Central Banks and Inflation
Historically the most significant issue that Central Banks dealt with, was not inflation, but rather financial instability.
The problem with financial instability, is not just that asset prices fall, but rather that the entire financial system gets arrested as entities are no longer able to make payments. When payments fail to be made on a large scale, the entire social order starts to break down including job markets and property rights. When people starve on a large scale, due not in fact from a real shortage of food, water or other necessities, but rather a financial breakdown, that is viewed as unacceptable and justifying large scale coordinated action to remedy.
At this point, we could get sidelined into political discussions, of who is at fault and why. At this particular point in the conversation, we will only consider that central banking was adopted to address this. Think of central banks as a shared storage unit for money. When money is scarce, then it gets lent out so that the problem doesn’t get worse. Unlike a shortage of food, where only the hungry person suffers, when there is a shortage of money that tends to spread, as money is used to pay debts, and so both the borrower and lender are hurt.
So you can think of a financial crisis as a famine that is also a contagious disease.
To understand why this is, we must understand what banks do. Before we do that, we should clarify that a financial crisis, is really a crisis of greed and desperation. Initially it does not have to coincide with a shortage of real goods and services. It results from a relative scarcity where both wealth gets concentrated, and much of the wealth we thought we
had was not really there in the first place.
The simplest and most common example of this is the failed entrepreneur. Someone claims to have found an amazing business proposition, so they hire a bunch of people, borrow money, and collect investments. For a time it all seems great, but then eventually it faces problems and takes losses.
Whether that is because they were a ponzi, or more commonly, the business is more difficult than imagined, or if it just an honest failure from bad luck, the business fails in any case. Regardless the reason, the result can hurt many people. The owner they cannot pay their workers, their
lenders or investors. Unfortunately, in our society we have taken an approach where the workers are often the ones that suffer the most when this happens, even if they were the least responsible. Like it or not,
business owners and entrepreneurs are leaders in our society, so their successes and failures affect more people than just themselves.
When events cause businesses and financial entities to start failing on a large scale, this leads people to tightly hold what money and wealth they have, and thus, make the problem worse in the short term. We should not omit to say that this kind of behavior is not all bad, that a willingness to conserve and save resources is generally a good thing in the long run, but that rushing to buy out all the toilet paper day 1 of a pandemic, for example makes you a literal asshole. A clean one, but an asshole none the less.
Banks turn any asset into money in order to operate payment systems.
Some people may erroneously believe that the fiat currency they use is “backed by” a certain amount of gold. Far more people may still think this way about money metaphorically. Even if they know that a dollar bill is
not reedemable for a specific amount of gold, it is hard to break this mental metaphor. Still others make a fuss that money that is not “backed by” a precious metal is a bad idea.
In truth today’s fiat money is still “backed by” real things with value, only that the conversion rate is not fixed beforehand. To get a loan you need collateral, and that collateral is what backs money when it gets created.
So instead of just being backed by gold, fiat money is backed by houses, and cars, and businesses. Basically, anything you can go to a bank and get a loan for, or lose if you fail to pay taxes, is what backs our money. Compared to just being backed by one thing with an unstable fluctuating price, this is much safer, effective, and fair, provided it is managed well. A diversified portfolio is always a smart idea, provided it is not diversified garbage.
When the price of assets falls, you can say that the price of money rises in relative terms. However, since we can actually establish a price reference point, that being the price of necessities tools and other goods, we can potentially distinguish between a rise in price of money, and a fall in price of assets. When the price of assets falls “in real terms”, that is different from when the price of money rises in real terms. These situations require different responses: when the price of money rises, or the price of assets falls.
Well today in fact we have a situation where the price of money, in terms of CPI, never actually rises. This is easy to achieve when money does not guarantee a specific amount of an asset. But the price of assets can still fall, leading to financial instability. This instability in asset prices is met with interventions to buy assets and stabilize the financial system, which is inaccurately and reductively called “lowering interest rates”, So to reduce inflation, it is supposed we need the exact opposite: “raising interest rates”.
However raising interest rates, even if it causes the value of fixed income assets to fall(incidentally by devaluing future cash), does not cause the value of money to rise, because a fall in asset prices is not necessarily a rise in the value of money. Rate hikes are done indiscriminantly to the quality of the assets, central banks today even pay interest on reserves! It is utter madness. Multiplying account balances through interest accrual dilutes the value of money, and does not increase it. And even to the extent it causes financial instability, financial instability is not automatically a remedy for inflation.
One consequence of excessive intervention to support asset prices may be increased inflation, but that does not mean that financial instability automatically a remedy for inflation. You can take a more disciplined approach to collateral appraisal directly. Yes, some financial entities with
overpriced assets may end up facing higher rates on marginal borrowing, but this is not the same as the utter insanity of paying higher rater on reserves and treasury bonds, as they are the most direct substitutes for money, and therefore the highest quality assets.
If a patient breaks their leg, a doctor may administer painkillers, (like supporting asset prices) to ease the pain and relax the patient, preventing them from making the problem worse. After the patient recovers, they may have to work through some pain as they seek to regain independent use of the limb. But we certainly would not intentionally instigate pain, especially not to unrelated parts of the body, and expect that to fix the leg.
Sometimes, cures can be painful, but that does not make arbitrary and unrelated pain an effective cure.
That is the issue with monetary policy today, we seek to simply replace one type of proven intervention, with an untested and unproven opposite intervention: because you took painkillers, now you have to take painmakers. That doesn’t help anyone. Disciplining collateral appraisal and the fiscal footprint of government spending can be painful, but not all forms of pain are an effective cure for inflation.
