been forced out of the currency business by another Civil War measure and this chart shows I know it's hard to read it shows what's happening to the supply of national banknotes from 1880 to 1909 and as you can see especially from 1880 to 1890 the mid 1890s there's a dramatic collapse of the supply of currency from over 300 million dollars worth almost 350 million worth to less than half that amount in the course of the first decade of shown on the chart this is a supply of currency that's contracting dramatically in a growing economy this is not a very good situation and it's all due to this guy city of bonds I'm explaining this to you because many people will tell you that we set up the Fed because unregulated banking didn't work before them but this is regulation causing trouble not lack of regulation the other thing that you should note about the chart is there's no seasonal adjustable adjustment of the supply of currency there are no peaks at harvest time yet it was notorious that at harvest time there was a very strong increase in the demand for circulating money relative to bank deposits our system was utterly incapable of accommodating that change seasonal change in the demand for currency now I'll talk about the other line on the chart later but let's ignore it for now and just point and let me just point out that this was one of several regulatory reasons why we had a series of terrible financial crises in the United States culminating in the panic of 1907 Illustrated here there were appendix in 1884 1893 1873 in all of them these restrictive regulations concerning currency played a very important role now if you don't believe that regulations were important then let's take another look at this chart because that other line in the chart what it shows is the supply of currency that seems to behaving the way our priors would think it should have behaved at the time as you can see there's some secular growth in supply and there's also a nice spike in the supply of currency consistent with the harvest season of August to September or October it looks to a modern central banker at least as if there must have been a good wise central bank managing the currency supply and Canada and making sure it was always just adequate to fluctuating needs and secular needs except if we take a closer look it turns out that this is the stock of Canadian bank notes Canada's about 1/10 the size of the US economy it uses the same dollar a standard much as Scotland and England used the same pound standard back when and still today the Canadian supply of currency does indeed seem to behave very well but central banking had nothing to do with it in fact Canada didn't have a central bank until 1935 yet this situation this flexibility of the Canadian currency supply allowed it to avoid all the crises from which America the United States rather suffered much as Scotland avoid the avoided the crises that England suffered and guess what the currency system of Canada was modeled after the Scottish system in fact it would set up by Scottish Canadians who call themselves scotch Canadians I believe and they had multiple banks of issue subject to very few regulations nationwide branching the whole thing repeated on the American continent so here we have two examples of course no two countries are like and Scotland is much smaller than England economically Canada was much smaller than the US and yet to collectively these I think these comparisons are very important the sad thing about them is that whereas people back when in the 19th century were perfectly a ware of the differences between these systems for the most part people have forgotten certainly in the United States today very few people know that Canada was crisis free at a time when we were battling with one crisis after another now as you know the United States did not deregulate its financial system in order to solve the problems that that system was faced with instead we set up a central bank the Fed in 1914 by the way this was only after numerous attempts to deregulate the system were made all Scotch the Republican leadership in the Senate which was in bed with New York powerful New York banks and favored therefore a solution that would protect the interests of those banks I have a new paper coming out about this called New York's Bank if you ever want to read it it will be available from the cato institute we know that the Federal Reserve did not in fact eliminate financial crises in the United States I won't bore you with the details we have a recent episode to drive that point home instead let me just say instability in the United States has not been reduced even compared to the terrible record of instability before the Federal Reserve was established here is a quote from a paper by Christina Romer one of our more authoritative fine ana tearing historians writing that major real economic indicators have not become dramatically more stable between before the first world war that's the period we were talking about and after world war ii only recessions have become slightly less severe on average slightly less severe that was in 1999 this comparison leaves out the period between the two wars as if it were practice if you put in the Great Depression and the also the crisis of 36 and 37 the crisis of the early 30s both being part of the Great Depression the crisis of nineteen twenty twenty-one the record of stability since 1914 is infinitely worse than the record of stability before 1914 which was terrible because of regulations now add in the subprime crisis and you're going to find that the statistics look even worse for the post Fed period for to claim for anyone to claim that the Fed has been a solution to financial instability is for them to ignore what the record actually shows well then what about price stability that's the other thing I'm supposed to say something about and the reason why I messed around with the title of my talk is because one of the main things I want to say is that a stable prices or a stable rate of inflation is not desirable or necessary for financial and overall monetary and macroeconomic stability and the simple reason for that is that prices general prices can rise or fall for more than one reason and it's a very important to distinguish these different reasons when central bankers talk about deflation today they have a tendency to assume that the only way deflation can happen is because spending is collapsing and of course if spending is collapsing then that is unfortunate the RAI decline in prices that happens is itself actually not what's bad what's bad is the fact that people are spending less and this is not only reflected in falling prices but more seriously reflecting info' reflected in declines in output with less output you also have less employment this is what typically happens in downturns like the downturn of 2008 2009 or 1936 and seven or thirty seven and eight or 1932-1933 a collapse of spending and by the way in every one of these episodes I just mentioned Federal Reserve mix misconduct played a crucial role I don't have time to go into it but in any event in these deflation episodes which are usually short relatively short term demand collapses and therefore there's less spending to purchase goods and fewer goods being demanded less labor will be demanded as well so unemployment ensues but but prices can also fall because there's more output of goods because supply has improved rather than demand suffering a setback and that's quite a different sort of deflation here we have more goods being produced at cheaper costs prices fall to reflect falling costs but quantities are growing is the quantity demanded is going up most deflation throughout history until the 20th century was this good sort of deflation for example in both the UK in the United States between 1873 and 1896 or so you had a long stretch we had a long stretch of deflation and a mild rate of something like what less than two percent annual rate but for the most part that deflation was good deflation that is it had nothing to do with collapsing demand although there were cyclical episodes where demand was collapsing it had it was mainly a result of productivity gains from all sorts of technological improvement which under the gold standard were allowed to be reflected in falling prices because the output of money into the gold standard was adequate to provide for some kinds of of growth population growth and other things but it so happened that it allowed prices to fall at least pending new gold discoveries in response to improvements in productivity there's a myth by the way still subscribed to by some economists that the whole period from 1873 to 96 was a another Great Depression a Great Depression it lasted more than two decades but they draw that inference some experts simply from the fact that prices were falling and the and by making the assumption that if prices were falling everyone must have been depressed oh how do you get in there here's a chart that here's a chart that actually is very revealing about the period I was just talking about focus on the red line the the blue line shows what prices were doing as you can see they're declining this is in the united states from an indexed number of just shy of 12 down to almost zero now if you look at the red line that's spending look at that line remember what I've claimed is what you want is stable flow of spending it can have a positive you can have positive growth in spending but you want it to be growing steadily that's not quite what you have you have these dips around eighteen seventy three four five and then there's another dip around eighteen seventy three four and then there's another dip around eighteen ninety three those are three of the crises I mentioned in every one of those cases you had bad deflation as well as good the bad deflation is related to the collapse of spending all the rest of the deflation is actually not due to any decline in spending any temporary decline it's all due to improvements in the availability of goods to productivity growth it's all good deflation and so it's stability of spending and it can be stability of spending that is consistent with prices tending to fall if productivity circumstances if the progress of productivity calls for it that's what is really desirable for overall macroeconomic and monetary stability the the alternative fetish with maintaining a stable rate of inflation without regard to what that implies about the management of spending is a cause of a lot of economic trouble for example during the subprime boom spending was growing very rapidly but their eyes fixed on the inflation rate American bank central bank authority's monetary authorities did not see this as a reason to raise interest rates and tighten credit and as a result contributed a lot to the subprime boom in 2008 in contrast when spending began to collapse and eventually it collapsed quite a lot still focusing on inflation and particularly on headline inflation which depended heavily on oil prices the authorities saw no reason to create more credit and to try to something that would revive spending in both cases they contributed to the overall calamity that was the subprime boom and bust here are some authorities talking about good and bad deflation economists have finally gotten around to discovering that good and good deflation is very common in the empirical record but the monetary authorities around the world are still lagging in this understanding and still therefore suffer from a price stabilization or inflation stabilization fetish which again can cause trouble it's not in other words simply that letting prices fall sometimes is harmless it's when central bank's prevent prices from falling at those times that they can actually create asset bubbles that end up popping this is extremely important by the way I just wanted to make clear most any monetary expert you talk to will agree that prices of certain things should get cheaper as their cost of production declines I can't I can't imagine an economist saying that there was anything that there's anything wrong with the price of computers declining over time because we're able to produce them and even produce better ones at lower and lower prices but many of those same economists believe implicitly that to the extent that we have goods like computers that are tending to get cheaper by gosh we'd better make sure we have some others that get more expensive or the price index will decline and that must mean that we end up depressed this is a sort of thinking that's very common in the economics profession that we really have to try to counter it is possible after all for the vast majority of goods or for many Goods anyway to be getting cheaper at the same time in unit cost of production why shouldn't the price index fall to reflect that the only answer is because central banks won't let it and when they won't let it they destabilize now this is just illustrate productivity growth and there's my computer's I've said all along that spending stability of spending is really what's required for macroeconomic stability not stability of any price index or inflation rate I've argued that a free banking system has a built-in tendency to stabilize spending because of the way the demand for reserves depends on how much spending is going on in all of this I have a common ground with the market monetarists and this slide shows two of them David Beckworth who's actually a student a former student of mine and Scott Sumner these fellows have been arguing I think quite convincingly that a lack of stability of spending contributed to the recent crisis and that central banks should adopt some stability of spending as their criteria of overall monetary stability well we're a little bit ahead of them we free bankers because we've kind of known that we just happen to think that central banks are poor instruments for implementing this idea and that markets can do it better if you would only let them now in the modern context of course we have got fiat moneys we don't have gold we have to have something to artificially constrain the growth of fiat monies whether you call it a central bank or not - mmm that's a matter of semantics but I believe that what we should have if we have any sort of central bank is something very stripped down that simply maintains a stable supply of reserves than if we would allow our banks to do their thing free from harmful restrictive regulations we could have a free banking system that replicates some of the success of former such systems so we come all the way back to the Scottish case we can't turn back the clock of course and nobody wants to I get accused of that sort of thing all the time it isn't a matter of replicating what unhindered markets did in the past but I think it is important to recognize what they did and ask ourselves whether we have taken the wrong path in the last century or more relying more and more on centralization of our monetary systems and regulation by government of those monetary systems instead of relying on competitive forces as we have done for most other industries to give us the kind of stability that's really desirable both stability of our financial systems but also the kind of price stability that's really desirable which isn't absolute stability but a stability that allows the price system to signal to us as clearly as possible the state of costs in society a price system that allows you to look at a good that's falling in price and say ah isn't it nice that that stuff is cheaper to make these days than it used to be that's what a that's the kind of price stability that really matters and the kind that we should be arguing for and it's only once people understand this that we may be able to take the next step and encourage them to embrace market-based financial regulation which produces the good kind of stability the right kind of price stability and not the phony kind that central banks have been obsessed with for so many decades now I think I will stop there is that a little earlier is it about right perfect very good

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Keywords: Institute of Economic Affairs, Cato Institute, Professor George Selgin, Free Banking, Central Banks

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Length: 43min 53sec (2633 seconds)

Published: Wed Jun 15 2016