Montrose Journal Summer 07

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Over the past 20 years the rise of independent central banks and their use of inflation targeting has revolutionised the management of western economies. Starting in a small way in New Zealand (and you can't get much smaller than that) central banks seem to have found a way to beat the inflation devil inherited from the 1970's without recreating the mass unemployment of the 1930's. But along the way they have also presided over a huge rise in asset prices—much greater, indeed, than the rise in ordinary prices that they seek to control.  

A history of paper money

Of course, governments, and the central banks they created, have been using their power to set short term interest rates to shape the economy since they realised that they could print paper money (as opposed to mining for the metal stuff) whenever they wanted to. (The first example of paper as money occurred in China more than a millennium ago). Europeans gave paper money a special name; fiat money—nothing to do with the Italian car, but from the Latin meaning "Let it be" as in Fiat lux ("let there be light"). It means you can just say it and it is so. They could have kept the same meaning by calling it "Abracadabra money" but we're talking central bankers here. Authorities could control the level of activity in the economy. But it was a rough and ready affair, usually muddied by government interference or control and with shifting and ambiguous rules. The introduction of formal inflation targeting in the late 1980s and the guarantee of central bank independence seemed to change the process from being a black art into something approaching a science.

There have been setbacks along the way and some have been notably more successful than others at avoiding the pain of unemployment. But the conventional wisdom is that the central banks have done a good job and should be allowed to get on with it without interference. In the USA, for example, inflation has tumbled over the past quarter-century, while gross domestic product, (GDP or national income) has grown fairly consistently. (See chart).

Central banks themselves preach the message that their job is to ensure "price stability." By that they do not mean that prices do not change. Rather, they allow that there should be some inflation, but not much—usually 2% a year or a little less. To achieve this, they change the interest rate at which they lend to their local financial markets. Charge more and that new factory that was going to be built becomes uneconomic; the company would have to pay its workers more to start it up. Charge less and mortgage rates go down, so people have more money left over to spend, boosting demand and boosting wages, assuming the economy is at or close to full employment. In all the major western economies the link is clear and often stated: central banks regulate inflation by regulating demand which regulates wages.

The US Federal Reserve ("the Fed"), America's central bank, is unique among advanced western economies in not having an explicit inflation target. One recent academic study argues that the real measure the Fed watches in deciding its policy is the unemployment rate. It appears to act to avoid unemployment that is either too high or too low. (In central banker land, unemployment can be too low if it is at a rate that pushes up wages). This is what has become known as the "Goldilocks economy", a phrase first used in 1992 to describe an economy that is not too hot and not too cold. (The fact that the porridge was private property belonging to the three bears and that Goldilocks was clearly guilty of theft never seems to get mentioned.)  

What about asset prices?

In all this there is no mention of asset prices. They only come into the picture indirectly. Yet the impact on asset prices of this new regime has been profound. Low inflation means low interest rates. The 1970's were cursed by inflation so high that interest rates had to be set at a level that choked investment. The growing belief that central banks could and would keep inflation low and stable allowed investors to make bigger bets on risky assets because they predicted that they were unlikely suddenly to face a higher cost of borrowing. That wasn't true simply of professional investors.

In the Anglo-Saxon nations especially, but increasingly in Europe as well, ordinary households realised that mortgage rates were likely to be lower and more stable in future, so they could afford to take out bigger mortgages. And with bigger mortgages, house prices went up. This meant that it was important to move up the property ladder as fast as possible, thus feeding the need for ever bigger mortgages. In Britain, the rule of thumb used to be that banks would lend up to 3 times a couple's joint income. Now, many banks will lend couples six times their joint income, and some turn a blind eye to what they must know are exaggerated income claims. In America, lax borrowing reached rampant proportions over the past few years. So many of the mortgages issued are going wrong that a major sector of the American financial industry— lending to sub-prime customers (those with a poor credit history)—has all-up seized up. And that is one important lesson which is beginning to worry some of the central banks. The more they try to remove uncertainty and risky behaviour from financial markets, the more inventive players in those markets will be at putting risk back in.

The yield on an investment is the profit divided by the price. So, as the price rises, the yield falls. And the lower the yield becomes, the more tempted people are to find ways to take bigger risks to juice it up. The emergence of low interest rates that apply even over the very long term—30 year corporate bonds are commonplace and even century-long bonds are not unheard of—has produced a phenomenal reduction in the premium that is charged for risk. That has been the result, over the past five years, of exceptionally "easy" monetary policy everywhere.

The bond markets are supposed to be the safe place to invest. Yet it is in these supposedly safe havens that all of the financial crises of recent years have started, whether the Savings & Loan fiasco of the 1980's, the near-collapse the Long Term Capital Management hedge fund in 1998 or the sub-prime problems of today.

Not my problem

That is one reason why the very limited view of the role of central banks is so attractive to them. If it is impossible to prevent occasional financial market excess, why not just let it happen and simply ensure that it does not wreak havoc in the whole economy as the banking crisis of the early 1930's did in the Great Depression? The Fed points out that share prices virtually halved between 2000 and 2003, but the economy barely blinked.

Few people in the real world share this indifference. Rising house prices are great if you already own one—or more— of them. If you are starting out and looking for somewhere to live, the picture is not so rosy. Similarly, the boom in stock prices (see chart) is fine if you own the shares going up; but the higher they go, the smaller the claim on a company's profits that a dollar will buy you. Both sorts of asset inflation mean that asset-owners—the rich to you and me—get richer, widening the wealth gap. Central bankers could reasonably respond that wealth distribution is not part of their mandate.

There are two reasons why people feel central banks ought to step in to stop asset prices rising too much. One is that they will keep going up and that will be bad for wealth inequality and for social cohesion. The other is that the bigger the rise, the further they have to fall when the bubble bursts.  

In the first school we see a lot of people from what we might call the Bundesbank School of central banking, which is influential at the European Central Bank (ECB). The Bundesbank never explained what it meant by price stability but it did say how much extra money it thought should be created each year, which was a pretty good proxy for what they thought should happen to asset prices. The ECB has kept the practice of setting a target growth rate for the money supply, but it is given much less prominence than it was by the Bundesbank. If "loose" monetary policy (i.e., a fast-growing money supply) goes on too long, you just build up inflationary pressure for the future. The trades unions would see share prices double and say their members ought to be getting some of the benefit accruing to shareholders. That would start the wage price spiral again. Similarly, if house prices went up so much that no one on the average wage could buy a house, there would soon be demands to increase the average wage.

In practice this hasn't happened in the last 5 years. In Germany the main share index, the Dax, has more than trebled (from 2,187 to 8,020), yet firms have been able to impose wage cuts. The reason is the huge impact of competition from China and India, which has dramatically weakened labour bargaining power. Nor has there been any sign of wage strength in any of the big western economies, even though they have all experienced a huge surge in asset prices. The fear that if asset prices doubled, the price of everything in the shops would eventually double just hasn't turned out to be right. To which the Bundesbankers would say "Not yet it hasn't, but it will if we go on like this." As with people who say the world is going to end tomorrow when asked about why their forecast that it would this morning turns out wrong, there is no real way of arguing with this view.

A deflationary world?

But there is a much more sophisticated theory which does have some attraction. Suppose inflation isn't the problem any more. Suppose that the natural inflation rate in the world is not 2%, which is what the central banks assume and make the basis of their action. Suppose that low cost production in China and India means that prices can actually fall without causing recession. The Bank of Japan, which has a lot of experience with falling prices, says that there are two kinds of deflation, (just as there are two kinds of cholesterol): "bad" deflation and "good" deflation. Bad deflation is when there is not enough demand in the economy to keep full employment and we get desperate price cuts in an attempt to offload stuff. Good deflation is when lower costs, for example lower oil prices, mean we can all be better off through prices falling while wages stay the same.

Suppose that into this benign world we inject central banks who are trying desperately to keep the inflation rate up to 2% by boosting demand. In this case, the effect is not to make the economy grow faster, but to shovel more and more money into inflating asset prices. A bubble emerges in the bond market or equities or house prices. That's bad enough. But one day the bubble bursts. And when it does the central bank is forced to pour even more money into the system to stop the burst turning into bust.

That is pretty much what happened in Japan in the 1980's. All through that decade consumer inflation in Japan stayed low but the stock market went up and up. And when it finally burst in 1990, the Tokyo market started a slide which took it from just under 39000 in January 1990 to 7600 in 2003. And while certain central bankers like to claim that there are no real consequences to monetary phenomena, along the way that bust destroyed many of Japan's banks, and contributed to that country's decade-long recession.

Who's right? We don't know. But it is going to be interesting finding out.   

David Blake is a financial analyst and commentator.
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