Central banks: running out of ideas, road

On page two of today’s Wall Street Journal Europe you will find the result of a readers’ poll from last Friday; Question: will the ECB’s rate cut help restore confidence in the bloc’s economy? Answer: 81 percent of readers say no; 19 percent yes.

Last week’s round of global monetary easing – another ECB rate cut, another round of debt monetization from the BoE, another rate cut from the People’s Printing Press of China – is, of course, more of the same old same old. It has a discernible touch of desperation about it and this is not lost on the public. Monetary policy is ineffective. Or, to be precise, it is only effective in delaying a bit further the much-needed liquidation of the massive imbalances that previous monetary policy helped create, and thereby is contributing, on the margin, towards making the inevitable endgame even more painful. It is counterproductive and destructive. It is certainly not restoring confidence.

Yet, many commentators and many of the establishment economists out there are not giving up. If only the ECB had cut by 0.5 percent instead of 0.25 percent, the equity market could have responded more optimistically. Maybe this would then have restored confidence? — Really? We are now below 1 percent in official interest rates, having cut by a full 400 basis points since the crisis started. How realistic is it to assume that another 0.25 percent is the difference between confidence-enhancing monetary stimulus and dread-inducing disappointment?

The advocates of ever more ‘stimulus’ are grasping at straws. What else can they do? Their pretty little world-view according to which, in a system of unlimited fiat money, the central bank can always create some additional ‘aggregate demand’ by giving a bit more artificially cheap funding to the banks lies in tatters.

Money is never neutral

That monetary policy would finally end in this cul-de-sac is no surprise. It only surprises those who share the mainstream’s simplistic view of monetary stimulus. Phrases such as “the ECB is attempting to unlock the flow of credit in the Eurozone”, are masking the complexity of the true effects of money creation and interest rate manipulation, and they make ongoing monetary stimulus look unduly harmless and straightforwardly positive. Who could object to unlocking credit, to liquefying markets or stimulating activity?

One of the major contributions of Ludwig von Mises’s monetary theory was his proof of the categorical non-neutrality of money. He demonstrated “that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the ‘level’ of prices.” (Ludwig von Mises, Memoirs, page 47).

A monetary stimulus never affects GDP and inflation directly and exclusively, these two statistical aggregates to which the mainstream assigns overwhelming importance. Every monetary stimulus affects and changes many other things as well, and these other effects have often more far-reaching consequences: monetary policy always changes relative prices, it always alters the allocation and the use of scarce resources, and it changes income and wealth distribution. Every monetary stimulus creates winners and losers.

This is being ignored by the mainstream. In his defence of QE, Martin Wolf argues in the FT that the central banks print money in the public interest. The assumption is that we all benefit from the boost to growth, short-lived as it must be, and that we all suffer the effects of higher inflation – if higher inflation materializes at all. But the new money does not reach everybody in the economy at the same time, and therefore does not affect prices ‘evenly and simultaneously’. As a general rule, the early recipients of the newly printed money benefit at the expense of the later recipients. Those who, in the chain of money distribution, are located closest to the money producer (the central bank) are always the winners. These are usually the banks and other financial market participants. They can spend the new money before it has dispersed through the economy and lifted a whole range of prices, and before the new money’s purchasing power has thus been impaired. At the present stage of the credit mega-cycle, more monetary accommodation helps the banks fund overpriced assets and bad loans on their balance sheets. Various ‘bubbles’ – which are uniformly the result of past monetary expansion – are thus sustained and even inflated further. Market forces that would adjust prices, reallocate assets and bring the economy back to balance are thus weakened or impaired completely.

Moreover, accommodative monetary policy can only lead to more economic activity by encouraging somebody to take out more loans, to take on more debt. The mechanisms by which ‘easy money’ leads to more GDP-growth is through the lengthening of balance sheets of banks and of more financial risk-taking, generally. We are in the present pickle precisely because this kind of stimulus policy has been conducted – on and off – for decades. That is what brought us to the point of a banking and debt crisis. Presently, authorities are fighting a debt crisis by encouraging more debt accumulation. They are fighting a banking crisis by encouraging the banks to take more risk. You do not lower interest rates and conduct QE and then realistically expect deleveraging and balance sheet repair.

In this context, I find it particularly bizarre that some economists argue that an even bolder intervention by the ECB, such as a deeper rate cut, another LTRO (funding operation for banks), or a commitment to more purchases of sovereign bonds, would have restored confidence. Do these experts really believe that the public will feel more confident if overstretched banks grow even more quickly with the help of the printing press? Will uncertainty over excessive government debt be laid to rest if the central bank promises to support these governments with essentially unlimited money-printing and bond purchases, thus making it easier for these governments to run deficits? Will that be seen as a solution or just a politically convenient postponement of the day of reckoning?

What causes loss of confidence is this: people do not know any longer what is and can be funded privately and voluntarily, and what is simply propped up by central bank intervention. They do not know the true prices of assets and the sustainable level of interest rates because everything is massively distorted through various central bank policies. Printing yet more money will not make anybody feel more confident.

Unintended consequences

Monetary accommodation is a form of market intervention, and like every other form of intervention it creates a whole range of unintended consequences, many of which are difficult to identify clearly and even more difficult to quantify but they are nevertheless real. My colleague at the Cobden Centre, Gordon Kerr, provided a good example during a recent discussion:

In supermarkets in London there is a trend towards replacing personnel at the check-out counters with new self-service machines that allow customers to scan their purchases and handle the payment process themselves. It is another incident of human labour being replaced with machines. We may say that this is a sign of the times, a consequence of technological progress, and thus inevitable. But such a development is, in each case, not only a consequence of what is doable technologically. It is also a result of economic calculation by the entrepreneur, in this case the owners and managers of the supermarkets. The expenditure for the machines, the capital they tie up and the interest charges that are associated with them, and any potential future losses from inappropriate handling by customers or even theft of produce due to reduced oversight will have to be compared with the cost savings from employing fewer personnel in the check-out area.

In modern-day Britain this calculation seems to work in favour of the machines but would it do so in a free market? The short answer is we do not know. But we do know that the supermarket workers and the check-out machines do currently not compete in a free market. Through the country’s numerous welfare-state regulations, among them minimum wages, social insurance, maternity- and paternity leave, health-and-safety legislation and other rules to ‘protect the worker’, the government has lifted the cost of employing people, it has made human labour expensive, while at the same time, the country’s monetary policy in favour of super-low interest rates and more bank lending has made capital cheap. From both angles, the worker is being squeezed out of the market. Legislation to protect him makes his work expensive; efforts to cheapen credit make capital investment a much easier alternative.

Do not get me wrong: our high standard of living is the result of a high ratio of productive capital to worker. If we want to increase our standard of living further we will have to keep increasing this ratio. This is the only way to enhance human productivity. But there is a right way of going about this, and there is a wrong way. The right way is to save, to put real resources aside, to redirect real resources from forms of employment that are close to present consumption and transform them into capital for future-oriented investment. How much we invest should not be the result of the decisions of central bank bureaucrats and their monetary manipulations but the result of voluntary saving decisions. That may well set a lower speed limit on capital investment but such a lower speed limit would be entirely appropriate. The resulting capital structure would be much more stable and sustainable, while investment that is funded by money creation rather than saving must lead to capital misallocations, which remains the primary source of boom-bust cycles.  The apparent need of large parts of our present capital structure for near-zero interest rates and further doses of monetary stimulus simply to be sustained in their current size is a clear indication that accommodative monetary policy has already created grave dislocations. How much more of these do we want? How much more of these can the system live with?

The point I am making here is this: It is either naïve or a sign of incredible hubris to believe that the central bankers can anticipate the myriad of consequences their monetary interventions will have. To say that they are simply, in aggregate, in the interest of the public is simply incorrect. We are dealing here with a financial bureaucracy that has lost touch with the complexity of economic reality but that has now dug itself such a deep hole that any self-motivated turn-around can safely be ruled out.

As my friend Tim Evans says, the system has check-mated itself, and so has the mainstream and the policy bureaucracy. Their policies are failing but they cannot consider the alternative, which would be a complete stop to monetary intervention and money-printing, and would mean finally allowing the market to liquidate what is unsustainable anyway. This would realign asset prices with economic reality and bring valuable assets into the hands of entrepreneurs rather than have them funded at unrealistic book-prices on bank balance sheets forever. Can they imagine this alternative but not dare to implement it? I am not so sure. I fear they may not even grasp it.

Will the ECB cut again? Will the ECB underwrite the bond purchases of the ESM via the printing press? – Yes and yes again. Of course, they will. Just give the ECB some time. Will it solve the problem? Of course, it will not.

We will see more rounds of QE, more rate cuts where this is still possible, and further expansions of central bank balance sheets. Pension funds and insurance companies will be forced by regulators to hold assets that the state wants them to hold (government bonds anyone?), and the reintroduction of capital controls appears a near certainty at this stage. Remember, a toxic mix of stubbornness and desperation rules policy making at present. It is best to be prepared for everything but the sensible solution.

Come to think of it, the title of this essay may be misleading. The central banks have reached the end of the conventional road but they will push their policies further.

This will end badly.

This article was previously published at Paper Money Collapse.


  • Paul Marks says:

    It is the virtue of your articles Sir that I can read them without disgust – a major virtue in these dark times.

    The last time I read an article by Martin Wolf (in that pile of used toilet paper that is the “Financial Times”) he claimed (at the end of an article demanding yet more pooling Eurozone debts so that the German taxpayers would be responsbile for other Welfare States on top of the crushing burden of the German Welfare State) that “even critics” of his position understood that Germany domestically needed “higher wages” and generally “more demand”.

    In short everyone (in the mental universe of Martin Wolf) is totally ignorant of how a labour market works and thinks that the best way to deal with unemployment is to create money (from nothing) and dish it out.

    Of course increasing the money supply is not neutral, long before Ludwig Von Mises explained this Richard Cantillon (John Law’s partner in “legal” crime back in the 1700’s) understood that a boom-bust event (which is what credit-money expansion really is) is not neutral – at the end of the process some people (normally the wealthy and politically connected) are better off than they would otherwise have been, and some people (normally the poor and not politicially connected) are worse off than they otherwise would have been.

    Nor is it a zero sum game – it is a negative sum game. The total economy is less productive than it would have been had no credit-money boom and then bust taken place.

    However, yes Ludwig Von Mises explained all this in a formal way – so that economists could understand it. Accept (as Martin Wolf shows) the “mainstream” still do not understand it.

    In Hayek’s “New Studies” (1978) there is a esaay on the “Ricardo effect” where Hayek mocks the Keynesian (and the Irving Fisher – Milton Friedman monetarist view) that increasing the money supply is like turning on a tap – with the water gushing everywhere (and to everyone) almost at once.

    That is not how it works (F.A. Hayek says) – increasing the money supply is not like a flow of water, it is more like a flow of treacle. With the sticky substance pileing up in certain places.

    And, of course, some people end up with sticky fingers.

    Effect of all this on Martin Wolf and the rest of the establishment elite?

    Zero – no effect at all.

    And (as pointed out above) they are not just ignorant of monetary economics, they are ignorant of the rest of economics as well. For example they think that unemployment is not best dealt with by getting rid of obstructions to the free operation of a labour market (i.e. government pro union regulations, mininum wage laws, welfare schemes, and so on), but by “higher wages”.

    The “logic” of the position of the international “liberal” establishment elite (Mr Wolf and his friends) is that the next time there is a strike in German industry, they should be out on the “picket line” (remember this is a MILITARY term – “peaceful picketing” is a contradiction in terms, “picketing” is about threats, it is obstruction), and if the strike is “won” and “higher wages” achieved they should expect lower unemployment.

    When HIGHER unemployment (of course) occurs they should then simply demand that more money is produced (from NOTHING) by the Central Bank, in order to “increase demand”.

    And then Mr Wolf and friends should move in with Tinkerbell in her wonderful fairy castle in the sky.

    It is impossible to reach the minds of these people by rational argument (the “education system” has so twisted their minds as to leave them no longer open to rational argument) – and if they really do control policy (as they appear to) then civilisation is in great danger.

  • Paul Marks says:

    Of course the European Central Bank “deposit rate” is now ZERO.

    And there is open talk of making it NEGATIVE (i.e. forceing banks to pay money for keeping money with the ECB – a practice that banks are led to by the ECB’s own regulations).

    This policy is designed to push banks to be more wildly insane and spendthrift than they have already been – so that the (created from NOTHING) money gets “out in the economy”.

    I repeat, with people who believe such doctrines are a good thing no rational discussion is possible.

    They see themselves as “beyond common sense” they take pride in their insane (sorry “counter intuitive”) doctrines (such as the idea that there can and should be large scale lending without REAL SAVINGS), and hold themselves to be superior to “ordinary” reason.

    And, of course, as the elite have so long done….. they hold themselves to be “beyond” ordinary ideas of “good and evil”. So that such things as lying (and so on) are perfectly legitimate for these “superior” people in their quest for total and absolute power – for the good of the “ignorant masses” of course.

    Hunter-Lewis (in “Where Keynes Went Wrong”) deals (in passing) with the ethical ideas of Keynes and his Cambridge “Apostles Club” and Bloomsbury friends – however this is just one example of a widespread attitude.

    The “intellectual elite” (as they think of themselves) do not just hold false ideas on economics – their basic moral ideas are false (indeed evil) also. And they do not just have wide influence in economics, in virutally every cultural insitution (from the “mainstream” churches to Hollywood) their view is powerful.

    This is no “Star Chamber” or formal conspiracy – there does not have to be.

    As the doctrines and attitudes are so widespread in the elite (thanks to the schools and universities) there is no need for meetings of “enlightened ones” dressed in silly robes.

    People do not need to plot in corners – when they are already in control.

    The problem with their ideas is not conspiracy (there is no conspiracy) – the problem with their ideas is that they are FALSE (utterly false).

    In the end their doctrines will not lead to the total power they crave – they will lead to DESTRUCTION.

    Total economic and social destruction.

    As Ludwig Von Mises pointed out in the last section of his work “Socialism” where he deals with the interventionists (rather than the formal socialists) in a section of the work titled “Destructionism”.

    The difference between the Marxist Frankfurt School (“critical theory”) crowd and Martin Wolf and his “liberal” friends is a simple one.

    The Frankfurt School Marxists (and allies such as the followers of Gramsci) know that “modern” economic and social ideas will lead to the destruction of civilisation (“captialist” society as they would put it). They lust for this destruction (for this sea of blood) – and prepare for it.

    Whereas the international “liberal” elite do NOT know – on the contrary they think that P.C. social ideas and print-more-money-and-we-will-all-be-rich economic ideas will lead to a happy wonderland which they will rule (for ever and ever).

    The “liberals” are actually more deluded (far more deluded) than the Marxists.

  • It is wholly true to claim, as Detlev Schlichter does, that because the alleged stimulatory efforts of central banks don’t work that therefor “The advocates of ever more ‘stimulus’ are grasping at straws.”

    And the simple reason for that is that many of us, myself included, have long regarded central bank’s attempts at stimulus as a nonsense, while favouring other and more fiscally orientated forms of stimulus. And there are plenty of others who think likewise. E.g. see about one minute into this video clip:


    or here:


    As regards Schlichter’s claim that stimulus is distortionary, I fully agree that monetary stimulus (i.e. interest rate manipulation or QE) IS DISTORTIONARY. That’s one of the many reasons I oppose it.

    In contrast, there is no reason for fiscal stimulus to have any big distortionary effect. That is, if such stimulus just consists of expanding ALL PARTS OF the public sector by the same amount, AND channelling extra money into consumers’ pockets, then private and public sectors will expand by roughly the same amount.

    Moreover, a NATURALLY OCCURRING increase in demand (e.g. because of increased confidence or “irrational exuberance”) is not always free of distortion. The reality is that consumers and business behave like lemmings: consumers may suddenly decide to purchase more new cars rather than other consumer goods, or bet on house price increases.

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