The Make-Believe World of Central Banking
Experience has taught us that if too much money is chasing too few goods, inflation will be the inevitable result. And as inflation has proven itself to be a costly evil – damaging investment, production and employment –, great efforts have been taken to design a government controlled money system which shall preserve the value of the currency. The current method for maintaining the principle of sound money rests on two key factors. Firstly, the conduct of monetary policy has been transferred to "politically independent" central banks. Politicians' expediency should no longer meddle in the running of day-to-day's monetary affairs. Secondly, most central banks have been charged with the primary objective of keeping inflation low; by doing so, low inflation shall not be traded off against growth and employment.
Whether this policy will live up to expectations is open to debate. Fears that today's money system might fail must not necessarily reflect concerns about bad intentions on the part of governments seeking a devaluation of the currency. Another source of concern should be that the remoter consequences of a government controlled paper money system might be far from fully understood in the handling of today's money affairs.
In particular, the potential ramifications of ongoing credit and money expansion – a characteristic feature of the government controlled paper money system – are no longer enjoying top priority in mainstream political and economic thinking. As a result, highly important insights may be missing in designing and running today's money system.
Ludwig von Mises tirelessly outlined the consequences of modern day's central bank policy: "The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion."
Mises looked well beyond the mere ups and downs of the business cycle. His argument highlights concerns regarding the consequence of a government controlled monetary policy expanding credit and money supply on an ongoing and de facto unrestrained basis. Mises states: "The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
Taking Mises's lead, it is worth questioning whether monetary policy induced swings in economic activity and its ensuing interest rate reactions may entail an unintended and rather undesirable result: downward trending yields over time, coupled with a rise in indebtedness of the economy. If such a scenario should occur, public and political support for preserving the value of the currency would most likely vanish – just as Mises feared: "In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about."
To address Mises's concerns, looking at the more recent history of short- and long-term market rates might be a good starting point. The charts below show central banks' nominal and real – inflation adjusted – short-term interest rates in Japan, Germany (as from 1 January 1999 the euro area), and the US, respectively, for the period 1979 to October 2005. These charts demonstrate that both nominal and real short-term interest rates have, on average, been trending downwards in the period under review.
Furthermore, in the euro area and US central banks lowered nominal short-term interest rates to historical lows lately. In real terms, short-term rates became close to zero in the euro area (that is since early 2004) and were even in negative territory in the US (October 2002 to August 2005) as official short-term rates were lowered below annual consumer price inflation. In contrast, given the ongoing decline in consumer prices in Japan, Yen real short-term rates have tended to remain positive, although at a rather low level.
The decline in nominal and real rates has not been confined to the short-end of the yield spectrum. Long-term yields, as measured by government bonds, have also revealed a marked downward trend in the last decades, gaining further momentum in Germany/the euro area since the early 1990s and in the US from the second half of the 1990s. In Japan, real long-term yields have declined as well, but appear to have stabilised during the second half of the 1990s.
What has caused the downward trend in international (real) yields? Less volatile output changes and declining inflation expectations appear to have contributed to the decline.  From this point of view, yield developments could simply reflect an adjustment period due to a new economic equilibrium: future output growth and inflation are expected to be more modest compared to previous decades and, as a result, yields have trended downwards accordingly.
For the more recent fall in yields monetary policy should have exerted a major impact. In the euro area and the US, the last lowering of central bank short-term rates was a direct result of the international financial market crisis, as epitomised by the so-called "bursting of the stock market bubble", which unfolded around the summer of 2000. In an effort to smooth its effect on output and employment, central banks in the euro area and the US adopted a hitherto unseen lax stance when measured on the basis of short-term interest rates.
In Japan, however, the situation has been somewhat different. The Bank of Japan started lowering interest rates in the early 1990s. The policy of easy money followed the "meltdown" of the asset price boom, which wreaked havoc on market agents' balance sheets, exerting negative effects on output and employment. The zero rate policy, or "quantitative easing" as some call it, has become the main characterisation of the Bank of Japan's policy stance over the past years. Lately, signs have increased that the Bank of Japan wants to end its zero rate policy.
Meanwhile, the US Federal Reserve (Fed) has made progress in bringing rates up to levels considered more "normal" by historical and economic standards. The Fed has raised interest rates in small steps from the record low of 1.0% established in June 2003 to 4.25% in December 2005. However, real short-term interest rates have remained at low levels by historical standards, as have long-term yields, especially in view of the latest pick-up in consumer price inflation.
The European Central Bank (ECB) increased borrowing costs to 2.25% in December 2005, the first rate rise since the bank brought rates to a record low of 2.0% in July 2003. Still, short-term rates have remained close to zero after adjusting for inflation. At the same time, the ECB has taken great efforts to sooth concerns that it will deliver a "series of rate hikes" going forward. 
Overall, the world's leading central banks – meaning the US Fed, the ECB and the Bank of Japan – have been making efforts to end their low rate policies and bring interest rates up to more normal levels. However, will they succeed in doing so? Will the yield decline be stopped, and even be reverted? For answering these questions it might be worthwhile to remind ourselves of how central banks have been conducting monetary policy in recent years.
Much analysis in economic literature has been focused on trying to understand central banks' reaction functions, that is, to identify the variables which induce central bank committee members to set interest rates at the levels they do. A common finding is that a central banks policy can be well described by a kind of "Taylor rule". Simply speaking, the Taylor rule states that central banks change interest rates in response to fluctuations in output and inflation.
The graphs below plot the nominal 3-month money-market rates against current consumer price inflation in Japan, Germany/the euro area and the US for the period 1979 to 2005. The charts show that when inflation moved up, monetary policy responded with raising interest rates and vice versa. This response is something one might expect from "good" central banks trying to keep inflation low. However, it is legitimate to ask, does it really reflect good central bank policy?
In the first place, the charts make clear that the central banks did not prevent inflation from increasing.  A (strongly) positive relationship between inflation and short-term interest rates simply attests that central banks did not prevent inflation from rising, but de facto waited until it increased and then set about reducing it. What is more, the charts touch upon the very question of the determinants of inflation: What role do central banks' short-term rates play in explaining inflation? Finding an answer to this question is all the more interesting in view of Milton Friedman's statement that "inflation is always and everywhere a monetary phenomenon."
Central banks' short-term interest rates enjoy the status of an "instrument variable". As a monopoly supplier of central bank money ("monetary base"), monetary policies determine the short-term rate, which serve as the price commercial banks have to pay for borrowing base money for a given period of time. With the holding of base money, banks can then create additional money and credit supply, thereby feeding monetary demand. 
So can one expect a stable relationship between short-term interest rates and money supply? Not necessarily. An economy's money demand depends on various factors. The central bank's short-term rate is just one of many. For instance, output, inflation expectations, bond and stock market yields change over time, and so will the demand for money. A given short-term interest rate might therefore be accompanied by various levels of money supply. As a result, inflation and a central bank's short-term rate might not necessarily correspond.
Given the rather uncertain relationship between a central bank's rates and inflation, does monetary policy react to changes in money supply? The three charts below show that monetary policies – at least to some extent – did react to money supply changes: on average, high (low) growth rates of money have been accompanied by rising (declining) short-term rates. However, the relationship seems far from perfect. What is more, the very existence of inflation suggests to that short-term interest rates have obviously been too low on average, having allowed money supply to grow at too generous a rate.
Did central banks respond more strongly to signals from actual inflation or money supply? The data appears to suggest that inflation played a more important role than money supply changes in a central bank's interest rate decision making. This, in turn, would indeed argue that central banks did not pursue a pre-emptive policy but simply waited until their policies led to inflation (or to a build up of inflation pressure) and then reacted to reduce it. Needless to say, conceptually speaking, such a policy fails to prevent inflation as it systematically acts too late.
The important finding, however, is this: A monetary policy that responds to actual inflation and rising money supply rather than preventing both occurrences altogether would not only create an "inflation bias". It could also entail another painful and less obvious consequence: it unintentionally may lead to an ongoing build up of debt which could cause serious trouble further down the road. The justification for such a concern – in the spirit of Mises's theory – might be explained by the following three interrelated issues.
Firstly, money supply growth affects prices with a time-lag. If inflation increases, it is because the increase in the economy's productive capital fell short of the proceeding increase in demand brought about by additional credit and money. If that is so, one would expect the rise in the stock of bank loans to outstrip the economy's income growth. If continued, it would raise the level of outstanding credit relative to income. An ensuing increase in debtors' interests cost burden would almost certainly provoke public calls for keeping central bank rates low or lowering rates even further.
Secondly, and in the same vein, an "artificially" lowered (real) central bank short-term interest rate (as a direct response of a "cyclical weakness" of the economy) could encourage low-return investments in particular. Of course, this could exert a positive effect on current production and employment. However, once interest rates start rising again as monetary policy tries to bring rates back towards the pre-cyclical weakness level, these investment projects become unprofitable –potentially triggering another economic downturn with output and employment losses. A central bank that is not willing to impose adjustment costs onto society is likely to end up with short-term rates at below pre-cyclical weakness levels.
And thirdly, artificially low interest rates might weaken rather than strengthening economic growth, though this hypothesis might go against mainstream economic thinking. A lowering of rates is a serious government interference with the market economy. Low rates might prevent less economically efficient players being forced out of the market, and make it harder for more efficient producers to gain market share. A government sponsored lowering of capital costs may not only cause inflation but could also undermine the economic incentive for bringing about product and process innovations, thereby making the overall economy less efficient. Ensuing disappointment with lacklustre income and employment growth could provoke public calls for lower rates – in the hope of reversing the lacklustre economic performance.
So if the central bank – having allowed money and credit to expand – gives in to pressure groups who seek to lower their individual interest cost burdens and/or shies away from imposing the adjustment costs entailed with a policy of "normalising" rates on the country as a whole, is left with the having to bring (real) rates lower gradually over time. As a result, one would expect short-term and long-term interest rates to show a downward trend. Such a process would, as hypothesised above, presumably be accompanied with rising debt relative to income.
The chart above shows indebtedness as a percentage of income in the government and private sector in Japan, the euro area and the US. In Japan, the decline in private sector indebtedness since the early 1990s has been overcompensated by rising debt on the part of government. In the euro area, government debt ratios have been on the rise since the late 1970s, a development that has been followed by a rise in private sector indebtedness since the middle of the 1990s. Total debt as a percentage of output is also rising in the US where, since around the mid-1990s, the trend is driven more by the private rather than government sector.
|Rothbard on US banking history: $25|
To conclude, a brief look at Japan, Germany/euro area and the US shows that declining short- and long-term interest rates in the past decades, particularly since the middle of the 1990s, have been accompanied by rising overall debt ratios. As long as credit supply increases faster than personal income grows, it could well be that central banks will continue to force down short-term rates (irrespective of current attempts to raise rates for cyclical reasons), be it through public and political pressure and/or a decline in trend growth. Such a development could lead towards a period of record low interest rates in international markets in the years to come.
However, from an economic point of view – and in line with Mises's theory – it would be hard to believe that the current path of increasing indebtedness – and a trend decline in yields – can go on continuously without causing serious problems for currency stability. Lessons from history would argue that at some point in time the deliberate acts unfold seeking a debasing of the currency.
Admittedly, abandoning the policy of relentless credit and money expansion would require major adjustments in the economies under review, with temporary negative consequences for output and employment. Against this background, the challenge for central banks – should they want to preserve the value of the currency on a sustained basis – has been summed up by Mises, who predicted that the public would opt for further increases in credit and inflation in an attempt to fight the consequences of rising credit and inflation.
In fact, Mises identifies the dangers that might unfold should a system of continuous credit and money expansion is set in motion – namely that it could all too easily end up in credit expansion overkill. Mises recommends moving back towards the sound money principle, meaning limited monetary policy, e.g., stopping altogether credit and money supply growth.
Commercial banks' deposit yields tend to be lower than central bank short-term rates. As a result, the losses for money holders can be expected to be higher than indicated by the level of negative central bank rates.
One should note that market long-term yields are driven by expected rather than actual inflation. That said, stripping nominal yields off actual inflation might not necessarily provide the real yield level investors expect for holding nominal yielding bonds. Unfortunately, market inflation expectation measures are not available for the period under review.
For an analysis of declining output volatility on yields see, for instance, Browne, F., Cronin, D., Kennedy, B. (2005), The Decline in Volatility of Output Growth: Its Causes and Consequences for Financial Stability, Bank of Ireland, Financial Stability Report 2005, pp. 111 – 121.
On 8 December 2005, Toshihiko Fukui, Governor of the Bank of Japan, said in a speech: "(…) future monetary policy will follow the path of the processes of "reducing the outstanding balance of current accounts toward a level in line with required reserves," "maintaining very low interest rates," and "gradually adjusting interest rates to a level consistent with economic activity and price developments." (http://www.boj.or.jp/en/press/05/press_f.htm)
Asked in an interview published in Paris Match following the interest rate increase on 1 December 2005, ECB President Jean-Claude Trichet said: "We did not decide "ex ante” to engage in a series of interest rate increases.” (http://www.ecb.int/press/key/date/2005/html/sp051215.en.html)
This approach refers back to the work of J. B. Taylor; see Taylor, J. B. (1993), "Discretion versus policy rules in practice”, Carnegie-Rochester Series on Public Policy 39, pp. 195 – 214.
Of course, one has to take into account that in the period under review, keeping inflation low did not always rank among central banks' top policy priorities.
Banks demand base money for actually three reasons: (i) fulfilling minimum reserve holdings, (ii) paying out part of non-banks' deposits in cash and (iii) transacting inter-bank payments.