The Mario brothers were in the news yesterday. Mario Monti – academic, former European Commissioner and now top man in Italy – called on Mario Draghi – former banker and now top man at the European Central Bank – to get a move on. Draghi, at the ECB, said last week he would do "whatever it takes" to keep Euroland in business.
“Believe me”, Draghi assured investors, “it will be enough.”
Trouble is, Mr Draghi doesn’t have enough of whatever it takes. Which is what animated Mr Monti yesterday. He thinks the Germans should be more generous with whatever it takes. He wants the healing gift bestowed on Draghi so that the ECB can do to Europe roughly want the Fed is doing to the US.
On the evidence, the ECB seems unable to fix the problem. It has laid its hands, more than once, on the European economy. And now, European banks shake and shiver with $3 trillion in 'impaired loans' – which is about 9% more than they had last year.
In the popular mind, if there is one, the Fed has what it takes. The ECB does not. So, the obvious question presents itself: whatever does it take?
That was the question that was on the table when we broke off for more important things yesterday.
The next few hundred words explore the question in more depth. But what they find at the bottom of it is, unfortunately, mud. Whatever it takes is apparently not something you can grab a hold of easily. And whatever it is, digging around in the murky depths of central banking, you probably won’t find it.
The financial press sat on the edge of its chair yesterday. It was waiting. Fed governors were meeting to decide their next move. When the announcement was made, however, the world found out that there was no move. Bloomberg:
The Federal Open Market Committee “will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability,” it said today in a statement at the end of a two-day meeting in Washington. “Economic activity decelerated somewhat over the first half of this year.”
Stocks fell on disappointment Fed Chairman Ben S. Bernanke refrained from taking action even as consumer spending flagged, job growth slackened and manufacturing cooled. Before its next meeting Sept. 12-13, the FOMC will assess unemployment reports for July and August, and the European Central Bank may take steps to ease Europe’s debt crisis at a meeting tomorrow.
“They were as blunt as you can get without actually pulling the trigger,” said Dan Greenhaus, chief global strategist at BTIG LLC in New York. “They’re saying, ‘Hey, things are not good and we’re an inch away from easing.’”
If Ben Bernanke has whatever it takes, he did not choose yesterday to show it to the world. Instead, the Fed sat tight.
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But what does he have? What does any central banker have? Only more credit. Or less. Central banks produce nothing. As far as we know, they invent nothing. They produce no miracle drugs. No market Viagra... no financial botox. No iPads. No automobiles. No wheat. No corn. No cattle.
All they have is credit. They regulate the flow of it. And, if they choose, they can create – out of thin air – notes of immediate maturity, which we know as dollars or pounds or euros, which increase not only the amount of credit, but the amount of cash too.
The problem confronting the developed economies is hardly a lack of credit. Even the most naïve and inexperienced observer would conclude that it is precisely the opposite – it’s too much credit that afflicts these economies, not too little.
But let us set aside our conclusions – as obvious as they are – and continue groping in the mud. Perhaps we will find something.
Let us imagine an economy – a small economy, because our imaginations are limited. This economy is not doing well. No need to worry about why it is not doing well. It just isn’t. Unemployment is high. Growth is low. Many companies and banks seem on the verge of going bankrupt. So, without prejudicial background, could the local central bank help?
It could increase credit. Or decrease it. Would either of these things make people more prosperous?
Answer: we can’t know. In a properly functioning economy, willing lenders and willing borrowers determine the amount of credit available – savings – and its price – interest rates. There is no way the central bank can increase the quantity of real credit available; it is what it is. Can it increase the price of credit? Well, yes, it could artificially set interest rates lower than the market decrees, but that would merely cause savers to reduce their savings, thereby actually reducing the quantity of real credit available. In the long run this would mean an even worse result.
Raising rates would draw forth more savings, but it would reduce the amounts available to business and spending – making the situation worse in the short-run.
But let’s just say the central bank decides that it must ‘do something’ bold and decisive. It has already lowered the cost of credit to almost zero, and still people have not taken up their old spendthrift habits. So, it decides to throw money – paper currency – out of helicopters!
Suddenly, it is raining dollars. This certainly makes people feel richer. They probably spend more freely. They probably bid up prices on houses... and consumer items too. For a while, there is what appears to be a genuine boom. Builders set to work putting up more houses (prices are rising!) Bankers, bakers, and candlestick makers are all raising prices. The central banker is called a hero in the local press. Everything seems to be going along well...
But then, how are they better off? They have more money. But things cost more too.
And then, months later, builders realise they made a mistake. So do the bakers, bankers, and candlestick makers. All that extra cash caused them to misjudge demand; the money was spent, and now the buyers are cutting back. Now, everyone is paying for his errors... and the economy goes back into a slump.
How then does the ability to manipulate the credit market – fixing interest rates by decree ... or actually printing and distributing more cash – really help an economy?
Answer: it doesn’t.
Implication: the Fed doesn’t have what it takes either.
What does it take?
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