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Who Has Captured the Banks?

Or are we the next Japan?

5:05 PM, May 3, 2012 • By DALIBOR ROHAC
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Ron Paul’s aversion to monetary expansion in the middle of an economic crisis is a fringe libertarian idea—and also widely held in America’s political mainstream, including by some Fed officials. This wave of thinking seems to foreshadow a worrisome trend: the ongoing Japanization of the West.

Japan’s Lost Decade was defined by no growth, extremely low interest rates and yet no inflation, rising debt burden, and a pervasive culture of bailouts and crony capitalism. Sound familiar?

Take cronyism and bailouts. Economists Daron Acemoglu and Simon Johnson are right to note that the Fed has followed a very distinguishable path in “deregulating finance, keeping interest rates low in the middle of a boom after 2003, providing unconditional bailouts in 2007-8 and subsequently resisting attempts to raise capital requirements by enough to make a difference.”

In the West, just like in Japan in the 1990s, gone are the days of Great Moderation, when central bankers delivered steady growth and low inflation, and when the idea of a central bank, run by competent technocrats, insulated from political pressures, was seen as a plausible description of the reality.

True, in Europe, the story is more complicated than in the United States, because the European Central Bank (ECB) and the Bank of England don’t have the same regulatory and supervisory responsibilities as the Fed. However, the behavior of both institutions in recent years has been telling. For instance, the ECB insists that any debt restructuring on the Eurozone’s periphery must be voluntary, so as not to damage allegedly frail banks. The ECB has also been very active in recent bond auctions, significantly exposing itself to peripheral debt at a time when most other banks have been ditching Spanish and Greek bonds.

But who really calls the shots on monetary policy? The financial services industry—which, of course, has disproportionately benefitted from low interest rates and thus wants the current policy to continue—and the Fed, the ECB, and the Bank of England will likely oblige. But, given the pattern of comments on monetary policy from coming from leading politicians in the United States and Europe, there may be something missing in the story of the capture of central banks by big finance.

Low interest rates are usually associated with loose monetary policy, which, the theory goes, eventually leads to higher inflation and higher nominal spending. A policy of historically low interest rates has been pursued since 2008. But, puzzlingly, it hasn’t led either to high inflation or the promised economic recovery.

There are two ways to explain this paradox. First, interest rates are a very bad measure of how expansive monetary policy truly is. If anything, low interest rates indicate a policy of tight money, rather than the opposite. Just think of the 1970s—an era of high inflation and rising interest rates. Conversely, the disinflation of the 1980s was associated with falling interest rates.

Second, just like in Japan in the 1990s, a new interest group has emerged throughout the developed world, with a keen interest in preventing central banks from raising inflation and nominal spending – affluent old people, living off asset wealth. Not only are populations in developed countries rapidly aging, but they are also becoming wealthier. In the United States, for example, the median net worth of a household headed by an adult of 65 years of age, rose by 42 percent between 1984 to 2009.

A monetary policy that would be effective enough in resuscitating nominal spending would raise inflation, at least in the short term. That would be no good for those who hold most of their wealth in bonds. If one is a shareholder, one might want to see the economy recover. But the connection between economic growth and growth in stock prices isn’t very close – the past couple of years have been marked by record corporate profits, which have served as a warm embrace for those with large holding of shares.

Coincidentally, affluent retirees share bankers’ interest in keeping the rates low in order to increase the value of their holdings. Yet, they further exacerbate the problem by also having an interest in low inflation – and therefore in low growth of nominal spending. The result – a policy of low interest rates and subsequent waves of seeming “quantitative easing,” which have nonetheless been completely ineffective in spurring either inflation or recovery. The West has thus become the new Japan – complete with ageing populations and monetary policy authorities that cater to the increasingly influential constituency of the elderly.

This might be a deliberate policy of central bankers catering to two powerful constituencies. While friendly relations have always existed between central bankers and large financial institutions, the rise of retirees as an important interest group, catered to by politicians and central bankers, is a more recent phenomenon, driven by the West’s demographics. And as we follow Japan’s lead, numerous economic headaches await us down the road.

Dalibor Rohac is an economist at the Legatum Institute in London.

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