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Central banks are doing stupid things

Aug 10 2016 14:57
Edward Ingram

These are exciting times for theorists in economics like myself and others. If central bankers have proved anything over the past decade, it is that they have a great deal to learn.

Their science is not so much a science as a complete muddle.

In science you start with sensible guesses about what is needed, you make deductions and then you test your theories.

Central bankers have not taken the basic step of making sensible observations and guesses about what needs to be done.

As I explained last week, they have not even asked for the financial framework of the economy to be made safe so that people's finances can adjust to the falling value of money.                                                                 

Macro-economic design is first and foremost about identifying the principles to be followed for the good design and management of an economy.

What follows from that are opportunities for innovators to create a new design and a new management regime.

Last week I gave an outline of how, if all savings and lending contracts were to be reformed to make us all safer, everything simplifies. If that were done, the management system would not have much left to do.

Even overlooking this failure to simplify their task, central bankers are doing stupid things.

The quantity of money

They are fully aware that an economy needs enough money in circulation to enable it to work efficiently. Without enough money to allow people to pay one another, people and businesses have to wait to be paid before they can pay their own bills. While they are waiting or costs are piling up, everything is slowing down. If too much money is created, the value of money falls and that is not such a good idea - except that having a little too much is probably better than having too little.

There are two kinds of money in circulation which can be used to settle accounts, but as explained in the next essay but one of this series, the meanings of 'base money' and of' fiat money' are both wider than I have attributed to them below. I would change those words but currently there are none with the exact meanings I give below.

There is base money which is printed either as paper cash and coins, or created by the central bank's computer and distributed to other bank accounts in one way or another. (How that is done is critically important - something for my next essay.)

Base money has the attraction that it has something of a permanent character, unless it is burnt in a fire or otherwise deliberately destroyed.

The other kind is called 'fiat' money. The problem is that when this fiat money gets repaid to the bank, the money goes out of circulation. More fiat money cannot be created to replace the money taken out of circulation when the loans are repaid, unless and until someone wants to borrow more fiat money to replace it.

The problem is that when this fiat money gets repaid to the bank, they are not allowed to keep it. If they kept it, they would endlessly enrich themselves without doing any work. Instead, they delete that money as the account gets repaid. More fiat money cannot be created to replace the money taken out of circulation when the loans are repaid, unless and until someone wants to borrow more fiat money to replace it.

So the economy expands and thrives just as long as there are enough borrowers willing and able to borrow ever-increasing amounts of fiat money.

Continuously reducing interest rates makes borrowing cheaper and cheaper. A similar pattern has been followed by most developed economies South Africa trades with.

Reportedly, a few years ago a point was reached when 97% or more of all money needed to run some economies was fiat money. When the economies of those nations started to slow down, they lowered interest rates.

In other words, instead of creating the necessary base money, they created a society which could not prosper unless it borrowed ever-increasing amounts. Soon a decade of prosperity will have been lost because people are already borrowed to the hilt.

Next time I will explain how they attempted to solve the problem. By doing so in the wrong way, they inflated the price of houses, bonds, and investments of every kind. They have exposed every borrower and every saver to heightened risks. The whole economy is now unstable in a way never before seen in history.

edward ingram  |  economics  |  opinion
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