Since the financial crisis broke in 2008, the Financial Times’ resident economic expert and leading commentator, Martin Wolf, has decidedly veered to the left. Having rediscovered the Keynesian faith and having apparently terminated his long public love affair with “free market economics” loosely defined, he has become a reliable cheerleader for fiscal and monetary ‘stimulus’ of all kind. His disdain for those still attached to free market principles and fearful of the consequences of endless debt accumulation, interest rate repression, and “quantitative easing”, is increasingly palpable in his writings. When recently commenting on the UK chancellor’s budget announcements, Wolf could hardly conceal his irritation at any policy that purports to limit the size of the state in the long run, even one as feeble as the British government’s. But two weeks ago Mr. Wolf abandoned restraint and tact, and in his FT column brashly declared those who fear the inflationary consequences of limitless money printing as being simply delusional and ignorant.
The hook of the piece was – again – the Bank of England’s recent publication on money creation in the modern economy, yes, the same piece that caused “Occupy Wall Street” activist and London School of Economics -professor David Graeber to exclaim excitedly: “The truth is out! The banks are rolling in money!” There is less hyperbole in Mr. Wolf’s piece but like Graeber he too believes that those who disagree with him on economics must somehow fail to understand the basics of the banking system. “It’s the stupidity, economists!”
Wolf and Graeber both believe that understanding how the central bank operates is key to ridding oneself of harmful monetary superstitions, such as a belief in sound money and fiscal discipline. At the core of these irrational beliefs seems to be the “myth of the money multiplier,” although both experts draw very different conclusions. Big government “anarchist” Graeber thinks that an unfounded belief in the money multiplier must lead to irrational acceptance of “austerity” and failure to appreciate that as long as the government is willing to borrow there is always enough money to spend. Born-again Keynesian and Bilderberger Wolf, on the other hand, thinks that an unfounded belief in the money multiplier theory must cause equally unfounded anxiety over inflation and failure to appreciate that such inflation only occurs if the central bank creates too much money, and surely, the central bank would not do such a thing.
The subtitle of Martin Wolf’s piece shows where his sympathies lie: “Failure to understand the monetary system has made it more difficult for central banks to act”. Those who worry or question the wisdom of never-ending “easy money” just don’t get it, and their ignorance is not only harmful to themselves, those pitiful fools, it is even a hindrance to the valiant efforts of our policymakers, who could evidently intervene even more forcefully were it not for the prejudices of the unenlightened.
Reasons to be fearful – Part 1
However, I can reassure you, dear reader, that all your fears of inflation and currency chaos are entirely justified. There is nothing irrational or delusional about them. Furthermore, there is precious little in the Bank of England’s paper and Martin Wolf’s summary of it that I would consider capable of laying such anxieties to rest. To the contrary, just the self-righteous tone of the Bank of England paper, the self-satisfied acceptance of its vast interventionist powers, and the lack of any awareness of the distorting consequences of its policies, is enough to terrify the discerning reader. The same goes for Wolf’s comment. Here is the leading economic commentator in one the most influential and respected financial newspapers openly cheering large-scale money printing, praising the policy of “raising the prices of financial assets” through QE, and contemplating larger powers to the state to circumvent “profit-seeking” banks entirely when creating money. Obviously, “profit-seeking” is becoming a term of disapproval in the commentary pages of the FT. Are you feeling reassured yet?
The multiplier “myth” – again
There is, so much shall be said in fairness to Mr Wolf, one specific cause for inflationary concern that the Bank of England does indeed address, but it is just one potential source of inflation and not the most troubling one. It has never been my chief concern but the Bank of England and Martin Wolf make a big deal of it. This is the belief that high inflation is already inevitable because the central bank has created vast amounts of new bank reserves as part of QE, and these reserves must feed a massive expansion of bank credit and thus inflate broader money aggregates in the future. The answer to this is that they might but that they do not have to. So if this happens to be your number one concern about central bank policy today, you may indeed feel somewhat reassured by the Bank of England paper.
Wolf – and others, such as Steve Keen and David Graeber – call this the multiplier “myth”, the faulty idea that banks “multiply up” the reserves given them by the central bank. If this was your view of things, don’t beat yourself up about it. It is not really a “myth” in the first place, it is just not the full picture, and by the way, the U.S. Federal Reserve apparently believes it, too.
Here is a news-release from the Federal Reserve Bank of St. Louis from March, 2009:
“The U.S. monetary base (the sum of currency in circulation and bank deposits at the Federal Reserve banks) more than doubled in size in the last several months because of the Fed’s unconventional responses to the financial crisis, including the purchase of private debt and billions of dollars in short-term loans. Normally, this scenario would lead to a sharp rise in inflation, but a combination of factors including the recession, the Fed’s payment of interest on excess reserves and distress in financial markets has kept inflation at bay. Nevertheless, policymakers will have to keep a close eye on the size and composition of the monetary base once the recession ends to ensure that inflation doesn’t return with a vengeance, said William T. Gavin, a vice president and economist with the Federal Reserve Bank of St. Louis.”
Is Mr. Gavin one of the “ignorant” and “delusional” people who fell for the multiplier “myth”? I don’t think so. I think he gives a rather good explanation for why the reserves thus far created have not or not yet led to much higher inflation. Banks are not short of reserves but short of capital, short of balance sheet, and short of good, credit-worthy borrowers willing to borrow. As a result of the massive credit boom that preceded (and caused) the crisis and as a result of the crisis itself, banks are careful to lend and the private sector is reluctant to borrow.
But what if the environment improves and becomes more conducive to lending and borrowing again? – Then, the interest the central bank pays on reserves comes into play. By simply paying a higher rate of interest on reserve balances kept at the central bank, monetary policy can increase the cost for each bank of potential outflows of reserves, and thus discourage additional lending on the margin. This is a point the Bank of England also makes in its paper. Thus, in order to tighten policy, the central bank does not have to reduce the outstanding quantity of reserves, mop up previously created reserves or unwind its QE operations (and thus off-load massive amounts of government bonds with dire consequences for asset markets). It can simply increase the interest paid on reserves and thus the cost of losing reserve balances or lending reserve balances to other banks. The central bank retains (pretty much) full control over the cost of reserves and thus over interbank lending rates and, ultimately, the profitability of lending. Past QE and vastly inflated reserve balances do therefore not meaningfully restrict the central bank’s maneuver room for future tightening. So if that was your concern, namely that the central bank could not tighten if it wanted to, then you should indeed take some comfort from the Bank of England paper.
However, I don’t think it should be the primary reason for inflation concerns that the central bank was somehow technically restricted or incapable of tightening but that it was politically ever more difficult to tighten. Via QE, the central bank expands the money supply and thus influences specific asset prices and yields on assets. There can be no doubt that this is a much more direct way of intervening in the market’s pricing process. Here is how Mr. Wolf puts it:
“Finally, quantitative easing – the purchase of assets by the central bank – will expand the broad money supply. It does so by replacing, say, government bonds held by the public with bank deposits and in the process expands the reserves of the banks at the central bank. […]The main impact of QE is on the relative prices of assets. In particular, the policy raises the prices of financial assets and lowers their yield.”
…and thus the cost to borrowers. Central banks have now made it their business to lower – directly and straightforwardly – the borrowing costs of governments, house buyers, and corporations. And once they got the hang of fixing market prices, it has been very difficult to stop. Why not fix more prices? Why not lower borrowing costs further? And why ever stop this? Just wait for the next dip in the economy or some glitch in financial markets. We know what will happen, and Mr. Wolf will cheer it on from his pulpit at the FT: More QE. Borrowing costs matter, why leave them to the market?
Remember Mr. Gavin’s statement from 2009? “…policymakers will have to keep a close eye on the size and composition of the monetary base once the recession ends to ensure that inflation doesn’t return with a vengeance.” – Well, the recession pretty much ended when he wrote that 5 years ago. The monetary base was then an already sharply inflated $1.6trn (Recently doubled due to unconventional policy, as Mr. Gavin put, although the policy is now quite conventional.) What happened next? The monetary base more than doubled again. It presently stands at $3.9trn. And the inflation that returned with a vengeance was asset price inflation.
Multiplier or no multiplier – that is not the problem
The problem is this, once you have become attached to fixing prices and cheapening borrowing costs it is difficult to stop, in particular as the distortions you inevitably create in financial markets and the wider economy will require yet faster money printing in the future to avoid the dissolution of these distortions at the hand of market forces. Or to put this differently, the 30-odd hyperinflations recorded over the past century did not originate with banks running amok with the “money multiplier” and relentlessly “multiplying up” bank reserves, but with the state central bank funding ever larger sections of society – and in particular the state – directly and finding it politically difficult (impossible) to turn off the spigot.
Martin Wolf’s view on inflation risks is a curiously mechanical one that ignores the confidence of the public. Once inflation moves higher, inflation expectations will also change. When the public loses confidence, things unravel. Inflation is therefore not just a simple linear response to a certain amount of money created. When the velocity of money rises, even an unchanged quantity of money can lead to higher inflation.
Hyperinflation, Martin Wolf writes, “might occur if the central bank created too much money. But in recent years the growth of money held by the public has been too slow not too fast. (Who is to say? DS) In the absence of a money multiplier, there is no reason for this to change.” This I hold to be a rather naïve view of things and hardly one that instils a lot of confidence.
Reasons to be fearful – Part II
Martin Wolf’s summary of the Bank of England paper does indeed provide illustration of the system’s many flaws and thus ample food for anxiety.
“In a fiat (or government-made) monetary system, the central bank creates reserves at will. It will then supply the banks with the reserves they need (at a price) to settle payments obligations. […] the central bank will influence the decisions of banks by adjusting the price it charges (the interest rate) on extra reserves. That is how monetary policy works in normal times. Since it is the monopoly supplier of bank reserves and since the banks need deposits at the central bank to settle with one another, the central bank can in this way determine the short-term interest rate in the economy.”
Here just the key words for those who believe that it was somehow capitalism that failed in 2008/2009: monopoly supplier of reserves; creating reserves at will; influencing decisions of the banks; determine short-term interest rates in the economy. Does that sound like a free market to you?
It is evident that the massive credit boom, including the “housing bubble”, the “reckless” balance sheet expansion of the banks and the vast debt accumulation that set the economy up for the recession was at a minimum tolerated but more frequently actively encouraged by the central bank. In our system of limitless elastic fiat money and lender-of-last-resort central banks, the extended artificial credit boom is not a bug; it is a feature, and the fingerprints of the central bankers are all over this mess. As the Bank of England proudly states in its paper: The ultimate constraint on money creation is monetary policy. That is right. It is not savings, it is not the capital of banks or individual banks’ reputation in a competitive banking market, it is ultimately not market forces at all. It is policy. And policy was not a constraint; it was – certainly from 1997 to 2007 – a license.
But what does Martin Wolf take away from this? – That the state needs more control so that it can create more money. Here, Wolf parades his own ignorance of monetary history and theory. “…subcontracting the job of creating money to private profit-seeking businesses is not the only possible monetary system. It may not be even the best one. Indeed, there is a case for letting the state create money directly.”
Mr. Wolf must believe that creating money is a natural prerogative of the state, some kind of natural monopoly whose exercise the state foolishly “subcontracted” to private bankers, who have sadly revealed themselves unfit for the task. This is not only false; it is the wrong way round.
As Wolf stated correctly earlier, “What makes banks special is that their liabilities are money – a universally acceptable IOU.” Banks have always issued forms of money; it is a business they created as free capitalist enterprises before state fiat money and central banks even showed up on stage and began to socialize the consequences of banking and politicize the sphere of money. In an entirely free market with hard, apolitical money at its core and no state central bank, the ability of banks to issue money is severely restricted and ultimately checked by its own customers, in particular depositors. (This does not mean that fractional-reserve banking is without inherent problems, even in a free market; only that free banking is limited banking and thus safer banking.)
“Profit-seeking” is not a mark of inferiority but of distinction. With “profit seeking” comes “loss avoiding”, and it is the reason we should embrace profit seeking/loss avoiding (that is, private enterprise) in everything in which we care about a rational, careful use of resources. In a free market the power to create money comes with the risk of lending to the wrong person. In the modern fiat money system, the state has politicized money and turned banking into a tool for economic policy. Profit and loss as regulators, as the market’s chief disciplinarians, have been weakened. All of our present problems are the direct consequence of this, but Wolf evidently wants to go further in that direction. If you think the banks lent stupidly in the boom, wait until the state bureaucracy does it directly, wait until money creation gets properly nationalized and the state-money advocates at Positive Money get their way and implement the “Money Creation Committee”.
We will have to see how Martin Wolf argues in favor of the full nationalization of money and credit but I doubt that it will make any of us less scared.
This will end badly.