Uneasy Davies

Before I delve into the blog posts of Gavyn Davies, I shall give him his due first. He is uneasy and uncomfortable with the unprecedented central bank support to the financial systems on either side of the Atlantic. That is a plus. Not too many are uncomfortable. That is unfortunate.

However, he is not bold enough to go beyond that. In fact, he falls back on the side of the ‘system’. There is too much at stake for many to come out and state that the system is broken and that trying to keep it going is like trying to pump the heart of a dead body.

I refer to his blog posts of Jan. 8th and Dec. 11th. In the post of Jan. 8th, he takes up from where he left off on December 11th. His conclusion on Dec. 11th sounded good and set a good platform to launch into a further critique of these central bank actions. But, on January 8th, he held his fire.

First, his conclusion on Dec. 11th:

Because this behaviour is so unprecedented, it is hard to predict the medium term consequences of such a massive dose of QE. Many economists argue that, in the absence of any rise in inflation expectations, central bank balance sheets are in effect infinitely large, and can be used as needed to combat the crisis.

Given the outsize scale of what the central banks are now doing, this argument needs increasingly careful examination in future blogs. But one conclusion already seems clear. If this strategy does not work, there will be little else left in the locker of the emergency services.

It is the careful examination that he promises in his concluding remarks that eluded him on Jan. 8th. Here is what he states on the inflation risk of central bank action:

I do not share the alarmist view that an explosion in central bank liabilities must inevitably lead to higher inflation. That basic monetarist link has already been shown to be invalid, at least over short periods, and at least when a liquidity trap is in operation.

This is unfortunate. This is what many people said about the unprecedented central bank rate cuts and ultra-loose monetary policy of 2001-2004. The results were there for all to see in 2007-08. Inflation eventually arrived. In the meantime, it made many indebted and insolvent and many a saver went unrewarded. That is being repeated now on a more massive scale. How can it now have consequences?

The distortionary effects of zero interest rates and loose money are too well known not to be probed rigorously by analysts. Casual dismissal of their effects by simply looking at current inflation rates won’t do because such a behaviour boomeranged on us.

In any case, inflation is not exactly low either in Europe or in the US, notwithstanding the known tendency of official inflation indices to understate true inflation due to their assumption of substitution effects and hedonic adjustments.

The second aspect that he does not treat at length – he might yet do so in future posts – is this:

In the absence of these injections, private banks would have been forced to delever their balance sheets in order to remain liquid. In all probability, some would have gone bankrupt, causing contagion throughout the financial sector and the economy at large. While no-one doubts that these central bank actions have been necessary, they have lasted much longer than ever before.

It is not much of an exaggeration to say that large parts of the financial sector have been quasi-nationalised. As liquidity injections have become semi-permanent, the private banking sector has existed only at the mercy of the central banks, and the distinction between solvency issues  and liquidity issues in the private sector has been increasingly blurred. The rise in the central bank balance sheet has prevented the need for further, and more overt, injections of capital into private banks by governments, and therefore by taxpayers. Whether this alternative would have been politically feasible is a moot point.

In other words, he admits that central banks have kept alive zombie banks. Those who are solid, trustworthy and credible would have been able to raise capital even if at higher costs. That would have had a salutary effect on their risk-taking. Central banks have basically allowed the financial system on both sides of the Atlantic to evade the discipline of market capitalism. So much for free-market capitalism!

Next, he comments on the helping hand that central banks have extended sovereign governments:

In the absence of these injections, private banks would have been forced to delever their balance sheets in order to remain liquid. In all probability, some would have gone bankrupt, causing contagion throughout the financial sector and the economy at large. While no-one doubts that these central bank actions have been necessary, they have lasted much longer than ever before.

It is not much of an exaggeration to say that large parts of the financial sector have been quasi-nationalised. As liquidity injections have become semi-permanent, the private banking sector has existed only at the mercy of the central banks, and the distinction between solvency issues  and liquidity issues in the private sector has been increasingly blurred. The rise in the central bank balance sheet has prevented the need for further, and more overt, injections of capital into private banks by governments, and therefore by taxpayers. Whether this alternative would have been politically feasible is a moot point.

It is clear that, here too, central banks have muted the information content of bond market yields with their aggressive purchases. That they are not directly monetising government debt is an eye-wash and downright hypocrisy. In fact, much worse, some Keynesians have the audacity to suggest that since the bond market has not revolted at the fiscal spending of governments, there is room for the governments to borrow more! It will be hard to beat this for chutzpah.

Talk is cheap. Hence, central bank chiefs are delivering lectures on fiscal prudence and price stability. But, in action, they are distorting markets, price signals and creating inflation and bubble-bust risks throughout the world with consequences for social stability.

After all, only the well-heeled and endowed can post margins to be able to borrow at record low interest rates. For others, asset prices are too high to be affordable, even if borrowing rates are low. So, these zero interest rate policies encourage wealthy borrowers, punish savers and hence do their bit to widen inequality.

This is serious crime.

2 Responses to "Uneasy Davies"

  1. paulie46   January 12, 2012 at 11:28 am

    The person writing this cannot be serious

  2. ScienceNotEcon   January 12, 2012 at 8:26 pm

    People don't choose to be rich or poor, as nobody has free will. People don't choose their genes or where they grow up. Both of those factors determine everything about the condition of a person's brain. People aren't responsible for their actions, since people didn't choose their parents or the childhood environment that shaped their neuroanatomy. Whether someone becomes a criminal or a hero is determined by the condition of their brain's frontal lobe. Sam Harris and David Eagleman are two neuroscientists who convincingly argue against the unscientific notion of free will.