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2 THE
BEAR'S LAIR The Gotterdammerung of central
banking By Martin Hutchinson
After pretending an unwonted firmness for
a few weeks, the central banks in both Britain and
the United States caved last week, accepting
financial-sector bailouts and, in the US Federal
Reserve's case, lowering interest rates. Moral
hazard has thus been made immoral certainty;
financial-market participants who indulge in
grossly speculative activity can be "highly
confident" (in the words of the old Drexel Burnham
commitment letters) that they will be bailed out
by the taxpayer. Rarely has there been
such
an obvious subsidy of the overpaid by the
beleaguered. It raises the question: What if
anything is the point of central banks in the new
world we have entered?
With the Northern
Rock debacle, Britain suffered its first run on a
major bank since the Overend, Gurney collapse of
1866. The Bank of England initially took the same
principled (if, in that case, mistaken) line it
took over Barings in 1995. As queues of
withdrawing depositors spread over British TV
screens, however, it was quickly overruled by
Chancellor of the Exchequer Alistair Darling.
Darling, not content with rescuing just
one bank, grandly announced that all failing banks
would have their deposits guaranteed by the
taxpayer, thus flushing 313 years of
bank-supervision policy down the pan. (It will be
remembered that in 1720 the Sword Blade Bank,
bankers to the South Sea Company, was allowed to
fail, since Robert Walpole, unlike his distant
successors, had a shrewd grasp of the "moral
hazard" concept.) By the middle of the week the
Bank of England was offering to lend money against
dodgy home-mortgage portfolios.
Meanwhile
in the United States, the Fed cut interest rates,
thus causing a massive Wall Street stock surge,
undermining the value of the dollar, sending gold
up to US$740 per ounce and doing very little to
help the home-mortgage borrower, since long-term
rates rose almost as much as he had cut short-term
rates - unlike Fed chairman Ben Bernanke, the bond
market fears inflation.
Then their
regulators allowed the over-leveraged and
accounting-inept housing agencies Fannie Mae and
Freddie Mac (the Federal National Mortgage
Association and the Federal Home Loan Mortgage
Corp) to buy another $20 billion of
mortgage-backed securities, to the further
ultimate risk of the taxpayer - Freddie promptly
snapped up CIT's US$4 billion portfolio of
securitized subprime junk, precisely the rubbish
that puts its solvency in most jeopardy. Finally
Ben Bernanke appeared before Congress and
supported legislation allowing Fannie Mae and
Freddie Mac "temporarily" to guarantee "jumbo"
mortgages above the current statutory limit of
$417,000.
The idea that large mortgages
should be in effect government-guaranteed beggars
belief in principle. It also supports the
overbuilt high end of the housing market, bailing
out borrowers who, being richer, should be more
able to bear the risk of lower house prices and
higher interest rates than their poorer
countrymen.
It is a subsidy from the
middle class to the rich, supporting the least
productive, most energy-inefficient and least
deserving sector of the US economy. John Edwards,
he of the $400 haircuts and the 28,000-square-foot
home, is no doubt rejoicing at the news.
This is all very depressing. When King
Philip II of Spain sat in the gloomy Escorial,
counting his gold and silver hoard from the
Americas, he doubtless pulled at his beard in
puzzlement at where all the damn inflation was
coming from. One rather hoped that modern central
bankers had gotten beyond Philip's limited
monetary understanding. However, it appears that
in times of crisis, when badgered by politicians,
they revert to a 16th-century world view. It's as
if after the Chernobyl nuclear disaster scientists
had resorted to alchemy in the hope of preventing
it happening again.
It is now clear that
all the intellectual advances in central banking
of the past 300 years have disappeared. Gone with
the wind are the concept of "moral hazard", the
idea that central banks should be independent of
political control, the idea that lowering interest
rates might cause inflation and the knowledge that
widespread deposit guarantees and bank bailouts
impose huge long-run costs on taxpayers and the
economy. In 1720, when the financial world was
young and innocent, this would have been
forgivable; today as then, it is likely to bring
economic chaos in its wake.
Once the
long-run costs of bad policy become all too clear,
policymakers will make changes, to ensure that
they are not repeated. It's thus worth pondering
what changes one might recommend.
Regrettably, one possible change, a
reversion to a gold standard, is not immediately
practicable. Gold supplies can be increased by new
discoveries by at most 1% per annum or so. Since
world population is currently increasing at about
that rate, any significant economic growth,
requiring an increased monetary base, would become
impossibly deflationary.
Deflation, as
Bernanke helpfully but irrelevantly pointed out in
2002, is more dangerous than inflation, because
the ability to store money in bullion form without
interest can cause the working money supply to
collapse (if you can get a safe zero return on
cash with 100% liquidity, and prices are dropping
3% a year, why ever would you invest in anything
else?).
The gold standard worked fine in
the 19th century, with the help of large gold
discoveries in California, the Transvaal and the
Yukon, but once world population growth started to
accelerate after 1900, it became impossibly
deflationary, as was discovered in 1925-31.
Reversion to a gold standard is an admirable
long-term aim, but it had better be deferred until
after the magic date around 2050 when the world's
excessive population stops increasing and begins
to decline.
Theoretically, it should not
be impossible under fiat money to run a central
bank that does a good job. After leaving the gold
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