Destabilizing Monetary Policy

Minsky’s endogeneity hypothesis, while integrating Keynes view on instability of expectations and Schumpeter’s view on destructive innovations, has yet to be supported empirically when confronted with actual role of central banks in major financial crisis. Notably, the present crisis was almost solely the work of central banks; it was caused by lowest interest rates in post war period set by the Fed following the bursting of the Internet bubble in late 2000. As a consequence, total credit expanded at an exceptionally high rate of 12 percent per year in the US during 2001-2008. This phenomenal credit growth was at the cost of creditworthiness and erosion of underwriting standards [[1] As liquidity became of little value, loans were extended to subprime markets. Examples of sub -rime loans were NINJA loans (no income, no job, no asset borrowers) that were extended to NINJA borrowers and were rated AAA by reputed rating agencies]. Soros (2008) wrote “when money is free, the rational lender will keep on lending until there is no one else to lend to”. Monetarists have sharply criticized interest rate setting and unbacked money creation by central banks and considered them as the main factors responsible for financial instability and inflationary episodes [Maurice Allais (1999) wrote: in essence, the present creation of money, out of nothing by the banking system, is similar – I do not hesitate to say it in order to make people clearly realize what is at stake here – to the creation of money by counterfeiters, so rightly condemned by law].

1. Interest rate setting as a cause of financial instability

Interest rate setting by the Fed at low levels during 1926-1929 to help Britain restore gold standard at pre-1914 parity was found to have led to speculative booms in housing and stock markets and to high economic growth. Reluctance of the Fed to raise interest rates with a view to protect farmers, builders, and the rest of the economy, contributed to uncontrolled credit growth during 1927-1929, which ended with the Great Depression. Interest rate setting by central bank has been sharply criticized throughout contemporary economic history by famous economists such as Thornton (1802), Wicksell (1898), and Friedman (1968, 1972), who opposed discretionary policy which creates both excessive credit and market risks for financial institutions. Interest rate setting is a form of price control that causes considerable distortions and inefficiencies; beside creating monetary uncertainties, it leads to an excessive credit expansion, speculation, and therefore to assets and commodities price instability [The current commodities boom could be easily explained by distortionary effect of interest rate setting. Interest rate on government bonds was 3 percent per year in July 2008. Return on oil futures contracts exceeded 120 percent per year in July 2008. Fixing prices in one market leads to lucrative speculation in parallel markets. Moreover, very low interest rates during 2002-2005 were found to be main driving factor for securitization. To bolster their incomes in the context of reduced margins and gain from abundant liquidity, banks were led to expand their assets through funds from securitization and supplement their incomes through fees and commissions from larger number of loans].

By targeting interest rate, a central bank abandons monetary aggregates and reduce substantially its direct contacts with individual banks. For instance, in the United States the role of District Banks has been curtailed and liquidity operations have been concentrated in the New York Fed [Under the regime of controlling monetary aggregates, District Banks used to have direct control of member banks’ portfolio and could detect problem banks at an early stage at the discount window level. Since mid-sixties, such direct contacts have become very limited]. The central bank wants only to control interest rates and stands ready to supply any amount of money required to maintain interest rate pegged at a fixed target rate, regardless of creditworthiness, and to support the price of government bonds and finance fiscal deficits, via essentially open market operations. Furthermore, as the general price level increases or asset prices rise, the central bank stands to accommodate higher money demand for transactions or for fueling credit expansion, which in turn increases liquidity [[1] As the German hyperinflation (1920-1923) showed, the central bank can indefinitely accommodate rising price levels and higher demand for transaction money in a hyperinflationary process. Actual policy actions of central banks undermine the stated objective of banking soundness and stability].

Thornton (1802), in his classic “The Paper Credit of Great Britain”, provided the first rigorous and systematic analysis of a two-way relation between interest rates and inflation. He distinguished between the market (loan) rate of interest rate and the interest rate (marginal rate of profit or natural rate) which equilibrates savings and investment. He expressed the doctrine that inflation results from a divergence between the two rates. Under fiat money, when the central bank pegs loan rate of interest below the marginal rate of profit, it sets in motion a cumulative expansion in the demand for and supply of loans, currency issue, and the price level. Inflation could continue without limit because, contrary to gold standard which precluded credit expansion that would drain gold reserves, there existed no automatically corrective mechanism under costless fiat money system to bring it to an end. Inflation, in turn, signals that real savings are rapidly falling, and therefore economic growth is slowing.

Thornton analyzed the reverse causation from inflation to loan interest rate and discussed the effect of inflationary expectations on loan interest rates. Even if the central bank increases the loan rate of interest in response to inflation, the real interest, if not negative, may remain indefinitely below the real marginal rate of profit inducing further demand for bank credit. Accordingly, Thornton argued that central bank should abandon interest rate pegging and regain control of money supply through ceilings on credit and monetary aggregates [In the same vein, Friedman (1968) strongly argued that central bank cannot control interest rate or unemployment rate. Its actions to do so can only destabilize the financial system. It can only control money supply and credit]. Control of credit has also been strongly recommended by Soros (2008).

In order to contain runaway inflation caused by low interest rates, the central bank might be compelled to apply practical quantity theory of money and force ceilings on money and credit, thus abandoning interest rates control. Under these conditions, interest rates will explode. Given the huge amount of outstanding debt and their low credit worthiness, such a rise in interest rates will set off a financial crisis and mass defaults. Given the large amount of public debt, sharp rise of interest rates will cause fiscal deficits to widen [The US Treasury may compel the Fed to maintain low interest rate. The 1951 Accord between the Fed and Treasury was meant to alleviate Treasury’s pressure regarding the setting of interest rates at low levels].

2. Unbacked lending and the central bank’s key role in financial instability

Financial instability erupts when there are not sufficient real savings to support lending. This occurs when a lender creates fictitious claims on final consumer goods and lends these claims out. The borrower who holds the empty money, so to speak, exchanges it for final consumer goods. He takes from the pool of real savings without any additional real savings having taken place, all other things being equal. The genuine wealth producers who have contributed to the pool of final consumer goods — the pool of real saving — discover that the money in their possession will get them fewer final goods [Rueff (1964) showed that excessive credit expansion creates a purchasing power that has no real goods counterpart; it can undermine real economic growth and even trigger starvation].

The reason is that the borrower has consumed some of the final goods. There is a diversion of real wealth (final consumer goods) from wealth-generating activities towards the holders of new money, created “out of thin air.”

As the pace of unbacked credit expands, relative to the supply of real savings, less becomes available to genuine wealth generators, all other things being equal. Consequently, with less real savings, less real wealth can now be generated. Real savings are required to support the life and well-being of individuals who are engaged in the various stages of production. In the extreme case, if everybody were to just consume without making any contribution to the pool of real saving, then eventually no one would be able to consume.

By means of monetary policy, the central bank makes it possible for banks to engage in the expansion of unbacked credit. Thus if Bank A is short of $100, it can sell some of its assets to the central bank for cash. It can also secure the $100 by borrowing it from the central bank. Where does the central bank get the money? Under fiat money system, it just makes it “out of thin air.” Obviously, Bank A could also attempt to borrow the money from other banks. However, this will push interest rates higher and will slow down the demand from borrowers, which will diminish the creation of credit “out of thin air”.

The conventional banking system can be seen as one huge monopoly bank, which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. Through ongoing monetary pumping, the central bank makes sure that all banks engage jointly in the expansion of credit “out of thin air.” The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

It appears therefore that the role of the central bank makes the present conventional financial system unstable and vulnerable to financial turmoil. It is not the expansion of credit as such that leads to an economic bust but the expansion of credit “out of thin air,” since it is through unbacked credit that real savings are diverted from productive activities to non-productive activities, which in turn weakens the process of real wealth expansion. The deliberate role of central banks in financial instability makes Minsky’s endogeneity hypothesis debatable.

As central banks in many industrial countries have been entrusted with the mandate of achieving full employment, financial stability has not been given the attention it deserves [Full employment is an important objective. However, it should not fall under the central bank prerogative. It should be under the government development planning. Progress toward full employment can be achieved through education, sectoral development (agriculture, industry, infrastructure, etc.), and fully competitive labor markets. In many countries, unions and labor laws can be an obstacle for full employment, since price and wage rigidities can become inimical to full employment in any economy and a source of exchange rate overvaluation]. Their pursuit of this mandate has been self-defeating. By insisting on long-term demand-led and inflationary growth, low interest rate policy has fueled asset bubbles in stock, real estate, and commodities markets, and has slowed growth and increased unemployment [Central banks do not seem to accept the notion that long-term growth depends on increasing savings and investment. Demand policies can only reduce savings and capital accumulation and will undermine long-term economic growth. Moreover, the bursting of asset bubbles can become a drag on long-term economic growth as in Japan in 1990-2001 or during the Great Depression 1929-33]. With the central banks forcing credit expansion in order to stimulate growth and employment, at the expense of creditworthiness, or to finance fiscal deficits through abundant liquidity, financial institutions will not be immune to financial instability, even if they comply fully with Basle I and II guidelines. Absent highly stable and predictable monetary framework, financial institutions will face recurrent financial instability with increased frequency [Henry Simons (1948) sharply criticized monetary uncertainty, which stems from unpredictable changes in credit and money and near-money aggregates, unpredictable changes in interest rates, and proliferation of money and credit instruments (i.e., financial innovations)]. Recent as well as past financial crises demonstrate the need for safe and predictable central banking. Promoting such safe central banking in the Basle framework, geared toward financial stability and not full employment objective, should be a top priority in the quest for financial stability.

Causes of International Financial Instability.

Because financial instability in one major reserve currency center could spread to the rest of the world, causes of financial instability were also analyzed at the international level by Keynes (1943), Triffin (1959), Mundell (2005), Rueff (1964), and many others. There is general consensus that contagious financial instability is caused by unsustainable fiscal and money policies and by beggar-thy-neighbor trade policies at the level of reserve currency centers. Inflating reserve currency countries are unwilling to tighten monetary policy and undergo a temporary contraction needed for stability. The resulting large fluctuations in exchange rates expose banks to foreign exchange risks. One solution advocated by all authors mentioned is the creation of a common central bank and a common currency which is to be issued under strict quantitative guidelines, not exceeding a growth of 2-5 percent per year. A proposed common central bank would be independent of any government, and therefore of any fiscal or full employment pressure. Hence, it would be able to provide a stable currency.

In an insightful analysis Rueff (1964) strongly argued that collapse of gold standard has created more instability and brought the world economy to the age of inflation. He pointed out that the balance of payments deficits of reserve currencies provide a basis for creation of new credit and therefore to more speculation. He showed that a reserve center can run an indefinite balance of payments deficit without losing real resources as these deficits are financed through issuing currency. Indeed, external deficits of the US have caused substantial capital inflows in the US banks that contributed, to a large extent, to recent housing bubble. Central banks and foreign financial institutions ex-patriate or place their dollar holdings in interest earning assets in US banks. These deposits provide a basis for US banks to increase credit. According to Rueff, there was large monetary expansion in relation to world stock of gold in the post-war period. He proposed a devaluation of currencies to reflect new price of gold, restoration of gold standard, and actual transfer of gold from deficit to a surplus country. Rueff’s analysis remains pertinent. Reserve currencies (such as dollar, euro, or yen) governments pursue national priorities at the expense of the rest of the world. They maintain monetary expansion in order to preserve full employment at home and prevent currency revaluation in order to maintain export competitiveness. This monetary expansion has created a hotbed of generation of financial instability. It has been inflationary and costly in terms of world economic growth, trade, and social stability.

Recourse to gold as reserve money has recently been gaining larger support in view of the fast depreciation of reserve currencies and mounting inflationary pressure in all reserve currencies centers. Monetary expansion has translated into rapid increase in foreign reserves of central banks, which rose by more than six fold during 2000-2007. In view of large currencies depreciation in relation to commodities and real purchasing power, these reserves will lose their real value rapidly. Use of gold as a reserve money will allow hedging foreign reserves against inflation.