Central banks: Running out of ideas, road

ECB, photograph by Florian K

On page two of today’s Wall Street Journal Europe you will find the result of a readers’ poll from last Friday: Question: Will the ECB’s rate cut help restore confidence in the bloc’s economy? Answer: 81 percent of readers say no, 19 percent yes.

Last week’s round of global monetary easing – another ECB rate cut, another round of debt monetization from the BoE, another rate cut from the People’s Printing Press of China – is, of course, more of the same old same old. It has a discernible touch of desperation about it and this is not lost on the public. Monetary policy is ineffective. Or, to be precise, it is only effective in delaying a bit further the much-needed liquidation of the massive imbalances that previous monetary policy helped create, and thereby is contributing, on the margin, towards making the inevitable endgame even more painful. It is counterproductive and destructive. It is certainly not restoring confidence.

Yet, many commentators and many of the establishment economists out there are not giving up. If only the ECB had cut by 0.5 percent instead of 0.25 percent, the equity market could have responded more optimistically. Maybe this would then have restored confidence? — Really? We are now below 1 percent in official interest rates, having cut by a full 400 basis points since the crisis started. How realistic is it to assume that another 0.25 percent is the difference between confidence-enhancing monetary stimulus and dread-inducing disappointment?

The advocates of ever more ‘stimulus’ are grasping at straws. What else can they do? Their pretty little world-view according to which, in a system of unlimited fiat money, the central bank can always create some additional ‘aggregate demand’ by giving a bit more artificially cheap funding to the banks lies in tatters.

Money is never neutral

That monetary policy would finally end in this cul-de-sac is no surprise. It only surprises those who share the mainstream’s simplistic view of monetary stimulus. Phrases such as “the ECB is attempting to unlock the flow of credit in the Eurozone”, are masking the complexity of the true effects of money creation and interest rate manipulation, and they make ongoing monetary stimulus look unduly harmless and straightforwardly positive. Who could object to unlocking credit, to liquefying markets or stimulating activity?

One of the major contributions of Ludwig von Mises’s monetary theory was his proof of the categorical non-neutrality of money. He demonstrated “that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the ‘level’ of prices.” (Ludwig von Mises, Memoirs, page 47).

A monetary stimulus never affects GDP and inflation directly and exclusively, these two statistical aggregates to which the mainstream assigns overwhelming importance. Every monetary stimulus affects and changes many other things as well, and these other effects have often more far-reaching consequences: monetary policy always changes relative prices, it always alters the allocation and the use of scarce resources, and it changes income and wealth distribution. Every monetary stimulus creates winners and losers.

This is being ignored by the mainstream. In his defence of QE, Martin Wolf argues in the FT that the central banks print money in the public interest. The assumption is that we all benefit from the boost to growth, short-lived as it must be, and that we all suffer the effects of higher inflation – if higher inflation materializes at all. But the new money does not reach everybody in the economy at the same time, and therefore does not affect prices ‘evenly and simultaneously’. As a general rule, the early recipients of the newly printed money benefit at the expense of the later recipients. Those who, in the chain of money distribution, are located closest to the money producer (the central bank) are always the winners. These are usually the banks and other financial market participants. They can spend the new money before it has dispersed through the economy and lifted a whole range of prices, and before the new money’s purchasing power has thus been impaired. At the present stage of the credit mega-cycle, more monetary accommodation helps the banks fund overpriced assets and bad loans on their balance sheets. Various ‘bubbles’ – which are uniformly the result of past monetary expansion – are thus sustained and even inflated further. Market forces that would adjust prices, reallocate assets and bring the economy back to balance are thus weakened or impaired completely.

Moreover, accommodative monetary policy can only lead to more economic activity by encouraging somebody to take out more loans, to take on more debt. The mechanisms by which ‘easy money’ leads to more GDP-growth is through the lengthening of balance sheets of banks and of more financial risk-taking, generally. We are in the present pickle precisely because this kind of stimulus policy has been conducted – on and off – for decades. That is what brought us to the point of a banking and debt crisis. Presently, authorities are fighting a debt crisis by encouraging more debt accumulation. They are fighting a banking crisis by encouraging the banks to take more risk. You do not lower interest rates and conduct QE and then realistically expect deleveraging and balance sheet repair.

In this context, I find it particularly bizarre that some economists argue that an even bolder intervention by the ECB, such as a deeper rate cut, another LTRO (funding operation for banks), or a commitment to more purchases of sovereign bonds, would have restored confidence. Do these experts really believe that the public will feel more confident if overstretched banks grow even more quickly with the help of the printing press? Will uncertainty over excessive government debt be laid to rest if the central bank promises to support these governments with essentially unlimited money-printing and bond purchases, thus making it easier for these governments to run deficits? Will that be seen as a solution or just a politically convenient postponement of the day of reckoning?

What causes loss of confidence is this: people do not know any longer what is and can be funded privately and voluntarily, and what is simply propped up by central bank intervention. They do not know the true prices of assets and the sustainable level of interest rates because everything is massively distorted through various central bank policies. Printing yet more money will not make anybody feel more confident.

Unintended consequences

Monetary accommodation is a form of market intervention, and like every other form of intervention it creates a whole range of unintended consequences, many of which are difficult to identify clearly and even more difficult to quantify but they are nevertheless real. My colleague at the Cobden Centre, Gordon Kerr, provided a good example during a recent discussion:

In supermarkets in London there is a trend towards replacing personnel at the check-out counters with new self-service machines that allow customers to scan their purchases and handle the payment process themselves. It is another incident of human labour being replaced with machines. We may say that this is a sign of the times, a consequence of technological progress, and thus inevitable. But such a development is, in each case, not only a consequence of what is doable technologically. It is also a result of economic calculation by the entrepreneur, in this case the owners and managers of the supermarkets. The expenditure for the machines, the capital they tie up and the interest charges that are associated with them, and any potential future losses from inappropriate handling by customers or even theft of produce due to reduced oversight will have to be compared with the cost savings from employing fewer personnel in the check-out area.

In modern-day Britain this calculation seems to work in favour of the machines but would it do so in a free market? The short answer is we do not know. But we do know that the supermarket workers and the check-out machines do currently not compete in a free market. Through the country’s numerous welfare-state regulations, among them minimum wages, social insurance, maternity- and paternity leave, health-and-safety legislation and other rules to ‘protect the worker’, the government has lifted the cost of employing people, it has made human labour expensive, while at the same time, the country’s monetary policy in favour of super-low interest rates and more bank lending has made capital cheap. From both angles, the worker is being squeezed out of the market. Legislation to protect him makes his work expensive; efforts to cheapen credit make capital investment a much easier alternative.

Do not get me wrong: Our high standard of living is the result of a high ratio of productive capital to worker. If we want to increase our standard of living further we will have to keep increasing this ratio. This is the only way to enhance human productivity. But there is a right way of going about this, and there is a wrong way. The right way is to save, to put real resources aside, to redirect real resources from forms of employment that are close to present consumption and transform them into capital for future-oriented investment. How much we invest should not be the result of the decisions of central bank bureaucrats and their monetary manipulations but the result of voluntary saving decisions. That may well set a lower speed limit on capital investment but such a lower speed limit would be entirely appropriate. The resulting capital structure would be much more stable and sustainable, while investment that is funded by money creation rather than saving must lead to capital misallocations, which remains the primary source of boom-bust cycles.  The apparent need of large parts of our present capital structure for near-zero interest rates and further doses of monetary stimulus simply to be sustained in their current size is a clear indication that accommodative monetary policy has already created grave dislocations. How many more of these do we want? How many more of these can the system live with?

The point I am making here is this: It is either naïve or a sign of incredible hubris to believe that the central bankers can anticipate the myriad of consequences their monetary interventions will have. To say that they are simply, in aggregate, in the interest of the public is simply incorrect. We are dealing here with a financial bureaucracy that has lost touch with the complexity of economic reality but that has now dug itself such a deep hole that any self-motivated turn-around can safely be ruled out.

As my friend Tim Evans says, the system has check-mated itself, and so has the mainstream and the policy bureaucracy. Their policies are failing but they cannot think the alternative, which would be a complete stop to monetary intervention and money-printing, and would mean finally allowing the market to liquidate what is unsustainable anyway. This would realign asset prices with economic reality and bring valuable assets into the hands of entrepreneurs rather than have them funded at unrealistic book-prices on bank balance sheets forever. Can they think this alternative but do they not dare to implement it? I am not so sure. I fear they may not even grasp it.

Will the ECB cut again? Will the ECB underwrite the bond purchases of the ESM via the printing press? – Yes and yes again. Of course, they will. Just give the ECB some time. Will it solve the problem? Of course, it will not.

We will see more rounds of QE, more rate cuts where this is still possible, and further expansions of central bank balance sheets. Pension funds and insurance companies will be forced by regulators to hold assets that the state wants them to hold (government bonds anyone?), and the reintroduction of capital controls appears a near certainty at this stage. Remember, a toxic mix of stubbornness and desperation rules policy making at present. It is best to be prepared for everything but the sensible solution.

Come to think of it, the title of this essay may be misleading. The central banks have reached the end of the conventional road but they will push their policies further.

This will end badly.