Central bankers and free markets: a convenient hate story

I often wonder why the level of understanding of the banking system and banking history at central banks is so low. Last week I mentioned this study that concluded that private money issuance is inherently unstable, despite all the available evidences that contradict this conclusion. Overall, the mistrust that central banks have towards free markets is frightening.


Vítor Constâncio, ECB Vice-President, is an expert at this game. His April speech titled Financial regulation and the global recovery cannot be more typical: all new regulations are effective, needed and actually have a ‘beneficial impact’ on economic growth (which, obviously, needs a ‘safe’ banking system that new regulatory measures indeed provide), and macro-prudential policies are exactly the tool needed for the clever and omniscient men in central banks to guide us, mere ignorant, risk-prone private market actors. Never ever does Constâncio even slightly question the measures taken over the past years. Everything is for the best in the best of all possible worlds. The whole speech makes for a quite uncomfortable, and depressing, reading. Pretty much everything he says is questionable (though it’s not the first time, far from that, see here). It seems like the ECB needs its own Andy Haldane, a (light) contrarian who dares questioning what the institution does.

But what’s really scary is central banker’s belief that finance was ‘deregulated’ since the 1980s, and that this was the cause of our boom and bust. As central bankers, and supposedly experts on banking, they should know that it is not the case. Constâncio says that we should not “return to deregulation and boom-bust cycles.” In a recent speech, Olsen, governor of the Norges Bank, declared that the crisis “showed that, left alone, the financial system is prone to excessive risk-taking.” I’m sorry but when has the financial system ever been ‘left alone’ since the old days of the free banking era (and only in a limited number of countries)? Certainly nowhere in the world over the past 80 years.

Equally, Sabine Lautenschläger, member of the ECB Executive Board, in another speech said that “after a long phase of deregulation, a comprehensive re-regulation has been in vogue since 2009.” Again, what ‘long phase of deregulation’? I’m still trying to figure out whether those central bankers and I have been living in the same world. Then she adds that she does “not believe in self-regulation, at least not in financial markets. You cannot have stable and functional banks without comprehensive regulation and energetic supervision.” Central bankers’ mistrust of free markets is startling*.

Philip Booth, from the Institute of Economic Affairs, just published a new report titled Thatcher: The Myth of Deregulation. Absolutely recommended reading. While the report only focuses on the UK, its conclusions are easily applicable to most of the Western World, especially Europe. Moreover, the report purposely avoids speaking about banking regulation, which has witnessed a boom from the 1980s with the worldwide introduction of Basel 1. But, as Booth makes clear, all other aspects of financial services became more regulated during and after Thatcher’s ‘Big Bang’ reforms. In his words:

Big Bang itself was undoubtedly an act of deregulation – but not in relation to state regulation. It is better seen as an act of prohibition. Big Bang prevented private regulatory bodies from developing their own rules for the benefit of their members and, arguably, wider society. This was one of two acts within the financial sector – the other being the abolition of the maximum commission agreement amongst insurance companies – where the power of the state was used to prevent private-sector rule setting on competition grounds in a way that led to unfortunate consequences. It could also be argued that this prohibition on private rule setting then led to government regulatory agencies filling the gap and doing so in ways that involved granting effectively unlimited powers to a statutory regulatory bureau or to a body that was ultimately accountable to politicians rather than to participants in the market. Certainly that is exactly what happened in the years that followed Big Bang. […]

Soon after Big Bang – the act of prohibition of private regulation – there was a huge extension of the statutory regulation of securities markets as a result of the Financial Services Act 1986 which came into operation in 1988. It is impossible to go through all the requirements of the regime in detail in this brief paper. Goodhart in Seldon ed (1988) suggested that just one rule book relating to one aspect of regulation that was developed as a result of the 1988 Act weighed around two kilograms. The Act itself is reproduced in 230 pages in the standard textbook by Wedgwood et al (1986) (not including the associated regulations). Regulation of this extent, detail and prescription had never been known before in the financial sector in the UK.

Add in the whole Basel banking rulebook, and subtract some actual banking deregulations that have happened (mostly in the US, like interstate banking limitations or interest rate cap on deposits, as well as reduced controls on UK-based building societies), and you end up with a financial system whose regulatory framework has largely boomed on a net basis between the 1980s and the financial crisis.

So much for deregulation and so much for central banker’s arguments, which seem to rest on the erroneous believes that 1. banking crises originate in Mynsky/Post-Keynesian-style endogenous imbalances and, 2. that finance has been deregulated since the 1980s. In short, facts seem to get distorted to ‘accommodate’ central bankers’ convenient rhetoric. By supressing a legitimate debate, this renders a disservice to society as a whole.

PS: Martin Taylor, of the BoE, dismisses all critics of ring-fencing as people who “have either failed to understand it or have chosen not to”… He of course doesn’t address any of the points I made in this year old post.

PPS: Glasner has a post on Is finance parasitic? that demonstrates he has a limited understanding of finance. Finance becomes parasitic when regulation and interest rates below their natural Wicksellian levels make it that way.

*Admittedly, unlike Constâncio, both Olsen and Lautenschläger seem to acknowledge some of regulatory and macro-prudential limitations. As does Taylor:

Charles Goodhart and others have pointed out that macroprudential policy, while intended by its very nature to be counter-cyclical, generally turns out to be the complete opposite. Put simply, we tend to tighten regulatory policies straight after a financial crash, when the economy is so weak that – all else being equal – we should prefer to loosen them.


8 responses to “Central bankers and free markets: a convenient hate story”

  1. tkojejohngalt says :

    Excellent post, and Philip Booth’s paper seems very interesting.
    Unfortunately, “the myth of deregulation” will hardly die.

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