An honest central banker
Developed country central bankers are in no mood to introspect; in fact, they are doubling down on dysfunctional policies
I recently concluded my reading of the book, The End of Alchemy: Money, Banking, and the Future of the Global Economy by Mervyn King, the former governor of the Bank of England. His term in office straddled both sides of the global economic crisis of 2008—before and after. The book does not disappoint, nor does it offer a comprehensive way out of the current economic situation in the world. Unsurprisingly, the book ends with a stark warning of the risk of global conflicts.
The book meanders in parts but the section that deals with how two different monies circulated in Iraq after the 1991 war is educative. There was the official dinar and the Swiss dinar (so called because the plates used to print the currency were made in Switzerland). The northern part of Iraq was not under the control of Saddam Hussein and used the Swiss dinar. The Swiss dinar did not derive its value from the official Iraqi government nor from any other government. King writes: “In other words, the value of the Swiss dinar had everything to do with politics and nothing to do with the economic policies of the government issuing the Swiss dinar, because no such government existed.”
That is a very important reminder of what underpins currency: trust and confidence and not government authority and its economic policies. It is a reminder to central banks in the West, particularly the European Central Bank, that there are limits to the monetary policy experiments that take public trust for granted.
King is no admirer of the European Union or the euro. He calls the latter a drag on the rest of the world. He would have voted for Britain to leave the EU. He could yet play an important role in the evolution of post-Brexit Britain.
The book does a better job than most with its diagnosis of what ails the world. It offers a few interesting ideas too. King proposes that central banks turn themselves into Pawnbrokers For All Seasons (PFAS) rather than remain Lenders Of Last Resort (LOLR). The latter gives rise to moral hazard as banks take on risks that they should not. Fearing systemic economic impact, central banks bail them out. He also wants banks to hold more capital than they do now. There is not much to quarrel with both solutions. However, he fails to tackle the other 800-pound gorilla in the room, and that is the financial market.
King correctly identifies the accumulation of debt as a major risk to the world. Indeed, he goes on to note that the monetary policy pursued by major central banks since the crisis might be perpetuating the very imbalances (or, “disequilibrium” as he puts it) that gave rise to the crisis. But, he does not acknowledge that financial markets, financial liberalization and the unfettered movement of capital across borders have all had a role in bringing about the imbalances he writes about—between saving and spending within and across nations; between the (low) interest rates that are deemed necessary to address growth today; between the (high) interest rate that is needed to bridge the savings-spending gap in Western nations and between returns to capital and labour.
In chapter 8, he deals with healing the global economy and the hubris that stands in the way. He notes that the theory of rational expectations does not have universal validity beyond its usefulness as a tool to analyse policy interventions and their effectiveness. Simply put, policymakers cannot repeatedly fool people all the time. But, from that, it became an article of faith, a clarion call to keep governments and regulation out. It led to policymakers becoming transparent and predictable about their policies, since people cannot be fooled or surprised beyond a point. It became the bedrock of financial liberalization and the unfettered growth of financial markets.
But, the more policymakers try to become predictable in setting policies, the more likely that people’s behaviour constrains them from changing course, when needed. For example, these days, central bankers reassure markets that interest rates will remain low. People adapt to it. Inordinate persistence with abnormally low interest rates gives rise to pessimism about the future, consequently, and real investment suffers. At the same time, low interest rates encourage financial engineering and speculation in financial markets.
The combination of low inflation, low real investment and high speculation traps central banks in a policy of low interest rates forever. Low inflation and low investment justify interest rates remaining low, and high speculation and asset bubbles induce fear of the economic consequences of them popping. Asset markets are decoupled from economic fundamentals. Rational expectations, therefore, do not restore equilibrium but perpetuate and worsen disequilibrium. This is the reality of G-7 countries today.
He cautions against central banks making themselves the only game in town. He does not believe that central banks conquered business cycles and achieved great moderation. But developed country central bankers are in no mood to introspect. In fact, after Brexit, they are doubling down on their dysfunctional policy choices.
We are headed down the wrong path for a very painful finale. I suspect Mervyn King would agree.
V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.
Comments are welcome at email@example.com. To read V. Anantha Nageswaran’s previous columns, go to livemint.com/baretalk
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