By Martin Hutchinson
September 24, 2007
SourceMartin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.comAfter pretending an unwonted firmness for a few weeks, the central banks in both Britain and the United States caved this week, accepting financial sector bailouts and in the Fed’s case lowering interest rates. Moral hazard has thus been made immoral certainty; financial market participants who indulge in grossly speculative activity can be “highly confident” (in the words of the old Drexel Burnham commitment letters) that they will be bailed out by the public sector, i.e. ultimately by the taxpayer. Rarely has there been such an obvious subsidy of the overpaid by the beleaguered. It raises the question: what if anything is the point of central banks in the new world we have entered?
With the Northern Rock debacle, Britain suffered its first run on a major bank since the Overend, Gurney collapse of 1866. The Bank of England initially took the same principled (if, in that case, mistaken) line it took over Barings in 1995. As lines of withdrawing depositors spread over British TV screens, however, it was quickly overruled by the Chancellor of the Exchequer Alistair Darling.
Darling, not content with rescuing just one bank, grandly announced that all failing banks would have their deposits guaranteed by the taxpayer, thus flushing 313 years of bank supervision policy down the pan. (It will be remembered that in 1720 the Sword Blade Bank, bankers to the South Sea Company, was allowed to fail, since Sir Robert Walpole, unlike his distant successors, had a shrewd grasp of the “moral hazard” concept.) By the middle of the week the Bank of England was offering to lend money against dodgy home mortgage portfolios.
Meanwhile in the United States, the Fed cut interest rates, thus causing a massive Wall Street stock surge, undermining the value of the dollar, sending gold up to $740 per ounce and doing very little to help the home mortgage borrower since long term rates rose almost as much as he had cut short term rates -- unlike Fed Chairman Ben Bernanke, the bond market fears inflation. Then their regulators allowed the overleveraged and accounting-inept housing agencies Fannie Mae and Freddie Mac to buy another $20 billion of mortgage backed securities, to the further ultimate risk of the taxpayer – Freddie promptly snapped up CIT’s $4 billion portfolio of securitized subprime junk, precisely the rubbish that puts its solvency in most jeopardy. Finally Bernanke appeared before Congress and supported legislation allowing Fannie Mae and Freddie Mac “temporarily” to guarantee “jumbo” mortgages above the current statutory limit of $417,000.
The idea that large mortgages should be effectively government guaranteed beggars belief in principle. It also supports the overbuilt high end of the housing market, bailing out borrowers who, being richer, should be more able to bear the risk of lower house prices and higher interest rates than their poorer countrymen. It is a subsidy from the middle class to the rich, supporting the least productive, most energy-inefficient and least deserving sector of the US economy. John Edwards, he of the $400 haircuts and the 28,000 square foot home, is no doubt rejoicing at the news.
This is all very depressing. When King Philip II of Spain sat in the gloomy Escorial, counting his gold and silver hoard from the Americas, he doubtless pulled at his beard in puzzlement at where all the damn inflation was coming from. One rather hoped that modern central bankers had got beyond Philip’s limited monetary understanding. However it appears that in times of crisis, when badgered by politicians, they revert to a sixteenth century worldview. It’s as if after the Chernobyl nuclear disaster scientists had resorted to alchemy in the hope of preventing it happening again.
It is now clear that all the intellectual advances in central banking of the last 300 years have disappeared. Gone with the wind are the concept of “moral hazard,” the idea that central banks should be independent of political control, the idea that lowering interest rates might cause inflation and the knowledge that widespread deposit guarantees and bank bailouts impose huge long run costs on taxpayers and the economy. In 1720 when the financial world was young and innocent this would have been forgivable; today as then it is likely to bring economic chaos in its wake.
Once the long run costs of bad policy become all too clear, policymakers will make changes, to ensure that they are not repeated. It’s thus worth pondering what changes one might recommend.
Regrettably, one possible change, a reversion to a Gold Standard, is not immediately practicable. Gold supplies can be increased by new discoveries by at most 1% per annum or so. Since world population is currently increasing at about that rate, any significant economic growth, requiring an increased monetary base, would become impossibly deflationary. Deflation, as Bernanke helpfully but irrelevantly pointed out in 2002, is more dangerous than inflation, because the ability to store money in bullion form without interest can cause the working money supply to collapse (if you can get a safe zero return on cash with 100% liquidity, and prices are dropping 3% a year, why ever would you invest in anything else?).
The Gold Standard worked fine in the 19th Century, with the help of large gold discoveries in California, the Transvaal and the Yukon, but once world population growth started to accelerate after 1900 it became impossibly deflationary, as was discovered in 1925-31. Reversion to a Gold Standard is an admirable long term aim, but it had better be deferred until after the magic date around 2050 when the world’s excessive population stops increasing and begins to decline.
Theoretically, it should not be impossible under fiat money to run a central bank that does a good job. After leaving the Gold Standard in 1931, Montagu Norman did an excellent job at the Bank of England, in an exceptionally difficult period. In 1931-39 his policy provided stable prices and facilitated in Britain an economic performance that relative to its major competitors was better than any since Lord Liverpool’s time. In the United States, Paul Volcker in 1979-87 did a brave and admirable job in spite of the Fed being an exceptionally politicized institution by central banking standards (his successor Alan Greenspan when appointed appeared likely to be as brave and successful, but wasn’t.) Bundesbank presidents from Karl Blessing through Karl Otto Pohl to Helmut Schlesinger made the Deutschemark the most trusted currency in Europe during the half-century of its independent existence.
These three successes were achieved with very different legal and financial structures. They shared only one common feature: exceptional independence from political pressure. In Norman’s case his prestige – he was Governor for 24 years – was huge and in 1931-39 his political counterpart Neville Chamberlain was both capable and sympathetic to his policies. In Volcker’s case, the alternative policy of sloppy inflationism had been wholly discredited by failure. In the Bundesbank’s case the institutional structure worked well; its strength and independence had been set up carefully by Chancellor Konrad Adenauer, himself no mean student of monetary discipline.
Independence is not merely statutory; it must be accepted by the political and banking system. In Britain, the incoming Labour government made the Bank of England nominally independent in 1997, but emasculated it in the following year by removing its banking supervision powers and transferring them to the Financial Services Authority quango. Why, given its lack of responsibility for Northern Rock’s operations, the Bank should be expected to bail it out is an interesting question; the system is a horrid mess, which doesn’t represent true independence. A free marketer might suggest privatizing the Bank of England and returning it to its pre-1946 corporate form, but in today’s world that would doubtless result only in its being bought by Dubai, China or Gazprom, not an improvement.
The United States had two perfectly good central banks in the two Banks of the United States, but on both occasions populist pressure led to their winding up. The Fed is a messy compromise, typical of Progressive legislation in that it has been given several internally contradictory mandates, and is constrained by an altogether excessive level of political control.
While the Bundesbank worked fine, the European Central Bank appears to work rather less well. In theory, it should be exceptionally independent since the various political factions pulling at it should be impossible to unite across Europe’s strong national borders. In practice, it appears to be frightened of stirring up political opposition, not surprising since politicians have spent the last decade blaming all economic problems on the creation of the Euro which it manages. Its conflicts are likely to become sharper in the future. The Euro in the next few years will be perpetually overvalued against the rest of the world’s currencies, so deflation in the Euro zone is almost inevitable. It appears impossible to create a monetary policy that avoids harsh deflation in some European countries such as Italy without causing idiotic housing booms in other countries such as Spain and Ireland.
Logically, we have now arrived at a position where no central bank can be trusted against the twin temptations of the gigantic financial services industry and the gigantic public sector. On the other hand, unraveling a century of “progress” and returning to a pure Gold Standard may be economically damaging as well as politically impossible. Setting up a Supervisory Committee of top economists is also unlikely to help much; a feature of the US monetary expansion and bubble creation since 1995 was the support for Greenspan’s folly by the world’s leading monetary economist, the late Milton Friedman. The only solution is to find another Paul Volcker or Montagu Norman, but those don’t grow on trees.
Rather than try to adapt a fiat money system to remove its deficiencies, it may be simpler to adapt a Gold Standard to remove its excessive deflation. The best way to do this might be that dusty staple of 1890s politics, bimetallism. If gold and silver were both coined, at a fixed ratio between them, new discoveries of both would increase the world’s money supply, giving it more flexibility than a pure Gold Standard (also, silver supplies could presumably be increased more rapidly than gold as the metal is more plentiful in the earth’s crust.) A World Monetary Conference could be held once a decade, to make modest adjustments to the coinage ratio between the two metals or if necessary to debase the coinage slightly.
Such a mechanism would give just sufficient flexibility to avoid excessive deflation. More important, it would provide an automatic check on central bank money creation, thereby preventing asset and stock market bubbles of more than modest size and duration. If such a system had been in effect in the late 1990s, for example, a money flow out of the US at the time of the LTCM crisis would have brought the bubble to a halt eighteen months earlier than it did, even if such a flow had not occurred earlier, at the time of Greenspan’s “irrational exuberance” speech. After 2001, a bimetallic standard would have prevented Greenspan from lowering interest crates so far, thus preventing the housing bubble, while the capital inflow in 2001-02, at the time of the strong dollar, would have avoided deflation.
A new monetary system will be demanded in the next few years, after the excessive inflation and moral hazard of the present system have caused the inevitable major crash. At that point, a bimetallic quasi-Gold Standard should be the alternative to work for against the statist and inflationary nostrums that will doubtless be proposed.