The Limits of Central Banking

Every system has limits. No one knows exactly where these limits are. All systems are complex, and no theory deals successfully with all of this complexity.

My favorite example of this was provided decades ago by Dr. Ibn Browning, a maverick climatologist. He described the following system: a pressure cooker filled with water, which is sitting on top of a stove’s burner, which is lit. At some point, he said, there will be a rapid shift in the system’s conditions. No one can predict exactly when. But he said that if you hit the pressure cooker sharply with a hammer, you can speed up the predicted shift in conditions. He recommended against doing this.

Most people ignore most systems most of the time. We live in a complex physical world which is made even more complex by mankind’s many social, economic, political, and other systems. No one can fully understand even one of these systems, let alone the interconnections of all of them. We therefore are forced to trust these systems.

But we don’t fully trust them, which is why there are always political pressure groups that are calling on politicians to change the rules governing thousands of mini-systems. Some of these pressure groups want to “level the playing field,” which they think will help them. Others want to tip the playing field in their direction, so the system will help them. All of them do this in the name of The People, who are said to deserve help. Help from what? The existing system.

There is a saying, “you can’t change just one thing.” It is accurate. Over time, all systems change, but they don’t change very much most of the time. These changes produce ripple effects throughout the connected systems. But changes are usually slow, so we barely notice them. When we do notice them, we get used to them. They become background noise for us.

Prior to World War I, taxes in all nations were under 10% of income. After World War I, no nation enjoyed this degree of liberty. We get used to the demons we know, including the tax collectors. History textbooks do not remind us of the low-tax world we have lost, because textbooks are written for use in tax-supported public schools, which do not call into question the prevailing tax level, except to suggest higher taxes on the rich.

Politicians in election years sometimes call for tax reform, but the public really doesn’t expect much change. The public is wise in this regard. The tax code is kept so complex by the politicians that no one can understand it. This is deliberate. This complexity allows special interest groups to persuade their politicians to slip goodies through the cracks of the code.

The ecomomy still bumps along. This is because the free market, with its extensive division of labor, is resourceful. Some people find ways to beat every system, while others find ways to milk the system. There is a constant quest for legal loopholes. There is also a constant quest for ways to cheat. We are told that cheaters never prosper, but the sales of My Life seem to refute this theory. (When Hank Williams wrote “Your Cheatin’ Heart,” he did not have in mind book royalties. Silly Hank.)

The fact is, the quest for profit in a free market economy favors consumers. Consumers hold the hammer: money. They determine which producers win and which ones lose.

The law enforcement system is flexible, which is another way of saying “arbitrary.” Politicians pass complex laws that are the products of compromise. Bureaucrats then enforce some of these laws, ignore other laws, modify all laws, and generally feather their own nests by increasing the complexity of law enforcement. This gives them greater arbitrary power over others, and it provides them with greater job security.

Round and round it goes, and where it stops, nobody knows.


In the 1930s, the economic system stopped working. Economists still debate over why it stopped working. John Maynard Keynes had an answer in 1936: not enough government spending. Milton Friedman had an answer in 1963: not enough money creation by the Federal Reserve System, 1929—1932. Murray Rothbard had an answer in 1963: too much money creation by the Federal Reserve, 1924—1929, and too much economic regulation by the Hoover Administration, 1929—1932. Keynes won the debate in academia for forty years, and in politics still has won it. Friedman has won the debate in academia, but not in politics, since about 1975. Rothbard’s answer is acceptable only to those few people who trust neither the politicians nor the central bankers to fix the system. I’m with Rothbard. I’m therefore with Frank Shostak.

The Great Depression has cast a long shadow over the voters and the politicians ever since. No one wants that to happen again. Keynesians say it will not happen again because politicians will always run deficits large enough to prevent one. Friedman says it will not happen again because central bankers learned their lesson. They will not again allow the banking system to run short of monetary reserves.

Rothbardians think that it will happen again. They debate over whether central bankers will first destroy the monetary units by inflation before the next Great Depression arrives. Meanwhile, they predict, central bank money creation will lead to a series of asset bubbles, all of which will eventually pop, and any one of which may trigger the next depression. For a Rothbardian or a follower of Ludwig von Mises, the economy resembles this astronomical phenomenon, which they refer to as the Greenspan Nebula.

But the economy keeps rolling along. Most Americans are getting by. Most Asians are getting by. Most everyone is getting by. The system holds. The free market system seems to be able to beat the many government-imposed systems that seek to thwart men’s ability to buy and sell with each other.

So far, so good.


Things usually change at the margin. At the edge of any system, trouble begins. The question is: Will trouble spread to the system as a whole? Will it force a transformation of the system, just as the hammer may transform the pressure cooker’s system?

On June 4, Warren Pollock published a disturbing report in his Macroeconomic Newsletter. He reported on a statistic that I had been completely unaware of: “settlement fails.” I was well aware of what it deals with: bank settlements. Banks must settle accounts with each other daily. Bank A owes Bank B, which owes Bank C, which owes Bank D, which owes Bank A. The system is enormously complex. It is interconnected.

If the settlement system ever fails, we will get what Greenspan has called “cascading cross-defaults.” In defending the New York FED’s decision to call together a 1998 meeting of commercial banks to encourage them to bail out Long Term Capital Management, Greenspan told the House Banking Committee in October, 1998,

While the principle that fire sales undermine the effective functioning of markets may be clear, deciding when a potential market disruption rises to a level of seriousness warranting central bank involvement is among the most difficult judgments that ever confronts a central banker. In situations like this, there is no reason for central bank involvement unless there is a substantial probability that a fire sale would result in severe, widespread, and prolonged disruptions to financial market activity.

It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM’s portfolio in a forced liquidation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the FRBNY’s judgment that it was to the advantage of all parties — including the creditors and other market participants — to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults.

Cascading cross defaults are the greatest single threat to the world economy. They could push the world’s banking system into gridlock. Then our plastic, credit-based money would no longer buy things. This would create a monumental crisis.

Think of your situation at a distant gas station: a nearly empty gas tank, far from home, little or no cash, and the message box on the gasoline pump says “card rejected.” All of your cards are rejected. All cards everywhere are rejected. Then what?

This is the hammer on the pressure cooker. Wham!


On two occasions, once after 9/11 and in August, 2003, the system came close to going into gridlock. The FED intervened both times to inject liquidity — fiat money — into the banking system. Pollock supplies a graph of what happened.

What is bothersome is that something like this happened again in May, 2004, when long-term interest rates began moving upward. Here is Pollock’s explanation..

The Federal Reserve provides the banking system with a framework to settle inter-bank transactions. On two occasions it is very clear that interest rate increases severely stressed the banking system. When the inter-bank settlement system temporarily fails to clear transactions banks are effectively “bouncing or kiting checks” to each other.

The 9-11 event triggered the first failure of the settlement system. For technical reasons a statistic called “Settlement Fails” surged to epic proportions. At the peak of the technical problem it became impossible to settle $1.4 Trillion dollars of inter-bank transactions. The Fed was able to smooth the failure over.


The system failed in July and August of 2003 when an unexpected market driven spike in long-term interest rates occurred. Rates were managed downward and the problem was temporarily solved.

The same condition of failure occurred in May of 2004. The failure was directly related to the recent rise in interest rates. Increases in M3 liquidity could be “a fix” to this problem.
Pollock then provides a graph of the 10-year treasury yield in comparison to the settlement-fails spike. He concludes:

The recent failures are timed exactly to interest rate increases. The settlement system has a significant problem absorbing modest changes in interest rates. The FED must have to step in periodically to prevent a crisis from occurring. Interest rate sensitive derivatives and interest rate arbitrage plays are putting pressure on the continuity of the banking system.

Given this condition, how can the FED raise interest rates to levels needed without blowing up the entire system? The problem is that the market will raise rates if the FED fails to do so.


The Federal Reserve System has intervened repeatedly because entrepreneurs always push every profit-based system to its limits. Someone will always press against the rules of the game. The 1998 failure of Long Term Capital Management provides an example of entrepreneurs who went beyond their ability to fulfill their debt contracts in the highly leveraged financial futures market.

The FED has bailed out the system so often that it has created a sense of abandon among entrepreneurs. These entrepreneurs have access to enormous lines of credit through the futures market. This is what the carry trade is all about: borrowing short to lend long, with an inverted pyramid of interconnected debt. No one knows how large this pyramid is. No one knows the limits of the system.

We trust the system: the free market. What choice do we have? We live in an era of digital money, secured by plastic cards by means of the banking system. Almost no one has enough cash (non-digital currency) to pay his bills for a month, let alone a year.

But the decision-makers at the FED do not trust the free market. Not really. This is why the FED has repeatedly intervened to keep the banking system from going into gridlock.

No one knows the limits of the world monetary system. The web of credit and debt is too complex. Complex systems generally hold together, just as spider webs hold together. But any system’s limits are beyond anyone’s ability to comprehend. This is true of the fractional reserve banking system, in which money is a form of debt, and the debt is pyramided inversely.

We live in an economic system in which arrogant but politically clever men believe that they can use political coercion to adjust the economy more favorably — more favorably for their constituents, whom they equate with The People. They intervene to make the system better. Problem: you can’t change just one thing.

We see the FED playing the role of the sorcerer’s apprentice. To understand Alan Greenspan and the system he represents, visualize Mickey Mouse in “Fantasia,” with the sorcerer’s pointed cap on his head, and the brooms hauling water and dumping it. There is lots of liquidity!

Have you ever noticed how much a sorcerer’s cap resembles a dunce cap?


You should do what you can to make yourself resistant to the web of debt that sustains the present world economy. You should have reserves that are not part of the debt system. These reserves must be non-digital. It’s not enough to have a money market fund. You need some currency, some silver coins, and some gold coins.

You cannot disconnect from the economy and still remain productive. But you would be wise not to place all of your capital eggs in a digital basket that is guarded by Alan Greenspan.

June 30, 2004

Gary North [send him mail] is the author of Mises on Money. Visit For a free subscription to Gary North’s newsletter on gold, click here.

Copyright © 2004