Book Review: ‘Escape From the Central Bank Trap’

Daniel Lacalle offers the right mix of realism and optimism
June 27, 2017 11:48 am Last Updated: June 27, 2017 11:48 am

Today, politics is polarized — and so is economics. There are those who believe in the system, who espouse mainstream economic theories without seeing their flaws in practice. Then there are those who say the economic system will collapse and there is no other alternative.

There are few thought leaders who offer a nuanced view—fund manager and economics professor Daniel Lacalle is one. In his book “Escape From the Central Bank Trap,” he offers practical solutions to improve financial markets and the economy from within the system, without buying into the mainstream economic fallacies. Using this approach, he covers the United States, Europe, Japan, and China, showing us how we got into this mess and how to get out.

“There is a tremendous opportunity for the world to show that financial operators, governments, and central banks can reorient their incentives and use their enormous power to reignite the growth of the middle class,” he writes.

And who could argue with this statement? Although Lacalle himself would like lower taxes, less regulation and central bank intervention, he says that getting there is only possible step by step.

The first important step is to stop pushing out cheap credit through central banks, commercial banks, and capital markets, which only leads to overcapacity and unproductive investments.

“Cheap debt tends to attract capital to low-productivity and short-term investments and leads to poor capital allocation. For example, it is no coincidence that nonperforming loans have risen in European countries and Japan at the same time as liquidity and low interest,” he writes.

Central Bank Fallacy

Daniel LaCalle, chief economist and investment officer at Tressis Gestión. (NACHO MARTIN)
Daniel LaCalle, chief economist and investment officer at Tressis Gestión. (NACHO MARTIN)

Here Lacalle exposes a central fallacy in central bank thinking. Low interest rates and quantitative easing are supposed to stimulate demand by getting people to borrow and spend. In reality, however, they fund projects to expand production which lead to overcapacity and relatively less demand compared to productive capacity. The result is the deflation that central banks are so desperate to avoid.

However, central banks get inflation in asset prices, or so-called bubbles, which they tend to ignore.

“Denying bubbles tops the list of central banks’ ‘problems.’ How can an average investor or citizen trust the biggest experts in finance and economics if they are unable to recognize, sometimes even justify, evident exuberance in financial markets?”

To avoid bubbles and discourage unproductive investments, Lacalle suggests central banks monitor money supply and credit growth in relation to GDP. Once growth accelerated beyond the five-year average, it would be a signal for central banks to tighten policy.

“When understanding the role of a central bank, it should be both to help break unnecessary panics and to attack unjustified euphoria. The latter is as dangerous as the former.”

Power to the Private Sector

As for the government, Lacalle supports the view that rather than doing its part to further unproductive ventures, it should get out of the way and let the private sector handle investment.

“Reducing the excess cost of healthcare, cutting red tape, and boosting disposable income through tax cuts is probably the best solution to secular stagnation… Let the private sector decide when and how investments should be made, allowing productive debt to overtake gratuitous deficit spending,” he writes.

Lacalle often stays at the surface of alternative economic theory which is why his book is great for people looking for different solutions to those espoused by central banks and finance ministries. It also provides many practical examples and valuable investment advice for the readers interested in broadening their economic horizon.