GLOBAL - Central banks base economic decisions on reasoning that is deeply flawed, and the whole system of lenders of last resort must be reformed, according to a group of top investors.

The knowledge base central banks act on to manipulate capital markets is based on faulty reasoning and presumed knowledge, and lies at the heart of today's global financial and economic crises.

The point is argued in the second paper of the 300 Club, a group of 10 investment professionals formed to show how the investment industry does not act in the long-term interest of its clients.

Dylan Grice, author of the paper and global strategist at Société Générale, said: "The idea that central banks can manage the economy efficiently by distorting markets on the basis of forecast behaviour has been proven incorrect.

"However, rather than changing their thinking, policymakers are applying it with even more rigour."

There was now more debt for insolvent borrowers, more financial engineering, more complicated banking regulations, more blaming speculators for everything and more monetary experimentation by central banks, he said.

"Our policymakers have absolutely no idea what they're doing, but they're giving it a go," Grice contended.

Central banks' key policy of setting narrowly defined inflation targets was defective and had a history of creating wider inflationary asset bubbles, he said.

This was because the idea that a stable rate of consumer price inflation equated to a robust economy contained false premises.

Grice said it was right to ask whether an economy was even something that needed to be managed, given the many financial crises that had happened over the past century.

It is a complex system, he said, but complex systems "organise themselves".

Questions should be asked, such as why central banks need to have a target for anything, and why they even have to exist at all, he added.

The Federal Reserve's latest announcement of an explicit 2% inflation target despite the failure of consumer price index (CPI) targeting regimes was a clear example of faulty reasoning and presumed knowledge.

He said there was little evidence that an explicit target would have made any difference to the last crisis, or that it would prevent the next one.

Grice noted that stable prices had first been targeted in the US in the 1920s. The policy was hailed as a great success, but this behaviour led directly to the Great Depression, he said.

"Like a driver focused on the speedometer rather than the speed, oblivious to the risk that the speedometer might be faulty, the Fed kept its foot on the gas until they crashed," he said.

"So focused were they on the stability of the consumer prices index, and so confident and convinced that it was the be all and end all of inflation, they completely missed what was happening in the credit markets."
 
He said there were three false premises around the practice of inflation targeting.

It is a fallacy, he said, that inflation is measureable, and also that consumer prices should be as "stable" as possible.

The third fallacy is that there is an "optimal" rate for consumer price inflation.

"Policymakers have fallen into the trap of fooling themselves," Grice said.

"They have assumed that inflation can be proxied by the CPI because it is easier to do that."

The paper is called 'A call for honest fools'. The title refers to the idea of admitting ignorance rather than feigning knowledge.

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