The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Central banking, David, raises emotions in a lot of us because we’ve seen, especially over the last decade, how effective, or ineffective, central banking is. It really does have an effect on our lives. We’ve talked to central bankers. John Taylor had the Taylor rule. There are other key players in this system right now that are still working in the system, that have been working in the system for decades, and we really need to look at what is their thinking, and what are their goals?
David: You look at Arthur Burns, and his sort of caving to political pressure, or William McChesney Martin, who famously said that the role of the center banker was to take away the punchbowl. Or Greenspan, who took the opposite view and created what is the Greenspan put, and basically allowed the stock market to go bonkers, coinciding with one of the great periods of growth, financially, in the U.S. and world economies. These are positions taken, they are ideas that are put in play, and some of these ideas have far-reaching consequences, positive and negative. What you have with different central banks is a clear set of goals, and those goals sometimes differ from the goals and expectations of the man-in-the-street.
Kevin: Our guest today, Dr. Charles Goodhart, has been with the Bank of England, he teaches at the London School of Economics, his voice has been heard for decades in the central banking community, but he warned in the 1970s, and this is Goodhart’s Law, that once you start focusing on something that you are trying to target, as a central bank, it changes people’s behavior.
David: And that behavior-changing, that is what makes the current era so complicated, because we have perhaps the need for re-regulation or some change within the financial system, and yet, any time you begin to sort of target a particular issue, Wall Street has this tendency to sort of game the system and take advantage of it. We have the issue of moral hazard. We have the issue of financial stability, and what central banks want is financial stability. But, Wall Street, seeing a set of choices put in place by central bankers, again, will tend to take advantage of that information for their own profit and loss statements.
Kevin: I guess the question that still needs to be resolved, as you talk to Charles Goodhart, is, does helping the banks actually help the man on the street, and I think we’re just going to have to see if that plays out.
David: And you could argue that certainly the period of the 1980s and 1990s, that was the case. What was good for the goose was good for the gander. Now the question is, in an era where perhaps we are at the far outer edge of a credit expansion, is what is good for the goose still good for the gander? Is creating financial stability ultimately going to trickle down to benefitting the man on the street?
Many years ago we enjoyed conversing with John Taylor about the Taylor rule. Today we have the pleasure of visiting with Charles Goodhart, who is known, not only for Goodhart’s law, but for his many years, 30 years, as an advisor on monetary policy to the Bank of England. Thirteen years of that was as a monetary policy committee-member, by doing the equivalent job of the FOMC at the Fed. So, from deciding the official interest rate, to today, implementing programs such as quantitative easing, or offering forward guidance, you can go from the Marriner Eccles building to Threadneedle Street, and these are the policies which today define market pricing, and frankly, market perceptions.
Mr. Goodhart, you also spent nearly 20 years teaching at the London School of Economics, where you are now an Emeritus professor. We wish to better understand where we are today. What trajectory is being set by policies being pursued by the most influential central banks of our day: The Fed, the Bank of England, the ECB, the Bank of Japan. Consider this, perhaps, a reflection piece on the successes, the failures, in monetary policy. The last decade will be discussed and learned from for decades to come. I’m interested, as we start today, “How should that commentary be read?”
Charles Goodhart: It’s been very varied. The central banks had achieved enormous success in maintaining their inflation target and price stability over the years, from the beginning of the 1990s to about 2007. And whatever else is said, subsequently, one should remember that those 15-20 years were probably the most successful years for the world’s economic development that had ever been seen. More people came out of poverty, and particularly in Asia. There was steady growth. There was low inflation, low unemployment, relatively stable interest rates.
It was a marvelous period. But partly because it was such a marvelous period, and because volatility had been cut back so much, there was a growing belief that these would always be this good. And when that occurs, as somewhat heterodox economists, like Hyman Minsky, taught many years ago, there is a tendency for people to take on a lot more risk, and to fail to see the risks developing. To some extent, that was true of the central bankers, as well. So when a number of countries experiencing a housing boom ran into difficulties in the sub-prime market, to give you an example, I don’t think either the central bankers or the financial system, or the commercial bands, or indeed almost anyone, was really prepared for what was to come.
But when the crisis hit, particularly when Lehman Brothers went down in the autumn of 2008, then the central bankers rallied round, I think, absolutely magnificently. They brought interest rates down, they introduced QE-I, and they increased liquidity dramatically, and I think they turned the situation around, after about two quarters and brought about a recovery. So they certainly did well then, although they hadn’t really foreseen a problem developing.
After 2008, again, I’m slightly more critical, QE-I was absolutely correct, because it introduced liquidity into a panicking system where cash was king. But after the financial markets had had their confidence and their stability restored, the problems really became somewhat different, and the central banks weren’t, at any rate, on their own, and they should not have been so much left on their own, the central banks really weren’t able to bring about a recovery at all quickly, and it is only just now in the last couple of years that some of the developed countries, mostly the U.S. and the U.K, are beginning to actually work their way out of the period of depression, with Japan and the eurozone still stuck in a state of very low growth, and for a variety of reasons, very low inflation.
David: Let’s discuss the nature of some of the problems we face today, starting with unnaturally easy monetary policies, now in place for years. We’ve had some boom and bust cycles, even in this last 14-year period, with each intervention creating another boom, and perhaps setting the stage for the next bust. Am I wrong in thinking that there is more at stake in each successive boom/bust cycle.
Charles: I believe there are, undoubtedly tensions. Some tensions have been easing, but others are still arising. The pattern of financial markets has, undoubtedly, been distorted by the massive increase in central bank balance sheets, and the attempt by central banks to flatten the yield curve and bring down long rates to very low levels, as well as short rates. And also, of course, you’ve got the debt overhang in the private sector that was brought about by the decline in equity prices and the value of houses, at a time when debt remained very high. So you’ve got serious debt overhang and a distorted pattern of financial asset prices.
And that’s another thing I think is slowly improving. The Eurozone situation up to 2012 when the ECB introduced its proposed outright monetary transactions, or OMT, that has been stabilized, and some of the imbalances in current account positions, I think, are beginning to reduce. The Japanese current account surplus is long gone. The Chinese current account surplus is declining. The pattern of demographic development, I think, suggests – and the German current account surplus will start declining fairly soon, as well – so the old pattern of current account imbalances around the world is likely to change. And indeed, the U.S., itself, I think, is likely to change from being the main current account deficit country, the country which could well be in balance, or even in surplus, which will change the name of the game, and will have great problems and opportunities.
David: There were past eras of financial stress leading to currency devaluations, whether that was because of excessive national debt, balance of payments problems, as you just addressed, even interest rate differentials, that is, prior to the era of zero rates we are in now. Remember James Harold Wilson, prime minister there in Britain, describing devaluation as a means of escaping a straightjacket. Do you find there is a straightjacket in our day, and is devaluation a likely tool?
Charles: The various countries of the world with their own currencies, do have adjustments in exchange rates, which, over the longer term, tend to allow their competitiveness to be maintained, and there is a straightjacket in the Eurozone. And the problem is that whereas maintaining a fixed exchange rate has certain undoubted advantages, if you are going to do it successfully, you need to have suitable and sufficient other adjustment mechanisms if you can’t [unclear] the exchange rate. And one of the problems within the Eurozone has been whether these other adjustment mechanisms were up to scratch, were sufficient, to offset the straightjacket of a single currency system.
David: Diving right in here, the law, that is, Goodhart’s Law, simply stated, “When a measure becomes a target, it ceases to be a good measure,” and after four decades of discussing the idea you penned in the mid 1970s, you may be weary of talking about it. However, in a world that has embraced ever greater central bank activism, perhaps you can reflect on a few examples today of measures becoming targets.
Charles: Well, Goodhart’s Law was never a detailed theoretical analogy. It directly arose from empirical observation, which was that in the 1970s, when I was operating in the Bank of England, most central banks were turning to monetary targets as a means of trying to calibrate and steer their monetary policies. For a variety of reasons, most central banks chose different aggregates as their main target. And it just appeared that whichever aggregate they chose was the one where the stability of the demand for money function collapsed most dramatically shortly thereafter.
And one of the issues about this is that people will adjust their behavior, so when a measure has been transformed into a target [unclear] hit the target. I think I was reading in the paper this very morning about a piece in an English hospital where somebody was sent home and not looked at at all because that hospital had to meet a target of seeing all patients within four hours. If they didn’t see him at all, it wasn’t counted, whereas if he had been seen after five hours, they would fail to hit their target.
So I described that in the social and official governmental world, the adoption of a measure as a target does change the behavior, both of those to whom the target is applied, and also from time to time, of those who are applying the target, because the government, for example, that sets the target, actually wants it to be hit. And so they, themselves, will secretly change the way that they operate, in order to be able to boast afterwards that their target has been successfully hit.
David: Today we have a combination of things in play: Inflation targets, GDP growth rates, unemployment rates, even asset prices, sort of the new target of central bank policy. Let’s talk about QE. Is QE responsible for the collapse in the money multiplier, following Goodhart’s Law?
Charles: Yes, and [unclear] and rarely has there been a greater collapse. And the increase in the commercial bank reserve in the U.S. since 2009 when QE really began, the increase in commercial bank reserves has been of a factor of 100 times, whereas the increase in the broad money stock in the U.S., or bank [unclear] of the private sector, whichever aggregate you’d like to name, has been relatively moderate, it’s been about 10-15%. So the money multiplier has totally disappeared, I mean, it’s just blown up.
David: Why is there not more discussion on the collapse of the money multiplier? Given the amount of bank reserves in the system today, there’s still a theoretical possibility of a return to a more normal multiplier, and with it, perhaps a change in inflation expectations.
Charles: The central banks can’t allow that, because if the banking system began to use all these reserves to expand their balance sheets commensurately, an increase in the money stock and bank lending would just be huge, and that would cause a kind of inflation that nobody wants to see. Now, there are a whole series of things that can be done. One of them is that effectively, you can just sterilize the additional reserves by telling the banks they are not allowed to use it, that they have to have a much higher excess reserve requirement.
And to give you an example, after World War II, the British banks have not been allowed to lend to the private sector, except the munitions industries, and so the British banks came out of the war with 70% of [unclear] with pretty liquid government securities, largely treasury bills, and only 30% in bank lending. So what the government did when the banks began to start lending again, was simply to tell the banks that they had to transform quite a lot of their treasury bills into medium-term government debt. So the government could do that and simply intervene, and say, “You’re not going to use your available reserves.”
Another approach, which Ben Bernanke talked about quite a lot, was that the interest rate on bank reserves would be raised to the point at which they would prefer to go on holding much of their bank reserves [unclear]. And then again, a third alternative would be that the bank reserves have been built up by a process of purchasing debt with QE. And the central bank could just start selling the debt, which would have a deflationary effect, which would certainly offset any tendency of the banking system to start using its reserve funds again for large-scale lending.
So there are quite a lot of things that could be done. I, myself, don’t view the massive increase in the reserve base as being an indication that inflation, or worse, hyperinflation, is upon us. And there will be a physical process of trying to renormalize or getting the structural interest rate in central bank balance sheets back to their pre-crisis normal conditions. But I don’t think that the likelihood of runaway inflation is any greater than the likelihood of runaway deflation, and central banks have got a difficult path to traverse in order to get back to normalcy. But I don’t think that it is necessarily going to be of a major inflationary nature, and at the moment, as we look around the world, the dangers in deflation seem to be greater than the dangers of inflation.
David: U.K. and U.S. inflation are on a parallel track. The U.K. is now at 1.6%. Only the EU is lower, at between 0.5% and 0.7%.
Charles: I can’t remember where Japan may stand. Japan is somewhere in the same ballpark as the U.S. and the U.K. It’s not yet reached its 2% target. Therefore Japan, the U.S., and the U.K. are on the order of 1.5 to 1.6, depending on which measure of inflation you use.
David: So, what would you attribute this disinflationary trend to, in spite of unprecedented central bank activity and credit creation that we have seen, even just in the emerging markets, 9.5 trillion dollars created over the last 10-15 years, just as a means of creating foreign currency reserves, and that’s in the emerging markets, and the advanced market economies, again, massive, massive credit creation. We see it on the central bank balance sheets. Of course, the ECB balance sheet has come down in the last few years. Here we are on the horns of a dilemma. Deflation, as you say, seems to be the greater threat. All central bank activity seems to be inflationary in nature, and I wonder at this point, can we say, is central bank activity like sort of a scientific process where we are looking for 2+2=4, or is there more yet to discover, in terms of the outcomes and unintended consequences of current monetary policy?
Charles: There is a lot more to discover, and financial sciences are not like the physical sciences, they’re much more difficult. The weather doesn’t change depending on what the meteorologists say. Behavior in the private sector does change, depending on what the economists say and what goverments do. So what they are acting on is continuously evolving. And what’s more, we can’t do controlled experiments in macro-economy, and economics is hideously difficult, and we’re not very good at it. We have a great deal more to learn, and it is not an area where you can say that 2+2=4. A particular cause may have had a particular effect in the past, but you try the same measure again, and you may get something quite different, because people will have learned from the previous experience.
David: So we have the ECB’s use of additional quantitative easing measures, that’s currently on the table. I’m curious. Have they failed to notice that the Bank of England and the Fed QE programs are running into the law of diminishing returns? What do they hope to accomplish, and how can they expect a unique outcome?
Charles: Well, remember, central bankers feel very much that they are left totally exposed as the only game in town. If you speak to a practicing central banker they will say that things like restoring the economy to health should really be a function of government, not a central bank. Central banks can try and deal with monetary issues. They cannot influence real development, or they are only one out of a number of factors that can influence real development. Central bankers feel that there is much too much weight placed on monetary policy, and that they have been put too much in the forefront and asked to bear burdens which they really are not capable of bearing alone.
David: Certainly, the conflict there between monetary policy and fiscal policy, where your politicians have careers at stake, really since the end of World War II, certainly in the U.S., with the introduction of universal suffrage we had the budget become far more politicized and economics became elevated. But now it is an issue that our Congress would prefer to punt on, leaving the heavy lifting to our central banks.
On QE, one more point there. We’ve triggered the desired wealth effect. We have the U.S. household net worth, which is now 17% higher than its pre-crisis levels, right around 81 trillion dollars. Maybe you could address this particular concern. We have household net worth as a percentage of disposable income, which is far above an average level, 525% has been the average since 1952. The NASDAQ peak gave us 616%, the housing bubble gave us 660%. Again, this is household net worth as a percentage of disposable income. Now we’re at 639%, arguably in bubble territory. Asset price inflation is not generating the economic growth anticipated. So where does monetary growth go from here?
Charles: Good question. But remember that in the U.S. and in the U.K., there is now developing what appears to be a somewhat sustainable recovery, getting back toward the old kind of trends so that life in these two economies is actually improving. And I think that the central banks would say that this is, in part, a function of what they have done, and as since this has now been achieved, they can proceed to taper the extent of aggressiveness, and the degree of accommodation in the monetary policy that has been introduced.
The Bank of England has brought its QE expansion to an end some time ago. The Fed is now tapering, and is expected to go on tapering until there are no more purchases of assets, and there is excited discussion in financial markets of when either of these two central banks will actually start to raise interest rates again, with the expectation that no longer being that the increase in official policy rates won’t take place for some unknown extended period, and the general expectation in markets is that one or other of these two central banks will begin to raise interest rates probably by some time around the late spring of next year, in about a year’s time, and we’re beginning to get back to normality.
David: We probably remain somewhat skeptical on that front, just looking at the necessary credit expansion and seeing that corporations and households are still very hesitant to expand their balance sheets, government is still filling the gap and quantitative easing is still a large portion of getting us here in the United States to what is a necessary 2.2 trillion dollars’ worth of annual credit expansion, and if we don’t hit that number, then recession looms.
Charles: Well, things are beginning to recover, and the banks in the U.S., and to a slightly lesser extent in the U.K., and to a much lesser extent in the Eurozone, have begun to restore their capital, and the very large required increases in bank equity capital under the new regulatory system are being achieved, and the banks are beginning to expand their credit creation, again, to a greater extent than in past years, enabling the central bank to stop its credit creation.
David: So, the recapitalization of the banking system, that is one of the achievements of the last several years, perhaps?
Charles: I’m not sure if the recapitalization of the banking system was done as well as it might have been. I think it was done much better in the U.S. than it was done in the U.K., and better in both those countries than it was done in the Eurozone. One of the issues, and a very important issue, is that while it was generally agreed, among those who would agree, that the equity base of the banking system in all our developed economies, had been allowed to slip to far too slight a sliver, nevertheless, there will be question of how should that recapitalization have been best undertaken, with the least damaging effect on our economies?
David: Keeping rates very low was certainly a part of that, what some have called financial repression. Are we wrong to assume that a low rate policy redirects capital from some to others? And as a follow-on, that stills seems to support the moral hazard in play within the financial community, how do we move away from privatized gains and socialized losses?
Charles: I think that is a very difficult issue, the whole question of moral hazard, and how you best deal with it, is a very tricky one, and I don’t think that we’ve actually handled it effectively. What actually normally happens is that you say that moral hazard is a terrible thing, and therefore we must rescue that. And then we go into a crisis, and then a bank, or banks, starts to fail, and the effect of not rescuing them then leads to such contagion and such a massive [unclear] downturn that actually we are forced to rescue them, because the alternative is just too awful.
So what happens is a sort of massive [unclear] inconsistency, in which we start off by saying, “We’re not going to rescue you,” and then we always do because we have to, and nobody actually believes you when you say that we’re not going to rescue you. And I don’t think that trying to do that exercise again would ever come to a different outcome, because governments simply cannot allow their financial system to blow up, and when faced with the kind of outcome that stared us in the face after Lehman, you do everything you can to stop that going on.
David: Just as we wrap up, there have been many who have suggested, and I’m thinking of Guido Montega, who has described what we are in today as a currency war, and I go back in time to Jacques Rouffe, who had been a French financial attache in England in the late 1920s and early 1930s, and witnessed the prevailing trends leading up to the 1931 sterling devaluation, around 24% devaluation. And interestingly, he applied those lessons in the 1960s, not to Britain, but to the United States, and he strongly advised de Gaulle of an impending dollar devaluation.
Fast forward to the present moment. Do you anticipate a period of stable exchange rates, or a period of currency wars, like Guido Montega has described, with competitive devaluations?
Charles: I think that we are beginning to come into a different era. What we have had has been a period in which a group of countries in Asia, the oil producing countries, and Germany, has run continuing large current account deficits, as the U.S. has been the main counterpart with the deficit. I think that could in the next five to ten years really change around really quite dramatically, and the U.S., which is, and remains, fundamentally, an extraordinarily strong and vibrant country, may turn into a country which runs a current account surplus.
And I wouldn’t be surprised, particularly if Putin goes on playing funny games in the Ukraine, if the result of that has made everyone more determined to achieve energy self-sufficiency, with the result that oil prices might go down, including with it, the surpluses of the oil-producing countries, so that the game is going to change, and what will the world look line in about ten years’ time? It’s very difficult to tell.
David: Well, as we wrap up, I am interested where we began the conversation today. This is an unprecedented period, the last 5-6 years, truly remarkable. For an academic to reflect on the changes, the events, the policy responses to those events, what would you advise, to either a young central banker today, or perhaps more common than that, a man on the street who is trying to make heads and tails of the world, how do you operate best in the years that lie ahead?
Charles: Think for yourself, and don’t necessarily believe the current conventional wisdom, learn from experience, and spend quite a lot of time reading the good financial press, namely the Financial Times and Wall Street Journal, and The Economist. We need to keep a very close eye on what’s going on, because what’s going on is changing rapidly, and we won’t get it right unless we are aware of the changes in the economic system that are occurring pretty rapidly before our eyes.
David: Dr. Goodhart, it has been a pleasure. Thank you for joining us, and elucidating some of the ideas, bringing clarity to many of the issues of our day. We appreciate your time and wish you well.
Charles: I wish it was clarity. The world is complicated, and things change, and there isn’t a wonderful magic sword with which you can cut through the difficulties.
David: No convenient Sword of Damocles in our day. Well, thank you again. We look forward to perhaps future conversations as well.
Charles: Okay. Cheers.
Kevin: So, David, whether you are a central banker, whether you are on Wall Street, whether you are a man on the street, I think we all agree, moral hazard is something that just continues to not go away. When you convince somebody, like a bank, that they cannot lose if they go out and loan money irresponsibly, as long as they are too big to fail, they know that they’re not going to fail. So it is interesting to hear that Goodhart still has a concern in that direction, even though he is seeing a strengthening of certain elements in the banking system.
David: Kevin, I couldn’t agree more with Dr. Goodhart’s conclusions that we should think for ourselves, that we should continue to look at the conventional wisdom with perhaps a certain degree of skepticism, or suspicion, or just caution. Weigh it, and weigh it with a grain of salt. Should we read the financial press today? Absolutely. And be apprised of, again, what is conventional wisdom and be able to sort out for ourselves the correct way to approach the marketplace.
Kevin: David, I agree. Reading the financial press, I know you read the Financial Times, The Economist, the Wall Street Journal, you keep up that direction, but not necessarily to fall into lockstep with what the current financial thinking is, but actually, to be a maverick and say, “All right, where are they possibly going wrong?” I loved what Goodhart had to say about meteorologists. He said, “This is not a hard science. When a meteorologist predicts the weather, it doesn’t change the weather.” When the Federal Reserve is coming out and saying, “Hey, this is our target,” guess what changes?
David: It makes me think in terms of reading for yourself, thinking for yourself. Mr. Bagehot, was at one time the Editor of The Economist magazine, and he famously suggested that in a crisis the central bank should lend freely, and we’ve done that, but he suggested that it be on good collateral and at penalty rates. Those last two things, our modern central banks have neglected. And so it is, I think, healthy to not only look at the past and advice that has been given then, but also the present and the future, and again, sort of stitch this together yourselves.
Kevin: And that’s what we try to make an effort doing with the weekly commentary, Dave. We don’t just talk to people who necessarily think exactly like we think. Most of the time what we’re trying to do is expand the discussion to understand what others are thinking.
David: That includes our conversation with Dr. Goodhart, with William White, with Otmar Issing, with Barry Eichengreen, with Michael Bordo, with Harold James, with Michael Pettis, and many, many others, as we try to make sense of the world and determine what the wisest course of action is.