Wolfgang Munchau, FT:
Every few decades or so, the world of central banking turns upside down. Over the last 100 years we had systems in which central banks targeted a fixed conversion rate to gold, the supply of money in circulation or, more recently, a rate of expected future inflation. A combination of deep changes in the money markets and financial crises is now conspiring towards another big change. This debate is still confined to a small number of experts in central banks, and academics. It is best to approach it in the spirit of the great physicist Richard Feynman, who remarked that he preferred questions that cannot be answered to answers than cannot be questioned. Much of economic orthodoxy that surrounds the world of central banking is unfortunately of the sort that avoids questions. And what makes this debate so unsettling for some is that we have no simple answers. One question is whether and how the changing role of money and finance in our modern economies could destabilise them. The economists Daniela Gabor and Jakob Vestergaard have done work on “shadow money”, a concept closely related to shadow banking. Traditionally, there used to be a clear line between money and debt. Debt is a tradable security. Its price changes. The issuer can default. Money is not tradable. Its value can be eroded through inflation, but money does not formally default. In the world of modern finance, money and debt become increasingly commingled, in a risky way. One financial instrument where this is the case is repurchase agreements, or repos. Think of a repo as a loan from one financial institution to another, against tradable collateral, mostly government bonds. These repos have all the characteristics of money, but with a twist. The debt, which serves as collateral, becomes an integral part of the package. Debt and money are no longer separate. The commingling of money and debt has important consequences. One particularly dangerous side-effect is a valuation doom loop. The more financial institutions trade in repos, the more bonds they require as collateral. That increases the price of those bonds and reduces their yields. This in turn makes these financial instruments even more attractive for the money markets. This type of money is critically dependent on governments issuing enough bonds to feed the beast. It is not hard to see how this snowball game can come to a violent end. And it raises fundamental issues about the separation between central banks and governments — the central bank is clearly not the sole or even the main source of money in the economy. The dominance of these instruments also reduces the central bank’s capacity to take control in a crisis. In the eurozone, for example, if all governments followed the German example by adopting structural fiscal surpluses, the result would be a dramatic shortage of collateral, which could easily trigger the next financial crisis. So could a sudden rise in interest rates by the European Central Bank. This is not about to happen, but may become necessary if inflation were to rise faster than expected. This is the astonishing conclusion of the research: “The political economy of shadow money is nothing short of radical. Shadow money erodes the Great Moderation institutional arrangement that celebrates independent central banks preserving price stability (and growth) and suspiciously demands fiscally prudent governments informed by neoclassical growth ideas.” It continues: “Co-ordination between the Treasury and the central bank becomes essential.” This means an end to central bank independence and an end to old-school fiscal stabilisation. The whole system would have to be ripped up, including inflation targeting, which became de rigueur in the 1990s. It is deeply rooted in modern economic theory. For a while it seemed to work, but that may only have been an optical illusion. Before the crisis, it was nearly impossible for central banks to miss their target. Since then, it has become impossible to hit them. This suggests that central banks exercise less control than they think. There is one point on which I agree with the conservative criticism of modern monetary policies, as expressed by Claudio Borio, chief economist of the Bank for International Settlements. He warned recently that central banks may have to fight the next financial crisis long before they hit their inflation targets. This is another potential doom loop, one of permanent financial instability coupled with permanent below-target inflation. Nothing in this analysis suggests that a crisis is about to hit soon. But the modern world of transactional money markets will either produce a crisis or force us to dump our policy orthodoxy, or both in succession.