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Sean Speer: Central bankers need a lesson in humility

Commentary

Last week former U.S. Federal Reserve Chair Ben Bernanke (along with two other economists) was awarded the Nobel Memorial Prize in Economic Science for his 1980s research on bank runs and the systemic risk that they pose for the overall economy. 

Of the 92 laureates since the prize was established in 1969, Bernanke is a unique awardee because he’s not merely a research economist. He actually put his research into practice in response to the global financial crisis during his tenure as America’s top central banker. 

The implications of his research and lasting influence from his eight-year term (2006-2014) at the Federal Reserve are currently the subject of some debate. On one hand, his use of extraordinary policies including quantitative easing and zero-bound interest rates to stabilize the economy during the crisis are credited with staving off a far-worse economic disruption. On the other hand, there’s a growing view that it normalized these policy tools and inadvertently turned the Federal Reserve into something of a “fiscal policymaker” in the subsequent decade including, most recently, in the context of the pandemic. 

The current spike in inflation has led to a debate about the relative role of this sustained period of loose monetary policy and what has come to be described by his critics as the “Bernanke bubble.” (For informative analysis on the causes and sources of high inflation, Hub readers should check out University of Calgary economist Trevor Tombe’s previous Hub articles on the subject.) 

Bernanke’s award—especially in a context in which his ideas and record are the subject of new, real-time scrutiny—had me recently thinking of the prize’s ninth recipient, Friedrich Hayek, and his famous Nobel lecture in 1974. 

Hayek was a heterodox economist whose deep attachment to classical liberalism (he famously wrote an essay entitled, “Why I’m not a conservative”) situated him as more of a moral philosopher than a hard-core econometrician. His Nobel lecture, which reflected a theme that was common throughout his career, was entitled “The Pretence of Knowledge.” 

Its brilliant exposition of the limits of human knowledge in general and the explanatory power of economics in particular is a much-needed rejoinder to the overconfidence and overreach of the Bernankean generation and its offspring. 

Hayek’s main thesis was that economics had in the post-WWII era assumed ambitions to think and talk about itself as a field similar to the physical sciences. These ambitions were, in his judgment, wrong. They had led to what he called “scientism”—a concerted yet misguided attempt to apply the rigour and confidence of scientific methods to the economy and society. 

He thought that this was mistaken because no model could possibly account for the complexity of the multitude of individual choices and preferences in a large, dynamic economy. As George Mason University economist Don Boudreaux summed it up in a short book on Hayek: “imagine a jigsaw puzzle of one billion pieces.” 

Hayek’s main takeaway was notwithstanding the best intentions of smart and capable technocrats to micromanage the peaks and valleys of the business cycle, we ought to be skeptical of their ability to wield the blunt tools of government policy to accentuate the upsides and circumvent the downsides. These efforts would invariably succumb to what he called the “knowledge problem.”  

Such technocratic tinkering effectively turned government policymaking into an exercise of dial-turning. Policymakers would move the policy dial in one direction to mitigate against an immediate-term problem and then would invariably have to move them in the opposite direction to inadvertent address the consequences of their initial action. The latter may even be worse for the economy and society than the former. As Hayek explained in his Nobel address: 

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.

There’s also the invariable tendency to forget the axiom that there can be too much of a good thing. Take our current economic context. An expansionary fiscal and monetary policy may have been justified in the global financial crisis. But the failure on the part of governments and central banks to restore a more normal policy in the ensuing decade has contributed to the current bout of stagflation. Hayek’s skepticism would have made him highly alert to this risk. Bernanke, by contrast, was in hindsight too sanguine about the potential for excesses in the application of his ideas. 

This doesn’t mean that he was wrong per se. But it may mean that he overestimated the capacity of policymakers to hold the dial steady. There’s a case that in hindsight the demand-side response to the global financial crisis begot some of the policy excesses that have produced our current economic challenges. Their short-term benefits need to be weighed against the long-term by-product of renewed technocratic hubris about our ability to perfectly fine-tune the public policy dials. The wrong takeaway for many, in other words, was that we could get the upside of a stimulative policy without any of the downsides. 

The downsides shouldn’t be discounted. The massive policy shift initiated by Bernanke artificially boosted economic activity, but it also distorted capital formation and investment decisions and minimized policy trade-offs in ways that circumvented a proper conversation about the structural reforms necessary to improve the country’s economic fundamentals. 

Reading Hayek’s speech can be interpreted as a from-the-grave critique of Bernanke. It’s easy to forget that he was actually referring to circumstances in his own era. In particular, he was lamenting the consequences of the policymaking hubris that originated from the ideas of his intellectual rival John Maynard Keynes whose “general theory” was arguably a proper response to the contingent circumstances of the Great Depression but came to be interpreted by his successors as a universalized theory of the role for government in the economy. 

This “bastardized Keynesianism” abandoned Keynes’s specific insights (including for instance the idea that governments should deleverage during periods of economic growth) and instead came to simply imbue the spirit of state activism. The eventual result, which was manifesting itself as Hayek delivered his speech, was the stagflation crisis of the 1970s. 

Hayek summed up his critique of the intellectual forces that had contributed to these economic conditions as follows: 

…economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

There’s a sense that we’ve made a mess of things once again. Central bankers are now trying to extricate us from the inflation problems that their own policies helped to create. The process is bound to be disruptive for households and the economy as a whole.

It ought to therefore be a lesson in the limits of our ability to turn the dials, the axiom that there can be too much of a good thing, and the ultimate need to focus on economic fundamentals. That might start with a refresher on the pretence of knowledge. 

Jules Boudreau: The feds are about to bail out the Bank of Canada

Commentary

Between April 2020 and December 2021, the Bank of Canada added $360 billion of bonds to its balance sheet as part of its quantitative easing (QE) program. It mostly bought Canadian government bonds, but also provincial bonds and mortgage-backed securities. 

Outside of the first few months of the crisis, when it helped prevent Canadian financial markets from seizing up, QE probably had a negligible effect on the Canadian economy. Swapping one type of government debt (government bonds) for another (bank reserves) did not cause the current surge in inflation.

But it did have a major impact on the state of government finances going forward. We will have a preview of this “QE bomb” on public finances when the Bank reveals it generated a negative net income in 2022 and Ottawa is forced to bail it out. The Bank should be transparent about the upcoming shortfall and add safeguards around the use of quantitative easing policies going forward.

Prior to 2020, every year the Bank of Canada sent around $1 billion to the government of Canada in remittances. Those steady remittances were “seigniorage” profits: because the Bank has a monopoly on currency issuance, it can produce bank notes at close-to-zero cost, sell the notes to banks, and use the proceeds to buy bonds. The business of trading bank notes, on which the Bank pays no interest, for interest-bearing bonds allowed the Bank to self-finance its operations, “which enable[d] the Bank to function independently of government appropriations”, as highlighted in the Bank’s 2019 Annual Report. It would then send the surplus to the government. Seigniorage is the federal government’s golden goose: the feds receive a steady billion annually in exchange for granting the Bank the privilege of issuing currency.

But in 2020, the Bank ditched its ingenious zero-reserves “corridor” monetary system, in which commercial banks send funds to each other to manage their liquidity needs, for a “floor” system, in which commercial banks hold reserves at the central bank. Think of reserves as central bank money, on which the Bank pays interest. The implementation of this new system, combined with pandemic QE, means that bank notes—the golden goose—today only make up 28 percent of the Bank’s liabilities, down from 78 percent in 2019 (chart 1).

Chart 1. Graphic credit: Janice Nelson

Bank notes are now eclipsed on the Bank of Canada’s balance sheet by interest-bearing reserves and reverse repos. When the Bank hikes its policy rate, it increases the interest payments it makes to banks and other financial institutions. 

With one hand, the Bank receives interest from its bond holdings. With the other, it sends interest payments to banks. The problem is that government bonds offer a fixed interest rate, while the interest paid by the Bank on reserves scales with the Bank’s policy rate. And with Canadian rates surging, the Bank’s interest expense is about to exceed its interest revenue (chart 2). The golden goose has lost its shine. 

Chart 2. Graphic credit: Janice Nelson

Because the Bank does not have sufficient capital to cover the losses, the government will have to bail it out with a loan or transfer. Based on market expectations for Bank of Canada rates, I estimate the shortfall to be $1 billion in 2022, $4 billion in 2023, and $2 billion in 2024. Instead of receiving $3 billion over three years from its golden goose, the federal government will have to cover a shortfall of $7 billion, the equivalent of two percent of annual government revenues (chart 3). The Bank of Canada is clearly aware of the issue. It just stopped paying interest on government deposits at the Bank, an accounting trick to reduce the end-of-year shortfall. The Bank should be transparent about the upcoming deficit.

Chart 3. Graphic credit: Janice Nelson

Now, it’s very possible the benefits of QE during the crisis outweighed the costs the government is facing today. And Canada is not alone in this position; the net cost for U.S. taxpayers will likely be even higher. But policymakers should reconsider the merits of having a central bank that is taking on interest rate risk. 

By swapping reserves for bonds, the Bank effectively reduces the average maturity of government debt. When the government sells a bond to finance its spending, it chooses the optimal maturity of the bond to issue. If it wants to “lock in” an interest rate to protect itself from future changes in borrowing costs, it will issue a long-term bond, for example, a 30-year bond. But what happens to the government’s balance sheet if the Bank of Canada purchases the 30-year bond? That long-term bond is replaced by an ultra short-term bond: bank reserves, on which the Bank—and by extension the government—pays the overnight rate. Instead of locking in an interest rate for thirty years, the government locks it in for a day. 

The data shows that the impact on consolidated government debt profile is immense. When we factor in the Bank of Canada’s holdings of Government of Canada bonds, the average weighted maturity of the government’s debt drops from 6.7 years to 4.7 years, rendering government borrowing costs about 30 percent more vulnerable to a rise in interest rates. 

Should the unelected Bank of Canada have such an impact on the government’s debt profile? Especially since, outside of periods of acute liquidity shocks like April 2020, QE’s effects on the economy are debatable. Hindsight is 20/20, and we can’t blame the Bank for emptying the cupboard in unprecedented times. But going forward, the Bank should install safeguards around the use of its balance sheet to gobble up government debt. The Bank of Canada should also commit to eventually returning to its previous corridor system to reduce its footprint in the government bond market.