Sunday, December 14, 2008

Keynesian Irrelevance VI: Central Bank

I'm getting a bit tired with this Keynesian stuff. But, since I posed the question in the last post - "Where is the central bank?" - I think I have better answer it.

Keynes did not say much about the central bank directly, but in the General Theory he did lay do the basic principles of money and in real life he was involve in Bretton Woods which dealt with central banking in a global scale.

The job of the central bank is to stablise the value of money - or more specifically the value of the currency. The man in the street may think of the rate of interest to be the value of money which of course is wrong because the rate of interest is the price for borrowing money (which clients of loan sharks painfully realised in the end).

One of the basic principles of the theory of money is that for a thing to hold its value, its supply must be restrained. What gets to become money in the end is the asset that has the most limited supply.

The abandoning of the gold standard by the world at large following the US when it overtook the UK as the world economic power and could not pay for the high oil price in the early 1970s. The removal of the shackles on the money stock and the exprimentation in the liberalisation of the financial market advocated and practicised by the Chicago School of economists in the last two decades have led to the problems of today.

My question of "Where is the central bank?" is a cry of frustration at the ineptitude of the central bank of today in managing the money stock, in not knowing when it has to exercise restrain.

As a result of this lapse in policy judgment, the central bank has allowed the economy to runaway onto a direction of excesses which has distorted the productive capacity of the economy.

The costs to the economy are in the form of inflation and depreciation of the currency which are subtle means of drawing resources away from the general population towards the wealthy - and generally lowering the overall welfare of society.

What can the central bank do after it has violated the basic principles of managing the money stock? Answer: Pay attention to the money stock and make sure that it is properly controlled.

Does the economy have to lurch from one episode to the next on the back of monetary explosions, massively distorting scarce resource in favour of the wealthy elite which the general public is told to keep silent and bear the burden?

It is one thing to recapitilise the banks when necesssary in order to restore public confidence in the existing system. But it does not mean that there is public confidence in the economic system. That is not the job of the central bank but the economic planners.

Of course, to be fair to the central bank, it is not totally in control of the whole financial system. The central bank only takes care of the banks and finance companies as part of what is called the banking system. The investment banks and stockbrokers are under the supervision of the securities commission. This is why to have an overall control of the whole financial system, we need a clever minister of finance.


de minimis said...


The way in which the modern economy has evolved seems to have created many gaps between financial and capital markets. As you pointed out, central banks monitor the banks. Securities regulators monitor the equities markets.

The entities such as investment banks and merchant banks and the like, that create hybrid equity-financial instruments and products, such as the infamous CDOs and CDSs in the U.S. fall between the gaps.

These products were non-existent and, therefore, beyond the ken of Keynes.

Can a "clever Finance Minister" be so clever as to understand the critical evolution of the modern economy, especially financial and equities markets?

I hope that real economic thinkers like you can develop a framework that will enable the rest of us to understand where this evolution is leading us. Or, perhaps, a debunking of this so-called evolution. A Matrix (the movie) type of re-boot may be required. But, how do we undo the unholy tangle that the U.S. financial markets have gotten the whole world into? Has a financial Armageddon begun?

Nehemiah said...

The source of the current financial crisis is the creation of a credit bubble caused by asset-based consumption and surplus savings from developing countries that did not have adequate channels to store their savings.

Keynesianism is basically a tool to prop up demand by spending public money when the private sector is depressed by a lack of animal spirits.

Keynes himself admitted his policies were very short run. In the long run, we are dead ...due to inflation.