How the authorities are encouraging rot
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Modern central bank management, like Caesar’s Gaul, can be divided into three parts: one part practical politics, one part financial hocus-pocus, and one part incomprehensible. To an economist with a sense of humour, this past week was particularly entertaining: we got to see them all.
“Liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate.” That was the advice of Andrew Mellon, US treasury secretary in 1929. He wasn’t being mean; he was trying to make things better. “It will purge the rottenness out of the system,” he explained. He meant that too many people had put too much money into losing propositions. The Roaring ’20s had been lucky years for Americans. Cars and electrical appliances rolled off assembly lines. And the financial sector was more dynamic than ever before. Huge inflows of capital created a boom on Wall Street; while new industries – including the film industry – were making ordinary Americans rich. Almost everything they tried seemed to work.
From strength to strength… to catastrophe. The crash came. The credit markets seized up. Risk was repriced upwards. Assets were repriced down. The US economy contracted 30%. Sixty years later, a similar boom hit Japan. Western consumers learned to say Japanese words such as Toyota and Honda. Then, executives worked on “kaitzen” and “zaitech”. Then, the Nikkei cracked… and we went back to speaking English. Seventeen years on, Japan has still not recovered its bonsai! vigour.
The US and UK financial authorities know the stories well, and are determined not to relive them. Economists have another 80 years of progress, they say; now they can avoid these problems. So, when depositors lined up in front of Northern Rock, they knew what to do.
The credit cycle is still more or less the same as it was in Mellon’s day. When people are flush they worry about the return on their money. When credit turns down, they worry about the return of their money. But the art of central banking has evolved. Practical politics comes into play faster; no government outside of Buenos Aires can afford to let teachers lose their savings on TV. Hocus-pocus plays a larger role too; problems disappear like magic. Do you see any rottenness? In the 21st century, central banking authorities would rather poke their eyes out than see rottenness.
Seeing nothing to purge, they got down to work. Chancellor Darling took just four days to make up his mind. Then, he stepped before the cameras to put the government squarely behind troubled mortgage lender Northern Rock. The Conservatives accused him of being “a bit slow” and said they would have given depositors a 100% guarantee as soon as the problems came to light. But what sort of financial quackery is this? Who else should take the loss other than those who asked for it? National Savings fixed-rate income bonds yield about 5.3%. Northern Rock offers a fixed rate of 6.2%. Take the risk out of the calculation and you make fools of the fellows who bought National Savings income bonds.
Meanwhile, in America, the central bank opened its discount window weeks ago – and practically forced Bank of America and Citigroup to take money. And then, on Tuesday, the Fed abandoned 4 years of inflation-fighting and took its troops over to the other side. Now, cutting the Fed funds rate by a half a point, its fondest wish is that consumer prices are higher tomorrow than they were today.
This latest bit of price fixing made the front pages. “Euphoria after half-point cut,” said one headline. But bad investments do not disappear just because central banks lend more money to those who made them. Nor do problems caused by too much credit disappear when you offer more credit. Householders still have mortgages they can’t afford. Asset-backed securities are still worth considerably less than their orginal purchase prices. And there is no decline in business, consumer or government debt. What is different is that, instead of permitting reckless speculators to get what they’ve got coming, losses will be socialised – redistributed to consumers and savers everywhere. And instead of allowing the market to liquidate weak companies and remove the rot, the rottenness is encouraged to spread. Progress in science and technology is incremental. But in love and central banking, progress is largely an illusion.
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