Is the central bank the only game in town during a crisis?

In the film Cabaret, set in Berlin in the 1930s, a song called ‘Money’ is played which goes:

“A mark, a yen, a buck or a pound

Is all that makes the world go around.”

Yet in recent years, with central banks printing money like never before and a world recovery still elusive, you could be pardoned for thinking that money doesn’t make the world go around. Unless you are a hermit on a deserted island, the past decade has been anything but boring. Across the globe, central banks were thrust into the limelight as the world plunged into its worst-ever financial crisis since the Great Depression. Money and banking may seem mundane technical topics but they generate immense excitement when things go wrong. Will Rogers exaggerated only a little when he said, “There have been three great inventions since the beginning of time: fire, the wheel, and central banking.”

The Old Lady Unveiled by J.R. Jarvie, published in 1933, is a devastating critique of the Bank of England. It begins: “The object of this book is to awaken the public to the truth that the Bank of England, commonly believed to be the most disinterested and patriotic of the nation’s institutions, has been since its foundation during the reign of William of Orange a private and long-sustained effort in lucrative mumbo jumbo...”. Indeed, central banks are more lucrative than ever, making huge profits from their monstrously expanded balance sheets. Although mumbo jumbo surfaces from time to time, plain speaking is now very much the flavour of the season.

The old central banking tradition of mystery and mystique paved the way to openness and transparency with the advent of inflation targeting. The old world was illustrated by Lord Walter Cunliffe, the World War I-era Bank of England governor, who, when giving evidence before a Royal Commission on the size of the bank’s gold and forex reserves, replied that they were “very, very considerable”. When pressed by the commission to give a rough figure, he replied that he would be “very, very reluctant to add to what he had said”. Today, the figures are published monthly.

If money and banks are as old as mankind, central banks are the new kids on the block. The cult of celebrity has descended on the sombre halls of central banking. U.S. President Bill Clinton was once asked by a journalist what it was like to be the most powerful man in the world. Pointing to journalist Andrea Mitchell, he replied, “Ask her. She’s married to him.” Her husband was the then U.S. Fed chairman, Alan Greenspan. Put on its cover by Time magazine, he was the key member of its ‘Committee to Save the World.’

The central bank is entrusted with the twin objectives of price stability and provision of liquidity by a “lender of last resort”—to ensure that in good times the quantum of money grows at a rate sufficient to maintain the stability of the value of money, and in not-so-good times the amount of money grows at a rate sufficient to provide liquidity. Concerns about the power of central banks remain a popular political stance, as expressed by the slogan “End the Fed”. Despite these challenges to their authority, governments have relied more and more on central banks—especially the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Japan, and the Bank of England—to deliver a recovery from crisis situations.

Milton Friedman’s Capitalism and Freedom—a major work of 20^th century economics and political philosophy which sold a million copies—begins controversially. Friedman writes that U.S. President John F. Kennedy’s popular statement in his inaugural address, “Ask not what your country can do for you—ask what you can do for your country,” was not worthy of the role of an individual in a free society. The book is a reiteration of what Adam Smith had said 200 years ago: left to their own devices and free of excessive government control, people prosper and create civilised communities.

The 884-page treatise, A Monetary History of the United States, jointly authored with Anna Schwartz and published in 1963, was Friedman’s magnum opus in terms of economic ideas. The book says that the U.S. government’s Federal Reserve system, through the clumsy use of the levers of the monetary system—specifically not increasing the money supply in the wake of bank collapses—turned a contraction probably lasting a year or two into a catastrophe called the Great Depression. In fact, they also attribute the 1929 stock market crash to the Fed’s actions. The stock market had steeply risen during the late 1920s, causing the Fed to implement a deliberate tightening of policy to curb speculation.

In a 2002 speech to commemorate Friedman’s 90^th birthday, Ben Bernanke, then a member of the Board of Governors of the U.S. Fed, apologised and said: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” Little did he know that soon, he would be given the opportunity to live up to those words.

Since the 2008 financial crisis, central banks globally have thrown the kitchen sink at reviving their battered economies, keen to avoid accusations of repeating the blunders highlighted by Friedman. The crisis introduced new ‘unconventional’ monetary policy tools into popular lingo—quantitative easing (QE), forward guidance, negative interest rates et al. All of this raises the question: are these tools actually working?

Built on the idea of a ‘liquidity trap’, injecting cash to boost the economy because interest rates have been cut to zero or even into negative territory is one of the most controversial tools of late. Simply put, QE denotes central banks electronically ‘printing' money and using it to buy bonds, which are government or corporate debt. This placed money on balance sheets of companies that sold their bonds for cash, which central banks hoped would be invested and boost recovery.

Bernanke felt “the problem with QE is that it works in practice but not in theory”. The Fed announced its first asset purchase programme in November 2008. The three programmes till 2014 saw the Fed accumulate a staggering $4.5 trillion in assets. QE totalled £375 billion in the U.K. or 22.5% of its 2012 GDP. In 2017, the ECB held assets equal to 40% of the 2016 Eurozone GDP. For each of the three central banks, the scale of their balance-sheet expansion was unprecedented.

Over time, the banks discovered new avenues, attaching increasing significance to the effect of its announcements in triggering the desired responses. At first it hoped to capitalise on their ‘surprise’ element. Once the surprise wore off, it emphasised signalling and ‘forward guidance’. When the bank acts, its actions offer clues to what it will do in the future (signals) and the forward-guidance channel works through policymakers making long-term commitments to keep interest rates exceptionally low. The policy boasts a placebo effect—a self-fulfilling prophecy stimulating a recovery sans the critical risks of expanding the central bank’s balance sheet.

Former Bank of England governor Mervyn King called this the “Maradona theory of interest rates”, illustrating the footballer’s dazzling display against England in the 1986 World Cup. His second goal was an example of the power of expectations. He remarkably ran, virtually in a straight line, 60 yards from inside his own half, beating five players before shooting at the English goal. Because they expected him to move either left or right, he was able to go straight on. Market interest rates react to what the central bank is expected to do. In recent years there have been periods in which central banks have been able to influence the path of the economy without making large moves in official interest rates. Last month, U.S. Fed Chair Jerome Powell said the Fed is “not even thinking about thinking” about rate hikes. The logic is that if the High Street banks can be convinced that they will be able to borrow overnight from the central bank at, say, 0.25% for many months or years to come, they will hopefully be willing to lend money to the rest of us for the longer term at a lower rate as well.

So how did this tool perform in 2008? Conducting an empirical assessment of the effects of QE is bedevilled by the presence of counterfactuals. However, the 2008 experience showed that QE failed to trigger bank lending. The stimulus recipients either did not spend it, or did not spend it on currently produced output, so ‘broad money’ bank deposits fell, even as narrow money (reserves) exploded. Over five years (2011-16) it failed to get inflation up to target and had a weak effect on output. In the language of economist John Maynard Keynes’s A Treatise on Money, the money got stuck in ‘financial circulation’. At best it achieved a small percentage of the expected output gain, but at the expense of pumping up unstable asset prices and a finance-led recovery. By enriching the already well off, QE increased the well-documented concentration of private wealth in ever fewer hands. The wealthy have a much smaller propensity to spend than the poor and this “savings glut of the rich” is a pile of capital that must find its way somewhere (read: the stock markets). It decelerated the velocity of circulation which at least partially offset the attempt to increase the quantity of money. For the real balance effect to work, agents must respond to an increase in deposits by really spending their extra cash. An increased propensity to hoard leads to the collapse of the transmission mechanism and a drop in the velocity of circulation. In January 2017, this led to an even more unconventional policy when Mario Draghi, the ECB president, started taxing ‘excess’ reserves held by commercial banks at the ECB in order to encourage them to lend.

Keynes had highlighted the problem in 1936 when he warned: “If, however, we are tempted to assert that money is the drink that stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip.” He identified two such slips or ‘leakages’ from the circular flow. First, creating extra bank reserves would have no influence on spending because the effect of money on prices depended on the amount spent, not on the quantity created. Second, even if demand were to be stimulated by cash infusions, it might be used to buy existing assets. In fact, such considerations led Keynes to conclude that the only secure way to get new money spent in a slump was for the state to spend it itself.

Cut to 2020. The five biggest central banks have unleashed an estimated $5 trillion in asset purchases. The Fed’s efforts to keep interest rates and bond yields low have offset the collapse in profits for S&P 500 companies, helping to keep the market aloft, making some believe that Wall Street is on a different planet. The current stock market rally is the mother of all liquidity-triggered rallies. Since the end of March, the balance sheet of the U.S. Fed has grown by $3 trillion—twice the growth seen during the depths of the 2008 crisis. Incidentally, over the same period, the S&P 500 market cap has jumped by $2.8 trillion. The correlation between the U.S. equity market and its central bank’s balance sheet is now more than 90%, higher than the close relationship between equity prices and the Fed’s QE moves in 2009-13.

A crisis will not be resolved by the provision of liquidity if there is also an inherent solvency problem. A $5-trillion central bank relief cannot conjure up economic demand or transform bad loans into good. Many companies are quietly sliding into insolvency, as their debts overtake their crashing revenues. In the first six months of this year, U.S. courts recorded 3,604 businesses filing for Chapter 11 protection.

Tackling the immediate signs of crises by using short-term measures to instil market confidence, usually by throwing in large sums of money, will only add to the underlying disequilibrium. Nearly every crisis begins with the belief that the provision of liquidity is the panacea for all maladies; but with time, the real solvency issues below the surface come to the fore. A reluctance to admit this fact, even if liquidity is a bridge to the right cure, lay at the heart of many of the past crises e.g. Japan’s asset bubble in the late 1980s, the 2008 financial crisis, and the Eurozone crisis.

Some people believe that central banks are the answer to all of our economic problems—the ‘only game in town’. Any central bank that allows itself to be described as the ‘only game in town’ would be better off getting out of town. Their popularity has waxed and waned over the last two centuries. However, what is clear is that political compulsions will always favour the provision of liquidity, while lasting solutions require the solvency issues to be tackled. Till then they are unlikely to be one of the three great inventions since the beginning of time.

Views are personal. The author is a Harvard alumnus and works for an investment bank in Mumbai. He is also a member of the Young Scholars Initiative at the Institute for New Economic Thinking, founded by George Soros et al.