Today’s Western institutions have long been deemed to be sacrosanct. As a matter of fact, though, nation-states are increasingly met with reservation or even outright resentment. Public trust in government is near historic lows, and pillars like the media or democracy are suffering from a loss of confidence.
But one modern institution seems to be standing as strong as ever: central banks. Although their role has changed significantly over the course of a few decades and their mandate has been infringed on more than once, they are still met with a high level of trust by financial experts, economic actors, and investors. With every looming crisis heating up, global liquidity is seeking refuge in government bonds and cash, while central banks are being called for immediate help.
This is all the more surprising when taking heed of the fact that central banks have been ballooning their balance sheets beyond any reasonable measure. While economists of all types been critically assessing today’s bloated central bank balance sheets, the general opinion seems to stand firm: central banks are without alternative, being the only actors that can stem the tide of economic and financial destruction. They have no choice but to intervene and bloat their balance sheets, the common understanding goes.
Indeed, the reach and influence of central banks has never been higher, one could argue. Initially being lenders of last resort for banks, they have also mutated into dealers of last resort for all kinds of shadow banking institutions residing outside official banking regulation. Today the Fed and other central banks have to see to the stability of the entire financial system by catering to the liquidity needs of these shadow banks even though they have developed and grown outside the central banks’ purview. Many proponents argue that central banks are like the Fire Corps coming to quench the fire. And as the governor of the Bank of Canada has stated: “A firefighter has never been criticized for using too much water.”
On the other side of the spectrum are those who argue that central banks have been mistaking water for fuel only to ever exacerbate the mess they maneuvered themselves into. Depicted as the Mordor of the financial landscape, central banking is even considered by some to be the root of all evil. In the eyes of such radical critics, central banks are not only the originators of modern-day financial crises but their swath of government-trained economists and technocrats are seen as clueless lemmings serving a financial elite and not the economy as a whole.
The clash of these opposing sides is intensifying, and this is becoming particularly obvious on social media outlets like Twitter. While the European Central Bank (ECB) is trying to appeal to the general public through today’s digital means to mitigate its image problem of being too elitist, aloof, and undemocratic, its tweet wall is only ever filling up with critics, detractors, and trolls.
Nothing to Measure
With all this controversy, let the following message cut through the noise: central bankers are highly competent people and they should have our utmost respect for having the task of managing our economy. The problem is not a personal but a systemic one: they are tasked with measuring something that cannot be measured.
Our economy, like so many other “things” in life, is a complex adaptive order. Variables are unknown, and even if they were known at some point in time, because of the adaptive nature of the system, variables constantly change unexpectedly, making precise measurement virtually impossible. It was Peter Drucker who perfectly described a central banker’s situation: “You can’t manage what you can’t measure.”
Nonetheless, central banks are tasked with the management of our economy and the financial system. That they can’t manage it by definition is one thing. But that they seemingly don’t even try is another thing. As one of their last responsibilities, central banks are obliged to measure inflation. In accordance with their models, they stubbornly stick to a consumer price index (CPI) that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
With the focus only on consumer prices, though, inflation in stocks, bonds, real estate, or any other financialized asset is left out of the picture completely. But this is rather sarcastic as people are degraded to mere wage earners not interested in owning any productive assets within an economic order.
Anyone in touch with reality would know that this could not be farther from the truth. People are really saving their money, not to buy a price-stable banana at the grocery store, but to afford a house to live in one day. And this very house is currently not incorporated into inflation measures. If it were, inflation would have to be officially reported as being much higher.
Because central banks have been relentlessly turning a blind eye to the fact of asset inflation when calculating overall inflation, one can’t help assuming that they don’t even try to get at least closer to the truth. One is reminded of a person looking for car keys under a street light at night. Asked by a passing stranger if the car keys have really been lost right here, the person answers no. Asked by the baffled stranger why he looking for the keys there, the person in search of the keys replies: “Well, this is where the light is.”
Going off Money Supply Targeting
The high level of asset price inflation that we have been seeing for the last few decades is a consequence of immense monetary expansion. In 1971, the US moved off the gold standard, initiating a battle of currency devaluation among different fiat currencies. In their ability to create base money, no central bank currency was tied to gold any longer. Under the Volcker administration in 1983, the US took another decisive step. No longer did the Fed target the money supply but decided to target the price of borrowing money.
By doing this the US central bank began targeting the federal funds rate and let the money supply float. This way the proverbial kingdom’s keys were given to private financial institutions that started determining the money supply on their own, which resulted in a huge monetary expansion through shadow banking. So while feedback mechanisms were still kind of intact right after the closing of the gold window, when central banks still targeted the money supply, after 1983 central banks, with the Fed leading the way, noticed that many of their monetary policy tools seemed to be getting more and more ineffective.
Because central banks went off money supply targeting, they were not able to account for the huge growth in money supply coming from private institutions. Only gradually did economists recognize that measuring the money supply in variables such as M0, M1, M2, and M3 is pretty incomplete, leaving out the many securities and assets that have developed a sort of moneyness over the years.
Take It for What It’s Worth
It’s particularly striking that the development of the shadow banking sector and securities turning into important money-like instruments has not been on the central banks’ radar for quite a long time. This again goes to show that the problem with central banks is really a systemic one. As stated already, they are tasked with an impossible task: anticipating, measuring and managing the economy. But all they can do is play God and try to uphold the illusion of competence. Yet again, central banks might miss another iteration of shadow banking, the emergence of the crypto dollar industry.
With the illusion of being able to measure and manage the economy crumbling, central banks will have to be taken for what they increasingly are: financiers of the economy and financial market types of institutions. With the so-called emergency measures fighting potential disruptions following covid-19, central banks have tightened their grip on the economy. Never before have they bought more assets, in greater amounts and of more diverse quality.
Seeing and defining central banks’ mandate this way might be more uncomfortable for many economists, but at least it would be more to the point. And this might not be the only aspect of central banks that economists will have to grudgingly change their perception of. With its new, intensely discussed report on a digital euro, the ECB seems to have gotten the race for a CBDC (central bank digital currency) really going. Although Western central banks explicitly state that their CBDC shall not be a tool of control and supervision, judging by their record of getting things right we should not be overly reassured.Author:
Pascal Hügli is the chief research officer at Schlossberg&Co, a Swiss asset manager focused on protecting its clients’ wealth from unprecedented and increasing monetary socialism around the globe.