Canadian Investment Review

A crisis of conventional thinking in central banking

Written by Avery Page on Friday, March 20th, 2020 at 9:12 am

David McWilliamsHistorically, financial institution decision-makers come from the same educational backgrounds, which have rewarded them for thinking in linear and conventional ways, said David McWilliams, professor of global economics at Trinity College Dublin, during a session at the Canadian Investment Review’s Plan Sponsor Exchange conference in February.

The single biggest concentration of conventional thinkers is deep inside central banks, he added, and future central bankers are taught that humans are rational.

“Economics is the science of us,” he said, noting markets are an amplified version of human behaviour. “Not only are we not rational, we’re highly irrational.”

It’s problematic when central bankers fall victim to groupthink, said McWilliams. “Although we say we like to hang around with people who challenge us, we don’t. What we do is, we surround ourselves with people who think like us, that confirm our biases.”

And this is how mistakes are made. “If you all think the same, it’s impossible to admit to the group or to yourself that you might be wrong.”

Further, central banks are too close to the financial systems, he noted, referring to quantitative easing as one example. With QE, central bankers are giving banks the potential to lend money, but in years to come, this will be regarded like leeching is in medicine, McWilliams noted. “You actually have a broken banking system, and you use it as your vector to try and refloat the economy.”

In turn, this led to a balance sheet recession and then QE was used to reflate the assets.

Subsequently, these actions amplified social inequalities, he said, because rich people who own assets get a free lunch. “And surprise, surprise, four years later, five years later, politics starts to react. Because the guy who has been left out of the equation by the genius central bankers might not have an asset or have a stake, but he has a vote.”

Another issue with central banking is that all central bankers are trained in Keynesian economics, which theorizes that when the economy begins to strengthen, prices will rise, inflation will rise and interest rates will increase, normalizing the cycle. Yet this hasn’t happened, McWilliams highlighted.

“We’re now not in a Keynesian world, we’re in a Schumpeterian world,” he said, citing the theory by economist Joseph Schumpeter that the economy grows by a relentless scale of creative disruption, which is essential to economic growth.

As well, central bankers aren’t identifying what point the economic cycle is at, McWilliams noted. “The nub of the issue is the central banks — which have been elevated to the epicentre  of policy-making — are making mistakes because they don’t identify the terrain they’re looking at.”

As such, today’s central banks are fighting the last war, he said, comparing this to when the British came at the German machine guns in WWI on horseback.

But an intellectual shift is coming and modern monetary theory will come to pass, said McWilliams, noting that, when Keynes first came around in the 1920s, people thought he was a lunatic. “Traditional economics said: This demand management stuff? This expanding government sector? This notion of the multiplier? And then it became totally normal. The beautiful thing about the history of human thought is nothing is stable.”

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