The Steering Wheel and Brake Pedal are Disconnected
November 26, 2005
Last week, I mentioned that “the steering wheel and brake pedal are disconnected,” implying metaphorically that the Fed can’t really steer the monetary policy vehicle even if it guesses correctly about what it should do next. This is not an inescapable condition.
The Fed, like other central banks, does not control interest rates directly. What it, and they, do, specifically, is adjust the amount of base money in existence. Base money consists of notes and coins (typically about 90% of the total) and bank reserves (10%), which are held electronically at the Fed. All monetary transactions are performed with base money. There is no form of money besides base money. When you write a check, what happens, exactly, is that your bank, Bank A, transfers bank reserves (a form of base money) electronically (at the Fed) to the account of Bank B, the bank of the recipient of the check. Much the same thing happens when you use a credit card. Thus, while it may seem as if these sorts of payment methods constitute a “type of money,” in actuality your bank makes the transaction using base money, and then adjusts the amount of money that the bank owes you (deposits) or that you owe it (credit cards).
Presently, the Fed adjusts base money, on a daily or even hourly basis, in accordance with an interest rate target. Adding base money tends to depress short-term lending rates, and subtracting base money tends to raise them, at least in the shortest term. In this way, the short-term interest rate is maintained near the Fed’s target.
Now, the Fed, and other central banks around the world, are not supposed to do this. They were not created for this task. Historically, base money was managed in accordance with the gold standard, and central banks were intended to provide base money on a short-term self-cancelling basis during episodes of systemic base money shortage, which were normally signaled by short-term interest rates in excess of 10%. Such conditions would be expected for only a few days a year, if even that. However, the urge to fiddle with economies via interest-rate manipulation proved to be overwhelming, so now we have central banks which are fully devoted to interest-rate manipulation, as if something worthwhile could be gained from it (not possible).
We were speaking, last week, specifically in reference to inflation targeting. OK, let’s imagine that the central bank decides to guess that inflation two years from now will be unacceptably high, and wishes to suppress/prevent such inflation. (Does this sound like something that might happen soon? Oh, yes indeed!) What can the central bank do? Well, the central bank can only do one thing, which is to increase or decrease the base money supply. It doesn’t have any other powers. The proper thing to do, assuming that the central bank correctly diagnosed a situation in which present currency value was too low, would be to reduce base money to support currency value. This would be represented by an increase in the currency’s value vs. gold. I.e. a “fall in the gold price.” What the central bank would likely do, however, is increase its interest rate target.
Then what happens? The short answer is: nobody knows. It’s a chaotic system. Sometimes it works great (like Brazil presently), and the currency soars higher. (It has helped that Brazil’s president Lula has been steadily lowering taxes.) Other times, it doesn’t work at all, or has the opposite effect. Like Brazil pre-2003.
To illustrate what I mean, let’s take a somewhat extreme example. Let’s say the Fed, worried about future inflation, tomorrow adopted a Brazilian-style interest rate target of 19%. Would the value of the USD rise? Or would it fall, as such a policy would amount to economic suicide for the U.S.’s debt-laden economy? If the USD fell as a result of such a policy, the effect would be worse inflation. Thus, we would have a collapsing economy and worsening inflation, i.e. “stagflation”. For one thing, higher short-term interest rates mean that the opportunity cost of holding base money (notes and coins and bank reserves), which doesn’t pay interest, increases. Thus the demand for base money declines, as people break open their piggy banks (metaphorically speaking) and loan the money to banks (deposits) to earn interest. As the demand for money declines, the value of money also has a tendency to decline, which of course means more inflation. At the same time, super-low interest rate targets are not a reliable method of avoiding deflation, i.e., lowering currency value. The Bank of Japan fooled around with low interest rates for years, with hardly any discernible effect on Japan’s horrible monetary deflation. The opportunity cost of holding cash (interest) is low, and the risk of depositing the money with banks rises (banks suffer from bad loans in a deflation), so the demand for money may rise, which tends to cause a rising currency and more deflation. Indeed, banks themselves may wish to hold more non-interest bearing cash, i.e. bank reserves, as a zero-percent return beats a negative return on loans that go bust. (This was also true during the 1930s.) After much prodding mostly by foreign investors, the BoJ finally adopted a rather timid “quantitative” methodology (i.e. NOT an interest-rate target) which finally produced exactly the effects promised, namely, the monetary reflation now being enjoyed there. It took way longer than it had too, however.
If all this is confusing, the point is: the steering wheel and brake pedal are disconnected. Even if the Fed correctly analyzes the monetary state of the economy (and how often does that happen?), the present interest-rate targeting system does not allow them to act effectively on their insight. And if their analysis is wrong to begin with, wellä.
The correct method of reacting to inflation (a currency value that is too low) is to reduce the supply of base money, thus causing a rise in currency value, as noted in the currency/gold ratio. The effect of this would normally be lower interest rates, as the threat of investment loss via inflation is reduced. This process is not chaotic, it is extremely reliable. The steering wheel and brake pedal are once again connected. There is a “cost,” however: the central bank is no longer allowed to fool around with interest rates!
Thus we see that the correct methodology of a central bank is the direct adjustment of base money, and the correct target is stable currency value, traditionally represented by a stable currency/gold ratio, i.e. a gold peg or gold standard. This has been tested for hundreds of years and works just fine.
It is important to see just how similar a gold standard and the present system are. Today, the Fed adds base money when the short-term interest rate is above its target, and subtracts base money when the short-term rate is below its target. This is an interest-rate peg. Under a gold standard, the Fed adds base money when the currency’s value is above its gold parity target, and subtracts base money when it is below its gold parity target. Virtually the same process. Vastly different outcomes.
So now that we have the steering wheel and brake pedal properly connected, these question is: who is driving this thing? A board of statisticians looking in the rear-view mirror (or guessing about the future view in the rear-view mirror), or gold? Since our stance on the matter is already clear, we’ll leave George Bernard Shaw with the last word:
You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.
–George Bernard Shaw, 1928
I am bringing these topics up now because I expect they will become more important over the next twelve months or so. Indeed, if someone at the Fed reads this, perhaps the outcome will turn out better than it would have otherwise. That might be a nice thing.