Real and pseudo monetary rules.

AuthorSelgin, George

Milton Friedman is perhaps the best-known exponent of monetary rules. He also wrote a well-known paper entitled "Real and Pseudo Gold Standards" (Friedman 1961). I wish here to pay twofold homage to Friedman by insisting on a distinction between real and pseudo monetary rules. Just as Friedman (1961: 67) maintained that, though they may "have many surface features in common," real and pseudo gold standards "are at bottom fundamentally different," I shall argue that despite their superficial resemblance, real and pseudo monetary rules are fundamentally different--both in their operation and their consequences. Indeed, I shall argue that what Friedman called a "pseudo gold standard" is really an instance of a pseudo monetary rule, while what he calls a "real gold standard" is an instance of a real monetary rule.

Real Monetary Rules

A monetary rule, as typically defined, encompasses two very different sets of possibilities. For example, Froyen and Guender (2012: 101) define a monetary rule as "a prescribed guide for the conduct of monetary policy." That broad definition includes both what I consider rules in the strict sense of the term--what I shall call "real monetary rules"--and rules in a much looser sense, which I consider to be "pseudo monetary rules."

To understand the difference between a real and a pseudo monetary rule, as well as my reason for insisting on these terms, one must briefly review the traditional arguments for monetary rules. The essence of these arguments is succinctly stated by Leitzel (2003: 50), who notes that while "discretion allows decisions to respond more closely to actual conditions ... in the hands of a fallible or corrupt decision maker, a greater reliance on judgment may not be such a good idea."

Jacob Viner (1962: 246) gives a more detailed summary:

On purely a priori grounds ... it can be said for an unambiguous rule, provided it is enforceable and enforced, that it is a complete protection within the immediate area of its subject matter against arbitrary, malicious, stupid, clumsy, or other manipulation of that subject matter by an 'authority.' It can be said for a ride rigid through time, if it works and is counted on to work, that it provides absolute certainy and predictability, with respect to the behavior prescribed by the rule [emphasis added]. A once popular and still occasionally heard objection to monetary rules is that discretion-wielding authority can almost always do better, since the authority can always reproduce the outcome of the rule yet can also respond to circumstances that the rule doesn't provide for. As Turnovsky (1977: 331) puts it, except when a rule happens to coincide with an optimal response, "a judiciously chosen discretionary policy will always be superior." In other words, a discretionary policy need never do worse than a rule, and it might do better.

Such arguments entirely miss the point. There are, first of all, several reasons why discretionary policy may in practice not be "judiciously chosen," in Turnovsky's sense of being an optimal response to the current state of the economy. The first, which O'Driscoll (2016) elaborates on in his contribution to this volume, is that the authorities may lack the knowledge required to employ discretion "judiciously." The essential point was best expressed by Friedman (1960: 93):

We seldom in fact know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two years from now. Leaning today against next year's wind is hardly an easy task in the present state of meteorology. Friedman is of course referring to "long and variable lags." His argument hinges on the fact that monetary authorities, being incapable of anticipating such lags with any degree of precision, can be guilty of errors of commission more serious than the errors of omission to which a well-chosen rule might commit them. The more recent findings of behavioral economics tend to reinforce the knowledge-based case for rules. Adam Gurri (2013) sums up those findings pithily: "The fact is that the matter of human beings using their discretion repeatedly in circumstances of high uncertainty has already been settled--they are terrible at it."

The insights of behavioral economists refer only to what one might call the "best-case scenario"--namely, the "well-intentioned, wise, and skillful exercise of discretionary authority," as Viner (1962: 247) put it. The case for rules offered by public-choice theorists, in contrast, views discretionary behavior as a worst-case setting (see Buchanan and Brennan 2008), in which the "natural proclivities" of politicians and bureaucrats predominate--including their tendency to make decisions based on a "narrowly defined self-interest" that "run[s] counter to the basic desires of the citizenry" (Brown 1982: 39).

A final, and especially subtle, argument for a monetary rule is that it can serve to avoid the suboptimal, "time-inconsistent" equilibria to which discretionary monetary regimes are prone. For example, suppose that a zero inflation regime is considered optimal, but that, where such a regime is in place and expected to remain so, a discretionary central banker would be tempted to take advantage of the fact by increasing the money stock so as to temporarily boost employment and output. The fact that the monetary authority will be tempted to do so means the public will anticipate inflation; thus, inflation surprises won't have any real impact. Consequently, the discretionary equilibrium is suboptimal. By tying the authority's hands, a zero inflation monetary rule can achieve an optimal outcome that could not be achieved otherwise (White 1999: 204-5).

It seems obvious that a genuine or real monetary rule must be capable of accomplishing the things that monetary rules are supposed to accomplish. Yet, it is no less obvious that most "prescribed guides for the conduct of monetary policy" fail to meet that requirement. As Jacob Viner (1962: 247) observed, "A rule doubtfully or irregularly enforced, and a rule subject at any time to revision, may involve less certainty and predictability than a control operated by a discretionary authority which follows a known set of principles." Such a rule may also involve more sheer error, causing more rather than less economic instability.

It follows that a real monetary rule, as opposed to a mere guide for policy, must be both strict and robust. By "strict" I mean that it must be rigorously enforced so that the public is convinced there will be no deviations from the rule. As Mullineaux (1985: 14) notes, "The monetary authority ... must do what the rule says and not something else." By "robust" I mean that the rule must be capable of perpetuating itself, by not giving either politicians or the public reason to regret its strict enforcement and to call either for its revision or its abandonment in favor of discretion.

Pseudo Monetary Rules

A pseudo monetary rule is one that is either not well enforced or not expected to last. Although real monetary rules have existed in the past, such rules are almost unknown today. In contrast, pseudo monetary rules are perhaps even more common than avowed monetary discretion.

To distinguish real from pseudo monetary rules, one must recognize the difference between a rule that is merely implemented and one that is enforced. Kenneth Rogoff (1986: 1) identifies three "institutional devices for implementing monetary policy rules"--namely, a constitutional amendment, an independent monetary authority, and an arrangement in which reputational considerations encourage abiding by the rule. In fact, of these three devices, only the first is capable of providing for anything like the strict enforcement that a real monetary rule requires. The other devices, in contrast, can serve only as the basis for pseudo monetary rules, for none offers any reliable assurance that a "prescribed guide for the conduct of monetary policy" will actually be heeded. (1)

As I have noted, the distinction between a real and a pseudo monetary rule matters, because a pseudo monetary rule--that is, a monetary policy "guide" that can easily be evaded, or that is likely to invite calls for revision if strictly enforced--lacks the advantages of a real rule. As Leitzel (2003: 51) has observed, "Evasion of the rule (or, relatedly, the possibility of varying the enforcement of the rule) lessens the distinctions between the alternatives.... When those who are governed by the rules have the power to enforce or amend or avoid the rules, resistance [to the temptation to take advantage of this]...

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