Friday, August 3, 2012

Central banks can't save the world; but they can cause unlimited damage

It is only fitting that in a week where the Bank of England's Andy Haldane admitted that economists share blame for the financial crisis and the ongoing recession:

  • Pimco's Mohamed El-Arian should point out that central banks, which are led by economists, can't save the world; and
  • Ros Altmann should point out that the pursuit of zero interest rate policies and quantitative easing has set off a 'death spiral' for pension funds and the real economy by diverting funds needed for growth to paying for pension obligations.
Regular readers know that Walter Bagehot, the man who literally wrote the book, Lombard Street, on central banking, observed in the 1870s that the lower limit for interest rates that was consistent with functioning financial markets and by extension the real economy was 2%.

Regular readers also know that Japan has confirmed the accuracy of this observation by pursuing zero interest rate policies and quantitative easing with a result of over 2 'lost' decades when it comes to meaningful economic growth.

However, the current generation of economists, particularly those in academia and that run the central banks in the EU, Japan, UK and US, are true believers in what Mr. Haldane refers to as a "theological doctrine".  

They justify and pursue policies based on their belief that the assumptions underlying their economic models are facts.  In reality, these assumptions are not facts.  Something that Walter Bagehot pointed out in the 1870s.

The result of pursuing policies based on flawed assumptions has been an unmitigated disaster.

Your humble blogger is an optimist and believes that it is still not too late to save the global economy.  However, doing so will require more than economists admitting they are wrong.

Doing so will require that economists, particularly central bankers, stop pursuing policies that are crushing the real economy.  This shouldn't be too difficult to do.  

They can start by following Walter Bagehot's advice and raising interest rates back to 2%.

At the same time, the Bank of England, ECB and the Fed can require banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.  

The central banks have the power to do this by simply making it a requirement for any bank to have access to central bank funding.  This is a reasonable requirement because the market will value all of the assets on and off a bank's balance sheet and the central banks only want to lend against assets where the value is well known.

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