Strategy & economics
It’s the way you tell ’em
Whether you are buying a new television for £200 or taking a decision to invest £200 million in a new capital project, there is one crucial ingredient that will determine if you go ahead: confidence. And if you narrow that down a little further, it is confidence that your future income will justify undertaking significant expenditure today. As much as anything else, it is changes in confidence that lead to inflection points in economic activity and turning points in the economic cycle. In the financial markets, you will often see the consequences of quite small changes in investor confidence become magnified in quite large swings in prices of financial assets. Sometimes, it is a change in information about current developments that triggers the shift. At other times, it can be difficult to determine just what has caused confidence to turn.
Policy makers play a key role in determining the level of confidence that manifests in both financial markets and the wider economy. And amongst these policy makers, it is central banks that are all-important. We probably place too much faith in central bankers. Just because they sit behind big front doors in monolithic buildings does not always mean that they warrant the faith we place in them. Indeed, I do not think it is unfair to assert that it was central banks that were partly responsible for the financial crisis. Nevertheless, central bank governors are probably the most influential people in the world financial and economic system. They have to be listened to – and listen we do.
As soon as a new central bank governor is appointed, he or she puts on a cloak of infallibility and climbs onto a pedestal. And we all dutifully assume that the best person for the job has been appointed and that he or she will subsequently display perfect understanding and foresight. We trust these unelected officials to be benign and to be in a position to steer the economy in the right direction. And lest you be confused, to the extent that things do occasionally move a tad off course, it is never the fault of the central bank.
Given the degree of faith that we place in central banks, it is disappointing to see how little leadership they are providing at the present time. Central banks should be both policy leaders and thought leaders. But in both areas, it seems to me they are failing. They have allowed monetary policy to be hijacked by financial markets and they have allowed economic debate to be hijacked by strands of thinking that bear little relationship to actual events. This is leading to policy decisions being taken that are at best inappropriate to current developments, and at worst that may prove counterproductive.
I have always been sceptical about the lasting impact of quantitative easing – as effected by the Bank of England, the European Central Bank (ECB) and the Bank of Japan. The US Federal Reserve was a little cleverer, but still continued to inject liquidity for far longer than seemed necessary or appropriate. And now we find ourselves in the era of negative interest rates. We seem to have drifted into this policy, without central banks fully articulating how they will work. To me, they look like a policy tool that is neither warranted nor likely to bring about the desired effects. If anything, negative interest rates may lead to a hoarding of money and a higher savings ratio. They are also likely to be detrimental to bank profit margins, thereby weakening the banking system.
More importantly, however, they send the wrong signal. And this is where the central bank’s loss of policy and thought leadership is particularly damaging, since it is also undermining confidence. It is undeniably the case that some parts of the world economy are under severe pressure. In particular, the emerging manufacturers and commodity producers that enjoyed such strong growth during the helter-skelter period of globalisation prior to the recession, are now finding it much tougher as western economies rebalance. Excess demand in the West has morphed into excess capacity in emerging economies. Longer term, this should lead to better balanced world growth. In the short to medium term however, the adjustment process will be painful. But there is only limited negative economic feedback from emerging to developed economies. The much greater impact on the West is helpful – through the boost to real demand provided by falling energy, food and manufactured goods prices.
By behaving as if the West is on the brink of recession, central banks are much more likely to bring about that dreaded eventuality. Rather, central banks should be trying to raise confidence. But they have allowed themselves to be taken hostage by financial markets and have responded by introducing an even more abnormal mix of monetary policy. So what should ECB have done at its last meeting? Simple: it should have tried to reassert its authority and thought leadership. Mr Draghi should have faced up to financial markets and pointed out that the eurozone economy is gradually regaining momentum, and then asserted that financial markets are overstating current risks to western growth. Instead, he acquiesced to pressure to do ‘more’. And in doing so, he sent negative signals to decision makers, small and large, and is more likely to have undermined confidence than to have enhanced the growth outlook.
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