The End of Central Banking

People have had enough of technocrats...

REMEMBER the days when politics didn't matter? asks John Stepek, editor of MoneyWeek magazine in its free Money Morning email.

When I started out writing Money Morning, that was the mantra. It was a variation on the old "inevitable progress of history" idea.

Whatever governments did, they couldn't or wouldn't stop the march towards globalised free-market capitalism and democracy. Indeed, political paralysis was often viewed as a boon, because it stopped governments from interfering with things too much.

So much for that theory.

The 2008 financial crisis probably represented the beginning of the peak phase for central banking power.

It was the culmination of an era in which former Federal Reserve boss Alan Greenspan had been hailed as the "maestro" for bailing out markets countless times, and presiding over a long bull market in stocks.

The central bankers were effectively in charge of the economy. Take Europe. The Eurozone was increasingly viewed as one big investment region, under one central bank, rather than a disparate group of countries with wildly different risk/reward characteristics.

Beyond tinkering at the edges with endless tax loopholes and "nudges", governments effectively delegated economic decision making to their central bankers. And the central bankers didn't really do much other than keep interest rates low.

So by the time 2008 came round, the central banks were the first port of call. Governments were effectively powerless. Or at least, they acted as though they were.

But now that era is coming to an end. We got a glimpse of the beginning of the end when the Greek crisis erupted. Suddenly, local politics mattered intensely once again. There was a period when Greece – of all countries – was never off the cover of the investment, political and business magazines (including MoneyWeek).

Mario Draghi at the European Central Bank (ECB) reined it all back in when he took charge in 2012. But you can only repress these things for so long. The wounds of 2008 were too deep. Central banking was always going to be a sticking plaster.

Our politicians dodged the hard questions – now we're seeing the results
And the trouble is, their solutions had side effects. Maybe they were the right solutions (or at least half-right). But a number of things happened that nobody voted for.

As Josephine Cumbo highlights in the FT, for example, the Bank of England has recently acknowledged that quantitative easing (QE) has resulted in "material reduction in UK company dividends and investment spending".

The trouble is that QE drove down bond yields. In turn, that made pension deficits explode. (Put simply, if you've agreed to pay someone £100 a year, and interest rates are sitting at 10%, then you only need £1,000 sitting in the bank to generate that £100 a year. But if interest rates fall to 5%, then suddenly you need £2,000 to generate the same £100).

As a result, companies had to divert money that could have gone on productive investment and higher dividend payouts, used it instead to fund artificially-exacerbated pension liabilities.

Overall, notes the paper, the deficit of the combined 6,000 defined-benefit pension schemes in the UK is thought to have grown "to around £300bn by 2015, more than 15% of annual GDP...At the same time as deficits have risen, investment has been subdued".

The Bank, of course, argues that QE was still worth it. Whether you agree or not depends on whether you're better or worse off for this. But the point is – nobody voted for it.

This is why populists are doing so well. People want politicians who will take charge – take back control, even. When Donald Trump was elected, he was clearly hostile towards the Fed in general, arguing that it had blown a huge bubble in the stockmarket (although he shut up about that pretty fast once he was in power).

And now we've got Italy rattling everyone's cages. The result isn't clear right now – this is Italy we're talking about – but as all but the most die-hard believer in polls might have expected, the "populists" have done a lot better than expected.

No one really knows what the populists stand for, beyond "whatever's most likely to get us elected". And until they start campaigning to leave the Euro, there is no immediate risk to financial markets. But suddenly everyone cares about politics again.

By the way, I would imagine that the route towards "Italexit" lies in the new party telling the Eurozone that it'll spend as much money as it wants to, and damn the deficit rules. The Eurozone authorities will probably then threaten to pull the plug on Italian sovereign debt and the banking system. The party in charge then can start to talk about leaving the Euro. It's just a theory, but it's the most obvious way it could play out.

What's the point of all this? The point is, we're seeing major market regime change. Janet Yellen has stepped down, Draghi is doing so next year. That marks the end of an era. The baton is passing from unelected civil servants conducting monetary policy, to elected politicians abusing fiscal policy. From technocrats with a mono-worldview, to viciously competing vested interests who want to grab what they can.

Expect inflation (added friction in the global trade system and aggressive competition between vested interest groups is more inflationary than deflationary), and a lot more volatility.