It’s Time to Review Our Central Banks
Over the last decade, developed market economies have stepped into historically unchartered territory with central banks lowering interest rates close to zero, and in some cases even negative (1). In addition, central banks have recently also bought assets greater in maturity (duration) and credit risk than is historically normal by purchasing asset-backed securities, corporate bonds and in some cases equities (2). By purchasing such risky assets during market downturns and keeping interest rates artificially low, central banks have conditioned investors to pay less attention to downside risk and take on more risk in order to generate returns (3). Moreover, the continued suppression of interest rates encourages the accumulation of debt by the public and private sectors, which burdens future generations. In addition, the easy monetary policy of central banks has contributed to the inflation of almost all asset prices, including bonds, equities and real estate (4). A consequence of this is increased social inequality, as it is generally the wealthy that own such assets (5). Asset price inflation has contributed to increased inequality across two dimensions: first, across social classes and second, across generations (6) (7). At the same time, by suppressing interest rates, central banks have sought to create greater economic consumption of the earth’s finite resources, particularly in carbon-intensive industries, at a time when climate change is a key policy consideration (8). It would therefore make sense to review whether the tremendous power granted to unelected members of central banking committees is in the best interests of society.
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The Current Central Banking Landscape
Central banks globally have maintained inflation-targets since the early 1990s (9). Even prior to inflation-targeting, it has long been believed that providing price stability (that is, stability in the general price level of goods and services) is the key function of a central bank, in addition to regulating fiat currency, acting as a lender of last resort and in some cases creating conditions for ‘full employment’. Price stability is paramount to a well-functioning market economy, as markets rely on the signaling value of prices as to where resources should be allocated. If the unit of account (that is, the currency that goods and services are priced in) varies more than the real value of the goods and services themselves, it can lead to the misallocation and wastage of scarce resources (10). The signaling mechanism of market prices is particularly important in the context of a world of finite resources, growing global populations and climate related concerns.
Most central banks target inflation within the 2-3% range (11). This arbitrary band is perceived to be a level that supports economic growth over the medium-to-long term by avoiding the costs of high inflation (constant price adjustments) or deflation (deferral of consumption if future items are cheaper). In order to maintain a target level of inflation, central banks increase or decrease the money supply, which affects the price of money (which is the interest rate charged on money). The interest rate that is typically varied by the central bank is the short-term interest rate that the Government can borrow at. This serves as a benchmark for all other interest rates, such as mortgages and corporate loans. Changes in interest rates affect the economy because when interest rates increase, less credit is extended to firms and households, which allows for less expenditure and consumption, which in turn slows the economy. The opposite is generally true for decreases in interest rates. Additionally, by manipulating a country’s money supply, the central bank is implicitly manipulating a country’s currency, which affects exchange rates with other currencies.
Despite the efforts of central banks, inflation has eroded the value of currencies during the 20th century. Since 1960, the average annual inflation rate in the USA, Europe and Australia has been 3.8%, 4.5% and 4.7%, respectively. This implies a loss in value of around 4% per year for the currencies of these respective regions. Figure 1 shows the equivalent of 1 unit of currency for each of these areas in 1960 adjusted for inflation through time. The graph demonstrates that it would take USD$10.14, EUR €15.38 and AUD$17.20 in today’s money to equate to USD$1, EUR €1 and AUD $1 from 1960. Figure 2 essentially shows the same phenomenon by charting the purchasing power of 1 unit of currency since 1960. The central banking models of the USA, Europe and Australia have been insufficient to prevent – and in fact have intentionally led to – the debasement of their currencies. A noteworthy point is that in 1971, the US abandoned the ‘gold standard’ of backing up the USD with gold reserves and instead opted to give the central bank full flexibility in printing money at will.
Figure 1 – Value of $1 in 1960 Adjusted For Inflation
Source: IMF, World Bank, https://www.worlddata.info/
Figure 2 – Purchasing Power of $1 Through Time
Source: IMF, World Bank, https://www.worlddata.info/
Problems Associated With Central Banking
Importantly, the price of money is determined by a committee of central bankers and not by a competitive process, as is observed in almost all other parts of the economy. That is, the government holds a monopoly over the money supply. This monopoly is run by a committee of unelected individuals that decide when and how to change the interest rate depending on their opinions. This is a peculiar feature in market economies where at a minimum almost all government monopolies have been partially dismantled and subject to the forces of market competition (e.g., airlines, oil refineries, automobile manufacturers, etc). It is quite remarkable, then, that a government committee determines the price of money much the same way socialism tried and failed to determine the prices of goods and services. One only has to think of the late former head of the Soviet Union, Mikhail Gorbachev, describing the ineffectiveness of socialism in allocating resources in Russia:
Imagine a country that flies into space, launches Sputniks, creates such a defense system, and it can't resolve the problem of women's pantyhose. There's no toothpaste, no soap powder, not the basic necessities of life.
In the absence of markets allowing prices to move freely to indicate where resources should be allocated, socialism attempted to use committees to determine how much of which goods to produce and which services to offer. If the socialist experiment of bureaucrats in committees determining prices failed so spectacularly in large scale across multiple countries, why should we believe that the price of something as important as money should be determined by the same process?
Central Bankers Are Also Human
Another concern is that the central bank committee members are typically appointed by politicians who clearly have their own political interests. Although central bankers claim to be independent, they are still subject to routine political pressure. Threatening comments from politicians to keep interest rates low are commonplace (12). A consequence of this is that by keeping rates low governments tend to accrue greater debt burdens on tax-paying citizens. Moreover, central bankers themselves are only human, and have their own agendas that influence their decision-making ability. For example, at the US Federal Reserve (also known as the “Fed”, which is the central bank of the USA) committee members Rosengren and Kaplan were forced to retire early after it became known that these members were encouraging the Fed to buy assets in emergency support that they themselves purchased around the time of the Covid-19 outbreak (13). In any other setting, this could be viewed as insider trading.
This brings us to a second related point, known as the “Fed put”. The term “put” comes from options trading, where a put option is essentially a tool investors use to limit exposure to and even profit from negative price movements. The “Fed put” came into being during the abrupt stock market crash in 1987, during which the then Federal Reserve Governor Alan Greenspan printed money to buoy the falling stock market (14). At the time, this was known as the “Greenspan Put”, but subsequent Federal Reserve Governors (Bernanke, Yellen, Powell) have adopted the same approach. Greenspan’s approach of intervening to support financial assets worked during the 1990s but backfired spectacularly during the tech bubble crash in 2001 and the global financial crisis in 2008 due to the change in investor behaviour it created (15). By creating the expectation that the Fed would print money to support markets if they fell, market participants began to take on an increasing amount of risk. This phenomenon is known as “moral hazard”, defined as “a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk” (16). This mechanism essentially privatizes the gains of individual traders but socialises their losses across the public. Clearly, this is undesirable from a societal point of view.
The moral hazard problem created by central banks extends beyond the stock market to real estate markets. Real estate investor behaviour has also changed as a result of the perception that central bankers will print money if asset prices fall. This has seen real estate debt levels sky-rocket globally over the last few decades. Indeed, many argue that the sub-prime mortgage crisis of 2007/08 was partially driven by Alan Greenspan keeping interest rates too low for too long in the aftermath of the dot-com bubble in 2001, which itself was in part fuelled by the cementing of the moral hazard psyche during the 1990s (17). As central banks print money and reduce interest rates in reaction to a perceived weakness in the market, investors care less about the downside and take on more risk to generate higher returns. Since the creation of the “Fed put”, the Fed has essentially dealt with bubbles popping by creating new bubbles.
Social, Economic & Environmental Considerations
Since 2008, central banks have kept interest rates extremely low – and in some cases negative – to try and buoy the economy. This is achieved by printing tremendous amounts of money, which has inflated almost all asset prices, ranging from real estate to stocks and bonds to the speculative frenzy in digital markets like NFTs and cryptocurrency. This has several important social ramifications. First, during this time, inequality has increased, as it is typically the wealthy that own assets (18) (19). Accommodative central bank policy inflates asset prices, which makes the rich richer. Not only has wealth inequality across social classes worsened, but it has also exacerbated intergenerational inequality (20) Nowhere is this more clear than in the real estate market. Real estate prices have surged since central banks began printing unprecedented amounts of money in 2008 as investors were encouraged to take on more and more leverage to generate a return. Central banks are aware of their impact on housing markets, having produced their own research stating “low interest rates explain much of the rapid growth in housing prices and construction over the past few years” (21). Young families in many parts of the world today face unprecedented multi-million dollar house prices. Many people under 35 may never be able to afford a home for their families. Again, one has to question whether central banking is beneficial from a societal point of view.
Second, by lowering interest rates in a bid to encourage households and governments to take on more debt to spur the economy (which they have), central banks have created unprecedented indebtedness, which will burden the next generation (22) (23) Third, the prolonged suppression of interest rates penalizes savers and forces investors to assume more and more risk to generate stable returns. This phenomenon is called “financial repression” and like Moral Hazard, leads to excessive risk-taking (24). Fourth, by printing unprecedented amounts of money, central bank policy has artificially buoyed economic growth, which has resulted in greater consumption of the earth’s finite resources than if interest rates had been higher. By propping up economic growth, central bank policy has accelerated the warming of the planet by causing greater than otherwise consumption and production. Moreover, research indicates that the corporate bond buying of e.g., the European Central Bank and the Bank of England has been concentrated in carbon-intensive sectors such as utilities, which has lowered the cost of financing to firms contributing the most to climate change (25). In summary, central banking by committee has created problems of moral hazard and sought to solve bubbles popping by replacing them with new ones, which has exacerbated class and intergenerational inequality and contributed to the accelerated warming of the planet.
The Fool In The Shower
Clearly, central banking by committee has had undesirable effects on society and the planet. They have changed investor behaviour and tended to keep rates too low for too long. One therefore has to ask the question of whether it is possible for a committee to determine the optimal interest rate for an economy given the complexity of the problem. Central bankers periodically collect price data on goods and services in the economy and aggregate this up to determine a general ‘price level’ for the entire economy. They then monitor changes in this general price level, which they perceive as inflation. There are several ramifications of this process. First, it takes quite some time to collect, collate and clean data on the thousands of items tracked. Hence, when the data is received by the central bankers, it is already stale. Second, it takes some time for the central bankers to analyze the data and determine an appropriate interest rate. Then, once this interest rate is determined, it takes quite some time to ripple through the economy and have an effect. Therefore, by the time a change in the interest rate has had an effect on the economy, the economy has most likely evolved into a different state than from when the original data was collected and the central bank’s arbitrarily chosen interest rate may no longer be appropriate. This phenomenon is what Milton Friedman called ‘the fool in the shower’: when the shower temperature is slow to adjust, constant tinkering of the taps all too often results in someone getting a scalding from boiling water or icy shock from cold water (26). This is evident in the Figure 3, which shows the difference between the US central bank policy rate and inflation. There is consistent evidence of prolonged over- and undershooting.
Figure 3 – Inflation Over/Undershoot
Source: US Federal Reserve Economic Data (FRED): https://fred.stlouisfed.org/graph/?g=6TK
The Economy is Complex
Given the lag in information collection, lag in analysis and lag in implementation, central bank committees are prone to over- and undershooting in selecting a target interest rate. It is also challenging to accurately model an economy and determine the appropriate interest rate to achieve a target level of inflation given the vast number of unknown and unknowable variables affecting the economy. The economist Friedrich von Hayek introduced the delineation of simple phenomena and complex phenomena to highlight this problem:
Simple phenomena: “closed systems” with a “sufficiently small” number of interconnected variables
Complex phenomena: “open systems” (of life, mind, society) where the outcomes of processes “depend on a very large number of particular facts, far too numerous for us to know in their entirety” (27)
The definition of each has implications for the types of conclusions we can draw from our research. Specifically, for complex phenomena, due to our inability to know the facts and circumstances relating to each agent and their interaction with other agents, at best we will only be able to determine an “explanation of the principle” and a “prediction merely of the abstract pattern the process will follow” (28). In contrast to being able to predict a specific outcome with simple phenomena (e.g., a chemical reaction in a controlled environment), with complex phenomena we cannot hope for more than being able to account for the general principle.
This is quite alarming when we think of the vast computational resources that central banks allocate to precisely mathematically modelling the economy and getting forecasts and policy responses ‘exactly’ wrong. The focus of central banking committees on mathematical models misses the point, as it leads to “a pretence of exact knowledge that is likely to be false” (29). Clearly, the economy consists of complex phenomena, being the aggregate outcome of the instincts and nature of millions of dispersed agents, each with their own fluid individual circumstances, personalities, consumption habits, objectives and risk tolerances, all of which is unknowable to any single being. Hayek argued that “the economic problem of society is … a problem of the total utilization of knowledge which is not given to anyone in its totality” (30). One would therefore question whether it is suitable for a single committee to even try and determine the optimal interest rate when the rest of the economy successfully runs by utilizing the decentralized information contained in market prices dispersed across millions of individuals.
This point is made clear by the success of the decentralized market economy relative to the centrally-planned socialist economy. In the decentralized market economy prices act as signals for the relative supply and demand of resources – if supply of an asset is low or demand for an asset high, prices typically rise (and vice-versa). Higher prices signal that this asset is relatively scarce and should be conserved and it is potentially now more profitable to engage in the production of this asset, which eventually should increase supply. In such an environment, individuals do not have to know why the price of a particular input has increased – they are free to adapt and experiment accordingly to find the optimal mix of inputs into a production process in a timely manner. Rather than relying on the lengthy process of collecting and communicating information to a central decision-making body and awaiting its judgement, the ‘person on the spot’ can make a decision that will allow for the efficient allocation of resources in a timely manner. This process occurs en masse in a market economy. As Hayek eloquently put it:
The market process utilizes the knowledge of facts dispersed among millions of people by means of the [price] signals which teach us how to adapt to events of which we know nothing, to changes in supply of resources of which we have no direct information, and to changes in demand and needs of which we also have no direct knowledge (31)
Instead of a central banking committee determining the optimal interest rate for an economy, one could allow markets to determine the optimal interest rate. This would allow the integration of much more information into the interest rate than a single decision-making body could collect and process and in a timelier manner. However, allowing markets to determine the short-term interest rate would be insufficient if the government still had any control of the fiat currency, because it could still alter the amount of currency in circulation which would affect its price (the short-term interest rate). Therefore, one would have to allow for some competition among local currencies in order to allow for a market-based solution. Such a development is arguably an inevitable extension of society’s continued evolution and general acceptance of the superiority of decentralized market-based resource allocations as opposed to centralized committees in allocating scarce resources.
A Market-Based Proposal
The idea of competition in forms of payment is alien to most members of society despite the prevalence of competition and private provision of goods and services in most aspects of life. To provide an example of how such currency competition could work, let us use the case of Australia, where the fiat currency is the Australian Dollar (AUD), the central bank is the Reserve Bank of Australia (RBA) and the financial system is dominated by 4 large banks (‘the Big 4’): Commonwealth Bank (CBA), Westpac Bank (WBC), Australia New Zealand Bank (ANZ) and National Australia Bank (NAB). Each of these banks could be permitted to issue its own ‘coin’, which could serve as a form of payment. Utilizing competition in forms of payment is not necessarily new, as it is something that we already do in some ways by utilizing the credit of competing firms e.g., paying in credit via a CBA account vs paying in credit via a WBC account vs paying in cash. Here we are implicitly assuming the credit and payment risk of CBA, WBC or the government (in the case of cash).
A simple first proposal could allow the Big 4 (which under the current regime benefit from government guarantees) to issue their own ‘coins’ as a form of payment. These banks would remain in competition with each other to acquire customers and for people to utilize their coins. Arguably, none of these banks would issue so much of its own coin or currency so as to inflate its own currency, as this would cause the currency to lose value. Additionally, as the Big 4 have the implicit backing of the Australian government in addition to long-standing reputations of stability and prudence, the trust in and perceived risks of the private provision of money would be low compared to e.g., a random cryptocurrency without any backing or intrinsic value. In this context, the volatility associated with cryptocurrencies would be less of an issue for Big 4 bank coins. Furthermore, the homogeneity of the Big 4 would contribute to lower volatility between bank coins as they would be more or less comparable, particularly when contrasted against the vast universe of heterogeneous cryptocurrencies with various raison d’etre. A clear regulatory environment would also boost confidence in bank coins and aide in this regard. One would have to establish boundaries or rules for the banks to adhere to, but allow them to play freely within the bounds of these rules, which is not necessarily different from the current regulatory regime. The AUD could initially co-exist with the Big 4 coins and allow for competition for individuals to decide how to transact without being forced to be subject to the intentional erosion of a currency’s value from the government monopoly on the money supply. After the establishment of such a regime, one could introduce coins from other banks, including overseas banks, to increase the level of competition among coin providers.
The introduction of competition into currency markets would overcome many of the short-comings of the central banking model. By allowing markets to determine short-term interest rates and the price of money, politicians will not be able to exert pressure on central banks to keep rates low. This will diminish governments’ ability to impose greater debt burdens on tax-paying citizens. Notably, before the extensive manipulation of interest rates and currency via QE, bond markets (where interest rates are determined) were known for imposing fiscal discipline on governments as governments with poorer fiscal histories tended to be penalized by investors (so-called ‘bond vigilantes’) (32). Another benefit of allowing markets to determine the price of money is that it will limit governments’ ability to engage in monopoly seigniorage – the practice of generating revenue by printing money and imposing an inflation tax on citizens. Private banks may engage in some level of seigniorage, but this will be limited by competition among coin providers in addition to any regulatory requirements. Moreover, by allowing markets to determine the price of money, the perverse incentives that central banks have created for investors to take on excessive risk in an environment of financial repression (low interest rates) and moral hazard could be unwound.
It is no coincidence that cryptocurrencies have emerged during a time when computing power has increased and the financial repression generated by the low and negative interest rate policies of central banks has debased many of the world’s currencies. Such a development is a necessary step in the spontaneous evolution of the growth of society and paves the way for the introduction of private currencies to determine short-term interest rates and the ‘price’ of money. The excessive volatility of cryptocurrencies has rightly served as a deterrent to their adoption as a means of payment. This could be overcome by the introduction of private bank coins with the implicit backing of governments and bank balance sheets and a sound regulatory environment. In the context of Australia, one could begin by accepting such coins as legal tender alongside the fiat AUD currency in a small territory, such as the Australian Capital Territory, or for a portion of the economy, such as corporate actors, in order to gather feedback and establish a suitable regulatory environment. The gradual introduction and refinement via trial and error is likely to lead to greater adoption, lower adjustment costs and lower volatility than a ‘big bang’ approach.
Society has learned so much of the benefits of market-based mechanisms for the allocation of resources compared to socialist-style centralized committee decision-making approach. This is evident in e.g., the airline industry, which began as a government monopoly. At the outset, to many members of society it was inconceivable that private companies could compete to efficiently provide airline services given the high fixed-costs of airline fleets and fear that competition and price-pressures would erode safety standards. Several decades later many members of society would now find it inconceivable that such services were ever a government monopoly! Cryptocurrencies, while unsuitable as a form of payment, have evolved in response to the largesse of central banks, and have laid the foundations for the introduction of bank-backed private coins as a form of payment. Developed market economies have privatized many facets of their economies with great success and the private provision of money is an inevitable, logical next step in the continued evolution and growth of society.
Central banking by committee has led to several problematic developments that societies across the world are now suffering from. These include the inflation of asset prices leading to social and intergenerational inequality and the accumulation of public and private sector debt that burdens future generations. The absence of a market-based mechanism allows governments and households to engage in fiscal largesse. Other problems include the creation of perverse investor incentives in the form of moral hazard and financial repression and the excess consumption of the earth’s finite resources by propping up economic growth.
The economy is necessarily complex, with millions of agents transacting, producing and consuming based on their own circumstances, budgets, constraints and objectives, all of which are not knowable to any single mind or committee. Failed socialist experiments have demonstrated the inherent inefficiency of attempting to collect and communicate such information to committees, who themselves take time to analyze and then act on such information. By contrast, markets allow ‘the man on the spot’ to use localized information of his circumstances and the informational content of market prices in a timely manner to determine how best to allocate resources. The success of a market-based approach has been demonstrated in numerous sectors that have previously been run by committee, such as oil refineries, airlines, automobile manufacturers, among others. Markets are therefore suitable as a mechanism to overcome the shortcomings of the government’s current monopoly on the money supply.
It is unsurprising that cryptocurrencies have developed at a time when technology has made significant advancements and central banks have eroded the value of many of the world’s currencies via financially repressive low interest rate policies. Cryptocurrencies are a necessary step in the spontaneous evolution of the growth of society. They pave the way for the inevitable, logical and continued adoption of market-based mechanisms in the form of the private provision of money from competing banks. In contrast to cryptocurrencies, however, bank coins would experience notably lower volatility on account of their implicit government backing, prudently managed balance sheets, homogeneity and regulatory environment. In the context of Australia, one could begin by accepting such coins as legal tender for corporations or in a small territory, such as the Australian Capital Territory, in order to gather feedback and establish a suitable regulatory environment. The gradual introduction and refinement via trial and error is likely to lead to greater adoption, lower adjustment costs and lower volatility than a ‘big bang’ approach and overcome the short-coming of the central banking system.
Full article available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4209973
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