The Nature of Monetary Manipulation
June 11, 2006
It’s pretty easy to see what effects are due to monetary manipulation, and what effects are merely natural phenomenon of the market economy. You simply ask: “could this happen in an environment of stable money?” Stable, meaning, of course, linked to gold. And to answer that question, you merely look back at the two hundred years or so of economic history prior to 1971, when the world was usually on a gold standard.
From this simple test, we can see that booms and busts, and occasional episodes of pure insanity, can certainly happen within the context of stable, gold-backed money. The Dutch tulip boom and the South Seas bubble, for example, were periods in which transactions were conducted with high-quality gold-backed (or physical gold) money. Certainly monopolistic central banks and floating fiat currencies are not necessary to create such events.
The next question is: what sort of events are created/engendered by monetary manipulation?
Most people seem to assume that the mechanism by which monetary shenanigans are transmitted to the economy in general is via “liquidity,” which is to say, something like a firehose of “money” which is turned on or turned off. The finger has been most recently pointed at the Bank of Japan, which has been reducing its “excess reserves” (base money) related to its “quantitative easing” policy in preparation to moving to an orthodox interest-rate target. This reduction of base money supposedly led to a reduction in credit extended at low interest rates to the “hedge funds,” leading to selloffs in asset markets worldwide.
Phooey. There is no fund that had been borrowing at 0% (the rate on high-quality short-term loans in Japan) that is not able to borrow at the same rate today. There is no bank that could have made such a loan previously, that is not able to make such a loan today. The rate on short-term loans is still 0%. What actually did happen, however, is that the BOJ’s base money reduction policy may have assisted a recent rise in the yen versus the dollar — although, in the end, that rise could be just as well explained by the decline in the dollar (as expressed by the dollar/gold ratio) during that same time, so maybe the BOJ didn’t have much effect on the yen.
JPY per USD
If there is any truth to this “hedge funds delevering” story (I haven’t seen a whit of real evidence yet), then the most likely mechanism would have been that such funds felt pressure not from Japanese banks calling in their loans due to a “reduction in liquidity,” but from the rise of the yen itself, which creates losses for yen borrowers with non-yen-denominated assets.
Thus, to continue a recent theme, if this hypothesis is correct, the mechanism by which the BOJ’s actions may have affected such funds was through a change in the value of the currency rather than directly through the “quantity” of excess reserves, base money, etc.
The only way that a central bank can really affect just one asset or asset class via its operations is to either buy or sell that asset, using the “magic checkbook” of money creation, with the asset then appearing on the balance sheet. In other words, the only way that Fed “liquidity” can “go into stocks/commodities/etc.” and only that asset class is if the Fed buys stocks or commodities directly. In practice, however, the Fed only buys and sells government debt, possibly supporting its price to a modest degree. Thus, there is really no mechanism for central bank “liquidity” to “flow” into this or that asset class. This “liquidity” that people are forever talking about is really investor interest, and it depends on fashion and perception rather than central bank manipulation. Let’s ask the question: would such a thing be possible within an environment of stable currencies, such as existed during the 1950s or 1960s? Yes.
When the actions of a central bank affect the value of the currency, then all users of the currency are affected together, at the same time. Thus we see that all such monetary effects are always economy-wide. They do not “start here” and “spread there.” However, one sector or another may react to changes in currency value in dramatically different ways. One reason we had a housing boom recently, instead of a tech/telecom boom, is because we had a tech/telecom boom previously, and thus it is too early to have one again. Relation to the Fed? None.
The other major way in which monetary manipulation affects economies is of course through the manipulation of interest rates. In this case as well, changes in interest rates affect the whole economy simultaneously. The Fed cannot make interest rates lower for certain borrowers, and higher for others (except through bureaucratic coercion). Interest rates are lower or higher for everyone simultaneously. Thus, once again, there is no particular means by which a central bank action can be directed only at one sector or another. Various sectors may react to the general change in interest rates one way or another, but the central bank has little ultimate control over this factor.
So, to add up the model we are presenting here, we have a market economy that is fully capable of booms and busts within a framework of stable, gold-linked currencies. This market economy may then be affected by central bank actions, with the transmission mechanism primarily the value of the currency and interest rate manipulation. Central bank “creation” or “reduction” of “liquidity” (remember the quotes mean that these are other people’s terms, and thus rather vague) doesn’t really do much by itself, but only as it affects the value of the currency and interest rates, and through these factors, the economy as a whole. There is no particular means by which a central bank can affect bank lending, for example, except to the extent that banks, as freely-acting entities, may react to changes in currency value and interest rates.
In practice, it is not quite so simple, as of course central bank “liquidity” (base money) operations are the means by which it produces changes in currency value and interest rates. Thus, the three tend to happen together, and are not mutually exclusive.
Of course it is best to have a currency manager that maintains a stable, gold-linked currency, and likewise has no effect on market interest rates. Then, the central bank/currency issuer’s influence on the economy would be nil, and the economy would be able to go about its business without being molested by the monetary manipulators.