Three years after publication, it is time for a new look at the arguments put forward in the book.
The book argued that the crisis was the joint product of inflation targeting, irresponsible banking and a weak international monetary system. The book tried to show how these were inter-related:
- First, inflation targeting, which had been a valuable tool in combatting 1970s inflation, had by the 2000s outlived its usefulness as a guide and discipline for monetary policy. On the contrary, it made central bankers put the risk of deflation above all other risks, causing them to follow policies that stoked up financial bubbles. Again and again, governments relied on boosting credit to achieve lift-off, with the lead taken by house prices, at the cost of ever larger imbalances.
- A deterioration in banking standards and ethics was the natural accompaniment of financial market liberalisation in the context of loose money and globalisation.
- In reaction to the series of crises that resulted, the state extended its protection and “backstopping” not only of the financial system but also in practice of individual too-big-to-fail banks. This was contrary to all the teaching of central bank policy since Bagehot.These factors together caused banking and finance to become irresponsible.
- While inflation targeting had outlived its usefulness, there was no other realistic framework for central banks – nothing that promised or could promise long-term monetary stability – within a world of flexible exchange rates. Therefore it followed inexorably that
- A reform of the international monetary system was needed. A return to stable exchange rates would be the only way to reimpose the monetary discipline missing since the collapse of Bretton Woods and of its successor regime, i.e. inflation targeting.
- This reform of world money must be accompanied by a reform of banking and finance. Every phase in the evolution of the international monetary system is accompanied by a new kind of market finance (banking and capital market). The next phase would be no exception. The existing banking system was morally and functionally bankrupt.
- I predicted that “too-big-to-fail” banks would be broken up, or subject to such restrictions as to render them unable to perform the important roles of financial intermediaries. The criteria for success in reforms both to world money and commercial finance would be whether they re-connected finance with the real economy.
- The best way to restore responsible finance and an orderly monetary system was through a return to equity and equity-type contracts and relationships. Banks should be replaced by intermediaries in which depositors/investors took some risks – or paid for the privilege of security. The monetary unit should be defined in terms of something real – a representation of the real economy; hence the concept of relating money to an Ikon or a fixed price of a basket of global equities.
- We would remain in the money trap so long as we were unable to understand, and lacked the political will to confront, the forces trapping us – forces that were driving official policy-makers and private bankers into costly errors not only once or twice but in a repeated cycle with No Exit, or a “huis clos” (Sartre’s vision of Hell, being a depiction of the afterlife in which three dead people are punished by being locked in a room together for eternity).
- I concluded that “In the absence of the needed transformation of monetary and banking arrangements, turbulence could become chronic”.
A grand bargain
Seen from a public choice perspective, the trap resulted from a “grand bargain” between the three most powerful types of institutions in modern society – governments, central banks and large financial groups/investment banks: governments got cheap money, central banks got prestige and power, large banks lapped up the gravy. Meanwhile, the masses were to be kept quiet with bread, circuses and computer games, and the middle classes by nicely rising property values.
That was the glue of social and institutional interest that held us, helpless, struggling and pathetic in the jaws of the trap despite its obvious intellectual weakness and foolishness.
Clearly, we remain in the trap. Popular anger has fizzled out. Governments’ will to reform fades. QE and tighter banking regulation amount to more of the same medicine as was used after previous crises: “more of the same”, as Bill White puts it. Fears of deflation are stoked up by central bankers to justify bad policies. These unhinge markets and exchange rates. Undeclared currency wars become worse.
Higher debt at household and national levels constrains rather than stimulates demand. Heightened monetary uncertainty dampens real investment. Will these trillions of bloated central bank balance sheets and bank excess reserves ever be unwound?
Emerging markets are vulnerable to uncontrollable inflows and outflows of capital in response of changing investor perceptions of Fed policies. Excessive levels of indebtedness are worst in Japan but continue to rise elsewhere. The controversy among influential academic circles is whether central banks should resort to even more monetary expansion.
Yet there are some encouraging signs
Jaime Caruana and the economists at the BIS continue to strike a defiantly dissenting voice from inside the serried ranks of the central banks, as they point to the persistent expansionary bias of policy. William White continues to use his perch at the OECD to good effect (see note below).
As predicted, some big banking groups are breaking up. Many are withdrawing from various activities or areas of the world. All have been bound so tightly by new regulations and continuous oversight – often by underqualified people – they can scarcely do their job. Equity and various other types of contracts are playing a much bigger role in the financial system through crowdfunding and other innovations. Banks have greatly increased their equity base. It all points to a move to equity contracts, but has not gone nearly far enough.
While some central bankers insist inflation targeting remains “sacred”, there are signs of a weakening in their faith. Don’t members of the MPCs feel foolish meeting with great expense, trumpets sounding, every month, deliberating for hours, days, months on end and then doing nothing while markets go crazy all round them?
In a new and powerful article, Stephen Roach says inflation targeting has become “an engine of instability”:
“Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability. A new approach is desperately needed.”
Spokesmen from large emerging markets such as India (in the shape of RBI governor Rajan) and China (through, for example, the influential economist Justin Lin) have sharply criticised the functioning of the international monetary system. Elder statesmen such as Jacques de Larosiere and Paul Volcker continue to call for a return to more stable exchange rates and wider international monetary reform.
Finally, of course, despite enormous pressures, the euro-area has stuck together, a fixed rate monetary union in the midst of a turbulent world. This shows that some of the oldest, most conservative and proudest central banks in the world recognise that there is no salvation to be had in currency depreciation at the national level. And so, it seems, do their peoples.