Saving the Central Bank (I)

In determining the future prices of shares and therefore the prices of options (financial instruments) written on such shares, commodities or other instruments, we were taught the Ito’s Lemma at master’s level. It all sounded so strange in the beginning and indeed the Professor did not explain what a ‘lemma’ was, or who Ito was.

I was to later find out that there was a Professor Kiyoshi Ito, who had arrived at a formula named ‘Ito’s Lemma’, so called because he actually could not prove or remember how he arrived at that conclusion. Lemma. You know, we all have dilemmas from time to time. That is two lemmas. As Professor Ito could not determine how he arrived at his formula, so also are we often nonplussed between taking a decision or not, especially where our choice will have consequences.

In mathematics, a lemma is a minor, proven proposition which derives its importance from the theorem it aims to prove. The word derives from Ancient Greek, meaning ‘gift’ or ‘bribe’.

Anyway, to continue the story, I remember that Ito’s Lemma (that formula), was combined with the formula for dispersal of heat or pollen (from physics), and through some mathematical abracadabra (algebra no doubt), what is known as the Black-Scholes Formula was derived. This formula was used in the pricing of those ‘options’ and was indeed (perhaps remains so because the academia hardly changes course even in the face of cataclysms), an almighty formula. Almighty, because the trio of Fischer Black, Myron Scholes and Robert Merton would in 1997 be jointly awarded a Nobel Prize for deriving this same formula (off the back of a lemma – an inexplicable mathematical theory).

Suffice to say that just a year after this Nobel Prize, the super Hedge Fund owned by these gurus, called Long Term Capital Management, collapsed, losing $4.6 billion, after receiving a Federal Reserve Bank-brokered $3.6 billion bailout from 14 top American banks.

I believe strongly that most people have not bothered to understudy the business of central banks and their challenges. People think it is easy work. Anyone from the comfort of their sitting rooms or beer parlours could do a jolly great work of being a central bank governor, but I don’t think it’s that easy. Indeed, I think it’s a curse. Well, in university (first degree level), we were introduced to the ‘unholy trinity’, also known as the ‘impossible trilemma’. We were told that this is a constant problem that all central banks – and indeed economies – must grapple with. This triumvirate include:

1. A fixed foreign exchange rate

2. Free capital movement (absence of capital controls)

3. Independent monetary policy

What this means is that if a country wishes to fix its exchange rate or defend it, it must have to dispense with one of the other two. Only two policy positions can be taken while the third must be let go. A country like Nigeria is currently straddling between managing her foreign exchange rate and keeping control of monetary policy. We do not have free capital movement for now. This is the agony of many believers in market-determined exchange rate – and indeed everything else in-between.

Whereas there was never a point at which a consensus was reached that the principal duty of central banks is to achieve price stability, this has been generally agreed around the world. I believe this is also a product of the heady days when we thought we had conquered booms and busts, pre-the Great Recession of 2008-10.

In those days we felt the financial markets had arrived and the upward trajectory was unstoppable. The same infusion of pure science into financial markets which were run by human beings with all the emotions and behavioural issues, led to the crash. But human memory is fleeting, and no sooner than taxpayers’ monies were pumped to stabilize banks, carmakers and others who had professed crass capitalism, we all went back to the same delusional ideologies.

I remember this was called ‘the privatization of profits and socialization of losses’ back in the day. So, whereas it is good to target price stability, I see no reason why a central bank cannot contextualize its priorities or pursue other goals within its ambit – in addition to price stability.

Milton Friedman, a famous monetarist and believer in perfect markets was the one who popularized the idea of central banks setting out to target only inflation when he said that ‘Inflation is always and everywhere a monetary phenomenon’, and that ‘There is one and only one basic cause of inflation: too high a rate of growth in the quantity of money’.

These famous statements however blindside us from other causes of inflation and indeed indoctrinates – almost hypnotizes – our minds from roaming freely, seeking solutions. It sounds very much like what Margaret Thatcher used to say ‘TINA – There is no alternative’. In economics though, there are always alternatives, different ways of doing things. And indeed, different ways of thinking. As Maynard Keynes’ ideas made a lot of sense and difference post-World War II, only to be flawed later, so also does Milton Friedman’s ideas make sense in an era, but must now be critiqued.

The stranglehold of neo-liberal economists on economic thought and academic pedagogy is what is still giving these otherwise dead ideas free reign. Many are fighting on the other side though, but their voices are drowned by the power of money.

I recall what Professor Robert Simon said when I asked him in that seminar in Harvard Business School in 2009 about the relationship between the great university and Wall Street, given that most buildings on campus have been gifted them by Bloomberg, JPMorgan, Goldman Sachs and the rest. He said ‘sometimes I’m at a loss, as to who dictates ideology, whether from Wall Street to Harvard, or Harvard to Wall Street’. It was a telling moment.

He then went on to tell us how Professor Mike Jensen was booed out of class by students in the year 2000 as he went on and on about market perfection and the maximization of shareholder value even when some students had lost quite a bit of money in the dot-com crash. Jensen had to resign from Harvard.

Now, if the unholy trinity, or impossible trilemma are basically about capital controls, exchange rates and monetary policy, where does inflation feature? Perhaps subsumed inside monetary policy. Should inflation not stand alone given its centrality (howbeit more recent), to central banking? I would wager instead that a central bank of a developing country has to juggle the following:

1. Inflation

2. Exchange rates

3. Interest rates

4. Banking sector stability

5. Currency and Money Supply management

6. Financial innovation for financial and economic inclusion

7. Macroeconomic stability – including fiscal stability (developing country central banks cannot live in a cocoon)

8. Maintenance of healthy foreign reserve for trade, emergency and economic growth and stability purposes.

9. There are more.

All of these must be kept handy and under control and like the management of the impossible trilemma, there is no way a central bank could control everything. Some have to be let go, if you want to make a success of another. The CBN today struggles to manage our exchange rates, but then came COVID, throwing every country into serious quagmire, and then inflation rate escaped. The Monetary Policy Committee is today increasing interest rate levels with the hope of slowing down inflation. Constant increases in inflation then slows down the economy and in a few instances has precipitated economic recessions as it hurts companies – especially manufacturers. Should the CBN have folded its arms while inflation – mostly coming from the supply-side – soared? Should we really allow forces of demand and supply to determine the value of our currency when inside the demand for US dollars in our country, we have a sizeable part coming from corrupt folks, kidnappers, and a thriving narcotics industry, who are fully dollarised? Let it be known, that devaluing the naira has never brought one extra cent from anywhere into Nigeria.