Central banks have finally put us on the long path to recovery, to an economy which produces things instead of one which engineers valuations. We should keep going despite the problems in the banking sector.
When I started Ipoleco one of the topics I kept returning to again and again was how the 2010’s monetary policy was not working. With interest rates at rock bottom and every central bank from London to Tokyo creating money to buy government bonds in an effort to stave off deflation. I kept repeating that that policy would inevitably be very difficult to go back to normal from, and the current instability in American and European banks looks like confirmation that my thesis was on the money. The current bout of inflation, rising interest rates, and wobbly banks could have been avoided. What should central bankers learn from this?
The most important lesson is that while normalising rates is difficult and can have serious externalities, having the price of money being nothing creates non-productive firms and speculative manias. And those effects worsen and compound with other issues over time. Central banks need to stay the course and keep up the fight against inflation in spite of the market conditions. Normalising rates will be difficult and might create a recession but lowering rates would just start creating more problems. I wrote last week about what I called the ‘valuation economy’, the system of unprofitable tech firms, venture capital funds, and private equity firms which made money through getting high valuations rather than through creating products and services which improve peoples’ lives. The valuation economy is predicated on a low interest rate environment so reversing course and lowering interest rates would enable all the worst trends of the 2010’s like crypto scams, corporate frauds like Theranos, and retail investors speculating on meme stocks.
Monetary policy is complex and I fully acknowledge that the instability in the banking sector and possible recession are important factors for central bankers to consider. But we have seen what rock bottom interest rates does to the economy. We do not want to go back. So far, I’ve not heard of any major central bank cutting rates but I fear that it is just a matter of time. I wrote in September 2021 that most central banks are complacent and unwilling to critically assess their own policies. Inflation forced central banks to change their tack but it’s entirely possible that they will change course again once the inflationary pressures ease. For a central bank with a simple price stability mandate the 2010’s looks great compared to now. Sure inflation was a bit low but that’s a far lesser problem than double digit inflation. Viewed holistically though, the 2010’s were not golden years of prosperity and low inflation, tech and finance sectors excluded.
The past ten years have really illustrated the limits to monetary policy. For a while there was a sense that central banks could do anything, and that Mario Draghi and Ben Bernanke saved the world but that’s a simplistic view of history. Many issues in the economy can be solved using fiscal rather than monetary policy, like struggling banks and deflation. But high inflation cannot be solved using fiscal policy; monetary policy is required. Central banks should take a step back from the markets and focus on a problem they helped creating and which only they can fix: high inflation.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson