Central banks are no longer the best key to understanding economic growth or decline.
By PINCHAS LANDAU
In last week's column we noted that because national economies are very complex mechanisms involving myriad goods and services, the simplest proxy for the overall economy was money (the national currency) and the way to track changes in the economy was by tracking the quantity and cost of money (the latter being interest rates). This approach is facilitated by the fact that modern nations have created a system in which the central bank has been given a monopoly role in both issuing money and determining short-term interest rates, by adding money to or withdrawing it from the financial system.
Since one institution thus has control over the most important single factor in the economy, the analyst's life becomes much simpler - because all he or she has to do is closely follow and interpret the words and actions of the central bank in order to know which way the economy is heading. This explains why the role of "Fed-watching" in the American context, and its equivalent in other countries, has assumed such importance in the field of macroeconomic analysis.
Unfortunately, however, it does not explain why the results of all this effort are so meager. In other words, merely tracking and analyzing what central banks do does not necessarily enable us to predict where the economy is going. There are too many recent examples of the theory not working in practice, begging the question - what is going wrong?
One possibility is that the central premise is incorrect - money is not a good proxy for the overall economy after all, so that changes in its cost and the quantity available are not good enough indicators of the economy's direction. Alternatively, the problem may lie not with money but with the other premise, that the central bank has control of it and hence, by extension, of the economy as a whole.
The second approach is intuitively more promising, since the role of the central bank is more recent and more artificial than that of money - although the latter is also an artificial construct, especially in its modern form of "fiat" money, issued by governments and with its value depending on confidence in the government and state that stand behind the paper and the promises.
But if central banks don't control money, who does? If, as is so widely claimed today, the global economy is awash in liquidity, where is all the money coming from?
The answers to these questions are of far more than academic interest, because if we could identify the sources of the current excess liquidity, we should be able to determine what might cause the existing economic and financial environment to change - and when and why that might happen.
The likeliest candidates that might be usurping the role that central banks used to have are two major forces at work in the global economy over the last generation - globalization and deregulation. The essence of globalization is that national economies cease to be self-contained but open up instead to the wider global economy. A key part of this process is opening up to flows of capital so that money moves around the world seeking the best returns its owners can find. In this process, central banks cease to be the sole arbiters of the quantity and cost of money in their national economies because firms, households and financial institutions who find local conditions unhelpful to their needs - interest rates are too high (for local borrowers) or too low (for local lenders) - can simply look elsewhere for better conditions.
This has generated "the carry trade," a long-standing concept that has now assumed gigantic proportions and is accordingly becoming increasingly well-known. The basic idea is extremely simple: if interest rates in country A are much lower than those in country B (or than most other countries), it is worthwhile borrowing in country A (in the local currency), converting into country B's currency and using the proceeds to make higher-yielding investments in country B.
This is exactly what has been happening in international finance in recent years, with Japan playing the role of country A. Because of its own severe domestic economic problems, Japan has had extremely low interest rates and its central bank has been willing to provide seemingly endless amounts of liquidity to whoever wanted to borrow yen. Since Japan is the second-biggest economy in the world, this phenomenon has been much more than a marginal curiosity, but has instead swelled to a scale that has a major influence on the entire global economy by providing a vast source of extra liquidity at rock-bottom prices.
This, then, is one part of the explanation as to where the money sloshing around in the global economy is coming from.
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