Central bankers’ reward for failure
Economic systems that work well do not have many heroes. The elevated status of the worldâ€™s central bankers â€“ seen in the close attention paid to their annual get-together last weekend in Jackson Hole, Wyoming â€“ is a sign that the financial system works badly.
Most of the modern economy flourishes without much help from professional economists. That would have pleased John Maynard Keynes. The British economist thought his peers should be like dentists â€“ â€śhumble, competent peopleâ€ť who could deal effectively with specialised problems. Such technicians do in fact take care of the production and distribution of goods and services, the allocation of incomes, the protection of the environment and even the development of new products.
These practical, almost anonymous experts have been a huge success. The prosperity of developed economies is fantastic by any historic standard, and many goods and services are available to rich and poor alike. The system deals fairly easily with innovations, changes in taste, natural disasters, military action and pretty much every sort of disruption â€“ except severe financial problems.
Of course, economic problems remain. In rich countries, the biggest by far is a shortage of good jobs. The recent positive German experience of falling unemployment suggests that the main solution is, as Keynes would have hoped, detailed and bureaucratic. The main tricks have been refinements in the terms and conditions of employment contracts and in the details of the tax and unemployment systems. In other countries, different adjustments are needed, perhaps more equal wages. But what is required is detailed work by economist-dentists.
For all that, most professional economists are still not much like dentists. They generally work with grand theories about such abstract concepts as equilibrium interest rates and economic cycles. They rely on idealised concepts like â€śthe firm,â€ť risk premiums and gross domestic product. Their simplifying equations are impressive, but not very useful.
The economists connected with central banking appear to be more like Keynesâ€™ dentists. They usually try to manage the financial system using small and carefully calibrated interventions. That would be grand, if their systems worked. Then the financial world would be stable, and the monetary authorities would be dull and effective. The leaders of central banks would be as obscure as the bosses in, say, the food-processing industry.
The system actually works badly. In the 2008 crisis, the failure of one big bank nearly brought the global financial system down, and was followed by six years of not very effective monetary policies. It is the equivalent of an explosion at a large bakery leading to persistent mass hunger.
Somewhat ironically, fame has been the central bankersâ€™ reward for failure. The leaders of this troubled trade are often treated as potential heroes, the only people who have the tools to strengthen the fragile financial system. Or sometimes they are considered notorious villains, whose treatments will again lead the system into disaster.
The picture of heroes and anti-heroes is wrong. The monetary authorities are neither great dentists nor awful ones. They are basically doing their best to implement a grand but fundamentally flawed theory about finance and the economy. For all their disagreement, almost everyone involved in central banking shares both an exaggerated respect for one monetary tool, interest rates, and an excessive fear of using the governmentâ€™s infinite power to create, destroy and guide money.
There is a better way, suggested by a small group of economists known as â€śchartalists.â€ť The group was inspired by Abba Lerner, an economist who studied under both Keynes and his great rival Friedrich Hayek. Modern Monetary Theory, developed by Larry Randall Wray of the Levy Economics Institute, is the latest articulation. It starts with the recognition that all money is fundamentally and inevitably a tool of government policy. The authorities are not custodians of an independent financial system. Rather, they create that system and have both the responsibility and the power to keep it intact.
With that insight, central bankers, working closely with the governments which give them their mandate, could develop far more powerful and precise tools. The infinite reserves available to central bankers can finally make the financial system as flexible and capable as the rest of the economy.
How would it work? The details may be diabolical but the principle is simple. The authorities should not hesitate to use the full panoply of their monetary and regulatory powers. Think of it like a dentistâ€™s toolkit. So if demand looks inadequate, they should not mess with overnight interest rates, but quickly put newly created money into banks or even directly into bank accounts. If fear threatens to slow economic activity, as it did in 2008, the authorities should immediately call up some of the systemâ€™s infinite financial reserves to calm nerves. If there is a setback in one industry, region or institution, they should put new money wherever it is needed to keep the damage from spreading.
Obviously it would take time to persuade politicians and economists of the virtue of direct and active monetary controls, and then more time to develop and master an activist monetary toolkit. There would undoubtedly be setbacks, as there were in the development of all the parts of the economy which now run much more smoothly than finance. But the current arrangement is like prohibiting dentists from using drills or installing fillings. The financial system and the whole economy deserve something more flexible, safer and ultimately duller.