CENTRAL BANKS MAKE A GOOD CASE FOR THEIR OWN ABOLITION

ECONOMIC PERSPECTIVES - 133 | EMILE WOOLF, APRIL 2023

My last essay described the toxic impact of deliberate and sustained interest rate suppression on the availability of affordable housing. But that was only one glaring example of what happens when credit is costless. In this essay I shall highlight some of the other horrors caused by the same feature of statist insanity: deliberately contrived and sustained suppression of interest rates - against all reason and natural law. 

Just as few in government know the real meaning of “inflation”, so it is with “interest”. Determination of interest rates is a behavioural issue that arises when individuals enter a commercial relationship. I might offer to lend you £5,000 in 2 years’ time, but if you want it now you may have to accept a discount and settle for, say, £4,500. Every parent is familiar with the “instant-versus-delayed-gratification” syndrome in child-rearing. It’s called “time preference” and it manifests itself in the interest rate: the greater the time preference the higher the rate of discount applicable. 

The myriad time preferences of individuals, as expressed in their transactions, coalesce in the money markets, which have the crucial function of channelling resources from savers to investors, collectively tending towards an equilibrium rate. This money-market function enables individual participants to contribute to wealth-creation in the community. 

The central bank knows better

The central bank’s attempt to override this natural process by imposing its own politically motivated “base rate” is therefore a disastrous intervention, as we shall see. Bank of England governor, Andrew  Bailey, declared last week that as well as maintaining financial stability, the predominant purpose of the Bank’s interest rate policy is to “control the level of inflation in the economy”. His belief, shared by most members of his Monetary Policy Committee, is that 2 per cent is the “goldilocks” inflation target - neither too hot nor too cold, but just about right. Why this particular number should be the target rate for so many central bankers has never been explained, nor why the means of achieving this, the wilful suppression of interest rates, has proved to be as useless in achieving that target as it has been disastrous for the economy.

When Mario Draghi was told that his actions were causing inequality, he glibly replied that his only concern was meeting “the target”. Such is their obsessional belief in the rectitude of their policies that central bankers simply ignore any evidence that the target is eluding them. Last year, when confronted by the spectre of a price-inflation tsunami, in unison they chorused that the rampant price increases were “transitory”. 

Like Humpty Dumpty, when a central banker “uses a word it means just what he chooses it to mean, neither more nor less.”  When central bankers talk about “inflation”, they are focussing on a rise in prices, remaining blind to what causes them to rise, notably the central banks’ own expansion of the money supply - the real meaning of inflation.

Blowing bubbles

The most pernicious outcrop of interest-rate suppression is the rash of “bubbles” it generates, compelling us to live in a state-controlled environment with fake money, fake interest rates, fake jobs - and fake politicians. As we know, it begins when the central bank floods the money markets with low-rate “gilts” - bonds representing debts on which the Treasury pays interest. (No surprise they’ll do everything to keep those rates low!) When the economy is awash with new money a fake world of asset bubbles is created - in antiques, vintage wine and whisky, cars, luxury homes, jewellery, even a phenomenon called non-fungible tokens (NFTs) - crypto-generated copies of great paintings. Such is the urge to get hold of something more enduring in this fake world of fiat money.

Displays of extravagant wealth have always signalled rising inequality, and the government’s interest rate policies have crippled returns normally available to savers and pensioners. Ultra-low interest rates were behind investors’ frantic search for yield, and financial risks were mispriced. 

When the cost of borrowing is low enough even the most absurd investments appear viable - which is what has happened in China, where authorities in the city of Shiyan ordered local mountains to be flattened to make space for new factories. Easy money was funnelled into steel production, creating a bubble of oversupply. When steel prices duly collapsed, the word was that “steel is cheaper than cabbage”. As in Europe, China’s economy became infested with corporate zombies, nourished on an unsustainable diet of cheap credit and state subsidies. 

When, as in Japan and Europe, real interest rates turn negative, market-coordination collapses. A severe misallocation of investments follows, rendering any meaningful comparison between present and future revenue streams impossible. Farewell, economic calculation.

Post-2008 reforms are failing

Make no mistake - the political classes have learned no useful lessons from all this. If the post-2008 banking reforms, requiring banks to hold larger reserves, had really helped we would not be witnessing bank bail-outs yet again. What those reforms failed to test was how banks would survive the inevitable rise in interest rates. The list of “global systemically important banks” (GSIBs), on which financial pundits focus, did not include California’s systemically unimportant Silicon Valley Bank (SVB). Yet when its inept management was faced with expensive short-term margin calls that its long-term bond investments could not match, the familiar bank-run of depositors queuing to get their money out filled our screens and cries of “contagion risk” were heard across the globe. 

The MD of the IMF warned that “the transition from low interest rates to the higher rates necessary to fight inflation inevitably generates stresses and vulnerabilities, as we have seen in recent developments in the banking sector”. Really? I’ll not waste time unravelling that nonsensical contribution. But we should never expect anything coherent from the IMF.

Instead of allowing the high-tech companies that trusted SVB with their money to face the consequences, President Biden and the Fed caved in and agreed to fund the shortfall above the statutory $250,000 deposit guarantee limit. This clumsy bailout will lead to more crises as people and businesses take on extra risks in the expectation of a bailout when things go wrong. Depositors with very large balances were supposed to be treated by the Fed as investors capable of assessing the likelihood of repayment by a bank to which they loaned money. (Remember: a deposit is a loan in a fractional reserve bank.) 

A meaningful reform whose time has come

It should never be the case that depositors are insured without limit - but we should go further and abolish all deposit insurance. This was the position in the UK before deposit insurance was imposed by an EU Directive in 1979. Deposit insurance, like contrived interest rates, is a distortive blight on the capitalist system. Depositors rewarded for risk-taking activities in good times should not be bailed out by the government when the markets get tougher.

To make such a move palatable the public must feel that the depositors had an alternative to making high-risk deposits. All banks licensed to receive deposits should offer 100-per-cent-backed, legally separated, “storage” deposits - as used to be available in the days of “trustee savings banks” that offered near-zero returns, but total safety. In this system everyone would know that fractional reserve depositors had consciously chosen to risk their deposits in order to get higher interest returns: no excuse for demanding government protection!

Since 2008 Western government-spending policies have put their economies on life-support. Regulators, ratings agencies and banking monitors have been asleep at the wheel. No one recognised the obvious: deliberate interest rate-suppression has its time limits. Rates can rise again, and rise very quickly. The laws of finance and economics have not, after all, been repealed.

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