Central banks

Reactors Not Actors

Reise, Architektur, Skyline Frankfurt am Main
The European Central Bank: Not as big or clever as it thinks. Source: dpa

In the 1980s, it was the investment bankers of Wall Street and the City of London who were deemed Masters of the Universe. But today, another type of banker has taken up the mantle: central bankers.

Ben Bernanke and Janet Yellen, the former and current head of the US Federal Reserve, are confident that they pulled America back from the abyss of the 2008 financial crisis. And there is a broad consensus that the European Central Bank under Mario Draghi kept the euro zone together during its recent crises.

Wherever commercial banks wreak havoc or politicians fail, where debts grow out of control or unsolved distribution problems poison the climate, the powerful masters and mistresses of central banks are in demand, and they are supposed to at least prevent the worst possible scenario with their power over capital markets, economic growth and jobs. But sometimes they also cause damage, for example, with low interest rates spoiling savers’ plans to make provision for old age.

By and large, central banks follow the trend of the real economy. They do not act, they react.

Up to a point, this perception is correct. But it does conceal another problem that is seldom mentioned: that the central bankers themselves are trapped and often have little scope for decision making. Either way, the idea that institutions such as the Fed or the ECB set interest rates autonomously is only half true. There is an entirely different version, which is probably more realistic: By and large, central banks follow the trend of the real economy. They do not act, they react.

Central banks can hardly ignore the real interest rate of the economy – that is, the capital market interest rate minus inflation. This real interest rate is the measure of the average real return on invested capital. Central banks more or less follow this real interest rate. If it is low they can hardly come up with high interest rates without slowing down the economy. If it is high, they have to tighten conditions to prevent overheating.

Base rates usually hover around the so-called real, neutral interest rate which experts refer to using r*. The fact that it cannot be directly measured makes the central bankers’ task only more difficult. Monetary policy exerts an effect mainly by deviating upward or downward from this mysterious r*.

But the big trend, whether the world is slipping into a phase of high or low interest rates, is not determined by people like Ms. Yellen or Mr. Draghi. Most central bankers don’t feel comfortable with an extreme monetary policy anyway and want to move away from it as quickly as possible. Overlooking the restrictions the masters and mistresses of money are subject to is to overestimate their power. Who knows – it probably even happens to them.


To contact the author: wiebe@handelsblatt.com

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