Central banks made a hash of things in the 2000s. But their failures – the credit bubble and the 2007 financial crash – have too many precedents.
There was the unexpectedly high inflation in the 1960s and 1970s. And two generations earlier, central bank activity and inactivity bore much of the responsibility for the boom of the 1920s, the great bust of the 1930s and quite possibly the United States’ fall back into recession in 1937.
Something has been fundamentally wrong with monetary policy. The central banks’ weakness is especially glaring when set against the ability of most parts of the economy to get over their serious problems. For example air and water pollution, widely considered existential threats, have been tamed thanks to the advance of technology, the widening of corporate agendas, and the dynamic efforts of governments and lobby groups.
Money and credit present a lesser challenge. It may sound easier to manage effluent than to restrain mass exuberance and forestall mass panic. But the monetary authorities have superpowers which environmental regulators could only dream of. Central banks can determine many interest rates, control lending, and create and destroy money at will.
They have not used these powers well. To do so, three intellectual revolutions are needed.
First, central bankers should recognise that price stability is at least as valuable for financial assets as for consumer goods. Raging stock markets encourage greed more than investment. They invite subsequent crashes and recessions. House price bubbles distort the behaviour of both buyers and builders. Sharp moves in commodities wreak havoc on producers and users alike. Unsteady interest rates can eventually lead to unsteady economic activity.
Central banks need not try to be omniscient and omnipotent central planners for asset markets. They do not have to decide the right price for copper or Google shares. But it is not that hard to tell when financial markets and emotions are getting out of hand. Besides, little is lost by acting firmly. Too-stable asset prices do much less harm than too-volatile ones.
It may take a few hard lessons for investors and speculators to learn about the new world order. But if central banks figure out how to squash big rallies and limit routs, the hot money will eventually retreat to horse races and other activities which can do little damage to the real economy.
But there is a problem, even if the successors of Janet Yellen at the U.S. Federal Reserve and Mario Draghi at the European Central Bank firmly believe they should push financial markets around. The current toolkit is nowhere near powerful enough. Policy interest rates are a blunt instrument –interest rates that are high enough to slow down financial markets will also crush economies. But the current techniques of financial regulation are not very ambitious.
The toolkit is the subject of the second revolution. Central bankers should take more control over money creation. The process is too important to be entrusted almost entirely to banks.
That is the current practice – bank loans create cash deposits. It often works reasonably well, but bankers in greedy mode create too much money, burdening the economy with leverage while fuelling speculation and inflation of asset or goods prices. In their fearful mode, bankers withdraw credit and deposits, starving the economy of useful funds.
Central banks need to get a grip, with the help of money-issuing governments. Most new money should be created directly by fiat, not by lending. Regulation of banks should be intensive, actively guided by economic principles. Loans should be limited to productive activities. Lending based on the value of land should be treated as radioactive. Lending which pushes up the value of land or any other financial asset should be taboo.
One financial asset deserves special attention – currencies. The current practice of allowing or encouraging the market to devalue the euro, yen or pound is counterproductive. Such falls provide only temporary economic relief, and currency volatility deters productive investments. It also creates international friction.
To change their ways, central bankers need a third revolution: they should become leaders in global thinking. Actually, this would be a counter-revolution. The maintenance of fixed exchange rates was for many decades a standard goal for monetary authorities. The goal was largely abandoned in the 1960s, for reasons which seemed good at the time. But sharply shifting currency values help spread financial instability around the world.
Discussions of monetary policy mishaps and financial industry malpractice are often fatalistic. It is said that excesses cannot be avoided since herd thinking, greed and fear are built into human nature.
Such pessimism is unnecessary. Consider the sharp decline in road accidents. These are mostly caused by the weaknesses of human nature: drunk driving, excessive confidence and poor judgement. But thanks to better rules and improved designs, deaths per miles driven in the United States have declined by 79 percent over the last 50 years.
An even greater decline in financial crises is perfectly possible. The first step is to change the accepted ideas of what central bankers can and should do.