Why Central Banks should stand back
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“Central banks seek to unblock markets,” said the FT last weekend. The gist of the story was that the financial industry seemed to be having something akin to a cardiac infarction and central bankers, rushing in like heart surgeons from the golf course, were attempting a by-pass. If successful, we were led to believe, Bernanke, Trichet and the lot would get their mugs on the cover of BusinessWeek and Time, and soon join the great assembly of capitalism’s saints. In fact, what the bankers were up to was the exact opposite. At the end of last week and the beginning of this one, central banks all over the world were engaged in a vigorous attempt at price fixing and market manipulation; that is, they were trying to block markets from doing what they needed to do.
As we wrote last week, no man worships capitalism. If he has any sense, he fears it, and aims to put a stop to it as soon as he can. In any economy, mistakes are made. People invest in projects that don’t pay off. They pay too much for a stock. They lend to people who can’t repay them. If these errors were to go unpunished, mal-investment and misallocation of resources would continue. Eventually, the whole shebang would collapse into a heap of unwanted products and un-performing assets. That is why we have corrections, bear markets and panics; they are an economy’s equivalent of natural selection, eliminating the weak and unfit.
The key variable in capitalism is the cost of money – the interest rate – which establishes a ‘hurdle rate’ against which to judge all investments. It is the natural environment in which capitalists must survive. If a new project will return 5% a year and the cost of money is 6% a year it never sees the light of day. But if the cost of money drops to 1%, even the most absurd and clownish investments get to reproduce. Soon, they are everywhere. Now, in a free market, the hurdle rate is set like all other prices – based on supply and demand. But central banks meddle with interest rates – typically pushing down on short rates, thus lowering the hurdle rate for all borrowers. Most of the freaks now crowding the financial world are the spawn of central bankers who kept rates too low for too long.
Corrections can take many different forms. Occasionally, speculators panic; they stop worrying about the return ON their money; instead they fret about the return OF their money. Then it becomes hard to borrow at any rate.
Over the last three weeks, capitalists have become edgy and disagreeable. Lured by an artificially low lending rate, maybe they lent a bit too freely. Maybe they spent a bit too much. Maybe their speculations weren’t as good as they thought. Mistakes were made; they needed to be corrected. And so markets began to wobble. Stock prices fell, with more than a trillion dollars trimmed from US stocks alone. Credit markets began to constrict; banks on both sides of the Atlantic were stuck with nearly half a trillion dollars’ worth of corporate loans that investors refused to take.
These were the facts on 9 August. The capitalist cops were doing their job. They were beating up homeowners who had bought houses they couldn’t afford. They were taking their cudgels to the lenders too, and to CDO speculators, hedge-fund players, imprudent bankers, and whiz-kid mathematicians. Once their blood was up, they were whacking away at everyone within range. Equity investors, pension fund managers, City investment banks – rich, poor, smart, stupid – they were giving them all a good thrashing.
But then along came the central bankers. On 9 and 10 August the Bank of Japan, the European Central Bank (ECB), the Bank of Canada and the Fed all began to intervene. One report said the ECB had ‘injected’ $215bn into the system. Others said the Fed had put $38bn to work. By Monday, the Bank of Japan (BoJ) was still at it, colluding to knock down the hurdle altogether. The BoJ put in another $5bn, which was already having a “calming effect” on Asian markets, said the papers. On Monday, too, the ECB put in another E47.7bn. Whatever the final numbers turn out to be, it is a lot of new money in a short period of time – more than at any time since the days immediately following September 11th in 2001. Lending by the New York Fed was so vigorous that the Fed funds rate fell to its lowest rate since 2004. The purpose of all this lucre was said to be to provide “liquidity”. What’s that, you may ask? Lo – it’s the same cheap money that got markets in trouble in the first place! It is as if they had opened a new mortgage lender in Santa Ana, California, offering no-money-down, teaser-rate, no-document adjustable-rate mortgages. If we’re lucky, borrowers won’t fall for it – and the cops can get back to work.
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