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How to control those central bankers

Stop treating people like donkeys!

Last Tuesday I went along to the Adam Smith Institute to listen to Brendan Brown launch his new book, “The Global Curse of the Federal Reserve”.


Brendan picked out three channels through which  central banks’ ultra-low interest rate polices can trigger asset price inflation (followed invariably by a crash):


  1. Central bank pegging of short-term rates together with forward guidance and sometimes other actions (such as direct intervention in long-term rate markets) mean that long-term rates become highly manipulated. They may fall far below equilibrium (neutral) level driving asset prices up.
  2. Long periods of low interest rates produce a search for higher returns. This search would be less desperate if there were sometimes periods of “good deflation” during which money yielded a real bonus. But there is no such bonus in the age of inflation-targeting.
  3. Stoking up anxiety about a jump in inflation at some uncertain point in the future adds further pressure on investors and make them liable to succumb to irrational, yield-searching behaviour. Fearing that inflation is coming down the road, they put on rose coloured spectacles and tend to underestimate risks.


Current activist monetary policies treat people as if they were donkeys, to be bullied, bribed and coaxed to do what the elite policy-makers want. Rightly, people refuse to be treated like that. Hopefully, this  is the last gasp of the snobby Keynesian mindset.

The only way to protect the economy from monetary-induced destruction is to take a quite different approach; building a regime of monetary stability. The proposal in Brendan’s book is close to that in The Money Trap – and indeed both stem from discussion between us. This is to restore the monetary base as the pivot of the monetary system – meaning much higher reserve requirements, no payment of interest on reserves, and a Friedman-style rule of x% p.a. expansion such as to be consistent with price level stability in the long-run. Central bank manipulation of interest rates would end.

In Chapter 5 of “The Money Trap”, I expand on this idea in the following way:


Monetary base control is the natural accompaniment of a preference for rules rather than discretion. This preference is based on a general political philosophy – for a society based on laws and distrust of arbitrary power – but also reflects the observation that discretion is often abused by monetary policy-makers and is subject to political manipulation. As a result, discretionary policies have an inflationary bias.


Under the gold standard, banks found by experience that they had to keep a certain fraction of their deposits in reserve in the form of gold (the monetary base of the time) so that they could at all times be ready to pay gold on demand. Gold was the ultimate regulator of the system; when the general level of prices was low, gold was scarce, and this encouraged mining of new gold, bringing of gold out of private hoards and an expansion of the monetary base.


Under a system of monetary base control without gold, rules would be mandated that mimicked the operation of the gold standard – thus, for example, the monetary authority could be required to produce a given average annual increase in the monetary base.


A system similar to this has been tried from time to time. In the US, it was used by the Federal Reserve under Paul Volcker in 1979–82 to break the back of inflation by allowing a sufficient rise in interest rates. In Germany, a version of it was practised by the Bundesbank, notably under my friend the late Otmar Emminger, for around 15 years from 1973, producing an enviable combination of low inflation without a property or asset price boom. In Switzerland it also met with some success, though the Swiss illustrated the difficulties of this approach to monetary policy encounters in small open economies. (In practice these regimes often targeted what is called narrow money, but this had a close correlation with the monetary base.)


Under a monetary base system, the central bank ensures that the monetary base grows in the long term at a rate consistent with the growth of the economy’s productive potential, plus an allowance for a low or zero inflation rate. In practice, the central bank would target bank reserves at the central bank, that is, the reserve component of the monetary base, adjusting this to take account of any shifts in holdings of notes and coin by the public. The central bank can change the quantity of reserves it supplies to the banking system through a combination of open market operations and other operations in government bonds, but also possibly in other assets. The monetary base is uner the full control of the central bank – th eonly monetary aggregate that is.


It would be essential, for the sucess of such a regime,  that political circumstances allowed monetary policy-makers to take a long-term perspective, possibly involving a period of several years of falling prices and rising unemployment. Only if a country can summon up the political will to sit through such periods can this route offer a solution to the conundrum. Many commentators rule it out on such grounds, quite apart from theoretical reservations. But historically, as under the gold standard, cyclicality of the price level has helped stabilize activity in the long term. If households and businesses see a dip in prices in a recession, but expect prices to rebound further ahead, then they are likely to boost spending in the present. The system relies on built-in incentives, rather than government activism, to act as stabilizers.


These, over time, should spur recovery and lead to growth of bank lending and the acquisition of other assets by banks and thus to a recovery in the broad money supply.


Again, one must always remember that the monetary policies tried in the USA, Europe and Japan in the past 40 years repeatedly produced crippling booms and busts that resulted in depression and high unemployment.


Isn’t it obvious that central banks’ policies since the start of the current financial collapse are not producing the hoped-for sustainable recovery? This is because economic agents “see through” policy activism. Rightly, it makes them fearful. The result? Continued stagnation.


The only answer is to put in place a robust policy framework to which agents spontaneously adjust, rather than to treat them as donkeys.


(Brendan and I differ on some issues, notably exchange rates, but that is another story. Here we afocus on the monetary policy regime suitable for a world of flexible exchange rates).