Central banks are the unexploded bomb that needs defusing

This is Iain Martin’s newsletter for Reaction subscribers.

Remember, BC Before Covid-19, when the arrest and escape of Carlos Ghosn was the definition of a big global news story?

The car boss (journalistic shorthand for someone who runs automotive companies) flew into Japan for meetings at Nissan in November 2018 and was arrested on charges of being up to no good. The claim was that the company he chaired had been pilfered, with properties and tens of millions of dollars in pretend extra “compensation” stolen. He denied the charges and refused to plead guilty after being incarcerated. Released on bail, he was trailed by the media. And then, in December 2019, he escaped suddenly, smuggled out by black ops people. They put him in a box, a musical instrument flight case, and flew him by private jet to  Lebanon. Ghosn is there now, unextradictable but living in high security luxury with the threat of being grabbed by the agents of foreign governments or the people who want him punished.

A few months before Covid hit, this was a giant whale of a story. It had the lot – riches, corporate excess, banquets at Versailles, the tough Japanese justice system, and a getaway worthy of a Hollywood film move. Yet after catching the technically terrific and highly watchable BBC Storyville documentary, when it aired this week, what struck me most was how small and even silly it all seemed compared to the epic events that have taken place since in the global pandemic.

The implausible Ghosn story is a tale of the sort that usually captivates me. Having written a book on Fred Goodwin, the former boss of RBS, I find these examples of corporate hubris intriguing. Why is there insufficient challenge? When and how does confidence and ability tip over into egomania? What on earth did the main characters think they were doing in the build up to disaster? Is there a natural cycle in human affairs of boom and bust, with optimism morphing into mania? Is it inevitable? How can we learn lessons?

The Ghosn story has another dark dimension, in the interplay between global business and the French state and the Japanese government. The suggestion from Ghosn is that the Japanese establishment resented the rising power of Nissan’s partner Renault and decided to target Ghosn to challenge France. The groups are bound together and Ghosn was the common factor. The French government owns a stake in Nissan and Ghosn had leading positions in both companies. Was he targeted because the Japanese establishment resented the way the French state and Emmanuel Macron were extending their power over a Japanese firm? As the Storyville account explains, it looks like that might be the case, making the scandal a case study in corporatism, the situation when business and big government become too intertwined and the consumer and taxpayer get stitched up.

Even so, for all that Carlos Ghosn had to leave Japan in a box and he missed his family throughout his ordeal, it is still, in the end, in essence just a story about people in mundane, large companies making cars. It’s not a war, a pandemic or plague, or a financial crisis, or a massive experiment by the leading central banks that might do something really serious like blow up the global economy.

That brings me to the biggest story of recent years that’s had too little coverage, perhaps because it’s difficult to follow and simply too big. It’s the story of QE – financial engineering crudely known as money-printing. The groundbreaking, critical report by the House of Lords Economic Affairs Committee published on Friday is one of the first proper in-depth examinations of the policy. On Reaction, we published a piece by Lord Forsyth, the chairman of the Committee, who explained the risks to the economy without a Bank of England rethink.

What is QE? The Bank of England creates new money to purchase government bonds, debt, on the open market. This is done to inject liquidity into the economy, helping keep interest rates low, increasing scope for lending, and boosting investment. That’s the theory. The scale of it so far is quite something. By the end of 2021, the Bank of England will own £875 billion of government bonds and £20 billion in corporate bonds. This amounts to almost 40% of British GDP. No-one involved seems to know where this leads. They genuinely don’t know.

Along with other central banks, the Bank of England embarked on this experimental policy in the aftermath of the financial crisis of 2008 to keep the show on the road, a perfectly worthy aim. It then kept going, adapting the rationale ever since to keep the same show on the road. The justification for this largely untried QE policy has shifted several times.

The distortions and resentment this creates are obvious. Adding liquidity and keeping interest rates so low has been to the benefit of those with assets, such as property and investments. And it has penalised savers earning no return. Those without assets get clobbered, year after year. This may have a profound political effect, with older voters voting for the status quo and younger voters feeling as though the system is stacked against them, which it is.

The committee report says: “The available evidence shows that quantitative easing has had a limited impact on growth and aggregate demand over the last decade. There is limited evidence that quantitative easing had increased bank lending, investment, or that it had increased consumer spending by asset holders.”

Not sounding great… and it gets worse.

“Furthermore, the policy has also had the effect of inflating asset prices artificially, and this has benefited those who own them disproportionately, exacerbating wealth inequalities. The Bank of England has not engaged sufficiently with debate on trade-offs created by the sustained use of quantitative easing. It should publish an accessible overview of the distributional effects of the policy, which includes a clear outline of the range of views as well as the Bank’s view.”

This is not a uniquely British problem, although the UK is exposed to rising borrowing costs on government debt. If inflation is not temporary and it really takes off, interest rates will have to shoot up at speed, government borrowing costs will rise, and QE will have helped create a disaster in the real economy.

The world’s leading Western central banks are in this together, and we are too as taxpayers, although I doubt many see the danger. As the central banks have accumulated ever more power – charged with keeping that show on the road to ensure there must never be too much pain that frightens the electorate – they have year by year piled up that bet on QE, on a largely untested policy, predicated on everything turning out fine in the end.

This is a troubling situation. Central banks such as the BoE have embarked on a highly risky experiment, fostering a public policy revolution. They have, it seems, no idea about how to bring this to an end. They have built, piece by piece, a bomb they don’t know how to defuse.

This makes the most consequential non-pandemic conundrum of our age – beyond, when will this pandemic fade? – the question of what is to be done safely with central banks to avoid a future explosion.

As the Committee report says…

“No central bank has managed successfully to reverse quantitative easing over the medium to long term. In practice, central banks have engaged in quantitative easing in response to adverse events but have not reversed the policy subsequently. This has had a ratchet effect and it has only served to exacerbate the challenges involved in unwinding the policy. The key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets, with effects that might spill over into the real economy.”

The best hope about the QE experiment is that, with a little luck, we just about get away with it as the authorities have got away with it since the financial crisis, while creating all manner of distortions. Asset prices continue to rise, debt can be inflated away, and the show goes on – again.

The too powerful leading central banks are like a bomb that needs defusing. I’m not for one minute suggesting that task is easy or that mere soundbites or simple ideological mantras will resolve the problem. Not doing any more QE and then trying to normalise rates looks like a practical, although not risk free, start. The Bank of England and other central banks reversed into this spot and admit they do not know how to get out. This is the real global story to watch.

I’m off next week, turning off the news and decompressing. My colleague Tim Montgomerie, who joined Reaction recently, is kindly standing in on this newsletter next week. It’s such a pleasure to welcome Tim to the team. We’re working on some interesting projects for the autumn that we hope Reaction subscribers will enjoy.