Central bank policy

Central banking has as many different approaches as there are central bankers. The aim of central banks is to provide oversight and stability to the financial system which gathers in national savings and disperses those savings to those who can make the most productive (that is, profitable) uses of them. Saving is undertaken individually by putting money aside for future use. But from a national economic perspective, saving is precisely the use of resources to strengthen the economy through productive investment. Watching the two separate streams – the money stream and the real resources stream – and keeping them separate while at the same time being aware of how they interact, is crucial if one is even to have the most basic understanding of the processes involved.

There are real resources (bricks and mortar, labour and machines) that can be used in a variety of productive (and non-productive) enterprises. But the only way for a business to get their hands on these resources is first to get the money that will allow it either to buy, hire or rent the inputs it needs. Thus, what the financial system does is lend money as the intermediary to securing the various resources needed.

There are no end of various financial intermediaries who receive money with the promise to return an even greater amount of money at a later date. Banks, insurance companies, superannuation funds, building societies, share markets and the list goes on. Money comes in because there is an expectation that an even greater amount of money will come out later.

Lots of people want to take your money, and will do that with the promise that they will give it back with interest. The only way they can do that is to lend the money to others who use that money in a value adding productive profitable way. They then repay the financial institution from their receipts which then repays the people from whom they had initially received the funds. The economy grows so long as the people who took the money have used those funds to build productive profit-making assets.

Financial institutions that do not lend to businesses which make a positive return, find they have lent to businesses who cannot repay their loans. The businesses go bankrupt, and for financial institutions, if enough of their borrowers fail to repay their debts, the financial institution will also go bankrupt.

Central banks keep an eye on the entire process, but their two major roles in every economy have always been (1) to keep solvent those financial institutions that run into temporary difficulty and (2) ensure that the financial system itself does not collapse because of a failure of enough liquidity to allow commercial transactions to take place. The role of central banks during the GFC was exemplary. Just what was needed.

Central banks have now taken on an additional role which is to adjust interest rates to affect economic activity. Interest rates will, of course, be generated without a central bank so its role is totally superfluous so far as interest rates are concerned. But many like this role since it seems to provide a form of stability. For myself, the stability is illusionary. They only provide a talking point but can never really do what is needed since they cannot know with sufficient detail about the future state of economic activity. No one else does either, which is why it should be left to the market to sort out all of the contrasting sentiments found across the economy.

But now central banks also adjust rates with the intention of stimulating economic activity and sometimes even slowing it down to slow inflation. Low interest rates are seen as a positively good thing since supposedly it will stimulate investment. But it is noxiously misguided because low interests have all of the following effects:

  • reduces the supply of saving
  • reduces the flow of real resources into the economy
  • misdirects investment since low interest rates allow borrowers with low productivity investments to secure funds ahead of others with riskier but more productive investments
  • lenders are able to choose their friends to lend to since there is an excess supply of funds relative to the period when rates were kept higher
  • money goes into the purchase of readily available forms of assets such as housing or shares
  • governments, who are almost invariably low productivity borrowers, find it easier and cheaper to borrow.

The result of such low interest rates:

  • price bubbles in share markets, housing or other types of value-holding fixed assets
  • higher inflation which may come in the form of higher prices, or if prices are unable to rise, a crumbling asset base across the economy leading to an ageing and decaying capital base
  • slower growth
  • higher unemployment
  • a fall in living standards.

Unnaturally lower rates of interest lead to prolonged periods of depressed economic activity which, given the useless way we teach economics nowadays, hardly anyone understands, while at the same time there is no political constituency for a rise in rates since those who borrow become infuriated at any government that happens to be there when interest rates begin to rise.

For a more detailed discussion, see Chapters 16 and 17 of my Free Market Economics. The 2nd ed will be even clearer on this than the first.