International Forecaster Weekly

Central Banks Breaking The Law

Like common brigands, central banks have been acting outside the law – their only real excuse being the supposedly higher purpose of economic necessity, a sort of Robin Hood-type operation where the ends justify the means...

Jeremy Warner | July 23, 2014

The best way to destroy the capitalist system, the Russian revolutionary leader Vladimir Lenin is reputed to have said, is to debauch the currency. The world’s major central banks have certainly been having a fair old go at it. In the six years since the financial crisis first broke, they’ve been printing money like there is no tomorrow.

            Fortunately, they have not yet managed to bring down the free market system. On the other hand, they have succeeded in putting a rocket under asset prices and, in so doing, they have greatly exaggerated the wealth divide.

            In a number of cases, including the US and the UK, they have also significantly assisted governments in financing burgeoning fiscal deficits. To the extent that quantitative easing (QE) has had any effect at all, it is asset prices and governments that have been the prime beneficiaries.

            This might seem something of an old issue now; the Bank of England stopped buying assets more than two years ago, while the US Federal Reserve is “tapering” fast. For the US and Britain, the age of “unconventional monetary policy” seems to be largely over.

            Elsewhere, however, QE remains very much a work in progress. In Japan it’s continuing at heroic pace, while on the Continent the European Central Bank is being urged by the International Monetary Fund to stop dilly-dallying in the face of deflationary pressures and get on with it.

            Full marks, then, to Prof Andrew Johnstone and Trevor Pugh, of Sheffield Institute of Corporate and Commercial Law, for a new analysis, The Law and Economics of QE, which concludes that not only has QE been largely ineffectual but that it was also illegal.

            Like common brigands, central banks have been acting outside the law – their only real excuse being the supposedly higher purpose of economic necessity, a sort of Robin Hood-type operation where the ends justify the means, only with a slight flaw; by driving up the value of financial assets and real estate, QE further skews the distribution of wealth towards those with already large holdings of it. It robs from the poor and gives to the rich. Not that there is any possibility of the courts judging QE in all its various forms to be against the law, the writers concede. In Europe, the European Court of Justice has admittedly been asked to rule on ECB bond buying, but will almost certainly deem it to be a necessary price for holding the eurozone together. Never mind the law, the single currency comes first.

            The director and deputy director of the IMF’s Europe division said in a recent blog: “So long as the ECB buys sovereign bonds in pursuit of its mandate and in a way that has nothing to do with fiscal outcomes it can rebut the oft-heard charge that QE violates the prohibition against 'monetary financing of fiscal deficits'.” Thus does looking for ways around the law take precedence over its observation.

            Lots of claims have been made for QE but no central bank has yet been able convincingly to demonstrate that it helps stimulate economic recovery. About the best that might be said for it is that it raised confidence at a critical moment in the crisis when financial and economic armageddon were threatened. But the persistence of asset purchases thereafter is much more questionable. There is not a whole lot of evidence to suggest it has played much of a role in restoring growth.

            QE is supposed to work in a number of ways; it is, for instance, hard to argue that it hasn’t depressed long-term interest rates. Some have benefited from this phenomenon undoubtedly, in particular mortgage holders and large companies, but it doesn’t seem significantly to have reduced the cost or availability of finance to the real economy, which for many smaller companies remains high and scarce.

            It was also meant to have led to “portfolio rebalancing”, with investors replacing the bonds bought by the central bank with other assets such as equities. This in turn might have marginally reduced the cost of capital but, again, for the vast majority of privately-owned businesses it has made no difference at all.

            Another declared purpose was to raise inflationary expectations, which in turn was meant to boost spending and wages. Again, nil effect, unless you count the scare stories in the early stages of QE of Weimar-style hyper-inflation. In any case, real wages, the chief driver of domestically-generated inflation, have gone nowhere for nearly a decade now.

            Expanding the money supply via increased central bank reserves was also supposed to have boosted bankers’ willingness to lend, artificially generating the same “money multiplier” effect that rules in more normal times, when commercial bank lending and money creation is buoyant. Again, there is very little evidence that this occurred.

            What very definitely did occur is that small cash savers got squeezed and debtors got bailed out.

            The biggest of these debtors were governments, particularly the British, US and Japanese governments. All of them were able to borrow more cheaply than otherwise and, with the central bank mopping up supply, were able to raise a great deal more money.      Central banks became enablers of continued deficit spending.

Remove the disciplines of the market, which is in effect what QE does, and governments will spend, if not with outright abandon, certainly with less concern than they would otherwise. Both in Britain and the US, much of the urgency of deficit reduction has been removed by QE. Governments can proceed at a leisurely pace. Heck, why not make deficit spending a permanent feature of the economic landscape?

            An invidious sophistry surrounds official explanations of QE, as well as a blanket denial of what it really is. No central bank will admit the unpalatable truth – that it is backdoor monetisation of government debt – certainly illegal under European law and possibly English law, too. As the Sheffield Institute authors argue, if you are going to use monetary means to finance government spending, you should at least be open and honest about it, as well as have a proper debate about whether QE is really the appropriate way of going about it.

            In any case, underlying all this monetary manipulation is a deeply depressing set of contemporary assumptions and received wisdoms – that government spending can somehow magic up economic growth; that politicians and regulators know better than markets how productively to allocate investment; that social equality should be the ultimate aim of all government activity. How ironic that QE has succeeded only in making this latter goal even more distant.