JOURNAL OF BANKING AND FINANCE
Journal of Banking and Finance 14 (1990) 821-831. North-Holland
Charles Goodhart, The Evolution of Central Banks Cambridge, MA and London, UK, 1988) pp. viii+205, bound), US %11.95 (paperback).
(The MIT Press: US $22.50 (hard-
This book addresses a kind of issue that economists should deal with, and in a fashion - with a language - that is the common province of everyone. Goodhart treats a question that has become fundamental for monetary policy: is your central bank really necessary? He finds it not only necessary but a ‘natural’ emergence in mankind’s evolutionary development. The records of central bankers in managing monetary systems over the last 70 years, however, have not been exemplary. By any criterion - price level stability, real growth, employment - economic performance under central banking has been significantly inferior to what occurred under an international specie standard for a similar period before World War 1. Furthermore, central bankers have proven not to be the vestal virgins of monetary virtue that the wishful thinkers of rule-by-men would have them. They have often carried out policies that have maximized the welfare of the governments they serve and, by extension, their own best interests, rather than the welfare of private households and businesses. As the institutional character of central banks has matured in the last quarter of the twentieth century; many economists, such as this reviewer, have posed for themselves a thought experiment: suppose that in an ongoing free market pecuniary economy private entrepreneurs were suddenly given license to produce money without a central bank to initiate the process. What would be the result? Would it be ‘chaos’ - the knee-jerk response? Or would a spontaneous market development bring order out of incipient chaos? Part of the big answer to these questions is theoretical and part is empirical. But whatever the conclusions, the arguments are at the present time strictly intellectual. The political victory of central banking is complete and will endure into the foreseeable future. Governments, composed of selfinterested ‘agents’, recognize all too well the advantage of monopoly control over monetary systems and they are not about to relinquish it. The intellectual battle, however, is now ongoing, and Goodhart addresses the issues forthrightly. He summarizes in his introduction the evolution of central banks from government depositories and monopoly issuers of paper notes to their ramification into larger roles - the ‘micro function’ of providing liquidity to individual banks at times of crisis, and the larger ‘macro function’ of overall monetary management (p. 7). Goodhart is largely 0378-4266/90/$03.50 0
Science Publishers B.V. (North-Holland)
concerned with the former role. He argues that the central bank in providing liquidity to needy commercial banks necessarily assumes a supervisory role. If the central bank assists banks without sanctions over their behavior, it opens up a ‘moral hazard’ problem. That is, if it acknowledges its willingness to lend freely in a crisis, it encourages laxity on the part of its commerical bank clients and thereby encourages the very crisis it seeks to alleviate with its bounty. Therefore, the central bank has to supervise and regulate its brood of commercial banks in order to prevent the more prodigal of its dependents from abusing their privileges. Goodhart examines the case for free banking without a central bank, noting that two preeminent economists who wrote classical works on this subject - Walter Bagehot and Vera Smith - favored free enterprise banking in principle but accepted central banking in practice. Goodhart brings the clearinghouse association (CHA) into the picture as the means that, free banking advocates argued, would prevent the overissue of bank liabilities. From an institution that made the payments system more punctual and economic, the CHA, Goodhart notes, extended its services to that of lender of last resort, and even assumed some supervisory functions to forestall the moral hazard problem. The CHA was one example of the ‘natural’ tendency of commercial banks to centralize reserves. Other ‘central commercial banks’, such as large banks in major commercial cities acted in this same capacity. However, a central commercial bank could not be profit-making and also sequester reserves to be used in a crisis. The most critical aspect of Goodhart’s argument centers on his rejection of the CHA in its role as a private lender of last resort. He does not deny the success of CHAs in stopping the contagion of panics in the United States during the latter half of the nineteenth century (including especially the Panic of 1907). His rejection of the clearinghouse institution centers on what he regards as the ‘conflict of interest’ between the role of the CHA as a provider of reserves for needy banks and the possible denial of reserve relief to banks that CHA directors would just as soon see go bankrupt in order to reduce competition with their own banking institutions. Goodhart makes this same charge to reject any kind of central commercial bank. His ‘natural’ evolution of banking ends with a government operated central bank that is free of conflicts of interest between private parties. Goodhart supports his conflict-of-interest argument with an empirical case study in which the New York Clearinghouse Loan Committee in 1907 denied loans to four banks that might have been saved from bankruptcy because of their connection with an unsavory banker personality (p. 42). This evidence, however, does not substantiate his case. Certainly, a private central banking institution sequestering ‘emergency’ reserves is incompatible with competitive profit maximization. The NYCHA, however, was not a bank. It tit more into the category of a ‘club’. Furthermore, not only did the NYCHA work, but
the whole system of CHAs worked. By 1907, the model of the New York Clearinghouse Association had become ubiquitous: ‘Clearinghouses’ popped up in towns where only one bank existed in order to provide emergency currency. All of which is a way of saying that CHAs themselves were competitive institutions trying to attract ‘club’ members. Therefore, they would be unable to discriminate unfairly among their client banks if they wanted the club to continue to exist. In addition to the conflict of interest argument which leads Goodhart to prefer a governmental central bank, he also makes much of the informational inadequacies of poor people in judging the quality of different private moneys. This problem, he notes, also can be solved by formation of a ‘club that disseminates information in the same fashion as a medical association or an investor group. Again, if the club is composed of private participants, it may result in conflicts of interest. When this analogy is applied to the central bank monetary system, Goodhart argues, the non-competitive becomes the proper institution. To confirm his argument, he states, ‘. . . the foundation (of central banks) has generally been supported by the (commercial) banks, certainly by the larger, well-established banks.. .’ (p. 72). Does not this argument, however, imply a conflict of interest? Why have the large commercial banks supported central banks? Did they not believe that the central bank would effectively subsidize their own operations? And did not many bankers believe that they would be able either to manage the central bank, or to control those who did, to their own advantage? In short, is not a governmental central bank a typical ‘rent-seeking’ public choice type of institution? The cost of the central bank ‘club’ is not cheap, Goodhart observes. So how is the cost distributed among the members? Either from seignorage or taxes, in which case ‘this problem (of payment) is less acute’ (p. 74). In the United States the Federal Reserve System currently realizes between $15 and $20 billion annually as seignorage. The U.S. Government gets 95% of this revenue, while the Fed gets a billion or so for its ‘costs’. Somehow, a central bank that can generate this much unaccounted and unlegislated revenue can hardly be cited as a ‘less acute’ problem. Goodhart also treats the possibility of private deposit insurance and the extension of banking services by non-bank institutions. His discussion here favors mutual fund banking as well as other innovations in the payments system. Even so, however, bank-runs from one bank to another, due to depositor portfolio changes, may still occur. This contingency requires a central bank to act as a yardmaster in channeling funds around (pp. 101-102). In this conclusion, Goodhart recapitulates his arguments for a ‘public sector’ central bank. He then devotes 50-plus pages to an appendix in which he gives cursory accounts of central bank evolution in several European countries and Japan.
The author has an impressive professional background for his views and analysis. Aside from the question of whether his all important ‘conflict of interest’ argument against private lenders of last resort, i.e., clearinghouse associations, is correct or not, another major consideration is: what is the alternative? The alternative to the private CHA is the government central bank. But this institution requires at least as skeptical an approach as the private institution. Occasionally, Goodhart recognizes the fallibility of contemporary central banks; but he does not balance his conflict of interest criticism of the private CHA with a similar exegesis on the public choice characteristics in government central banks. If he had, he could properly pose the question: when all the benefits and all the costs of each institution are weighed in the scales, what are the conclusions? The Evolution of Central Banks is a worthwhile addition to the literature on monetary systems and central banking. It shouId be read by every economist who is concerned with the systemic fundamentals of current monetary systems. Whatever conclusion one reaches, the debate itself is crucial - not only for monetary systems but also for the existence of constitutional processes in free societies. Richard H. Timberlake The University of Georgia Athens, GA, USA
Clifford W. Smith, Jr., Charles W. Smithson and D. Sykes Wilford, Managing Financial Risk (Harper & Row, New York, NY, 1990) pp. xvi +416, us $45.00. Over the last decade,
financial markets have become highly voiatile. convinces the reader that this financial risk threatens to endanger even the soundest company. At the same time, however, it suggests that a remedy is not far away because various kinds of financial risk, as well as the degree to which firms are exposed to these risks, can be ‘measured’. Given the wide variety of hedging opportunities provided by the ‘financial building blocks’ such as forwards, futures, swaps, and options, any risk profile can be altered through a sophisticated use of these instruments. The authors quite successfully try to convince the reader that nothing more than an understanding of the basic features of these instruments is required for their sophisticated use: ‘This stuff is not as hard as some people make it sound (p. xiv). Part I provides an overview of the management of financial risk. The increased volatility of exchange rates, interest rates, and commodity prices in the 1970s and 1980s is, respectively, linked to three factors: (1) the Managing