For decades, central banks have been manipulating the price of capital to make it artificially cheap. But it’s come at a serious cost, says Simon Gordon. 

Announcing the latest inflation forecast, Mark Carney was quick to blame a rise in inflation on the fall in the relative value of the pound. He was less candid about his own role in stoking it.

Inflation is, after all, the one thing over which central bankers have a large degree of control. Tighten monetary policy, and inflation will fall. Loosen it, and inflation will rise.

Yet central bankers only ever seem to do the latter. When interest rates were cut to record lows nine years ago, they were only supposed to stay at that level temporarily. As growth returned, interest rates were meant to return to normal too.

But they didn’t. Instead, the Bank cut them even further in 2016 – in deference to a supposedly imminent recession that never materialised.

In truth, loose monetary policy has little to do with emergency liquidity. Rather, central bankers worldwide are deliberately manipulating the price of capital to make it artificially cheap – and they have been doing so for decades.

Although nominally inflation has been low for the last decade by historical standards, the headline figure is deceptive. In real terms, many goods are much cheaper than they were twenty years ago. Clothes cost consumers 70 per cent less in constant prices. Consumer electronics, 90 per cent less.

At the same time, the prices of assets, whether houses, stocks, or bonds, have surged. There’s no disguising that inflation – so it is simply excluded from the general index.

Inflation is clearer still when currency is measured against commodities. Since 1971, when President Nixon decoupled the dollar – and by extension money globally – from gold, every major currency has depreciated against it.

Meanwhile, the long-term average price of oil measured in gold has remained fairly constant. In other words, gold hasn’t become scarcer. Money has become more plentiful.

The system of global fiat money that began in 1971 enabled a huge increase in the money supply. Since the late 1980s, the broad M3 measure of money has multiplied ten-fold – from £260 billion in 1987 to £2.6 trillion today. Effectively, central banks gained a licence to print.

But it has come at a serious cost. Artificially cheap credit, especially in the housing market, was the root cause of the global financial crisis a decade ago.

So why haven’t central banks changed tack?

Largely because they don’t serve the public interest so much as the vested interests of their two main clients: governments and big commercial banks.

Central banks were, after all, created either to lend money to the state (the Bank of England) or to act as lender of last resort (the Federal Reserve). From an economic perspective, both functions are problematic.

When a central bank buys gilts, it is effectively enabling government to tax by stealth. Quantitative easing, for example, doesn’t merely fund government spending. It also increases the money supply – which is inflationary. Wealth is effectively transferred from savers to the government.

Bailing out banks creates similar perverse incentives. It treats the symptom of bank failure by fuelling the cause.

Financial instability is often driven by fractional-reserve banking. Banks maintain only a fraction of demand deposits on hand for immediate withdrawal, essentially because banks lend by issuing new deposits, which aren’t backed by cash. As the economist Ludwig von Mises wrote a century ago, “banks that issue notes or open current accounts… have a fund from which to grant loans, over and above their own resources and those resources of other people that are at their disposal.”

The lower the ratio of liquid reserves to deposits, the less safe a bank is. So, to make banks safer, that ratio needs to rise.

However, the existence of a lender of last resort encourages banks to cut their reserves.  Banks have an incentive to take greater risks in the sure knowledge that their losses will be socialised. Hence, the average capital ratio of American banks fell from almost 25 per cent in the late 19th century to barely 5 per cent by the mid-twentieth century.

Manipulating the money supply to serve big banks and big government isn’t merely unfair, or unfree. It’s unsustainable.

Loose monetary policy is the cause of chronic misallocation of capital. It incentivises consumption over saving. It diverts capital into assets, instead of productive investment. It transfers wealth from the asset-poor to the asset-rich. In short, it is hindering economic growth, and widening inequality.

The trouble is the system is now so dependent on cheap credit, there’s no easy way out. Central bankers now seem reluctant to raise rates under any circumstances for fear of bringing the whole system crashing down. The cure is seen as worse than the disease.

The first step, however, must be to return interest rates to normal and raise capital requirements for banks. Otherwise, a repeat of the 2008 crisis is more than likely – especially in Europe, as research by the UKIP Parliamentary Resource Unit highlighted in 2015.

But it may be time for a bigger rethink of monetary policy. The forty-year experiment with fiat money hasn’t been a resounding success. Fixing the price of capital by official diktat has produces the familiar unwanted consequences that afflict every government attempt at price control – from food to rents.

In no other sphere do we expect government to be able to price resources better than the market. Perhaps capital markets need to be set free.

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