Monday, 23 June 2014

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.


  1. Nice article. Glad I found your blog and looks like there is plenty of reading for me to do.Cheers :)

  2. You have a good site neighbourhoodeconomist. Though rather than talk about all the points I agree with, which are most of them, I would like to bring up another point instead.

    "Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans"

    Many people say this and talk about banks creating money from thin air but do they? Well yes but only in the short term, as you have to pay back more money than the loan and debtors do not have a printing press, the long term effect is to destroy money.
    This means that a booming property market at first creates a lot of extra money from the loans and then as the loan is repaid, sucks it up from the rest of the economy. Much of this money going to property owners, estate agents, banks and the elderly, a mostly regressive money redistribution.

    1. Thanks for your comments.

      I would agree with your interpretation in that banks create money by issuing loans but that money is also destroyed when the loans are repaid. The long-term effect is neutral but there is a tendency for the amount of debt in an economy to grow over time which would suggest an expanding money supply.

      The issue that I was trying to raise in this blog post was that central banks no longer have much control over the money supply. If the money supply fluctuations due to the actions of banks (more lending during a property boom), it makes it more difficult for central banks to manage the economy. I do not think that setting interest rates has much of an effect and controlling the money supply would give central banks more leverage especially if extra cash could be put in the hands on consumers rather than banks or into the property market.

      I wrote a blog post on this line of thought if you are interested,

      I also agree that the extra money in the economy (which includes the cash created through quantitative easing) is often working for the benefit of the wealthy and older portion of the population. Due to their weight in numbers and tendency to vote, the older generation is doing better out of the current setup of the economy. The financial sector also gets more than their fair share of the wealth that is created. These are two topics that I have written about in the past. I do not think that this is fair but it make take a new generation of leaders and some fresh ideas for any of this to change.

      Please let me know if you have any other follow up questions.