I received an interesting question from LRFotS Kapios via my Telegram channel (make sure you join if you haven’t already), in response to my view that actual inflation in the UK is running at close to double the official rate. The background here is that the Bank of England predicts inflation in PommieBastardLande will exceed 10% by the end of the year. That is devastating for any major economy, but it is even worse in a country that is supposedly known for a stable and efficient monetary environment.
Here’s what Kapios asked:
The answer is somewhat complex and has to do with all sorts of economic theories. I will try to simplify it as much as I can, but the core answer is actually quite simple:
The Western Central Banks CANNOT raise interest rates, because they have every incentive not to do so.
A Bit of History
To understand why this is so, you must first understand what a central bank is.
Contrary to popular understanding and opinion, a central bank is not an arm of the government. It is a private institution, though the MFIC is usually – these days – a government appointee. This was not always so, and certainly was not the case during the monetary history of the USSA’s three central banks.
Yes, you read that correctly. Most people don’t know that the USSA has actually had THREE central banks, not just one.
The First Bank of the United States was an abortive experiment whose charter was not renewed, because it did such an appallingly bad job of managing the paper money in circulation after the War of Independence. It is because of the incompetence of the FBoUS that the Constitution mandated the US dollar to be defined according to a very specific weight of gold and silver, introducing the “bimetallic standard” that caused no small number of headaches for decades afterwards. But at least it was some kind of hard standard on the dollar.
The Second Bank of the United States, however, was a privately formed institution, and its third president, a prominent and very wealthy banker named Nicholas Biddle, became notorious for inflating away the value of the currency. It took the iron hand of “Old Hickory”, Andrew Jackson himself, to destroy that bank, in what we know of today as “the Bank War“.
During that war, Jackson’s veto of the extension of the SBoUS’s charter caused Mr. Biddle to effectively hike interest rates in an act of vengeance and wrath, causing a financial crisis and recession in the USA. It was a contest of wills and powers, and only ended when Jackson more-or-less nationalised the SBoUS’s assets by moving Federal funds out of that bank and distributing them into other banks around the country. That act of vengeance, though, backfired, and the SBoUS lost that war quite decisively.
The importance of Jackson’s victory cannot be overstated. His destruction of the fiat-money engine of the SBoUS ensured that the US had a hard-money standard, to which the country returned even after the devastation of the War Between the States. And that hard-money standard powered America’s transformation into the greatest economic engine the world had ever seen.
But the damage had already been done, the precedent had been set. A privately run bank, staffed by bankers, working for banks, came to be seen as a better steward of money and prosperity than the traditional use of gold- and silver-backed currencies, which are inherently deflationary, by definition and intent.
(The very best book that you can read on the subject of central banking is probably The Creature from Jekyll Island, by G. Edward Griffin. It goes into deep detail about much of this history, and explains all of this.)
Central Bank Incentives
Now you know what a central bank is – a privately run non-government entity, created and designed to serve the interests of banks, NOT the broader economy as a whole.
What, exactly, do banks want, then?
Most banks these days exist in a world of fractional reserve lending. The idea behind this concept is that banks can safely lend out MORE in loans than they have in deposits, because the probability that EVERYONE who deposits his money at the bank will show up all on the same day to demand it back, is so small as to be non-existent. (So goes the theory, at any rate. Nobody EVER expects a bank run to happen – until it happens. And they are much more common than banksters want to admit.)
Therefore, in order to avoid tying up lots of capital to just sit and mildew away in some bank account (or, these days, in a digital file system), banks lend out more money than they can back up with deposits. They keep only a fraction of that money in their accounts in reserve.
The result of this is that when the central bank engages in open market operations – that is to say, it buys very short-dated government bonds on the secondary market, after they have been issued, from banks that have already bought those bonds, and lends that same money out to the banks within the Federal Reserve system – it then deposits that money at those banks. The diagram above shows you how it is all supposed to work.
The problem with this neat little theory is that banks ALWAYS prefer LOWER RATES OF INTEREST, because that means they can lend out more money in the form of home loans and consumer credit.
The fact is that banking is actually a ridiculously lucrative and safe business, if you do it right – literally, all you have to do is take in money, provide some piffling rate of interest on it for short-term deposits of 30 days to one year, and lend out multiples of that money to consumers at a spread of a few HUNDRED basis points over the course of decades, and then just sit back and watch the cash roll in.
This is the “secret sauce” of banking – “borrow” money from customers in the form of deposits, and pay them interest for very short-dated loans, and “lend” many multiples of that money back out again at much higher rates of interest for very long-dated loans. It is literally that simple.
When interest rates are low, consumers and businesses borrow more. When they borrow more, banks lend more. And when banks lend more, they receive more money. Win-win-win, right?
The Twin-Mandate Fallacy
Central banks these days are supposed to accomplish two objectives, seemingly impossible to reconcile with each other.
On the one hand, central banks must maintain price stability. That is to say, they must keep prices relatively constant. The whole point of a central bank is to avoid the dreaded horror of deflation, which is when prices in general fall over time. This is what tends to happen with a gold standard, which, as I said above, is inherently deflationary.
Here’s how it works. When you spend more than you can back up, you MUST cut back on your spending, or else you go bankrupt, because all of the people to whom you owe money, will pull out their actual physical gold.
So you have to cut spending to compensate. And this tends to result in sharp recessions that force a “reset” of the economy, government finances, wages, and general prices. This is why a gold standard, or really any hard-money standard, is deflationary in the long run. (That is NOT to say you cannot have rampant inflation with a gold standard. You can. It’s just very rare and requires a literal flooding of the monetary system with gold, or the debasement of the currency – which in practical terms is exactly the same thing.)
This is horrible for businesses, which prefer high prices, and for consumers, who want high wages. The spectre of deflation haunts economic planners, and has done for centuries, because it often means disaster for all of the most important actors in any economy – governments, consumers, and businesses.
The flaw in all of this neat logic is that wages always change SLOWER than prices do. So, when prices for consumer goods and services go down, your money goes further, even though, over time, your overall wages go down. So your standard of living actually tends to rise in the long run. And this has generally (not always) been the case with countries that used a gold standard – prices generally stayed stable or fell over time, and standards of living rose.
Central banks seemed to solve this terrible, gnawing problem of deflation, by providing for a way to generate “harmless” inflation of 2-4% every year. The theory says that this level of persistent, steady, predictable inflation is good for an economy, because it keeps interest rates low enough to spur investment, while also permitting consumers to save money for the long term.
This is a profoundly stupid argument, without any real backing in monetary history. If you look at the rates of interest and taxation in the gold-backed economies of the early 20th Century, you might be startled to find that, in the absence of democracy, central banking, income taxes, and government meddling in economic affairs, interest rates, inflation, and overall tax rates were LOWER than they were throughout much of the later 20th Century, and standards of living were exceptionally high relative to what they had been just 100 years earlier. The great Dr. Hans-Hermann Hoppe makes this point superbly in his seminal work, Democracy: The God that Failed.
Moreover, do you know how long it would take for your money to lose half its value at these “benign” rates of inflation? It’s not that hard to compute mathematically. If you want a rough approximation, use the “Rule of 72” – divide 72 by the rate of current inflation. If inflation runs at 2%, that’s 36 years – if 4%, it’s 18 years. The exact results from precise mathematical calculations are quite close to these values.
In other words, in just one or two generations, even with “low” inflation, your money will be worth half as much. THAT, brothers, is the true danger and evil of inflation.
The reality is that a central bank CANNOT perform both functions, of low employment and low inflation, without eventually making a huge mess of one or the other. The incentives required for each policy are totally incompatible with the other. Even a cursory look at the history of fiat money will bear this out – you will note that, if you look at the history of the Federal Reserve in the 1960s, in particular, the “dual mandate” really gave way to the “one mandate” of high employment, and never mind inflation.
The Liquidity Trap
To all of this theory, we must add one more idea, and then we shall see how it all connects together.
There is a concept within neo-Keynesian/neoclassical economics called The Liquidity Trap. The Keynesians try to explain this with all sorts of muddled mathematics and mumbo-jumbo and handwavium and jiggery-pokery. I actually understand the mathematics just fine, personally – it’s not that hard to figure out, and I studied this stuff earlier in my life. But you don’t need maths to understand the basic concept, you just need that rarest of all commodities – a modicum of common sense.
When the central bank lowers interest rates ever closer toward zero, keeping in mind the dual-mandate of price stability and full employment that, in practice, most CBs operate under, it eventually gets to a point where adding yet more money to the economy has ever lower effects. This is directly in line with the Law of Diminishing Marginal Returns.
In simple English, this means that the first cup of coffee that you drink in the morning will refresh you and wake you up – but the 10th cup of coffee will make you want to hurl and pee at the same time. There is such a thing as “way too much”, and that point tends to occur very suddenly within both humans and economies.
This is the core of the “liquidity trap” idea – too much money chasing too little stuff, resulting in runaway inflation that cannot be controlled.
Raising interest rates at this point becomes nearly impossible, because to do so would require killing the economy. Once you hit the liquidity trap point, the “real economy” has essentially been cannibalised – we call it “financialisation”, wherein real, productive economic activity has been largely replaced by “money making money”, and actual production no longer takes place domestically.
THIS IS THE SITUATION IN WHICH VIRTUALLY EVERY MAJOR WESTERN ECONOMY FINDS ITSELF TODAY.
Western Benchmark Rates at All Time Lows
Take a look at the slideshow below, which shows you the benchmark interest rates for the USA, the EU, the UK, and Japan. The rate histories go back a full 25 years, or as close to that as possible. You will notice immediately that the rates plummeted in 2008, in the wake of the Global Financial Crisis, and have NEVER recovered:
They never recovered because we are, in fact, deep within the liquidity trap. There is NO WAY for central bankers to raise interest rates without causing a full-on collapse of the banking system.
How will that happen? Because raising rates means raising the cost of borrowing. That means stopping consumers and businesses from borrowing on credit. That in turn cuts off the supply of cash coming into the banking system, and every bank in the West depends heavily on that cash flow to keep itself going, because every Western bank is basically over-leveraged. Their total asset bases are a fraction of their total liabilities, in the form of deposits, hard-to-value loans from other banks, and other nasty things which have to be paid to other people.
Cut off that supply of blood-money, and you kill the entire banking system.
Recall now what I wrote above. Central banks are run by bankers, for bankers, within banks – that is the core truth, no matter how much economists try to dance and dissemble around it. I don’t care if you think that Greenspan, Bernanke, Yellen (Jews, all of them, by the way), and Powell are “independently chosen” for their “special skills” and “knowledge of the monetary system”. In reality, they are politicians and bankers at the same time. They represent the interests of the banking system, of banks and bankers. That is the simple truth.
Conclusion – Breaking Bad
There is one other reason why central banks will not raise interest rates – because if they do, the one man (or woman) in charge will be faulted for creating a financial and fiscal disaster.
The ECB is supposed to have a single mandate – price stability. Yet it is led by a woman – the most globalist of GloboHomoPaedocracy types, Christine Lagarde. And she has brazenly continued the ECB’s policy of monetising debt, through what the banksters call “quantitative easing”, by buying longer-dated southern European debt from Italy and Greece, in order to keep interest rates there low. She HAS to do this, because if she stops, borrowing costs in those economies skyrocket, and they go immediately into default. This would result in a cascade effect throughout all of Europe, and the richer “northern” countries – Germany and the Scandis, basically – would have to bail out their “lazy, shiftless, good-for-nothing Mediterranean cousins”. (That’s not what I think, that’s what Germans think of the southern Meze types.)
What central banker would be willing to go down in history as the instigator of the greatest financial collapse of all time?
Exactly. None of them would. So they all kick the can further down the road, desperately hoping that it eventually becomes someone else’s problem.
The answer to extremely high inflation is to raise interest rates, HARD. To hell with credit, lending, and economic activity – you HAVE to break inflation by causing a sharp, severe contraction. That would cause the most overleveraged companies to go bankrupt almost instantly, and thereby would allow for a process of “cleaning out” and readjustment, that is extremely necessary to fix the original problem.
But if you keep delaying that day of reckoning, and you keep pushing it ever further away through ever more easing, you simply make the final reckoning that much harder and more costly.
And the end result is precisely the “crack-up boom” that the legendary Ludwig von Mises predicted – the total hyperinflation into nothingness of the currency, combined with the collapse of the financial system and the national debt, and the complete destruction of the nation itself.
Great essay, captures a lot of complexities in a concise way.
“What central banker would be willing to go down in history as the instigator of the greatest financial collapse of all time?”
Its a fractal of all bureaucratic operations, the Agency Problem of the individual measured against the goals of the organization. It is inevitable and intrinsic to human nature to CYA above all else. So inflation into oblivion is the inevitable consequence of central banksters.
In regards to bimetalism: I don’t think the USA had a bimetal format where silver and gold were both backing the USD. It had a gold standard for sure. But recall this EPIC speech (https://www.youtube.com/watch?v=UV2wRCcWJa8 a re-recording 20 years later) by Williams Jennings Bryan in 1896, where he campaigns for a bi-metal standard to loosen up the currency for the benefit of Labor and Agriculture against the Capital interests in the urban control centers.
“Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests, and the toilers everywhere, we will answer their demand for a gold [only] standard by saying to them: “You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold.”
The Gold Standard worked so long as the frontier still held gold to bring to the surface. The gold rush in San Francisco, the Dakotas, the Yukon, all infused liquidity into the markets with real genuine value. When those gold rushes ran dry the liquidity problems emerged and the non-capital types were desperate for solutions…silver may have been the best middle road between Biddle 2.0 and Gold only.
Long-term thinking: If we had stayed on Gold only, we would have needed new frontiers to mine gold from. Not frontier left on earth, but whatever was undeveloped and had gold would have quickly been developed.
Next step? Space. There’s gold in them-thar-asteroid-belts. The Gold Standard could have fueled a genuine space-faring economy. Who knows, maybe the solar energy innovations from that would have broken us out of this petro-arm-bar all economies are in.
Inflation is now beyond the bounds of the Fed to control. Whether this was done intentionally or not can be speculated, but mortgage people, who usually kiss the Fed chairman’s ass unashamedly, are being very critical of Powell. I was telling people in the winter of 2020 that the boom was going to lead to a bust, and we needed to have a plan for it. Nobody did, everyone got fat and lazy, and there’s an undercurrent of panic that nobody is talking about.
The party is over.
The central banks are all behind the curve in regards to inflation. Should’ve been raising rates and taking out the liquidity over a year ago. That BS MMT, is BS. But the CB’s are going to have to raise rates, regardless, because…hyperinflation in food prices will lead to out of control circumstances. Peasants revolt, middle class do revolutions. A recession is already happening with high inflation. Gee, seems like the good ol days of the 70’s, but only better with high sovereign debt levels. Plus the central banks balance sheets, yeah how are they looking? In the USSA, the 10 year treasury as of 6 May 2022 is clocking in at 3.12ish percent. Did you just hear the car crash of the mortgage market in the USSA? I did. To your hypothesis of not raising interest rates, you are correct in a way. The Fed can’t do what Volcker did in the late 1970’s-early 80’s, because too much debt in the USSA’s balance sheet. But, that is what is needed to be done. Oh, don’t forget about the stock market. If you can go to cash (not a great proposition, but…), do so, to preserve as much capital as one can.