The Financial Times has become even more erratic of late, mixing first-rate stories with all-too-obvious pumping for special interest. Today, the pink paper had a twofer in the articles it flagged above its masthead, Tamper with tax havens at your peril and Martin Wolf’s Don’t blame central banks for negative rates. While Financial Times readers laughed off the first article, they are likely to take the second one seriously.

Wolf is too good an economist not to know that his column exculpating central bankers is off base, but he’s also regularly invoked (as he does here) Bernanke’s “saving glut” theory, which conveniently lets the Fed and its confreresoff the hook.

Here is what is wrong with his article:

Contra Wolf, central banks are largely responsible for the mess we are in. The Fed stopped supervising primary dealers in 1992. Later that decade, after a derivatives crash that destroyed more value than the 1987 crash, the Fed took the view that it was fine to let banks not only use derivatives with minimal supervision, but allowed them to develop their own risk models with no central bank involvement, insuring that supervisors would be behind the curve. Greenspan and Rubin later fought successfully against the regulation of credit default swaps, a major driver of the crisis. The Fed ignored warnings its own Ed Gramlich and from the Bank of International Settlements about a housing bubble in the early 2000s, and refused to act to supervise and restrict subprime mortgages as required under the Home Owners Equity Protection Act.

The Fed, which was slow to see the crisis was coming, then overreacted. It made steeper cuts in the Fed Funds rate than were neeed to signal that it was on the case and ready to provide liquidity; the mantra at the time was “75 is the new 25” (basis point rate cut). At the time, I saw cutting the Fed Funds rate below 2% as crossing an event horizon.

Central banks bailed out the financial system without making demands or imposing reforms. No bank boards or executives were replaced. Banks were not told they’d need to write down and modify dud loans, most of all consumer mortgages. At the very outset of the crisis, Japanese authorities warned the US that their big mistake had been being soft on the banks. That advice was ignored. Before you try arguing they lacked authority, they were plenty creative in finding authority to do all their emergency footwork even though many of their actions were an overreach. And let us not forget that Sheila Bair at the FDIC, despite being fought by Treasury and having comparatively limited regulatory authority, forced Citigroup to downsize considerably in 2009.

Central banks also overwhelmingly rely on economic models that treat the economy as having a natural propensity to be at full employment; any other state is as a result of an external shock. Economists do not include the banking system at all in their models, and refuse to recognize that the financial system can and does produce endogenous shocks; in fact, Andrew Haldane of the Bank of England pointed out in 2010 that bankers have strong incentives to run wild:

Tail risk within financial systems is not determined by God but by man; it is not exogenous but endogenous. This has important implications for regulatory control. Finance theory tells us that risk brings return. So there are natural incentives within the financial system to generate tail risk and to avoid regulatory control. In the run-up to this crisis, examples of such risk-hunting and regulatory arbitrage were legion. They included escalating leverage, increased trading portfolios and the design of tail-heavy financial instruments.

Those models overstated the speed of recovery and understated the severity of damage done by the crisis. This in turn provided poor guidance to governments in terms of how much spending they needed to undertake to create enough demand to offset the damage of the financial train wreck. For instance, when Haldane in this same paper did a rough estimate of the total cost of the crisis, and used one times global GDP as his working figure, he was attacked as being way too pessimistic. That now looks to be about correct.

More generally, central bankers have continued to fight the last war, of inflation, and have done serious real economy harm by using the reserve force of workers (higher unemployment) to reduce labor bargaining power as their method for keeping inflation down. Michal Kalecki’s 1944 Essay on Politics and Ideology pointed out that the obstacles to achieving full employment were social and political, not economic. Even though businessmen would make more money with full employment, they would have less power and status relative to workers. And Kalecki foresaw that the end game of letting businessmen have their way was negative interest rates:

We have considered the political reasons for the opposition to the policy of creating employment by government spending. But even if this opposition were overcome — as it may well be under the pressure of the masses — the maintenance of full employment would cause social and political changes which would give a new impetus to the opposition of the business leaders. Indeed, under a regime of permanent full employment, the ‘sack’ would cease to play its role as a ‘disciplinary measure. The social position of the boss would be undermined, and the self-assurance and class-consciousness of the working class would grow. Strikes for wage increases and improvements in conditions of work would create political tension. It is true that profits would be higher under a regime of full employment than they are on the average under laissez-faire, and even the rise in wage rates resulting from the stronger bargaining power of the workers is less likely to reduce profits than to increase prices, and thus adversely affects only the rentier interests. But ‘discipline in the factories’ and ‘political stability’ are more appreciated than profits by business leaders. Their class instinct tells them that lasting full employment is unsound from their point of view, and that unemployment is an integral part of the ‘normal’ capitalist system…

In current discussions of these problems there emerges time and again the conception of counteracting the slump by stimulating private investment. This may be done by lowering the rate of interest, by the reduction of income tax, or by subsidizing private investment directly in this or another form. That such a scheme should be attractive to business is not surprising. The entrepreneur remains the medium through which the intervention is conducted. If he does not feel confidence in the political situation, he will not be bribed into investment. And the intervention does not involve the government either in ‘playing with’ (public) investment or ‘wasting money’ on subsidizing consumption.

It may be shown, however, that the stimulation of private investment does not provide an adequate method for preventing mass unemployment. There are two alternatives to be considered here. (i) The rate of interest or income tax (or both) is reduced sharply in the slump and increased in the boom. In this case, both the period and the amplitude of the business cycle will be reduced, but employment not only in the slump but even in the boom may be far from full, i.e. the average unemployment may be considerable, although its fluctuations will be less marked. (ii) The rate of interest or income tax is reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously.

Central bankers, particularly in panicked period right after the crisis, could readily have told governments and legislatures in private or public, “We can’t solve this problem. You need to run deficits big enough and long enough to get the economy back on track. The best way is through social safety nets, since those expenditures rise in bad times and fall off in good ones, so you won’t have to intervene much, which is controversial and hard to fine tune even if when you have the votes and the right leaders.” But they didn’t.

Wolf: “Ultimately, market forces are determining what savers get.”

This is rubbish.

First, Wolf is selling the “loanable funds” model which was debunked in part by Keynes and put to rest by Robinson and Kaldor. Investment is not limited by the amount of savings. Banks can create new deposits, meaning new money for investment, out of thin air, by lending. The Fed has very quietly admitted this fact (although in a typical intellectual disconnect, it does not seem to penetrate its policy view or its key models). The Bank of England has been more straightforward, even in recent years discussion endogenous money in basic primers. And a recent sighing comes in a VoxEU post by a Bank of England advisor: Banks are Not Intermediaries of Loanable Funds – and Why This Matters.

So in Wolf’s post, every time you read formulations like, “The central bank has nothing to do with this, it’s all Mr. Market,” that’s code for the loanable funds theory.

Second, central banks work very hard to influence what prevailing returns on financial assets are. Why do you think central bankers spend so much time telegraphing their rate expectation and planned interest rate moves if they were mere rate takers? Did Wolf manage to forget the taper tantrum of 2014?

Third, negative interest rates are not a state of nature. Before central banks decided to drive rates into negative terrain, they were observed intermittently, and at very low negative levels, in Japan in the 1990s. And let us not forget that the Bank of Japan bears primary responsibility for the unheard-of bubble that led to its colossal bust. In the 1980s, after the Plaza Accord drove the yen to stratopsheric levels (hurting exporters) and the Louvre Accord to undo that wasn’t as successful as desired, the authorities decided to lower interest rates for the express purpose of boosting asset prices to create a wealth effect to produce more consumption. Instead, they got more inequality, which was particularly divisive in Japan, as well as the eventual train wreck. Yet Western central bankers have continued to copy from Japan’s failed playbook.

Wolf: “The world economy is suffering from a glut of savings relative to investment opportunities.” The savings glut is a corollary of the invalid loanable fund theory, but I wanted to flag it separately.

We have lousy infrastructure in the US, and the world desperately need to undertake a World War II level effort to combat global warming. That’s just for starters.

The reason for underinvestment by business is very bad fashion and incentives. Corporations are now so short-termmist that as of the early 2000s (when underinvestment was becoming visible in the data) that McKinsey could not persuade clients to undertake projects that would have a payback of 11 months because they didn’t want to have a negative income statement impact (any investment project inevitably has a part that can’t be treated as “investment” and put on the balance sheet. For example, you have to engage experts, pay marketing expenses, hire more people). More generally, Andrew Haldane and others have found that businesses set their required return rates considerably higher than they need to to have profitable ventures, even allowing for a risk premium. The implication is that businesses chronically underinvest, particularly in opportunities with back-loaded paybacks….like infrastructure and R&D. That’s why those in more rational times are heavily funded by government.

Another reason for the lack of more investment is lousy demand. Businessmen don’t run out and invest more when money is on sale, which is what the loanable funds and savings glut story assumes. They invest when they see an opportunity. So the cost and availability of financing might constrain expanding, but making borrowing cheap won’t facilitate it. The big exception? If the cost of money is one of your biggest costs. Cheap money is a big subsidy to bankers and speculators, which has not gone unnoticed by the great unwashed public.

The one upside of Wolf’s fundamentally misleading article is that it says central bankers are feeling the heat. Unfortunately, a well-connected economist told me that he is suddenly hearing a lot of neo-Austrian talk from British economists that he says clearly know better. So while Wolf is merely sticking to established, if bogus, positions his latest bout of central bank public relations, there appears to be a concerted campaign, at least among some economists, to circle the wagons in support of deeply wrongheaded negative interest rate policies. If they don’t wind up reaping an economic whirlwind, they will in due course get a political one.


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