The Future of Monetary Policy

The current monetary policy framework has lost all semblance of credibility. More importantly, it has lost its democratic legitimacy. A fundamental change in thinking is urgently needed.

The ceding of so much power to unelected officials rests on the dual premise that central banks both understand the inflationary process, and also possess the policy instruments to keep inflation within its target band. Given the experience of the past decade and a half, it is not difficult to conclude that this dual premise is false.

For some time following the global financial crisis, the problem policy makers faced was that inflation was considered to be too low. This led to fears of deflation, prompting policy measures so extreme that past generations of central bankers would have judged them not just irresponsible, but unthinkable. Then, when inflation finally re-merged, the first response was denial. It was “transitory” they said. Once that became an untenable position, rate hikes followed at a pace not seen for half a century. At times this has seemed like blind panic, rather than a sober assessment of the pros and cons. The well-known “long and variable lags” of monetary policy did not warrant even a mention.

Central bankers have offered few apologies for their failure to see inflation coming. Worse still, there has often been a “not my fault” tone to speeches and press releases, sometimes coupled with self-righteous lectures about the need for wage restraint, or the need to do something about poor productivity growth. Oddly, there has been no suggestions that a decade of near-zero rates, and a five-fold increase in central bank balance sheets, might have played a role.

Andrew Bailey has at least confessed that central banks cannot control inflation. More recently, he even admitted that the models used by the Bank of England failed not only to forecast the re-emergence of inflation but have also failed to predict its persistence.

Given the painful impact on the lives of hundreds of millions of people from such a material and rapid rise in global interest rates, how can it simply be business as usual? How can politicians sit and back do nothing?

Perhaps the group think on economics and monetary policy has become so entrenched that our political leaders see no alternatives. Perhaps the collective view is that errors of judgement should be forgiven, due to the difficult nature of the challenge. Perhaps they fear savage financial market retribution if they suddenly change the rules of engagement. Perhaps it is just a little early. Maybe inflation needs to persist, or the world economy enter deep recession, or something else go wrong, before a profound change in thinking about the role and conduct of monetary policy emerges.

Few economists, market commentators, or politicians seem to appreciate that the appropriate role of central banking and monetary policy has been debated for over three hundred and fifty years. Or that many different philosophies and operating models have been tried. TINA thinking is deeply ingrained.

But the simple fact is that there is not just one approach: not one universal truth.

Indeed, since the Second World War, there have been at least five distinct monetary policy regimes. Each change in regime was either the result of actual or perceived failures of the previous regime, major geo-political shifts in global financial markets and the world economy, or both.

Both those pre-conditions are currently in play.

“Our Theories Were Wrong Ma’am”

When the late Queen asked the economics establishment of Britain to explain how they failed to forecast the global financial crisis of 2007-2009, the answer was – “a collective failure of imagination”. A more accurate answer would have been “our theories were wrong Ma’am.”

Alan Greenspan confessed to Congress in 2009 that he had found a “flaw in the model” of his thinking on how the economy worked. And Larry Summers admitted in an interview in 2011, that the “vast edifice” of post-war economics had been virtually useless during the crisis. He found reading Walter Bagehot’s “Lombard Street” on the UK banking crisis of 1866, published in 1873, more helpful. Many other prominent economists confessed that the financial crisis had taught them a lot about the dangers of leverage, particularly hidden leverage.

Some 15 years later, one could be forgiven for thinking that the collective memory of just how close the global financial system came to collapse in the 2007-2009 period has faded. Aside from some tightening in financial regulation, it is not clear that central bankers and economists have really evolved their thinking on how the capitalist economy actually works.

Economies and Markets are Complex Adaptive Systems

The fundamental problems with orthodox economic theory are well known. Thousands of books have been written on the subject.

The short summary is that a “general equilibrium” cannot exist in evolutionary time; economic agents cannot “optimise” in a world of uncertainty; competition is not “perfect”, but Darwinian; and “shocks” are not “exogenous” to the economy but emerge from within.

The science of complex systems has revolutionised the understanding of the natural world over the past 70 years. It began in 1953 with the discovery of how all organic life evolves from two helical strands of DNA. Since then, complexity theory has touched every branch of science, and been applied to modelling an astonishing range of highly non-linear real-world phenomena, from everyday traffic jams to climate change. Now it is revolutionising the digital world, in the form of Artificial Intelligence.

A complex system is one that exhibits emergent behaviour. Put simply, emergence means the whole is always more than the sum of its parts. Other properties are self-organisation, as with the coordinated flight of flock of birds; chaotic behaviour, where small changes in initial conditions cause large changes over time, like earthquakes and hurricanes; and fat-tail events, like the extinction of species.

Complex Adaptive Systems feature interacting organisms or agents, who learn by doing and seeing, and adapt their behaviour over time, usually in increasingly complex ways. Sound familiar? It should.

Read any introductory book on Complexity Theory, and the first example of a Complex Adaptive System (CAS) is invariably the economy and financial markets.

Why do proponents of orthodox economics seem oblivious to the fact the economy and financial markets are a Complex Adaptive System, when it is self-evident to scientists in the field?

If one reads Kuhn’s “The Structure of Scientific Revolutions”, or even Bill Bryson’s more amusing?“A Short History of Nearly Everything”, the answer clear - they are human beings. If your career, livelihood, and reputation depend on a set of beliefs, a method of analysis, and a body of work, it is difficult to accept you are simply wrong. As Max Planck famously quipped, when faced with orthodox opposition to quantum theory, including from Einstein:

“A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die...”.

Complexity Economics views economies and markets as evolving, living organisms, with a past that cannot be revisited and a future that is uncertain. Economic agents main focus is to survive, not “optimise”. They learn by experience and adapt their behaviour as circumstances change. And they compete against each other in the true sense of the word.

Booms and busts, bubbles and crashes, and all manner of things we see happening every day are not “anomalies”, or “market failures”, or the result of “irrational behaviour”. On the contrary, they should be seen as essential elements of the economic and financial ecosystem. Rather than a virus inflicting harm, they are like the immune system going into overdrive, to ensure that the body economic survives, in spite of its tendency to self-destruct.

Monetary Policy and Credit Creation

When it comes to monetary policy, the critical failure of orthodox theory is that it ignores the process of credit creation; that is, the generation of leverage in the financial system.

Why? The answer is the nature of the mathematics underpinning orthodox theory.

When Ken Arrow and Gerard Debreu first identified the mathematical axioms require to prove the existence of General Equilibrium in the 1950's, they borrowed equations from physics, specifically from the First Law of Thermodynamics. This relates to the conservation of energy. In other words, the total energy in a system remains constant, even if it changes form (e.g., from kinetic energy to heat). The mathematic property of relevance is termed "boundedness".

Credit creation, like many other real-world phenomena, is mathematically unbounded. It is therefore not consistent with the assumption of general equilibrium. Something we see happening every day does not "fit" with orthodox theory, and so it is overlooked.

By precluding the generation of leverage, monetary policy has a well-defined role in the theoretical and quantitative models used in orthodox economics. It is modelled as a “reaction function” to real variables, like actual unemployment relative to its so-called natural rate, or actual GDP to some estimate of potential GDP.

In the real world, the role played by monetary policy is not well-defined. It cannot control inflation, as Andrew Bailey admitted. In fact, it cannot?control?anything. All monetary policy can do is seek to?influence, at the margin, the degree of credit creation and the volume of leverage in the financial system.

Money and Debt

The accepted definition of money is that it is a unit of account, a medium of exchange and a store of value. In other words, something to measure prices in, transact in, and hold as an asset.

But that is simply a definition of what money does. It is not the true nature of money. The true nature of money is that it is debt.

Banknotes are debt of the sovereign issuer. A bank deposit is debt owed by a bank. But both of these become money when those debts are transferred to someone else. When a bank or other financial intermediary lends money to a business or individual a debt obligation is created. If that bank or intermediary endorses that debt, and sells it to a third party, money is created. If that additional debt is also transferable, the process continues. This is what makes money so hard to define in our globalised and deregulated financial system.

The leverage created by financial intermediation ends up somewhere. It can be used to buy goods and services, financial assets, or real assets. The inflation that is the focus of monetary policy is inflation in the prices of goods and services. But there is also inflation in the prices of real and financial assets. Most borrowing requires assets to be posted as collateral. When asset prices rise, collateral values increase, which then feeds back into the credit creation process. Indeed, despite the occasional correction, real and financial asset prices have been steadily rising for decades, even while good and services inflation was low.

Many economists, market commentators, and the media, still make Friedman-like claims that money growth causes inflation. They are both right and wrong. Right in that the money created via the transfer of debt is inflationary; wrong in that it does not have to go into goods and services inflation. In the Complex Adaptive System of the economy, the degree of leverage, and its ultimate destination, will be driven by our collective behaviour.

The current level of debt, or degree of leverage in the financial system, is at record levels. S&P have estimated that global debt (government, households, companies, and financial institutions) reached 350 % of GDP as of June 2022. This was one-quarter higher than in June 2008. Non-financial sector debt is up one-third, while household debt is up a more modest, yet significant, 15%. Also, as of June 2022, the BIS estimated that off-balance-sheet leverage in US Dollar currency swaps and forwards was more than double on-balance sheet exposures. This hidden leverage was also at record levels, more than double what it was in 2007.

When debt ceases to be transferable, the credit creation process stops. When a sufficient number of lenders begin to fear default on that debt, the process turns into credit destruction. There is a so-called Minsky Moment, where chaos ensues. That is why the history of the past five hundred years has seen one financial crisis after another. All different, and yet all the same. The generation of leverage gets to a tipping point, where the process ends, and then goes into reverse. The crisis in the UK Gilt market last year, being the most visible recent example.

In this sense, credit creation is ultimately bounded, but not in a way that can be modelled by orthodox economics. The tipping point is determined by our collective behaviour, by a shift from greed to fear.

The BIS flagged last year that smaller banks were at risk of failure due to the sharp rise in official rates. This has already proved to be the case in the US. Other vulnerable groups identified were households, particularly those with large mortgages, and/or credit card debt, at the middle to lower end of the income scale. Defaults on credit card debt was also flagged as a potential risk for larger financial institutions. Lower rated, or unrated, corporate debt was seen as particularly vulnerable.

Central bankers, in contrast, keep assuring us that both corporate and household debt do not pose a systemic risk. But there has never been such a dramatic rise in global interest rates with debt this high.

With inadequate theories, and inadequate models, such assurances should be taken with a pinch of salt.

Understanding the inflationary process

We all know what inflation is – rising prices. The economic definition is a persistent rise in the general level of prices. But just like money, the nature of inflation creates a theoretical muddle for orthodox theory.

The first problem is that orthodox theory struggles with the difference between “normal” inflation and “hyperinflation”. Analytically, they are the same thing, but the rate of one is obviously much higher than the other.

From a complexity perspective, they are different. Hyperinflation is due to a loss of faith in the unit of account – the sovereign currency - usually due to endemic political corruption, war, or the collapse of the rule of law. Often when this happens, the medium of exchange will become something else. Inflation in the new medium of exchange is lower or non-existent. Those that see hyperinflation coming will seek a store of value in some other currency or commodity. “Normal” inflation might be present at the beginning of a hyperinflationary period, but the process that turns that into “hyperinflation” is more akin to a phase transition in physics, where a solid turns into a liquid, or a liquid turns into gas. In this sense, it is chaotic behaviour. Bouts of chaos are inherent in Complex Adaptive Systems but are ruled out by the mathematics of general equilibrium.

The second problem is that due to the assumption of general equilibrium there needs to be a theory of the equilibrium inflation rate.

There are three main variants: the rate where money supply growth equals money demand growth; where aggregate demand growth equals aggregate supply growth; or the rate of unemployment is equal to the natural rate, or the non-accelerating inflation rate of unemployment (NAIRU. Given these theories of equilibrium inflation, excess inflation results from excess money supply growth, excess demand growth, or excess wages growth.

Central banks have totted out just about all of these theories in recent times. Each has some validity but falls short of a coherent and consistent theory of the inflationary process. For example, during the long period of low inflation, economists often cherry-picked whatever theory seemed most plausible at the time, as a basis for forecasting imminently higher inflation, which never eventuated. None of these theories predicted the recent re-emergence of inflation.

One other theory of inflation is that it stems from changes in so-called inflationary expectations. This is akin to a self-fulfilling prophecy. Inflation will happen if we expect it to happen. In the Dynamic Stochastic General Equilibrium (DSGE) models used by central banks inflationary expectations need to be “model-consistent”, that is based on parameters and equations within the model. But this is of not much use in policy formulation or forecasting, so central banks use different, more pragmatic, approaches to estimating inflationary expectations. Surveys of consumers and market professionals are one source: future implied inflation rates from bond markets another. Both of these have shortcomings, particularly the latter, as it implies that financial market pricing reflects some "rational" forecast of the future, rather simply being the current market price.

The potential role of inflationary expectations is one aspect of orthodox theory consistent with Complexity Economics. Since adaptive agents learn by experience, after a long period of low inflation, they would come to expect low inflation to continue. By setting an inflation target, the current monetary framework seeks to provide a “nominal anchor” to inflationary expectations. In many respects it was a key element in moving to inflation targets, after the failure of money growth targets.?

Now, whether this aspect of the inflation targeting regime worked as intended, we will never know for sure. But maybe it did play a role in the period of low inflation. And underneath all the textbook nonsense being peddled by central bankers at the moment, there is a real sense that the rapidity of rate rises, never-ending “hawkish” talk, and the occasional condescending lecture, is a boots-and-all attempt to put the inflationary expectations genie back in the bottle.

While the economic orthodoxy still struggles to explain why inflation was so low for so long, and then suddenly re-emerged with a vengeance, this path of inflation is recent decades is readily explained if one takes a complexity perspective on the inflationary process.

China’s admission to the WTO, led to the globalisation of production lines, and offshoring of manufacturing. The fall of the Berlin Wall had a similar effect in Europe. Companies saw cheap foreign labour as an opportunity to materially reduce costs, and within a few years, offshoring production to low wage countries exploded. At the same time, digital technology was revolutionising the world, also lowering costs. Offshoring labour crushed the bargaining power of unions, and individual employees, especially since those baby-boomer employees were aging, having children, taking on debt. Corporate profits surged, leading to a material shift in the profit share of global income. Globalisation also opened up markets in one country to companies in other countries. Competitive pressures intensified like never before. Customers being able to cheaply compare prices on the internet, added to this competitive pressure. Interest rates fell and stayed low, further reducing operating and investment costs.

Whether monetary policy played any role in this process is debateable – if it did it was minor. There was certainty no basis for central bankers taking the credit for low inflation. In fact, most of the time they were fearful of deflation, and trying desperately to get it higher.

Based on this explanation, the re-emergence of inflation is readily explained. All the disinflationary forces have now gone into reverse.

De-globalisation is already underway, being replaced by regionalisation. Geo-politics now means supply-line security is more important than lower costs. Demographics are fundamentally different. Baby boomers are dying and retiring in large numbers, and in many countries, population growth is giving way to population shrinkage. Right-wing populism is leading to anti-immigration policies in some countries, leading to acute shortages of labour in “unpleasant” jobs. As a result, pricing power has returned to both companies and labour. In the real world, only the foolish would not seek to use that power.

Emergent inflation, like emergent disinflation, is the result of collective rational behaviour, not in the orthodox economic sense, but in the human sense. We compete to survive and prosper, to feed and educate our children. We adapt our behaviour, economic and otherwise, as we see the world change in front of us.

Some level of inflation is an inevitable product of the competitive process. A payback for our ability to differentiate our products, services, and skills. In the evolutionary battle to prosper, rent-seeking and profit-seeking are the driving forces of economic life. While these forces produce periods of higher inflation, the same competitive process will work in the opposite direction, when profit and rents reach extremes, providing a self-correcting mechanism.

This is arguably what happened after the Second World War. The inflationary effect of the removal of price controls and supply bottlenecks eventually worked themselves out, and inflation duly subsided. Inflation might also have dissipated of its own accord in the late 1970’s if economic agents had been given the time to adapt their behaviour to structurally higher oil prices. Unfortunately, we will never know, as the Volcker-era rate hikes, and recession that followed, were credited with solving the problem.

But the idea that bursts of inflation are the result of structural change is consistent with the available evidence that inflation has been low and stable throughout most of history. Periods of high inflation are remarkably rare. And each one had easily identifiable causes.

If you look at inflation as a natural outcome of geo-political and demographic change in the world economy, and our collective response to that change, it seems like less of a problem.

But you cannot think this way if you are central banker, burdened with the wrong theory of how economies work, and charged with meeting an inflation target. If the only tools in your toolbox are aggressive rate increases, reversing QE, and relentless “jawboning”, you play all those cards and hope that the “narrow path” of getting inflation back to target, with minimal damage to the fabric of the economy and society, magically eventuates.

First, Do No Harm

"Doing no harm” should be the guiding principle for designing a new framework for the conduct of monetary policy.

The idea that economics could “fix” things has always been a seductive proposition. Borrowing from the title of the book by former BoE Governor, Mervyn King, it has the lure of alchemy, which even the greatest minds of history, most notably Isaac Newton, found difficult to resist.

Putting an “end to boom and bust” as Gordon Brown infamously said, was indeed a noble objective. But what if in “fixing” things, you simply interfere with an evolutionary process, create imbalances, and anomalies, that ultimately lead to its demise. Humankind has done irreparable damage to our planet. Let us hope that misguided interventionist monetary policy has not done the same to the economy.

Under the current policy framework, monetary policy has been asked to deliver price stability, and in some countries full employment as well. Central banks have been expected to twiddle the dials of policy to deliver an impossible outcome.

Though at times it appeared they were delivering, they have failed. Even if the theories that guided them had been right instead of wrong, it would still have been an insurmountable challenge. Controlling, or even just steering, something as complex as the capitalist economy is beyond our capabilities.

Schumpeter argued that capitalism is about “creative destruction”. He was in many ways, the first proponent of Complexity Economics. Interfering with evolutionary process has consequences. The current policy regime has led to excessive leverage, excessive risk-taking, and fostered too much investment in financial assets and too little into expanding the productive capabilities of the economy.

Monetary policy needs to revert to what it was originally designed to do – provide some stability to an unstable system. To ensure that when the complex network of transferable debt ceases to function, only the insolvent go broke, not those who were solvent, but lacking liquidity. Providing a nominal anchor is also important, especially in a world where the medium of exchange in the future will likely have no physical presence.

What the future framework of monetary policy?should not do?is underwrite risk-taking. This is not simply about bailing out any institution or entity deemed too big to fail, while leaving those that suffer the consequences of their risk taking to their own devices. It is about?not fostering?a culture of certainty in the economy and financial markets.

Central banks have tried hard to keep markets “informed”, so that they will make rational decisions, or decisions that policy makers want them to make. So-called “Forward Guidance”, in all its forms, has played that role. But rational decisions in the artificial construct that is orthodox theory are different from rational decisions in real world of uncertainty.

In a Complex Adaptive System, agents learn from both success and failure. If you know central banks will come to your rescue if equity markets fall, or credit dries up, then you take more risk. The punishment for failure is minimal while the rewards for success are large. Periods of loss-making and economic instability are essential, to reward the prudent and punish the reckless. If these things are indistinguishable, the system will stagnate, and risk extinction.

The Future of Monetary Policy

In terms the specifics of the future framework, the model of political governance, the policy objectives, and the policy instruments used should all be reconsidered.

On political governance, the importance of so-called “independence” has been overstated. This word should always be italicised, as no government institution can be wholly independent in a democratic system, especially one which can so profoundly impact our lives. Central banks have always had some autonomy, and this should unquestionably remain the case. But the degree of authority ceded in the future needs to be more limited.

One idea recently suggested by George Cooper, was that the policy rate should simply be fixed at some sensible level, say 3%. This could play the role of a nominal anchor. Fluctuations in the cost of credit would evolve to reflect only the creditworthiness of the borrower.

Another option would be to provide a legislated discretionary range for official rates, say 2-4%. The guiding principle of this limited activist policy being to “take away the punchbowl as the party gets started”, as William Chesney Martin famously said in the 1960’s. In short, focus on avoiding excessive leverage in good times while providing a cushion in bad times. Unlike in recent decades, when the punch bowl was regularly topped up, to avoid the hangover kicking in.

Looking at the long history of the rate setting by the Bank of England, adjustments in the policy rate were rare and modest, on average around 0.5%. There were periods of several years, where no changes were made, despite wars, revolutions, and banking crises.

In terms of policy instruments, the ability to use the central bank’s balance sheet for lender-of-last resort purposes, will remain essential. Access to the facility might need to be opened for non-banks, as was suggested at one point during the crisis in the UK Gilt market last year, where most pension funds were forced to dump gilts and other assets, simply due to a short-term liquidity squeeze. As economies and markets become more complex, limiting access to short-term liquidity to a chosen few will likely be ineffective.

The use of less conventional measures, such as outright purchases of sovereign debt and other assets, should be prohibited. At best, it is a blunt instrument, with uncertain consequences. At worst it is a discriminatory measure, which blurs the line between fiscal and monetary policy. The losses made by central banks on their QE assets might be just “accounting”, but so is the fiscal position of governments. Pumping cash into banks and expecting taxpayers to foot the bill, should not be something unelected officials are ever allowed to do again.

All of these suggestions are, of course, aimed at avoiding the mistakes of the past. But the new framework for monetary policy will need to be future proof, at least to some degree. Digital central bank currencies might be the future, but only if the democratic and legal safeguards are robust. The future scope of AI is currently unknowable, but the financial system will feel its impact in multiple ways.

In recent decades, the framework for the conduct of monetary policy has evolved slowly, based on unifying principles and global agreement and cooperation. This might also be what the future holds – a series of incremental changes. But is wise to remember that change in monetary frameworks can also happen quickly.

Woodrow Wilson was elected President in 1912 on pro-business platform that included the establishment of the Federal Reserve. The American people were tired of banking crises, and the Panic of 1907, when the Dow fell 50%, was the last straw. Many argue that this was critical in his election victory. The Federal Reserve Act was passed into just over a year later in December 1913.

When Nixon suspended the convertibility of the dollar into gold in 1971, the Bretton Woods system of international finance, ceased to operate with the stroke of a pen. The agreement was never formally rescinded. The conduct of monetary policy changed in an instant. By 1973, the world had transitioned to a system of floating exchange rates, where all the old rules of monetary policy ceased to be of much use.

What might a future President Trump do if the dramatic turnaround in global monetary policy not only fails to control inflation, but results in a debt crisis, and deep global recession?

Suffering voters will want decisive action, and radical change.

He might just give them what they want.