Fighting the last war

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23 February 2016 Est. reading: 12 min read

My late father possessed what appeared to be an irrational fear of tuberculosis. He’d regularly pass a house in our town and lean in as he whispered to me, “Consumption”. In the Ireland of his childhood during the war, TB was a big killer and consumption was something you feared. Typically, the poor afflicted person was removed from their contaminated house and sent to a ‘sanatorium’ which was usually a chilly and remote Victorian structure, where the poor soul would cough his lungs up. Even though TB was completely eradicated in Ireland by the early 1970s, my Dad was still suspicious of coughs and wheezes as only a man who believed in confession could be.

Call them superstitions, prejudices or biases, one thing is clear: these irrational fears, which can be formed by experiences in our youth or formative years, tend to stick with us, long after any actual threat or danger has disappeared.

We see this irrational pattern all the time. Indeed, behavioural economists have made a career pointing out the limitations of classical economics. Elementary classical economics courses begin with the rather absurd notion that humans are rational, yet anyone who has ever spent time with our fellow humans knows we are not rational at all; in fact, humans are highly irrational. Despite this, economists try to convince themselves (largely, to make sure their elegant mathematical models work) that we are clear-headed, evidenced-based creatures. However, like my father, we are a collection of memories and experiences that can morph into fears, hopes and blind misconceptions.

In addition, our memories are not like retrievable computer files that we call up and download. Memories are selective, massaged and sometimes not even factual at all. More critically, memories too are subject to biases.

According to Aristotle, we are at our most vulnerable and malleable when we are young; however, when it comes to critically understanding the world around us, we probably form our views in our early twenties. These views can become entrenched and, if enough people – particularly those that describe themselves as ‘serious people’ – believe them, they become ‘conventional wisdom’. Once ideas become conventional wisdom, they are hard to shift. Conventional people (who like to think of themselves as serious people), find it very difficult to admit that they might be wrong. We see this stubborn behaviour at the top of many organisations because conventional people tend to promote those who have the same views as themselves and this reinforces the conventional wisdom. In time, only ‘cranks’ question the conventional and this is how intellectual conformity solidifies in the commanding height of society. As JK Galbraith pithily observed, “When faced with the choice between changing his mind and finding the proof not to do so, the conventional man always gets busy looking for the proof”.

The old enemy versus the new

Let us examine these biases and conventional wisdoms from the perspective of the world’s central bankers who have to deal with the new enemy deflation, having spent most of their lives fighting that old enemy, inflation.

As the world economy begins to falter again, the world’s policymakers appear to be conflicted and hesitant. Could their unwillingness to act decisively against the threat of deflation be the result of their own inflation biases? And if so, how dangerous might this be?

One thing is clear: quantitative easing (QE) on its own has not been successful in generating the sort of growth rates that are consistent with low, sustainable levels of unemployment. Since 2008, the world has relied on monetary policy to drag it out of the mire, but it has not worked or at least, it has only worked sporadically. Clearly, it can’t do the job on its own. Real wages are stagnant, underlying demand is fragile and prices are falling not rising. So QE has not pushed the economy onto a higher growth plateau.

Einstein once observed that the definition of insanity was doing the same thing over and over again and expecting different results.  Simply repeating or executing more QE in Europe, Japan and China is not enough. In the meantime, the US economy is slowing and, more critically, is suffering from a profound absence of investment, which is undermining income and productivity. Low investment begets low productivity, which in turn, begets low wages, leading to lower consumer spending and lower savings and this, in turn, compromises income.

I don’ t subscribe to Einstein’s view to the extent that policymakers are insane, but they are showing some other characteristic or ailment which is precluding them from seeing deflation as the unambiguous problem. What could that be?

Why no alternative?

Most of today’s central bankers went to university in periods of very high inflation and wasteful government spending. This has changed them and altered their world view. If you spend your life fighting inflation, it is understandable that it might be difficult to accept that today the problem is deflation. And isn’t it also understandable that conventional central bankers find it hard to admit that when the problem is deflation, the solution is inflation?

It is often said that generals are brilliant at fighting the last war – could we say the same of central bankers?

At this point, I need to make a disclosure. I write as a former central bank economist. I remember as a young whippersnapper being sent on an anti-inflation induction tour from the Irish central bank to the Bundesbank in the early 1990s. This was a time when the Irish problem wasn’t inflation, but recession with high levels of unemployment, excessive government debt and huge emigration.

I can understand the Bundesbank’s fear of inflation because ‘sound money’ was one of the cornerstones of the successful West Germany. However, it is worth pointing out that Hitler – the bogeyman of German political nightmares – came to power in a period of deflation 1930-1933, not a period of inflation 1922-23.

We are all products of our past

Central bankers of a certain vintage are scarred by a searing experience with inflation and fiscal pump-priming in their youth and formative years. Most went to university during the 1970s’ spike in inflation and this may explain why they have consistently over-estimated inflation in this most recent cycle and discounted the threat of ongoing deflation.

This underestimation can be seen clearly in figure 1 below, with inflation consistently undershooting central bankers’ targets in recent years.

Chart showing inflation year over year for the UK and eurozone

Let’s look first at inflation. You can see from figure 2 that the heyday of inflation was in the late 1960s and the 1970s, coincident with an intellectual movement away from Keynesian economics towards monetarism.  This was when the conventional central bankers were in college.

Inflation heyday of early 1970s coincided with the decline of Keynesian economics

Meanwhile table 1 below, shows when and where exactly the major players in the world’s central banks were educated.

Table1: Central bankers’ age & academic credentials
Name Age Education Years in education
Federal Reserve
Janet Yellen 69 Brown, Yale 1963-1971
Stanley Fischer 72 LSE, MIT 1962-1969
Daniel Tarullo 63 Michigan Law School, Duke, Georgetown 1969-1977
Jarome H. Powell 62 Princeton, Georgetown 1971-1979
Lael Brainard 54 Wesleyan, Harvard 1979-1989
Mean age 64
European Central Bank
Mario Draghi 68 Sapienza University of Rome, MIT 1966-1977
Vítor Constâncio 72 Universidade Técnica de Lisboa, Bristol 1962-1974
Benoît Cœuré 47 École Polytechnique, Paris Diderot, ENSAE, EHESS 1986-1992
Sabine Lautenschläger 51 University of Bonn 1984-1990
Yves Mersch 66 Pantheon-Sorbonne University 1969-1975
Peter Praet 67 Université libre de Bruxelles 1968-1972
Mean age 62
Bank of England
Mark Carney 50 Harvard, Oxford 1984-1993
Ben Broadbent 50 Cambridge, Harvard 1982-1997
Nemat Minouche Shafik 53 AUC, Massachusetts-Amherst, LSE, Oxford 1980-1989
Jon Cunliffe 62 Manchester University 1971-1975
Andrew Haldane 48 Sheffield, Warwick 1985-1989
Gertjan Vlieghe 44 Vrije Universiteit Brussel, Sussex University, LSE 1989-2006
Ian McCafferty 59 University of Durham, University of Amsterdam 1967-1979
Martin Weale 60 Cambridge 1974-1977
Kristin Forbes 45 Williams College, MIT 1988-1998
Mean age 52
Bank of Japan
Haruhiko Kuroda 71 University of Tokyo, Oxford 1963-1971
Kikuo Iwata 73 University of Tokyo 1962-1973
Hiroshi Nakaso 62 University of Tokyo 1974-1978
Mean age 69

If we average out the main decision makers from the Fed and the ECB we can see that their formative years in college coincided with the worst years for inflation from the end of the 1960s to the end of the 1970s. Given that many central bank big wigs will have spent some extra time in academia, we are looking at people whose crucial years, the years where they formed their views about the threats to the economy, would have been when inflation and fighting inflation were paramount.

These were also years when government spending and fiscal pump-priming went out of vogue, so much so that today in the Eurozone, running a large fiscal deficit in a downturn has been outlawed by the central-banker-driven fiscal compact.

Look at chart 3 below showing us the rates of inflation when the main Fed and ECB policymakers were in university.

Chart showing inflation year over year for the US and eurozone alongside the times when Fed and ECB governors were in education

Although not scientific, I think that biases have led the world’s policymakers to eschew fiscal policy in favour of monetary policy at a time of deflation.

Over-dependence on monetary policy leads us to where we are now: negative interest rates. However, as banks make money by charging interest, not charging interest is the way banks go bust! Unfortunately, the central assumption of using monetary policy to fight deflation is that the banks are in rude health and bank lending will be the engine of growth, stimulating the economy. Nothing could be further from the truth. In fact, the opposite is the case.

The world economy is reeling from a series of bursting bubbles, the 2008 developed country housing/credit bubbles, then the 2013 commodity bubble in emerging markets and now the 2016 bursting of the Chinese bubble.

Bursting bubbles destroy leveraged balance sheets, leading to balance sheet recessions. And balance sheet recessions lead to a specific dilemma: the old-fashioned 1930s-style, Keynesian liquidity trap where:

  1. The private sector has too much existing debt and it doesn’t want to borrow no matter what the rate of interest and
  2. The banks have too much bad debt and they don’t want to lend. In this case, monetary policy becomes ineffective.

Negative interest rates amplify this problem precisely because negative rates make fragile banks weaker, not stronger, undermining the very institutions which were supposed to be the foundation of the recovery.

This is where we are now as the world economy shudders again.

The continued failure of conventional policy means we need to break the conventions! Alternative policies that could help to solve the global economy’s malaise aren’t necessarily that unconventional either. The use of expansionary fiscal policy, for example, whereby public investment drags the faltering economies upwards, would hardly be revolutionary – it’s been done before and it worked, it’s just out of fashion. More radical would be the use of ‘helicopter money’, which Jeremy Corbyn has called ‘QE for the people’. I discussed these options with Martin Wolf recently in this interview.

If the world economy slumps this year, you can expect the calls for a significant lurch in policy to fight off deflation to steadily louden. Already, market behaviour so far in 2016 suggests that markets are beginning to lose confidence in policy and policymakers.

Put simply, when the problem is deflation, the solution is inflation. However any such moves to meaningfully tackle deflation will imply a massive move away from the legacy of inherited biases and an elimination of the conventional man’s weakness for fighting the last war.

David McWilliams (Twitter: @davidmcw) is one of Ireland’s leading economic commentators and was the first economist to identify the Irish boom as nothing more than a credit bubble, warning of its collapse and the consequences for the country. His objective is to make economics as widely available and easily understandable on as many platforms as possible. His daily market commentary is read by tens of thousands of his over 230,000 Twitter followers.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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