Can Central Banks Be Tamed?

A return to sound money

by John P. Cochran

Austrian economists have, since the latest boom-bust cycle and financial crisis, called for a critical reexamination of the "rationale of central banking" by emphasizing the role of central banking in generating business cycles. The argument is well summarized by Roger Garrison:

The decentralization of money, as proposed by Hayek (1976) and explored by Selgin and White (1994), has an increasing strong claim on our attention. Concerns with political feasibility should be separated from the more fundamental reconsideration of a market based money supply. In light of our continuing experience with a bubble-prone central bank, we might well anticipate that a comparative-institutions analysis would favor a market solution to our money and credit problems. At the very least, a better understanding of the workings of a decentralized monetary system would help identify the perils and pitfalls of continued centralization. ("Interest-Rate Targeting during the Great Moderation: A Reappraisal," p. 199, links added)

Thanks to Congressman Ron Paul's strong interest in a market-based money, Austrian economists have had the opportunity to argue in favor of abolishing central banks and for a decentralization or denationalization of money in testimony before Congressional committees. (For examples see Salerno, White, and Cochran here, Ebeling here, and Herbener and Klein here.)

Gerald P. O'Driscoll provides more background and raises issues and concerns in an important new working paper at The Cato Institute, "Central Banks: Abolish or Reform?" He cautions,

Plans to abolish central banks constitute an extreme reform. It is doubtful that such plans can succeed without broader institutional change, occurring either first or simultaneously. That is likely true regardless of the strength of evidence on central bank performance. (p. 2)

O'Driscoll concludes,

We have two bad systems: the fiscal and the monetary. They are intertwined now as they were in the 18th and 19th centuries. They must be reformed, or together they will destroy the economic system that sustains them. They have become parasitical. The unsettled question is whether anything less than radical reform of both will work. Can central banks be constrained to a Bagehot‐like role, or must they be abolished? Can a "bad system" be made better, or do we need wholesale replacement? That is the question that monetary economists should be discussing. (p. 30, links added).

While most Austrians favor replacing central banking with a market-based decentralized money, most mainstream economists opposed to broadly discretionary monetary policy favor rules to restrain central bankers' actions, not abolishment of central banking. As examples, John B. Taylor strongly defends rule-based reforms, while Scott Sumner and market monetarists recommendnominal GDP targeting. However, some economists are clearly beginning to recognize, as most Austrians have, that central banks are or are becoming dangerous financial central planners.

Hayek, in his writings in the 1970s, made recommendations on how central bankers could "best" function while also arguing ultimately for the elimination of central banking. He thus argued, given the widespread existence of central banks and the general acceptance of active monetary policy, which was heavily influenced by a Keynesian economic macro framework, the best policy in this environment was that "Though monetary policy must prevent wide fluctuations in the quantity of money or the volume of the income stream … the primary aim must again become stability of the value of money." To paraphrase, in normal times there is a need to, a la Friedman or Taylor, have a more or less automatic monetary framework, but if policy still generated boom-bust cycles, then to prevent "liquidity crisis or panics" there is a need "to ensure convertibility of all kinds of near-money into real money." For this, "the monetary authority must be given some discretion" (Hayek 1979, p. 18). But because he recognized the strong interconnection between monetary and fiscal policy that would threaten long-term economic stability, Hayek strongly favored a denationalization of money. As quoted in Pizano, Hayek reflected,

I do not believe that we would have major industrial fluctuations if it were not for the present banking system, which in turn depends on the government monopoly of the supply of money. I have been driven into proposing the denationalization of money. (Conversations with Great Economists, p. 10)

He continues:

Anyhow, depressions are not the result of the operation of the market. They are the result of government control, particularly in the sphere of monetary policy.

A related issue, of interest to Austrian economists, raised in debates by proponents of reform, centers on whether the Fed contributed to the recent crisis by keeping interest rates too low for too long from 2003 to 2005. Much of the discussion was triggered by John B. Taylor's March 31 "Policy Failure and the Great Recession." A review of the discussion should reinforce how important and useful Austrian insights are for properly interpreting causes of the current crisis, as argued by Garrison and Cochran, and in guiding discussions of appropriate ways to reform monetary institutions, if a goal is to make such crises less likely in the future.

Taylor used his interpretation of Robert Hetzel (The Great Recession: Market Failure or Policy Failure?) as platform to attempt to bolster his positions that (1) rules are preferred to discretion, and (2) excessive discretion allowed the monetary authorities to make two significant policy errors during the Greenspan/Bernanke watch; interest rates were too low for too long in 2003–05 leading to a boom and a necessary consequent bust and the subsequent bust was compounded and/or triggered by interest rates being too high in 2007–08. While the point that the Fed moved rates too high in 2007–08 does not appear to be controversial among economists who favor rules over abolishing a central bank, many commentators, especially supporters of nominal GNP targeting, strongly reject the rates-too-low-for-too-long argument. Defenders of the Fed policy circa 2003–05 argue, contraAustrians and Taylor, that, since Fed policy did not lead to either significant price inflation or significant increases in inflationary expectations, the policy generated no problems for the economy. For them, but often also for Taylor, major policy-induced problems for the economy areFriedman plucks, policy errors that create too much money and credit constraint, triggering a recession as the economy performs temporarily below potential.

Taylor has the key element essentially correct: rates were too low for too long. But working from a highly aggregated model, Taylor has no really adequate response to his critics. He is forced to rely on rhetoric and historical interpretation of Fed actions during the relevant period of time. Taylor relies on his reading of Hetzel, who in general defends Fed policy in 2003–05, but per Taylor, Hetzel provides evidence for the too-low-for-too-long policy error when he argues,

In 2003–2004, the Greenspan FOMC did make a decision that would later have enormous implications. At this time, The FOMC backed off its long-run objective of returning to price stability and instead adopted an ill-defined objective of positive inflation.

Thus for Taylor, as for Austrian critics of Fed policy, "there is a clear connection between the too easy period and the too tight period"; and to stress the importance of this, Taylor adds, "I have emphasized the 'too low for too long' period in my writing because of its 'enormous implications' (to use Hetzel's description) for the crisis and recession which followed."

Taylor, unlike his critics, who see the only errors by the Fed as the "Great Moderation ended as being too tight right before the bust," recognizes, as do the Austrians, that the "Fed's action in 2003–2005 should be considered as possible part of the problem." Too bad he is unfamiliar with or unwilling to use Austrian analysis to support his position relative to 2003–2005. Austrian monetary theory and business-cycle theory provide a much better understanding of why a monetary-policy-driven credit expansion, such as the 2003–04 period, fuels a boom-bust cycle in a no- or low-inflation environment and, as Ravier, in "Rethinking Capital-Based Macroeconomics" (pp. 367–371), explains in detail, even if the policy is intended to speed recovery from a recession.

Cochran ("Hayek and the 21st Century Boom-Bust and Recession-Recovery") argues the macroeconomic developments in the US economy from 1995 to present cannot be understood without a reference to a capital-structure-based macroeconomic framework. There were, in fact, back-to-back policy-driven boom-bust cycles. The first boom-bust of the period, 1995–2000, should have provided evidence that even with stable prices or low inflation, distortions in the structure of production caused by money and credit creation can create significant coordination problems in a growing economy. The monetary growth which accommodated a productivity shock generated a boom with a high-tech bubble. The resulting "bust," at least measured in terms of the cycle impact on GDP, was relatively mild. The significance of this cycle for the role of monetary policy was perhaps missed because it occurred at the end of the "Great Moderation." This period was a time of better policy — at least compared to monetary policy of the 1960s and 1970s — but, as discussed byGarrison (2009), not necessarily good policy. During this period, central banks were heavily influenced by macroeconomic events of the 1970s that seemed to discredit the neoclassical synthesis/Keynesian consensus. A vast economic literature from the consequent policy-effectiveness debate emphasized central-bank policies that — at least in the long run — aimed, much like Hayek had recommended, at price stabilization as a dominant policy goal. The Fed, while not explicitly inflation targeting, followed a policy that mimicked a Taylor-rule policy. Garrison (2009, p. 187) characterizes this as a "learning by doing policy" which, based on events post-2003, would be better classified as "so far so good" or "whistling in the dark."

The actual result of this "learning by doing policy" is described by Garrison in "Natural Rates of Interest and Sustainable Growth":

In the earlier episode, the Federal Reserve moved to counter the upward pressure of interest rates, causing actual interest rates not to deviate greatly from the historical norm. In the later episode, the Federal Reserve moved to reinforce the downward pressure on interest rates, causing the actual interest rates to be exceedingly low relative to the historical norm. Although the judgment, made retrospectively by economists of virtually all stripes, that the Fed funds target rate was "too low for too long" between mid-2003 and mid-2004, it was almost surely too low for too long relative to the natural rate in both episodes. (p. 433)

Thus the mildness of the first recession of the 21st century was followed by a relatively slow, jobless recovery. This led many economists and pundits to encourage the Fed to re-inflate — create another boom or bubble — to ignite growth and employment. Taylor is right: the Fed accommodated the requests leading to, as argued by Austrians and by Taylor in 2008, "a boom and an inevitable bust" (emphasis mine). The resulting housing-bubble-led boom-bust was a classic misdirection of production driven by monetary stimulus of an economy operating below potential. Far from being beneficial or at best benign, this attempt to use monetary policy to reduce unemployment in the short run did, as predicted by Hayek (1979, p. 11), become a cause of "more unemployment than the amount it was originally designed to prevent." From about 2005 to late 2007, the economy appeared healthy, and, at least temporarily, growth returned to its potential GDP growth path. As the end of the housing bubble clearly illustrated, and as many Austrian had predicted, the health was only apparent.

Responses to Taylor by David Glasner, Marcus Nunes at Historinhas, or Scott Sumner focus on how a central bank in a fiat-money system can do "better policy." A better understanding of the cause of crisis based on an Austrian capital-structure-based macroeconomics should shift the focus away from rules versus discretion to the more fundamental question raised most recently by O'Driscoll, echoing Hayek: are there monetary institutions that could generate consistently better economic outcomes? Research by Selgin, Lastrapes, and White strongly suggest that conclusion should be yes:

Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is … pressing today.

Central-bank response to the most recent crisis makes the discussion for abolishing the Fed even more important. The Fed has moved in the direction of greater, not lesser, central-bank involvement in the economy. John B. Taylor reported that the Federal Reserve purchased 77 percent of the net increase in the debt by the federal government in 2011. The Fed's monetary policy is now a "mondustrial policy." It is an intervention framework financed by money creation. The Fed has done extensively more in response to this crisis than Hayek's recommended prevention of a secondary deflation. It has engaged in picking winners and losers — crony capitalism at its worst. As recognized by John H. Cochrane of the University of Chicago in "The Federal Reserve: From Central Bank to Central Planner," "The Fed's 'nontraditional' actions have crossed a bright line into fiscal policy and the direct allocation of credit."

The Great Moderation did represent a period of improved monetary policy and provides some reason for the optimism of a Taylor or Sumner that a rules-based reform might restrain a Central bank from becoming Hummel's gigantic financial central planner. However, the back-to-back boom-bust cycles that effectively ended the Great Moderation reinforce Austrian arguments that such a policy would still leave economies subject to recurring credit-creation-driven booms and the resulting recessions accompanied by financial crisis. As shown by White, "a gold standard with free banking would have restrained the boom and bust."

Thus it is even more imperative that Austrians continue to make as strong a case as possible for a return to sound money. The is why monetary freedom matters, as it is ultimately the way forward for an eventual withering away of central banks and a return to a commodity-based money; a sound market-based monetary system.