Chapter 4 MONETARY POLICY

At one level, the collapse of socialism seems, indeed, to be all around us. The Soviet Union and East Germany no longer exist. Poland and Romania have overthrown their Socialist hierarchies. The Berlin Wall is in pieces; the Iron Curtain seems irreparably torn. In many parts of the world, the rhetoric—if not the action—is that of the free market. Even the most dedicated leftists have ceased praising the traditional Socialist paradigm, that is, what one might refer to as “state socialism” or “comprehensive planning.” Of course, the economic fallacies that doom state socialism to failure were unmasked long ago by Ludwig von Mises (1981)¹ and Friedrich Hayek (1944; 1945). More recent critiques include those by Don Lavoie (1985), Hans-Hermann Hoppe (1989), and Hayek (1988). As a result, these fallacies, which lie at the heart of socialism, are now widely discussed, although they are, perhaps, still not thoroughly understood. What is being overlooked in the celebration of the retreat from state socialism is the fact that the thirst for planning continues to afflict many politicians, bureaucrats, and economists. The species socialism may be dead, or at least gravely ill, but the genus collectivism is alive and well.²

One manifestation of that collectivist spirit is what may be described as “noncomprehensive planning.” Unlike pure socialism, where the professed goal is to control every minute aspect of the economy, noncomprehensive planning hopes only to control one key sector or a few sectors, in order to direct the general path of the economy. By far the most important example of noncomprehensive planning is the monetary policy conducted by central banks.

Every first-semester economics student learns that money is unique in that it plays a role in virtually every transaction in a market economy. The phenomena affected by changes in the supply of or demand for money include interest rates, prices, wage rates, consumption and investment decisions, national income, exchange rates, and the external trade balance. Furthermore, theorists as diverse as Milton Friedman (1959; 1968), Murray Rothbard (1975), Friedrich Hayek (1933; 1935; 1941), and Clark Warburton (1951; 1962; 1966) have pointed to monetary disturbances as the prime source of business cycles. It would seem clear that fluctuations in money reverberate throughout the economy.³ In short, the advocates of a centrally dictated monetary policy are in one sense too modest. To advocate such nominally noncomprehensive planning is, in fact, tantamount to proposing that there be bureaucratic influence upon the great majority of economic events. In another sense, they are, perhaps, too boastful. They seem always to assume that the relevant economic knowledge is (or will be) available to the monetary authorities.

The intent of this chapter is to argue that central banks are not only unwilling, but also—and this is the more radical proposition—unable to follow a rational monetary policy. First of all, several alternative monetary frameworks will be compared. Only one, the maintenance of monetary equilibrium under a productivity norm, will be seen to be optimal. Second, the insights of public choice theory will be utilized in order to reveal the typically perverse incentives of all monetary authorities. Finally, the work of various Austrian economists will form the foundation of an “impossibility argument.” It will be shown that, no matter what its incentives may be, no monetary authority can possess the economic knowledge it would have to have in order to maintain monetary equilibrium.

ALTERNATIVE POLICY GOALS

A multitude of possible monetary approaches have been proposed in recent decades. Most of these can be categorized as either a “rules” approach or a “discretionary” approach. That is, either bind the central bank to a specific objective from which it must not depart or grant the central bank the broad powers to follow any path it chooses to certain macroeconomic results. Enormous controversies have been generated regarding the alleged superiority of one over the other. As will be seen, the rules versus discretion controversy is not really relevant. To survey all such proposals would require a book-length treatment and, therefore, will not be undertaken here. Five of the more common proposals will be examined: (1) countercyclical actions to offset variations in employment and output, (2) the maintenance of a stable price level, (3) a constant rate of money growth rule, (4) a fractional-reserve gold standard, and (5) the maintenance of monetary equilibrium.

Countercyclical Policy

The objections to countercyclical actions have become familiar fare. It has been argued that attempts at stabilization will, more often than not, prove to be destabilizing. This seeming paradox has usually been explained by noting (1) the long and variable time lags between the initiation of presumably countercyclical monetary actions, for example, the purchase or sale of government securities, and the resultant effects on the economy, and (2) the unreliability of econometric forecasting. Friedman has quite pointedly stated (and this hints at part of the argument in a later section) that even if the monetary authority were to choose a relatively noncontroversial task, such as achieving the natural rate of interest or the natural rate of employment, still the problem remains that

it cannot know what the “natural” rate is . . . And the “natural” rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the “natural” rate, and attempted to peg the market rate at that level, it would not be led to a determinate policy. (1968, 10)

He concludes that countercyclical policy generally leads to either accelerating inflation or accelerating deflation, thus exacerbating the business cycle.

Hayek offers the related observation that “the present unemployment is the direct and inevitable consequence of the so-called full-employment policies pursued for the past twenty-five years” (1979a, 39). Hayek’s assessment is grounded in the Austrian theory of the business (or trade) cycle,⁴ which argues that monetary expansion leads to malinvestments that must eventually be liquidated. When they are, unemployment rises. Many years of continuing expansion would create both a pervasive honeycomb of malinvestments and a chronic unemployment problem.

One should not overlook the “new-classical” position on countercyclical policy (Lucas 1973; 1975; Sargent and Wallace 1976). Theirs is a world in which agents utilize all available information and, as a result, cannot be systematically fooled by government actions. Any attempt to exploit a “Phillips curve tradeoff” by rapidly increasing the rate of inflation is doomed to failure. Individuals learn how policy makers react to certain economic conditions, and they adjust their inflationary expectations accordingly. Central bank manipulations of the money supply affect the price level, but have no net effect on real output or employment. In the new-classical approach, countercyclical actions are pointless.⁵

Considering the foregoing, one is driven to conclude that attempts at countercyclical policy (despite their enormous political popularity) have failed to attain their avowed object and/or often proven to be counterproductive.

Price-Level Stability

To maintain a stable price level has long been a popular proposal among many monetary economists. One of the most influential expositors of this notion was surely Irving Fisher (1920; 1963). At first glance, the concept appears unassailable. Nevertheless, despite its popularity, the idea of price level stabilization is not without its problems. Even such an ardent admirer of Fisher as Milton Friedman has declared that seeking a stable price level is a suboptimal monetary goal. His major point seems to be that the connection between monetary movements and the price level, although a strong relation, is “not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities” (Friedman 1962, 242).⁶

Moreover, it has been argued that to maintain a certain price level regardless of other conditions could introduce serious micro- and macroeconomic disturbances. George Selgin (1988a, 98–100; 1990) considers a constant price level in the context of a general increase in productivity. If the income velocity of money is constant, real income rises because of the productivity gains, unit costs of production fall, and the price level is to be held constant, then the money supply must rise. This causes nominal producer revenues to increase. Extranormal profits are made. In the opposite case of a decline in productivity, the money supply would have to fall, bringing about lower nominal revenues. Unusually low (perhaps negative) profits would be experienced.⁷ To put this in the terms used in Chapter 3, when productivity rises, effective demand exceeds notional demand; when productivity falls, notional demand exceeds effective demand (given a stable price level rule). A policy of maintaining a stable price level will, on occasion, be inconsistent with Say’s Law (Selgin 1990, 281).

It must not be forgotten that price-level stabilization has little hope of even limited success unless a price index can be constructed that is a reliable and unambiguous indicator of actual prices. No thoughtful economist would deny that price indexes are less than perfect reflections of the structure of relative prices, but are they sufficiently reliable to be useful? Here there is a considerable divergence of opinion. Some few have argued that all index numbers are illegitimate and deceptive aggregations. Such economists insist that the price structure can never be revealed by a single number—however meticulous is its construction—but that, indeed, only the “array of prices in all their specificity” will suffice (Rothbard 1988a, 182–83; Mises 1966, 220–23).

Others have suggested that the practical problems associated with the construction of a meaningful price index are so nearly insoluble that one must despair of success in this endeavor. For example, Selgin has identified three key problem areas: (1) how to decide which goods to include in, and which goods to exclude from, the index, (2) what measure of central tendency to use in order to reduce the individual measures to a single number, and (3) how to assign weights to the specific prices (1988a, 97–98).

Such practical issues might be of minor importance were it not for the fact that each of the countless ways of resolving them (there is no obvious, right solution) leads to a different index which would, in turn, suggest a different schedule of money supply adjustments. Presumably, if any one schedule is correct for maintaining monetary equilibrium, the others cannot be. (Selgin 1988a, 98)

It is appropriate also to ask whether a stable price-level approach would suffer from the presence of nontrivial time lags regarding policy makers’ responses. Ideally, one would need a price index that could be reconstructed and recalculated rapidly enough for the monetary authority to respond to every economic event of significance. Given the magnitude of the task, this would seem to be unlikely.

Richard Timberlake takes what one might describe as a cautiously optimistic position regarding the price index issue. He declares that “the conceptual validity of a price index seems logical . . . the validity of the concept cannot be denied because of the imperfection of the method used to measure it” (1987, 89). A price index “should be used, however, with caution and with an understanding of its frailties” (Timberlake 1987, 91). As is well known, those “frailties” include, for example, the quality, substitution, and housing biases from which the CPI suffers. Even elementary textbooks discuss such index number problems.

Timberlake’s point is well taken. Index numbers can be conceptually useful. However, the issue at hand is not whether a price index is of value heuristically or pedagogically; the question is whether stabilization of a price index is both feasible and desirable as a benchmark for monetary policy. One must answer that question in the negative. The practical problems of constructing a proper index are enormous, and, in the context of productivity gains (or losses), a price-level rule could be destabilizing. A stable price level is certainly preferable to the inflation that seems always to accompany “full-employment” policies. Nevertheless, it remains a suboptimal monetary goal.

Constant Money Growth

If a price-level rule is less than ideal, then what of a constant rate of growth in money rule? This idea is, of course, closely associated with the work of Milton Friedman (1959, 77–99; 1962, 242–43; 1985, 5–7). The common form of the proposal is that the central bank, by means of manipulations of the monetary base via open market operations, should maintain a fixed rate of growth in some selected measure of the money stock, say M1. The goal is to produce a pervasively stable set of long-run economic conditions, with short-run fluctuations assumed to more or less offset one another. Friedman, as well as a number of other monetarists, proclaims this approach to be the optimal central bank policy in a world characterized by general uncertainty.

Nevertheless, a constant money growth rule (CMGR) faces several obstacles and objections. Most fundamentally, one must ask what measure of “money” is to be used. This is critically important, since the quantitative relation between the monetary base and M1, M2, and M3 is different in each case. That is, the respective money multipliers differ both conceptually and numerically. The linkage between the purchases undertaken by the central bank’s open market trading desk and the growth of money can be quite sensitive to how one defines money. Furthermore, it does not suffice to suggest that one simply always use that definition of the money stock that correlates most closely with some other macroeconomic variable, such as GNP or national income. To switch back and forth between various money measures would be likely to introduce considerable additional instability by means of increasing the uncertainty in the minds of market participants.⁸ The growth path of, say, GNP is not likely to be invariant relative to one’s measure of money.

Moreover, switching monetary targets under a CMGR might gain nothing in another way. In order for a CMGR to work as planned, two conditions must be met. The intermediate target chosen (M1, M2, M3) needs both to have strong and predictable effects on some ultimate target like GNP and to be systematically affected by changes in the operating target (the monetary base).⁹ Only then can the central bank hope to smooth the long-run path of the economy by engaging in open market purchases of government securities, which change bank reserves and the monetary base. To switch money measures might improve the link between intermediate and ultimate targets, but the relation between operating target (the monetary base) and intermediate target (money) might well degenerate. For example, M2 might be more closely correlated with GNP than is M1 at the same time that M1 is more closely correlated with the monetary base than is M2. Changing targets from M1 to M2 might achieve nothing.

A CMGR also is not necessarily consistent with Say’s Law. If the money supply increases by some fixed percentage that approximates the long-run average rate of change in productivity, then disequilibria may result. If, for example, productivity increases significantly so that production costs generally decline, then effective demand will exceed notional demand unless the rate of monetary growth falls.¹⁰ If productivity declines and production costs rise, notional demand will exceed effective demand unless the rate of money growth rises. Over the very long run, a CMGR would indeed keep average money growth in line with the average change in productivity, but this is not sufficient to escape business cycles.

Two assumptions that may be essential to a CMGR have been challenged. First, those who adopt this Friedmanite position appear always to assume that changes in the money stock are, in the long run, neutral with respect to real magnitudes (O’Driscoll and Shenoy 1976).¹¹ In contrast to this, one finds the literature of the Austrian school, in which it is argued that monetary manipulations are neutral in neither the short run nor the long run (Mises 1966, 538–86; Rothbard 1975, 11–38; Garrison 1978; Hayek 1933).

It is also assumed that aggregate money demand is a stable and predictable function. If this were not the case, then sudden fluctuations in the demand for money would bring about considerable instability in the form of monetary disequilibrium, despite the slow and steady growth in the money supply. The stability of money demand is, of course, open to question, especially if one is concerned with short-run as well as long-run conditions. For example, if the interest rate on CDs rises relative to that on NOW accounts, then depositors will tend to transfer funds to CDs. That is, the demand for money—as measured by M1—will decline relative to the demand for “near money” (M2). To maintain a constant rate of growth in M1 would result in an excess supply of money. “Portfolio preferences could shift between actual money and near-moneys with extreme sensitivity to interest rates, causing important inflationary or deflationary effects even with the money supply constant” (Yeager 1968, 59).

Moreover, even if total money demand (however measured) remains absolutely constant, changes in the composition of money demand can have disequilibrating effects in the context of a CMGR. Specifically, consumers’ desired holdings of currency relative to demand deposits may change. If, for example, consumers decide to hold relatively greater quantities of currency, the result—in the absence of an offsetting increase in the monetary base—will be a multiplicative decline in the money supply (Friedman 1959, 66–67).

This is necessarily true of any central banking system in which there exist (1) fractional reserves and (2) a monopoly issuer of legal currency (Selgin 1988a, 113–15).¹² This fundamental problem arises because the single legal currency serves both as hand-to-hand currency for the public’s daily transactions and as part of the reserves of the banking system. Thus, an increase in currency demand constitutes a drain on reserves, which, through the familiar money multiplier process, brings about the net decrease in the money supply. The only solution is for the monetary authority to vary the monetary base as the composition of money demand varies.¹³ That, however, violates the essential idea of a CMGR (Friedman 1985).

Finally, Hayek has made an interesting observation about the Friedmanite proposal of a CMGR. Apparently inspired by a comment made by Walter Bagehot, Hayek expresses concern that panic conditions may occasionally be unavoidable under such a monetary rule. As he puts it, “I would not like to see what would happen if under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met” (emphasis added) (1978, 77).

If there existed no superior approach, a CMGR—despite its flaws—might be a wise choice, but there is a preferable alternative. A CMGR is clearly suboptimal. Regarding the “discretion versus rules” debate over the proper conduct of monetary policy, Selgin speaks to the core issue:

These arguments for having a central bank adhere to a growth-rate rule are valid and compelling. But they do not see the issue as involving a choice between central banking and free banking. They offer what is perhaps the best solution to the problem of money supply given that currency issue is to remain a government-controlled monopoly. Nevertheless, central banking, even when it is based on a monetary rule, is decidedly inferior to free banking as a means for preserving monetary equilibrium, (emphasis in original) (1988a, 106)

A Gold Standard

There have been, and are, a number of different gold standards one might propose: a gold coin standard with 100 percent reserves, a gold coin standard with fractional reserves, a bullion standard with no coin in use, a gold exchange standard with general convertibility, or a gold exchange standard with convertibility limited to official institutions, such as under the Bretton Woods agreement (Bordo 1984, 198–99). The bullion standard constrains consumer choice by eliminating the possibility that consumers may seek liquidity in coin form. Furthermore, both versions of a gold exchange standard significantly violate the central idea of a gold standard: that there exists one base money (gold) that functions as both the reserves of banks and the basis for international transactions and (occasionally) is held by consumers. The gold/dollar exchange standard of Bretton Woods represented a serious dilution of the gold standard concept. Therefore, only the first two proposals will be considered here.

First consider a central banking system with 100 percent gold reserves. Commercial banks may issue deposit credits, but not currency (banknotes).¹⁴ The legal currency is issued by the central bank on a one-for-one basis with the existing stock of monetary gold (specie). The key virtue of such a system is that, allegedly, neither an excess of money nor an excess of credit could be created.¹⁵ Also, changes in the composition of money demand would not bring about net changes in the money supply. Certainly, it is true that banks could not make loans (issue deposit credits) that exceeded the total of gold they held either in their own vaults or on deposit with the central bank. However, it seems equally clear that both the supply of money and the supply of credit would periodically be deficient. Imagine that money demand increases because of population growth (with no change in per-capita productivity). Unless the supply of specie reserves increased proportionately, there would be excess money demand, and notional demand would exceed effective demand. The inside money supply would be far too “inelastic” to respond properly to such an event. Here, again, one sees the false dichotomy of rules versus discretion. In order to curb excessive monetary growth, it is not necessary to make the money supply unresponsive to all changes in economic conditions.

Two further problems should be mentioned. First, with 100 percent reserves, banks cannot make loans from their deposits. Every dollar deposited must be held, ready to be redeemed, at all times. This severely restricts the available credit in the society. One could make a very plausible argument that much of the real economic growth that has occurred would have been impossible in a world of 100 percent reserve banking. Furthermore, banks resent such an imposition. Reserves are not interest-bearing assets¹⁶; to require banks to hold such reserves is, in essence, to place a tax on banking, and the higher the reserve percentage, the greater the tax burden.

Second, a gold standard with 100 percent reserves is an inefficient use of resources. As many economists have argued, for example, Friedman (1959, 4–6), such a system would require that a significant fraction (perhaps 2.5 percent) of GNP be devoted to the production of money. This is a telling point, although some advocates of gold have tried to rebut it by arguing that the benefits of stability outweigh the losses in terms of resources. This latter is an argument not without merit. However, strictly speaking, such a defense of gold only applies to free banking with fractional gold reserves.

As another variant of the gold standard, one must also consider the possibility of a free-banking regime with 100 percent reserves. This seems unlikely to occur, since none of the historical examples of free banking were based on 100 percent reserves. Nevertheless, the proposal needs to be addressed, and it will be addressed (along with other versions of free banking) in Chapter 7. Suffice it to say at present that free banking with 100 percent reserves seems not to be justified on either economic or ethical grounds. As for free banking with fractional gold reserves, nothing more need be said at this time. It has been examined and defended throughout Chapters 2 and 3.

This leaves only a gold coin standard with fractional reserves and a central monetary authority. The so-called “heyday of the classical gold standard” (1879–1914) is the best example of such monetary regimes in operation. Within the constraints of gold, the Bank of England directed monetary actions in the United Kingdom and the Treasury functioned as a quasi-central bank for the United States (Timberlake 1978). As Michael Bordo has stated in an excellent statistical review of that time, “one dominant feature of the classical gold standard was long-run price stability” (1984, 222). In theoretical terms, the expected long-run rate of inflation was approximately equal to zero. This fostered stable long-run contractual arrangements, greater saving and investment, and strong long-run economic growth. However, at least when compared with the heavily managed post-World War II period, the classical gold standard exhibited greater short-run instability of real output, employment, and prices (Bordo 1984, 225).¹⁷ One might say that the classical gold standard worked quite well, but it was not perfect.

There are two serious shortcomings of a centrally managed gold standard. First, to work efficiently, such a system requires that a (temporarily) inflationary country must lose specie because of the concomitant trade deficit. A (temporarily) deflationary country must gain specie because of its trade surplus. This makes for a system that is (1) integrated internationally and (2) self-correcting. However, central banks may thwart this process by indulging in “sterilization.” That is, central banks are able in the short run to offset the effects of international gold flows on their domestic money stocks. This they undertake in an attempt to insulate the domestic economy from actions abroad. Sterilization reduces the equilibrating virtues of a gold standard.

Second, from a purely domestic standpoint, central banks—even on a gold coin standard—may not respond appropriately to a change in the demand for money. If the fraction of income consumers wish to hold as money (the Cambridge k) changes, then the money supply should change in the same direction. This occurs under free banking because free banks have clear market signals to guide their actions. The signals conveyed by the processes of reflux and adverse clearings lead free banks to monetary equilibrium.¹⁸ Assuming that central banks are nonprofit, “public-interest” agencies, consumer demands for redemption (reflux) may not constrain central bank actions. This is obviously true when central banks decide to suspend payments (refuse to honor redemption demands), and suspension was not unknown among central banks on a gold standard. Furthermore, central banks experience no adverse clearings.¹⁹ That is, they do not have to settle accounts with other banks vis-à-vis either notes or checks (at least not domestically). As a result, short-run monetary imbalances become likely.

Monetary Equilibrium

It has been shown above that the first four frameworks for monetary policy—discretionary countercyclical actions, a stable price level, a constant money growth rule, and a centrally managed gold standard—all suffer from theoretical and/or practical flaws. The optimal monetary policy is one that seeks always to maintain monetary equilibrium (subject to a productivity norm), in both the short run and the long run. Many distinguished economists have endorsed this productivity norm approach to monetary equilibrium: Alfred Marshall, Francis Edgeworth, Ralph Hawtrey, Arthur Pigou, Dennis Robertson, Erik Lindahl, Gunnar Myrdal, Ludwig von Mises, F. A. Hayek, Gottfried Haberler, Fritz Machlup, and Frank Taussig, for example (Selgin 1990, 270–71). Furthermore, monetary equilibrium is the only one of the alternatives that meets all three of the criteria for successful policy suggested by Friedman: (1) to prevent money itself from being the cause of economic disturbances, (2) to provide a stable economic environment, and (3) to offset major disturbances that arise from nonmonetary sources (1968, 12–14). Free banking with fractional gold reserves provides just that.

As explained in earlier chapters, free banking maintains the money supply equal to money demand, the market rate of interest equal to the natural rate, and effective demand equal to notional demand. Under free banking, nominal national income remains constant. Hoarding of cash balances does not lead to deflation and depression, changes in productivity are accommodated so that producers’ revenues stay in line with producers’ costs, and changes in the composition of money demand do not cause changes in the money supply. The goal of monetary equilibrium is intrinsically a countercyclical policy, but one that is motivated purely by the self-interest of each market actor. It is the expression of an Hayekian “spontaneous order.” Moreover, free banking reveals that the clash over “rules versus discretion” is not ultimately germane to the issue. Neither rules nor discretion is superior. Free banking is superior to a central bank that adopts either approach.

One may find it illuminating to realize that the other policy goals that have been reviewed are all surrogates for monetary equilibrium. It has just been pointed out that to maintain monetary equilibrium is to take countercyclical action. Regarding a stable, and therefore predictable, price level, James Buchanan acknowledges that “such predictability implies, of course, continuous monetary equilibrium. And if this were accomplished, the actual course of change in the absolute price level would become largely irrelevant” (1962, 161). The CMGR of Friedman is clearly aimed at the achievement of approximate monetary equilibrium in the long run, though not in the short run. Furthermore, the classical gold standard was, of course, a system in which monetary disequilibria were corrected via supposedly automatic changes in international gold flows.²⁰ To put it briefly, one may say that as long as there is continuous monetary equilibrium, all other monetary goals are superfluous.

Despite all the foregoing, the productivity norm is not without its critics. One in particular should be given serious consideration: Kevin Dowd. Not only are his arguments articulate and forceful, but he also is himself a well-known advocate of free banking. Dowd does not condemn laissez-faire approaches to banking, but he does question the alleged superiority of the productivity norm (199le). He identifies three arguments that have been used to support the contention that the productivity norm is superior to a stable price level: equity, price-adjustment costs, and stabilization.²¹

The equity argument proposes that the results of unexpected changes in productivity should be shared by both debtors and creditors. This would be true of a productivity norm. Under a stable price level rule, both gains and losses would accrue only to entrepreneurs (debtors). Dowd grants that at one level the whole equity issue is something of a red herring. “To avoid getting bogged down in interminable arguments over the ‘just’ division of the gain or loss ex post, all one needs to do is take the analysis one step back and allow agents to trade claims to the (as yet) uncertain outcomes” (199le, 16). That is, let agents contract in accordance with their preferences regarding risk. All that is necessary is to enforce all valid contracts. Dowd adds the penetrating observation that “we cannot take contract form as fixed, and then compare how that fixed contract performs across the two price-level regimes. The choice of contract depends on the regime itself” (emphasis in original) (1991e, 17). This suggests a fundamental question: If the likely form of free banking is that based on fractional specie reserves and that version of free banking naturally follows the productivity norm, then is not Dowd’s point moot? The choice may be either free banking and the productivity norm, or central banking and (among other possibilities) a stable price level. Free banking under a price-level rule may not be on the menu.

Dowd pursues his point about price-regime preferences. He offers two reasons why a productivity norm would not be chosen (1991e, 17–18). First, he emphasizes the costs of dealing with a less predictable price level. That such costs exist cannot be in doubt. One must ask, however, whether it is more costly to deal with unpredictable commodity prices or with unpredictable wage rates. The productivity norm takes nominal wage rates as given; the price level rule takes commodity prices as given (Dowd 1991e, 24). Given the choice, is it not plausible that most individuals would prefer stable nominal wages to a stable price level?²²

Second, he argues that a productivity norm would discourage innovation and productivity improvements on the grounds that gains would not fall entirely on the entrepreneurs (debtors), whose actions often affect productivity. However, workers also affect productivity.²³ In addition, they, as the ultimate creditors, would be denied a share of the gains from productivity improvements under a stable price-level rule. As a result, the flow of funds so essential for financing research into more productive processes might decline. Both debtors and creditors may need to benefit from innovation. It would seem that neither regime is obviously preferable insofar as the encouragement of productivity improvements is concerned.

The second argument for the productivity norm is that it entails lower price-adjustment costs. Dowd declares that this is true—but only if both the costs of price adjustment are fixed costs and productivity shocks are discrete events that do not occur continuously (1991e, 20–21). He suggests that both of these conditions are questionable and, therefore, concludes that a price-level rule is superior.

Dowd argues that if one considers factors, such as the timing of purchases, inventory decisions, and the risk involved with a greater price variance, it will become plausible that price-adjustment costs are largely variable costs. This is a good point, but several counterpoints must be made so as to present the complete picture. First, as discussed earlier, a price index that is fully consistent with monetary equilibrium is probably impossible to construct. Second, a change in that “ideal” price index does not necessarily impose an additional net cost on all market participants. For certain individuals, the relevant specific price(s) may not change despite the change in the aggregate price level. Price-level variance is not synonymous with (specific) price variance.²⁴ On the other hand, any monetary regime that disrupted the structure of relative prices in order to maintain the price level would bring about monetary disequilibria. If one perceives business cycles as rooted in microeconomic discoordination, then it is the price-level rule that may become suspect. Finally, price changes in response to a productivity shock may be thought of by economic agents as neither wholly unpredictable nor costly. As Dowd himself argues, gains in productivity are often the conscious goal of entrepreneurs (1991e, 18). Imagine a firm that strives to increase productivity so that it may lower its production costs, lower its product price, and gain market share at the expense of its rivals. It would be odd to argue that such a firm experiences an increase in costs. Any price-adjustment costs are clearly overwhelmed by the lower production costs. Price-adjustment costs should not be taken out of the context in which they arise.

As for the frequency of productivity shocks, Dowd seems to allow that this depends largely on personal interpretation (1991e, 20fn). He sees such events as occurring more or less all the time, whereas Selgin speaks as if they occur only occasionally. The difference may lie in the contrast between product-specific shocks, which appear very frequently, and pervasive shocks, which affect a number of goods and appear much less frequently.²⁵ It would seem clear that the latter pose the greater danger to market coordination if they elicit an inappropriate monetary response. In the context of infrequent, pervasive productivity shocks, the productivity norm is superior to the price-level rule.

The third argument for preferring the productivity norm to a stable price level is the claim that it is more likely to achieve macroeconomic stability (minimize cyclical fluctuations). This Dowd disputes as well. Yet he grants that the core distinction is that “prices were given under the stable price regime, and nominal wages were given under the productivity norm” (1991e, 24). Which would consumers prefer, a stable price level and flexible nominal wages, or a flexible price level and stable nominal wages? This is, presumably, a testable proposition. However, there seems already to be considerable evidence that the latter would be their choice. For example, many consumers (as workers) willingly contract for nominal wages that are fixed for periods of a year or more.²⁶

Dowd raises fundamental questions about the productivity norm vis-à-vis a stable price level. His arguments are lucid and insightful; they bring to the fore certain subtle aspects of the productivity norm position. Nevertheless, in the end, his critique is not quite persuasive. The productivity norm remains the preferable approach to monetary policy.

THE INCENTIVES OF MONETARY AUTHORITIES

Assuming the maintenance of monetary equilibrium subject to a productivity norm is the theoretically optimal goal of monetary policy, it is nonetheless the case that two critical questions remain unanswered. First, are monetary authorities likely to eschew other possible goals in deference to that optimal end? Second, even if monetary authorities sincerely wish to achieve continuous monetary equilibrium, do they possess the requisite knowledge? The first, a problem of incentive structures, will be discussed here. The second, a problem of economic epistemology, will be dealt with in the next section.

James Buchanan suggests that three basic models of a central monetary authority are possible: (1) a monolithic authority that is subject to neither constitutional nor electoral constraints, (2) a monolithic agent subject to direct electoral pressure, and (3) a monolithic agent free from direct electoral pressure but bound by certain general constitutional rules (1986).

The first, which Buchanan calls a “benevolent despot,” has no incentive to follow any policy that is not utility-maximizing in his own terms. Thus, a policy of revenue-maximizing inflation will be the nearly certain result. “In this model, it is evident, quite apart from any historical record, that the despot will find it advantageous to resort to money creation over and beyond any amount that might characterize the ‘ideal’ behavior” (Buchanan 1986, 141). To increase “social welfare” will not be the object of monetary actions in such a regime.²⁷ The second possibility, where voters may exert direct pressure on the monetary authority, suffers from the well-known problem of having to satisfy the median voter (assuming a simple majoritarian decision mechanism). That voter tends to be “myopic” regarding inflation. That is, he has an incentive to place great weight on the short-term gains in terms of employment that he may experience and to have little concern for the long-term harm done to the economy as a whole (Buchanan 1986, 143). The predictable result is an economic environment that is unstable and inflationary.

Electoral impatience, of course, is incompatible with meaningful economic reform, and in particular with a consistent anti-inflation policy. Political leaders who seek to apply policy in a consistent manner invariably lose out to “reflationists” and price controllers. Thus, anti-inflationary efforts are undermined at every turn over the long haul . . . once employment and productivity figures begin to appear. (Smith 1988, 157)

The third case may be thought of as approximating the structure of the Federal Reserve System. The members of the Board of Governors are not permitted to use their monetary powers to increase their personal wealth, and they are generally expected to follow “socially desirable” macroeconomic policies. Otherwise, they appear to possess a high degree of independence (as is often argued). This arrangement, Buchanan claims, reduces the sense of responsibility experienced by such monetary decision makers, because they neither enjoy the full benefits nor suffer the full costs of specific policies (1986, 145). This, in turn, leads to decisions that are less well considered, based on less information, and more sensitive to transient whims and fads than they would be under a more appropriate incentive structure. “Viewed in this perspective, and in application to the Federal Reserve agency in the United States, and perhaps notably after the removal of international monetary restraints, there should have been no surprise that the behavior exhibited has been highly erratic” (Buchanan 1986, 146).

Buchanan concludes that monetary disequilibrium is the likely result under a central authority modeled in any of the aforementioned three patterns. He thinks the only solution might be to index the salaries of those employed by the central bank, so that any departure from a stable price level would impose personal losses on those responsible (1986, 148). This proposal is flawed, however, in that it assumes that continuous monetary equilibrium is synonymous with a perfectly stable price level. Under most circumstances, they are the same, but in the face of productivity shocks, they clearly differ.

Richard Wagner (1986) offers a variation on Buchanan’s theme. He argues that the Fed is best understood as an exercise in congressional rent-seeking. In his view the Federal Reserve is a creature of Congress—specifically, an agent of the House and Senate banking committees—and exists for the express purpose of achieving certain distributional effects by means of counterfeiting (monetary expansion). “The Fed would seem to be principally involved in the supply of counterfeiting, and to do so by virtue of a license from Congress” (Wagner 1986, 531).

Whatever particular interpretation of central bank behavior one employs, one thing seems clear in the light of public-choice theory:²⁸ No monetary authority is likely to adopt any policy that might be termed “socially optimal.” Realistically, that is, monetary equilibrium will never be the preferred goal of central banks.

THE KNOWLEDGE PROBLEM

The ultimate challenge to the possibility of rational monetary policy being undertaken by a central bank is neither procedural nor political, but epistemological in nature. Even if one grants that the monetary authority has both accepted the premise that monetary equilibrium is the theoretically optimal policy goal and adopted that goal as the guiding principle for its actions, it still does not follow that said authority will be able to achieve its objective. Indeed, it will here be argued that no central authority can ever possess sufficient economic knowledge to reach such an objective.

It is essential to understand that the problem facing monetary authorities is not simply one of insufficient data or inadequate data processing. It is far more fundamental. The problem springs from two interrelated sources: (1) confusion regarding the nature of economic knowledge and (2) a failure to perceive the market as a process of discovery.

That economic knowledge is not a monolithic whole susceptible to manipulation by some bureaucratic entity has been well expressed by Hayek:

[T]he concrete knowledge which guides the action of any group of people never exists as a consistent and coherent body. It only exists in the dispersed, incomplete, and inconsistent form in which it appears in many individual minds, and the dispersion and imperfection of all knowledge are two of the basic facts from which the social sciences have to start. (1979b, 49–50)

Not only is knowledge widely dispersed, but it is also resistant to aggregation. Objective data, such as changes in specific prices, are not the basis for human action. Humans act upon their interpretations of those data, and each interpretation may be different. “A rise in the price of a given commodity, for example, will have different meanings depending on the ‘elasticity of expectations’ of the receiver. A price rise may signal higher or lower future prices when the subjective context of the data is taken into account” (O’Driscoll and Rizzo 1985, 41).

Furthermore, knowledge may be inarticulate in form. That is, underlying much that can be articulated, one finds the implicit or “tacit” definitions and rules of presentation without which explicit statements cannot be made (Lavoie 1985, 59–63), and some knowledge seems difficult to articulate at all—how to ride a bicycle, for instance.²⁹ If any significant portion of knowledge is implicit, subjective, and (perhaps) meaningless when aggregated, however, then how can any centralized agency ever collect—much less understand and use—such knowledge? Data are available in abundance, but since “knowledge is not the same as data” (Lavoie 1985, 57), the collection of mere data does not necessarily constitute an increase in one’s store of knowledge.

Inextricably interwoven with the above conception of economic knowledge is the understanding of the market as a discovery process. Such an understanding may ensue from the following line of reasoning. Humans, being finite and fallible, act in order that they may remove or reduce some dissatisfaction in their lives. In contrast to humans, “a perfect being would not act” (Mises 1976, 24).³⁰ To achieve this reduction of dissatisfaction, individuals engage in a great variety of market transactions with a multitude of other individuals. The intent is, generally, to benefit (to profit) from those interactions. The most common—though not the only—guides for such actions are prices.

However, “prices are useful guides or signals because, and insofar as, they reveal discrepancies, previous maladjustments, and errors. . . . Prices reveal what people want relatively more urgently now, and in the future, not what they would want in a hypothetical and unattainable equilibrium” (O’Driscoll and Rizzo 1985, 106). Furthermore, the knowledge of prices is “of temporary and fleeting significance” and tends to be profitable precisely to the extent that and only so long as “others do not also know it” (O’Driscoll and Rizzo 1985, 103). That is to say, useful economic knowledge is essentially a private knowledge of disequilibrium conditions. Knowledge is never a “given” for any economic agent except in the Walrasian world of eternal general equilibrium, and in that context, such “knowledge” is not really economic in nature, but merely engineering knowledge about physical production relations. In the real world, individuals must discover the relevant facts by means of trial and error, which means that the generation of knowledge is only truly effective in the absence of artificial distortions and constraints, that is, under competitive conditions. It would seem obvious that every intervention by a monetary authority distorts not only current conditions, but also individuals’ expectations of future conditions, and the more extensive the intervention, the more one finds that resources are diverted to learning about the interventionists rather than about market participants. Finally, the relevance of any particular bit of information cannot be established independently of the values, goals, and expectations of the actor. Economic knowledge is, to some irreducible extent, idiosyncratic (Butos 1986, 851).

If true economic knowledge is widely dispersed, at least partly tacit in nature, discovered by trial and error in a free market context, and both goal- and agent-specific, then central monetary authorities are confronted by an insurmountable obstacle. They attempt to aggregate data that cannot, when aggregated, represent meaningful economic knowledge, and, on the basis of that data, they undertake macroeconomic actions designed to achieve goals that (even when desirable) can only be attained at a microeconomic level.

To put it bluntly, one must conclude that the optimal goal of monetary equilibrium is likely within a free-banking structure but probably impossible for a central bank.³¹ Free banks have the advantage of market signals that are both more reliable and more rapid than any mechanism available to a central bank. For example, consider the processes of “reflux” and “adverse clearings.” One may recall that whenever an individual free bank expands its outstanding liabilities (either notes or deposit credits) beyond the desired cash balances of its customers, the excess will be returned for redemption. This depletes the bank’s reserves and, for any given reserve ratio deemed optimal by the bank’s officers, forces a contraction in the supply of the distinctive money issued by that bank. Furthermore, if the income velocity of money changes—resulting, perhaps, from consumers’ changing expectations regarding future commodity prices—free banks’ optimal reserve ratios will change in the same direction, which means that the money supply will change in the opposite direction. Market forces at the local level push the banking system toward monetary equilibrium.

To compare the decentralized adjustment mechanisms of free banking to the tools of central bank policy is something akin to placing a scalpel rather than a blunt instrument in the hands of a surgeon. The typical central bank tools—changes in legal minimum reserve ratios, changes in the discount rate, and open market purchases or sales of government securities—are creatures of aggregation. As such, they attempt to correct at the national level what may only be an imbalance at the local level.

For example, assume that the income velocity of money falls for the society as a whole, because it falls in one geographical area but remains constant elsewhere.³² The central bank, if it detects the change at all, will increase its open market purchases (or, alternatively, lower either the legal reserve ratio or the discount rate) and thus increase the overall money supply.³³ This may or may not reestablish monetary equilibrium in the area where velocity fell, but it will introduce an excess supply of money into the rest of the nation, which condition must be corrected by further macromanipulations, and so forth. To reiterate, monetary disequilibrium is a problem that has profound macroeconomic effects but that must be solved at the microeconomic level.

SUMMARY

For decades it seems to have been a tenet of faith among most economists that a central monetary authority is essential to a stable and efficient economic system. They perceived such authorities as benevolent, public-spirited benefactors whose prowess was limited only by data processing considerations. This chapter has presented a radically different position. First of all, several plausible frameworks for monetary policy were reviewed. Only monetary equilibrium subject to a productivity norm was seen to be defensible as a rational goal. The alternatives that were considered—discretionary countercyclical actions, a stable price level, a constant money growth rule, and a centrally managed gold coin standard—were not without some merit. However, all were seen to be “second-best” solutions. This is largely due to the fact that those alternatives are macroapproaches to what is fundamentally a microproblem.

Second, it was demonstrated that monetary authorities are very unlikely ever to aim for any policy goal that might be construed as “socially optimal.” Public-choice theory seems to present an irrefutable argument that central banks are either rent-seekers or the agents of those who seek political rents. To aim for monetary equilibrium at all times would be to forgo such rents.

Finally, it was argued that, even if a central bank both identified continuous monetary equilibrium as the rational policy goal and was willing to seek that goal, it could not possess the knowledge necessary for such a task. The more common, contrary assumption is based on two errors: (1) a misunderstanding of the nature of economic knowledge and (2) a misunderstanding of the market process. Continuous monetary equilibrium becomes feasible only in a decentralized, competitive environment in which profit and loss signals nurture a “spontaneous order.” Free banking is the “first-best” solution to monetary problems.

NOTES

1. Mises’ critique of central planning first appeared in 1922 in German. It was later (1936) translated into English.

2. In most of the non-Communist nations during the post-World War II period, this collectivism has appeared in the form of what is variously called “the mixed economy,” “democratic socialism,” or “welfare state capitalism.” Its defining characteristics are (1) nominal private property, (2) extensive regulation regarding the use of that “private” property, and (3) a tripartite coalition of government, business, and labor that seeks to direct the economy. See Hayek (1944) for a discussion of the origins of this approach.

3. See Chapter 3 for a detailed discussion of this.

4. It should be pointed out that Hayek contributed mightily to the development of the Austrian theory. Indeed, it might be—and has been—referred to as the “Mises-Hayek theory of the trade cycle.”

5. This is a severely simplified summary of the new-classical position. The rational expectations/new-classical treatment is both quite sophisticated mathematically and, in some respects, rather elegant. Perhaps the most laudable thing about the new-classicals is their recognition of the fact that a sound macroeconomics must be consistent with microeconomic principles.

6. This may seem like a critique of the free-banking model in Chapters 2 and 3. However, the author would argue that Friedman’s comments apply only to central banking—which, of course, is what Friedman had in mind anyway. Under free banking, the quantity of money is strongly related, even in the short run, to the velocity of money, goods’ production costs, bank reserves, the price of specie, and interest rates. The connection between prices and money is thus more robust under free banking than under central banking.

7. Selgin assumes that the changes in nominal revenues are not perfectly anticipated by all economic agents.

8. This would exacerbate the problem the CMGR is intended to attenuate.

9. One must assume that Friedman’s overall object is to minimize (over the long run) either the net departures from the natural rate of unemployment or the net departures of GNP from its trend. Of course, these may amount to the same thing.

10. See Chapters 2 and 3.

11. It is only fair to point out that this may not be an entirely accurate picture of the “monetarist” position. Thomas Humphrey (1984, 17) argues that several renowned monetarists have, indeed, acknowledged the nonneutrality of money. For example, Irving Fisher “recognized how interest rate changes can alter the time structure of production and thus the composition (mix) of output.” In addition, Clark Warburton saw that “due to the lag of wages and other costs behind prices and the resulting impact on profits, monetary changes have real effects.”

12. See Chapter 2.

13. This is the “only solution” only if one takes the central bank for granted.

14. The alternative—free banking with 100 percent reserves—is discussed next.

15. Tangential to this are the claims that commercial banks would be less prone to failure and the central bank could exercise tight control over the money supply.

16. They do not bear explicit interest. During deflation, reserves do bear implicit interest in the form of a greater purchasing power per dollar. Also, it is conceptually possible for central banks to pay interest on the reserves they hold on behalf of commercial banks. Nevertheless, this is rarely done by central banks.

17. Some of this “instability” may be spurious. See Christina Romer (1986a; 1986b).

18. See Chapters 2 and 3.

19. This assumes a legal tender currency, issued exclusively by the central bank.

20. It was the sterilization by central banks that often prevented or delayed such corrective movements.

21. Dowd’s comments are sympathetic criticisms of certain aspects of Selgin’s work on free banking. By implication, therefore, they are also criticisms of the present work.

22. This would seem particularly true if workers could, by their own efforts, increase per-capita productivity and reap the gains of lower commodity prices (higher real wages) under a productivity norm.

23. One may think here of worker investments in “human capital,” for example.

24. Perhaps to think of the price level as a portfolio of specific prices would be helpful. The variance of the price level depends on both the variances and co variances of the individual prices.

25. Pervasive shocks would also be less predictable than product-specific shocks. The degree of predictability is also of concern to Dowd.

26. One might respond to this by suggesting that nominal wage contracts involve lower transaction costs than do, say, commodity futures contracts. That is, futures markets are not generally accessible to consumers. Might the lower costs, however, not be the result (rather than the cause) of more widespread use, that is, the result of consumer preference?

27. This is not to suggest that “social welfare” is a meaningful concept as it is usually employed, only that the central authority will act in response to one’s own preferences rather than those of the citizenry.

28. For the seminal work in public-choice economics, see Buchanan and Tullock (1962).

29. Note in this vein how it is common to encounter financial analysts who say they simply “feel” stock prices will rise (or fall) but who may not be able to identify exactly why they “feel” this will occur.

30. This may be the only interface between modern economics and theology, but it is an intriguing one.

31. If monetary equilibrium were achieved in a central banking regime, it would be by accident. The argument here is that it is impossible for a central bank consistently to either (1) attain such equilibrium or (2) know that it has been attained. The requisite knowledge is simply not available to such an agency.

32. Monetary economists usually do not pay much attention to this, but it is nevertheless true that the velocity of money does vary from region to region and industry to industry. See Richard Selden (1962).

33. One may question whether the central bank will react in a timely fashion even if it does detect the change, and any significant time lag might exacerbate the imbalance.