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Why your hairdresser wants a Central Bank with a single mandate

by on November 4, 2010

The task of a Central Bank to ensure that money holds its value is frequently misunderstood – this is why.

Why your hairdresser wants a Central Bank with a single mandate

What is money? Money is a medium of exchange that facilitates trade, with the advantage of eliminating inefficiencies of barter. It is a unit of account, which facilitates valuation and calculation, and it is a store of value which allows economic transactions to be conducted over periods of time as well as geographical distances. Money must therefore, be affordable, durable,fungible, portable and store value.

Gold and other precious metals fulfil most of these criteria and were therefore regarded as ideal monetary material. Now, however, we no longer carry gold Aureus or silver Denari (Roman coins, which outlived the Roman Empire), but pieces of paper, copper and a magnetic strip on a plastic card, which by themselves are quite useless. Yet this money does have value, even though it is no longer linked to a precious metal, because society accepts it as a convenient form of payment for trade. To keep the trust in any currency intact, the Central Bank has the responsibility to make sure the currency holds its essential properties. As digital and paper money in this age is generally affordable, fungible, durable and portable the central bank has just one main responsibility – to ensure that money holds its value, through stable prices.

Often in history this task has been misunderstood. When the Spanish found silver in South America they thought they were rich beyond all imaginations. In reality all the silver of the New World could not bring the rebellious Dutch Republic to its knees, nor could it save the Spanish from an economic and imperial decline. What the Spaniards, like many before and after them, failed to understand is that the value of something is not absolute. Money is worth only what someone else is willing to give you for it.  An increase in the supply of money will not make society richer – monetary expansion over time will merely make prices higher.

Economies are subject to trends. After the great depression and the Keynesian revolution, governments felt they could manage the economy, exchanging inflation for unemployment. In practice, however, this experiment also ended with the familiar story of increasing prices.

Now again though, policymakers are making a similar mistake. Theoretically price stability is the prime task of central banks and the single target for the European Central Bank. Yet central banks with both price stability and a growth mandate, like the Federal Reserve and the Bank of England, are using Quantative Easing to push prices up and devalue currencies; a worldwide currency war is what many economists now fear. The rationale for devaluing one’s currency is clear: it makes your country’s products cheaper, because wage costs become relatively lower, and this subsequently can lead to a higher output and employment.

This policy of currency depreciation and inflation is a bad solution to a deeper problem of labour market inflexibility. Inflation and currency devaluation decrease the value of my and everybody else’s money so imports become more expensive, whereas in the best case scenario domestic prices only rise slightly. In effect the policy of subsidizing the export-orientated industries makes everybody else worse off.

A better solution would be to increase productivity and to cut wages in those industries that can not compete at current wages. For export-orientated industries this means that they must compete at a global level, without reliance on the government. As Keynes wisely remarked: “If nations can learn to provide themselves with full employment by their domestic policy…there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbour.” It would become, instead, “a willing and unimpeded exchange of goods and services in conditions of mutual advantage”. In other words, today’s turmoil over currencies and trade is a direct result of our failure to solve our employment problem.

And so we come to the hairdresser. A hairdresser does not compete at a global but a local scale, and his/her wage depends on her relative local productivity. Yet with QE she will be subsidizing the export industries, due to a reduction in the value of her real wage, which is subject to prices (if prices are higher she can consume less).

When your hairdresser exchanges her labour for your pounds, she is essentially trusting that the Central Bank does not repeat Spain’s error of creating so much money that her pounds end up being worthless. There would be a lot more trust if the Bank of England had a single mandate: price stability.

We see unemployment and the related issues in the labour market as a principal problem, which will be touched on in future articles. What is your opinion on monetary policy, the economy or the labour market? We’d love to know!

See Ferguson, Niall. “The Ascent of Money a Financial History of the World” and Skidelsky, Robert. “Wars of Austerity”, Project Syndicate for further reading.

This was first published on The Graduate Times

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