At source, money is a public good provided by central banks, but public does not mean for free. This raises the natural question of how money should be priced. Under perfect competition, the price of private goods is mainly determined by their marginal cost of production. However, in the presence of a monopoly, the price of goods can be set in order to maximize the profits for the monopolistic firm.
Monetary authorities enjoy the monopoly of money domestically – Bitcoin aside – and operate as an oligopoly at a global scale. They have the prerogative of unilaterally setting the price of money, which is the official short-term interest rate. Although central banks make money from the spread between the statutory lending and deposit rates that they set, an activity known as “seigniorage”, their aim as public institutions is to maximize social profit over their own P&L. Our economic knowledge however falls short of being able to measure the social benefits and costs of monetary policy over time. As a consequence, monetary policy falls in the realms of ideology rather than science.
To illustrate the point, it is instructive to review the main benefits and costs of our modern monetary system. In addition to its use as a convenient store of value, society profits from fiduciary money in a number of ways. Its broad acceptance as a liquid medium of exchange dramatically improves the efficiency of economic transactions, whilst the provision of credit fosters a better allocation of capital. In principle, both should translate into greater economic activity and more employment. Conversely, the coinage of physical money is somewhat costly, and so is the supervision of the banking system but, on the margin, the greater cost of expanding the monetary mass is the debasement of money, caused by either inflation or asset bubbles.
The problem is that consumer and asset prices affect workers and capitalists in opposite ways. Inflation can be a tool for redistribution when it is the price to pay for enjoying higher employment levels (that was when the Philips curve used to work). Asset bubbles on the contrary foster inequality, as the wealthy benefit disproportionately from them. Concentrated benefits and diffuse costs are a recipe for political lobbying and suboptimal societal outcomes, a problem that is compounded by the lack of democratic accountability of the monetary institutions.
Source: Federal Reserve Bank of St. Louis
In fact, the trade-off between inflation and employment is at the heart of the Fed’s mandate, which is to maximize employment whilst achieving price stability. Other central banks on the contrary – like the ECB – focus exclusively only on controlling inflation. Although it may look as if the US was a more socialist country, what lies at the core is a clash of economic ideologies: Neo-Keynesianists, who believe that the government can influence output through monetary policy, against advocates of the Policy-Ineffectiveness Proposition (PIP), which states that monetary policy is useless in the long run.
Empirical evidence is mixed, as (hyper) active monetary policies have apparently been successful in stabilizing economic growth, but at the expense of creating large debt and asset overhangs, a result of up-fronting many years of economic activity and capital market returns. The risk is that if the PIP thesis holds, macroeconomic variables – most critically inflation – will sooner or later return to their respective long-term averages. This would have negative investment consequences for all asset classes, and would also imply a mean reversion in terms of social equality.
Fernando de Frutos, MWM Chief Investment Officer
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