The Mystery At The Heart of Central Banking

Economists love decentralized competitive markets. There’s nothing an economist likes to see more than some decentralized entrepreneurs starting businesses with well-defined property rights, competing with each other to serve the interests of others in order to serve their own interests, coordinated through decentralized prices which transmit information about relative scarcities, with success determined by profits and failure by loss. We love decentralized competitive markets so much that we even call them “perfect.” Any deviation from this perfection is labeled “inefficient” and “failure” and economists quickly design a correction intended to push the system back towards perfection with minimal interference.

Now let’s look at central banking and try to predict whether economists would love or hate it. To what extent does central banking approach economists’ vision of perfection?

Is the bank decentralized? Nope, it has “central” in the name for crying out loud.

Competitive? Central banks are monopolies by law. Competing with a central bank is a crime.

Private actors serving the public good through self-interest? No, central banking uses government-employed technocrats whose motives are apparently supposed to be public-spiritedness in the manner of politicians and government bureaucrats.

Success determined by profits and failure by loss? The central bank is not a profit-maximizing entity and in any case has the explicit backing of the government in case it runs into trouble, a support central banks the world over have repeatedly had to turn to in crisis.

Coordination through decentralized profits? On the contrary, the central bank is the entity that is supposed to be doing the coordinating, these days on a global level, when economists are convinced that in every other industry centralized planning runs into insurmountable information and incentives problems at a scale far below what central banks these days are expected to manage.

So what do you predict? Are economists supportive of central banking or not?

That’s right, economists support central banking over competitive decentralized banking near-unanimously. The only university of any significance that might have an economics department a majority of whom support free market banking would be George Mason University. There are also a couple of very small colleges with an “Austrian” economics program that are also most likely supportive of a free market in banking and oppose central banking. Otherwise, economists spend quite a lot of time and effort both staffing and running central banks, gathering data and developing theories, trying to learn what mistakes central banks made in the past and how to avoid them in the future, arguing over what central banks should be doing in the present and what they should be prepared for in the future, etc. Support for a banking system that doesn’t include a central bank is a minority fringe view.


...Is not what anyone would expect, if they knew what economists generally think about decentralized competitive markets versus government-supported monopolies tasked with managing the macroeconomy before they knew how near-unanimously supportive economists are of central banking. So what’s going on?

Not all industries are identical, and banking is unique among all the different kinds of markets since it has a unique relationship with a unique good, money. So while you shouldn’t expect economists to support central banking, you also shouldn’t be too surprised by their support if they have a good explanation for why they do.

And of course economists will have a good explanation for their support for central banking. Central banking isn’t new—if you date the beginning of economics at 1776, when Adam Smith published The Wealth of Nations, then centrally banking pre-dates economics—so they’ve had plenty of time to think about it. Economists have been working and theorizing for central banks for centuries, so they’re familiar with central banking and the many ways it differs from the “perfect” arrangement economists are usually so fond of. Plus central banking is simply something that should clash so strongly with their normal intuitions—seriously? A government-protected monopoly centrally managing the macroeconomy—that every new generation of student economists would stridently demand explanations from their professors. Finally, centrally banking is really important, and it is something economists have responsibility for in a way that isn’t true of any other institution. Getting the right answer on central banking versus some other banking regime is one of the most important things that economists could do.

So let’s ask Greg Mankiw, professor and chairman of the economics department at Harvard University, where among other things, he teaches introductory economics, just why it is economists support central banking. Mankiw is the author of a very popular macroeconomics textbook for undergraduates. He’s smart, well-read, and a very popular and successful educator. If anyone would have developed a thorough, persuasive answer to the question of why economists support central banking, it would be Greg Mankiw.

“The economics profession does not have a good answer.”

Oh. Uh--

We economists have rigorous and fundamental theory to explain why we have environmental regulation (externalities) and to explain why we have antitrust laws (market power), but there is no consensus about what market failure calls for the existence of a central bank. “

Okay, well “no consensus” isn’t so bad. It must be a hard topic. But economists must be hotly debating all kinds of answers--

“The answer has something to do with the benefits of a system of fiat money. And it has something to do with the possibility of short-run monetary nonneutrality (due to sticky prices and/​or imperfect information about prices). But the precise combination of elements that would yield a satisfying answer is still elusive.”

Wait, so nobody has an answer?

And let us note that “the benefits of a system of fiat money” seems insignificantly different from “the benefits of central banking” because that’s pretty much what a system of fiat money is. And I can’t for the light of me see how “the possiblity of short-run monetary nonneutrality” should be sufficient to move economists from their normal support of decentralized competitive markets to support for a government-backed monopoly tasked with central planning, or even how it should move economists in that direction at all, and Mankiw doesn’t explain or even link to someone else’s suggestion.

Please, Professor Mankiw, if you don’t know the answer just tell us who does--

“If anyone has a good answer, let me know, or publish it in the American Economic Review.”


Okay, is it just me, or does it kind of sound like Greg Mankiw, professor and chairman of the department of economics at Harvard University, perhaps the most popular economics educator in the United States, not only not know the answer, but he doesn’t even know of anyone in the economics profession who has ever offered a good answer.

It’s almost as if Mankiw has never heard a reason why economists should support central banking (at least, one that doesn’t beg the question—“the benefits of a system of fiat money” explains nothing). He also—professor and chairman of the department of economics at Harvard—doesn’t think that any other economist ever has come up with a good reason, even one that he hasn’t personally heard.

And he doesn’t even seem particularly concerned about what is essentially the most important question in monetary theory.


I did my own search, and I can confirm that Mankiw isn’t simply lazy or ignorant. The economics profession really doesn’t have a good answer to this incredibly important question. They do have an explanation for why they don’t support unregulated banking: banking regimes that lacked central banks suffered financial crises and recessions—for example, the repeated financial crises of postbellum America that led to the demand for banking reform which culminated in the creation of the Federal Reserve system.

This is a weak argument, however. It doesn’t even work as a strike against a free market in banking because banking regimes like that of postbellum America were heavily regulated despite the lack of a central bank. Lightly regulated banking regimes like Canada and Scotland did at different times in history did a better job of avoiding and weathering financial crises and recessions than did America’s and and Britain’s over the same period of time. Furthermore, banking regimes that include central banks have also suffered from financial crises and recessions. We’re still feeling the effects of one today. So if the occurrence financial crises and recessions were arguments against the system that preceded, then they are just as equally arguments against the current system, the system of central banking.

So the one argument economists have is an incredibly weak argument against a free market in banking, and it is an argument against central banking.

And economists really don’t seem to care about this. It is something they are simply not curious about. They don’t write about it, not even things like “Boy, It Sure is Weird that We All Just Accept Central Banking.” When you study any other industry in economics, first you learn about how it works in the “natural” unregulated state, and then you decide if regulations are desirable and what those regulations might look like and what consequences they will have. When it comes to banking, the textbooks start with a central bank. Free market banking is completely ignored. If any justification is offered, it is a brief version of “the past system had a lot of crises” argument that cuts just as strongly against central banking.

Now, and this might be presumptuous, but there is an obvious explanation for why economists would be entirely uncurious about central banking and be perfectly content with that state of affairs.

First of all, people are naturally uncurious about things. Hopefully scientists are more curious, at least about the subject matter of their own science, but in remember that central banking pre-dates economics. Central banking is what economists are used to. This is more of a barrier than it might seem. It is well known in economics that people are entirely comfortable with markets in things that they are used to and extremely skeptical and suspicious of markets in things that they are not, even when they work by the exact same principles—look at the resistance and apathy towards prediction markets for an example. There is something of a joke in economics to the effect that if the market for sandwiches had always been controlled in a top-down manner, then calls to open the market to free competition would be met with cries of “But where will the sandwiches come from?” and things to that effect. People have a very hard time imagining how markets they aren’t used to will work. This should be doubly true of a free market in banking, which doesn’t have a great number of historical examples, and those examples (Scotland, Canada, Australia) aren’t very well known. Just as importantly, banking is a particularly, perhaps uniquely, abstract and difficult industry to understand. If there was every a set of problems economists would be tempted to run from, it would be the economics of banking.

Second of all, there is the obvious problem of self-interest. Central banking raises the income and status of economists, and strokes their ego. It lets them work cushy, secure high-paying high-status jobs where they get to do what they enjoy and feel like they are in charge of the economy to some extent. They can flatter themselves that they are controlling things and fixing the world while pulling in a nice income doing the work that they like.

Given those two points, it’s not that surprising anymore that economists support central banking, don’t have any reasons for supporting central banking over a free market in banking, and aren’t very bothered by this.

To see if that explanation holds up...

...And to find out for ourselves what kind of banking regime, central banking or other, is actually justified by the economics...

We’ll start exploring from the beginning: just why do economists generally support decentralized competitive markets over government-backed monopolies? Why should economists have to be persuaded of the merits central banking from the more obvious position of free market banking, the opposite of the status quo? That is where we’ll begin.