Central Banks Are On the Defensive

Gary North

All over the Western world, central banks are under pressure from their governments to inflate. Governments are not satisfied with short-term interest rates at historic lows, such as a federal funds rate of 0% to 0.25% in the United States. Politicians want rapid economic growth, and they are convinced that this is possible after a major recession only with more fiat money. In short, they have accurately understood the message of their college-level textbooks. This is what textbooks have been saying for over 50 years. This is the new, improved Keynesianism. Keynes focused on the need for large government deficits and increased government spending, not monetary inflation. The new Keynesianism wants large government deficits and lots of fiat money.

These twin pillars of neo-Keynesian policy are not working anywhere in the West. They are working for now in China, which has become the world's bubble economy, but not in the popped-bubble economies of the West.

The Bank of Japan

On February 18, Bloomberg ran a story on a statement by the governor of the Bank of Japan, who warned against government interference. The government is running a large budget deficit. It is pressuring the Bank of Japan to inflate. The Bank has refused.

Interest rates are low today because commercial bankers still refuse to lend. This has been Japan's problem for two decades. Investors still buy the Treasury securities of their governments. The central banks initially pushed rates down through monetary inflation (more reserve money to supply the commercial banks), but today, rates are low because lenders are frightened of the private sector, and the private sector is afraid of more debt. The central banks are not inflating, yet short-term government debt rates are extremely low. The economic boom is nowhere to be seen. The recovery is slow.

Traditional Keynesian textbooks say that to keep short-term rates this low, there must be rapid monetary inflation. But these rates are low today without monetary inflation. This fact conflicts with textbook Keynesianism. The policy-makers are in disarray, both in the government and the central banks.

We can see this in a Bloomberg report on Japan.

Feb. 18 (Bloomberg) – Bank of Japan Governor Masaaki Shirakawa countered government pressure by suggesting it should develop a plan to contain the world's largest public debt.

"It's important to gain trust of financial markets by showing a path for fiscal consolidation," Shirakawa said in Tokyo today after his policy board kept interest rates at 0.1 percent and refrained from expanding monetary easing steps.

As Hans Sennholz used to say, "Wait a minute!" If the Bank of Japan "kept interest rates at 0.1%," how did it do this?

The governor is protesting government pressure to inflate. The official textbook explanation for the boom-producing effects of monetary inflation is that this policy will lower interest rates. But the bank rate has been one-tenth of one percent. Japan's central bank did not "keep" the rate this low this week, or last week, or last year, or last decade. It has done approximately nothing for 15 years, yet the rate stayed this low.

The Bank of Japan has barely inflated the money supply since 1994. M2 has rarely increased above 3% per annum. As a result, there has been little price deflation in Japan since 1994. Consumer prices fell slightly in a few years: about 1%. In other years, consumer prices rose a little. You can see the chart for yourself.

So, the story of Japan's long-term price deflation is a complete myth. I have discussed this before.

The Bank of Japan is not keeping the rate low. The free market is. Lenders want safety. They will pay for this: low interest rates on government debt. The rate on 10-year Japanese bonds is 1.3%. With consumer prices falling at a rate of 2% per annum – the first time they have fallen this much – 1.3% is a real rate of return of a little over 3%. Not much.

Private borrowers want safety, too – by not taking on more debt. So, rates stay low.

The Bank of Japan can of course expand its purchases of government debt. But why should it do this? The government can sell its debt at low rates. What will more fiat money do for the government's ability to sell its debt? Nothing.

The Bloomberg story goes on to say that the governor insisted that the central bank needs independence from the government. This is the cry of central bankers at all times, in all places.

Have you ever read of the senior tenured bureaucrat in any government-protected, semi-private monopoly agency recommending that the nation's Congress or Parliament take over the operations of his agency, because government protection has made the agency unresponsive to the public good? The next time will be the first.

In his strongest warning yet on the country's growing debt burden, Shirakawa said governments need to "respect" that monetary policy isn't aimed at funding fiscal spending. His remarks came after Finance Minister Naoto Kan earlier this week stepped up heat on the central bank to fight deflation by saying Japan needs an inflation target of at least 1 percent. . . .

"Monetary policy isn't aimed at fiscal funding," Shirakawa said at the news briefing. "It's aimed at achieving sustainable growth under stable prices. It's important that governments respect this stance and markets have faith in it."

He is not alone in his protest against government interference.

"Accountability is Autonomy"

On February 17, the President of the Federal Reserve Bank of Philadelphia gave a speech to the Philadelphia chapter of the World Affairs Council. Whenever an official gives a speech to a WAC chapter, we can be sure that the official regards this as an important speech.

The media do not talk about the World Affairs Council. There may be an occasional report about a speech at a WAC chapter, but there will be nothing said about the WAC: what it is, who belongs, and what influence it possesses.

The WAC has an important social function. It is the single most important membership organization for the nation's senior elite Establishment to communicate the latest perspective to the nation's elite.

According to the brief entry on Wikipedia, the WAC has 535,000 members in 89 separate councils in 39 states. There are 175 million adults in the United States. This means the WAC's membership is a little over three-tenths of one percent of the adult population. I call this an elite.

The WAC was founded in 1918, three years before the Council on Foreign Relations was founded. Like the CFR, the WAC officially is concerned with international affairs. Also like the CFR, the WAC deals with domestic issues as well.

The President of the Philadelphia FED, Charles Plosser, titled his speech, "The Federal Reserve System: Balancing Independence and Accountability." This sounds boring. For those who understand the function of the Federal Reserve and its influence, the speech is not boring to read.

The target of the first half of the speech was Ron Paul. It was a warning against Ron Paul's bill in the House of Representatives that would authorize the Government Accountability Office to audit the FED. The House's leadership has kept the bill from coming to the floor for a vote, despite the fact that a majority of the membership has officially supported it, and despite the fact that a majority of the House Financial Services Committee voted for it, 43 to 26, in November 2009.

The FED has consistently opposed this bill. The official explanation is that this would in some way constitute interference with the FED's policy-making. This argument has never been clear. The fact that the General Accountability Office will verify the numbers in no way constitutes interference with FED policy, unless FED policy has been carried on under false numbers.

Nobody at the FED will say what is really at stake: an independent audit of the government's gold holdings, which are officially held for the government by the FED for safekeeping. If the gold is gone, or if there are legal claims against it by foreign central banks as a result of FED swaps, this would constitute fraud on a massive scale.

The real power in the FED has always been the Federal Reserve Bank of New York. In all textbook accounts of the years leading up to the Great Depression, the focus is on Benjamin Strong, the President of the New York FED. He set policy, not the Board of Governors.

The bulk of the world's gold holdings are stored in the vault of the New York FED. This includes most of the deliverable gold (99.9% fine) owned by the FED as trustee of the U.S. government's gold. The gold at Ft. Knox (probably coin melt, 90% fine) constitutes a second holding area, said to be 20% of the nation's gold. No one knows. It has not been audited since the early 1950's, not even by the private accounting firms that audit the FED on an annual rotation basis.

The FED demands secrecy. It proclaims that it pursues transparency, but it does not on any issue of substance.

Bloomberg News in November 2008 sued the Board of Governors under the Freedom of Information Act to find out which institutions received how much money in the October 2008 bailouts. The Board of Governors refused to comply on this legal basis: this would expose trade secrets of the recipient banks.

Even though a district Federal judge in August 2009 ruled that the New York FED must turn over these records, the FED refused to comply. She gave the FED five days to comply. It did nothing for six months.

Anyone who thinks that the Federal courts have operational authority over the Federal Reserve System is ignorant of the last century of American history.

The Board of Governors appealed the ruling on January 11, 2010. A ruling will not come down for months. A recent summary of this bizarre story appeared in the New York Times. In a rare form of candor, the writer added this observation, deep down in the bowels of his article:

The Federal Reserve has wrapped itself in secrecy since the turn of the 20th century, when a select group of financiers met at the private Jekyll Island Club off the eastern coast of Georgia and, forgoing last names to preserve their anonymity among the staff, drafted legislation to create a central bank. Its secrecy, of course, persists today, with Ben S. Bernanke, the Federal Reserve chairman, refusing to tell even Congress which banks received government money under the bailout.

"Secrecy is Transparency "

Mr. Plosser gave the usual reasons for opposing the audit.

So, our uniquely American form of a central bank strikes a balance between centralization and decentralization; between the public and private sectors; and among Washington, Wall Street, and Main Street. The result is a central bank that achieves a delicate balance: it permits policymakers a good deal of independence when conducting monetary policy but in return requires transparency and accountability to the American people.

Why does setting monetary policy require this degree of secrecy? Officially, the FED is rather vague on the answer. It is all about accountability, the FED says. You see, transparency and accountability to the American people require secrecy, so that Congress is kept in the dark. You understand this, don't you?

The elite at the World Affairs Council did not bat an eye. "Of course, of course." There was no response comparable to a town hall meeting in a Congressman's district over the bailouts. There were no catcalls. There was polite acceptance.

From the point of view of economic analysis – the pursuit of self-interest – secrecy by the FED is required because the FED is the administrator of a cartel of government-protected commercial banks. The government has created barriers to entry, thus creating the cartel. Bankers do not want the government to police the cartel. They want their own agency to do this. They nominate the Presidents of the 12 Federal Reserve Banks. The big banks want to milk the cartel for all they can. They got the bailout money, and in their view, that ended any legitimate interest Congress may have in pursuing the matter. So, Mr. Plosser said this:

Another frequently mentioned proposal under consideration would politicize the governance of the 12 Reserve Banks by making the chairs of the boards of directors, or the Reserve Bank presidents, political appointees. Other legislators have suggested eliminating the votes of Reserve Bank presidents on the Federal Open Market Committee.

As I hope I've explained, such changes would weaken the regional and decentralized structure of the Federal Reserve System and lead to a more centralized and political institution and less effective policy. Were regional Reserve Bank presidents or chairs to become political appointees, they might be more attuned to the political process in Washington that selected them, rather than having a public interest in the broad economic health of the nation and the Reserve Districts in which they reside. Politicizing these important positions might also discourage some talented, public-spirited individuals to serve as part of our nation's central bank.

The hearts of World Affairs Council members must have swelled with pride. "Yes, yes, we understand. Far be it from us to discourage some talented, public-spirited individuals to serve as part of our nation's central bank."

The message was clear: we must keep politics out of the most powerful cartel in the country. No audit! No control over who gets to be President of a regional FED bank!

Central bank independence means that the central bank can make monetary policy decisions without fear of direct political interference. It does not mean that the central bank is not accountable for its policies.

Allow me to summarize:

1. Autonomy is accountability.
2. Secrecy is transparency.

George Orwell saw it coming. Newspeak is alive and well inside the FED.

CONCLUSION

For the first time since 1914, the Federal Reserve System is under serious attack. The attackers are not members of the World Affairs Council. The attackers are from the hinterlands. The bailouts angered them in October 2008. The bailouts confirmed Ron Paul's warnings in his Presidential campaign. The Web has made it possible for the troops to get mobilized.

The FED has never had to deal with anything like this. It does not know how to respond. Mr. Plosser's speech is an indication of just how little the FED understands public relations. A minority of critics have seen through the Wizard of Oz's smoke and mirrors. The Web has given these people access to information that could be concealed before.

The genie will not go back into the bottle. Opposition to the FED will spread, no matter how many speeches that high-level FED officials deliver to local chapters of the World Affairs Council.

February 20, 2010

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2010 Gary North

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