Below is an extract from a commentary originally posted at www.speculative-investor.com on 1st July 2007.

Most economists can readily explain why it would make no sense for a government committee to set the price of eggs. They will tell you, quite rightly, that no committee could ever gather sufficient information and react quickly enough to changing circumstances to ensure that the egg price set by the committee was consistently equivalent to the price that brought supply and demand into balance. They will also tell you, again quite rightly, that the price-setting errors that would inevitably be made by such a committee would create problems in the egg market. Specifically, they will point out that setting the price of eggs too high would create a glut because egg producers would respond to the artificially high price by producing more at the same time as egg consumers were responding to the artificially high price by consuming less; and that setting the price of eggs too low would create a shortage because it would cause producers to cut back at the same time as consumers were trying to take advantage of the low price by ramping-up their buying.

None of this is rocket science. It is, in fact, the main reason why Socialism and its various derivations (Communism, Fascism, Welfare-Statism, Interventionism, etc.) don't work and free markets do work. Strangely, though, when it comes to central banking many of the economists and financial market commentators who claim to believe in free markets dispense with this fundamental logic. They have no difficulty explaining why a central planning agency could not consistently set the correct price of something as simple as the humble egg regardless of how well-intentioned and well-funded this agency happened to be, and yet in the next breath they will argue that a central bank -- a central planning agency responsible for setting the price of something as complex as credit -- is a good thing. In doing so they prove that they are either disingenuous (they don't really believe in free markets at all) or clueless.

As is the case with eggs, when a central planning agency responsible for setting the price of credit (the interest rate) gets it wrong the inevitable result will either be a glut or a shortage of credit, although there is an important difference between the egg market and the credit market. The difference is that the producers of eggs have costs that effectively set a low limit on the selling price at which they will be prepared to produce, but under the current monetary system the main producers of credit -- the central bank and the rest of the financial establishment -- have no such limits (they can create credit/money at zero cost ad infinitum) or have devised ways of getting around any limits (structured finance and the Yen carry trade spring to mind). Therefore, unlike the producers of eggs the main producers of credit have the ability to profitably grow their businesses by ramping-up supply in response to every increase in credit demand spurred by a falling price.

Given that the right price of eggs or credit or anything else is the price that would bring supply and demand into balance, which is, in turn, the price that would be set by a free market, why on earth do we have central banks?

The answer is that the central bank's purpose is NOT to set the price of credit at the CORRECT level (the correct level is where the price would be in the ABSENCE of the central bank). Instead, the main purpose of the central bank is to facilitate inflation by ensuring that the real price of credit remains at an artificially LOW level most of the time. That's why, after several decades of central banking, we have arrived at the point where there is an enormous and unprecedented global glut of credit (sometimes mistakenly referred to as a savings glut).

Incredibly, the logical inconsistency of the self-proclaimed free market advocates who also advocate central banking goes a step further in that every major problem caused by a central bank's intervention in the markets routinely gets trumpeted, by these people, as a reason for even more intervention by the central bank. For example, when a central bank creates a 'boom' by holding the price of credit at an artificially low level for an extended period and the 'boom' turns into a 'bust', as all inflation-fueled booms inevitably must, you can be sure that the 'bust' will be cited as justification for even more central-bank-sponsored inflation. It is akin to a doctor prescribing increased alcohol consumption for a patient suffering from the deleterious effects of alcohol consumption, and would be laughable if it weren't so serious.