Rajan & Central Bankers: They Are The Real One-Eyed Kings In Land Of The Blind

Among the side-issues that emerged in the Raghuram Rajan exit (Rexit) debate is the independence (or lack of it) of the central bank. It is being said that Rajan was an independent Reserve Bank Governor, and by not extending his term, the government is trying to place a yes-man in the job. That is, damaging the independence of the RBI.

It is a pointless debate. With or without independence, central bankers have little ability to alter the course of events given the tools at their command. Governments have far more room to influence events than central bankers. The performance of the US Federal Reserve and the European Central Bank (ECB), both with constitutionally guaranteed independence, since 2008 is evidence of their impotence.

An entire media and analyst industry has developed to interpret the messages coming from central bankers, but why do we need to interpret something that bankers themselves understand very poorly? The fact is the emperor has no clothes. While central banks may have nominal independence, this independence is of little value when they have no special abilities to predict which way the economy or inflation is headed, except in the short term. If a central banker raises rates and inflation falls, it does not mean his actions have worked. Most likely, he got lucky – as it happened with Rajan’s rate hikes and the dramatic fall in inflation due to the oil price crash.

Central bank independence largely revolves around their right to set interest rates based on their best guesses about inflation (or deflation), but even this limited independence is circumscribed by the other roles they are asked to perform. These roles are about guaranteeing liquidity, and insuring against systemic failure. This is why they actually have less room for manoeuvre than one thinks. Their independence is illusory.

Consider the US Fed, which had kept interest rates at near zero levels for nearly seven years with little to show for it barring a claim that it averted another Great Depression. The ECB is still at zero, and has even gone towards negative interest rates in some cases.

The only proof that central banking worked is the absence of an event – a 1930s type depression. Absence of an event is no proof that it would have happened but for central bank action.

But consider this clear failure: Zero interest rates means savers get no returns. Financial repression seems to be the answer to poor growth.

The ECB’s zero rate policy is intended to promote dissaving and spending, in the hope that this will encourage consumption and investment – and hence growth. Japan has been trying this for more than two decades and hasn’t gotten anywhere. The US, being a more dynamic economy, has managed some growth and jobs, but only by pouring endless amounts of money into the economy for free (or nearly free). But this debt on the nation’s balance-sheet will eventually have to be repaid. In short, all the central banks may have achieved is shifting the next recession a few years down the line.

The US Fed is still hesitant about raising rates. Despite its fabled “independence” and the desperate need to boost savings and investment, its hands are tied by what happens elsewhere on the globe. It can keep rates low and still attract the world’s savings as the dollar is a “safe haven” currency. If you can attract money with near zero rates, what does the central bank need its independence for?

Or consider the ECB. The Keynesian solution for triggering growth is for governments to spend more, but the ECB has been asking governments to cut deficits, especially in those countries that are hurting most badly and are in deep trouble over excessive debt.

The right solution for countries in deep debt is for their bankers to take a haircut – a sharp reduction in their loan values through debt forgiveness. But what did the ECB do? It forced bankrupt countries to tighten their belts in order to protect German bankers who had lent imprudently to the PIIGS – Portugal, Ireland, Italy, Greece and Spain.

Is working on behalf of German banks a sign of central bank independence, or a covert nod to Germany’s superpower status in the European Union?

Did the US Fed lower rates to near zero to improve the economy or to help US banks survive 2008?

When central banks have to protect the banking system, they can’t be called truly independent.

Now consider what Mario Draghi, ECB chief, said when accused by the Germans of damaging savers through his zero interest rate policy. “Low interest rates are a symptom of low growth and low inflation. If we want to return to higher interest rates we need to return to higher growth and higher inflation.”

What Draghi is saying indirectly is that interest rates are not really set by the central bank (except in a theoretical sense), but are determined by the level of economic activity. The causality between rates, inflation and growth runs in both directions.

In a fundamental sense, central banks are thus a needless intermediary between savers and borrowers. They are trying to nudge rates in a certain direction, when they have no special crystal ball telling them what is right. They react rather than act. They can’t influence the direction of growth or inflation except to a small degree.

The global economic system is so complex and responds to so many stimuli and variables that central bankers cannot be anything more than educated astrologers or soothsayers trying to predict economic movements. More likely, they look at the sky and forecast the weather.

If you don’t believe this, consider how many central bankers have missed all the big economic events in recent history.

Alan Greenspan had no idea his low-interest rate policy would precipitate a subprime crisis and global meltdown in 2008.

The ECB, despite signals from 2008, had no clue that there would be a Eurozone/euro crisis two or three years later.

The Bank of Japan, despite two decades of cheap money, still has no clue if the Japanese economy will ever revive.

We give Raghuram Rajan credit for raising a whole lot of dollars in 2013 on the assumption that the US Fed will raise rates, but the rate hike happened two-and-a-quarter years later, and still failed to rock the markets. So we essentially gave NRIs a free run on our money.

China operated the biggest stimulus after 2008, and rates were cut repeatedly by the Bank of China, but growth has crashed. Chinese commercial banks are overloaded with domestic debt, making it riskier for them to lend further. If China had borrowed abroad instead of internally, investors would have fled and crashed the currency.

Central bankers and banks may be inevitable in a modern economy, but their utility can surely be called into question.

They are the real one-eyed kings in the land of the blind. They should not be treated like Nostradamus.