The Harms of Central Banks

The 'Guilded Age' of Finance

This article was written in late 2021, but never published. It still seems to have some relevance so seems worthwhile to publish it here.

The harms of Central Banks.

Taken together central banks across the globe have significantly enhanced the power and wealth of insiders; they have acted to create a new guild of bankers whose interests are not obviously aligned with those of society. This development has been led by the Federal Reserve, and widely emulated across the globe; a global guild. Let’s look at some of the evidence.

Quantitative easing (QE) has been a mainstay of central bank policy in the USA, Eurozone, UK, Japan, Australia, Canada, New Zealand for years. It was implemented to help countries recover from a series of economic shocks; the Global Financial Crisis, European sovereign debt crisis and recently the COVID-19 pandemic. Unfortunately, QE was engaged in haste whose effects will be repented at leisure by citizens for decades to come. This article will not address the current inflationary episode that may have been worsened by central bank policy. Inflation may be temporary, and the topic is well covered by other commentators. Instead, this article looks at some less-discussed yet trenchant problems of recent central bank policy more generally. 

The main role of a central bank is to foster confidence in the currency and thereby encourage provision of credit throughout an economy and allow optimal allocation of scarce resources for the collective benefit of society. Unfortunately, this tenet has been diverted. Central banks’ policy across the globe has mutated into sustaining the welfare of a relatively narrow financial class.

Consider the effects of Quantitative Easing (QE) on the economic inequality. There are two major impacts.

Central banks purchased assets in massive quantities which lifted prices of bonds, equities, and real estate and was a direct gift to existing wealth holders. The greatest gains accrued to the largest holders. Along the way QE forced investors into riskier assets so raising the value of risky assets and providing an unwarranted fillip to unproductive businesses.

Secondly, a currency is founded on cash, ‘the promise to pay’ printed on some bank notes such as British pounds. These used to be the largest portion of central bank liabilities and were an asset of the public at large. Since QE began, however, central bank liabilities became dominated by system reserves which are assets of commercial banks, not of the public. System reserves are the liability counterpart to the massive increase in central bank assets under QE. By design, QE exchanged liabilities used by everyone (notes and coins) for liabilities used only by the commercial banking system (system reserves).

The massive increase in system reserves is not ‘dead money’ for banks. Instead, reserves are deployed as a medium of exchange for securities settlement between banks – a closed shop. More reserves mean more securities settled between banks. Reserves also take up space on commercial banks’ balance sheet that may otherwise be used for loans to the public. We have moved from a fractional banking system to a fractional securities system, whose beneficiaries are existing financial actors.

Defenders argue that absent QE society would suffer lower employment, higher levels of poverty and social disruption. This sermon of despair should bring the obvious riposte that fiscal policy can be used to alleviate economic downturns without raising the wealth of the already wealthy. It is hard to avoid the suspicion that QE chimed nicely with vested interests and conveniently circumvented public debate that should accompany alternative policies.

Not surprisingly, extreme policy measures such as QE involved gross interference into private price setting process for the benefit of existing dominant companies.  This seems to be an echo of Karl Marx’s dictum about the inherent contradictions of oligopolistic capitalism. Bond yields have been driven down, polluting both investment and saving decision making. The purchase of bonds by QE and resulting low interest rates, fostered a belief that the cost of fiscal expansion could be outsourced to central banks. This may be no bad thing, per se, except discussion of pros and cons has been missing. ECB policy for the last decade has been an exercise in fiscal support for Italy, with only scattered (mostly German) discussion in European media.

The higher levels of debt itself may entrench an inappropriately low interest rates for fear of fiscal disruption if rates rise. As repeated crises hit the Western economies since 2007, the response always led to higher government debt, sustained by QE which hid a good part of the additional spending on the balance sheets of central banks. Debate has been minimal.

And central banks increasingly have sought to pick winners, without any democratic mandate. For instance, the European Central Bank Bank (ECB) allows bonds linked to certain sustainability targets to be used for its credit operations and outright purchases. Bank stress tests overseen by central banks award higher scores to ‘sustainable’ loans. It is not cynical to suggest that these sustainability targets will encourage exaggeration to qualify and will starve other industries of credit that are either not keen on cheating. Even if we believe in the expansion of the state and industrial policy, these decisions should be in the realm of the representative democratic process. This is not a task for bankers.

If the massive extension of central bank influence on economies was accompanied by sage analysis with clear economic benefits for the whole of society, then the actions should be applauded. Unfortunately, evidence of such wisdom is absent. Economic projections by central banks are at least as bad as the private sector and frequently worse. Their policies have not discernibly improved growth and productivity has not risen. Inflation was for years too low, now it is too high. Policy makers are overcome by the inertia of their existing models – demonstrable failure in policy rarely leads to a change in approach. Failed policy leads to more policy failure.

Central banks are unable even accurately to forecast their most important of tasks; the daily liquidity needs of money markets. These flows directly affect borrowing costs for banks, individuals, and companies. Prior to the bankruptcy of Lehman Brothers, central banks used a liquidity shortage system; liquidity was deliberately restricted which revealed how much was needed. The shortage could then be alleviated (or not) by central bank intervention.

The immediate liquidity demands of the Global Financial Crisis caused central banks to shift to a system of permanent excess liquidity; if you didn’t know how much was needed, better to err on the safe side. The shift to excess liquidity seemed to alleviate emergencies, for a time. Unfortunately, it also obscured understanding of short-term demand for money. In September 2019 completely unexpectedly, wholesale US short-term interest rates abruptly rose. A threshold had been breached that was unknowable because the surplus system removed understanding. The Federal Reserve was surprised; according to their own calculations, the system still showed massive ‘excess liquidity’. A policy aimed at avoiding monetary accidents caused a monetary accident. There has been no convincing improvement in forecasting money demand since then. Further accidents are assured.

And like the dinosaurs of Jurassic Park, liquidity has escaped direct control of central banks. There have emerged ‘shadow liquidity providers’; non-central bank actors who can influence central bank liquidity outside the control of the central bank. The US$ trillion-dollar (and more) accounts held at the Fed on behalf of the Treasury, and ‘reverse repurchase’ accounts for money-market funds are examples. At the ECB, the Deposits Held by Non-Residents in Euro similarly acts as a massive store of ‘autonomous’ liquidity; funds that are controlled by sovereign wealth funds and foreign reserve managers, not central bankers and certainly not citizens.

Unfortunately, it gets worse. QE will cause losses for central banks and require a transfer of capital from government. Tax revenue may need to be diverted from social programmes or defence, or government borrowing increase. The threat of losses from QE has already been acknowledged by some on the ECB as a reason to carefully consider interest rate rises. A similar problem afflicts all central banks who have engaged in Quantitative Easing. A policy originally conceived to help support economies may require a tax-payer bailout.

That is quite a charge sheet.