Time for a Rethink on Monetary Policy

When 2,300 business leaders and government officials met for the Asian Financial Forum in Hong Kong this week, they were asked to vote on what they saw as the greatest threat to the world economy. Opinions were divided between troubles in emerging markets (52 per cent) and the withdrawal of monetary stimulus by the US Federal Reserve (32 per cent).

However, one could argue that both issues have so much to do with each other that they are almost identical. Inasmuch as the US proceeds with ‘tapering’ of quantitative easing, this will put pressure on smaller, developing economies in Asia and Latin America.

It is extraordinary that a potential return of monetary policy to more normal conditions now passes as a veritable threat to economic stability. I say ‘more normal’ conditions because even after the end of quantitative easing, interest rates may well remain close to zero for quite a while, which is anything but normal. So why is there so much panic around the move from monetary life-support to just intensive care?

The problem lies deep in the nature of the monetary system. Once upon a time, money was a means of exchange, a store of value and a unit of account. In fact, this is the standard definition of money still being taught to economics undergraduates. Unfortunately, it does not have much to do with the reality of so-called money in our paper money world.

Since the departure from commodity-backed forms of money, typically linked to precious metals, money could no longer be seen as a reliable store of value. Since nothing was limiting the creation of more money anymore, there are no guarantees that a pound, a dollar or a euro would still be worth roughly the same tomorrow as they are today. The value of these currencies now depends almost solely on the trust and reputation in their issuers and the governments backing them.

For governments there are endless reasons why there is never enough money around. There are always projects which ‘deserve’ more funding and come with good reasons to shift burdens from the present to the future.

With these state-backed money creators around, the foundation is laid for a system that effectively depends on inflation for its survival. Inflation here is meant in its original meaning: blowing up the money supply. Only as a result of this increased money supply would prices then go up as well. The price increases are nevertheless only the result of inflation, not inflation itself.

If money was a true store of value, across-the-board price increases would be ruled out by definition. Of course there could be reasons why individual prices went up occasionally, say a bad harvest. But there would not be a general upwards push on the price level. Quite the opposite would be the case with productivity increases translating into price cuts. Deflation would be the normal state of affairs in a world in which money was a store of value. In fact, this is precisely what happened in, say, 19th century Britain under the gold standard. A massive expansion of economic output was accompanied by a slightly falling price level.

In today’s world of endless money creation, deflation is anathema. Nothing is seen as a bigger threat to the economy than a falling general price level. But sometimes prices have to fall. Investments may have created overcapacities, or indeed whole economies may have become too expensive and thus uncompetitive. When markets then try to correct these excesses, central banks try to avoid these corrections by pumping in more money. These extra injections are supposed to stop the self-cleansing mechanisms of markets from working.

It is in this context that we have to understand both the fear of US tapering and the announcement by Mario Draghi, President of the European Central Bank, to do ‘whatever it takes’ to save the euro. The reasons why tapering sends shivers down the spines of business leaders while Draghi’s pledge to save the euro has calmed nerves in markets have the same underlying cause. The prospect of ‘more money’ is seen as a good sign; the thought of withdrawing the creation of more money is identified as a danger.

If we are thinking about the nature of money, this is absurd. If money is just a unit of account and a means of exchange, there is no quantity of money that is better than any other quantity. Any quantity of money is able to facilitate all the transfers happening in the economy – it is only the value of each unit that would change. Also, as discussed before, an ongoing creation of extra money means that money cannot properly fulfil its role as a store of value any more.

Central banks are desperately trying to keep the illusion alive that what they are administering to their economies is real money. In actual fact, it is possible to argue that what currently passes as money in our zero interest, quantitative easing, paper money world hardly deserves to be called money any longer. To a large degree, it is a money substitute, a money illusion.

The illusion becomes visible when asking the most naïve questions about what central banks are doing. What real effects does it have when a central bank creates new money? Does it create actual wealth, value, products, prosperity? What contribution does Mario Draghi make to the turnaround of ailing Southern European economies? Does he create jobs, improve productivity, foster innovation, reform labour and tax laws? Or are both the Fed and the ECB just keeping illusions alive for a while (while creating further problems down the track)?

A global economy that fears little more than the withdrawal of artificial monetary stimulus is not normal. It is sick. And it is sick because it is built on a sick system in which money can be created at will, at the click of a button and nowadays even without the use of ink and paper.

For the past forty-odd years, since the US’ final departure from the Bretton Woods system and the last remnants of the link between the US dollar and gold, we have indulged in the idea that the old definition of money no longer mattered. We thought we could just declare what ought to count as money.

The signs that this system of monetary ruthlessness and lawlessness has run its course are overwhelming. A world that cannot bear the thought of a return to normal is a case in point.

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