Reality Check (Jan. 24, 2013)
The governor of the bank of England is Mervyn King. He is about to be replaced by the man who is presently the governor of the Bank of Canada, Mark Carney.
This replacement is unprecedented. A man who is not a British citizen is being brought in to run the most important economic institution in the United Kingdom. Even more amazing, Carney still has two years to go in his term of office in Canada. He is a very heavy hitter. He is a member of the Board of Directors of the Bank for International Settlements (BIS). He is a member of the Foundation Board of the World Economic Forum, which is meeting this week in Davos, Switzerland. For 13 years, he was a high level employee of Goldman Sachs. Surprise, surprise!
On December 10, King gave a speech at the Economic Club of New York. In his speech, he revealed a great deal about the operations of the bank of England. He also said what we should expect in 2013. Because he is about to leave the position, he was far more forthright than could be expected from the head of any major central bank.
In his introductory remarks, King mentioned that 30 years ago, he and Ben Bernanke occupied offices next door to each other at the Massachusetts Institute of Technology. He said that as young men, they believed that economics had solved the problems of the Great Depression. He added this: "Well, we were wrong."
He then went on to say that central banks this time avoided the worst of the problems of the 1930s, "because of the stimulatory policies injected into the world economy by central banks and governments around the world, although it is fair to say that a recovery of a durable kind is proving elusive." It surely is. He went on to describe the problems facing the present economy.
BEGGAR THY NEIGHBOR
He pointed out the obvious. First, in Great Britain the government adopted massive deficits, meaning it adopted what Keynesians call a stimulus. Second, the central bank expanded the money supply in order to fund this fiscal deficit. He pointed out something most of us did not notice, namely, that this created a 25% decline in the average exchange rate of the pound sterling against all other currencies. This was a very large decline, he said, the largest since the Second World War. He specifically called this "a gain in competitiveness." Better put, it was a return to the policies of the Great Depression known as "beggar thy neighbor." He knows it, and he went on to discuss it later in his speech.
It did not work. There has been no gradual recovery of the economy. Output has been flat. He called it a zigzag pattern. But the policy of debasement did increase British exports. He said: as far as the depreciation went, it was "very effective in stimulating exports of goods to the rest of the world, exports to the Euro area have now fallen back." The reason why exports have fallen back has been the crisis of the eurozone. He discussed that. But there is no question that he knows exactly what the benefits were for the domestic economy of Great Britain: a subsidy to the export sector.
This is mercantilism, and he made it clear in the early part of his speech that this was beneficial to Great Britain. But it was not beneficial to Great Britain. It meant that most British citizens had to pay more for the goods and services they purchased, because they were facing competition from foreign purchasers of these goods and services. Goods and services were shipped abroad, leaving citizens in Great Britain with a smaller pie to compete for. Adam Smith warned against this in 1776, but the very smart fellows who used to teach economics at the Massachusetts Institute of Technology have yet to understand the argument.
Here is the bottom line. The central bank monetary policy of currency depreciation, which is adopted in order to beggar their neighbors, in fact beggars the general population that is not employed by the export sector of the national economy.
The problem Great Britain faces is that the British banks are heavily exposed to the eurozone. The banks have not lent to the governments. They have lent to private firms in the periphery of the eurozone. Anyway, this is his analysis.
What can the Bank of England do? He said it has done exactly what the Federal Reserve is doing. First, it engaged in what he calls "a significant program of asset purchases." In other words, it adopted monetary inflation.
Second, it has adopted a program called funding for lending. The bank of England guarantees commercial banks in Great Britain that it will cover for any loans suffered by the banks if they will lend to the real economy. This guarantee will last for four years. In other words, this is a direct subsidy to the commercial banks. This is a big bank bailout.
Third, it has informed banks that they must increase their capital investment. Their current capital is overstated. This problem is still hanging over the head of the Bank of England. He says this: "These problems are all manageable. There is nothing inseparable about the need for our banks to raise somewhat more capital. But manageable though they are, they have to be done." Translation: it has not been done. It ought to be done, but it has not been done.
He referred to what he calls the paradox of policy. He was referring to central banks in general.
But the problem that we all face is what I have called the paradox of policy. Namely that what seems to be the right thing to do in the short run to maintain support for aggregate demand is absolutely the opposite of what we know we need to do in the long term."
Amen to that. This is the great challenge, which means that this is the problem they are going to kick down the road as long as they can.
And the big challenge facing monetary policy is to work out at what point it is sensible to switch policy from focusing on the short-term to supporting the long-run adjustment that is needed because we in the U.K., and I believe the world economy more generally, needs to move to a new equilibrium position.
Put differently, the entire world is run by central banks that are focusing on short-term problems, and the solutions that they are offering to deal with short-term problems are the opposite of what needs to be done. What needs to be done is a stabilization of money, and that is what is not being done. They have to switch to the other policy, he said, but they refuse to do it.
Of course, the phrase about a new equilibrium position is poppycock. There is no such thing as equilibrium, other than in textbooks that abstract from reality. Inherent in all reality is change, and equilibrium applies only in a world in which everyone knows the future, in which there are no profits and no losses. Equilibrium is a convenient absurdity that virtually all economists use in order to explain economic change, yet the assumption behind the concept is that equilibrium always lies outside of history. It is therefore totally unrealistic. The fact that King would use this language indicates that he has not escaped from his experience at the Massachusetts Institute of Technology.
He made this comment. "On the eve of the financial crisis, the total assets of banks in the United States barely touched 100 percent of annual GDP. In the UK the assets of our banks were over 500 percent of GDP, almost at the levels of Switzerland and Ireland. . . ." What's that? Swiss banks had a total of five times the total GDP of the entire country? And we are supposed to trust the wisdom of Swiss bankers? Not I.
He continued:
Both your economy and mine need to re-balance. But the need to re-balance is not confined to those countries which previously had large trade deficits. Indeed by the laws of arithmetic if we have to re-balance, there must be some other countries out there that have to re-balance. In this contrast between the surplus and deficit countries is a problem overshadowing us all. It is not a new problem. It was a problem discussed at length at Bretton Woods in 1944. No solution was found to it then. And we have not found a solution to it since.
KEYNESIAN NONSENSE
This is all nonsense. It is Keynesian nonsense. There is no more need to re-balance the economies with respect to foreign trade and capital flows than it is to re-balance the trade and capital flows between citizens of Nevada and citizens of Utah, or between citizens of Vermont and citizens of Massachusetts. The only reason why Keynesians and government officials talk about the balance of trade and the balance of payments -- the surpluses as well as the liabilities -- is because they are trying to plan an entire economy. They do not need to plan the entire economy. They need to let the economy loose, and let individual decision-makers decide what they want to do with their money.
If owners of goods and labor services want to buy something from across an invisible line -- a state border -- so what? If they want to buy something from across the invisible line known as a national border, so what? It is only a problem for central bankers, because central bankers try to control currency exchange rates. They try to beggar their neighbors.
Central planners find it difficult to plan for the decisions made by individual owners of goods and labor services, who decide to exchange goods and services with each other. It is not a problem for the free market; it is a problem for Keynesian economic planners.
This leads me to King's statement that was widely quoted by the financial media. It has to do with Keynesian central planning. It is not a problem for the free market. It is only a problem for central planners. Here is what he said:
Again these challenges are manageable but manageable challenges are only managed if action is taken, and there is a need to do this today. Otherwise my concern is that in 2013 what we will see is the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy with interest rates at very low levels, with balance sheets having expended a great deal, and with the inability of monetary policy indefinitely to postpone the adjustment that is required to bring about the rebalancing, some other mechanism will be needed and you can see month by month the addition of the number of countries who feel that active exchange-rate management, always of course to push their exchange rate down, is growing.
What does this mean? It means currency wars. It means beggar thy neighbor monetary policies. It means mass inflation in order to force down the international value of a nation's currency. It means a race to the bottom. It means, in short, the adoption of exactly the policies that the bank of England adopted in 2008, and which King praised as benefiting Great Britain. Well, two can play that game, and so can a dozen.
This is mercantilism in action. This is mercantilism, but without the limitations that were imposed on the older mercantilism by the international gold coin standard and the domestic gold coin standard. Take away the restraining factor of people who can go to their local banks and demand payment in gold in exchange for a fixed quantity of their now-depreciating currency, and you get the modern world. You get an imbalance of trade and an imbalance of payments.
TOO BIG TO FAIL
Then he went on to discuss that favorite topic, banks that are too big to fail. On pages 18 and 19 of the transcript, he related one of the most remarkable stories I have ever heard from a central banker. This got zero coverage in the financial media. I am going to quote it verbatim, because this is truly dynamite. This came up in the question-and-answer session.
Well, let me start with an anecdote about the height of the crisis when there was a G7 meeting in Tokyo, and we all flew over for a meeting that lasted about three hours. And we had to stay overnight so the central bank governors had dinner. And I said, well, wouldn't it be a good idea if we had a discussion over dinner, make some use of the time in Tokyo. And they said, good idea Mervyn, what question do you suggest? And I said, well, why don't we talk about what would happen if one morning we went into the office and say Goldman Sachs rang us up and said, terribly sorry chaps, things have gone badly wrong, we're bust. What would we do around the world in dealing with that? And everyone said you must be joking. This is far too difficult a question, let's just enjoy a good dinner. (Laughter).
The guy is a real laugh riot.
He is not exaggerating. The central bankers of the world literally cannot conceive of what they would do if Goldman Sachs ever did go belly-up. This would threaten the entire world economy. This is why governments and central banks are not about to allow Goldman Sachs to go belly-up, which is why Goldman Sachs indulges in high-risk, high-return speculation: managers know that the firm will be bailed out. This is called moral hazard, and it is basic to the modern economy.
CONCLUSION
Keynesian economic theory focused not on monetary policy, but rather on fiscal policy. It called for massive government deficits to overcome recessions. We now have these deficits all over the West, and we have them in Japan and China, too.
Monetary policy was always an afterthought in the original Keynesian system. Modern Keynesians have come to the conclusion that the central bank must increase the money supply in order to fund the national deficits at low rates of interest. But today's monetary expansion is at a level so incomprehensible prior to 2008. It is unfair to blame John Maynard Keynes. Neither he nor anybody else imagined the kinds of deficits that are acceptable today in a peacetime economy. In a wartime economy, economists keep their mouths shut, and central banks inflate. Governments impose price and wage controls. There are massive shortages of goods and services. But all this is done in the name of the war economy. All this is done in the name of victory over the enemy. Nothing like this has ever been seen in peacetime, ever since the end of World War II, in any industrial nation.
The big banks are too big to fail. The central banks will always bail them out. The governments will demand that the central banks bail them out. But to fund the central bank bailout, central banks will have to create fiat money. That is the big threat. There will be no return to the so-called equilibrium of before. King knows this. Bernanke knows this. In the absence of any explicit policy statement showing how the central bankers will get the nations back to the older equilibrium by shrinking the monetary base by two-thirds, we should conclude that nobody at the top believes it is possible. All talk about an older equilibrium is moonshine.
Bon voyage, Mervyn King. I wish I could say the same to Ben Bernanke.
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