Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.
The 2nd edition of his excellent Paper Money Collapse is available for pre-order.
“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.
The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.
So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.
ECB mistrusted by Keynesian consensus
Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.
The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.
This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?
Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”
Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)
This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.
Argument ignores time preference
Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.
Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.
If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.
As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.
Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?
That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.
Argument ignores opportunity costs of holding money
The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)
I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.
Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.
Monetary causes versus non-monetary causes
If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”
But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:
Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.
Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?
To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.
There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.
There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.
And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.
One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.
The fallacy of macroeconomics and macroeconomic policy
Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.
We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.
It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.
Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.
According to commentators, sanctions imposed by the US and the European Union are pushing Russia towards a recession. However, we hold that some key Russian economic data have been displaying weakening prior to the annexation of Crimea to Russia. This raises the likelihood that sanctions might not be the key factor for an emerging recession.
The yearly rate of growth of monthly real gross domestic product (GDP) eased to 0.3% in February from 0.7% in January and 1.8% in July last year. After closing at 12.2% in March last year the yearly rate of growth of retail sales fell to 7.7% in January before settling at 9.6% in February.
We suggest that the key factor behind any emerging slowdown and a possible recession is a sharp decline in the yearly` rate of growth of money supply (AMS) from 67.1% in May 2005 to minus 12.2% by September 2009. We hold that the driving force behind this sharp decline is a strong decline in the growth momentum of the central bank’s balance sheet during that period (see chart).
There is a long time lag from changes in money supply and its effect on economic activity. We suspect that it is quite likely that the effect from a fall in the growth momentum of money during May 2005 to September 2009 is starting to dominate the present economic scene.
This means that various bubble activities that emerged on the back of the prior strong increase in money supply are at present coming under pressure. So from this perspective irrespective of sanctions, the Russian economy would have experienced a so-called economic slowdown, or even worse a recession.
Now, to counter a further weakening in the ruble against the US$ the Russian central bank has raised the seven day repo rate by 1.5% to 7%. The price of the US$ in ruble terms rose to 36.3 in March from 30.8 rubles in March last year – an increase of 18%.
Whilst a tighter interest rate stance can have an effect on the present growth momentum of money supply this is likely to have a minor effect on the emerging economic slowdown, which we suggest is predominately driven by past money supply.
There is no doubt that if sanctions were to become effective they are going to hurt economic activity in general i.e. both bubble and non-bubble activities.
On this one needs to exercise some caution given the possibility that major world economies are heading toward a slower growth phase.
Hence from this perspective, regardless of sanctions the pace of the demand for the Russian exports is likely to ease.
We hold that it is quite likely that the Euro-zone, an important Russian trading partner, is unlikely to enforce sanctions in order to cushion the effect of the possible emerging economic slowdown in the Euro-zone. (Sanctions are likely to have a disruptive economic effect not only on Russia but also on the Euro-zone). Observe that Russia’s export to the Euro-zone as a percentage of its total exports stood at 54.1% in 2013 against 52.9% in 2012. In contrast Russia’s export to the US as a % of total stood at 2.1% in 2013. As a percentage of total imports Euro-zone imports from Russia stood at 8% in January whilst American imports from Russia as a percentage of total imports stood at 0.8%. Note that the Euro-zone relies on Russia for a third of its energy imports. Hence it will not surprise us if the Europeans are likely to be more reluctant than the US in enforcing sanctions.
Russia’s foreign reserves have weakened slightly in February from the month before. The level of reserves fell by 1.1% to $493 billion after declining by 2.1% in January. The growth momentum of reserves also remains under pressure. Year-on-year the rate of growth stood at minus 6.2% in February against a similar figure in January. A possible further weakening in China’s economic activity and ensuing pressure on the price of oil is likely to exert more pressure on foreign reserves.
Meanwhile, the growth momentum of the Russian consumer price index (CPI) displays a visible softening. The yearly rate of growth stood at 6.2% in February against 6.1% in January. Observe that in February last year the yearly rate of growth stood at 7.3%. Based on the lagged growth momentum of our Russian monetary measure AMS we can suggest that the yearly rate of growth of the Russian CPI is likely to weaken further in the months ahead.
Summary and conclusion
According to some experts sanctions imposed by the US and the European Union are likely to push Russia into a recession. We suggest that the key factor which is likely to push Russia into a recession is not sanctions as such but a sharp decline in the growth momentum of money supply between May 2005 and September 2009. Given the possibility that major world economies are heading towards a renewed economic slowdown, we suggest that regardless of sanctions the pace of the demand for Russia’s exports is likely to ease. Now, given that the Euro-zone relies on Russia for a third of its energy imports it will not surprise us if the Euro-zone proves likely to be more reluctant than the US in enforcing sanctions.
Supporters of sound currency have a pretty good idea about what’s wrong with the present paper currency and banking arrangements. They also have clear views on what should replace it, although some put more emphasis on gold, others on baskets of commodities.
I remember the excitement I felt as I first read Friedrich Hayek’s The Denationalisation of Money. My preference was for gold, though the fluctuations of the early 1980s made me aware that reintroducing the Gold Standard could be turbulent. It would be politically “courageous” if not a sure election loser.
After grasping the idea that a basket of goods could be more stable than gold on its own, I eagerly turned to the last page. I hoped to find a compelling step-by-step guide to how to bring this “standard” currency into existence.
Antoine Clarke was the Economic and Political Adviser to the Finance Minister of the Slovak Republic, and a member of the Slovak Prime Minister’s Policy Unit. | Contact us
28 March 14 | Category: Economics, Free Trade, Politics | 4 comments
I chanced this morning on the superb collection of essays from Ludwig von Mises, The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (PDF).
In his Stabilization of the Monetary Unit—From the Viewpoint of Theory written in 1923, he showed considerable foresight:
Only the hopelessly confirmed statist can cherish the hope that a money, continually declining in value, may be maintained in use as money over the long run. That the German mark is still used as money today [January 1923] is due simply to the fact that the belief generally prevails that its progressive depreciation will soon stop, or perhaps even that its value per unit will once more improve. The moment that this opinion is recognized as untenable, the process of ousting paper notes from their position as money will begin. If the process can still be delayed somewhat, it can only denote another sudden shift of opinion as to the state of the mark’s future value. The phenomena described as frenzied purchases have given us some advance warning as to how the process will begin. It may be that we shall see it run its full course.
Obviously the notes cannot be forced out of their position as the legal media of exchange, except by an act of law. Even if they become completely worthless, even if nothing at all could be purchased for a billion marks, obligations payable in marks could still be legally satisfied by the delivery of mark notes. This means simply that creditors, to whom marks are owed, are precisely those who will be hurt most by the collapse of the paper standard. As a result, it will become impossible to save the purchasing power of the mark from destruction.
And in 1946, he commented on using easy money and deficit spending to stimulate the economy after a long period of cheap credit (The Trade Cycle and Credit Expansion):
In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptizing it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the artificial boom has caused. As things are now, after a long period of artificially low interest rates, the question is not how to avoid the hardships of the process of recovery altogether, but how to reduce them to a minimum. If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923.
The Bank of England hopes to avoid all this by manipulating people’s expectations about inflation and GDP growth. I don’t think it can be done – too many commentators can see through it.
Nevertheless, they are going to give it a try. The best that can be said for it in the context of the German experience which Mises predicted and lived through is that at least if coming events are well understood, contemporary errors may at last produce the paradigm shift in economic thought necessary to put us on a more just and moral economic path.
Steve Baker is Conservative MP for Wycombe and a co-founder of The Cobden Centre. He was previously an aerospace and software engineer. Among other things, he worked with major banks and regulators internationally. His personal and political website is at stevebaker.info. | Contact us
22 August 13 | Tags: Books, Inflation, Mises, Money | Category: Economics, Politics | 7 comments
EQUITY markets jumped yesterday after the Bank of England shocked investors by indicating that rates would stay at historic lows in the near future, despite recent signs that the British economy is starting to strengthen.
That investors are shocked by the news that Mark Carney plans a further extended period of easy money is more surprising than the news itself. But it turns out markets are good at responding to superficial data over the clearly stated intent of big players in the market, like central bank officials.
Consider the evidence of Lord George, former Bank of England Governor, to the Treasury Select Committee in 2007, in which he confesses his role in seeding economic disruption in an attempt to avoid recession:
Tuesday 20 March 2007 – Treasury – Minutes of Evidence
Q117 Ms Keeble: What makes it worse is that the one tool that the MPC has is interest rates and that filters through to our constituents in the form of higher mortgages. That makes them complain even more; it becomes cyclical.
Lord George: Yes, if house prices are going up. But one has to step back and recognise—I referred to it earlier—that when we were in an environment of global economic weakness at the beginning of the decade it meant that external demand was declining. Related to that, business investment was declining. One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption. It is true that taxation and public spending can influence the demand climate and consumer spending, but confronted with what we saw we knew that we had to stimulate consumer spending. We knew that we had pushed it up to levels that could not possibly be sustained in the medium and longer term, but for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out, but we really did not have much of a choice about what we did unless we accepted that we would yank it back or give up stability altogether. That is the point I am trying to make in answer to Mr Newmark. There are some people—maybe lots—who say that house prices is the biggest problem, that the mortgage rate is going up, housing is not affordable and so on.
And a few weeks ago, the Bank’s Andy Haldane confessed that they “have intentionally blown the biggest government bond bubble in history” (I abridge a little):
Wednesday 12 June 2013 – TRANSCRIPT OF ORAL EVIDENCE
Q41 Mark Garnier: … If you thought that QE was creating financial instability, would you try to warn the MPC and, if so, how would you do it?
Andrew Haldane: I absolutely see it as my one of jobs as an FPC member to alert not just the MPC but this Committee and the wider world if I thought that QE, or monetary policy actions more broadly, was posing significant risks to UK financial system stability. …
To the substance, this is a risk that I feel very acutely right now. If I were to single out what for me would be the biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally, for any one of a variety of reasons. We have seen shades of that over the last two or three weeks. Let’s be clear, we have intentionally blown the biggest government bond bubble in history. That is where we are, so we need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted. That is a risk. It is one we as FPC need to be very vigilant to.
So, by officials’ own admission, the Bank under Eddie George created levels of debt-fuelled consumption which they knew could not last in the hope of avoiding recession and, following that bubble bursting, they have now deliberately inflated the biggest bond market bubble in history. When I see markets herding in response to the pronouncements of these big players, I think “What could possibly go wrong?”
It is certainly true that the central banks can alter economic expectations but the idea that they can do so helpfully is fanciful. It is founded on the same errors as socialism and like socialism, it cannot work because the information necessary is not available and because it relies on aggregating away much that makes us human.
We’ve had two confessions from central bank officials. I feel I can predict confidently that Mark Carney will one day confess, more or less, “We thought we could manage the economy by steering the expectations of tens of millions of people using monetary policy to blow various bubbles while making pronouncements about policy. We were wrong.”
One of the great tragedies of our circumstances is that so many people will label this central planning “capitalism”. Eventually, the state will have to get out of money and banking. Mark Carney’s coming failure should accelerate the day.
What the Bank of England is trying to do is restart the money creation process which dropped us into this mess while keeping expectations of inflation low. It’s an extremely dangerous game, one which Hayek explored in his Nobel lecture: it is a policy which cannot create sustainable prosperity but which may create massive inflation, with all its destructive effects.
Having mostly failed to see this crisis coming before failing to predict even the general pattern of events, senior economists now want more of the medicine which already nearly killed the patient. This may look like madness or stupidity to those of us without a high level of formal education in economics. It is neither. Contemporary economists are trapped in an intellectual prison founded on now-old errors of method and epistemology: the knowledge and simplifications necessary to make their mathematical models work are unavailable and invalid respectively.
As a result, economists and central bankers in particular think it is their task to intervene when the choices and actions of tens of millions of people produce aggregate statistics they, and politicians, don’t like. Massive economic disruption and misallocation of resources — ultimately, human suffering — is the result. Unfortunately, it looks like those few who hold the terrible power of monetary policy are determined to test their ideas to destruction.
Following the UK credit rating downgrade, I gave Newsnight an interview. They chose a couple of sentences in which I pointed out the reality that welfare, health, education and debt interest are about 3/4 of spending on 2012 figures and that they will have to be cut eventually if we are serious about the state living within its means. You can find it at 17:00. If I had been given longer, I would have said those things you can find in this interview with RT:
We have been on a merry-go-round of deficit spending, excruciating taxes, heavy borrowing and easy money for most of 40 years. That merry-go-round is now running down and will stop. Attempts to spin it up through monetary policy are extremely dangerous: they will store up worse trouble for later.
If the Government does not act to end expansionist policy in time by a return to balanced budgets, by ending government borrowing from the commercial banks, by stopping quantitative easing and by letting the market determine the height of interest rates, then it will have chosen the German way of 1923.
In this podcast we discuss how debts are undermining Western civilisation, the significance of unequal taxation and how iDemocracy most definitely does not mean voting by computer. And, oh yeah, what is the difference between a metaphor and a simile?
Blue-chip mystique still clings to it but you can feel the reputational parabola slowly gathering momentum on the downside. Its projects are too large and diffuse, the resources to achieve them too crude and there are mounting signs of unhappiness and confusion at the top.
Given their long-standing rock star status, pity the central banker; the fall from grace may be vertiginous.
♦ ♦ ♦
The Governor of the Old Lady seems more attuned to this unfolding trend than most. On my reading, he metaphorically ran up the white flag in a recent speech. It was the oddest mixture of explanations, implicit apologies and rationalisations imaginable from such an august perch. Do have a look; it’s not long.
King finished with an amusing touch: “As for the MPC [Monetary Policy Committee], you can be sure we shall be looking for as much guidance as we can find, divine or otherwise. What better inspiration than the memory of those children on Rhossili beach singing Cwm Rhondda.”
Perhaps the South Wales Chamber of Commerce seemed a forgiving place to lay out some of central banking’s many puzzles.
Put simply, his message was: I know what we’re doing seems a bit crazy, and I know all the fundamental problems are still out there waiting to be solved, but what else can we do?
What’s even scarier is that I understand what he means. After all, most of the really important stuff, like correcting the monstrous accumulated imbalances of recent decades and setting a more sensible course for the future, isn’t within the Bank of England’s remit. And yet, because the magic wand is in their hands, everyone looks to them to do something. Anything.
Which, as we know, they did. Cumulative QE (so far) of £375 billion, or 25% of GDP, enough for top spot amongst its Western institutional colleagues. As King suggested, the market is well and truly sated:
During the crisis central banks have provided liquidity to banks on a truly extraordinary scale, so much so that there were no takers for additional liquidity in our latest auction. It is still useful to keep their auction facility as an insurance policy. But banks are now overflowing with liquid assets.
Insurance policy indeed. Any more QE would seem in danger of plunging the whole business into farce.
♦ ♦ ♦
King, as he often does, got to the nub of the matter early on in his speech:
In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce the trade deficit, to repay our debts, and to raise the rate of national saving and investment. So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today. Almost 4 years ago now, I called this the “paradox of policy” – policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term. Although we cannot avoid long-term adjustment to our economy, we can try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.
He’d be only too aware, I’m sure, that our current intolerable mess is the result of giving in to a long succession of apparently desirable short-term policy measures. In each of the would-be and actual recessions of recent decades, politicians and central bankers strove to “limit the immediate damage to output and employment.” And, for the most part, succeeded. Trouble is, of course, in doing so earlier excesses were never allowed to sort themselves out; instead, they were carried forward with compound interest and then added to afresh.
How does one ever decide that now, finally, is the moment to pay the piper?
Thing is, even if King thought the time was now (or, quite possibly, a few years ago), it’s out of his hands. He can advise, plead, cajole, threaten to resign, but he can’t decide. So too with his compatriots elsewhere, many of whom have also been delicately (and sometimes not so delicately) pointing out the limits of of monetary policy and pleading for deeper structural reform.
As King said immediately after his comment about banks now overflowing with liquid assets:
Their problem remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in many parts of the industrialised world. The verdict of the market is clear – without central banks support banks still find it expensive to borrow.
What’s true of the banking system is no less true for the economy more generally. There’s way too much debt and not enough equity. Until that imbalance is dealt with (together with all the real world distortions it fostered) there’s no chance of organic growth, just the hyped up, artificial variant produced by great bouts of fiscal and monetary stimulus.
Central bankers are burdened with a kind of original sin. After all, without their unfailing support and encouragement (together with the very nature of the fiat fractional reserve banking systems over which they preside), the credit excesses of recent decades would have been quite impossible. Can any of them coolly and dispassionately disentangle and measure the system in which they’re so deeply embedded?
I don’t know, but it’s not hard to imagine King lying awake in the early hours of the morning.
♦ ♦ ♦
So what’s the endgame?
With overall debt levels rising (still), rates pinned to the floor and vast amounts of excess liquidity sloshing about (thank you Mervyn, Ben, Mario et al), a private sector busily trying to repair its collective balance sheet and economies everywhere in the doldrums because of massive imbalances, anyone who says they know the answer is dreaming.
What we can say is that policy is distinctly, perhaps even irretrievably, assymmetrical. Central bankers are conditioned to leap into action at the merest hint of renewed weakness, much less deflation. As with both fiscal and monetary stimulus in recent decades, the political incentives all run one way. In the absence of sustained, reassuring economic growth, it’s hard to see what might change this bias.
Right now, all the resulting excess liquidity is mostly languishing in reserves at various central banks, collecting a paltry return and seemingly doing no harm. There’s a bit of fresh lending going on here and there, but demand is low and the banks, generally, remain relatively cautious. Fact is, central bankers are tearing their hair out because of the financial system’s lack of responsiveness.
Careful what you wish for, perhaps? According to Ashwin Parameswaran, the market’s current willingness to hold unusually large quantities of money because of the crisis induced desire for safety and liquidity may not hold if “real rates turn significantly negative”:
Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the free lunch level of nominal interest rates enforced by the central bank.
Whether these huge reserves might one day wreak unexpected havoc is something I’ve long wondered about too. What I hadn’t realised until I read Ashwin’s links was how critically important explosive private credit growth has often been in earlier hyperinflations.
It makes perfect sense, of course. Once the incentives are strong enough (and what could be stronger than seriously negative real rates?) the whole machinery of credit and money creation is unleashed. One shudders to think how silly things could get.
Could it really happen today, in the US, the UK, or Japan? Could central bankers miscalculate or lose control so badly as to set this particular doomsday machine in motion?
Cassandra though I often am in these matters, I struggle to see it. After all, there’s no shortage of historical horror stories at hand. Still, like armies, central bankers are inclined to fight the last war, and after the 1930s they’re understandably paranoid about letting debt deflation get the upper hand. As Bernanke said at a conference honouring Milton Friedman on his 90th birthday: “Regarding the great depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”
So it’s not inconceivable. It just needs inflation to get away enough to generate juicy negative real rates. With so much dry tinder already around and central banks all leaning one way, that’s not inconceivable either. Remember too that while individual banks can get rid of reserves through making loans or purchasing investments, overall, banks can’t. What one loses, another gains. One can therefore imagine an accelerating rush by individual banks to deploy reserves, all of it, at a systemic level, entirely fruitless and on the other side newly hungry demand intent on exploiting negative real rates. While the notion of hyperinflation still seems . . . well, a bit hyper, it doesn’t strike me as an easy beast to rein in if it bolts.
To bring it under control, central banks would either have to vaporise sufficient reserves through sales from their portfolio to give banks pause, or, raise the rate they pay on reserves high enough to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these bone china delicate times. As for the latter, with reserves so high (and still growing) it sure wouldn’t be cheap.
Although everyone agrees that freedom is important, political freedoms are often prioritized over economic freedoms. Many believe that the best way to maximize personal freedom is to furnish each individual with an equal voice in the democratic decision-making process. After all, the logic goes, how can you be unhappy with a choice that you had a hand in making?
Professor Jason Brennan explains that an equal vote is not tantamount to personal freedom. In fact, he posits that many democratic outcomes are injurious to individual freedom. Unless it is limited by a constitution that protects certain rights, majority rule can make individual liberty all but illusionary. If we truly care about freedom, Professor Brennan argues, then individuals should be given the largest possible sphere of personal and economic autonomy. Only then will individuals be allowed to take full control by making choices about all facets of their lives – not simply which lever to pull on election day.
As Professor Brennan concludes, economic liberty is about much more than dollars and cents; it’s about allowing individuals to “lead the lives that they regard as authentically theirs.”
Those of us who believe liberty under the law is the best route to peace and prosperity owe a tremendous debt to everyone involved in the Learn Liberty project. If ever we are tempted to despair at the state of contemporary public debate, we need only remember that our generation is blessed with this fabulous communication mechanism, the Internet, and all the wonderful resources provided by fellow travellers who share our view that civilisation is best advanced by the voluntary cooperation of free people.
Steve Baker is Conservative MP for Wycombe and a co-founder of The Cobden Centre. He was previously an aerospace and software engineer. Among other things, he worked with major banks and regulators internationally. His personal and political website is at stevebaker.info. | Contact us
24 August 12 | Tags: Democracy, Economic Freedom, Video | Category: Politics | 2 comments