Fabian Bogg
Having previously examined the Argentine economic history and its role in paving the way for Javier Milei's meteoric rise (see part 1), it is time to scrutinize the most important and controversial puzzle pieces of Milei's proposed agenda. While providing in-depth reasoning would be out of scope, essential thoughts and theories are explained concisely. This section deals with his idea of abolishing the central bank.
Regarding the President's views, the idea that shocked the world most was the abolition of the Argentine central bank.
Understandably, most readers cannot imagine a world without their central bank, let alone know about alternatives. It represents a constant in their life comparable to X-rays, electricity, or cars. However, all these findings and inventions precede the Federal Reserve System, which just commemorated its 110th anniversary. Indeed, the Federal Reserve Act that established the central bank was rushed through Congress during Advent 1913 when most Congress members just wanted to catch their trains home. Congress enacted it on the 22nd and 23rd of December, and President Woodrow Wilson signed it into law the same day. Little did the representatives realize they had just taken one of the most crucial votes in world history.
Undoubtedly, this little excursion into US history begs the question: "Why would one opt to abolish such a venerable institution like their central bank?" The following attempts to elucidate some of the answers.
The first central bank trouble is the assault on sound money it naturally brings. Laying the ability to extend the money supply in the hands of bureaucrats enables them to erode the value of this medium of barter.
Destroying the value of money is unjust for at least two reasons, one of which is conventionally overlooked by both layman and mainstream economists.
The first and most obvious reason is that deviating from the principle of sound money through inflation unduly infringes on the purchasing power of each citizen. Without any wrongdoing on their part, they can buy fewer products than they could a year ago. Beware that this is not a bug but a feature of the system. The desire for annual inflation rates of around 2% is embedded in the entity' goals, and those figures are actively targeted. To exacerbate matters, central banks, in pursuit of their objectives, diverge from the original meaning of the term inflation, derived from its Latin predecessor "inflare," which denotes the bloating of the money supply. Paradoxically, they rely on a consumer basket to measure inflation, concealing the full impact of their monetary expansion activities – a concept that has unfortunately permeated contemporary economics. For instance, an originally-defined inflation rate of 5% might equate a contemporarily-defined inflation rate of 1.5% as new free trade measures and efficiency have countered a substantial part of the money supply effects. Without the printing activities, though, one might have experienced deflation, an effect veiled for the average Joe. At least prima facie, it is not abundantly clear that the inflation targets are needed and that we cannot aim to relieve the population's burden through deflationary innovation (examples such as TVs and akin products speak against the idea of considerable buying restraints in deflationary environments).
The second and less obvious unfairness in weakening a currency is its over-proportionately negative effect on poorer parts of the citizenship. This is attributed to the so-called Cantillon effect, a phenomenon recognized not only by Austrian-school economists but also by "staunch free-market advocate" John Maynard Keynes. As realized by Arkadiusz Sieroń, the root of the Cantillon effect lies in a physical reality, namely that helicopters do not drop money. Instead, money distribution is executed by lowering bank reserve requirements (which in a fractional-reserve banking system leads to banks creating additional money out of thin air), buying securities, etc. This results in an uneven distribution pattern, as Friedrich August von Hayek illustrates through the following honey analogy: "If you pour honey into a cup, it won't spread out evenly. It will clump in the middle of the cup first before spreading out." As our instinct tells us, this is highly problematic. Banks, major corporations, proactive entrepreneurs, and other entities with close ties to the state gain access to additional liquidity early on, enabling them to convert money for additional goods and services at today's uninflated prices.
In contrast, actors that lack government proximity and do not commonly and rapidly secure financing are disadvantaged. This group, which significantly overlaps with the poorer group of society, is forced to fully bear the burden of inflation by purchasing products at tomorrow's inflated prices. To make matters even worse, they mostly buy everyday goods whose value diminishes as opposed to the former buying assets whose revenue streams likely increase along with inflation. (Understandably, some common misconceptions about the Cantillon effect exist. My article titled "Cantillon Effect. A Brief Look at Common Misconceptions" delves into further detail, elaborating on the questions that arise.)
The second reason for opposing central banks lies in their role within the democratic framework. Central banks face a duality of aspirations that inherently cannot be conciliated.
On the one hand, they ought to be independent to tackle the challenges and reach the goals outlined by their founding acts. Advocates want the central bank to act on what they view as expert knowledge and, understandably, reject all external interference. They argue that government pressure should not be exerted, and once the decision-makers of the central bank are appointed, they should be solely accountable for their goals and serve all regions, nations, etc., neutrally as mandated by their role.
On the other hand, central banks wield a staggering influence on the economy, indirectly impacting everything from birth rates to societal developments. Their leaders repeatedly rank within the top 100 most influential people globally, and their actions can evaporate economies. More importantly, their sphere of influence interferes with the state's most inherent sphere of influence, such as the authority to tax, coin money, or dictate industrial policy. Given that inflation resulting from increased money supply must be considered a hidden tax, citizens must have a democratic say in central bank actions. Otherwise, central bank behavior can easily contradict the voters' choice and undermine their policy preference and, hence, the whole democratic system. Certainly, the gullible objector might highlight the appointment of central bank members through elected officials. Yet it must be abundantly clear that an indirect election resulting in the appointment of a virtually irremovable central bank member for 4 to 8 years does not meet the standards for selecting some of the most influential individuals globally. Moreover, in the Eurozone process, the power is further diminished as each governmental entity can only significantly influence a fraction of the central bank decision-makers. This setup adds stark sovereignty concerns to the long enumeration of problematic features associated with central banks.
As the clever reader recognizes, this structure is poised to fail even in theory. Our system of checks and balances and the separation of powers does not allow space for such an entity and its duality of aspirations.
Practice only merits our view as politicians often pressure central banks to take more extreme measures to defer the next recession. While regrettable, it is reasonable from the politicians' point of view. Political pundits and politicians alike acknowledge that reelection chances strongly depend on the state of the economy. Or to say it in the words of the Clinton Campaign "It's the economy, stupid!". Unfortunately, central bank decision-makers often succumb to pressure for various reasons, may it be the desire for tranquility in their daily lives or an aspiration to be invited to infamous high-society cocktail parties. A 2021 study has reinforced this understanding, demonstrating that members of the European Central Bank (ECB) council from high-debt European countries tend to adopt a more dovish stance (as measured by their public remarks) compared to their counterparts from low-debt European countries.
The third reason for opposing central banks is their role in distorting markets. They harm the market mechanism in three different ways. Firstly, they distort prices. Secondly, they rescue failing businesses, and thirdly, they capriciously give preferable treatment to specific actors and sectors.
To better understand the problematic nature of these interferences, we shall remind ourselves of market functioning and its role in satisfying customer needs. First, it is worth remembering that asset prices are influenced by their underlying risk and reward profile. Moreover, we know that prices of goods or services are a function of supply and demand. Lastly, we must grasp the dynamic process that allows the market to mirror customer preferences. In said process everyday consumer purchasing decisions reflect the populace's unfiltered preferences and tilt the market through its effect on prices. When consumers increase their lived preference for certain products over others, demand increases, resulting in higher revenues. This, in turn, allows trending companies to further invest in lowering their costs or bettering their product, creating a virtuous cycle comparable to a flywheel. The dynamic readjustment process continues until the psychological customer choices, expressed through their willingness and ability to buy, are fully portrayed in the new market constellation. (Of course, in practice, there is no endpoint to the dynamic processes.)
As indicated above, central bank behavior interferes here threefold.
When central banks increase the money supply by purchasing bonds, they artificially inflate the demand, increase prices, and decrease the yield. Consequently, bond prices do not reflect their intrinsic risk anymore. As if that was not enough, this leads to a ripple effect with a share of the government bond investors fleeing into corporate bonds, leading to a decrease in their yield. A share of them, in turn, flees into high-yield bonds, decreasing their yield, and this pattern continues. This sets off a vicious cycle, compelling many investors to accept a lower yield or move into a riskier asset class. Overall, the ripple effect leads to yield compression and artificially high risk-taking. Furthermore, an artificially low (government) bond yield unduly favors government spending at the expense of lending to private actors.
Secondly, central banks commonly (in)directly bail out large businesses through security purchases (e.g. asset-backed securities) or simply by providing governments with very cheap funding opportunities. At first sight, this may sound great. Yet, it is unbelievably harmful. Apart from the fact that businesses fail due to their inability to satisfy customers, Joseph Schumpeter recognized that the history of capitalism is a history of creative destruction. In the same way, a forest needs occasional wildfires to free some nutrients for beautiful new plants to grow, capitalism needs freed-up resources through business failure. Thus, upcoming entrepreneurs with revolutionary ideas can get cheap access to (human) resources and rapidly expand their businesses.
Thirdly, central banks give preferential treatment to specific actors based on the security purchases they undertake. Green tilting, for example, was used by the ECB to purchase bonds from green borrowers. This not only raises grave democratic legitimacy questions but also disrupts the above-mentioned mechanism in which consumers' lived preferences determine a business's success. (Let alone the door it opens to corruption due to the arbitrary nature of declaring something “green”.)
Last but hardly least, we must focus on the harmful effects of setting interest rates, typically taking the form of artificially low interest rates.
To begin with, the mixture of low interest rates and high inflation rates leads to negative real interest rates. While potentially neglectable for wealthy parts of society, this scenario is peculiarly harmful for poorer people. Their lack of disposable income forbids them to invest in securities. Commonly living paycheck to paycheck, their only rate of return is determined by the interest rates provided by their bank accounts (strongly driven by the central bank rates). A world driven by expansionary central bank policies thus slowly expropriates them or forces them into unreasonable speculations.
In addition, artificially set interest rates are detrimental to the long-term development of an economy. Indeed, this should not be a shock to anybody. We have long known that minimum prices lead to excess supply while maximum prices lead to shortages. The interest rate price does not deviate from that norm. As Ludwig von Mises and Friedrich August von Hayek realized in their Austrian business cycle theory, a top-down interest rate regime leads to significant boom-and-bust cycles. To briefly summarize the effect, artificially low interest rates misguide investors by sending wrong market signals – the existence of lots of spare resources – leading investors to allocate money in an unsustainable way. Namely, the investors are seduced to invest in low-yielding projects that would not be profitable under equilibrium rates. Initially, that may seem beneficial - low unemployment and a surge in economic activity. After the party, though, inevitably comes the hangover. The wastefully built projects meet a lack of saved resources, i.e., an absence of demand. Thus, comes the bust. Companies must sell off resources, fire employees, or close their doors indefinitely.
Furthermore, interest rates rise due to the supply-and-demand dynamics, adding pressure on low-yielding investments. This correction mechanism continues till the economy has sobered up and the toxins have left the economic body. As a result of this policy, living standards are lower than they would otherwise be because an excess of resources is spent in ways not aligned with consumer preferences, and breakthrough innovation is substituted by incremental progress.
Having examined the drawbacks of central banking, it is now evident why Milei is an adamant proponent of central bank abolition.
To recap, central banks assault sound money, disproportionally hurt poor people, and are irreconcilable with the foundations of a democratic state. They distort markets, blur the risk function of prices, and hinder economic development.
That being said, the question about potential alternatives, as well as Milei's pragmatic but sub-optimal proposal, remains. A question for another day.
"Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance." – Daniel Kahnemann