Why the Banking System Should Be Regulated
It has long been taken for granted that the financial system should be regulated. That this should now be open to question is to be welcomed. It is important in general to question assumptions, but it is particularly important to do so in the case of a sector which has undergone such major change over the last few decades. It is necessary therefore to go back to first principles and examine the implications of these principles in the current environment. The outcome outlined here is a renewed case for regulation, but one which takes account of the changing nature and role of banks. Historical evidence aids our understanding of these changes, but historical evidence must be used with care; the advocates of free banking misinterpret and misuse this evidence to support their position. The case for regulation rests on the very special economic role of money and the uncertainty associated with it. This uncertainty in turn renders free banking unworkable since the proposal requires the non-bank public to assess the expected value of the portfolios of the issuers of money. Adequate knowledge could only be generated if money-issuing were concentrated in a dominant institution, or set of institutions, which operated like a central bank. This outcome would only occur, and be socially acceptable, given a high degree of social cohesion. Rather than eradicating regulation on the grounds that it is flawed, and risking financial chaos, the more appropriate response is to consider how to improve regulation.