It Just Ain't So

So America's financial system was unregu lated before 1930? It just ain't so! In truth, Civil War legislation nearly wiped out the antebellum state banking industry, setting up new national banks that were forced to back their notes with government bonds. Eligible bond collateral became increasingly scarce during the last quarter of the nineteenth cen tury. Over the course of any year, such banks were prevented from meeting seasonal peaks in currency demands. The result was an inelastic stock of national bank currency, 4 which gave rise to serious "currency short ages" in 1884, 1893, and 1907. Government regulation thus played a key role in the "destructive business cycles" that Mr. Garten so unhesitatingly blames on the invisible hand. In addition to setting unnatural limits to the stock of currency, the government also pro hibited national banks from setting up branch networks. This resulted in the proliferation of thousands of under-diversified and failure prone banks. In Canada, where chartered banks were free to issue notes and to branch nationwide, bank failures were few and far between, and not a single bank failed during the Great Depression. In the United States, by contrast, several thousand banks failed during the 1930s alone, and almost all of them were "unit" banks lacking any branches.

Canada, it should be noted, established a central bank in 1935. Economic historians still wonder why, since its monetary system had withstood the depression better than those of other nations having central banks, includ ing the U.S. system. Mr. Garten suggests that central banks such as the Fed prevent business cycles. But the United States suf fered a serious downturn in 1921 and its most serious depression of all starting in 1929, notwithstanding the Fed's establishment in 1913. The years since World War II have not witnessed another Great Depression, but the business cycle has hardly disappeared, and secular inflation has become an additional problem. The truth is that in combating financial crises, central banks have proven to be highly costly and unreliable substitutes for structural improvements in the banking industry, name ly, branch banking, competitive note issuance, and foreign bank entry. Central banks have all too often undermined the solvency of private financial firms. The U.S. savings and loan industry became insolvent in the early 1980s mainly because of Fed-sponsored inflation, which dissolved the value of long-term home mortgages negotiated a decade or more before. The S&L mess was worsened by the perverse effects of deposit insurance, admin istered in this case by the Federal Savings and Loan Insurance Corporation, which subse quently failed. So much for the stabilizing effects of "progressive" New Deal financial regulations.

According to a recent study by Kurt Schuler, central banks have done a poorer job historically at promoting low inflation, exchange-rate stability, open exchange mar kets, and economic growth than non-central banking arrangements, including free bank ing and currency boards. Indeed central banks offer only one clear advantage over these other arrangements: the ability to print money for their sponsoring governments. And that is one advantage the public can live without. Seemingly unaware of the role national central banks have played in generating finan cial turmoil around the world, Mr. Garten can think of no better solution to the world's financial troubles than a global central bank. He does not appreciate the link between central-bank pegged exchange rates and spec ulative currency runs like those recently expe rienced in Southeast Asia (runs to which non central-bank arrangements, such as currency boards, are invulnerable); he does not consid er the possibility that Japan's present slump may be the payback for its aggressively expansionary monetary policy during the 1980s; and he doesn't contemplate the fact that Russian bank depositors might not have to watch their savings gradually erode were they free to do business with foreign banks.

Worse still, Mr. Garten somehow imagines that the errors of national central bankers would somehow be avoided by an internation al bank, as if ignorance and shortsightedness were unable to transcend national boundaries. Take Russia as a case in point. From June to October 1992, Russia's central bank tripled its lending to commercial banks. Most of this credit was in turn re-Ient, at a loss, to the banks' own state-enterprise owners! The loss es were then made up for by Russia's finance 5 ministry. In the meantime, genuinely private Russian firms went begging for funds. Eventually, the massive flows of central bank credit began to reduce the value of the ruble, undermining Russian banks' ability to pay their foreign debts and rendering them that much more insolvent. And how has Rus sia's central bank proposed to resolve the cri sis? By lending still more credit to commer cial banks that should have been declared insolvent long ago!

Would a global central bank help? Not at all. On the contrary, such a bank would mere ly encourage Russian authorities to continue their perverse policies, by forcing citizens of other countries to bailout an essentially cor rupt system. Instead of performing their self-assigned task of stabilizing national financial markets, central banks have routinely attempted to prop up unsound banking systems with easy money. Jeffrey Garten believes that the cure for this failure is a bigger, better central bank, capable of acting as a world "lender of last resort," when in fact loans from such an insti tution would only make it easier for national governments to delay needed financial market reforms. Perhaps Mr. Garten believes that a global central bank would rise above domes tic politics, resisting any pressure to bail out insolvent banks. But the record of existing central banks, and of the IMF and World Bank for that matter, provides no grounds for such optimism.

On the contrary, experience suggests that a global central bank would quickly be captured by international banking interests and that it would serve those interests (rather than the interest of the general public) by rushing to guarantee their loans even when doing so would be tantamount to rewarding irresponsi ble government policies and banking practices. So Mr. Garten, kindly spare us a world cen tral bank: your quaint belief that, when it comes to regulating financial markets, gov ernments can never go too far, just ain't so. -GEORGE SELGIN Department of Economics University of Georgia The Government Spiral by Eric Nolte T he graveyard spiral is a maneuver known to students of airplane accidents as one of the most common reasons that inexperienced pilots unwittingly kill themselves. In this utterly preventable maneuver, a pilot untrained to fly on instruments flies into clouds. Disoriented and suffering tunnel vision, he doesn't notice the airplane's bank.