Nick O’Connor – Capital and Conflict (Great Britain) –
Central bankers are tasked with making our economy run smoothly. But what if central bank policies are the cause of economic problems, not the solution to them?
Britain used to have the National Coal Board, the British Gas Corporation, and many other agencies and institutions by which the government controlled the economy. They’ve since been privatised or shut down because people came to realise that the free market does a much better job than the government.
Central banks are no different, we just haven’t realised it yet.
Central banks used to loom large in the world of investing. These days they are the primary driver of investment trends. It’s lucky their mistakes and consequences are there for you to grasp. I hope that after reading this you’re well on your way to doing so.
Let’s take a look at the flaws of central banking and how they turn into investment opportunities for you…
Rates too low for too long
If central bankers are in control of the economy, you can imagine why they’d over-stimulate and artificially prop it up. They want to keep their job and their political appointors happy. The way they do this is by keeping interest rates artificially low for too long. This was Alan Greenspan’s legacy at the Federal Reserve. His replacement Ben Bernanke had to mop up the mess.
If interest rates strike you as artificially low, you know this will encourage borrowing. The investment asset most tied to borrowing is of course property, as people use a mortgage to buy it. So it should be no surprise that property bubbles are a consequence of central banking.
In Europe this is easiest to see because different countries share the same monetary policy. In the lead up to 2007, the European Central Bank’s interest rate was high for Germany and low for Ireland. The result was a property boom in Ireland and a lagging economy in Germany.
Then the worm turned after the financial crisis. The interest rate is now too low for Germany, which was less hurt by the crisis, and the Germans are experiencing a property boom. The Irish struggled for some time. Greece still is.
The UK has its own currency and monetary policy. But the same effect still applies. If Bank of England governor Mark Carney is keeping interest rates low to stimulate economic growth, there will be an artificial property boom, or bubble, again. He’s very unlikely to keep them high, although the inflation crackdown in Margaret Thatcher’s era is one example.
An irrational fear of deflation
Central bankers are tasked with meeting their inflation target – around 2%. Governor Mark Carney’s interest rate policy is designed to achieve this. But there are many types of inflation that happen for many different types of reasons.
Take for example an oil shortage. This causes great inflation. But the best way to solve the oil shortage is to allow the inflation to occur. It incentivises more oil production and allocates the oil we do have to the best economic use. If the inflation is prevented from happening, the incentives to solve the problem are hidden. As commodity traders say, the best cure for high prices are high prices. It encourages more supply.
On the other side of the coin is the emergence of China out of communism. Over the last few decades this meant all sorts of goods have become cheaper for consumers. But central banks offset this by stoking inflation to prevent it. That’s why they left rates too low for too long, as explained above.
As the famous economist Milton Friedman once said, “Inflation is everywhere and always a monetary phenomenon.” He meant that true inflation is caused by central banks fiddling with the money supply. Other changes in price levels are the economy sending itself signals about what to produce, how to produce it, and how much of it. If you prevent these signals, you get economic disorder.
Another reason for the inflation target is that central bankers fear deflation. Falling prices make debt more expensive to repay. And that’s a central banker’s worst nightmare because they use borrowing to stimulate the economy. In a debt deflation the economy spirals down as falling prices trigger defaults, which cause prices to fall further.
The strange thing is that moderate deflation simply isn’t a bad thing if you look through history. The Industrial Revolution is one great example where technology dramatically drove down prices to the benefit of consumers.
Imposed stability is false stability
The Russian economist Hyman Minsky explained how stability breeds instability. What he meant was that we become complacent over time if we never face adversity. The economy is really just a reflection of human action, and so it exhibits the same dynamic.
In the lead up to the global financial crisis, we had what was called the Great Moderation, given to us by the steady hand of Alan Greenspan at the Fed. Inflation, employment and GDP were all steady and stable. Then disaster struck in 2008.
When central banks impose stability on the economy, it encourages more and more borrowing. People don’t fear tough economic times because they haven’t experienced them for a while. In this environment, the people willing to borrow the most have the highest standard of living.
But debt has a binary outcome. If you can’t afford it, things go bad very quickly. This usually occurs when interest rates are increased by the central bank to fend off the inflation they’ve created with their slack interest-rate policy.
Stockmarket crashes are prohibited
These days, stockmarkets are no longer allowed to crash. It’s too much of a political nightmare for central bankers’ bosses – politicians. Alongside government bailouts, central bankers stand at the ready to support banks and financial markets in times of stress. It’s what they were originally designed to do.
But what’s new this time around is that central banks are intervening into financial markets far more directly than before. Historically, central banks usually bought only government bonds to administer their interest rate policy. There’s a long list of reasons why, which aren’t worth explaining here.
But now some of them are buying other investments to increase the money supply and to bid up investments. The Bank of Japan is so keen to goose stockmarkets that it is buying vast amounts of shares. It’s now a top-ten shareholder in around 90% of stocks in the Nikkei 225 index!
If central banks have an infinite budget and consider it appropriate to bid up the stockmarket, then a stockmarket crash is nigh impossible.
The limit to the debt bubble
Because central bankers use interest rates as their primary tool to control the economy, they influence how much we borrow. To increase economic activity, they lower interest rates. We borrow more and the economy fires up. If things are running too hot and inflation rises, central bankers increase rates and we can’t afford to borrow as much.
This is the tightrope walk of a central banker. They constantly wobble between inflation on one side and deflation on the other. But no ever stopped to wonder where the wire leads to.
The answer is a mountain of debt. It’s no surprise that central bankers have been pushing more and more debt on us over time. They want economic growth. It’s what gets their bosses and appointees elected. And the easiest way central bankers can generate growth is more borrowing through cheaper interest rates.
The Institute of International Finance estimated world debt at 217 trillion US dollars, or 325% of global GDP. And it’s steadily grown in the era of central bank monetary policy.
But there’s a limit. Debt has to be repaid, plus interest. At 0% interest rates, how can central banks continue to force people to borrow more? It couldn’t be more cheap.
Without ever increasing levels of debt and borrowing, where will economic growth come from now? Will we be able to repay our debts?
I don’t know. We’ve never been here before. But it certainly doesn’t bode well for GDP growth in the future.