As many readers will be aware, central banks are playing a central role in the management of the current economic crisis. As such, I thought that it may be worth reviewing their role in the creation of the crisis itself. After all, if they contributed to the crisis, it might be reasonable to question what role they may be playing in the attempts to fix the crisis.
Before starting , I had better start with a brief description of the role of central banks, and exactly what they are (for conspiracy theorists see note 1). As an example, the Bank of England (BoE) gives its core purposes as financial and monetary stability and similar explanations for other central banks can be given. In order to allow them to achieve their purpose, they are normally given a monopoly on the issue of currency so that they are able to control the supply of money in the economy. To these, I would also add that they have a secondary and perhaps just as important purposes. This is to support government borrowing (not an overtly stated purpose), as well as being the banker's bank. I am simplifying here, but that is the basics.
For the purposes of this post I want to focus on central bank targeting of interest rates. If I have time I will post a couple of notes at the end to explain the process, but suffice to say that an underlying purpose of interest rates is controlling the amount of money in the economy, meaning that the central banks either 'create' money, or 'destroy' money'. One of the key measures that drives interest rate targeting is the rate of inflation - too high and they reduce the money supply. It is here that we come to the first problem.
We have all come to accept the official rate of inflation as being a relatively uncontroversial measure of the change in the cost of living, but this acceptance of the official rate is very questionable. An excellent explanation of why this is the case can be found in an article which details the many manipulations of the method of calculation of inflation. I strongly recommend reading the article in full, as it shows an excellent case study of how it is in the interest of governments to manipulate official rates of inflation.
One point of particular note in the calculation of inflation (e.g. in the UK) is what it does not measure, and that is property prices. This is a most curious omission, as a house is one of the largest items of expenditure for most individuals, whether renting or through buying a house. As we are all very aware, we went through a period of massive house price inflation, and the problem is that this did not show up in the statistics.
It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.
You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.
In consideration of inflation, it is important to move away from the official figures, and actually understand what inflation really is. It is actually very simple. Inflation is a an increase in prices resultant from an increase in the amount of money chasing a particular good or service. The causes of inflation can come from an increase in the supply of money, changes in the demand for a good or service, a reduction in the supply of a good, or a combination of these.
In the case of house prices, one of the primary factors in the inflation was an increase in the supply of money, which can be seen in the mortgage markets with increased multiples of income being considered, 'ninja' mortgages, self-certification and many other means of softening lending criteria. In other words, there was a significant increase in the money supply creating inflation. This, even by the self-defined purpose of central banks, should have been a matter which would be of concern to them. Instead, they merely looked at the official inflation and ignored the reality of real inflation 'on the ground'.
To this problem of the measurement of inflation, I should also add another problem with one of the measures used by central bankers which is GDP. However I will not discuss this again, as I have done so in some depth in other posts (e.g. here).
As such we have a situation in which, for example, central banks in the UK and US showed negligence. However, it is not just these central banks that are to blame, and I will give the rather curious example of the influence of the Japanese central bank in the housing bubbles of the UK and US. Japan's central bank is just one central bank that played a role, but it is a very interesting example.
As many readers may be aware, Japan had its own property crash in 1990 as a result of its own bubble. The result of this crash was to see a period of economic contraction in Japan, with the Japanese central bank eventually responding with a long period in which interest rates were virtually zero, and also with the Japanese central bank following a policy of quantitative easing, or printing money.
As regular readers know, I warn of the danger of hyper-inflation when central banks print money. Printing money has two impacts; on the one hand it transfers the value of the existing money supply onto the new money, such that the value of each unit of money is reduced (inflation), which has the effect of more money chasing the same goods (inflation). So why did Japan not have a bout of hyper-inflation?
The answer is rather odd. As fast as the Japanese central bank pumped out newly printed money, Japanese banks also pumped money out of Japan into Western banks. Having reduced inflation to virtually zero, any holdings of the currency were moved into countries with higher interest rates in what was known as 'the carry trade'. In other words, the lack of the ability to earn interest in Japan drove Japan into diverting lending outside of Japan.
In this trade, what was happening was that you could borrow at no cost in Japan, drop the money into a Western economy, and be paid interest on money that you borrowed for nothing. In doing so, even though the money was being devalued by the government printing more money, you could offset the devaluation by the interest you gained through investing it in Western countries. The following is a (grossly) simplified explanation:
If you are printing money such that the base money supply increases by 5% per year, and interest rates are zero, you can borrow that money, invest in a country offering 7% interest, and actually make a currency whose value should be falling, increase in value. In investing the money overseas, you are actually creating an improvement to your current account that offsets the impact of the increase in units of your currency. You are creating greater foreign reserves as a result of the return on that overseas lending, such that you are accumulating ever more foreign reserves, thereby strengthening your currency. If you look at a chart for the value of the JPY against the $US, you will see that the rate fluctuated but has only recently fallen significantly.
The story is not as simple as I paint it here, as Japan also has a large trade surplus and considerable savings, other countries were inflating their money supply and so forth.... The reason for pointing this out is that we have in principle is a system in which it is possible for a central bank to print money, flood that currency into another market, and still retain the relative value of the currency. It is quite an extraordinary notion and I therefore find it hard to believe myself and, as such, comments on this are welcome.
As an aside, the only problem in such a scheme is currency risk, where you expose the lending to fluctuations between your home currency and that of the destination currency. i.e. if the destination currency falls in value, then you risk your money.
What we then have is a situation where there are several results. The first is that, as fast as the money is printed, it is pumped out such that the money supply in the economy never expands, and the country remains in a situation of deflation or very low inflation. By keeping the interest rate so low in Japan, the central bank defeated its own purpose. The second result is that an ever larger 'wall' of money leaves Japan for the Western economies in the carry trade.
A good example of the results of the carry trade in the destination economy is provided by New Zealand, whose size makes the effects more apparent. The curious thing about New Zealand is that, unlike the US or UK, New Zealand kept interest rates relatively high and still created a house price bubble. When we think about the carry trade, it is apparent why this would be the case. In particular, the New Zealand central bank was between a rock and a hard place....
If the central bank increased interest rates, it would encourage the carry trade, and the carry trade means an injection of more money into the economy. However, if the bank reduced interest rates, thereby discouraging the carry trade, then you have a situation in which the central bank is itself increasing the supply of money into the economy. In other words, whichever way the central bank jumped, it would not reduce the money supply. It is almost enough to make you feel sorry for the central bankers (almost).
What I am trying to paint here is a picture in which central bankers are pulling their various levers to control the economy, but the measures that they use to guide their lever pulling are actually faulty. Furthermore, the problem that arises is that, even as they are pulling their own levers, other central banks might be pulling levers that will confound their own actions. In essence, you have a situation in which there is an illusion of control, but a reality of very little control.
At the heart of the problems is that the central banks have control over the monetary supply, and that money supply is therefore subject to their manipulations. In particular, the problem is that they are able to create money, and in creation of money they create ripples of distortion both in their local economy and in the wider world economy. It is perhaps for this reason that the central bankers are calling for ever more co-ordination between the central banks.
However, co-ordination between the central banks creates even greater risks than the current system. If we remember that the central bankers have made basic mistakes in the management of their local economies, and that these have contributed to the current crisis, it is more than likely that co-ordination will make the mistakes systemic, and create even greater distortions in the world economy. A good example of international co-ordination creating systemic risk can be seen in the Basel banking regulation frameworks, which have played a major part in the development of the current crisis (see posts here and here for how).
The only real solution to the endless and distorting tinkering of these central banks is to actually remove from them their facility to create money from nothing. In practical terms, that means to go back to a commodity based standard - whether gold, platinum or silver really does not matter. I have explained the benefits of such a system, and why it is better than a fiat currency in another post.
As it is, we can see that these tinkerers are not really to be trusted, and that their current tinkering in each individual economy can only set up new ripples and distortions in the world economy, whilst all the while the ripples and distortions of the activities of other central banks will only serve to confound their own plans.
First of all, despite what conspiracy theorists suggest, they are not institutions that are in the hands of a few wicked and clever individuals with huge power to shape the world. Instead, they are rather mundane institutions that have an illusion of power...
I watched one of the conspiracy theorist videos listed in Google, and they presented a picture in which the federal reserve was run and owned by a group of shadowy international bankers. However, I noted that they never actually revealed who the shadowy owners actually are, or that many central banks have been nationalised. If you have any doubts, take a look at this site, which details the ownership of the federal reserve......and how much money goes to the shareholders, and how much to the government. They are not part of an international secretive bankers conspiracy. A two minute search on Google found a paper that revealed the structure and ownership of the federal reserve, and it seems funny that this was excluded from the three and a half hour video....
For those who wonder how a central bank creates money, the process is shockingly simple. If they decide they want to increase the money supply they simply buy something (normally some kind of government securities), and do this by simply doing the equivalent of writing a cheque for it. This means that a credit appears in an account of whoever accepted the cheque and money has appeared. The trouble is that central bank has not actually used anything to pay for the securities - it just creates the credit, and the money supply has increased by the amount of that credit. Money from thin air....if a central bank wants to decrease the money supply, it simply sells the asset, and the money simply disappears...
I was tempted to go into a more comprehensive explanation, but hope this serves the purpose for this post.
It occurred to me that, with the explanation of the Japanese money printing, some might think this offers a justification for printing money. It should be noted that this system only worked due to the differential available in the interest rates, and the ability for Western countries to soak up the money in their asset bubbles. In the current climate, the only place for money to go is into lending to governments. Lo and behold, governments throughout the OECD are on a borrowing binge of epic proportions. Not only that, but every country central bank in the OECD is targeting low interest rates, the US is printing money, the UK is printing money....In other words, around the world there is a massive inflation in the money supply.
The problem here is that, unlike the past, there are no assets that are going to soak up the excess of money. Although the house price bubble represented real inflation, it did not 'feel' like inflation because people believed that they held an asset that offset the inflation. I am misusing the term, but the housing bubble partially sterilised the money that was entering the economy. However, as the governments start to absorb and utilise the massive increases in the monetary base, this money will start flooding into activity in the economy that is measured by official inflation, and that is when hyper-inflation kicks in. The increase in the money supply has nowhere to go but into the purchase of goods and services.
I must be a little careful about the use of the word inflation in general. The problem is that there is a situation of real inflation, and official inflation. For example, right now, there is real deflation if house prices are included, as the cost of this good is dropping very rapidly. I will try to ensure I make a distinction in future posts, but it is easy to use the word without thinking whilst meaning 'official' inflation.
With regards to using measures like inflation and GDP I should add that any such measures are of themselves subject to problems, regardless of whether they are correctly applied/understood. A couple of years ago, I read a very good illustration of this (I think the author's name was Neeley), in which a visitor to an airport saw a very strange sight. A plane came to a halt, the baggage handlers opened the hold and one of the baggage handlers then grabbed a bag, ran across the runway at breakneck speed, before depositing the bag on a carousel, and then starting the carousel. It turned out the performance measure for baggage was a measurement of the time that it took from the plane coming to a halt, to the first bag arriving at the carousel, and the carousel starting....the figures looked good, but the underlying real performance remained very poor.
The point here is that if you focus on a particular measure, you will end up distorting behaviour to meet the outcome of what is being measured. As such, in the case of GDP, the focus of so much attention, nobody stopped to think about the underlying meaning of the measure, such that debt driven activity was encouraged - after all, such activity increased GDP.... in other words, the way the measure was used was no different from the principle of the baggage handlers...
I have hesitated to hit the publish button on this post, whilst I have tried to think through the issue of the Japanese money printing.
However I look at it, it appears that it really is possible for a central bank to print more money and see the value of the currency increase (even if only in the short term). Eventually such a system is unsustainable, as it must lead to some kind of inflation, even if it is not in the domestic market. In this case, in the end the lenders lose, as they have accepted IOUs in return for their money which are actually of equally dubious value as the money that was lent, and this is due to the inflation created in the source of the IOUs. In other words, they exchanged debased currency for debased IOUs. I hope this makes sense and, as I have mentioned before, comments are welcome, in particular any challenges to the idea that I have put forward.
I am re-reading The Wealth of Nations again, and for those of you who find economics a puzzle, I can not recommend this book enough. It is clearly written, free of jargon, and just makes excellent sense. The language is a little archaic in places but, as you read it, you find that you stop noticing as you are so absorbed by what he is saying. It really is an outstanding book. Perhaps a copy posted to all of the OECD leaders might help?