Central Bankers Really Have No Idea What They're Doing with Money

The ECB this week maintained its commitment to steadfast blindness. Don’t worry, they’ve done this before. Twice, actually. At least in 2018 they are only pledging to end what will be nearly four years of quantitative easing. There hasn’t been any easing, and given how QE has been changed along its trajectory it can’t have been too quantitative, either.

In 2011, believing similarly it had reached the end of its task Europe’s central bank exited then, too. Seven and a half years ago, officials voted for two successive benchmark rate increases, first in April and then again at the beginning of July. Mere weeks after the second, the world was in crisis again. Before the end of the year, Europe’s entire economy was in recession for a second time in three years.

Central bankers didn’t cause that contraction just as they hadn’t the first time. In July 2008, Europe’s Economists declared Europe free from overseas turmoil. The Americans were in trouble but even then it seemed, to Economists anyway, they would pull out of it before it went too far. The ECB raised its benchmark rate 25 bps to 4.25%.

Just as it would in 2011, in 2008 the institution ended the year going in the other direction. Officials were quick to declare the panic “unexpected” and therefore what could they do? One ECB Executive Board Member, Gertrude Tumpel-Gugerell, would attempt to explain ten years after the rate hike:

“Lehman was unpredictable. It’s true that we saw strong credit expansion in the years before, but the systemic crisis couldn’t have been foreseen. Our main objective was to keep inflation expectations anchored, even if growth was slowing somewhat.”

Balderdash. For one, what did Lehman have to do with euros? To answer that question honestly would mean seeing these central bankers for what they really are.

Markets are being reminded again in 2018 after, frustratingly, giving them the benefit of the doubt in 2017. There was some mild enthusiasm over globally synchronized growth, the idea that after a decade plus of stumbling around Economists had finally hit upon the right mix of policies to engineer full recovery at long last.

It was a preposterous idea given recent history. What were the chances, really, that after getting everything wrong for so long they would just get it right out of nowhere? Random good fortune, which the world holds in shorter supply than eurodollars these days, would have been the better bet.

In announcing his intention to end QE, ECB President Mario Draghi acknowledged this week, “incoming information, [is] somewhat weaker than expected” but that won’t deter the policy. Why would it? Draghi is merely returning to tradition, European officials who see an economy doing the very thing it isn’t.

There’s trouble in Germany, and if there’s trouble in Germany it will be worse elsewhere throughout the Continent. While Draghi was sounding petulant, that country’s IFO Centers for Economic Studies (CESIFO) released more troubling news. Sentiment weakened as conditions deteriorate, or “somewhat weaker than expected” if you prefer. Manufacturing assessments, in the aggregate, fell to the lowest since early 2017. Incoming orders declined for another month.

“Firms were less satisfied with their current business situation and less optimistic about the months ahead. Growing global uncertainty is increasingly taking its toll on the German economy.”

This follows closely another German economic survey, the ZEW, which worsened again also in September. Its Indicator of Economic Sentiment dropped back to -24.7, matching a multi-year low seen in July. The last time the ZEW was this bad on the way down was…August 2011.

If we look back at 2011 and 2008 what we find in both is the same “growing global uncertainty” as 2018. As yet, however, central bankers haven’t learned how to account for it, which is one reason why they don’t. In their view, Lehman was subprime mortgages and yet it was the final spark before full-blown worldwide panic and a global economic crash. Greece was supposedly the issue in 2011, but everywhere from China to Latin America to America the economy hasn’t yet recovered from it.

How did it get this way?

The answer is Paul Volcker. Mr. Volcker has been in the news, too, this week. Apparently in ill-health, the former Chairman of the Federal Reserve, the one before Alan Greenspan, Volcker has a lot to say. He told Andrew Ross Sorkin of The New York Times, “We’re in a hell of a mess in every direction.” It’s impossible to argue with him on that point.

“Respect for government, respect for the Supreme Court, respect for the president, it’s all gone. Even respect for the Federal Reserve.”

You can sense in his words great regret, a palpable degree of serious lament over how his predecessors at the Fed may have squandered his legacy. But what was his legacy really?

Volcker left the central bank in 1987 but wasn’t exactly a shoe-in to be reappointed in 1983 for a second four-year term. It was in his first stretch that made him the legend. One New York Times article written in March of ’83 on the topic of his uncertain reappointment ably summed up convention on Volcker.

“More important than theory is the fact that Mr. Volcker has come to be regarded as the helmsman who deserves most of the credit - blame, some say - for the tight-money policy the Fed pursued until last summer, a policy that brought on a deep recession that, in turn, slowed inflation from roughly 10 percent to 5 percent.”

He would come to be seen as the roaring eighties roared without the reemergence of the inflation monster as the man who single-handedly ended the Great Inflation. It would have been no small accomplishment, either, given that for fifteen years inflation was widely alleged as beyond anyone’s control.

Volcker would push short-term interest rates into double digits - twice. There were two recessions in the early part of the decade as a result, the second standing until 2008 as the worst since the Great Depression. His resolve in the face of unrelenting criticism was truly legendary. That much cannot be argued.

It was from this resolve that everything moved – a committed central bank could accomplish anything no matter what. The Federal Reserve itself would evolve as a consequence. It started the Great Inflation targeting money, and it ended it doing something altogether different. Because of the end of inflation, this different regime came to be regarded as the right choice.

As I have written about for years, in the tradition of a very few before me, the sixties and seventies were the period of “missing money.” If you are a central bank whose given mission is low unemployment and inflation, and intend to accomplish that mission naturally by targeting the money supply since inflation is a monetary phenomenon, missing money is an existential threat; which accurately and succinctly describes the Great Inflation.

If you can’t define money you certainly won’t be able to target it. Everything else falls into line from there. That includes the shift in monetary policy. Moving from Volcker forward, there wouldn’t be any money in it anymore. The Fed began to target other things simply because targeting money was, for them, impossible.

The global system (eurodollar) had begun to use exotic and undocumented transactional formats as money equivalents. Repo was a big one in those days, but tame now by 21st century standards. These were then expanded to offshore shadow spaces and expanded some more. Alan Greenspan would a quarter-century later only partially lament this “proliferation of products” before getting back on TV.

But if the central bank could no longer target money as it had done before, what did they do instead? Policymakers would shift beyond money into the real economy. What I mean by that is that they would take no notice whatsoever of the monetary system itself, the actual transactions in all their gory, incomprehensible details. In place of money they would stand to target a single interest rate.

By doing this, they set up what was essentially a default position. Banks operating in money markets would do whatever it is they wanted to do, and central bankers would take little or eventually no note of all that. Control would be removed from monetary cause and economic effect to working backward from economic effect.  

It came to be believed that by doing so banks could define and use money in any way they saw fit, but all those hidden formats and uses would be governed in the aggregate by that single interest rate. When you step back and really appreciate what was attempted, it really is staggering conceit.

This requires a dramatic change in the way policy is made, too. When you target the money supply, you target the money supply. Forgive the tautology but it’s just that simple. You have to make judgements about the target, of course, but if the money supply starts to rise in relation there isn’t much thought about your response.

And that response is immediate.

In non-money monetary policy it is very different. Entering the economic process closer to the end than the monetary beginning, the central bank is forced into the future with its intentions. It has to rely on often far-out forecasts. It doesn’t know anything about money, therefore it is basing policy on the perceived results of what it doesn’t know.

In a simple system, if money becomes too plentiful we expect inflation to result. Under a money targeting system you don’t need to wait for the inflation to act; you stop the monetary growth before it ever gets that far.

But if you can’t define money and stop measuring for it, you have to predict inflation as it relates to other factors, often distant and indirect. It’s not so simple, and it puts the central bank in a huge bind. This method essentially trades monetary competence for the lust over forecasting skills. Thus, the unmovable infatuation with econometrics, especially of the neo-Keynesian variety (that doesn’t include the financial system as a modeled component).

I am oversimplifying here, but after Volcker in the early eighties this approach seemed to be corroborated by events. Consumer inflation stopped and the economy started to grow again without it. The so-called Great Moderation developed in the aftermath.

Without being able to define and measure money, however, there was no way to really be sure this evolution in monetary policy was responsible for it. Or whether it really was so moderate.

That’s why more than halfway into the Great “Moderation” many economists began to wonder what was really going on. The term itself was coined by a couple Ivy League Economists who, in the aftermath of the dot-com bust, were a little worried about being unable to explain exactly why everything was the way it was – and be able to tell if it would continue that way.

James Stock and Mark Watson in April 2002 would nervously conclude:

“But because most of the reduction [in economic volatility] seems to be due to good luck in the form of smaller economic disturbances, we are left with the unsettling conclusion that the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times.”

This was the real legacy of Volcker; determined monetary ignorance had left Economists unable to see or explain the very basis for the global economy. It wasn’t some minor, trivial matter to have puzzled over. 

That much the world would confront just five years later. When faced with a problem in US subprime mortgages, Ben Bernanke, Volcker and Greenspan’s intellectual heir, was sublimely confident it was all a big nothing. European officials, too, which is why just two months before Lehman they were more concerned about their economy overheating. All of them relying on economic forecasts rather than being able to check those assumptions by close scrutiny of actual, effective monetary conditions.

But what is most scandalous of all is how this hasn’t been changed despite what happened ten years ago. Central bankers are still making forecasts from the same position of monetary ignorance, and thus they repeatedly get them wrong. They seek comfort in continuing to do things the way they’ve been doing them since Volcker, but they shouldn’t.

Many people have been betting that 2018 would be different. This time the forecasts (already trimmed down) would for once prove valid, they said. That’s always a possibility, but it would require more “good luck” than anyone has available.

Central bankers and Economists are sticking with their forecasts regardless. Draghi is matched and even exceeded in optimism by the Fed’s latest Chairman Jay Powell. Money markets, these eurodollar shadow spaces, are rendering them inoperable all over again. In one other development this week, the effective federal funds rate is now equal to IOER. They really have no idea what they are doing when it comes to money. And if they don’t know that, how can they have any idea about economy?

Just as Volcker was beginning his second term in 1984, former Treasury official Robert Roosa was very differently warning about:

“…the enormous expansion in markets for U.S. dollars offshore, and the new networks of interbank relations that made possible the creation of additional supplies of dollars outside the United States and beyond the control of the Federal Reserve.”

Roosa did this at a conference in Bretton Woods sponsored by the Fed’s Boston branch.

What really happened in the early eighties, and this is the part most people have the greatest difficulty accepting, central bankers by losing touch with money let themselves become bystanders. They really believed they were in control of everything, and this what we’ve all been taught from Econ 101, by moving just the federal funds target around a little here and there. There was, in this detached view, no downside or detriment to knowing nothing about how anything was being funded (or where). It was all just myth and legend, beginning with Paul Volcker.

In the biggest ironic twist of them all, their continued forecast errors are predicated on this very myth. Every one of the central bank models simply assume that central banks aren’t really bystanders, which is why they never get them right.

The ECB’s rate hikes in 2008 and 2011 remind us of this uncomfortable truth. Europe’s central bank didn’t cause either crisis, for Europe or anywhere else, it merely went along for the ride completely helpless just like all the rest of them. Mario Draghi forecasts still good things ahead, but how would he know? It was Volcker who taught him and his compatriots they don’t have to.

This explains a lot about the last eleven years, and says even more about 2018.