IT ONLY SEEMS LIKE A PARADOX
EDU DDA Mar. 31, 2025
Summary: Faced with a prospective global downturn buffeted by the possible reverse to a stock bubble , the risks of financial volatility are slightly elevated, to put it mildly. This unfortunately puts central banks on the spot and back in the spotlight and raises several questions. It’s not can they be effective if push comes to shove, rather was the central bank idea ever viable at any point? The theory has been tested thoroughly if only due to what at first seems to be the central bank paradox.
IT ISN’T A PARADOX SO MUCH AS EVERYTHING WE’VE BEEN TOLD IS BACKWARDS.
With growing signs of economic distress across the global system, the chances of a more than purely macro downturn rise with each lower low in stocks, or decline in bond yields. This week began with both, though equities managed to turn things around throughout the day transforming another sharp drop into a mixed closing stance. Bonds were bid anyway, lowering the 2-year Treasury rate down to 3.88% and a new recent low.
As recession signals pile up, fragility across the financial system will be tested. Credit spreads were ultra-low in February and have since picked up with many of them rising again Friday and today (those that have been published through the end of Monday). How far – and how fast – they go will depend on a few factors, then more importantly it will help determine the intensity of any downturn.
There is still no definitive indication as such, only a noticeably elevated probability. This will have the Federal Reserve back in mainstream focus, as the behavior of the 2-year spot on the yield curve has already highlighted.
This is not strictly an exclusively American matter. In China, for example, the PBOC is grappling with several challenges more advanced than any of those in the US. Yuan liquidity is once again showing signs of strain, with interbank rates rising into the quarter-end (we’ll watch to see if they stay that way tomorrow and beyond). The Chinese financial system, having already absorbed massive government bond issues has to prepare for even more alongside other pressures starting with negative sentiment.
Expectations are rising for Chinese authorities to “unleash” another RRR cut in an effort to “boost” liquidity, or, more precisely, the appearance of it. There is little correlation between any of the PBOC’s past efforts extending back over a decade and conditions either within the banking sector or, just as importantly, the real economy.
Even the mainstream Western media has been able to catch on to the game actually being played:
Control over the reserve requirement ratio is one of the most potent tools in the PBOC’s arsenal, meaning a cut would send a strong easing signal that indicates a readiness to help the economy weather US tariffs. [emphasis added]
While still adhering to the current dogmatic phrasing, this one passage from Bloomberg does manage to accurately describe how this all really works, or is supposed to: “a strong easing signal.” An RRR cut does not unlock hundreds of billions of renminbi, as was once said about any of them by everyone.
What’s odd here is how it took the PBOC’s “reform” last year to give the media authorization, of sorts, to finally admit the truth about the whole thing. There are no monetary policies at central banks, only signals and pathways for communications. This is categorically different from the idea of central banks wielding a printing press and actively intervening with money.
It’s substantively distinct from the widely-accepted notion of interest rate policies, too. Central bank actions are thought of as immediately and directly impacting banks if not money, yet that’s not what’s on offer in China or anywhere else. Signals. Psychology.
Why?
I’ve covered this idea from the Chinese side before, and it’s worth extending into broader terms and then taking it back farther into history. China’s “central bank” had gone essentially unchallenged forever, it seemed, until more recently. Questions surrounding its “transmission mechanism” began to be seriously pondered as far back as 2018 into 2019. They were brought to the forefront more recently in 2023 and 2024 as what precipitated the PBOC’s “reform” in the first place (and therefore giving the media “permission” to finally report some truth).
As long as whichever central bank claimed to directly intervene in money and banking, that was how it would be reported. Since that intervention didn’t work, central banking itself has shifted with the central bank to emphasize the signals aspect. The PBOC is behind the times in that respect.
We need to go beyond recent years even decades to ask the question, did central banking ever work?
This is a query almost no one has considered, certainly not in the modern era. It has become hardened conventional wisdom, the kind of thing we all just reflexively accept without ever thinking anything of it. Of any criticism, it goes entirely in the opposite direction; not has central banking ever worked, all the critics say central bankers have too much power not the near-zero it does.
What if they never had any in the first place?
Before the Great Moderation, conventional wisdom was far closer to that notion than not. The Federal Reserve’s history up until then was a tortured litany of failures, both Great and not-great. Its original purpose was to establish an elastic currency since politicians and the public had come to realize inelasticity was repeatedly the cause of deflation then depression.
However, the Fed’s creation in 1913 (beginning operation in 1914) was itself a gamble not the sure thing it has been described as. It stemmed from an assumption, an enormous one at that.
Following the Panic of 1907, even the most resistant authorities were brought around to the idea of a central bank by the simple fact there was no Depression of 1908. This is how it had been since the antebellum era: bank panic, systemic interruption in the flow of money and credit (deflation), followed by widespread unemployment and downturn (depression). Something historic, therefore, must have changed in early ’08 (just as it would for the opposite reasons the next one).
Everyone has heard the story of JP Morgan riding to the banking system’s rescue. This is only partly true (and there is more to it where it comes to the crisis in the first place, how the New York Clearinghouse had refused to admit trusts like Knickerbocker; but that’s another story), the vast majority of the banking rescue was pieced together by the clearinghouse associations along with the federal government.
The latter had shifted deposits of real money, taking them from accounts in other parts of the country not experiencing illiquidity and panic and moving the cash to the biggest central reserve city banks in New York (and some went to Chicago, though it was less needed there since, for one thing, the Chicago Clearinghouse had let in trusts who were the shadow banks of that era).
Most of all, the bank associations had created quasi-money (clearinghouse debt certificates) to the tune of a quarter billion, compared to JP Morgan’s syndicate which had managed only one-tenth that sum (though much of it in hard cash).
Altogether, it was enough to save the banking system from the full deflationary nightmare, choking off bank runs before they were able to more fully develop and thus limiting the scale of the damage to more reasonable degrees (there was still a sharp recession in 1908, painful yet nothing like the 19th century depressions). In the aftermath of such success, the federal government set about to improving upon what had been an ad hoc and scattershot rescue.
It seemed quite reasonable that it would be greatly improved and enhanced to centralize any future one, placing it in the hands of a dedicated public institution always standing ready to act as necessary. No more depending upon the whims or generosity of bankers, nor to be bothered by so many regional differences and distinctions which might create pathways for systemic panic, as in 1893, for instance.
From a top-down perspective, the Federal Reserve as an idea made a lot of sense. It was even equipped with its own form of special-purpose quasi-money: the bank reserves it still uses today.
And it has been a complete and total failure, never once building on the 1907 example. Only a decade and a half after it was empowered and began operation, it did little to halt or even mitigate the worst monetary, banking, and economic calamity of modern humanity. Rather than improve upon the ad hoc rescue from two decades before, the Fed instead failed in every way imaginable while America and the world bore the full brunt of it – and would continue to well into the 1940s!
There are a number of reasons for this, technical matters and those relating to backward theories. Looking past those to the bigger picture, what if the Fed failed simply because the entire idea of a central bank is itself flawed? In other words, like we see today in the PBOC or ECB, it never really stood a chance.
Consider, first, where this idea of an effective central bank has come from. Before the eighties, central banks in general were laughable because of what had happened before and during the Great Depression – and I don’t mean, as too many do, being too “accommodative” with money or some policies leading to the precursor bubble. This is part of the modern problem, where the idea of a powerful central bank has been retroactively applied; retconning, as they call it these days.
Even those institutions which had broadly maintained a decent reputation following the debacle, like the Bundesbank, were really only highly thought of for their ability to manage foreign currency flows. And it was still hugely overstated, a fact revealed by the breakdown of Bretton Woods which, by the late sixties already, left central banks to constantly scramble to unsuccessfully contain the fallout from the eurodollar conversion.
The only period in history when central banking as a concept appeared to work as designed was the eighties and nineties, the so-called Great Moderation which is where this notion of a potent central bank really comes from. Yet, it, too, was an assumption and one which has been thoroughly tested.
Whereas there was success in early ’08 a century ago after the private banking system had cobbled together an effective plan, there absolutely was not in March 2008 as Bear Stearns’ failure signaled systemic downfall and unleashing the world’s return to depression economics. Think about it this way: the Fed only seemed useful and effective between depressions (the Great then the Silent) so long as they didn’t happen.
Everyone had assumed they didn’t happen because of the Fed, which gets cause and effect completely backward (like everything else associated with this topic).
Had it actually been effectual, these depressions would have happened. And what had really kept depression (starting with precursor deflation) from erupting, from the forties right on through to August 2007 wasn’t a central bank, it was the eurodollar. In short, when the monetary system – meaning banking system – operates effectively, central banks appear to be achieving their goals.
Once bank money breaks down, there is little or nothing a central bank can do about it. A fact we can observe everywhere.
IT’S ALWAYS CIRCULATION - NOT SUPPLY - THAT MATTERS.
We know this was the case from before the Great Depression, too, as throughout the 19th century the world – not just the US – had been riddled with deflationary episodes. Walter Bagehot had written the “elasticity” blueprint for the Bank of England and the rest of the world in 1873 (Lombard Street) formalizing what had been looser doctrine in use from before.
Yet, even after Lombard Street, the world was plagued by a monetary and bank panic in that aforementioned 1893 crisis, one that was amplified by pressures stemming from overseas (from the US perspective). In London, specifically, dramatic illiquidity created a panic there which forced financial concerns to sell assets internationally, including American shares, in order to try to obtain gold since no forms of cash were forthcoming from the Bank of England in anywhere close to sufficient quantities (monetary globalization was not invented in the second half of the 20th century).
There has been numerous European bank panics before, too, even as central banks in England and elsewhere had been in operation for centuries. Though their original purpose(s) was as a means to maintain a market for royal debts and for centralizing payment flows, central bankers from a long time ago had come to realize the benefit of “market liquidity” and how lending to banks seemed to help at times and on small-scales.
However, it has never been established that central banks, even those adhering to the Bagehot Doctrine (lend freely on good collateral at high rates), have ever been successful at systemic matters. They are as much an idea - even an ideal - than practical fact where it comes to general economy and banking matters.
I will argue they’ve never actually worked at all. They are a concept more than anything else.
This is why the Fed seemingly installed on the 1907 model failed catastrophically almost right out of the gate. It’s also why for decades it seemed to at least not fail in the same way, as long as the eurodollar kept deflation at bay, and only appeared to suddenly become effective when absurdly being forced (not voluntary) to begin targeting a single interest rate (fed funds) later on.
Only to then utterly fail in exactly the same way as before when finally confronted with the first monetary breakdown since that previous episode. Depressions before the eurodollar, depression after its 2007 reckoning. Central banks along for the ride in every case.
They are the apex of coattail riding, depending solely on the function of the monetary system which, in our current age and stage of money evolution, means banks. This is, again, entirely backward from how we’re supposed to believe it all works – banks are said to rely on central banks when it is the other way around.
Even the recently proposed hedge fund bailout facility (video above) I covered last week (Saturday) is another prime example. The more central banks are proposed to do, it’s only because of how ineffective they are. Think of it this way: before 2007, the Fed hardly did anything apart from occasionally moving a single interest rate here or there. The entire world experienced heretofore undreamed-of prosperity reaching practically every corner of the world.
Since August 2007, that prosperity has disappeared while the Fed and its peers have ended up doing more and more and more. QEs, constant policies, hedge fund bailouts, always looking to the what’s allegedly the center.
It is the central bank paradox: the more everyone wants it to do, the less effective you know it had been. Why? Banks are always what have matters, not central banks. We can see the results.
This, by the way, is no endorsement, merely recognizing the facts. Banks were a necessary evolutionary step in order to make money mobile and therefore effective by extending reach and greatly enhancing efficiency. We’ve outgrown that stage, now have (or will have in the not-entire-distant future) the ability to move beyond it.
China is offering more proof as to the need, exposing the PBOC. Western banks have done the same since late 2007, thwarting QE and bank reserves. This is no neutral proposition, however.
Misplaced and misguided faith and belief in these things is preventing doing something productive about the real problems the world faces. In bigger picture terms, that’s the ongoing global Silent Depression. More immediate and pressing, what happens if financial conditions begin to spiral into something more serious than merely a macroeconomic downturn which turns global forgot-how-to-grow into remember-how-to-get-bad real quick?
There is no backstop.
To be clear, I’m not saying this leaves the world on a track to repeat 2008, or, since 2008 will never be repeated, another deflationary collapse or near-miss. This lack of backstop has already been plaguing the world the past seventeen, almost eighteen years. It is embedded in the financial system as sporadic heightened volatility (I don’t mean stocks).
Unleashed again in 2025, the risk is a downturn’s negatives are amplified by that volatility, becoming a bigger macroeconomic setback than it might otherwise.
Fortunately, we aren’t there and, as it currently stands, warning signs are either scant or only at their most initial states (like credit spreads). Even so, last year’s dollar shortage (December to mid-January) is a potent reminder. Had that happened more recently, or maybe shows up again over the next little while, that’s the kind of thing a real central bank would be useful for.
Recognize there isn’t one and act accordingly. The markets won’t hesitate to do so, even if that doesn’t mean a 2008-rerun. The worst part about it is that we aren’t just being sold a fantasy, we really are supposed to live by it while staying quiet and pretending it is real.
