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Conclusion: A timely warning about central bank folly

3D printed percent symbols are seen in front of dollar bills in this illustration taken May 25, 2020. REUTERS/Dado Ruvic/Illustration

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LONDON, July 8 (Reuters Breakingviews) – Edward Chancellor’s scholarship, expertise and wit are no secret to readers of his Breakingviews columns. However, some of you may not know that he also has a strange sense of timing.

In 1999 he published “Devil Take the Hindmost”, his superlative history of speculative manias. Within a year, the Internet bubble had burst. His next book, published in 2005, prophesied that it was “Crunch Time for Credit”. Eighteen months later, the biggest banking crisis in history had begun. Now Chancellor has given us “The Price of Time”, a searing polemic against the evils of artificially low interest rates. Just at the right time, the butter sauce of ultra-loose monetary policy came to a halt. So maybe you should not only buy this book but sell all your shares.

“The Price of Time” tackles the biggest economic question of the past 15 years. Have the experimental monetary policies pursued by the world’s main central banks since the financial crisis of 2007 and 2008 been a miracle cure or a historical error? It places this contemporary dilemma in a rich historical context. For this is only the latest installment in an old debate about the nature and role of interest in a well-functioning economy.

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The Chancellor defines the fundamental questions at stake with the help of a famous debate, conducted in 1849, between two members of the French National Assembly on the type of monetary policy that would best serve the new democratic ideals of the revolution of l ‘last year.

On one side, the radical anarchist Pierre-Joseph Proudhon. He argued that charging interest on capital retards investment, reduces employment, and is socially unjust. “I call it interest theft,” he concluded, arguing that in a progressive economy, credit should be cheap and ideally free.

On the other side of the argument was Frederic Bastiat, France’s leading advocate of liberal capitalism. Positive interest rates, he insisted, are essential to the health of the financial system. Without them, lending would dry up and growth would stall. The “free credit propaganda”, he replied, “is a calamity for the working classes”.

For the next century and a half, Bastiat’s opinion prevailed. But after 2008, a miraculous conversion happened. One by one, the world’s major central banks have cut their policy rates to zero – and in some cases below. In 2020, bonds worth over $18 trillion were trading at negative yields. In Denmark, home buyers were paid to take out mortgages. Proudhon’s anarchist self-interest theory has finally made its way to the sun.

The results, according to Chancellor, were just as dire as Bastiat predicted. Capital allocation has been distorted; poorly assessed investment risk; destabilized pension systems; fossilized social mobility; and moderate investors polarized into idle rent-seekers or once-living speculators. The Chancellor argues convincingly and worryingly that excessively loose financial conditions are behind it all.

How did central banks come to make this fateful transition from capitalist to anarchist economics? The Chancellor identifies two main culprits. The first is the widespread adoption of inflation targeting from the 1990s. By focusing on consumer price increases, central bankers have become blind to the collateral damage caused by low interest rates. The result was “a massive real-time Milgram experiment, with the citizens of the world as guinea pigs.” It’s a memorable metaphor, though central bankers will rightly counter that the prosecution unfairly ignores their enormous efforts to improve financial stability through banking regulation.

Chancellor’s second allegation, however, is more fundamental. This is because the contemporary central bank has made a mistake in its basic methods. Again, “The Price of Time” represents the latest salvo in an old debate. Should central banks limit their ambitions by strictly adhering to a passive rules-based framework, while letting financial markets determine interest rates in response to the changing needs of the economy? Or should they try to fine-tune economic and financial cycles through discretionary interventions?

Modern central bankers have tried to have their cake and eat it, combining the practical freedom of discretionary policy with the theoretical straitjacket of aiming for a “natural,” non-inflationary real interest rate. Yet this natural rate is an elusive norm: it can only be inferred retrospectively from the absence of inflation. The fear is that this circularity will at best lead to late rate setting; and at worst to a hall of mirrors in which a supposedly independent monetary policy instead becomes a residue of the market environment it helps to create. The eruption of inflation over the past 12 months has done little to ease this concern.

The Chancellor maintains that breaking this impasse is only possible by restoring strict monetary policy rules. As an example, he names base money issuance in line with the trend GDP growth rate. Free from the interference of central bankers, he predicted that interest rates would rise to their natural level and the economy would be restored to proper functioning.

With the resurgence of inflation now forcing the issue, reforms like these deserve serious consideration. The only question – and it is not trivial – is whether the balance sheets bloated by the era of ultra-low interest rates can manage the necessary transition without major crisis. The carnage caused by the same modest increase in borrowing costs so far in 2022 is not encouraging.

At least if you’ve read that scintillating book and listened to the Chancellor’s infamous signal, you’ll know what to do when we emerge from the wreckage. And you will soon do so.

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“The Price of Time: The Real Story of Interest,” by Edward Chancellor, was published by Penguin on July 7.

Felix Martin is an economist and fund manager. He is the author of “Money: The Unauthorized Biography”.

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Editing by Peter Thal Larsen and Oliver Taslic

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias by principles of trust.

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