How do they do it? Analysts speak metaphorically when they say, as I also sometimes do, current problems with recession/inflation (r/i) are due to governments’ policy of printing too much money. As well, when they discuss the “cure.” they blithely speak about raising the interest rate, as if such action is equivalent to turning down some sort of economic thermostat.
Let us speak more precisely so we may understand why the current case of r/i came about and why it will be so difficult to cure it.
Although China and the US have different economic systems, the complex workings of the banking and financial cultures responsible for both cause and cure have deep similarities. The reason for this parallelism is that money, interest rates, productivity, risk and stability are fundamental aspects of any social and economic order.
First, how does new money get created?
The closest the real world gets to the reply “by the printing press” is the rare, even exotic, policy recently and unprecedently followed in the US. There the government actually sent “checks in the mail” to ordinary citizens who did nothing to earn the money.
But this policy is almost freakishly unusual. In any case, in the US, the odd idea did not account for much of the excessive and inflationary increase in total financial claims on output and on other financial instruments.
Open market operations
Open market operations are the more usual policy by which governments put “money” into circulation – that is, put into circulation more claims upon current and future production as well as claims on current and future financial instruments.
Here I am generously extending the narrow technical meaning of the term “open market operations.” My stretched interpretation of the term allows me to say it applies equally to operations of the People’s Bank of China and the Federal Reserve system in the US, both being central banks, or banks for bankers.
My loose and easy definition of open market operations (OMO) is the following: Whenever central banks add money to their economic order, they just buy stuff – any stuff at all, including the materials used to prepare the tasty servings of Maryland crab I used to heartedly enjoy in a white-tablecloth and polished-silver lunchroom when I was a visiting professor at the Board of Governors of the Federal Reserve system in Washington.
The key idea is dead simple. Money is created when a central bank buys something of any kind, ranging from raw crabmeat to bonds, stocks, mortgages, foreign currencies, gold or its own government’s notes, which are promises to pay (pay what, you might well ask – more later), long or short term.
Conversely, money is destroyed, or at least taken out of circulation and “frozen” when a central bank sells into the market any of the above – although never during my time at the Fed did I observe the Board selling any crab, raw or cooked.
(Well, if you pin me down and twist my arm, I will admit I paid for my crab lunch, but I will say as soon as you let me go that I paid a highly subsidized price, and therefore there was a small net increase resulting in the money supply.)
The downstream consequences of an OMO purchase or sale do vary with the exact nature of the item bought or sold. Let us think about the price paid and the price received during OMO.
Classically, the thing being bought or sold is government bonds and notes, along with international currencies, including the central bank’s own currency. More recently central banks have taken to buying mortgages and stocks (the Hong Kong Monetary Authority famously made profits after buying and later selling back HK stock during the Asian crisis some years ago), giving them an ownership interest in domestic companies.
As well, central banks have recently purchased promises to pay issued by ordinary commercial banks, sometimes notes issued by troubled commercial banks in need of a bailout.
Each of these OMOs has its own impact on r/i. The point is that each unique impact, in addition to adding or subtracting liquidity to the total system, has its own, often harmful, side effect. These side effects may be so large they make the aggregate r/i problem worse, not better.
What ‘money’ means
Before we discuss side effects, let us address an overriding question: With what form of money does a central bank make its purchases, and what form of money does it ask for when it makes a sale, and does it matter?
It buys, or attempts to buy, merely by offering its own promissory notes, these days based on nothing but its own tax base (remember the central bank is part of government), its general borrowing ability and, it least when dealing with its own citizens who have no alternative, its own raw power.
When selling, the central bank may ask for (maybe it gets it or not, depending ultimately on raw power) its own money (which is thereby “frozen” out of circulation) or, if it is a junior power in the financial scheme of things, whatever the opposing buyer is willing to pay.
When things get totally out of hand, the central bank may have so badly damaged its creditworthiness that no one will take its promissory notes when it buys, and when it sells, everyone on the buying side will offer the worst and cheapest form of money available.
In severe cases, failing central banks are cut out of the international payments system altogether, and their domestic economy falls to pieces. This worst case can happen whatever is their bank’s “home-town” political culture. Creating such financial isolation is the ultimate weapon used in sanction wars.
The dangerous side effects are these: In order to buy things – anything – from the market, the central bank must pay more for it than it is “worth.” Unless the seller of the thing – anything – gets paid enough that he is willing to remove it from his own portfolio in exchange for something else, a profit of some sort must be paid.
After all, at existing prices, the potential seller is holding the asset. When central banks buy assets in bailout situations, they reward bad management; when they buy stocks or bonds or property or mortgages they must, by definition, pay more than anyone else in the market, or else the seller will deal with the player making a better offer. So the central bank thereby pays more than market, sometimes rewarding bad investment decisions, or at least adding to inflationary pressures in the securities market.
Moreover, the lucky players who own the items being bought up by the central bank get an unearned capital gain, making the system seem unfair, despite the necessary technical reason for its being paid.
By the way, such price increases in the market value of the item being purchased, in the case of financial instruments, will reduce the interest rate they pay. To take an extreme example, if a 1,000-yuan bond paid 100 yuan in interest (a 10% yield) before the People’s Bank of China’s buy-in pushed the bonds price to 2,000 yuan, the unchanged dividend pay-out of 100 yuan means the yield has fallen to 5%.
If a deal of this sort goes on in the form of a bailout of the bondholder, who happens to be a troubled property investor, such a rate drop might conflict with the simultaneous policy of interest-rate hikes, designed to deal with a case of combined financial instability, inflation and recession: a situation that we are living through right now.
Interest rate or bond rate or Fed fund rate policy as actually practiced by central banks may also give rise to undesirable side effects. As implied above, the interest rate is not a dial on the wall that the central bank may spin to whatever value it likes. The policy rate is the rate charged by a central bank or some other agent of government such as a treasury or finance department when that official entity lends money to the market, or to commercial banks, or to lesser governments.
It is theorized that such a rate is connected to all other interest rates in the financial community by arbitrage. But the connection may fail or not exist at all at the very time when it would be most valuable, for policy purposes, to be able to move the general family of interest rates and specially to influence, up or down, the general availability and liquidity of the capital market.
Again, think of the present moment: On both sides of the Pacific certain capital markets, in particular property markets, are in disarray. Moreover, general inflation is high and rising and recession, or at least significant fall-offs in productivity caused in part by the after-effects of Covid lockdowns combined with currency fluctuations, supply-chain bottlenecks, all contributing to citizen dissatisfaction in the form of strikes, political unrest and unmet – perhaps unmeetable – demands that “somebody do something to fix it all.”
At times such as these, the policymaker knows that higher interest rates may choke off inflation, or at least make it more expensive for speculators to feed the boom with borrowed money. But the higher rates might make it difficult for young families to get funding for the purchase of their first condo.
If at the same time production and GDP output are slowed down by the onset of recession, higher rates may dissuade investors who otherwise, if only capital was cheap enough, help “fix things” by financing new ideas and rewarding the inventors, innovators and owners of “brain capital” whose creative imaginations have been the real secret source of economic progress ever since the Industrial Revolution.
Finally, the sense of just how inadequate are the usual instruments of economic policy gives rise to economic problems that reflect a need on the part of all players, East and West, governments and private actors, to “find shelter,” hide out, seek higher ground: The problem goes by many names and it takes a multiple of forms.
But just one sign of such a situation is now evident in currency markets: The dollar, even though it is attached to an economy suffering from major (self-inflicted) wounds, is the high ground to which many players are fleeing, resulting in near record-setting exchange-rate alterations: the euro is trading at parity with the dollar; a pound sterling costs a mere US$1.15; as I write these words, one US dollar in the retail market will buy 7.082 yuan in the exchange shops on St Catherine Street in Montreal.
When displayed with help of a chart, the US/China relationship shows a long hill climb for the dollar. It is important to know that the situation does not mean the US is in good shape; it is not. And I am certain that behind the scenes, all the relevant central banks are doing their utmost to resist these abrupt and trade-disrupting changes in relative currency values.
I also believe that speculators who think the central banks will fail in their attempts to “fix” or “repair” these unwanted changes in the costs and benefits of international trading power will be active in their attempts to frustrate and countermand the plans of the central bankers.
The battle between the speculators and the central bankers can devolve into a sort of financial Gunfight at the OK Corral: lots of damage to property and persons. And the supposed peacemakers, or lawmen if we remain true to the gunfight metaphor, are not much help because they are slinging bullets and imposing costs with as much vigor as shown by the “outlaw” speculators.
Leaving behind the fanciful world of imaginative figures of speech, I anticipate that these highly unusual changes in relative currency values will diminish the odds that the international “family” of central bankers will find an easy way to bring about a solution that will please all the players.
There is plenty of blame to be assigned to players, East and West, government and private, today’s and tomorrow’s. The Covid lockdowns and lack of policy debate and transparency were especially severe in China. The political name-calling, impeachments and electioneering-by-way-of-free-money that so disgraced the recent history of American politics will be an object lesson in bad governance for years to come.
These deep errors and the remaining unwillingness to face them cannot be “fixed” by manipulations of interest rates or any form of open market operations.
Perhaps only time and the eventual restoration of the wisdom that comes from an honest study of one’s own mistakes – mistakes made East and West – will make it difficult for the same mistakes to be made again.
Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.