Honest money.

Author:Jordan, Jerry L.
Position:Monetary policy - Report

This article addresses some of the recent proposals for the conduct of monetary policies in the post-bubble environment. Advocacy of higher inflation targets is analyzed, and the challenge of maintaining monetary discipline in the face of massive fiscal deficits and mounting government debts is presented. Proposals for reforms of monetary arrangements must be based on consensus regarding the objectives of such reforms. The article concludes with some suggestions for near- and intermediate-term changes to present arrangements, as well as ideas for longer-term reforms.

The Psychology of Money

For several years now I have been seeking to change the conversation we have about money--not to something new, but to something old. John Stuart Mill ([1848] 1987: 488) wrote,

There cannot ... be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. I welcome very much James Buchanan's recent remarks that "members of the public, all of whom are transactors in money values, must come to trust the value of money as iconically sacrosanct. The whole psychology of money in modern times must become different" (Buchanan 2010: 257-58).

As we continue to debate the issue of asset bubbles mad monetary policy, we should keep in mind the importance of honest money and "not waste this set of crises by exclusive recourse to jerry-built efforts to patch up the failed monetary anarchy we have witnessed" (Buchanan 2010: 288).

Unfortunately, in my view, too much of the conversation about monetary policy has been about the strategies and tactics for the formulation and implementation of discretionary monetary policy, and not near enough on reforms of monetary arrangements that might assure a constant monetary yardstick. To be fruitful, a dialogue about possible reforms must be preceded by development of a consensus about the objectives of constitutional monetary arrangements.

I will first comment on some of the proposals for conducting discretionary monetary policy, and then turn to my views on what should be the objectives of monetary reform and how we might realize those objectives.

Misguided Policy Prescriptions

In the wake of the 2008-09 financial crisis, there have been numerous proposals for enhancing the effectiveness of monetary and fiscal policies. Most of these proposals have dealt with reducing the "pain of hangovers." They prescribe greater policy activism and, thus, even more discretion for policymakers to address the aftermath of bursting bubbles. This approach is in sharp contrast to F. A. Hayek's idea that the best way to avoid the pain of recession is to prevent monetary distortions in the first place.

The most dangerous suggestion with regard to monetary policy is that central banks should target higher inflation by allowing prices to rise, on average, by more than the conventionally accepted 2 percent. Inflation "doves" acknowledge that debasing the currency is a form of taxation, yet they defend higher inflation by saying that it is no worse than other forms of taxation.

Economists who advocate inflation--as a way out of recession--assume that monetary policy works solely, or at least primarily, through interest rates, and they fret about the "zero boundary problem." The argument is that since nominal interest rates can't go below zero, the Federal Reserve should target inflation at more than 2 percent to ensure that nominal rates include an inflationary premium and are at a level that would allow the Fed to cut rates when necessary.

The central idea is that if aggregate nominal demand for output declines for any reason, a judicious reduction of interest rates by monetary authorities will spur consumers and businesses to spend more, thus sowing the seeds of recovery. The claim is that if the crisis is severe it takes larger cuts in interest rates to reverse the contraction in aggregate demand, so higher interest rates to begin with the result of higher inflation--give the policymakers a bigger weapon.

In the case of the Great Recession of 2008-09, this policy prescription is misguided; it is the result of a faulty diagnosis. The error stems from having concluded that the trigger for the crisis was a contraction in the financial sector--credit availability shrank, so household and business demand for output fell. Policy activists want more powerful monetary and fiscal tools to address such conditions.

That diagnosis fails to consider that what has been characterized as a "housing bubble" was not sufficient to cause the economic damage we have seen. Neither the dot-com bubble of the 1990s nor the rapid increases of house prices in Canada or other countries were followed by widespread declines in output and employment as well as banking failures. The key to the differences is what was happening on the other side of the balance sheet. Asset price increases need not be accompanied by debt increases, but when they are then the subsequent declines in asset prices have much broader implications.

Some 20 years ago, mortgage equity withdrawals (MEWs) during refinancing had been only 1 to 2 percent of personal disposable income. However, by the 2004-06 period...

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