A glimpse into the mind of a central banker

While the general public may see low inflation and low (even negative) interest rates as preferable, central banks often prefer higher inflation and especially higher interest rates, which give them more leeway to manipulate the economy.

• As people approach retirement age, they tend to save more money if they can, which contributes to lower interest rates.
• As people become wealthier, they tend to accumulate assets, contributing to what some economists refer to as “increasing wealth inequality” which also pushes interest rates down.
• Limiting people’s ability and desire to save money can therefore be seen as advantageous for central banks, which may approve of methods to achieve this such as:
  • Redistributing wealth via taxation and spending
  • Raising the retirement age
  • Introducing negative interest rates
  • Moving toward a digital currency
• All of the above is supposedly designed to benefit the national economy, even if the majority of individuals actually suffer as a result.

One of the problems that comes from having a central bank is that its directors want to “do something” to help the economy. Central bank governors tend to believe that they are at least partially responsible for the wellbeing of their countries' finances. But scratch the surface and you find that their definition of “helping” isn’t necessarily the same as that of the general public.

Central banks, in the public perception, are supposed to keep things stable and functioning. They should prevent banks from collapsing (and swallowing up the money held there by regular citizens); they should also keep inflation down and interest rates at “normal” levels. But what do the bankers themselves think about all this—what is their idea of promoting stability?

Do you like low interest rates on your mortgage? The central bank doesn't

Gertjan Vlieghe is currently an adviser to the British Chancellor of the Exchequer, Jeremy Hunt. A few years ago, when he was still a member of the Bank of England's Monetary Policy Committee (which sets the base interest rate for the central UK bank), he gave a speech outlining some of the problems facing the UK economy and suggesting possible solutions.

One of the main problems he highlighted was low interest rates. Interest rates are currently low in many countries, and people with mortgages or small business loans may appreciate that state of affairs. For the central bank, however, low interest rates mean less room to maneuver in the event that they have to stave off a financial crisis.

Low neutral rates means limited space for cutting the policy rate when the economy needs stimulus.

According to Vlieghe, low interest rates are primarily the result of two things: too many assets being held as savings and too much “wealth inequality.” Since low interest rates are, in his book, a threat to financial stability, it therefore follows that too much money in savings and too much “wealth inequality” are problems that should be dealt with.

Vlieghe then describes three ways of addressing these problems: negative interest rates, higher inflation, and measures to combat inequality such as raising the age of retirement:

To address limited monetary easing space, there are three types of policy available. Changes that enable policy rates to be cut into deeply negative territory; temporarily or permanently higher inflation rates; policies that raise the neutral rate by lowering time spent in retirement or lowering inequality…

Vlieghe is careful to note that, “These are policies for government to decide” and that, “It is not for central bankers to decide any of these measures.” Just a year after giving this speech, he was hired as an economic adviser to Chancellor Hunt, which was perhaps quite natural given his expertise, and also naturally resulted in his having quite significant influence on the policies that the government decides on.

Here's a closer look at the three methods of regulating the economy that Vlieghe set out in his speech.

Inflation should rise

Vlieghe pays lip-service to the common perception of inflation as bad, noting:

Low and stable inflation is a very good thing, and the inflation targeting framework has served the UK very well.

He then adds that, all the same, allowing inflation to rise a little might also be a good thing if it serves to bring interest rates down:

... a number of academics have put forward the argument that the inflation target could be revised ... it might be a slightly higher target than today. And the higher target might be permanent, or it might be temporary and conditional on ... policy rates approach[ing] their effective lower bound.

Aim for income equality

Vlieghe introduces the idea of income equality by referring to “the share of income earned by the top 10% or 1% of earners.” However, he subsequently mentions only “those earning a higher income” with no reference at all to their share of the pie, and the arguments he uses seem to suggest that the problem is not in fact their larger share of the pie, but their increased income itself. 

The fact of income inequality (which of course exists in all societies) is often presented as evidence of the drawbacks of capitalism. What may be overlooked or ignored is this: Just because the richer are becoming wealthier does not mean that it comes at the expense of others. This was tidily illustrated by former UK Prime Minister Margaret Thatcher in one of her last “Questions to the Prime Minister” sessions in the House of Commons:

Vlieghe may be right when he says that “Rising income inequality has been experienced by most advanced economies over the past four decades.” Historically, this has sometimes translated to worsening conditions for the poorest of society; at other times, the “wealth of a nation” has increased for all (albeit often due to the seizure of resources from abroad). It can also be true that as their wealth increases, those in the highest decile are increasingly able to exploit those in the lower deciles.

However, Vlieghe does not refer to any of these factors when describing how the increasing tendency to amass assets in the wealthy pushes interest rates down. His problem is simply with prosperity itself, and the effect it has on people who now “have a lower marginal propensity to consume.”

His suggestions for addressing this problem are two: “regulatory policy and redistributive taxation,” though he is currently an adviser to a nominally right-wing government. He notes many of the problems that have become endemic in the economy of developed countries, especially since the COVID lockdown period—reduced competition, rising profits, weaker investment, a rise in spending on political lobbying—and proposes to combat them via stronger unions, anti-trust legislation, higher income tax especially on the wealthiest, and higher corporation taxes.

As he surely knows, the very wealthiest, those probably most guilty of exploiting the poor, will inevitably find ways around any such measures (via tax havens, outsourcing, etc.). The burden will then fall disproportionately on the middle classes.

Most revealing, though, is his claim that inherited wealth is problematic:

Low inheritance taxes allow income inequality in one generation to become entrenched in future generations.

Negative interest rates

Central banks, of course, cannot directly set the interest rates at commercial banks. Some suggest that even if a central bank sets a negative interest rate, this need not translate to negative interest rates for private account holders. Nonetheless, it is clear from what Vlieghe says that he anticipates that there will be a knock-on effect.

As the International Monetary Fund (IMF) has already noted, negative interest rates present banks with a problem: Savers may decide to withdraw their money and tuck it under the mattress:

When rates go below zero, banks may be reluctant to pass on the negative interest rates to their depositors by charging fees on their savings for fear that they will withdraw their deposits … This could in turn lower bank profitability and undermine financial system stability.

Vlieghe would perhaps prefer to have the option of taxing cash:

... it is rather impractical to either pay or charge interest on cash...

Since that is not an option, the solution he proposes is to coerce people to keep their money in the bank—which becomes possible if cash withdrawals are banned by moving to a completely digitalized economy:

... central banks, including the Bank of England, are considering a move to central bank issued digital currency (CBDC), [and so] this constraint [of being unable to tax cash] can potentially be moved more easily in the future. If digitisation becomes sufficiently widespread so that cash is used much less, this opens up the possibility of having more deeply negative interest rates in the distant future, without causing any negative effect on bank profits…

Other measures—demographics

Vlieghe notes, as many before him have also done, that a combination of a decreased birth rate and longer average lifespan presents modern economies with certain difficulties.

The three key variables here are the birth rate, longevity, and the time spent in retirement.

“Pushing up the birth rate” in order to provide central banks with greater leeway in managing the economy he dismisses as “too radical an option.” In any case, he adds, “higher population growth has other [undesirable] consequences, in particular related to climate change...”

“Lowering longevity,” he continues, “well, I am going to rule that out as a policy option for obvious reasons.”

That leaves us with reducing the time spent in retirement, which should be on the table. Many countries, including the UK, are already slowly raising their retirement age ... The question is whether it can be increased more, sooner.