In October 2019, Mario Draghi’s eight-year term as president of the European Central Bank (ECB) is due to end. He is in a race against time to avoid an unusual accolade for a central banker: never once to have raised interest rates during his tenure.
In decades gone by, central bankers earned their spurs by their expert navigation of the ebb and flow of the business cycle. For Draghi, however, no such dexterity has been required. All he has done is cut rates – eight times, from 1.5 per cent to zero.
He is far from alone. Mark Carney has been even less busy. In the 66 months that Carney has been governor of the Bank of England (BoE), the chore of adjusting interest rates has troubled him for only three – and the policy rate remains a mere quarter of a per cent above its lowest level in 300 years.
But the ECB and the BoE have nothing on the splendid lassitude of the Bank of Japan. Not only has its governor since 2013, Haruhiko Kuroda, never once raised rates; his predecessor Masaaki Shirakawa, whose term began in 2008, didn’t either.
This is the striking truth of the world’s most advanced economies. While GDP growth, inflation and unemployment in have long since recovered to historically normal levels following the crisis of 2008, their financial systems remain mired in an unprecedented experiment – one that has paralysed monetary policy for a decade.
Recent turbulence on the world’s stock markets suggests that many investors fear the prospect of central bankers bringing this Great Monetary Experiment to a close. Yet perhaps no less problematic are the consequences of allowing it to continue.
Modern monetary policymaking is based on the simple idea that by varying the policy rate (or “bank rate”), a central bank can influence demand, and in doing so, control the rate of inflation. Raise interest rates, and borrowing becomes more expensive throughout the economy, cooling growth and inflation. Cut interest rates, and borrowing gets cheaper – with the opposite effect. Toggle nimbly between the two, and a target rate of inflation – say, 2 per cent, as in the UK – can be hit.
One important detail is that this effect is achieved not only directly, by adjusting the cost of borrowing, but also indirectly by making assets cheaper or more expensive. When the interest rate available from the central bank falls, other, higher-yielding assets become more attractive – so their prices get pushed up. When the policy rate rises, by contrast, alternative assets look relatively less alluring – so they are sold down, until their price falls enough to entice savers back.
Because borrowing at any scale depends not just on cost but on collateral, this valuation effect of monetary policy constitutes a second important channel of its effectiveness. When interest rates fall, the value of capital assets used as collateral for loans – be they shares, intellectual property, or real estate – inflates. As a result, credit becomes not only cheaper to service, but easier to access.
Few would dispute that the process of asset price inflation has taken place across most advanced economies as a result of the Great Monetary Experiment of the past decade. A glance at a graph of house prices or stock markets will establish that. And, insofar as it has been an integral part of central banks’ efforts to achieve their target rates of inflation, this has not been controversial. The problem is that asset price inflation has also had two major side-effects, whose social and political consequences are far less benign.
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The first is distributional. Central bankers view things from the Olympian perspective of the economy as a whole. From the perspective of a particular household, or a particular region, however, the question of who owns the assets that have gone up in value is very important indeed. If the Great Monetary Experiment has worked in part by inflating asset prices, then its impact on the distribution of wealth, as well as the stability of inflation, needs to be weighed in the balance.
We are not talking about small change. It is important to grasp the size and speed of the inflation in asset prices that have benefited those fortunate enough to own them over the past decade, relative to what might have been accumulated through actually saving out of income.
Between April 2009 and April 2016, for example, the price of an average London house rose from around £245,000 to just over £461,000. For the lucky owners this amounted to a windfall of £216,000, or just under £31,000 a year. If, on the other hand, they had enjoyed the average London household disposable income over that period, and saved 5 per cent of it each year, they would have notched up £14,000 in total.
The Great Monetary Experiment created a market in which owning a home was more than 15 times as lucrative as saving for one, delivering for homeowners a century’s worth of saving in just seven years – and all without the need to cut back on spending at all. This “miracle” is in one very important sense an illusion. For the economy as a whole, this huge revaluation of assets has created no new net wealth; it has only transferred it from one group to another. Just as there is a buyer and a seller in every transaction, so there is a loser for every winner when asset prices go up. The social and political dividing lines exaggerated by this once-in-a-generation step change in the distribution of wealth – between rich and poor, and between young and old – is, however, very real.
The second major side effect of the Great Monetary Experiment is perhaps even more of a problem. The environment of very low interest rates poses a major challenge to the great institutional infrastructure of pensions and insurance on which the advanced economies are built. The blunt fact is these monuments of commercial civilisation are, as currently constructed, not sustainable when savings offer no returns.
Old-age pensions provide a stark and simple example; 25 years ago, long-term UK government bonds delivered a yield of 9 per cent. So, £100,000 of pension savings generated an income of £9,000 a year with a minimal degree of risk. Today, those same government bonds yield 1.25 per cent. At this rate of interest, delivering £9,000 a year requires a pot of £720,000.
In theory, one solution is simply for everyone to save more. With smaller returns but bigger pots, future retirees could expect the same pension income in retirement. In reality, the scale of the increase in savings required is unrealistic for most households.
It will not have escaped the alert reader that in many cases, the two side-effects described above will have worked in opposite directions for a single household. The homeowner close to retirement when the crisis struck a decade ago has seen the value of their house rocket while the income earned on their savings has shrivelled.
This brings us to the most insidious of the unintended consequences of the Great Monetary Experiment: what could be called, with only a little hyperbole, the re-feudalisation of the economy.
Last year, a study by the Financial Times revealed an important new trend. Confronted with the combination of sky-high house prices and rock-bottom rates of return on savings, British households have been remortgaging their homes and spending, or passing on, the cash.
Popular uses, the study reported, include paying school fees or providing children with a deposit for a house of their own. The policies of the Bank of England have created the Bank of Mum and Dad.
The great economic project of the past 100 years – in a sense, the great project of democratic capitalism since at least the financial revolution of the 17th century – was to replace dynastic inheritance and charitable donation with entrepreneurship and the welfare state as the master mechanisms for the distribution of wealth.
The Great Monetary Experiment, it seems, is turning back the clock. Sudden huge changes in asset valuation have reinstated the family, rather than the state or the market, as the sorting hat of where one ends up in life. “An Englishman’s home is his castle,” the old saying goes, and in the neo-feudal economy of the early 21st century, it conveys a contemporary truth.
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Do central bankers really have the power to transform modern economies into neo-feudal facsimiles of their former selves – and all by simply doing nothing? I am fairly sure that all the central bankers I know would laugh at the suggestion. Yet so pervasive is the influence of monetary policy in today’s ultra-financialised economies that I am not so sure. Either way, we may soon have a test of the hypothesis. One leading central bank has already awoken from its slumber, and is in the process of reversing the Great Monetary Experiment. It happens to be the most important one of all.
With a vigorous new chairman, Jerome Powell, at its helm, the US Federal Reserve has raised interest rates nine times in the past three years – back to a level which, at 2.5 per cent, almost smacks of normality.
Will everything now swing into reverse so that asset prices tank, yields rise, the traditional machinery of saving judders back to life, and panicked grandparents are left surveying the wreckage of their trashed balance sheets? Or will central banks lose their nerve in the face of powerful new vested interests?
My money is on the latter outcome. After all, it took the Black Death to do for feudalism the first time round.
Felix Martin is the author of “Money: the Unauthorised Biography” (Vintage)
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