Scrooge or Santa? Central Banks Should Be Neither

Commentary, Economy, Ian Madsen

As the financial markets around the world erupt and gyrate, dampening the usual festive and hospitable spirit that commonly obtains at this time of year, there have been a number of reasons given.  There are some notable geopolitical risks, in the Middle East, Ukraine, North Korea, Pakistan, and other, less-usual suspects. There is the trade war between China and the United States. Then, there are some signs of slowing global growth.  All these are weighing on stocks markets.

Perhaps the most predictable one, and the one that usually causes both bull markets and economic expansions to end, is an increase in interest rates by central banks, and, more atypically, attacks (in India, Turkey, and the United States) on the dubious sanctity of central bank independence.  Once again, we all are compelled to wonder if central banks are about to overreach and, by trying to rein in inflation, artificially stimulated economic growth, and financial speculation and over-leverage, thusly will bring on yet another recession, when we have, it feels like, just finished recovering from the last one.

In all this, nobody seems to ever ask:  Is it a little strange that we are so dependent on the machinations and ponderings and internal analysis and considerations of institutions and mere human beings in such a, well, ‘centralized’ way?  Is this how it should be? If so, why? Could there be at least one, perhaps more, alternatives?

Answering these questions requires looking at the standard reasons given for the existence and operation of central banks.  Among these are: Supervisor of all banks and financial institutions, to ensure that they are solvent, liquid, and soundly run; Guardian and issuer of the national currency, to keep it respected, unforged and used honestly; Controller of the money supply, the liquidity of the national economy, to allow enough credit to keep commerce and personal finances rolling and flowing while keeping inflation neither too high nor too low, principally using short-term interest rates and ‘open market operations (buying and selling bonds)

There is more: Lender of last resort to financial institutions in case of financial panic or illiquidity; Fiscal agent for the government, issuing debt and handling its outstanding debt structure; Clearing house for financial transactions, mainly between banks; Collector and publisher of economic and financial, for its own use and that of the public and government and others.

That is a long list.  It is not clear that central banks are fulfilling these functions well, at all.  For lender of last resort, that did not work out too well in the Asset-backed Commercial Paper crisis in Canada ten years ago, nor in the even-worse Financial Collapse of Lehman, Bear Stearns, Merrill Lynch, Countrywide Financial, Fannie and Freddie, Ally Bank, AIG and others in the United States, and Northern Rock in the United Kingdom. Central banks also failed in the 1982 recession, and, most famously, 1929-32.

Central bankers were slow to recognize that anything was wrong in 2017-2018, and certainly did not see much of anything in advance to warn them, even though part of their job is to look for such weaknesses.  They also raised interest rates in advance, to well above supposedly ‘neutral’ levels, and which led to the economic slowdown they did not appreciate that they were exacerbating.

When it comes to being the guardians of sound money, they should earn little must not get much adulation for that, as the plethora of alternative currencies keeps growing:  bitcoin, Ether, and several other blockchain ‘cryptocurrencies’ demonstrate this lack of faith. They may be a blind alley at present, but the continuing attempts to create new means of avoiding the standard currencies show that this role is not being fulfilled. The loonie, US greenback, euro and other currencies fluctuate wildly. Electronic payment systems, such as mPesa in Kenya, show that central bank clearing is not vital, either.

As for being stalwart fighters of inflation, the very opposite is true.  Prior to the establishment of central banks in the way that they function now, about a hundred years ago, inflation was minimal, and, in fact, deflation was quite common, as currencies were based on silver and gold and the money supply could grow no faster than the production of those metals.  Since central banks were created, inflation has been well above zero, except in the 1920’s and 30’s, when real(adjusted for inflation, negative or positive) interest rates were high and credit tight.

Once central banks were founded, and their role as bankrollers of central banks became, indeed, central, inflation became common, and often very high, destroying savings and lenders, disrupting and devastating financial markets, and making ordinary consumers and citizens’ lives miserable. This was most vividly true in World Wars I and II, the Korean and Vietnam Wars, and during the attempts to debase Western currencies to counteract the price rise in oil in 1973-4, and again in 1979-81.

Finally, the idea that central banks help temper economic booms and busts is laughable; they actually cause them or exacerbate them.  Nearly every recession of the past seventy years has been preceded by an inverted yield curve: short term interest rates, determined by central banks, exceeding those of long-term rates (bond yields).  They also credit to expand to speculative levels, over and over again.

So, central banks have been more likely to cause recessions, either by raising rates too much or too early or too late, or by allowing too much financial speculation, the latter abetted by having rates be too low.  Central banks may never have served a useful purpose in the past. It is not clear that they do so now. We should not be looking to wise men in the East to chart our financial futures, nor to be either Santa or Scrooge.  Other alternatives of a decentralized, more innovative, transparent, free-market and less imposed-from-above sort, may be bring us much more Happy and more Prosperous New Years.