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Many mainstream economists say that such thing is impossible. Is there some specific reason why the financial system needs a central bank?

In this video http://m.youtube.com/watch?v=BcuAOdXD0Go, Krugman says at 03:00 it's impossible to leave the central bank out of the equation today. Why is this?

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    $\begingroup$ What exactly do you mean by possible? Certainly you can dollarize your economy like Panama and have no central bank. mises.org/library/panama-has-no-central-bank $\endgroup$ – BKay Apr 27 '15 at 17:10
  • $\begingroup$ Canada had none until 1934 and it fared just fine. $\endgroup$ – tadejsv Apr 28 '15 at 7:17
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It surely is possible: For a long while, Gold was the basis for the value of money in many "modern" countries, leaving central banks with little room for policies.

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    $\begingroup$ I see what you mean. as long as you consider 1973 modern. However. many (most?) of the countries on the gold standard also had central banks -- right? $\endgroup$ – BKay Apr 27 '15 at 18:28
  • $\begingroup$ @BKay I presumed the question was about monetary policy, not about central banks. Note that MP was the only reason that the other answer also brought forward for the case of central banks. $\endgroup$ – FooBar Apr 27 '15 at 18:38
  • $\begingroup$ +1. I've heard that even back in the days of metal money, political authorities still found ways to intervene on money supply. Cannot find a reference right now, but I remember being told about a process called “rognage” in french, which consisted in some political authority seizing as many coins as they could, scratching them on the edges, and making new coins with the metal dust they gathered. Later, the original coins where (in the best cases) returned to their initial owner. Apart from the value of the metal stolen from the initial owner, this seems very similar to printing paper money. $\endgroup$ – Martin Van der Linden Apr 27 '15 at 19:03
  • $\begingroup$ But as I remember, that was more a middle-age practice than a modern one. Anyone heard of something similar and know more about the details of such practice? Maybe should make another question out of it... $\endgroup$ – Martin Van der Linden Apr 27 '15 at 19:03
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    $\begingroup$ Yep, coin shaving is why many older coins made of precious metals were designed with ridges on the edges, so this practice could be detected (US quarters retained this as a design feature, though this is no longer an issue). $\endgroup$ – dismalscience Apr 27 '15 at 19:12
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Mechanically speaking, there are two functions that have to be centralised, although the second one need not be performed by the central bank historically it usually is.

There is an absolute requirement for a guaranteed lender of last resort, since banks can run into liquidity issues through no fault of their own. Liquidity in this context, is the availability of asset cash or equivalents to meet intra-bank transfers (say money is transferred between deposit holders at two different banks.) A bank can be solvent long term, i.e. their loan book is healthy so they are guaranteed to receive cash long term, but still have issues in the short term - if a big transfer occurs. (Inter-bank lending is necessary but not sufficient for sorting out short term liquidity issues because of competitive issues.)

The second issue is how the banking system's expansion of the money supply is regulated. Historically reserve accounts at the central bank were used for this, and that mechanism can provide absolute control, provided it is applied to all liability deposit accounts in the system. Other mechanisms could be designed that didn't use a centralised method - indeed many banking systems currently no longer use reserve accounts, and are relying on a mixture of Basel capital controls, and control over other factors, such as direct limits on borrowing - the long term effectiveness of these controls is yet to be demonstrated though.

A third issue is who is going to handle physical clearing, generally these days that's not done by the central bank, but occasionally small countries do it that way for expediency (using the reserve accounts).

Apropos the old gold standard. Gold was treated as an asset in the system, and effectively regulated lending, and consequent deposit expansion. However, it wasn't a very good regulator in and of itself, since there was a feedback relationship embodied in the price of gold, which was affected not only by the banknotes issued by the banks, but also by deposit expansion. Every time somebody wrote a cheque, and bought gold with it, the quantity of bank deposits also impacted its price. (Leaving aside a whole bunch of other instabilities surrounding the quantity of bank notes being issued by private institutions.)

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    $\begingroup$ Lender of last resort is an absolute requirement - What do you even mean by that? Certainly a country wouldn't cease to exist without that function. Perhaps you should rephrase it as saying "This is how a country would look like without it". $\endgroup$ – FooBar Apr 28 '15 at 1:29
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    $\begingroup$ This is looking at things from a systems analysis perspective. There are intrinsic stability issues (that can be shown formally), if there isn't a lender of last resort, even in the absence of loan default. Without it, a country would look like a pre-central bank regime - i.e. Sweden before 1668, etc. $\endgroup$ – Lumi Apr 28 '15 at 1:39
  • $\begingroup$ A private lender of last resort could also emerge, couldn't it? $\endgroup$ – snoram Apr 28 '15 at 4:44
  • $\begingroup$ It could, but it would raise competitive issues - since it's very easy to abuse the position - which is the problem with just relying on inter-bank lending. It's been suggested this used to happen in England before the Bank of England was established. $\endgroup$ – Lumi Apr 28 '15 at 14:05
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The central bank is not a physical necessity, like lungs. So one could imagine a world where no central banks exist.

However, the central banks do hold substantial power that can be used to lower inflation and unemployment. Society seems to benefit from these organizations in many theoretical and practical settings. So societies without central banks may see fit to develop them over time.

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