THE GREAT RESET: CENTRAL BANKS OR COMMERCIAL BANKS? / MACLEOD FINANCE

The great reset: Central banks or commercial banks?

Those talking of a great reset assume that it will be driven by governments and not markets. But if past failures are to be eliminated, what is the future of banking?

ALASDAIR MACLEOD

Surely, it is now apparent that central banks are guilty of mismanaging the economy. 

By slashing interest rates to zero and in some cases to an unnatural minus figure; then flooding financial systems with currency-level credit, followed by rapidly increasing interest rates in an attempt to stem the consequences central banks have bankrupted themselves and much of their entire economies.

Even though hapless economists and money managers are still in thrall to them, central banks have proved themselves to be unfit for their purpose. 

It is time for a new system based on true productive economic demand for credit without state interference. 

It is time to consider central banking versus free banking, given that with their losses on quantitative easing central banks are trading while insolvent — a criminal offence in the private sector for which directors would risk being jailed.

This article compares free banking under gold standards without central banks, and today’s fiat currency system which gives central banks the power of debasement. 

Commercial banking without central banks is the historical norm, and the evils of statist currency management is a more recent development.

England’s 1844 Bank Charter Act is the basis of central banking

Given that the Romans invented banking, and that Italian banks adopted the modern form of credit creation through double entry bookkeeping in the late-fifteenth century, commercial banking without central banking has a far longer history than with it.

While the Bank of England only existed as a central bank following the 1844 Bank Charter Act (it had for a long time previously operated as a commercial bank with the monopoly of the government’s business, which is not the same thing), and America’s Federal Reserve Board came into existence before the First World War, central banking per se spread more widely from then on, coinciding with the end of gold standards, particularly in Europe.

The failures of the Bank of England in the years following the 1844 Bank Charter Act were down to its crude attempts at interest rate management. 

The Act, which was based on currency school precepts, assumed that the separation of the issue department from banking was the solution. 

It wasn’t, proved when the provisions of the Act with respect to gold cover for the note issue were suspended only three years later in 1847, then in 1857, and in 1866.

Amazingly, the legislators and the bank itself did not anticipate that the run on its gold reserves would come not from the public cashing in bank notes for sovereigns, but from deposit balances in the banking department being encashed for bullion.

The Bank made the further error, which persists to this day, of trying to manage interest rates to achieve economic outcomes. 

Interest rates should have been managed solely in the context of maintaining gold reserves. 

At least modern currency board operators have learned this vital distinction.

Today, modern economists tend to dismiss currency boards as well as free markets. 

Their solution to problems, mainly of their own creation, is to double down on regulations by increasing their scope and complexity. 

An entire industry of regulators, policy managers and hangers-on has been created to intervene.

Naturally, those employed in bank regulation support its continual expansion. 

For this reason, the practical simplicity of a gold standard and currency boards gets short thrift. 

This ignores the lessons of history, that the world evolved from its feudal state through the industrial revolution to a standard of life for the commoner which would have been the envy of kings only a century before — all on the back of the availability of commercial bank credit.

There have been upsets along the way: but the question to be addressed is whether commercial banks in their relationships with each other can minimise those upsets, or can governments through their central banks achieve a better outcome?

The monopoly over currency provision stems from the 1844 Bank Charter Act in English law, not adopted by the Scottish banks — Scotland had and still has its own legal system, which to this day sees the major banks issuing their own bank notes fully backed by reserves at the Bank of England. 

The withdrawal of the facility whereby English banks issued banknotes only served to consolidate the government monopoly over currency.

Currency has come to be regarded as national money, and not the credit liability of a central bank. 

The importance of this development tends to be overlooked. 

Few economists today seem to understand that a banknote is actually a liability of the central bank, and not money without counterparty risk.

When a commercial bank issues banknotes, the notes are bound to have a similar rating to a deposit at the bank, the only difference is that a banknote is a promise to its unknown bearer. 

Notes issued by the Scottish banks are readily accepted as if they were issued by the Bank of England.

If the facility was reintroduced more widely, a bank could issue banknotes to rank as a substitute for the national currency. 

It may be that a bank would not take up this facility anyway, bearing in mind that London bankers ceased issuing notes in the 1790s, fifty years before their issue was prohibited in the 1844 Act. 

But there is no substantive reason why issuing bank notes should not be permitted, and if demanded by a bank’s customers a commercial bank’s notes would simply circulate alongside notes issued by the government issuer, as do the Bank of Scotland’s in Scotland.

Therefore, the credibility of a bank’s notes is closely tied to that of the national currency. 

Statist involvement in credit should be limited to providing stability of this value. 

It can only be achieved by issuing banknotes and deposit facilities totally backed by real, legal money, which is gold. 

The issuer must be charged with the sole responsibility of ensuring gold backing for its liabilities is always there. 

The issuer’s balance sheet would consist of notes and deposits as credit liabilities, and the assets entirely comprised of gold bars and coin. 

It is a public service. 

And the directors of the issuer must be charged with managing interest rates purely with a view to maintaining gold reserves. 

The issuer must be independent from all other financial activities.

In this way, credit generated through banking operations becomes a purely commercial consideration. 

Bank credit is a function of commercial banking, referenced to the rate set by the issuer solely by virtue of its management of gold reserves. 

To satisfy its depositors’ likely demands for coin or bullion, a commercial bank can either maintain a deposit at the issuer gained by submitting gold in exchange or buy coins and bullion in the market. 

This is sufficient to tie the value of commercial bank credit to that of the national currency, which unquestionably becomes tied to gold.

The error in the 1844 Bank Charter Act was to split the Bank of England into two departments, but under the same management. Its banking department was no less a credit dealing operation than any commercial bank. 

It was the inherent conflicts, particularly over the setting of interest rates which led to the 1844 Act’s failures.

Whether the state maintains a banking presence in the commercial banking system becomes a separate issue. 

But management of economic outcomes by interest rate manipulation has proved to be a dead duck, and that interest rate management can only be to maintain and manage gold reserves. 

Then there is still to address the thorny question of the need for a lender of last resort.

Free market theory posits that this is unnecessary. 

In the knowledge that there will be no bail outs, bankers can be expected to pay proper attention to their own counterparty risk and that of their peers in wholesale markets. 

The faintest suspicion of irregularity would be immediately reflected in a bank’s credit rating in interbank rates. 

And it is not beyond the ability of banks within the commercial network to deal with banking failures, because it is obviously in their collective interest to maintain systemic credibility. 

This is another lesson drawn from the pre-central banking era.

The perfection of clearing systems

The volatility of prices due to Britain’s bank credit cycle abated in the decades following the Napoleonic wars due to improvements in clearing systems, as the chart of wholesale prices below shows:

A clearing system for the London banks was set up in the late eighteenth century, when for the first-time daily differences were settled between the banking members on a net basis. 

The Bullion Report in 1810 stated that there were 46 private bankers in London who cleared a gross value of £4,700,000 daily by a net settlement of £220,000 in bank notes. 

This was a significant improvement on the earlier system whereby bank clerks walked around London, visiting other banks to settle claims.

In 1854, joint stock banks were admitted into the London clearing system, and the Bank of England only joined in 1864. 

By then, the system of settling balances in banknotes was done away with, replaced by bankers’ drafts settled twice daily with a final reconciliation in the late afternoon. 

Furthermore, over time other cities established similar clearing systems as well as developing intercity arrangements.

Over the time covered by these increasing refinements to interbank settling, wholesale prices became decreasingly volatile. 

In other words, as commercial banking became increasingly efficient, the impact on prices from the bank credit cycle as credit was alternately expanded and contracted diminished. 

This was despite cyclical banking crises late in the century, such as the Overend Gurney failure in 1866 and the Barings crisis in 1890.

Given that the objective of a central bank is to ensure price stability, it amounts to evidence that its intervention function in economic affairs is not only not needed, but it is disruptive. 

No central banker will publicly admit this. 

An insistence on maintaining the central banking status quo strongly suggests that an admission that economic intervention always fails for the reasons stated herein will only occur when the failure is total.

In other words, central banks’ intervention in economic affairs will only stop when it takes down all value in their currencies by which their credibility is measured. 

Those who argue that central banks represent progress from free banking are clearly in the wrong.