A comparative institutional analysis of free banking and central bank NGDP targeting.

Author:Murphy, Ryan H.
  1. Introduction

    As the Great Recession continued, some of the most ardent supporters of the free market began entertaining the possibility that "demand-side" problems were causing persistent unemployment. Although the right-wing press has criticized the untraditional behavior of central banks, monetary policy actually appeared tight by the standard set forth by one of the most eminent and stringent inflation hawks of the 20th century, F.A. Hayek. This standard requires constant total overall spending in the economy (Hayek, 1931; White, 1999). This implies that M*V should be kept at a constant level for money to remain "neutral." Following the equation of exchange, this is in effect the same as a Nominal Gross Domestic Product (NGDP) target of 0%. For the first time in many years, NGDP fell in the United States, suggesting that money may have been too tight from the standpoint of even Hayek.

    A number of economists have pointed out that NGDP was allowed to fall during the recession. Modern mainstream macroeconomists had taken some version of NGDP targeting seriously in the past, albeit with a target greater than 0% (e.g., Hall and Mankiw, 1994; see Frankel, 2012 for an informal literature review). Many prominent economists and commentators have since come out in favor of this policy objective in place of other targets for central banks (Woodford, 2012; Romer, 2011; Cowen, 2011; Krugman, 2011; Goldman Sachs [Goldstein, 2011]; Barro, 2012; Avent, 2011). Meanwhile, many advocates of free markets coalesced around this policy objective as a solution to aggregate demand deficiencies that did not resort to fiscal policy. This latter position, led primarily by economist Scott Sumner, became known as market monetarism.

    Meanwhile, modern followers of Hayek had moved in an entirely different direction prior to the crisis arising in the first place. Concerned with a central bank's ability to possess the necessary information and incentives to perform effective monetary policy, this group identified an alternative institutional framework that would not succumb to those problems. By deregulating banks and the supply of money, competitive pressures would constrain private banks in such a way that their note issue would follow a logic consistent with consumer demands for money. This institutional arrangement, known as "free banking," would yield an approximation of NGDP targeting--a "productivity norm" (Selgin, 1997)--that has many similarities to the policy Hayek originally envisioned.

    Early on in the Great Recession, the Cato Institute sponsored a symposium intended for the public that allowed Sumner (before the phrase "market monetarism" was coined) to present his position that money was too tight to an audience that would typically believe the opposite (Sumner, 2009). Among those responding to his position were free banking advocates taking notice of how similar the two schools of thought were. For example, "Scott Sumner's general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I'm hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery" (Selgin, 2009). This paper can be seen as a continuation of this exchange but from a slightly different perspective. Instead of determining what monetary policy is optimal to escape the Great Recession, I wish to contrast the effectiveness of free banking and central bank NGDP targeting in overcoming obstacles to minimizing long-run unemployment.

    There are a number of well-honed objections to central banking from the standpoint of the Hayekians, the best three of which I will discuss. Objections to free banking, especially for those who take the concerns of Hayekians very seriously, are less common; objections to free banking typically involve attempting to pull the rug out from under it using standard market failure arguments. In place of that, this paper seeks to identify issues in optimally targeting NGDP that would arise under free banking but not under central banking. The disagreement then devolves into a set of empirical questions that are difficult to answer satisfactorily.

    Part II will review the standard objections to central bank NGDP targeting. Part III will provide what I believe are legitimate concerns in the efficacy of the free banking system. Part IV will offer interpretation and policy prescription. Part V concludes.

  2. Objections to Central Bank NGDP Targeting

    There are three traditional economic objections to central banking made by proponents of free banking. One, although economists may have an ideal monetary policy, central bankers have their own sets of incentives. Two, central banks, because they are a top-down mechanism, lack the information a market setting provides. Three, central banks have no way of determining the optimal currency area, and the size of the currency area in practice is merely determined by arbitrary political boundaries. In these ways free banking is superior to any policy for central banks.

    1. Public Choice

      What economists believe a central bank should do and what central banks do in practice are two different things. Famously, Arthur F. Burns was notorious for caving in to political pressure from Richard Nixon, who pressed for monetary stimulus in time for the 1972 election. The field of public choice within economics acknowledges that government officials and bureaucrats are human beings, and whatever assumptions we make about individuals acting on the market and within government should be symmetrical (Brennan and Buchanan, 2000, pp. 53-75). If economists assume narrowly defined self-interest when it comes to the behavior of financial institutions, they should assume narrowly defined self-interest when it comes to central bankers.

      Good outcomes in central banking require that the central bankers possess a certain public-spiritedness, the correct ideology, or a desire to be well-liked among economists. Otherwise, a narrow utility maximizer will take advantage of the powers of central banks (Wagner, 1986; White, 1988; see especially Boettke and Smith, 2012). Advocates of free banking make no such assumption about individuals in their banking system. It is driven entirely by the signals of profit and loss. In assuming one of the very dangers of central banking, free banking advocates are able to show how their system will still work. On this margin, free banking is far more robust than central banking.

    2. The Knowledge Problem

      Central banks lack the knowledge requisite for optimal macroeconomic outcomes (Butos, 1986; Selgin, 1988, pp. 89-94; see also Hayek, 1978). Assume away all public choice issues mentioned above. In that case, one would still be left a bureaucracy hoping it is doing more good than harm. The situation is as Mises described the behavior of bureaucracy (1944). Even if we have altruistic central bankers, they will still possess less knowledge than a...

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