This week, the first Annual Summit on Economic Freedom will take place in the European parliament.
I will have the pleasure of debating with the director of IMF Europe, Jeff Franks, on the topic of “Central Banks: The Solution or the Problem?”.
From 2008 onwards, central banks have generally been regarded as the heroes that saved the day from the volatile and dangerous free market, but an interesting counter-narrative has developed: monetary policy has increased inequality, distorted markets, and – perhaps most importantly – created an even larger global debt bubble than that of 2008.
To comprehend why we are in this position, it is important to understand the work of Friedrich von Hayek.
Hayek won the Nobel Prize in Economics in 1974 for his work on how central banks distort the economy by setting interest rates.
Price manipulation has failed in every sector of the economy in which it has been tried – economic history is littered with failed attempts by governments to set prices, ranging from the edict of Emperor Diocletian setting prices in Ancient Rome in the year 301, through to Britain during the 1970s. Thinkers at Diocletian’s time, such as Lactantius, pointed out the distortions caused and predicted that the edict would lead to widespread hunger and shortages.
When central banks set interest rates, they distort the pricing mechanism of credit. In a free market, interest rates would be set by the amount of people saving and the demand for borrowing – if more people saved, interest rates would fall, allowing for more investment. Central banks setting interest rates, just like governments attempting to set the price of food and other goods, causes false signals to be sent to the market.
For example, the US housing bubble was largely generated by the Federal Reserve’s one per cent interest rate policy of 2003-4, which resulted in more houses being built than were justified by the amount of resources and saving in the economy. In a free market, the sudden rise in demand for borrowing would have caused higher interest rates. The current protracted low interest rates have resulted in a global debt bubble which dwarfs the debt bubbles of the last decade.
Many institutions are now pointing out the negative effects of central banks’ monetary policy.
The Bank for International Settlements – the central bank of central banks – has done excellent work showing the extent of bubbles in financial assets, and has cited Hayek’s work in its papers, while the chairman of the Economic and Development Review Committee at the OECD has averred that we are in a worse state now than we were in 2007, due to the extra debt accumulated largely as a result of monetary policy.
Bureaucratic price setting has a staggeringly high failure rate. We are not surprised when Venezuela has food shortages resulting from the government setting prices – we should also not be surprised when central banks setting interest rates lower than they would be in a free market results in a $230 trillion global debt bubble.
When the bubble bursts, it will be important that people understand that the crash is not some act of God, random event, “animal spirits”, or innate feature of financial markets, but rather a consequence of having interest rates set by central banks which has created a global debt super-bubble. The only way to prevent this is to have interest rates set by the market rather than central bankers.
I look forward to the debate in Brussels with the IMF, and applaud their openness to new ideas.
The IMF would never recommend to an emerging economy that they set up a team of bureaucrats to fix the price of food, fuel, or consumer products. They should apply this same principle to interest rates so that they, like other prices, can be set by the market.