The rule of central bankers turns rotten

If the government set the price of coffee or coal, you’d know what to expect. A mess.

There’d be shortages and surpluses, quality problems, questionable business practices in the industry, and suspicious links between politicians and big business.

But even the people who I learned this from, and the politicians who implemented those ideas politically, never applied their own thinking to central banking. Despite exactly the same problems featuring.

If you have a government institution controlling the interest rate, you’ll get shortages and surpluses of debt. You’ll have quality problems in the form of sub-prime lending and bank bailouts. You’ll have bankers taking up all sorts of shifty practices, such as front running central bank decisions and manipulating interest rates. And the political power of banks will surge.

I’m not sure why I used the hypothetical in that paragraph. You can see all this in the news. The news yesterday was especially filled with central bank meddling. Three major central banks were active.

In Turkey, President Recep Tayyip Erdogan criticised the central bank before its interest rate decision. “I have never seen the central bank meeting its year-end inflation forecast,” Erdogan told the Confederation of Turkish Tradesmen and Craftsmen in Ankara.

What came next utterly mystified foreign observers. Erdogan believes that high interest rates fuel inflation – the opposite of what everyone else thinks. You can describe him as clueless, but given the prolonged failure of other central bankers to hit their inflation targets with low interest rates, nobody should be feeling too smug.

The Turkish lira plunged on Erdogan’s comments. But hours later, the Turkish central bank published its decision to hike interest rates from 17.75% to 24%, 3% more than expected by the market. The lira skyrocketed 5%.

This is precisely the sort of instability you can expect from a government institution running things. Whether it’s exchange rate controls, interest rate policy, or policy to control the money supply, volatility eventually strikes. Instead of blaming manipulation for the trouble, those in charge of the manipulation blame the free market.

Which takes me back. There is no shortage of articles out this week about what caused the financial crisis. I still don’t understand how anyone can blame anything other than central banking.

If a government institution controls the price of debt, the amount of debt, leverage rules, and how banks can operate, how on earth can anyone other than central banking and government be blamed for any crisis? The most regulated part of the global economy caused a crisis in 2008, and people blame free markets…

Back to what the central bankers have been up to lately.

The Bank of England’s Mark Carney has agreed to stay on until 2020. Having Remainers in government to deliver Brexit is not enough. We also want one at the Bank of England, an institution which had a history of being sceptical of Europe once upon a time.

May I point out that the term of the current president of the European Central Bank (ECB), Mario Draghi, ends in October 2019, so he may be a suitable replacement for Carney when the time comes…

Carney’s latest prediction about Brexit, proving how much central bankers actually do believe in confidence, is a plummeting property market. Given I’m still trying to move to London, my first reaction was that this would suit me just fine. Having property that is affordable to British renters seems like a good idea to me.

The trouble is, this would destroy huge amounts of wealth and leave many homeowners underwater, as Carney most carefully pointed out. But why? Why did property prices become unaffordable enough that British demand for property can’t support them?

Might it be because of Carney’s monetary policy? He controls the interest rate, which determines the affordability of the debt used to buy property…

Yes, the supply of property is crucially important to. Which is also governed by government institutions…

So you have the supply and the demand for property determined by government institutions. But both the central bank and civil service are blaming Brexit for putting house prices at risk!?

If Carney is worried about the UK economy, he should be encouraging Brexit. Because the ECB is putting the eurozone and thereby most of the EU at risk, as we’ll look into next.

The nation state could rescue Europe

With the ECB’s extraordinary amounts of quantitative easing coming to an end this December, the question becomes what to do about reinvestment. Having bought huge amounts of bonds, the ECB can’t just let them mature and take the cash. It has to reinvest that cash in order to keep things steady. But reinvest in what?

The first variable is maturity. Does the ECB buy long or short dated government bonds? Two-year or 30-year? Its decision will influence the interest rate that governments need to pay for different time periods.

Since 1961, central banks have been using this variable to control and manipulate the economy. They call it Operation Twist because it twists the yield curve – a chart showing different interest rates paid on bonds of differing maturity. By making long-term debt cheaper, that supposedly encourages growth.

The second variable is whether the ECB reinvests maturing debt into the same country’s bonds. It’s not entirely clear what the rules are here. Does the ECB have to stick to its capital key? Can it just reinvest German bond returns into Italian debt?

What is clear is how reliant governments are on the ECB’s financing. Without the flood of money into their bonds over the past decade, how would southern Europe’s borrowing rates look?

We’re about to find out, according to the ECB guidance:

[…] after September 2018, the Governing Council will reduce the monthly pace of the net asset purchases to €15 billion until the end of December 2018 and anticipates that, subject to incoming data confirming the medium-term inflation outlook, net purchases will then end.

This is of course just when Italy’s new government budget requires financing. And it’s expected to increase borrowing.

The first dribbles of rumours are coming out about the Italian budget debate already. The finance minister supposedly threatened to resign over being stuck between a rock, a hard place, an anvil and a German boot. Somehow Giovanni Tria has to reconcile Five Star, Lega, bond markets and the EU with his budget. He’s sick of being blamed for the inability to compromise. And Five Star may have threatened to chuck him out. Although Tria and others deny any outburst or threats occurred.

If you ask the Italians, it’s clear where the problem lies. With the central bank – at least they’ve figured it out. They know Italian yields are under ECB control. So any jump in yields must be political manipulation.

This is a convenient way to manipulate half-truths. The ECB only intervened to temporarily rescue Italy. It’s trying to restore normal conditions now. Blaming the ECB for the gradual doses of reality that the Italian government is getting is a bit misleading. But before you get sympathetic, consider this is exactly the typical sequence of events. “Nothing is so permanent as a temporary government program,” said Milton Friedman.

It’s depressing to see central bankers making the same mistakes that our rationing boards and nationalised industries used to. But things turn amusing because, faced with the consequences of their own mistakes, they never take the blame. Nor do they admit that the only solution is to give up their powers and interference. Just one more intervention and rule will solve the problem of the previous intervention and rule.

The EU and eurozone are heading down the interventionist drain. What’s new, though, is the ability of national governments to oppose this. Usually, it’s those national governments which are imposing these sorts of problems.

If the power and legitimacy of national governments can be used to fight back against the EU and eurozone’s interventionism, perhaps a resolution can happen.

Unfortunately, thanks to the build-up of debt encouraged by the central banks, a resolution implies a major financial crisis this October. I explained why to our publisher Nick O’Connor here.

Until next time,

Nick Hubble
Capital & Conflict

Category: Central Banks

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