The Changing Role of Central Banks

D. Chorafas

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137332288
• Topic: Economics
• Subtopic: Economic Policy
• Index: Economics

The Changing Role of Central Banks derives lessons from current economic and financial challenges as well as failures in confronting them. Through this approach, it brings under perspective political and social reactions to major economic problems of the last ten years, particularly those pertaining to money and initiatives taken by central banks.

1

Queen Elizabeth II and the Economists

1. Economic Theories Never Die. Maybe They Should.

On November 5, 2008, not quite two months after the Lehman Brothers bankruptcy and the Western economy’s descent to the abyss, Queen Elizabeth II inaugurated a new building at the London School of Economics. Referring to the financial crisis, she asked the professors: “Why did nobody notice it?” The faculty was caught off guard. Among prominent apologies, the Queen received a letter signed by renowned British economists stating:

In summary, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.¹

If it were a failure of collective imagination, then its origin can be easily found in the tunnel vision of economists following different schools, whose masters are long dead, and the problems they faced, which were quite different from current realities. Though old recipes don’t necessarily apply, still the large majority of today’s economics experts think in “old school” terms because they have been trained in different theories whose time is past. Therefore, it comes as no surprise that when they adopt their modus vivendi, they choose from:

• Monetarist theories,

• The Austrian School,

• Keynesian theories, and

• Marxist manifestos.²

These are passing theories, not universal laws. According to Mao Zedong: “A universal law has a predictive value which asserts the certain existence of the phenomenon described by that law in instances as yet unobserved. The universal law thus draws attention to, and guides analysis of the phenomenon . . . (while) the particular law would be revealed by an empirical investigation informed by the knowledge of the relevant universal law.³

The man who rebuilt the devastated Chinese economy from scratch proved to be a successful practical economist,⁴ deriving his know-how from what he described as theory-practice-theory. Practice validated an existing theory, or led to a new one after having demolished the old. This is exemplified by Mao’s famous quotation that “there is no construction without destruction,” words evoking the ancient Chinese philosophy of yin and yang, of flowing and damming.

Not only the economy but science also is built on these premises. However, unlike theories in physics, where even the most beautiful ones are disregarded because of a new “nasty fact,” theories in economics linger on even if they have been disproved by extreme failure, like communism in Russia. It is as if, like old soldiers, economic theories never die, because economists have not been taught:

• How to integrate the lessons of political history with those of economics,

• How to think “out of the box,” and

• How to apply practical, not theoretical, solutions to emerging problems.

The truth behind these three bullets has been indirectly confirmed by the letter the British economists wrote to Queen Elizabeth II, including the “mea culpa.” Not only failure of collective imagination but also inertia is to blame. In early May 2012, Mervyn King, governor of the Bank of England, admitted he should have “shouted from the rooftops” about the risks that were building up in the financial system before the crash of 2008,⁵ but he did not.

The financial risks of 2007 and 2008 had practically no precedents and therefore they could be addressed by none of the existing economic theories. Instead, they provide the new evidence, the “nasty fact” that demolishes theories. To better understand this argument, the reader should appreciate that both in economics and in physics, existing theories have this in common: Contrary to what many people think, their proof is not in their reasoning; it is in the results they produce when applied.⁶ Down to basics, theories are concepts in the form of tentative statements and, as such, they fail to provide the linkage:

• Between what is theoretical and what is practical, and

• Between creation of wealth and exercise of power.

These and other shortcomings arise from the fact that today economics is taught without its historical background and without a close connection to politics.⁷ The result is economic theories in a vacuum, with deliverables that are neither realistic nor a good guide to reasoning when confronted by novel, unprecedented, and acute conditions.

Economic history is fundamental to understanding what is going on now, and politics brings realism into economics since the two work in unison; keeping them apart makes no sense. Beyond this lies the fact that if history and politics are kept out of the picture, then what is left of the science of economics can only show what has happened on the surface—even if the most important events are to be found at the root of the problem. Study the past, Confucius said, if you care about the future.

In every catastrophe there exists an original sin for which, usually, there is more than one reason but very often (albeit not always) the key factor is political. For instance, failure on the part of politicians to answer the call of duty when the economic scales tip over, accompanied by a search for easy solutions, loose monetary policy, and regulatory laxity.

Disinterest by common citizen in protecting their longer-term interests, leading them to wrong-way thinking; for instance, that entitlements (like diamonds) are forever. These are issues that the present-day crisis in Europe and in America has put squarely on the table, and they need both deeper and wider analysis than is available now.

Here is an example of superficial reasoning. In late 2011, the University of Chicago asked 40 renowned economists, including some short-listed for the Nobel Prize, if they agreed that the outcome in price stability and employment would be better for the average American if the dollar was tied to gold. Each one of them disagreed with this hypothesis.

When asked to explain their position, many of the economists stated that the volatility in the supply and the price of gold make it an unreliable anchor.⁸ This one-sided vision totally ignored the fact that the balance sheets of four major Western central banks—Federal Reserve, Bank of England, European Central Bank, and Swiss National Bank—have tripled, and in one case quintupled, within a short span of four years (2008–2012). Is printed money a stable anchor?

Critics say that another reason for worrying about “established” economic theories is that they are constantly interpreted and misinterpreted as a large number of economists today base their judgment on a relatively short subjective experience. As a result, there may well be levels of reasoning, as well as realities and truths, in economic events that are missed.

In many cases, while helpful, our common sense⁹ falls short of revealing the total picture that could guide us to a better understanding of current events and predicting future events. To this are added misconceptions often originating in personal bias as well as in confused directives “from above”:

• “Spend, don’t save,” say the governments of Western countries as their economies hover between sluggish recovery and recession.

• “Save,” say the same governments as they contemplate the need for savings to finance public projects, confront the aging of their populations, and ease the growing strain of paying pensions as well as paying for health care and other entitlements.

Victory belongs to him who successfully confronts the challenge, said Arnold J. Toynbee, the historian. We confront our challenges neither by “failures of collective imagination” nor by making contradictory statements and giving confused directives. If we plant sick trees, then we reap bitter fruits, Mao has said.

2. The Economic and Social Future Is Uncertain

The economists responding to the Queen’s query should have informed the sovereign that one of the worst fallacies in the last three decades has been the widely shared belief that America, Britain, and Euroland’s member states are “rich nations.” For Britain and France, this was true prior to World War I, but it became questionable between the two world wars and is a bogus statement today. As for America, its economic might at the end of World War II has been eroded by successive governments and their handouts.

Riches come and go, particularly when they are badly managed. In 2012 no Western nation could call itself “rich.” Western resources are largely depleted; with few exceptions, the budgets of Western sovereigns are in the red and the current accounts of many are negative. Even if among its citizens “this” or “that” jurisdiction counts billionaires,¹⁰ household wealth has taken a beating—and so did the common citizen’s standard of living.¹¹

The recent case of an industrial country’s rise and fall is revealing. For three decades, 1960s through 1980s, Japan was Asia’s economic miracle, its richest and most powerful economy. It was the first Asian nation to industrialize but the emerging Asian tigers—Hong Kong, Singapore, South Korea, Thailand, Malaysia, and Taiwan—followed in Japan’s tracks and by 1990 Japan’s highly leveraged economy lost its might and fell out of gear as its banking and real estate sectors imploded.

China’s economy, which was tiny during the same period, is now bigger than Japan’s and aims to become the no 1 economy in the world before 2020. In terms of purchasing-power-parity (PPP) in 2012, GDPs per person in Singapore, Hong Kong, Taiwan (in that order), and, more recently, in South Korea, are ahead of Japan’s. Singapore with $70,000 per person, and Hong Kong with $60,000, have left Japan and its $40,000 GDP per capita in the dust.

No existing economic theory reflects this rapid turnaround and its dramatic aftereffects. Therefore, the faculty of the London School of Economics should have informed the Queen that the nineteenth-century economic theories have been shaken to the ground by their shortcomings, their failures, and the fact that the premises on which they rest are no longer believable. Society has changed, and not only in moving away from the work ethic.

• In the pre–World War II years and for nearly three decades after the war, the West had a working society—a société de travail, as the French call it.

• But ...

Table of contents

• Cover
• Title
• Prologue
• 1 Queen Elizabeth II and the Economists
• 2 Money
• 3 Monetary Policy
• 4 Currency Exchange in a Globalized World
• 5 Preserving the Value of Money
• 6 Central Banks Are Reserve Institutions, Not Firefighters
• 7 The Challenge of Bank Regulation
• 8 Loose Ends of Bank Supervision and Regulation
• 9 Counterparty Risk, Data Points, and CDSs
• Epilogue
• Notes
• Index