Are you concerned about rising living costs and runaway inflation? Have you noticed how social inequality has accelerated in recent decades? Are you uneasy about the tremendous amount of debt both the public and private sectors have accrued, likely to be dumped on the next generation? All of this – and more – is linked to the policies of central banks, according to hedge fund analyst Toby Carrodus.
This article originally appeared here: https://www.econotimes.com/Central-Banks-Have-Caused-Much-of-Our-Current-Malaise-Toby-Carrodus-1645933
We recently sat down with Toby to discuss the problems associated with the current central banking landscape and what can be done about it. We think Toby Carrodus is uniquely qualified to discuss these topics. After studying macroeconomics at university, he has spent most of his career focused on “global macro” trading strategies that require an in-depth understanding of central banking policy, among other things. His career has spanned time at multi-trillion-dollar investment managers such as PIMCO and multi-billion-dollar hedge funds like Winton, as well as public research institutes including DIW Berlin. Where Are We and How Did We Get Here? Toby Carrodus explains that the current regime of central banks seeking to generate a target level of inflation arose from the 1970s era of high inflation. By the 1990s, central banks around the world had more or less implemented an arbitrary inflation rate target of 2-3% and been granted independence from elected officials to pursue this. If inflation is above the target range, central banks can increase interest rates (i.e. the ‘price’ of money) by reducing the money supply. If inflation is below the target, they can print unlimited amounts of money to lower interest rates in a bid to hit their target. If you think the fact that central banks can invent money from thin air is astonishing, you’re not alone. This truly is baffling, especially when you think about the fact that our money supply is essentially a government monopoly run by a committee of unelected technocrats! The most remarkable part? For Toby Carrodus, this is the observation that most Western democracies have adopted market mechanisms for the allocation of resources for almost everything in our economies, but we somehow retain the belief that a committee of bureaucrats running a government monopoly on the money supply is going to lead to better outcomes! From 2008 to 2021, central banks continuously missed their inflation targets and proceeded to print unprecedented amounts of money (and yes, it came out of thin air). Toby Carrodus highlights that this money-printing bonanza had several ramifications. Inequality The rapid amounts of money printed by central banks inevitably sought a new home. Much of it ended up in assets such as real estate, the stock market and bonds, creating asset price inflation. As a result, the “cheap money” policies of central banks have exacerbated social inequality, as it is typically the wealthy that own these assets. Moreover, the surge in real estate prices driven by cheap money has worsened intergenerational inequality, as it is typically the older generation that owns the most real estate. This has created a generational divide in access to housing, where most young families have been priced out of the real estate market. Reckless Speculation It doesn’t stop there, however. By taking interest rates down to zero – and in several cases negative – central banks have penalized savers and forced them to take on excessive risk to generate returns on their cash. This is hardly a prudent, sustainable strategy. What is more, argues Toby Carrodus, is that the current central banking practice of cutting interest rates during market downturns causes speculators to increase their exposure to risk as they no longer bear the full cost of that risk. That is, by creating the expectation that central banks would print money to support markets if they fell, speculators engage in more reckless risk-taking activities. Accelerated Global Warming Another problem associated with excessive money printing is the acceleration of global warming. By propping up economic growth artificially with cheap money, central banks have led to greater consumption of the earth’s finite resources than if interest rates had been at a higher level. Furthermore, Toby Carrodus cites research by the London School of Economics that the corporate bond buying activities of central banks such as the Bank of England and European Central Bank have been concentrated in carbon-intensive sectors such as utilities. This has directly lowered the cost of funding to industries emitting the most carbon, encouraging greater carbon emissions by making it cheaper to emit carbon than would otherwise be the case. Boom Bust Cycles Toby Carrodus explains that monetary policy is famously a blunt instrument. It operates with long and variable lags. Central bankers must first gauge the general price level of an economy by collecting data on the prices of all sorts of goods and services. They must then process this data, analyse it and decide on the appropriate short-term interest rate for the economy. By the time the interest rate is agreed, the data used to set it is already stale. Moreover, it takes months for a change in interest rates to ripple through the economy. Hence, a tremendous amount of time passes between the time when the data on the state of the economy is collected and the impact of any change in interest rates, meaning that there is a large disconnect between a monetary policy decision and the state of the economy at any point in time. Toby Carrodus argues that this is the main reason monetary policy tends to over- and under-shoot its target range. The implication? We end up with large boom and bust cycles. Interest rates tend to stay too low for too long, only to violently shoot in the other direction, as we have seen in 2022. Overall, the boom and bust cycles of interest rates create tremendous uncertainty for both companies and workers. Indeed, by over- and under-shooting their target rates and exacerbating boom and bust cycles, central banks tend to achieve the exact opposite of a ‘smooth business cycle.’ An Alternative Toby Carrodus proposes an alternative to committees of bureaucrats second guessing themselves in setting interest rates. Instead of a government monopoly on the money supply, we could adopt a competitive, market-based solution. Society has learned so much of the benefits of market-based mechanisms for the allocation of resources compared to the centralized, committee-based approach that has been shown to fail so spectacularly in countries such as Russia, China and Cuba. As an example of how countries have beneficially adopted the use of markets, Toby Carrodus cites the airline industry, which began as a government monopoly. At the outset, most of society thought it inconceivable that private companies could compete to efficiently provide airline services given the high fixed-costs of airline fleets and the fear that competition and price-pressures would erode safety standards. Several decades later many members of society would now find it inconceivable that such services were ever a government monopoly! Banking Coin We already use a competitive market-based mechanism to determine longer-dated interest rates with much success. In order to remove the government monopoly over the money supply and short-term interest rates, we would need to allow for competing currencies or forms of payment. The most ideal way of doing this that Toby Carrodus can think of is by allowing large banks to issue their own coins as a form of payment. In a way, we already do this when we pay with a credit card from a bank instead of cash. E.g., when you use a Wells Fargo credit card, you are implicitly assuming the credit and payment risk of Wells Fargo (instead of assuming the credit and payment risk of the government when you pay in cash). The benefit of allowing banks to issue their own coins is that they are regulated. They also have the implicit backing of the government. Furthermore, Toby Carrodus argues that banks issuing their own coins would remain in competition with each other to acquire customers and for people to utilize their coins. Arguably, none of these banks would issue so much of its own coin or currency so as to inflate it, as this would cause the currency to lose purchasing power. The Power of Price Signals Toby Carrodus argues that allowing markets to determine short-term interest rates would mitigate many of the adverse side effects central banks have created by persistently over- and under-shooting due to the tremendous lags involved in setting interest rates by committee. One of the key reasons behind this is that by relying on the signalling information of market prices, markets make use of dispersed, decentralized knowledge that is not capable of being communicated to any single individual in its entirety. By relying on price signals, the ‘man on the spot’ can make suitable and timely decisions based on localized knowledge as opposed to engaging in a lengthy process of collecting and transmitting information to staid central committees and waiting for them to make a decision.
Toby reasons that relying on price signals is powerful because one does not need to know why a given price has increased or decreased. Instead, if a price has risen, this communicates in a timely manner that there is a shortage of supply relative to demand in a given market and workers and companies in the economy are free to choose whether to increase production in this good or to substitute this good for a cheaper good that is in greater supply.
What About the Crypto Bros? It is no coincidence that cryptocurrencies have emerged during a time when the low and negative interest rate policies of central banks have debased many of the world’s currencies. Cryptocurrencies were a necessary step in the spontaneous evolution of the growth of society and paved the way for the introduction of private currencies to determine short-term interest rates and the ‘price’ of money. The excessive volatility of cryptocurrencies has rightly served as a deterrent to their adoption as a means of payment.
Toby Carrodus argues that due to the strong regulatory regime imposed on banks after the Global Financial Crisis, as well as the implicit backing of the government and homogeneity among big banks, bank coins would not suffer from the same level of volatility as cryptocurrencies, many of which were invented for reasons other than serving as a form of payment. Indeed, much of the speculative frenzy that occurred in cryptocurrencies is a result of the cheap money excess of central banks, which could not occur if we ended the government monopoly on the money supply but instead allowed banks to issue their own coins!
Wrapping it Up So, there you have it. As Toby Carrodus has explained in depth, the archaic way of setting interest via centralized committees is really a remnant of a bygone era and fraught with problems. Western societies have demonstrated time and time again the advantages of allocating resources via market-based mechanisms. Allowing large banks to mint their own coins as a means of introducing competition into currency markets is a natural, inevitable step in the continued evolution of society and offers a promising alternative to the problems inherent to central banking.
If you found this interesting, Toby has written in greater detail on this topic here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4209973 We thanks Toby Carrodus for his time in explaining this and hope you learned something valuable too!