In response to this blog post (frankly, a slightly shorter and more abrupt version of it sent as an email), a friend responded with three comments. I address his comments here.
He wrote the following:
- The role of monetary policy may have become even more relevant in managing financial stability.
- There is a compelling case that central banks (their autonomy and inflation-fighting mandate) contributed to reining in reckless governments.
- None of these refute the case for monetary policy nor is there any strong case that (either research or historical evidence) markets can do the job of calibrating interest rates in response to inflation.
My responses to each of them are as follows:
(1) That is precisely what I had said in the earlier blog post. They – central banks – have a role in banking regulation and in maintaining financial stability. The latter requires different targets and different instruments. Importantly, it requires a big mindset change and also to recognise and get out of ‘capture’ by the financial industry. The blame is squarely with the Federal Reserve and all the revolving door appointees now seen not just in the Federal Reserve but also in ECB and in BoE.
‘Inflation targeting’ was (a) a response to the 1970s high inflation and (b) a war against labour. They succeeded because globalisation, technological advances and commodity prices doused inflation in a big way. The first two took the wind out of the sails of labour bargaining power. Labour arbitrage on a global scale was enabled. There is brilliant and very persuasive correlation between the inflation rates in the US and in the UK and wage growth.
I had used those charts in my piece for ‘Evergreen Gavekal’. Pl. read my piece for EVA Gavekal, if you had not done so.
(2) Absolutely not. They did nothing of the kind. The proof of the pudding is in the data. In the last thirty-five years since 1980, Government debt/GDP ratio had risen inexorably from 30 to 40% of GDP to more than 105% of GDP. Very powerful failure of central banks role in reining in’ governments – nothing of that sort happened. Nor did the market do so.
(3) The case for central banking is different from the case for inflation targeting. Actually, for discussion sake, I would go further. The world would be fine without central banking. There would be accidents. But, there is no basis a priori basis to argue that they would be worse than what we have been encountering in the last thirty-five years.
Indeed, it is possible to argue the opposite. Central banking is like insurance. It has turned out to be the source of moral hazard. Without them, the risk premium on debt would be much higher both for government and for non-government debt because there would be no backstop. Growth and markets would be more volatile and hence, excesses would be self-correcting.
We need a banking regulator and, as long as, central banking does not address financial stability, front and square, I would argue that they are more harmful than helpful to the real economy.
On the second part of your sentence, I am absolutely convinced that markets have been distorted by central banks’ focus on short-term rates and inflation. Markets have been seduced or drugged not to take the long-term view. Without central banks, markets have no one to backstop them. They would price risk far better than they have done in the last thirty-five years. That is as true of bond markets as they are of equity markets.
As a compromise, I can agree that central banking with rules of the game – domestic and external – rather than ‘discretionary central banking’ will make for a better world than what it is today. All things are cyclical. The time for ‘discretionary central banking’ is up. It has run its course. At the minimum, the cycle of ‘discretionary central banking with inflation targeting mandate’ is over. At the maximum, there is a serious case for contemplating a world without central banks.
This is not a rant nor is it some form of nihilism to propose the abolition of central banking, as it prevails today, particularly in the advanced world. Indeed, this blogger believes that quite a big chunk of the problem can be solved if the Federal Reserve Board in the United States could be fixed. That is possible by finding people to fill positions falling vacant in the next 12 to 24 months who do not share the prevailing Federal Reserve orthodoxy on asset prices transmission to the real economy, on leaning vs. cleaning, on ties to Wall Street and on the relevance of transparency and forward guidance for the real economy.
But, it would be useful to consider an extreme proposal intellectually such as considering doing with central banking altogether for it would make other useful and urgent reform proposals seem less radical.
Just to be doubly sure, radical proposals or thoughts on central banking (and modern financial capitalism) have emerged from William White, Mervyn King, Raghuram Rajan, John Kay, Paul Volcker, et al.