Vera Smith’s five reasons for central banks : Are They Any Good?

I doubt how many of today’s monetary scholars have read Vera Smith’s dissertation- The Rationale for a Central Bank? What must have been a must read some years ago is hardly part of any course these days. The thesis was written under Hayek’s supervision and looked at reasons behind formation of various central banks.  We take central banking for granted without looking at various ways in which they come in different countries.

Karl-Friedrich Israel has a piece in Mises Institute which looks at five reasons given by Smith for having a central bank. Smith gave these reasons during GOld Standard days. After many years, do the reasons remain valid?

In a time when Federal Reserve reforms are discussed more openly than ever before, it seems appropriate to also think about the more fundamental question of whether central banks are needed in the first place. In 1936, Vera C. Smith (later Lutz) published her doctoral dissertation The Rationale of Central Banking written under Friedrich A. von Hayek at the London School of Economics. Smith reviewed the economic controversies around central banking from the nineteenth to the early twentieth century in France, Belgium, Germany, England, Scotland, and the United States.

Smith made very clear that central banks are not the result of natural developments in the banking sector, but come into existence through government favors.

So what are the justifications for central banks? Smith identified five main arguments for central banks from an economic point of view. Although Smith has written with a gold standard as the underlying monetary system in mind, it is interesting to look at these arguments with the benefit of hindsight more than 80 years later. Has any one of the arguments actually made a strong or even conclusive case for central banking?

What are the five reasons?

  • One: Uniform Distribution of Risk
  • Two: Over-issue of Notes and Excessive Credit Expansion
  • Three: The Lender of Last Resort
  • Four: Central Banks as a Means to International Cooperation
  • Five: Rational Monetary Policy

It is the fifth point which has led central banks to come to prominence:

The last argument gained attention in the post-World War I era and is indeed the most relevant for us today. Traditionally it has been the aim of monetary reformers to introduce automatic mechanisms of adjustment into the financial system. According to the fifth argument, however, it would be beneficial to pursue an active and rational monetary policy of controlling the volume of cash reserves and credit guided by “scientific criteria.” A central bank would be indispensable for its implementation. The main policy tools would be discount rate setting and open market operations.

The abandonment of the classical gold standard and the introduction of a fiat standard has indeed given more power into the hands of central bankers and fostered the notion that central banks should consciously manipulate the money stock. Any argument or scientific criterion that requires monetary expansion of a certain magnitude is implicitly at least also an argument for fiat money and, a fortiori, for central banks.

The first criterion that has been held up as scientific was price stability. The money stock should be expanded at the rate of real economic growth to keep the general price level constant. However, as Vera Smith pointed out this criterion “has been suspect in theory and just as unfortunate in practice.”

Modern macroeconomics that has developed after the publication of Smith’s work has rationalized monetary expansion even further by arguing for a stable rate of price inflation instead of price stability. Yet, again no study has been presented so far that can be regarded as proof of the overall economic benefits of inflation. In particular no study has shown that the problems of moral hazard, increased systemic risk, perverse redistribution of wealth from bottom to top, and unsustainable inflationary booms are in any way offset by potential benefits of expansionary central bank monetary policy.

That there are benefits of central banking for certain groups is pretty obvious. Leland Yeager in his preface to the Liberty Fund edition of Smith’s book pointed out that it is reasonable to suppose that central banks are valued today, among other things, for providing prestigious and comfortable job opportunities for economists. Nothing is so bad that it couldn’t get worse.

The last para says it pretty much. Who better than economists to respond to incentives? Central banking jobs bring so much prestige with media and financial sector attention. Add several “government funded/subsidised perks and benefits” to make the package even better..


One Response to “Vera Smith’s five reasons for central banks : Are They Any Good?”

  1. 2 – Blockchain History: 1996, Douglas Jackson and EGold | Traffic.Ventures Social Says:

    […] with as little state involvement as possible, as the best vision for an economy. Through his self-taught knowledge about the history of money and central banks he deduced that letting go of the gold standard was a […]

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