Macro Economic Outlook for Central Banks
The following is an edited version of a speech made at the LBMA Bullion Market Seminar at Merchant Taylors Hall, London, on 10 December 2012.
Executive Summary in 10 Bullet Points
- Central bank policy is getting looser around the world
- Macro-economic outlook: this is bad for the long-term rate of growth
- Solution: officialise gold as second currency alongside national paper money
- Research shows coexistence of two currencies in the same country can be beneficial
- Changes the incentive structures of all the players
- If more than 10% of citizens use gold as money: signal to tighten monetary policy
- People vote with their wallets
- Advantage: will boost central bank independence and reduce public sector profligacy
- While preserving central bank ability to print money to solve genuine crises
- Macro-economic outlook: this will be good for the long-term rate of growth
I. Current Framework
1. Legal Monopoly
The first important point about the current framework is that central banks control the money supply because they have a monopoly on the creation of money. This legal monopoly is granted to them by the state and its institutions. It is also enforced by the state police: if you start printing money in your basement with a colour copier, the police will come and arrest you. For these reasons, central banks are intrinsically dependent on the state for their very existence. No state, no monopoly, no central bank.
At the same time, in the current environment, central banks claim and try to be independent. But how independent can they be from the entity – in this case, the state – that guarantees their very existence and their power? There are some limits. There is an apocryphal quote that says: “The Fed is independent from the US Administration – as long as it does exactly what the Administration wants it to.”
There are three players: the first player is the state, the second the central bank, and the third player is the market (or the citizens/the economy). The central bank is caught in the middle. It would like to do the right thing for the citizens, but the state is leaning on it to do the wrong thing. We have to change the power relationship between these three entities in order to make any permanent change to the situation.
There is a trade-off between the possible actions that a central bank can take, and I will give you the extreme possibilities. One is that monetary policy is completely obedient and subservient to the desiderata of the administration. An extreme example of that is Austria from 1914 to 1924, when there was hyperinflation. I could also have given the recent examples of Yugoslavia, Zimbabwe, etc. The other extreme is when the money supply is exogenously determined. An example would be the US prior to World War I. In that case, gold was money, so however many ounces of gold were in the US was the quantity of money, and that was completely independently determined.
4. Pros and Cons
Right now, we are somewhere in the middle, which is probably a good thing. The pros and cons of each extreme of the trade-off are obvious. If you have a responsive central bank that can print money and throw it at any problem, you can get out of crises more quickly.
I believe that, in terms of the evolution of the economy, there is path-dependency. If you get stuck in a bad situation, you could remain there for a long time. The best thing to do is to take some action financed by printing money out of thin air.
The advantage of not being able print money out of thin air is more of a long-term advantage in terms of the average growth rate of the economy. Indeed, when money is a stable yardstick of value, the division of labour between different market participants is enhanced; i.e., I am willing to exchange my labour against your goods at a price which is measured by the money price of the goods or the labour. I know what those prices are and I trust them, and there is very little uncertainty and conflict. We know the value of things. It encourages the division of labour. It also encourages the accumulation of capital, because, in this case, interest rates tend to be higher than they would be under current policies.
“The advantage of not being able print money out of thin air is more of a long-term advantage in terms of the average growth rate of the economy.”
Capital accumulation, as we know, is the only way to make labour more productive. I have snow outside my house in Switzerland. I can either shovel it with a shovel or I can buy a snowplough that costs about 3,000 Swiss francs. It is, however, very effective and I can clean up my driveway much more quickly than if I used a shovel or just my bare hands. Clearly, then, my labour is more productive once I accumulate some capital. As a result, the long-term GDP growth rate goes up. There is a famous study by Carmen Reinhart and Ken Rogoff that says that, if you have too much government debt that is facilitated by the central bank having loose policies – eventually, above 90% debt-to-GDP ratio – long-term growth rates are cut by 1% per annum.
We want the best of both worlds, and the optimum is in between. While this is not an exact science, there are some long-term advantages to being fairly inflexible, there are some short-term advantages to being fairly loose, and the optimum is probably somewhere in between, where you have a combination of the short and the long term, which both have to work in your favour.
II. The (mis)measurement of inflation
The way that this is usually measured is through inflation. We might say, ‘We are going to have a very loose monetary policy, but only as long as there is no inflation in the economy’. The problem is that inflation is measured by the government. The government has every incentive to under-report inflation; certainly, a few years ago, they did it in Argentina because they had inflation-indexed bonds, and the head of the official statistics office resigned over that. Everybody knew that they were underestimating it by about 8%. If you do it by 8%, clearly it is a bit too obvious, and the Argentines did not do it discreetly enough.
There are, however, some clever ways to do it a bit less manipulation, such as the notion of hedonic adjustment. I have an iPhone 4S, prior to which I had an iPhone 4. This has 64GB of memory and the other had 32GB. They are the same price – $500. With hedonic adjustment, however, this one is counted as being half the price, so inflation goes down. I am only using 3GB, so it does not make it much better for me that I have 64GB instead of 32GB, but this is the kind of accounting that they do.
Another trick is the geometric mean: instead of having the average of all the percentage rises in all the different goods being an arithmetic mean, which is the standard mean, they take the geometric mean, which involves some logarithms. You can prove mathematically that it will always be a lower number. All these changes took place in the 90s. They started in the US and they were adopted very quickly pretty much everywhere else in the developed world without much of a debate. Government statisticians also exclude house prices – sometimes they include rents but not the price of the house; they often exclude food and energy prices, but people have to eat food and to put some gasoline into the tank of their car.
This led to some literature about behavioural psychology in public finance. There are psychologists who wonder why it is that people on the street perceive inflation to be much higher than what the government reported. You can interview random people and they say, ‘Yes, inflation is and feels about 5% or 6% per year’. When you look at the government numbers, it is 0% or 1% – so why the gap? This literature did not exist before the 90s. Presumably, then, the man on the street at that time accepted the government numbers. So government-reported inflation may not be the most reliable indicator for picking the optimal trade-off between loose and tight monetary policy.
III. Short- versus Long-Termism
The problem in the current state of the world is that the balance is shifting towards more short termism and looser monetary policies. Without wanting to point the finger at any one bank or event, in my opinion central banks are very responsive to government wishes: they end up funding or helping fund, through their actions, chronic budget deficits. I am French, and the last time France had a balanced budget was in 1980. This is only possible because the interest paid by the government to service that debt is low, because the central bank is setting those interest rates quite low. This was not the intended role of central banks.
I am not a Keynesian, but I guess he is as good a reference as you are going to get these days.
He said that it should not be to fund chronic budget deficits that you increase money supply, but to respond to a crisis. Once the crisis is over, you mop up the excess liquidity. This is exactly what happened during the Napoleonic Wars. Wellington’s statue is conveniently located near to the Bank of England. Napoleon created a crisis on the Continent, and he had to be stopped somehow. They had to pay the soldiers to go and defeat him and, after he was incarcerated in St Helens, prices eventually fell back down to their original levels.
But this is not what is currently happening. Nowadays, we see the money supply increase in response a crisis, but it does not come back down afterwards; if anything, it resumes its inexorable upward trend from a higher level. This is problematic. Systematically loose central bank policies hurt the long-term GDP growth rate, the excuse being to boost the short-term GDP growth rate. Yet you should not sacrifice the long term for the short term.
The solution that I recommend is based on my research into the coexistence of different monies. The basic idea is that, in the economy, some citizens are short-term oriented and others are later long-term oriented. Let them vote with their wallets on how short- or long- term oriented the policy of the central bank should be. They will vote with their wallets if we allow them the choice between two different currencies. One would be hard and the other soft. The hard currency has to be the hardest possible, which I presume is gold, because you cannot print gold out of thin air; you have to go into the ground and drill it out, which is very expensive. If gold was officially made legal tender, alongside paper money, then people would have a real choice between two different currencies, and their choice would be very revealing and informative.
“The problem in the current state of the world is that the balance is shifting towards more short-termism and looser monetary policies.”
The price of gold coins would have to float freely with respect to the value of paper money and, every day, there would be an exchange rate between the two currencies. This is not a problem. For example, in Switzerland for many years, even before the peg of the euro to the Swiss franc, you could pay at service stations in euros, and all prices were freely floating. The oil price was floating, as was the euro/Swiss franc exchange rate, and service stations would display the price of one litre of gasoline in both currencies at any point in time. So it is not a problem practically.
The advantage of this dual currency system is that you would be able to monitor the percentage of usage of gold. That is the interesting bit, because if you have more gold usage than is tolerated by the central bank – I suggest taking 10% as a cut-off but it could be any other number – that would mean that people were voting with their wallets against paper money and against a central-bank policy that was too loose. If, on the other hand, only 8% of people were paying the butcher with gold coins, that would mean that there is quite a bit of leeway for the central bank to have a looser monetary policy and to throw money at various problems that need to be fixed, of which there are always some.
”The advantage of this dual currency system is that you would be able to monitor the percentage of usage of gold.”
The way this would work is similar to the process of dollarisation that took place in certain developing countries in the 60s, 70s and 80s. What dollarisation means is that, if a developing country’s central bank is too loose and is abusing the printing press, the citizens start to vote with their wallets against the local currency by trading with one another in dollars. That was at the time when the dollar was as good as gold. Nowadays, this assumption is more questionable, but it is something that existed. Ultimately, people who used dollars were saved from hyperinflation and its deleterious consequences. This also served as a signal to the government and the central bank to stop abusing the printing press. What I am recommending is basically the same idea, but with gold instead of dollars. Also we would have to make it official: some dollarisation was done on the black market, whereas the monetization of gold has to be legally endorsed in order to function properly.
1. Power to the People and to Central Banks
In terms of advantages, we would have a new input into monetary-policy decisions: the percentage usage of gold, compared to the target usage rate. It is much better than inflation, because it reveals the real preferences of the people. Each citizen would individually vote with his or her wallet, which would give central banks leverage over the state to refuse funding chronic deficits. In turn, the state would have to cut back wasteful spending, which would be positive for the economy. Even if it all failed and you could not convince the state to stop its profligate ways, at least you could protect a fraction of the capital of the nation, which is better than nothing.
From the point of view of a central banker asking ‘What is in it for me?’: on the one hand, you lose control of 10% of the monetary mass, which is a mall negative; but on the other hand, you regain the right to tighten and to say no to the government when it says, ‘Print me some money so I can pay next month’s bills’, which is a huge positive. Right now, central bankers have the right to loosen but they do not really have the right to tighten or, for some reason, they are not exercising it quite as harshly as they used to. On balance, this is a net positive for the central banker.
2. Democratic Legitimacy
It would also give central banks democratic legitimacy, because the president is elected by 51% of the people, but the paper currency managed by the central bank is chosen by 90% of the people. The central banker could say: ‘90% of people like our paper money, so we are doing a good job’, which would, once again, reinforce their independence from political power and boost the long-term growth rate of the economy.
” My recommendation to central bankers, then, is to not oppose these initiatives. They do not threaten you, instead they give you more leverage against the state when you want to tighten.”
My recommendation to all central bankers in the world is to do absolutely nothing, because there are popular initiatives afoot in Malaysia, Utah, Switzerland, Mexico, etc, to legalise, as a means of payment and savings, gold and/ or silver coins. The likelihood of some these initiatives going through is quite high.
- In Malaysia, it is already working. The gold dinar and silver dirham are sharia-compliant and you can use them in certain parts of Malaysia to buy a chicken on the market.
- In Utah, Governor Gary Herbert legalised the use of gold and silver coins as legal tender in 2011, and the Utah Precious Metals Association (UPMA), which is modelled somewhat on the LBMA, is making good progress on having people do business in Utah with such coins.
- In Switzerland, there is a popular initiative that is asking for 100,000 signatures. Under Switzerland’s unique democracy, obtaining 100,000 signatures allows you to hold a referendum, which, if accepted, goes straight into the constitution, bypassing any potential opposition from the political elites.
They are in the process of raising funds to finance the signature collection campaign.
- The project in Mexico is more oriented towards silver coins.
My recommendation to central bankers, then, is to not oppose these initiatives. They do not threaten you, instead they give you more leverage against the state when you want to tighten.
The bottom line is that, whether or not we like it, the countries that legalise gold as concurrent currency and monitor the usage of gold as money among their people to avoid an excessively loose monetary policy will have a long-term boost to their GDP growth rate and, as a result, will outgrow, outspend and, eventually, dominate those countries that do not adopt such a policy.
Dr Olivier Ledoit Permanent Research Fellow in the Department of Economics, University of Zurich
Dr Olivier Ledoit is Permanent Research Fellow in the Department of Economics at the University of Zurich. He is also Visiting Professor of Finance at HEC Business School in Paris and at the UCLA Anderson School of Management. Prior to that he was Managing Director at Credit Suisse in London, responsible for the Statistical Arbitrage desk in the Proprietary Trading unit. He is the author of over a dozen academic papers published in the top peer-reviewed research journals in the fields of Probability Theory, Statistics, Finance and Economics. He holds a B.Sc. in Engineering from Ecole Polytechnique in Paris and a Ph.D. in Finance from the Massachusetts Institute of Technology.