Central Banks: Who Needs Them?

No One
As the Federal Reserve hikes its lending rate to a range of 0.25–0.50 percent, murmurs
are heard around the world, with financial pundits predicting doom due to the increased
pressures imposed on the cost structures of firms that are recovering from the pandemic
lockdowns. The Federal Reserve is the leader of the group of central banks around the
world that are ostensibly directed by their respective countries to pursue stability and
smooth functioning of their economies.
The alleged legitimacy of central banks rests on three fundamental goals that central
banks around the world share. The first goal is price stability, which is the belief that
central banks should expand and contract the money supply in relation to actual demand
and supply pressures from the economy. Goal number two is fueling macroeconomic
growth prospects, which is done through lowering the cost of borrowing, which
supposedly leads businesses to increase their investments, leading to increases in output
and overall growth.
Finally, the last goal is performing countercyclical measures, which are actions that the
central bank undertakes in order to offset the high unemployment rates that may result
from falling output during a trough in the business cycle.
Price Stability
The role of the central bank in maintaining price stability in effect lies in controlling the
value of money; i.e., not allowing a general inflation or a general deflation to take place.
An index is created comprising a basket of goods that are weighted in terms of
expenditures on them, and then their price movements are tracked as a proxy for changes
in the general price level in the economy.
The increase or decrease in value of the index is judged alongside a constant percentage
growth rule. When the value of the index increases or decreases more than the designated
rate of constant growth, usually 2 percent, the central bank steps in with its monetary
policy instruments to influence the value of money in the markets.
While the idea of preserving the value of money may be well-intentioned, it suffers from
a misunderstanding of the role rising and falling prices play in the market economy.
Prices act as coordinating signals that convey information about important economic data
scattered around in a decentralized manner. The rise in prices in a well-functioning
market has a specific role: when an object becomes scarce in the market, rising prices are
a signal to consumers to economize on it while at the same time pointing out more
profitable employment of resources to suppliers, who increase the supply of the object
until supernormal profits are all exploited, bringing down its price in the process.
Therefore, when the prices of goods in the basket of goods rise, the value of the index
increases, providing the central bank with reasons to interfere in the market in order to
offset the increases in price, but by doing so, central banks interfere in the market
process. This prevents entrepreneurs from capitalizing on high-profit opportunities; if the
rise in prices is caused by demand-pull inflation, the intervention also stops consumers
from getting goods that would make them better off.
Macroeconomic Growth and Countercyclical Goals
Modern central banking traces ups and downs through the deviations of the actual growth
rate of the economy from its long-run trend rate of growth. In other words, a growth-
cycle upturn (downturn) is marked by growth higher (lower) than the long-run trend rate.
The health of an economy is understood in terms of the closeness between its current
growth rate and its projected growth rate based on long-term trends. Central banks also
use other lagging and leading indicators such as consumer confidence surveys, weekly
work time surveys, and the industrial production indices to gauge the current health of the
economy.
When the current growth level or the value of the indicators suggests that the economy
needs to be stimulated, various monetary policy instruments are used to influence the
demand and supply of money in the economy to accomplish the goal of bringing the
economy back on track. In trying to lower the cost of borrowing for firms, the central
banks also lower the cost of lending for commercial banks, which would then lower
commercial banks' own interest rates. The decrease in interest rates is supposed to lower
the cost of borrowing for firms such that the return on investment becomes marginally
greater than its cost and thereby increase investment and output through the multiplier
process.
But while at first glance such measures against falling output and spending may seem
sound, they warrant a deeper look, as the actions of central bankers impact the economy
disproportionately. The total spending in the economy consists of two parts, one being
spending to support the structure of production and the other being spending on the final
products. The spending on the structure of production consists of spending on capital
investments to increase the productivity as well as the scale of firms, and on circulating
capital, which is used as input to produce outputs, while the spending on final products
implies consumer spending on finished goods and services.
Firms often save a part of their profits and use this pool to finance their capital
investments in the future. When firms resort to saving instead of spending, there might be
falling output, but such a fall in output and spending is not a sign of bad health of the
economy but merely a process that the economy needs to undergo that results in
increased productivity, innovation, and efficiency in production due to lowered costs.
This efficiency results from changes in the capital structures of firms as they change their
machines or increase their scale. The process also results in an increased value of money,
as the goods per unit of money spent increase.
A fall in output would soon taper off to a greater level of productivity and prosperity for
the economy, but if the central bank intervenes with an easy money policy to reduce the
cost of borrowing, it leads to Cantillon effects. Savers lose due to an additional
generation of artificial money, which lowers the value of their money, leading to
inflation.
Conclusion
Easy money policies fuel unsustainable booms that eventually result in misallocation of
capital, as capital investment is redirected in an unsustainable direction. Each firm makes
its investments on the basis of a comparison of costs and benefits. When the costs are
artificially lowered through decreased interest rates, investments that were previously
unprofitable now seem profitable, but since such profitability is not based on true
underlying consumer demand, inflation soon increases as producers compete for scarce
resources.
The increase in inflation shrinks the profit margins originally fueled by artificially low-
interest rates where an additional monetary push would again be needed to keep current
investments from becoming unsustainable. Thus, we conclude that central banks create
business cycles and distort market processes. Therefore, we should reexamine the need
for central banks, since they are the source of a lot of economic ills.

Note-
It was originally published on mises.org: https://mises.org/wire/central-banks-who-needs-
them-no-one