Central bankers are a fickle breed.Â On one hand, they are more than happy to take credit for a booming economy and a robust housing market.Â On the other, they point the finger of blame at anyone and everyone when a fiat engineered boom reaches its unavoidable end.Â If taking responsibility for your actions is the measuring stick for responsibility, consider central bankers to be children among men.
Bank of Canada head Mark Carney recently mastered the tactic of guilt dodging in a speech to the Empire Club of Canada.Â Rather than acknowledge the role his central bank is playing in incentivizing a rise in consumer debt by keeping interest rates artificially low, Carney blamed the â€œfree market.â€Â Economic truth goes against the modern day central bank orthodoxy; hence Carneyâ€™s need to obfuscate and deflect scrutiny.
In his latest foray in addressing the economic intelligentsia, Carney abandons the blame game and praises himself for the steps the Bank of Canada took to guide the country through the financial crisis.Â At a speech given to the U.S. Monetary Policy Forum, not only does the BoC head congratulate himself for taking adequate steps to blunt a great deal of damage caused by the crisis of 2008 but also heaps praise on his fellow central bankers. Â In doing so, Carney perpetuates some of the popular myths regarding inflation and how much control he and his cohorts have in manipulating such a rate.Â This piece is meant to focus on some of those false but all-too-often believed justifications for aggressive and countercyclical monetary policy.Â Carney begins by noting:
â€œIndeed the crisis has shaken the foundations of monetary economics, making this a great time to be an academic but a more challenging one to be a practitioner.â€
Great time to be an academic?Â Where, pray tell, Mr. Carney were all those supposed intellectually gifted economists warning over a multitude of global housing bubbles prior to the crisis?Â Were not the majority of them more than happy to ride the wave of public sentiment and go along with the â€œgood timesâ€?Â If the financial crisis has proven anything, it is the ineptness of those who spend their time as tenured academics with unrealistic models over ever changing human behavior.
The â€œThreatâ€ of Deflation
â€œIn the crisis economies, policy-makers are battling the possibility of deflation.â€
Here is where Carney recites the same tired fallacy his central banking peers continue to champion in any forum that grants them speaking time.Â The mythical â€œthreatâ€ of a contracting money supply disallows these central planners to fully understand the cause of sharp economic downturns.Â Every major media outlet has hosted a great number of commentators warning over deflation since the Great Recession began.Â According to the deflation fearmongers, the printing press is the only device capable of saving humanity from an abrupt instance of generally falling prices.Â This is myth number one.
Of course the sudden deflation Carney wants to prevent is merely the market correcting itself to their previous inflationary policies.Â Therefore, it is not to be feared but fully embraced as it means a return to sustainable economic growth.Â In a hard money environment with the money supply not tied to the whim of just a few central planners, deflation can be better forecasted by analyzing the practices of businesses that mine or produce new money.Â Today, deflation can wreak havoc on business forecasting precisely because it is influenced to a high degree by secretive, central bank policy.Â At the same time, when fractional reserve banking, that is the issuance of banks of currency unbacked by saved deposits, creates money out of thin air, it also creates the possibility of money disappearing in such a fashion as well.Â Were it not for fractional reserve banking and a central bank implicitly providing a liquidity backstop for its failure, sudden deflation and extinguishing of the money supply wouldnâ€™t be an issue.
Those who fuss over deflation put the cart before the horse as it is inflation through the state-backed practice of fractional reserve banking that creates a money supply capable of depleting itself in an aggressive fashion.Â The same reasoning applies to Carneyâ€™s next blunder:
â€œWith households and banks in these economies aggressively trying to delever, output gaps remain large and hysteresis threatens.â€
Carney again follows Keynesian orthodoxy in concentrating on the output gap caused by a decrease in spending and debt deleveraging.Â What he doesnâ€™t account for is that the previous rate of output in certain industries was unsustainable and fueled by a housing bubble and suppressed interest rates around the world.Â Where the Austrian school trumps its rival schools of thought is in its individual methodology that focuses on both capital theory and its general understanding of the market as a time constrained process.Â While schools in academic prominence focus on aggregate statistics, they miss what is fundamental to all market processes: individual economic calculation.Â With the bursting of an asset bubble comes a recognition by many market participants that their previous investments were not profitable or as lucrative as originally thought.Â This means scarce capital must be devoted elsewhere as workers and resources in turn follow the money.Â In the case of central banking, artificially low interest rates distort price signals and lead to this malinvestment.Â Rather than let the market sort this process out, Carney and his Bank of Canada pals followed the lead of Ben Bernankeâ€™s Federal Reserve and took it upon themselves to cut the prevailing borrowing interest rate of Canada to historically low levels to gin up spending.Â This only impedes a robust recovery as toxic assets (mainly mortgages) have been papered over.
Carney and the Austrian School
In what should be considered a shocking consideration, Carney acknowledges the Austrian school and its critique on central banking.
Second, the stronger critique of the Austrian school is that inflation targeting can actively feed the creation of financial vulnerabilities, especially in the presence of positive supply shocks. For example, in an environment of increased potential growth resulting from higher productivity, inflation-targeting central banks may be compelled to respond to the consequent â€œgoodâ€ deflation by lowering interest rates. From the Austrian perspective, this misguided response stokes excess money and credit creation, resulting in an intertemporal misallocation of capital and the accumulation of imbalances over time. These imbalances eventually implode, leading to crisis and â€œbadâ€ deflation.
As I will argue later, this critique places monetary policy in a vacuum divorced from broader macroprudential management. Moreover, it offers only a counsel of despair for current problems: liquidate, liquidate, liquidate.
Again, Carney misunderstands the function of deflation by labeling it â€œbad.â€Â Most sane economists would agree that lowered prices caused by increased productivity and supply is a good thing for improving overall living standards.Â But then there is a large sect of thinkers who see deflation, that is the rising of a currencyâ€™s value, as terrible when an inflationary boom comes to an abrupt end.Â Indeed, as production takes time in respective industries, forecasting becomes disrupted during a bust where money is demanded at a higher degree, thus heightening its purchasing power and lowering catallactic prices not equally but at different rates.Â If the capitalist is investing or paying a certain price for inputs when the previously inflationary price of his final product, be it a house or share in a tech company, plummets as a central bank engineered boom wears off, losses have to be incurred.Â But it is the function of â€œmacroprudentialâ€ monetary management Carney espouses that is the cause of this deflation.Â Like any good central banker, Carney vague invocation of â€œmacroprudential managementâ€ offers no explanation as to what such management entails.
Carney makes a critical mistake in asserting the Austrian schoolâ€™s only offered solution to cyclical busts is â€œliquidate, liquidate, liquidate.â€Â What the Austrian school recognizes is the need for market participants to reorganize their spending and investing patterns along less distorted lines of production.Â The liquidationist process is the only way for the market to return to sustainability in lieu of a inflation-driven tapering off.Â If Carney wanted to delve into the true solution offered by Austrians, he would acknowledge the need to quit his position as head of the Bank of Canada immediately along with shutting down the central bank for good.
Can Central Bankers Target Inflation?
Is there a simple answer in such a messy world? It might not surprise you that, as the governor of a central bank that helped pioneer inflation targeting, I will argue today that flexible inflation targeting remains the best response.
The true cause of the boom bust cycle is not the only Austrian insight relevant to Carneyâ€™s preferred monetary policy.Â Inflation targeting is not a new strategy by any means as unofficial levels of inflation have been known to be in use by various central banks for decades.Â Proponents of inflation targeting conceded themselves too much expertise however when they assume that a specific rate of inflation can be generated.Â In his invaluable article The Use of Knowledge in Society, Friedrich Hayek explains how information is greatly dispersed amongst all market participants as central planners will forever be at a loss wield control over all market processes.Â This decentralized nature of information means decisions most relevant to business practices should be left to those most concerned about adaptable change and not so far removed from the real time dynamics of the market.
If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we insure that the knowledge of the particular circumstances of time and place will be promptly used.
The idea of inflation targeting is a firm rejection of the lesson Hayek taught.Â Central bankers who believe themselves capable of hitting such a target presume their knowledge level is far superior to the millions of individuals for whom they hold a currency monopoly over.Â As Ludwig von Mises points out in The Theory of Money and Credit, inflation is
an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.
Though Rothbard, writing in Man, Economy, and State, defines inflation as â€œthe process of issuing money beyond any increase in the stock of specie,â€ the process of hitting an inflation target canâ€™t be hit unless market participants undergo the process Mises describes.Â Currency debasement, though the impetus for bidding up prices, doesnâ€™t immediately lead to general price increases.Â The price fluctuations brought about by central bank printing happen in accordance with the actors who receive the new funds first.Â After, say, Carney and his pals print up a new $100 billion, the banks that receive those funds after selling government bonds (typically) to the Bank of Canada can then multiply that amount into credit lending through fractional reserve banking.Â Where that money goes depends on willing and able borrowers and a myriad of other market factors.Â This doesnâ€™t guarantee however that the new money will be lent out.
In short, Carney can print all he wants; if the bankers arenâ€™t lending and entrepreneurs arenâ€™t borrowing, than the reported inflation rate will fail to increase.Â His counterpart in the U.S., Ben Bernanke, has run into this dilemma as the dramatic increase in the Federal Reserveâ€™s balance sheet has resulted in many of those funds being lent back to the Fed as excess reserves.Â This does not prevent market distortions from occurring however.
It can never be stressed enough that the strategy of inflation targeting, besides assuming central bankers can accomplish such a feet outside instances of pure luck, is accompanied by the unquestioned ideology that inflation in itself is a good thing.Â While an increase in any good confers a social benefit since it must mean that good satisfies an end less it would fail to be produced initially, money itself is different.Â As Murray Rothbard writes:
Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not–unlike other goods–confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices–i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value.
The true, insidious nature of money printing is to confer a monetary benefit to the first receivership of the newly created funds.Â Money, being a physical commodity, is bound by the same physical limitations of all tangible goods.Â It must move from ownership to ownership like any other good.Â In doing so, itâ€™s used to bid up prices of whatever goods or services its then-owners prefer; all of which must occur before the overall impact of the newly printed â€œwealthâ€ is assessed and felt by all market participants.Â In short, legally mandated tender laws combined with a government granted monopoly over currency creation really is a zero sum game as some benefit at the expense of others.
This is the untold secret of all central banking.
Do We Want Stable Prices?
Inflation may be a boon to some initially while slowly eroding the purchasing power of everyone, but Carneyâ€™s real mistake doesnâ€™t lie in a religious devotion to printing money.Â Carney spend a great deal of his speech outlining opposition viewpoints to inflation targeting without addressing why a stable price level is something to be desired.Â In an economy with a fixed or slow growing money supply, the tendency is for falling prices as productivity increases and technological innovations expand at a faster rate than new money entering into the economy.Â The late 19th century in the U.S. is demonstrative of this phenomenon as it marks one of the greatest time periods of wealth generation in the countryâ€™s history.Â Carney realizes this disconnect when addressing the Austrian school but fails to do his history homework and see why concentrating on stable prices is precisely what lead to the greatest economic calamity of the 20th century- The Great Depression.Â During the 1920â€™s, the Federal Reserve pursued a stable price policy which resulted in vast amounts of money printing to offset productivity increases.Â Between mid-1921 and the tail end of 1928, banking reserves within the Fedâ€™s control increased by â€œ138 percent or 18.4 percent per yearâ€ in turn leading to the money supply increasing by â€œabout 61 percent, yielding an annual rate of monetary inflation of 8.1 percent a yearâ€ according to Joseph Salerno summarizing the work done by Murray Rothbard in Americaâ€™s Great Depression.Â As many economists at the time saw a stable price level, the underlying inflationary forces distorted the capital goods industry by bidding up the price of wages and stock as productivity gains offset major consumer price increases.Â In the end, Rothbard writes:
Federal Reserve credit expansion, then, whether so intended or not, managed to keep the price level stable in the face of an increased productivity that would, in a free and unhampered market, have led to falling prices and a spread of increased living standards to everyone in the population. The inflation distorted the production structure and led to the ensuing depression-adjustment period.
The focus on the stable price level alone allowed many economists to dismiss any concern over the forming of an inflation driven bubble.Â This negligence resulted in the most damaging and prolonged economic crisis of the century.Â The same thoughtlessness lead many to dismiss concerns over a U.S. housing bubble during the first half of the last decade.
(image via FRED)
(chart via FRED)
Given the zero-bound interest rate policy Carney admits he and his central banking colleagues are engaging in, there is no telling where the money created to suppress rates will funnel into and thereby cause distortions.Â Canada is already experiencing what many are determining to be a housing bubble.Â Should the bubble burst, as they all invariably do, the blood of the financially distraught will be on Carneyâ€™s hands.
Carneyâ€™s speech to the U.S. Monetary Forum is filled with the usual lackluster understandings of inflation and the originator of the boom-bust cycle.Â While he takes credit for the steps the BoC took following the 2008 financial crisis, Carneyâ€™s focus on inflation targeting and confusion over deflation leave him hapless to determine the true cause of the countryâ€™s economic ills.Â This hardly differentiates himself from any other central banker who relies on the printing press for anything and everything. Their reckless policies of manipulation over the laws of supply and demand ultimately create more harm than good.
With guys like Carney at the helm, it shouldnâ€™t come as a surprise that the world economy still remains in the doldrums.Â After all, he saved Canada with the same policies that got it into trouble to begin with.Â No logical fallacy here, right?