How we got into the money trap – and how to get out

The world took time to get into the money trap. But with one bound it can be free.

Since the 1970s governments have tried various approaches to the challenges of managing money. In the 1970s, they put full employment top. They used monetary policies to expand demand, taking risks with inflation. The results included high inflation, high debts, the Third World debt crisis, and high unemployment.

The 1980s saw a backlash. Popular discontent with high inflation made policy makers give priority to price stability. This led the way to inflation targeting (IT) and central bank independence (CBI).

After meeting with apparent success in The Great Moderation, the 2008 crash showed this policy model was also deficient.

Since then reforms have focussed on strengthening bank capital and the introduction of macro-prudential policies. However, the basic framework of the former system – IT + CBI with flexible exchange rates – continues.

This period culminated in some of the biggest monetary experiments ever.

Central banks hugely expanded their balance sheets, they held official interest rates near zero for several years and they also in some cases deliberately depreciated/devalued their currencies in an effort to stimulate economic growth.

The true meaning of Brexit and Trump

Now there has been a backlash against this approach also. That is the true meaning of Brexit, the election of Donald Trump and the rise of populist parties in Europe and other countries. The people are angry.

So called “unconventional monetary policies”  have had seriously adverse unintended consequences. Productivity growth has declined in the United Stares, Europe and other developed countries.

The formation of new businesses has slowed down. In many economies, so called “zombie” companies have been kept alive by “zombie banks”.

Moreover, the prices of almost all assets, whether financial or in property, have been bid up in many countries to levels that increase the prospect of severe future losses.

This uncertainty has reduced the incentive for businesses to invest in new capacity.

Unconventional monetary policies have greatly widened inequalities of wealth.

Bankers, regulators and former policy makers have not been held to account for their mistakes – mistakes that cost  taxpayer dearly.

How can we get out of the money trap?

My book puts forward an inter-related number of policies and structural reforms:

• A reform of monetary policy frameworks, including an end to inflation targeting and its replacement by an international commitment to sound policy.
• A reform of the international monetary system with a return to stable exchange rates. This is the only way to reimpose monetary discipline on central banks and governments  – disciplines that are needed to effect timely adjustment of balance-of-payments positions. This will mean an end to currency manipulation.
• A parallel reform of banking and finance. The pre-crisis banking system was morally and functionally bankrupt. Some reforms have been made but they need to go much further. Indeed, under the system proposed in The Money Trap, banking as we have known it will not exist. Companies will finance themselves mainly by equity.
• Measures to re-connect the monetary system to the real economy of jobs and work; hence the concept of linking money to what I called the Ikon –  a basket of global equities. The real money supply would rise as prices fell to reflect real global growth.

At present new capital investment in many countries is held back by a huge systemic fault: the perception, indeed the likelihood, of a massive asset price collapse. People know asset prices have been artificially boosted. So they naturally fear a relapse when the unconventional monetary policies (UMP) are withdrawn.

This means that businesses have to reckon not only with the normal risks attending a new investment – whether its return will cover the cost of financing it – but the added systemic risk of a fall in all investment valuations.

This systemic fault has been worsened by recent monetary policies but it is in fact inherent in the type of monetary policies followed in recent years.

The trick is to hold the prices of  (a representative bundle of) tradable equities constant, and through that to moderate greatly swings in asset prices generally. Such a new “investment currency” geared to the needs of real investors rather than consumers would remove the systemic, monetary sources of risk.

It would thus create conditions for a revival of real capital investment.

That is why we need a new kind of money.

PS  By the way, The Money Trap has proved so popular in Japan that it has been translated and will soon be available in Japanese edition.

The working of the Ikon is explained more fully in various posts here and here