Central banks, the real creators of economic crises?

By Benedict Chong

“A system of capitalism presumes sound money, not fiat money manipulated by a central bank. Capitalism cherishes voluntary contracts and interest rates that are determined by savings, not credit creation by a central bank.” – Ron Paul

Every great financial crisis has its roots and consequence. The latest Great Financial Recession in 2008 was triggered by widespread mortgage defaults in America. Debtors could no longer meet interest and loan payments, leading to collateral recalls. Fire sales of real estate quickly overwhelmed declining demand, depressing prices and led to further defaults from owners who owed more than their homes were worth and thus could not afford refinancing.

Blame for this episode was largely directed at Wall Street Institutions and the ‘greedy’ bankers inventing esoteric financial instruments such as adjustable rate mortgages (ARMs), mortgage backed securities (MBS) and credit default swaps (CDS).

In the years that followed, banking executives were subpoenaed by government agencies and congressional testimonies. There, they were grilled by unforgiving regulators and legislators for their perceived role in a global economic recession that the world has still yet to fully recover from.

Global banking institutions have been slapped with billions of dollars in pecuniary penalties for allegedly miss-selling financial derivatives to eager clients who had been all too willing to part with their monies for higher returns and their perceived role in the financial crisis.

The perceived greed of these bankers leading to the global recession also resulted in questions aimed at the efficacy and feasibility of market self-regulation. The free market system was then the target of academic vitriol for not preventing the financial crisis.

Armchair critics quoted several indices which ranked the American economy as one of the freest in the world, thus substantiating their views that the free market had failed. But just as ranking 100 criminals according to degree of innocence does not make any of them innocent, so too can a similar analogy apply to the indices. The American economy is thus not as free as commonly believed.

In addition, since the turn of the 21st century, the American economy has progressively become less free and was quickly overtaken by countries such as Singapore and Hong Kong, whose economies are not entirely free in the first place.

Therefore, are these banking institutions really responsible for the crisis that unravelled? Or were they simply easy scapegoats to draw attention from the real cause – the central banks?

What are central banks?

Monopoly-MoneyA central bank is defined as the state institution responsible for monetary policies. They are typically vested with the duty of meeting certain targets such as currency stability, being the lender of last resort and regulating the financial sector in the economy. Examples of central banks include Federal Reserve in America and Monetary Authority of Singapore (MAS) in Singapore.

Central banks are expected to be politically independent to safeguard against the monetisation of government bonds. Unfortunately, because central bankers are usually nominated by political leaders, their independence is highly questionable. In Singapore, we simply do away with the pretence and appoint the Finance Minister as the chairman of MAS.

Every country’s fiat currency draws its value from a reservoir of trust because it has no intrinsic value beyond the scrap paper or polymer that is what we call money. Due to fiat money’s inflationary nature as a result of unrestrained monetary expansion, that trust is quickly eroding as inflation persists.

In Singapore, the statistical inflation in 2013 released by Singstats was calculated to be 2.4% year on year. However, is it really 2.4%? Anecdotal evidence will probably give a much higher if incalculable figure. While the method of weighting various consumed items is not within the scope of this article, it is seriously flawed for failing to take into account energy expenses while giving housing expenses lower than accurate weighted proportions.

The nature of inflation and deflation

According to common misconceptions, the absence of inflation will mean deflation. The prospect of deflation is one of the most highly feared by mainstream economists and central bankers worldwide. Both parties hold near parallel standpoints on this issue – that deflation is bad.

However, what is so bad or scary about deflation? Keynesians, who run the majority of the world economies today, would argue that deflation leads to a sustained decrease in general prices, which would then result in consumers postponing consumption in expectation of lower prices in the future. This would then lead to a vicious cycle of ever decreasing prices and foregone or postponed consumption.

The solution, then, is to press the panic button and take on highly accommodative monetary policies. This is done through open market government bond purchase, reduced discount rates and lowered capital requirements for banking institutions. All these are done to inject more money into the system in the hope that cheap monies will encourage consumption and increase inflation.

The logic is that low savings rates will encourage consumers to save less and consume more since the opportunity cost of savings will be lowered due to lower returns. But while this logic may apply in certain countries, they are not necessarily true for every country.

In countries with a culture of saving for the future, decreasing savings rates may actually encourage more savings. This is because a drop in returns will require higher present savings to attain a similar sum of monies in the future.

“Managing” the “crisis”?

Such accommodative monetary policies and blanket rejection of the free markets’ ability to set interest rates in favour of more arbitrary guidance probably led to distortions in the market for high yield bonds with low credit ratings. Such artificial demand may in fact have led to the great financial recession of 2008.

MAS managing the Singapore economy (image - screen capture from STOnline)
MAS managing the Singapore economy (image – screen capture from STOnline)

Closer to home, MAS is in the midst of formulating various new regulations for the local financial market in response to the penny stock crash last October. They do so under the guise of sound management, conveniently overlooking the fact that the market manages any company in sounder ways than they ever can.

By introducing more stringent rules and regulations such as trading collateral requirements, MAS is removing the ability of brokerages to conduct their own risk assessments in favour of another state sanctioned one-size-fits-all policy.  Due to their “sound’ policies, the local bourse continues to record ever decreasing liquidity quarter on quarter.

It is indeed extremely convenient and appealing to denigrate the free market for any economic crisis that may occur. Yet, we must remember that at this point of writing, no economy is entirely free of state intervention. So long as an all-powerful state sanctioned monopoly called the central bank operates within, the economy is never truly free from state control.

Therefore, is it really logical to place blame not on the regulators and overseers, but on the free market? The free market invented and produced goods and services such as our smartphones and television sets which humanity holds so dearly today. What has the state, together with their unwieldy central banks, produced? Economic crises.

Top image – Monetary Authority of Singapore website

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