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Nightmares of a Central Banker

February 6, 2007Antony P. Mueller

Tags The FedInterventionism

Since its inception, modern central banking has gone through various fashions and has adopted opposing paradigms along the course of its history. The US Federal Reserve System began operating in 1914 and stood ready to provide the monetary conditions for financing US entry into World War I.

Likewise, the US central bank provided the monetary ammunition for its government to fight in World War II and in the many other military conflicts that were to follow. In Europe, the consequence of the beginning of World War I was abandoning the gold standard and turning the central banks into the willing tools of governments.

In the early 1920s, the US central bank adopted Irving Fisher's proposal of using the consumer price index as the guide for monetary policy, ushering the economy first into unsustainable economic boom and then into the Great Depression. In Europe, the Deutsche Reichsbank produced a hyperinflation in the early 1920s, and in the United Kingdom, the Bank of England toiled haplessly with a decades-long slump. By the early 1930s, the political supremacy over central banking was complete. Irrespective of the degree of socialism, nationalism, and totalitarianism, the politicization of money and central banking encompassed the central banks from Moscow to Berlin and from Paris to Washington and Tokyo. Central planning and interventionism had won the day.

After World War II, there was a short period when the so-called Bretton Woods System was firmly in place and it was expected that the philosopher's stone for monetary stability had been found. With the establishment of a link of the US dollar to gold and a fixed-exchange-rate system with adjustable peg for its member countries to the dollar and thereby among themselves, the Bretton Woods System reflected the political power structure at that time with the United States at the center, surrounded by the satellites.

Yet in the 1960s Keynesianism became the dominant doctrine of central banking. Interest rates had to be low, so the mantra said, in order to stimulate investment and economic growth. Consequently, the United States government ignored its obligation to limit the dollar emission to the size of its gold stock, and the US central bank put no breaks on the expansion of the money supply. This policy led right into a decade of inflation first and stagflation later on.

In West Germany, the newly founded "Bank deutscher Länder" (later called "Bundesbank") got its seat in Frankfurt and not in the capital city thereby signaling a certain symbolic detachment from politics. The law that created the new German central bank obliged monetary policy to pursue "price level stability." Yet in the late 1960s and during the 1970s, inflation and then stagflation hit Germany and other European countries also. One reason for that was the existence of the international monetary system itself, which obliged the member countries to stabilize their exchange rates against the US dollar.

While the foundation of this system was cast aside with the expansion of the supply of dollars, the Bundesbank, along with other central banks in Europe and Japan, became the "buyers of last resort" for the weakening greenback. The world experienced a massive increase in liquidity originating from the US dollar that spilled over to the other major currencies. When the central banks in Europe and Japan bought dollars in exchange for their own currencies in order to stabilize the exchange rate, they automatically expanded their domestic monetary base. After a short liquidity-driven boost, the world economy slipped into the stagflation of the 1970s.

The experience of stagflation led to a turnaround of monetary policy in the late 1970s, when the US central bank embarked upon the monetarist experiment. Now, it was the money supply that became the magic word and the most important guideline for central banking. In the 1980s, price inflation rates began to decline. However, this happened more by accident than by design, because with the onset of the monetarist experiment, the velocity of money circulation — which had been trend-stable for decades — began to contract.

Inadvertently, the moderately restrictive monetary policy that was put in place became drastically contractive. In an ironic twist, the major tenet of monetarism — that the velocity of money would be stable or at least trend-stable — no longer held. This happened at exactly that point in time when monetarism was adopted by the central bankers as their new credo. The recession of the early 1980s wiped out inflationary expectations. This result was not brought about by design, but by a monetary policy error — an error, however, with beneficial results.

With Alan Greenspan (chairman of the Board of Governors of the Federal Reserve System from 1987 to 2006), the US central bank abandoned monetarism and embraced the next fashion: supply-side economics. Greenspan liked to look at productivity growth as the guideline and the money-supply number became less important. His doctrine said that a central bank can generously expand the monetary base and have low policy rates when productivity in the economy is rising. This laid the groundwork for the great financial-asset boom of the 1990s. The chairman became the darling of Wall Street, its guru and oracle, and the reliable bail-out of last resort for the financial markets.

In Asia, meanwhile, the Japanese central bank produced first an unsustainable economic boom in the 1980s, then instigated the bust of 1989–90, and has tried desperately to re-inflate the economy ever since. In the 1980s, the Japanese central bank saw no need to curb the booming stock and real-estate markets because the price index remained relatively stable, and Japan was seemingly on its way to becoming "number one." The Bank of Japan boosted its monetary base in the 1980s, and after the bust, it lowered its policy rate to almost zero. While the expected recovery did not happen, the Bank of Japan inadvertently provided a bonanza for financial speculators who practice the yen-carry-trade by borrowing at low interest rates in Japan and lending at higher interest rates abroad.

In Europe, a common currency was introduced in 1999 and the statutes for the establishment of the European Central Bank (ECB) called for a clear priority of "price stability" as the guideline for monetary policy. The seat of the European Central Bank is in Frankfurt, almost equidistant to Brussels, where the executive branch of the European Union is hosted, and Strasbourg, where the European Parliament resides, thus symbolizing the idea that the ECB should be completely autonomous and free of political influence.

The autonomy of the ECB has quasi-constitutional status within the European legal system. It remains to be seen what will happen when more serious challenges arise in the eurosystem. Instead of risking the departure of a member state in financial trouble, the ECB will most likely act like any other central bank and boost the money supply according to the central bankers' motto: après nous le deluge. As of now, the ECB is still struggling with the problem of which indicators to use as guidelines in order to achieve its legally prescribed inflation target of less than two percent.

In the United States, Ben Bernanke has been the chairman of the Board of Governors of the US Federal Reserve System since early 2006. He, too, is an adherent of inflation targeting, yet the US central bank is not explicit about what definite desired rate of inflation (as it is measured by the consumer price index) should be its goal.

The concept of inflation targeting is not new. It has its origins in Irving Fisher's monetary theory. By following this monetary policy concept, the US central bank created the boom of the late 1920s and consequently the great bust. Nevertheless, this theory is now experiencing a revival in Europe and the United States.

The monetary policy concept of inflation targeting suffers from the fundamental problem that a valid price index does not exist. There is no such a thing as a representative basket of goods and services. Fisher's idea was already problematic in the more simple economy of the 1920s; nowadays it is outright obsolete to establish an index that would be representative of the highly complex and diverse economy as it exists today. Actually, each individual person has his specific basket of goods and services, and its composition will change for the same individual over time.

Although a uniformly valid price index cannot be constructed, central bankers use this indicator as a guideline in order to formulate a monetary policy that affects the whole economy. Irving Fisher is back, center stage, in the person of Ben Bernanke. He sells his inflation-targeting concept as something apparently new, when in fact it is the re-digestion of Irving Fisher's theory — a theory completely discredited by both the facts of history and the economic theory of of the Austrian School.

The record of modern central banking is bleak. Serving as a bailout machine for the financial markets and as a reliable financier of the state, modern central banks by the very nature of their origin and existence do not curb the booms (which they could) and do not prevent recessions or depressions (which they would wish to do but cannot). Monetary policy suffers from the same faults as any other centralized economic policy and other forms of interventionism, and like all centralized economic policies and interventionist measures, the monetary policy of active central banks has been failing again and again.

Modern economies are too complex and diverse for central control. The more complex and diverse the economy gets, the more the data will have to be compressed, finally to such a degree that they lose their meaning and become useless at best and misleading at worst as informational tools for decision-making. For monetary policy, which acts like a central-planning agency when it comes to the money supply and the interest rate, the informational quality of the data that central banks use is rapidly deteriorating. Aggregates and averages such as the Gross Domestic Product or the inflation rate, productivity growth, or the many other economic indicators that are so popular nowadays with central bankers and the financial press and in econometric studies, hide more than they reveal and are often utterly misleading for decision-making and economic analysis.

Given that there are no constant quantitative relations among the variables, central bankers have no reliable guideline in order to calibrate their monetary policy measures. It cannot be known for sure how monetary impulses affect economic activity. It is not known to which degree the monetary impulses affect consumer prices or how they will modify investment or impact upon asset prices. How the monetary transmission mechanism has worked, can only be known retrospectively, and the results are valid only for a specific period of time.

Research of this kind is history. The results of these inquiries provide no certainty about how the transmission mechanism will work in the future. The monetary impulse coming from the monetary base can transform into various degrees of strengths depending on the monetary multiplier and the velocity of circulation, and from there it can affect in different degrees the components of the real economy. It all depends on individual human action; and human expectations, plans, and actions change over time, sometimes quite drastically.

Statistical aggregates per se do not cause anything in the economy. What is being measured by the aggregates and averages are the effects of human action, not the causes. There is no way to know ex ante whether a specific monetary policy measure affects primarily the so-called price level of final goods — whether the main effect goes into the asset market, or leads to more investment at home, or more imports from abroad. Central bankers do not know whether changes of the money supply and the interest rate will cause a change of credit demand for business investment or a change of credit demand for private and public consumption.

Central bankers sometimes describe their activity as "more art than science," which is implicit recognition of their ignorance. The "art of central banking" is the art of pretending to know what one does not know. Not only is it not a science; it is not even an art. At best it is alchemy; at worst it is a gigantic cheat.

When economic systems grow in complexity and diversity, central planning and interventionism become exponentially inefficient, and the need arises for more decentralized coordination mechanisms. Modern economies, and in particular modern financial markets, have become too complex for active central banking. Monetary policy cannot be improved by more research and better central bankers. What is needed is something quite different: a monetary system that can do without an active central bank.

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