Trading Freedom for Order
Looking at the world today, it seems that there is a growing fondness for a Leviathanic approach to governance (freedom is sacrificed for order). Notably, in China it appears from the outside that liberty is curtailed and freedom of expression is rationed so that the greater project of order and national progress can prosper. We can take this view a step further and say that today the version of the world proposed by the Levellers’ agreement and that proposed by the Leviathan are increasingly competing models of governance. One is the classical republican view that supports strong institutions and democratic and liberal values and espouses a more interlinked and interdependent world order. The other is a world where countries, and perhaps also companies, are run by small groups whose bargain with the people is to exchange liberty for order and a sense of national prestige. The distinction between these two views is not limited to democracy, nor is it limited to the distinction between developed and developing worlds. It can also be applied to finance. Specifically, in the developed economies—the United Kingdom, Japan, the United States, and Europe—Hobbes’s vision of the Leviathan seems increasingly manifest in the form of central banks.
Since the global financial crisis, they have become part of a great Faustian bargain in which central banks provide economic and financial stability—at great effort—in return for encroaching deep into the territory of policy making, politics, and financial markets. Central banks dominate all three areas today—though few people realize this.
Going back to the late 1990s, each bout of economic crisis has seen political, economic, and international institutional powers surrendered to central banks, to the extent that in recent years they have been described as the “only game in town.”3 Paul Tucker, an insider in central banking at the Bank of England, makes this point eloquently in his book Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. The Leviathan-like bargain central banks appear to have struck is to buy financial and economic stability in exchange for an inordinate level of influence over world affairs. It is important to stress that I am not suggesting that there has been a conspiracy by central bankers to acquire power, but few have tried very hard to unburden themselves of it. But the costs of this bargain are growing. Financially, in the dulling of market sensitivities to economic and financial imbalances, to inequality, and to the numbing of the urgency for politicians to address a litany of critical issues.
“You Must Have Misunderstood Me”
The sense of the mystical power of central banks in the modern era effectively began with Paul Volcker (chairman of the Federal Reserve from 1979 to 1987) and continued during the long tenure of Alan Greenspan from 1987 to 2006.4 In the 1990s, investors curious to divine the future path of interest rates looked at the size of Greenspan’s briefcase.5 If it was packed with material, then the Fed chief was arming himself to persuade colleagues of the need to raise interest rates. Today, central bankers do much of the predicting for investors, releasing forecasts of the future path of rates (forecasts that have regularly been wrong) and sometimes indulging in brave and bold open communications, memorably in the case of ECB president Mario Draghi’s “do whatever it takes” comment during a speech in London in July 2012. At the time, the eurozone economy was struggling, and bond yields for periphery countries (Italy, Spain, Greece, Portugal, and Ireland) were very high. Draghi compared the euro to a bumblebee—which shouldn’t be able to fly but does—and then, having accounted for the structural progress made in the development of the euro, he declared, “But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”6
Greenspan had little time for such clarity. He famously commented, “If I have made myself clear, you must have misunderstood me.”7 This comment was part of a rich heritage of obfuscation by central bankers. Montagu Norman, the secretive governor of the Bank of England in the 1920s and ’30s, used to emphasize the code “Never explain, never excuse.” Greenspan’s generation and that of predecessors like Paul Volcker were inflation crushers and rate raisers (to 20 percent in Volcker’s case). He at least believed that investors and economies had to bear the consequences of economic imbalances.
Much of the openness and clarity that characterizes central banks today result from attempts to correct the Greenspan approach. It is generally accepted that the lax regulatory and monetary approach of the Greenspan Federal Reserve led to the swelling of Wall Street and the financialization of the housing sector in the United States, which then helped produce the global financial crisis. One of the ironies of Greenspan’s career is that his PhD thesis tackled the link between economic activity and asset prices and examined the danger that rising asset prices pose to the business cycle.
However, in seeking to amend for the sins of the Greenspan era, central banks have arguably been answering too little intervention in the early part of the twenty-first century with too much today. The major central banks now play an outsized role in markets and in many cases have come to dominate them. In the late 1990s, effectively the early part of this period of globalization, a well-known trade economist, Jagdish Bhagwati, called US multinationals the “B-52’s of capitalism.”8 This place in the vanguard of world affairs has now been taken by the major central banks, and we might even replace the term “B-52” with something more domineering, such as “empires” or “gods of Finance.” Increasingly, central banks have reinforced the fault lines associated with a stretched and strained world, and perhaps without realizing it they have exacerbated many of the causes of the levelling. There is now a strong case to be made that central banks, in overreacting to the economic and financial issues besetting the world, many of them structural or design issues (in the case of the eurozone), are diminishing their own credibility and creating new risks.
Lombard Street
Central banks were not always so powerful. The oldest central banks, the Bank of England (founded in 1694 as the debt-management office of the government) and Sweden’s Riksbank (founded in 1668) have great pedigrees, but in general they were not as accommodative in the past as they are now.9
The financing of wars, state bankruptcies, and financial crises were more frequent in centuries past, and in many cases the outcomes were starker. For instance, in the second half of the nineteenth century there were several railway bubbles. Indeed, in 1900 railway stocks accounted for over 60 percent of the market capitalization of the US stock market and for 50 percent of the UK stock market. In the nineteenth century, financial panics (such as in 1893) were more frequent than in recent decades, partly because there were few financial system safety nets to prevent them, and in fact many of today’s central banks did not exist then.
These frequent crises and the habitual collapse of banks led Walter Bagehot, a journalist (one of the early writers for the Economist, which was owned by his father-in-law), to write Lombard Street, in which he distilled his observations on the British banking system. One of his recommendations was that in a crisis central banks should lend freely to solvent institutions, provided they would receive high-quality collateral in return and on the condition that this lending would not distort financial incentives. Bagehot’s dictum was resurrected during the global financial crisis, though it may well be said that central banks have increasingly ignored his prescriptions in supporting weak banking systems in countries like Italy and Portugal.10
The era in which Bagehot lived saw the beginnings of the first wave of globalization, and the later part of this period, in the early 1900s, was marked by financial and economic crises (e.g., in 1907) as well as political ones. The severity of the economic turbulence in the early part of the century begot the need for a central bank in the United States, and by 1913 the Federal Reserve System had been established.
One of the better accounts of how central banks acquired their power comes from Liaquat Ahamed’s Lords of Finance, which as a book is refreshing
for its passion and detail and as a story is notable for the way a small group of individuals coordinated policy and set the foundations of the international financial system as we know it. The heads of the US, British, French, and German central banks in the 1920s constituted the first “committee to save the world.”11 Compared to today’s central bankers, those of the 1920s were a somewhat strange and difficult bunch, and one lesson we may draw from the consequences of their actions is that the aftermath of financial crises can have long-running political implications, with Germany of the 1920s and ’30s being a case in point.
One policy question that arose in the 1920s is how central bankers should react to bubbles in asset prices: should they act early to halt exuberance, or should they accept that this is neither the responsibility nor within the capability of central banks? Financial market bubbles are usually evident with the benefit of hindsight,12 though often the behavior of people involved in a financial market bubble is a good indication of its existence. Charles Kindleberger and Robert Aliber’s book Manias, Panics, and Crashes is perhaps the best text on the topic, though Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds, published in 1841, is a reminder that investors and perhaps policy makers do not learn from history.
Sorcerer’s Apprentices
The global financial crisis, centered on the US housing market, had many of the classic characteristics of a bubble. The rise in house prices was leveraged in different ways: in the enormous amounts of derivative contracts that multiplied the risks of a fall in house prices, in the very large amounts of debt taken out by households in relation to stretched housing valuations, and in the business model of banks.
Banks and bankers acted like J. W. Goethe’s Sorcerer’s Apprentice: their financial innovations produced an explosive cocktail of risk. In this respect, the blame for the financial crisis lies at the feet of the banking and financial services industry. Equally, much of the recent work of central bankers has been directed at undoing and calming the damage done by the financial crisis. We should at the very least bear this in mind when criticizing the extremes to which central bankers have gone in their attempts to revive growth.
Financial market bubbles are an unfortunate and recurring part of central banks’ relationship with financial markets and economies. The response to the emerging-market crisis in the late 1990s, a series of emergency interest rate cuts led by the Federal Reserve, helped create the dot-com bubble of the next decade, and, arguably, the policy response to the global financial crisis (over seven hundred interest rate cuts internationally by 2018) is creating extreme risks in economic and market behavior today. Central banks seem to keep wanting to juggle the plates without ever stopping the music and resolving the underlying economic problems we face. Most central banks have yet to raise interest rates; Mario Draghi is representative of many central bankers in that during his time as the head of the European Central Bank, he has only cut interest rates. Even the Federal Reserve, which has increased interest rates, remains a massive holder of government debt and is intellectually and psychologically deeply invested in quantitative easing as an ongoing policy tool.
Quantitative Easing
The debate on central banks and bubbles has evolved from the time of Alan Greenspan. The orthodoxy in central banking now centers on whether and how to use what are called “macroprudential” rules to guide the ebb and flow of financial activity. For instance, instead of raising interest rates to slow the rise of house prices, a central bank can require banks to make mortgage conditions (e.g., loan to property value ratios) more stringent. In China, the authorities are now beginning to face many of these questions. In the context of historically very high house prices, excessive industrial capacity, and generally high levels of debt, Chinese authorities have begun a process of deleveraging: trying to get companies, business people, and companies to pare down debt levels.
Since the financial crisis, central banks have followed two paths in response to the shockwaves unleashed in 2007: a QE-led drive to push interest rates down to and below zero and a regulatory regime that aims to increase the capital that banks hold on their balance sheets and to oversee their activities in much greater detail.13 In many cases these efforts have helped slowly support economic growth and make banks less risky. But in recent years central banks have overstretched to the extent that they are creating new fault lines. In particular, they are sowing the seeds of a more multipolar financial system where banks are less interlinked than they were before the global financial crisis and where the lion’s share of their business takes place within, as opposed to between, regions.
Quantitative easing, the chief element in central banks’ response to the financial crisis, has its roots in a 2002 speech by Ben Bernanke, then a member of the Federal Reserve Board and later the successor to Alan Greenspan as its chair. Bernanke’s speech may have started as an intellectual musing on what the Fed should do if it were confronted with the enduring combination of low inflation and low growth that followed the collapse of the Japanese house-price bubble in the 1990s. Bernanke listed nine new and dramatic policy measures that could, theoretically, be enacted were the United States to be confronted by a severe financial economic shock. At the time, he probably did not consider that he would end up implementing most of those measures.
One of the first emergency policy steps by the Fed was the announcement in late 2008 that it would buy mortgage-backed securities. From then on, consistent with the Bernanke speech, the Federal Reserve adopted a broad policy of quantitative easing—simply put, of buying government bonds in order to push down long-term interest rates (bond yields or rates move inversely to bond prices, so extra demand for bonds from central banks pushes bond prices up and drives yields down). The first, positive effect of this was to support financial market confidence, providing the conditions whereby US banks issued large amounts of debt to better fund their balance sheets. The intended longer-term effect was that businesses and households, seeing the fall in long-term interest rates, would feel better placed to invest and consume more.
The best analogy I can think of to explain quantitative easing is a medical one. A person who has had a heart attack or a bad accident is often given adrenaline to stimulate the heart. This works well on a one-off basis and helps doctors better manage the patient while a long-term recovery plan is put in place. However, in central banking, every day for the past decade has been an adrenaline day. Central bankers should know that adrenaline doesn’t fix broken legs or mend clogged hearts. In this respect, Europe’s Mario Draghi has a whole ward full of sick patients—some mad as well as unwell. Giving them monetary drugs will suppress their pain but not make them better. Worse, over time they and those around them will develop an addiction to monetary drugs. So a more disciplined doctor/central banker might prescribe a short burst of monetary morphine, followed by economic restructuring by, for example, permitting bankruptcies, closures of defunct businesses and banks, and skill development and funding for new businesses.
House of Debt
Some central bankers have talked about this line of reasoning, but hardly any have acted this way. So, as QE has continued, its long-run net effect has become steadily less economically impactful.14 The initial changes in both market returns and growth in response to quantitative easing were strong, but in the period running up to the election of Donald Trump as US president, the immense effort of central banks had produced a lingering, lethargic recovery. Economic growth and inflation had failed to respond to additional waves of QE, so much so that economic commentators spoke of “secular stagnation” and a “new normal” (lower growth being normal). As Atif Mian and Amir Sufi’s book House of Debt notes, consumers who were encumbered by already-high levels of household debt, lower house prices, and an uncertain economic outlook saved extra cash or used it to pay off debt rather than spend it. Broadly speaking, both of these factors have contributed to a slow and drawn out recovery in the United States. In many instances, the ongoing pros
ecution of QE created a sense that something was still wrong with the economy (which left a lingering uncertainty in the minds of consumers) and did little to directly lower debt levels.
QE also became fashionable in the United Kingdom, the eurozone, and Japan. One reason may have been that the Fed is regarded as the intellectual leader among central banks, and there is a large degree of groupthink among the major central banks and the academics who feed into them. Another reason for the popularity of QE programs is that one of their pronounced effects, at least in their early stages, is to weaken the currency of the central bank that prosecutes them. In this way, the effect of QE is to help make export-oriented companies more competitive, though often to the detriment of competing companies from other regions.
In this respect, regions beyond the United States had an incentive to also implement their own QE programs. It has led to what a former Brazilian finance minister, Guido Mantega, called “currency wars,” the stealth (or in some cases, not very subtle) currency devaluations undertaken by the major economic regions. For example, in the wake of QE programs in the United States and Japan, the euro traded at a stubbornly high level of 1.38 (to the dollar), but once the ECB hinted at and then began QE, it fell to close to parity with the dollar, boosting the competitiveness of German exporters, among other effects. This was good for Germany as the leading export economy in Europe, but it raised suspicions in other currency zones that the ECB was participating in stealth devaluation.
Intended at first as an emergency policy, QE has now become the norm. In the aftermath of Brexit, for instance, the Bank of England reignited its QE program. Sweden’s Riksbank gives us perhaps the best example of how QE clouds the judgment of a central banker, and the way QE is prosecuted by the Riksbank is akin to dousing a fire with petrol. Between the years 2016–2017, the Riksbank continued to engage with a QE program, despite GDP growth of close to 5 percent, mounting inflation, and house-price growth of nearly 10 percent.
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