The power of central banks

I’ve been re-reading one of the great books on Japan’s financial crisis, Princes of the Yen by Richard Werner (2003). We have often written about how independent central banks have a central flaw: their existence is undemocratic. Why? Because little matters more for an economy than how its money supply is controlled.

Central bankers know this, and control money supplies. Look to Japan in the 1990s. Despite an “obvious deflation problem” and a shortage of credit (despite low interest rates) that stopped most potential borrowers from doing so, the Bank of Japan (BoJ) refused to expand the money supply, says Werner.

Worse, at “crucial junctures” it even “actively reduced” the money in circulation. This cut domestic demand, deepened the recession, and strengthened the yen.

Why? Many believe the BoJ was just incompetent. Werner does not. For him, its refusal to help out Japan’s elected government was about its “desire to promote structural change”. Money creation would have given Japan a recovery – but not the kind the BoJ wanted.

You may think the BoJ is right on structural reform. But why should the power to insist on social and economic change rest with a central banker? Let’s not forget that by 1998, suicides in Japan were at a postwar high.

Japan’s prime minister and BoJ governor are now working together to move the country on (one reason we are bullish on it). But this is a story worth bearing in mind as you look at other economies.

Would chancellor George Osborne be as celebrated as he is today for the turnaround (however temporary) in the UK economy without the tailwind money supply expansion via quantitative easing? Of course not.

And would things still be so bad in Europe (where the banks are now shrinking lending) if the European Central Bank was obliged to accept instructions from, rather than work independently from, Europe’s suffering democracies?

We’ll come back to this, but I think it is fair to say that the power of unelected central bankers inside democracies should be top of the list of political conversations we all need to have over the next decade.

Another thing I suspect we will be talking about for the next decade is alternative finance (born out of a mixture of the shortage of credit in our own economies, the internet and very low interest rates). It is set to be one of the most disruptive movements of our generation – and that makes this week’s cover story a must read.

If you are anywhere near retirement, the same goes for David C Stevenson’s piece. We are all going to be responsible for creating our own pension incomes from now on. Some types of alternative finance (peer-to-peer lending, for example) will help with that. But for ideas on how to build a balanced long-term retirement portfolio, read How to build your nest egg.