The Marginal Utility of Central Banking
By: Ben Esget, www.Outsider-Trading.com
Economists often discuss the marginal utility of goods and services. For instance, your second donut is less satisfying than the first and by the fifth donut the value of one additional donut is slim. With each passing donut the marginal value of another donut is small. The question we now pose is does monetary policy and by extension all central banking have a marginal utility curve, and if so what is the optimal amount?
On one extreme you get the popular mantra “Abolish the Fed”. Free market advocates often side here explaining that central bankers have a terrible track record throughout history and most often make the problem worse. The Nobel Prize winner Milton Freidman was an advocate for this style of monetary policy well before it was in fashion. He went on record saying we should do away with the Federal Reserve and instead tie interest rates to inflation. One of the primary strengths of this strategy is that excesses are quickly cleared from the system often through deflation and liquidation. Famed investor Jim Rogers explains simply that recessions are like small forest fires that clean out the system of excess. If the fire is prevented the kindling accumulates until a larger crisis occurs.
The major downside of a Fed-free model is that the economy and asset prices become extremely volatile. In fact, the process that often clears out excesses is an increase in either inflation, deflation, or both. These periodic shocks make corporate planning very difficult, which in turn would create a higher reluctance to hiring, leading to higher unemployment. Moreover, a more volatile economy would likely lead to corporations holding more cash (like we have now), which leads to underinvestment and sub-optimal efficiencies.
The other extreme view is that the skilled hand of the federal bankers is a critical part of stability and crisis mitigation. When shocks occur the Federal Reserve can step in to provide liquidity. Perhaps the most famous advocate of this view is Paul Krugman, the Nobel Prize winning economist who frequently defends larger government action across the board. This strategy appears to be what central banks around the world have adopted, as explained in our piece It’s the Economy Stupid. The benefits of this strategy are transparent. The government has the ability to create liquidity, change the price of credit, or even become the buyer of last resort. These benefits, overall, promote price stability and more full employment. But the benefits of central banking can quickly become perverse.
In Naill Ferguson’s book The Ascent of Money: A financial history of the world, professor Ferguson explains how at the height of money printing in the Weimer republic it was a nightly event to see tens of thousands of youths gather into some sort of parade selling their bodies. Inflation was so high that “anyone with anything of value was happy to get rid of it before it was worthless, and anyone without any assets were willing to sell anything they had, including their bodies to gain something of value.” Similarly, Japan “engineered” a soft landing when the economy turned in the late 1980’s. Unfortunately, this soft landing has turned into a 25 year long runway. Central banking may add stability in the short run but can create massive instability if left unchecked. Today, we are starting to see cracks in high levels of central banking in Europe, Japan, China, and even the United States with quantitative easing becoming the norm and global interest rates racing to zero. So, one has to ask, is there an optimal amount of central banking?
I agree with Milton Friedman’s view that interest rates should generally be tied to some type of metric. Unfortunately, finding meaningful inflation data is difficult because of how it is measured. ShadowStats.com keeps data comparing the old way the CPI was calculated (prior to 1981) and the way it is calculated now, and the discrepancies are huge (currently they show the old CPI at near 11%). For this reason, I recommend tying interest rates to a basket of commodities such as the Rogers commodity index. However, during times of duress it makes sense to give central banks some freedom to act. I would suggest a set standard deviation from the index where the Federal Reserve would be allowed to act if the board agreed. Moreover, allocating Central Banks a PREDEFINED amount of money they can use to create liquidity in emergency situations would add a certain level of price stability without giving seven men carte blanch over our fiscal wellbeing.
A system like that discussed above would keep many of the benefits of having a central bank but would keep their power within reason. Today’s system promotes stability over resilience (ability to come back from massive shocks). Limiting the power of central banks would create a system that is both stable and resilient.
I don't have any concrete solutions but I am pretty confident in saying that as we approach QE3, the marginal benefit of more Fed stimulus has turned negative.
There is an optimal amount of central banking: zero. The primary task(s) of Central Banking run contrary to market mechanisms - namely price-setting and creative destruction. Most central banks are charged with setting the prevailing interest rates and preventing bank failures. Both of these efforts are incredibly distorting in the marketplace. The interest rate is perhaps the most important price in the market- the price of money. It coordinates the inter-temporal allocation of capital and aligns consumers with production and investment. When we operate with an interest rate set by 7 guys in D.C. we get mis-allocation. (Who honestly believes interest rates should ever be 0%?). That's not to mention the strong inflationary bias of central banks the world over...
To address volatility, there is a great paper by Nassim Taleb written for the Council on Foreign Relations entitled "The Black Swan of Cairo". Very succinct (8 pages) and discusses this perceived stability argument. We think we have put in place a system that increases stability, when in reality we are masking risks until something blows up. We have traded frequent tremors for punctuated equilibrium (long period of seemingly calm conditions interrupted by cataclysm). Volatility is not something to be feared or a thingto be destroyed. It comes and goes depending on the circumstances.
Some people (read: Keynesians) think that central banks can apply magical salves to the market place that will cure economic ailments. However, their conviction in the effectiveness of central banking (and fiscal policies) is largely due to ignoring unintended consequences and knock-on effects. The U.S. has had 2 central banks before and both were eliminated. The Federal Reserve is not immutable.
And as far as "who honestly believes interest rates should ever be 0%," the answer is a lot of people judging by yields in the US, UK, Germany, even France. People are accepting negative yields right now. Yes that is insane, and yes the Fed Funds rate plays a major part in that but when you consider negative yields in Europe where the ECB rate is higher than here, it's a fair guess to say that were it solely up to the market to set yields, they'd be pretty close to 0% right now.
I think Greenspan and Bernanke are two of the worst Americans to ever have lived. But let's not pretend our pre-Fed days were some golden age of pure and efficient capitalism or drag Keynesianism into this argument.
1) Keynes would support monetary policy to deal with the "long-term equilibrium unemployment" that is accompanying the de-leveraging, so it would seem that he'd endorse the current policy in addition to the fiscal stimuli provided by Congress.
2) Preventing bank runs is part of the problem. If risks are simply masked (because every time a problem occurs, you have the Greenspan or Bernanke put to 'save' the day), the system is not any sounder- you just don't see them. That is part of the reason we are having so many 3-,4-, and 5-sigma events happening more frequently- fat tails as Mr. Taleb would put it. Bank runs are politically unpopular, but serve a economically vital function- they stop excessive risk-taking earlier. Would it not have been better to have stopped the lowering of lending standards in 2002 or 2003 by having a bank run or two? Bush or the Congress wouldn't have liked it, but we would be much better off. I repeat, I would suggest you read that paper- or even his book(s) on risk.
3) I would agree that government policy has been central in introducing moral hazard, such as implicit guarantees and FDIC as well as TARP and the Treasury. However, you cannot ignore that central banks, namely the Fed, have been instrumental in creating a substantial amount of moral hazard, namely the perception that the central banks would intervene to prevent the economy from every experiencing a severe downturn (the "puts" I mentioned earlier).
3) As for the interest rate of 0%, let me propose a thought experiment to illustrate the untenable nature of your argument: Would you rather have $1 today or $1 (or $0.95) a year from now (assuming no inflation)? It is obvious that having the money today is the clear choice. There is a inherent time value to money- that is an immutable fact. And this is the economic reality that zero/negative interest rate policy tries to suppress. Zero percent interest rates, or even negative rates, are not something that occurs in un-manipulated markets. As for what is occurring in bond markets around the globe, you are ignoring an important piece of information- central banks are the biggest buyers of sovereign debt today, driving down those rates! And, second, you may be ignoring the speculative aspect to buying bonds- people would buy to bonds on the expectation others will be come in later to buy bonds, not to hold the bonds to maturity (this logic is the only reason I'm holding as many dollars as I am). I would challenge you to demonstrate why in the open market rates would be at historic lows just a few years after the largest banking crises the world has ever seen? Is it the glut of available savings? (hint: there is no glut) Is it the extraordinary soundness of financial institutions? Maybe you are one of the investors who thinks that, for example, Japan is fine and its interest rates fully capture the risks of loaning the Japanese government money. Not I. To that I simply say, everything seems fine until it isn't.
3A) My reference to 0% interest rates was primarily aimed at Federal Reserve funds rate. It is not a free market rate. Is BoA equally as risky as J.P. Morgan Chase or Wells Fargo? No, but the Fed treats them the same.
4) I agree, let's not pretend. The idea that markets are purely efficient is ridiculous (It would be nonsensical to try to outperform the market- yet we know it can be done). It is because human interactions are inefficient that we need a mechanism that can assist us in correcting those inefficiencies. The questions is: Are the self-correcting mechanisms built into free markets better than the calculations and interventions of central bankers?
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