At another Foundation for Economic Education event in mid-July, the Young Scholars Colloquium, I gave a lecture provocatively entitled"Why Fractional Reserve Banking is More Libertarian than the Gold Standard." Since both Bryan Caplan and Larry White have given it nice plugs on their blogs, I might as well do so myself. You can find it here, along with all the other podcasts from this summer's FEE seminars, including some by Bryan and Larry, and all those from the History and Liberty seminar mentioned in my previous post.

Bryan returned to the subject of my lecture, discussing a question he had posed to me during the seminar's recorded Q & A:"Agree or disagree: In developed countries during the last 10-15 years, central banks have become (close to) the most efficient state enterprises." After some hesitation, I had to reluctantly agree, despite my unequivocal advocacy of the Fed's abolition. But I throw the question open to discussion: what is your candidate for the least inefficient state enterprise?

Bryan of course approves of my answer, which is why he posed the question. But his reasons are somewhat different than mine. He gives two in his post: (1) the public's exaggerated fears of inflation partially offset the time-inconsistency problem that would otherwise cause central banks to generate higher inflation; (2) central bank independence allows them to rely more on economists, who do a better a job than mere mortals.

I have already questioned the claim that the public exaggerates the danger of inflation relative to economists in an ECON JOURNAL WATCH article. Economists only consider inflation's deadweight loss, ignoring inflation's transfer, which bothers the public just as much and just as reasonably as the transfer from the income tax. Does it really make sense to say that the public hates taxes too much because most of the extracted revenue is just a transfer?

Bryan's second reason really combines two points, one with which I agree and one with which I disagree. I do think central bank independence is important but not because it results in employing more economists. The economists I know seem to be just as susceptible to incentives as the general public. They may cast more intelligent votes, where as Bryan argues incentives are weak, but I don't see how it follows that they will make more public-spirited (i.e., welfare enhancing) decisions when faced with the temptations of power.

Here are my three reasons, given somewhat sporadically in my lecture, for the better performance of central banks in developed countries since the 1980s:

1. Highly developed financial systems with widespread fractional reserve banking have reduced government seigniorage, even at double-digit inflation rates, to a trivial source of revenue. (During the Great Inflation of the 1970s, direct seigniorage never covered more than 2 percent of the U.S. government's outlays.) This greatly diminishes the incentive for central banks to generate high inflation.

2. Globalization and international competition have approximated Hayek's world of competing private banks issuing fiat money. The major difference is that we have competing central banks. Investors can fairly easily move from one currency to another, which means the market immediately prices changes in central bank policy and punishes them when necessary. Central banks are still the major noise traders in the interest-rate and foreign-exchange markets. But whenever a central bank goes up against speculators and tries to seriously misprice its currency, the central bank almost always loses and the speculators almost always win. This tends to discipline central banks.

3. Central banks are freer to respond sensibly to this growing international competition and market discipline because of their political independence.