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PostOn Wirecards, Punchbowls, and "Teutonic" Central Banking (David A. Westbrook, USA, 06/29/20 3:49 am)
The punchbowl metaphor (see Tor Guimaraes, June 27th) is ancient in central banking. It has been attributed to a speech given in 1955 by then Fed Chair William McChesney Martin, who himself credits an unnamed "writer" for the metaphor.
Conversable Economist on Punchbowl
The basic idea is this: the job of the inflation fighting central bank is "to take away the punchbowl just as the party is getting good," i.e., to tighten credit as the economy booms, so that it does not "overheat." (Exactly why this is bad rests on a worldview that may be questioned, but let's call it the Teutonic orthodoxy, which tends to be more concerned about inflation than about other things, i.e., the core job of the central bank is to ensure price stability.)
Taking away the punchbowl (usually raising interest rates) when the party is getting good is politically difficult. Not only are powerful parties making money by borrowing cheaply and reinvesting successfully, risk is demonstrably, statistically, lower, until it isn't. Hence the bubble-enhancing problem of credit (leverage, e.g., buying stocks on margin), and hence also the core argument for central bank independence.
At present, there are no signs of inflation, just the opposite. This is no party. So central banks and governments the world over are doing all they can to make capital available. They are indeed pouring booze into the punchbowl. The problem is everybody worries the punchbowl is poisoned, or at least the party is. So people are not failing to start businesses because they can't get financing. They aren't starting businesses because they have few ideas, opportunities looks scarce, etc. In many places, inflation is too low (the conventional target is 2%), and the specter of deflation looms. But one of the few things the world's elites collectively believe in is monetary policy, and central banks don't have very many tools that are different in kind, so more booze, just different flavors.
As an aside and to respond to Tor, the Wirecard story has a kind of cultural pathos. Germans especially want to see their mighty economy generate start-ups, tech companies. They have a very different, fundamentally conservative and long term, business culture. Think Henkel knives, or even Daimler. But if "innovate or die" is the law of modernity, that's a problem. There is nothing remotely like a German Alphabet, Facebook, Amazon, Apple, etc. So Wirecard was celebrated as a German, but American-style, tech/finance company. Not just celebrated, unfortunately. Rumors began to circulate that something was rotten at Wirecard, leading to journalistic investigations, largely by Dan McCrum at the Financial Times, and short selling. Wirecard accused the FT of colluding with short sellers, an argument that the German regulators bought, and must have wanted to buy. In response, German regulators protected their champion, dismissing any doubts as some sort of Anglo-Saxon capitalist perfidy, prosecuted journalists and suspending short selling, etc. It's fascinating and a bit sad:
Coming back to central banking, one might argue (I have argued) that we are indeed seeing inflation in financial asset prices. Stock market, paradigmatically, but other stuff, too. If anything, central banks have contributed to this inflation, first by cheapening money and lowering debt yield, and second, lately and directly, by buying all sorts of assets themselves, injecting cash into the economy but conversely driving up asset prices.
If central banks are about controlling inflation, one might ask whether central banks should attempt to dampen asset price inflation, if they could. Controlling asset prices is not part of the Fed's "dual mandate," nor the mandate of any other central bank of which I'm aware. At the same time, many central banks do have some regulatory authority over the financial system, and central banking has its roots in financial crises and the lender of last resort function. And, as the GFC [Global Financial Crisis] conclusively demonstrated (and as we now understand the Great Depression), a financial market crisis can precipitate a real economy crisis. So if we look at the European sovereign debt chapter of the GFC, we see action taken to support the financial system, even if the ECB is supposedly guarding monetary stability. Just before the pandemic, the Fed was doing very interesting things in the repo market. By the same token, the Volcker Rule governing trading by banks is, after all, named for a famous central banker. That is, central banks are supposedly in charge of monetary/macro policy, but that must be understood through the banking system, and more broadly, through the portfolio economies on which so much depends, what I call social capitalism. So what should banking policy be, now?
Banks, unsurprisingly, want to be as free/profitable as possible. And if they blow up, we socialize the disaster, as we did during the GFC. So they want to roll back the regulations passed after the GFC, hence John E's cry, have we learned nothing from the GFC? Maybe, maybe not. Banks are safer, we think, but Wirecard casts a bit of doubt. One might also be worried about so-called leveraged loans bundled into CLOs (which are an awful lot like mortgages bundled into CDOs), as my buddy Frank Partnoy recently argued in The Atlantic. So, from a purely bank regulatory perspective, we should be skeptical of the desire to roll back the Volcker Rule and otherwise deregulate.
At least as I see it, the difficulty is this: our current economic problem does not have its roots in the financial markets. COVID-19 is a huge disease that is keeping people from working, or even spending much money. The pandemic is as real economy as it gets. So money is being used to--we hope--stimulate activity. More interestingly, worldwide, money is being used to bridge the mismatch in payment temporalities that the pandemic has caused. Think of a restaurant that must make a monthly rent payment but has no daily, not to say monthly, revenue. (If the GFC taught us about uncertainty and money, COVID-19 is teaching us about time. This is really interesting and deserves further thought, but I digress.)
Where does this money come from? A great deal of it comes from the government, either directly (fiscal spending) or through monetary policy. But--and I do not know why this isn't more widely understood--almost all the "money" in an economy is generated by banks, through lending. (The usual ballpark figure for an advanced economy is 90%. See generally Mervyn King's brilliant The End of Alchemy, which I reviewed in International Finance if you can get past the paywall.) That is, precisely because we need so much money to go into the real economy right now, banks can make a strong case that they should be allowed to operate as profitably as possible.
But there are limits to how much booze any punchbowl, not to say financial market actor, can hold. I'm hardly an inflation hawk, but "more money" hardly solves all problems, a thought I'm going to leave undeveloped here. Most of the foregoing has been pretty conventional/received wisdom (in admittedly wonky circles), but over the last year or more I've been musing upon and occasionally speaking about the political economy of central banking, the "Teutonic" view with which I began, and which animates the vast majority of central bank policy. I have, however, been rather distracted by recent events...
JE comments: This is a great essay, Bert; thanks! It's technical but also accessible. I had to review the Fed's "dual mandate," which since 1977 has been codified as promoting "maximum employment, stable prices, and moderate long-term interest rates." Shouldn't that be a triple mandate?
You also make a very WAISly observation about Germany. Why is the German track record with tech start-ups so poor? It even trails tiny whippersnappers like Estonia. As for the "Teutonic" dogmas of central banking, might this be more than a metaphor? The ethos of Germany's finance policy traces back to memories of hyperinflation of the 1920s, which arguably contributed to Hitler and WWII. Bert, what would the concerns of a "post-Teutonic" central bank look like?