Fantasy of the magic money tree

Central banks will come under increased pressure to “do good” by politicians

Tim Congdon

This article is taken from the April 2021 issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering five issues for just £10.

There is no such thing as a free lunch.” Or so Milton Friedman assured us in the title of a 1975 collection of his newspaper articles. However, economies are complicated mechanisms and Friedman’s dictum is not entirely true. 

The state has the undoubted ability to create money, nowadays usually delegated to central banks. In a depressed economy — where output is a few per cent beneath its trend level — a sudden injection of extra money balances boosts economic activity, and so increases output and employment. Money injections of this sort — “quantitative easing” — do not in any meaningful sense require costly resources. Central banks seem to have a magic money tree which does provide free lunches.

The temptations are then obvious. Once it is understood that central banks have great power over economic outcomes, the major constitutional question arises of how that power should be exercised. Should the central bank have just one mandate: to conduct operations in the pursuit of a single easily-defined and technical objective such as price stability? Or should it kowtow to political instruction in the apparently costless pursuit of assorted other ends, including a wide range of socially desirable objectives? Why should it not become a dual-mandate or multiple-mandate organisation?

The rapid inflation of the 70s and 80s persuaded governments that central banks should have independence

The rapid inflation of the 1970s and the 1980s persuaded governments in many countries that central banks should have operational independence to focus on protecting the real value of the currency. The Bank of England was granted this status in 1997. It delivered excellent macroeconomic results in the following decade, but the Northern Rock crisis broke in September 2007 and the Great Recession followed about a year later. In 2009 the Bank responded to the challenge by a big and highly controversial QE programme. The recession came quickly to a halt, but the debate on the Bank’s constitutional position was re-opened.

One aspect of this debate is long-standing and has been discussed in a vast academic literature. QE’s achievement in promoting recovery might be thought to argue that the central bank should be made responsible for full employment. The American central bank, the Federal Reserve, does have a dual mandate — to seek both price stability and full employment — and its present chair, Jay Powell, seems to take full employment more seriously than price stability. As inflation is undoubtedly accelerating in the US, the wisdom of Powell’s position and the dual-mandate approach will be tested in 2021 and 2022. 

But why limit the central bank to the quest for full employment? Future generations are threatened by global warming which may bring civilisation to an end, or so we are told and as many people (perhaps wrongly) believe. Does it make sense to insert in central bank legislation a few clauses about how money market operations should somehow be structured to lower the earth’s temperature in 2044? 

If that sounds implausible, why not at least require monetary policy committees to give instructions about purchases of bonds issued by tidal power companies and battery technology start-ups? Decarbonisation and renewable energy are obviously good things, are they not? And — if so — why shouldn’t experts and do-gooders advocate that central banks help in a global environmental clean-up? 

The dominant long-run economic problem remains the efficient allocation of scarce resources

This is not theoretical. In January the European Central Bank president, Christine Lagarde, gave a speech on “green banking and green central banking”, saying, “ECB Banking Supervision has requested that banks conduct a climate risk self-assessment and draw up action plans, which we will begin assessing this year. We will conduct a bank-level climate stress test in 2022.” The plan is evidently that banks making loans to oil companies will be punished. Even the phrase “Green QE” has been put into circulation by the Positive Money pressure group.

For now the UK legislation on the Bank of England’s role focuses on price stability, despite an ever-changing elite consensus and fickle public opinion. Traditionally, central bank operations have been monetary in intent and conducted in government bonds free from default risk. The Bank of England may soon be expected to invest in green bonds and lend to green companies. There is a far from trivial housekeeping issue: that its officials will need to ensure the money is repaid. If losses on green investment were to become substantial, the Bank would need to ask the Treasury to top up its capital and would become yet more vulnerable to political interference. 

The success of QE has become dangerous. In 2009 it proved an effective and virtually costless response to recession when a proportion of the nation’s resources was unused. But the dominant long-run economic problem remains the efficient allocation of scarce resources. Central bankers are not magicians. Public figures who advocate giving them a multiplicity of mandates, including full employment and climate change, are engaged in misguided virtue-signalling. 

In all of the US, the eurozone and the UK the quantity of money has risen by over 10 per cent in the last year, far ahead of the underlying growth rate of output. The coming rise in inflation will not be good for the reputations of Powell, Lagarde and their supporters in the commentariat who fantasise about the ability of the printing press to create something from nothing.

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