A Global Race to the Bottom: How Central Banks Are Responding to the COVID Crisis

Brendan Brown is a founding partner of Macro Hedge Advisors and senior fellow at the Hudson Institute. He is a regular contributor to mises.org and is the author of several books on monetary policy including A Global Monetary Plague (2015) and The Case Against 2 Per Cent Inflation (2018). He received a PhD from the University of London, MBA from University of Chicago, MSc from London School of Economics, and an undergraduate degree from Cambridge University.

In this interview for the Mises Wire, Dr. Brown discusses new developments with global economy and the future of monetary policy.

Mises Wire editor Ryan McMaken: In the past you have expressed some hope that Powell might be less inclined than Yellen toward dovishness. Do you see any big differences between the Powell Fed and the Yellen Fed?

Brendan Brown: Powell seemed to have a less dovish veneer than Yellen through his first year at the helm of the Fed. The new chief, convinced that the big business tax cuts enacted in spring 2018 would bring a Reagan-style boom, proceeded to oversee loquaciously tiny quarterly rate rises. Then, realizing that the boom had failed to arrive, the Powell Fed switched abruptly (in winter 2018/19) into easing mode as the stock market swooned.

In responding so to a threatened reversal of asset inflation amidst a growth cycle slowdown Powell acted according to the same playbook as Yellen (confronted with a faltering stock market and growth cycle downturn, she rolled back the planned series of small rate cuts through 2015–16), Greenspan (his famous “puts” in 1987, 1995, and 1998), and Strong (his “coup de whiskey” of 1927).

Any big differences even so from the Yellen Fed? Yes, look to the mega–relief package put together by the Powell Fed and the Mnuchin Treasury for the private equity barons struck by the pandemic crisis—in Fed-speak an estimated $1 trillion high-yield bond purchase program. The Yellen Fed, a stickler on regulations, would surely have kept to the script of only systemically important banks being at the receiving end of its largesse.

RM: In your book The Case Against 2 Per Cent Inflation, you note that the rise of the 2 percent standard represented something new from what came before. With the onset of the current crisis, are we still in the 2 percent era or has something new begun?

BB: The 2 percent inflation standard had its roots in the collapse of the monetarist experiment.

In the US, Paul Volcker’s abandonment of monetarism culminated with his applying monetary policy in support of Treasury secretary Baker’s dollar devaluation policy (from the Plaza Accord in September 1985 to the Louvre Accord in February 1987). The result was a new episode of monetary inflation (spawning both goods inflation and asset inflation) around the world, extended and deepened by Greenspan’s giant stimulus in response to the October 1987 stock market crash.

The Bundesbank alone persisted in defiance of the Fed, but the resulting sharp appreciation of the Deutsche mark and the related pain inflicted on German exporters played an infernal role in Chancellor Kohl’s decision to join President Mitterrand in launching the train to European Monetary Union. This spelt the end of German monetarism.

A brief and sharp monetary tightening led by the US tamed the late 1980s inflation (US CPI (Consumer Price Index) peaked at above 6 percent year on year). There was now a fork in the road. How to consolidate that achievement? There were two alternative routes.

First was the construction of a sound money regime on more solid foundations than the monetarist one. Under this, free markets would determine short and long interest rates; the monetary system would have a firm anchor in monetary base; and a set of automatic rules would control the growth of this aggregate in a way such that the prices of goods and services over the long run would tend to revert to the mean. This route’s destination could have been a return of the dollar to gold.

Along the second route, the central bank would set the path of short-term interest rates, using all its powers of manipulation to influence longer-term interest rates with the aim of holding the inflation rate stable at a low level; other aims could include high employment and rapid recovery from recession. Econometric modeling based on neo-Keynesian principles would be the guide to the interest rate fixers.

For the record, President Reagan’s Gold Commission had effectively rejected the first route in 1982, but accumulated evidence since then had made its majority judgment ever more unsafe. Even so, the US, as monetary hegemon, took the world along the second route, as steered at first by Fed chair Greenspan, highly tuned to dominant political currents in the White House and Congress

Yet the 2 percent inflation standard has essentially been an emperor’s new clothes standard. The econometric relationships on which it depends are flimsy. Operational success turns on inertia of inflation expectations and irrationality in the long-term rate market, which lasts so long as it lasts.

Crucially, this standard ignores with fateful consequence the natural rhythm of prices over time (determined by such influences as fluctuating productivity growth, pace of globalization, business cycle stages, resource abundance, and nature of technological change). In the near quarter century since the Fed started to adopt the standard, a powerful and evolving combination of nonmonetary disinflationary forces has been operating. The Fed, by trying to combat these and thereby achieve 2 percent goods and services inflation, has stimulated recurrent episodes of asset inflation. Its tools of combat—low interest rates and money printing—have been popular with successive administrations under which public finances have plunged ever deeper into the red.

As the pandemic swept our world it seemed at first that asset inflation was entering a phase of burst. If this happened, the 2 percent inflation regime and its officials would likely escape the blame. It was all the fault of COVID-19, stupid! In any case, the regime—the Fed and Treasury operating as one—has sought to contain and reverse the burst. So where to from here for the 2 percent inflation standard?

Most likely the aftermath of this pandemic will be an era of high consumer price inflation. Widespread economic obsolescence of the existing capital stock (whether due to past malinvestment or changed structure of demand), coupled with many enterprises now financially crippled, could mean that the rate of return on new investment would be extraordinarily high. Yet the Fed will keep rates at zero, given the powerful political coalition of forces in favor of debt write-off in real terms by inflation. Buoyant demand led by capital spending could be a key element of the inflation process. Also the natural rhythm of prices will be turning up coincidentally as globalization goes into reverse and cumulated malinvestment weighs on productivity.

None of this means regime change. Our monetary officials will hail the breakout of inflation as temporary and “natural” (to offset earlier inflation undershoots).

RM: You have distinguished between asset price inflation and consumer price inflation. Commentators often focus only on consumer prices, but why should we be concerned about asset price inflation also?

BB: Monetary inflation shows up in both goods (and services) markets and asset markets. In the former, a key symptom is most usually the emergence or acceleration of consumer price inflation; in asset markets the symptom is prominence of investor behavior suggesting impairment of rational mental processes (yield chasing, positive feedback loops from capital gains to confidence in dubious speculative hypotheses, booms in momentum and carry trading, a boom in financial engineering, contagious spread of speculative narratives which would normally be treated with high skepticism).

Each symptom is not always present. For example, when nonmonetary disinflationary forces are strong, monetary inflation might not mean positive consumer price inflation. Similarly, asset inflation does not always show up in tremendous increases in leverage and financial engineering booms. Hunger for yield is not always prominent.

Why do so many commentators focus on consumer price inflation and ignore asset inflation?

At one level the explanation is simple. Much of the public has an interest in what is happening to the purchasing power of the dollar. At a different level, that of economic inquiry, we could attribute the ignoring of asset inflation to the difficulty of measurement.

According to Milton Friedman’s principles of positive economics, we should reject concepts which cannot be easily tested—and asset inflation is one of these. Yes, simplistically some might define asset inflation as how far asset prices are above fundamental value in some sense. But where can we find fundamental value benchmarks?

Asset inflation, though, is a much broader concept than empirically ascertainable divergence between market and fundamental value. Capital market price signaling in general becomes corrupted, causing the invisible hands to malfunction. Commentators who try to point this out and elaborate the consequences run up against the popularity of asset inflation during its virulent stage. Their pessimism about the long-run outcome is met with Keynesian refrains of how in the long run we are all dead or how the market can remain irrational longer than you can stay solvent.

What should be the countercase to this rebuke? It is that asset inflation imposes severe long-run economic costs and that an individual-level action to limit future damage from Torschlusspanik (the doors slamming shut in the asset inflation burst) does mean present bankruptcy.

The economic costs emanate fundamentally from the missignaling of capital prices—especially as driven by the false narratives which get a popular following—and the related fragilties created by a boom in financial engineering (including much camouflaged leverage). Missignaling and financial engineering drive malinvestment, ultimately exposed in the burst phase of asset inflation and beyond. The long-run consequence of malinvestment is impoverishment and economic prosperity foregone.

RM: Why is yield chasing a problem?

BB: Yield chasing is one possible symptom of asset inflation. It refers to the situation where the central bank is suppressing interest rates at low or negative levels—well below where they would be under a sound money regime. As Bagehot observed, John Bull will stand for many things, but rates below 2 percent drive him mad.

In more sophisticate language, behavioral finance theorists find that if you give us a choice between certain loss and a bad bet, we will almost all opt for the bad bet. They don’t go one step further and explain that we don’t like to admit to taking a bad bet so we become highly receptive to dubious narratives which seem to turn the fundamentally bad bet into a good one.

Hence the yield chasers who buy risky bonds to get a pickup on negative or low rates on safe bonds spin a narrative according to which the credit risk is actually lower than usual (for example in the energy patch they may have subscribed to the speculative hypothesis that oil prices would remain permanently high); if they boost returns by taking on exchange risk, they tell themselves this is unusually subdued. In the equity and real estate markets we have heard much about “there is nowhere else to go,” but in rational mode the individual would know that prices already reflect the desperation of investors struck by interest income famine.

In such famine conditions, financial engineers—their job is to work on the capital structure of firms in ways to bolster apparent rates of return in a rising equity market—find that the demand for their services booms. A main technique they apply is to ramp up leverage, camouflaging this as much as possible (income famine investors are unusually susceptible). Hence growing financial vulnerability accompanies the accumulating malinvestment. Even the yield chasers at the back of their minds fear a bust but they convince themselves that this cannot happen in the short run. Hence long-gestation capital spending is eschewed at additional cost to prosperity.

Yield chasing can become an embedded phenomenon. Yes, in one cycle the actual duration of abnormally low rates might be quite short, as from 2003–04/05. The preceding business cycle downturn, however, may have been quite mild or short-lived, meaning that the widespread irrational behaviors which formed during the prior period of monetary inflation might not have been shaken out, with much malinvestment and overleverage still latent. That may well have been the case with respect to the Greenspan asset inflation of 1995–2000.

RM: In the past you have noted that the problems with the current “monetary experiment” of widespread asset inflation won’t necessarily materialize in the form of a major financial crisis. You’ve said it could come in the form of gradually decreasing standards of living. Some other authors have suggested that this is happening now in Japan. What are your thoughts?

BB: A long episode of asset inflation could come to an end without financial crisis if indeed the leading banks are highly capitalized and if short-circuiting in areas of high leverage can be halted swiftly by widespread equity-debt swaps. Even if this were the case, there would still be a burden from the cumulative malinvestment which occurred during the asset inflation—and related to this, a growth in monopoly power. Asset inflation is a source of cheap and abundant equity to the star firms which investors believe will be successful in “building a moat” around themselves. With this financial power, these firms can crush competitors by predatory action.

As of now (spring 2020) we can see the malinvestment already in the oil and gas space, the aircraft/travel space, the overextended global supply chains, the bloated export sectors in Europe and Asia, the commercial and high-end residential real estate markets around the world, but not yet possibly in the biggest area of all, overdigitalization, as the pandemic has given this a new lease of life.

How does Japan stand out in this process?

Huge monetary inflation in Japan under PM Shinzo Abe has not shown up in high goods and services inflation because of a particularly rapid rate of globalization, here related to integration with China and East Asia. This has driven nonmonetary disinflation and generated real income gains for Japanese households, including the elderly who hold most wealth and much political power. The latter may have resented the heavy monetary repression tax (implicit in interest rates far below where they would be under sound money) levied by the Bank of Japan (BOJ), but they could gain cheer from the apparently high returns on risky foreign bonds, in the equity market and more recently on local real estate.

Now these same households cannot look forward to an income bonus from globalization. And some of the high yield bets around the world are failing spectacularly. The elderly would not welcome high inflation—but they may end up with this by falling for the promises of Shinzo Abe or the even more populist party rivals to reverse their falling income standards by some sort of miracle which turns out to entail monetary debasement.

RM: How do you think the various central banks will come out of this current crisis? Will other central banks make the dollar look like “hard money” by comparison, or will the Fed follow a similar path to the European Central Bank (ECB) and the BOJ?

BB: Since the end of World War I the Federal Reserve has been the global monetary hegemon, other central banks in the main following the US monetary lead. The only large and prolonged exception was the Bundesbank’s defiance in the era of the hard mark (say, 1971–90). Otherwise, the feared costs of defying the US inflationary lead, in terms of a big overshoot of the national currency in an upward direction and the resulting pain for the export sector, have led to resigned acceptance.

Sometimes there has been no inclination to defy the US inflationary lead and instead a willingness to inflate by even more. That has been the case with the ECB since the European sovereign debt crisis and with Japan under PM Abe. Now we have the Fed engaging in massive monetary “stimulus” in response to the massive supply shock of the pandemic. Other countries have been only too willing to follow the US lead, though in some cases they have less degrees of freedom.

A key element of the US has been the Treasury providing partial guarantees to a given spectrum of debt issuance; such paper is eligible for use in the Federal Reserve’s money-printing operations. In the European Monetary Union there is less scope for this, most of all because Germany would not participate in such guarantee operations with respect to the debts of other member nations, whilst the local sovereign guarantee on its own (as for Italy) would not shelter the ECB from loss.

The likelihood is that the ECB will nonetheless match and in fact overtake the Fed in terms of money printing. But at some stage this will present Germany with a stark choice. Does that country ultimately stand behind the ECB with its rotten balance sheet full of delinquent loans? Or does Germany pull out and let the losses of the ECB get distributed between all citizens of the EU? The means of doing this would be for Germany to convert only its own citizen’s deposits with German banks and holdings of German government bonds into a reincarnated Deutsche mark.

So, compared to the euro, the US dollar may have a hard image even though most likely the aftermath of this pandemic will be high inflation in the US as in Europe and Japan. Why high goods and services inflation in the US? The pandemic (including the economic lockdown) is fermenting a strong coalition of debtors with much political sway in favor of high inflation. There is no likelihood of the Fed standing in the way of an increased momentum of consumer price inflation, however and whenever that emerges.

In the present monetary system, long without any firm anchor, the telling of the tale linking money printing to inflation is not simple. The starkest and easiest to comprehend chapter will be currency collapse.

The country (or monetary union) where inflation and inflation fear spikes ahead of others is likely to experience sharp decline of its currency, which in turns feeds a vicious circle of further debasement. The high inflation era which looms beyond this pandemic is likely to be interwoven with stories of high drama in currencies.