Central banking is broken. There are countless reasons for this, but all cause similar issues. In fact, the damage done recently by central banks is well known to the public, but few understand its causes. The truth is that central banks are to some extent responsible for most major problems in developed economies. Asset and housing bubbles, productivity crises, wealth inequality. Monetary policy is directly at fault for all of these, to varying degrees.
To correct these issues, we must understand the role of monetary policy, set by central banks, in causing them.
The root issue is ultra-low policy interest rates combined with QE. Combined, these policies have resulted in super cheap money, driving borrowing and debt. This has given rise to countless ‘zombie firms’ in the economy. These are firms which are inefficient but survive on cheap debt. Inefficient firms being propped up is a huge drag on productivity. For productivity to recover, these firms must be allowed to go bust. This debt can only be financed at such low interest rates, so when they rise defaults will skyrocket.
QE, though, has done even worse damage. Last week, I wrote on the catastrophe waiting to happen which is the Eurozone, arguing that QE would become responsible for the death of the single currency thanks to the asset bubbles and low yields it has resulted in. In reality, these problems are echoed everywhere QE has been implemented on a large scale, including the UK. The intricacies of the EU’s currency make the damage much harder to fix in the Eurozone, but that does not mean there is no damage elsewhere.
The primary reason the policy has caused such damage is the effect it has had in inflating markets. As central banks buy government bonds, they drive up bond prices and drive down bond yields. Rising asset prices mean that those who own them – those who are already rich – get richer, driving wealth inequality. This also promotes housing bubbles by encouraging demand for housing as an asset. Further, when investors cannot make viable returns on safe government bonds, they buy riskier assets. Many own assets which are not truly compensating them for their risk. When rates eventually rise, a good deal of those issuing these risky assets will fold and investors will suffer. This will be catastrophic for financial markets and the economy.
From the above analysis of the issues, it would be easy to conclude that what is needed is an increase in interest rates and an end to QE. This, though, would achieve nothing on its own. As previously discussed, a rapid end to cheap money would send defaults skyrocketing. This would cause a huge shock for financial markets and most likely cause another recession. Rates must rise slowly and QE must end cautiously, to control the impacts.
Make no mistake, there must be some hit taken. Zombie firms must be allowed to die. This will mean job losses, but it is the only way to end the productivity crisis. The existence of such firms prevents new, innovative ones from entering markets and improving efficiencies and competitiveness. Yet beyond ending the disastrous policies of ultra-low rates and QE, far more must be done to fix central banking.
The necessary solutions involve wholesale reforms to the way central banks operate. Due to the specificity involved I will look specifically at the Bank of England, but similar arguments can be made for other central banks. One of the issues with the BoE’s current operation is that it is meant to have one main target in implementing monetary policy – achieving 2% inflation. Yet the Monetary Policy Committee consistently makes decisions which do not help in achieving this target. When the target is missed, the Governor of the BoE simply writes a letter of apology to the Treasury.
There are a plethora of issues evident in such a system, but there are two particularly crucial ones. First, that there is almost no true accountability regarding missing targets. Second, and far more important, is that targeting 2% inflation – or, indeed, inflation targeting in general – is wrong. Such a practice is unlikely to result in a stable economy, because (strictly) targeting a specific rate of inflation will require vastly different monetary policies each year.
Rather than targeting specific inflation rates, it would be more effective to begin the practice of nominal GDP targeting. This would mean more inflation in times of slow growth but less in times of rapid growth. The result of this would be that even if real growth slowed, total spending in nominal terms would continue to rise. This would prevent situations in which there is not enough money to pay wages during slowdowns (as wages are set in nominal terms) and thus prevent slow growth from necessarily causing unemployment or being an excessive drag on wage growth. Such situations under the current system often damage the economy themselves even more than the initial slowdown. Large scale unemployment means the economy is not operating at capacity, and this takes take to remedy.
It is clear that nominal GDP targeting by a central bank is not going to solve every issue, but it would go a long way towards promoting stability within the framework of a monetary system in which a central bank exists.
Still, a simple switch of targeting would not fix central banks. It is vital that central banks become politically independent. Mark Carney, Governor of the BoE, has consistently involved himself in politics. Four members of each BoE committee are appointed by the Treasury. A central bank should be wholly independent, politically neutral and shouldn’t attempt to second guess effects of government policy. When targets are consistently missed, there must be action taken – accountability must be present. Until these issues are solved, central banking will continue to cause problems.
An alternative solution, and a much more radical one, is the elimination of a central bank from the monetary system. Such a non-centralised system, in which private banks issue their own banknotes, is referred to as ‘free banking’. It would involve far less regulation, and each bank’s notes would be convertible to a ‘base’ form of money – currencies like GBP could remain in existence for this purpose. Such a system may seem alien, but it has existed before, such as in Scotland from 1716 until 1844. Historically, free banking monetary systems have performed well, and there is no reason this cannot take place today. A detailed analysis of the case for free banking, though, is for another day…