Trust (not money) makes the world go ‘round
Trust is essential for virtually all economic activity. I must trust that the takeaway coffee I buy is not poisoned and the vendor must trust that the five pound note I hand over is not fake. When we order products online, we must trust that the item will arrive, will be of the quality we expected and that our credit card details will not be misused.
More broadly, our entire monetary system is based on trust. Although British banknotes contain the phrase “I promise to pay the bearer on demand the sum of x pounds”, this is a meaningless gesture. No gold or silver exists to back it up. Rather like the fairy Tinkerbell in Peter Pan, who is kept alive because the audience claps to affirm its belief in her existence, it is our faith that keeps the system going.
What exactly do we believe in? While fiat money is not a formal debt of government, its widespread usage surely depends on our faith in a reasonably efficient government that can keep the economy running and allow only gradual erosion of the value of money. When that faith breaks down, as it did recently in Zimbabwe, then citizens start to use alternative currencies such as the dollar. Indeed, the enthusiasm of traders for accepting dollars (or euros) instead of local currency is a pretty good indicator of the government’s economic competence.
Alternative currencies, such as Bitcoin, that lack government backing have received a lot of publicity. But short of a serious economic crisis, it seems unlikely we will be using them at market stalls any time soon.
As the 2008 crisis made clear, our faith in the banking system is very closely tied up with our faith in governments. When the banking system struggles, government finances are sure to follow; neither Iceland nor Ireland had much government debt before the crisis. Given the existence of deposit insurance, few retail investors pay much attention to the balance sheets of commercial banks these days; they assume that, if a bank fails, the government will step in. While this may create moral hazard, the consequences of “bailing in” depositors have not been that encouraging, as the Cyprus example has showed.
Arguably, our faith is based, not on governments in general, but in central banks in particular. The European debt crisis indicated that some banking systems are too large for even the national government to rescue. In such cases, help from the international community is required. Various bailout plans came and went but the problem appeared to be spreading until Mario Draghi, in the summer of 2012, announced that the European Central Bank would do “whatever it takes” to save the euro. Italian and Spanish bond yields promptly fell and have not regained their former levels.
And it is not just bonds. The equity markets hang on every announcement from the Federal Reserve; they wobbled briefly when the Fed talked of tapering (reducing asset purchases) last year. The 30% gain for the US stock markets in 2013 was not really the result of a rapid increase in profits (excluding financials, earnings per share were up by 7.5%) but by investors’ willingness to but shares in the face of low yields on bonds and cash.
Central banks are the ultimate rich uncle; able to dole out goodies without any apparent limit. When a central bank guarantees a loan or buys bonds to depress yields (quantitative easing, or QE for short), there appears to be no immediate cost. There is a potential liability of course; the guarantee might be required and the bonds might be sold at a loss. But economists still debate whether a central bank’s balance sheet has any real significance; would it matter if a huge hole appeared?
By the same token, the “monetisation” of government debt used to be regarded as a deadly sin, and is ruled out by the European Central bank’s charter. In history, it was the resort of desperate regimes such as the French revolutionaries after 1789 or the Confederates in the American Civil War. What government, faced with a hostile electorate, would ever raise taxes or balance its budget again, if it could simply rely on the central bank to come up with the money?
The official line is that quantitative easing is not monetisation; the bonds will either eventually be sold or the central bank will hold the bonds until maturity, and then not reinvest. But the QE programmes have gone on longer than was originally thought and there is no sign yet of them being reversed.
As yet, of course, there has been no sign of the inflation that critics feared would result, largely because commercial banks have been shrinking their balance sheets while central banks have been expanding theirs. Broad money growth has been sluggish, especially in Europe. But perhaps the biggest area of trust, or faith, is that central banks will be able to retreat from these huge bond market positions without causing severe financial disruption.
This faith in central banks is touching and may well have been the reason the world avoided a second Great Depression. But it raises some fundamental questions for democracies. Are we happy for so much power to reside in the hands of unelected technocrats, especially as their polices can have substantial redistribution effects, e.g., pushing up equity markets and benefiting the rich while pushing down interest rates and cutting the incomes of the retired? If the central banks do get things wrong, who can we blame? Most importantly, if central banks do lose our trust, will this undermine the financial system completely?
* Philip Coggan is author of The Last Vote: The Threats to Western Democracy, published in 2013, Allen Lane.
Philip Coggan, Buttonwood Columnist, The Economist*