How central banks thought they had slain the main threat to the economy but the real menace was lurking elsewhere
Economics is a narrative on how the economy is supposed to work, but the path to economic success and riches is often fraught with danger. The cautionary tale of interest rates and money supply serves as one such example. The hero of the story was meant to be central banks whose role was to control monetary policy which involves looking after the amount of money in the economy. Interest rates were deemed the best weapon to regulate the money supply and a couple of decades of success ingrained a belief in this view of the world. However, the global financial crisis put an end to hopes for a happy ending and economists are still struggling to come up with a new script.
What was supposed to happen
The original scenario relied on central banks being able to influence the money supply by setting interest rates to the appropriate level. Central banks would not target money supply directly but focus on inflation instead. Economic theory states that inflation is the result of an expanding amount of money in the economy. More money equals higher prices. So, if prices are rising too fast, this is due to an excess of money in the economy. Higher interest rates act as a damper on inflation because the amount of money moving around the economy drops off as the demand for loans falls and consumers leave more cash in the bank.
The focus on inflation also stemmed from its leading role in telling how well the economy was doing. Inflation has gotten out of hand and wreaked havoc in the past so economists are determined that this storyline was not to be repeated. Inflation is also easy to keep tabs on compared to money supply which is tough to define, let alone measure (the money supply could include cash as well as money in banks (current or savings accounts) and other funds).
All good in theory. And it even worked in practice for a couple of decades from the late 1980s. Economists thought that their ideas had enabled them to conquer inflation and smooth out the boom and bust cycles. But all of the good work of economic policy was undone due to an inherent flaw in the theory. Growth in money supply not only affects consumer prices, which central banks watched over-closely, but also in asset prices, which were not seen as a concern.
Need for a new narrative
It is no surprise that the villain in this story is the banking sector. Banks were left in charge of setting the money supply which rises and falls depending on the amount of lending. The volume of loans (along with the money supply) exploded during the favourable economic conditions over the years leading up to the global financial crisis. Banks were able to take advantage of the growing demand for credit due to innovations in finance that meant that banks could pass loans onto others and not have to worry about loan repayments.
A large portion of the loans was used to buy existing assets such as houses or shares. The resulting gains in asset prices, which surged ahead of growth in the underlying economy, sowed the seeds for the crisis to come. Meanwhile, a dramatic increase in global trade meant that inflation was no longer determined in the domestic economy but was highly influenced by global markets. Cheap imports from China reduced the prices of products like clothes and electronics. Imports were also on the rise and the prices of any internationally traded goods no longer depended on the money supply in any one economy.
Subdued inflation meant that the results of the rampant increase in money supply did not jump out at central banks. Their focus on consumer inflation led central banks to disregard the asset price bubble growing in their midst. Instead, it was argued that financial markets would always set the appropriate prices and that central banks should not get involved. The irony is that any extra cash tends to influence asset prices even more than consumer prices (as shown by the effects of quantitative easing) but this effect is near impossible to separate from other factors (hence the reliance on inflation).
It was revealed that central banks had been setting interest rates too low to keep the economy from getting into trouble. The whole messy chapter could have been avoided if the money supply had been kept under control. A simple solution would be for the economy to be left to its own devices with a relatively stable money supply. Greater demand for loans would push up interest rates, stopping debt levels from becoming excessive while also benefiting savers.
Despite the obvious solution, economists are loath to give up on the fairy tale they always believed would come true. It may take time for a new economic story to be written but the changes should mean a brighter turn in the future of the economy. With this, at least the sobering ending to the latest chapter of the economy should come with a silver lining.