A few years ago, the National Health and Medical Research Council (NHMRC) in Australia researched into the effectiveness of homeopathic remedies. They found these remedies were effective about one in five to six of cases, but this was less than the placebo effect.
This was a startling discovery; not that homeopathy doesn’t work – I could have told them this – but that the placebo effect is so significant. This means that if I complain to a doctor about an ailment, all she has to do is diagnose e something in medical jargon and prescribes me a course of sugar pills this might cure me 20% of the time, with no side effects and at very low cost.
This placebo effect explains a lot about the success of central bankers.
Financial stability and monetary policy are run not by men in dark suits rather than white coats, talking in soothingly esoteric jargon. The economic placebo effect is intuitively much more powerful than the medical one, for which your mind has to enact a physical change in your body which is quite spooky, whereas much of economic activity is driven by beliefs.
Some complain about the hubris of central bankers, yet this is essential – for the placebo effect to work, they have to act like they are in charge and know what they are doing, and indeed have a superior understanding of the workings of the economy to mere mortals.
I do not want to undervalue the importance and indeed success of having independent central banks with the twin mandate of overseeing financial stability and monetary policy. However, by understanding the secret of their success, gives an insight of where it might come undone.
The placebo effect is not the full story – the central bankers also got lucky – the 1970s and 80s were a period of high inflation, which by the 1990s had largely been tamed and it was at this time that central banks (CBs) were given their mandate for targeting inflation.
The first decade of their reign, called – by them – the great moderation, coincided with a period where increasing demand could be met by China (and then other rapidly industrialising countries) increasing production apparently ad infinitum, with the Chinese central bank immunising worsening terms of trade by buying up dollar assets.
This kept inflation low over the years. After the 2008 financial crash, where central banks resorted to unconventional methods, inflation was also not an issue. All this meant that central bankers have earned a fantastic track record at keeping inflation at bay, when actually this had little to do with them.
Their other mandate is financial stability, and for this the placebo effect was perhaps even more important. CBs are a reassuring presence in financial markets, particularly as they are run by grey main who are not going to do anything rash.
The very fact that they are sensible, generally stick to rules and are not going to do anything too drastic, and avoid knee-jerk reactions to the news cycle, gives a great deal of comfort to market actors like, as it takes out the element of risk that you might get from erratic or unpredictable behaviour of monetary uthorities.
During this period, they generally pursued pro-market policies – they repeatedly (in particular the Fed) intervened when things looked like they were going out of control – coordinating wind up of troublesome institutions (eg the hedge fund LTCM), reducing interest rates when bubbles burst (which came to be known as the Greenspam put – after the chairman of the Fed reserve Alan Greenspam). And indeed they exercised this with a great deal of skill and understanding of how financial markets work in practice.
The great moderation period, prior to the financial crisis cemented their reputation, but this came under question with the 2008 financial crisis. However even as they were blamed for this event (for the wrong reasons, see below), these were the guys who were competent and understood the financial system, and they assumed leadership, often in the absence of effective government, in the crisis and aftermath; being the only adults in the room; generally to the relief of everyone concerned.
Although measures they have had to employ during and after the crisis had negative consequences, they “saved” the system.
Since then, critics have observed an emerging saviour complex, where CBs have started to get into areas which are not obviously the mandate of central banks – for example climate policy. But even this move has largely been applauded.
Yet hubris gives rise to nemesis.
The main tool central bankers have for controlling inflation, the interest rate, is not a very good tool. The causes of inflation are complex and could be specific – for example Russia’s invasion of Ukraine precipitated a rise in energy and food costs, whereas the interest rate a very blunt tool, like using a power drill to perform surgery.
Worse, keeping inflation under control can be contradictory with financial stability. After the financial crisis this was not the case, whereas it appears to be now.
Which brings us the role that CBs played in the financial crisis. Much of the blame levelled at them was that they were not properly measuring and recognising risk. The ultimate cause was that they caused the risk in the first place; they were too good at recognising and immunising localised risk, but this caused systemic risk.
Market players knew that they would step in whenever a crisis was brewing, which enabled them to take more and more risk, when their bets won they won, but – when they lost – CBs would step in to ameliorate. So CBs trained market players to take more risks which eventually blew up.
In stopping forest fires, they ultimately caused a conflagration. And they have not learned – the recent rescue of Silicon Valley Bank being a case in point.
Inflation has now returned, and so central banks have reacted by increasing interest. But interest rates are a blunt tool, and of questionable efficacy. They could get lucky, and inflation could go down again, as markets are currently predicting. But in the early 1980s under Paul Volcker the Federal Reserve had to deploy very high interest rates – over 20 per cent and for a long period to tame inflation under. If this is what is required now or in the future, CBs are not in a position to repeat this.
Unlike at that time, we have become used to 20 years of very low interest rates, and this has trained a financial system, and economy, which expects and functions on these low interest rates. Neither the current financial system, nor the economy would survive a Volcker-like policy.
CBs do not have a social licence to cause so much harm. At some point they will be unable to control inflation. As we stand today it looks like they may not be able to maintain the stability of the financial system either.
CBs’ nemesis is the actual economy.
It is not an equilibrium system that can be governed by interest rates and simple rules, but a complex system which evolves, often in reaction to the behaviour of CBs. When CBs repeatedly do something that appears to work (like maintain financial stability), but instead this trains the system and rewards market players to take more risk, or more leverage after years of low interest rate, this causes a future crisis.
Where to go from here? If I am correct, then at some point central banks’ credibility will be shot and crucially their inflation mandate will no longer be viable – and their credibility is everything.
It has been argued that monetary policy should be brought under democratic control rather than be in the hand of unelected technocrats. The failure of CBs’ mandates would be a perfect opportunity for this.
However, whilst I have sympathy for this view, I think it would be a mistake. The tools of monetary policy are powerful, but they generally do more harm than good, and governments are tempted to use them which end up doing long term damage to economy – which is why they handed monetary policy over to CBs in the first place – the economic benefit you gain in national economic credibility outweighs a chimeric loss of control over monetary policy.
The idea of an independent body deploying the tools of monetary policy is therefore a good one, but the days of the intellectual monoculture that has dominated to date are over. Monetary policy tools are powerful economic weapon, but they have far-reaching, often unpredictable, consequences.
A new monetary policy committee might have the following characteristics:
Diversity – it should consist of a variety of intellectual disciplines.
Humility – it should employ the Hypocratic principle of only taking action if it is confident of doing no harm.
Complexity – it understands that the economy is a complex system and that any action will have unforeseen consequences, and that the system will adapt in a way in reaction to intervention.
Consequences – any action will have a wide range of consequences over different time-frames. In making decision the committee requires to balance the different outcomes.
Specific tools: the committee can suggest other interventions besides traditional monetary policy tools which might be more appropriate for a specific policy outcome – so for example if an asset bubble is brewing, then a temporary transaction tax on that asset might be a much more appropriate action than increasing interest rates.
The structure of this committee and how it is overseen is no easy matter, but will be proposed in Radix’s forthcoming manifesto.
The oversight of such a committee – which needs to balance public interest, democratic accountability, and technical expertise, could form a useful model in how a democracy effectively manages policies in an increasingly complex world.