Central banks should focus on banking not money
Central banks confront the kind of scenario outlined in The Money Trap. In the book, I anticipated a world of generalised deflation, with zero nominal rates on risk-free assets. At the time of publication, in 2012, this seemed unlikely, to say the least. But it is materialising. The challenge now is to seize the chance to recast our money and banking systems.
We have a golden opportunity to reform. We must get central banks to withdraw from activist monetary policies that do no good and mandate them instead to focus on banking stability and ending too-big-to-fail.
What is stopping it?
Partly a fear of what might happen to asset prices if artificial monetary stimulus were to be withdrawn. The central banks are part of the problem. So are the politicians. They like to pretend they can hold central banks to account, when we all know they are subject to global forces over which they have little control.
Giving up illusions of the benefits of active monetary policies is essential if we are to forge a better monetary system. There is no point in having independent central banks when all they do under their current mandates is to fight currency wars that make us all worse off.
But if inflation targeting and activist monetary policies are to be thrown away, what can replace them?
This is where the current deflation and zero rates help. They prepare the way for what we really need. This is a currency suited for investors and real investment.
The big step is to shift the objectives of central banks from inflation targeting to managing the reform of banking and finance.
A regime of negative interest rates – penalising banks for not lending – is the reductio ad absurdum of activist monetary policies. It shows central banking is in crisis.
Put base money in the freezer
We should as a first step to reform adopt Milton Friedman’s proposal to freeze base money (cash plus bank reserves):
“ I would—if I had my choice—freeze the amount of high-powered money. Not increase it.”
“I would freeze that ….and have it as sort of a natural constant like gravity or something. Now, you would think that that’s a bad idea because there would be no provision for expansion; however, high-powered money is a small fraction of total money and the ratio of total money to high-powered money has been going up over time. So the economy would create more money and on average, you would have a pretty stable money growth and a pretty stable monetary system.”
Interest rates, long and short-term, would then be determined by the market. This would make them more predictable, rather than be subject to the vagaries of committee decision-making. This in turn would encourage real investment and new forms of financing. The public would hold the amount of money it needed.
The second part of the new central bank mandate would be to get them to focus on financial reform, promoting competition, ending too-big-to-fail and encouraging the growth of alternatives to commercial banking, notably equity finance as described in my previous note. This would carry to its logical conclusion an evolution already at work in the role of central banks. It would involve a change in the focus of their “financial stability” mandate.
Such a two-headed reform would link changes in the overall money supply to banks’ autonomous readiness to lend and encourage them only to finance credit-worthy projects (whereas negative interest rates encourage them to lend at any cost, i.e. to make bad loans). True, the money supply may fall initially as banks cut back on loans they reckon would turn bad in the new environment. Some asset prices would doubtless also fall. However, after a time, demand for finance by healthy businesses, especially SMEs, would grow as businesses and financiers came to understand the true implications of the withdrawal of the state from monetary activism.
An important part of that evolution will be a relative decline in the role of banks in the financial system. This will indeed be a natural accompaniment of a world of deflation and zero interest rates: bank finance will simply become too expensive for many borrowers, forcing a shift to equity finance. This will be especially important – and difficult to manage – in Europe and other parts of the world with bank-centric financial systems.
Central banks should not encourage gambling!
Current monetary policies encourage investors to bet on the future of asset prices, and when in doubt to keep piles of cash, i.e. do anything rather than invest in viable projects for the long term.
The reforms would change all that. No longer would monetary and price signals and interest rates be distorted by rash monetary activism and all the experiments associated with it.
The burden of delivering the impossible – a sustained expansion of demand when businesses and households are over-burdened by debt – would be lifted from the shoulders of central banks.
Freezing the money base and abandoning the illusions of pro-active national or regional euro-wide monetary policy activism would be key steps towards the needed reform of international money. At last, the age of national monetary policy autonomy would pass into history.
The age of the Ikon would dawn.