Rethinking Central Banking.

• Author: O'Driscoll, Gerald P., Jr.

Central banks are a relatively recent development in monetary history (Smith [1936] 1990). Money can and has been created privately and competitively. (1) In many cases, princes coined money but their coins had to compete for acceptance with other coinage both princely and privately produced. The Maria Theresa Thaler was first struck in Vienna in 1741, and it was adopted globally for international trade. The dollar is a government monopoly in the United States, but globally the greenback must compete for usage.

The creation of the Federal Reserve System was an innovation. It was not created to conduct discretionary monetary policy but to manage the gold standard. "There was no provision in the Federal Reserve Act for discretionary monetary policy" (Jordan 2016a: 373). So, both theoretically and historically, there are alternatives to central banking.

The Federal Reserve's foray into credit allocation has moved it into a form of central planning. In this article, I initially focus on the problems inherent in conducting discretionary monetary policy in a central bank. I then offer a public choice analysis of why we are nonetheless stuck with discretion. Finally, I present policy reforms that need to be implemented if we are to move from discretion to a policy rule. Congress, or at least the House of Representatives, has indicated a willingness to mandate rule-based monetary policy. It is important that these reforms be implemented in order that a rule-based policy can be successfully executed.

The Knowledge Problem

The knowledge problem is most closely associated with F. A. Hayek, who emphasized that the knowledge needed for decisionmaking is localized and dispersed across the population. (2) In markets, prices economize on information and communicate what is needed for economic actors to make allocational decisions. That part of Hayek's argument is generally understood. (3)

There is more to Hayek's argument, however. Much relevant economic knowledge is tacit. Individuals have unarticulated knowledge vital to decisionmaking but no understanding or theory of why what they do works. As Caldwell (2004: 337) observed, "The dispersion of such knowledge is a permanent condition of life." It is permanent because tacit knowledge by its nature cannot be articulated and, hence, cannot be transmitted.

The knowledge problem is an obstacle to achieving intertemporal equilibrium even if money were neutral. The existence of monetary shocks greatly complicates the formation of intertemporal expectations. It also complicates the conduct of monetary policy. A central bank confronts the problem of assembling dispersed knowledge, some of which cannot even be conveyed. The problem of implementing an optimal monetary policy is conceptually the same problem confronting a central planning authority. Implementing optimal monetary policy requires surmounting the knowledge problem, which is impossible.

Milton Friedman presented his own take on the knowledge problem in Friedman (1968). He offered two propositions, the first being that monetary policy should do no harm. Too often, central banks violate that norm. Second, he argued that monetary policy should provide "a stable background for the economy" (Friedman 1968: 12-13). "We simply do not know enough" to engage in discretionary monetary policy (Friedman 1968: 14). His analysis of the knowledge problem is what led to his advocacy of a simple monetary rule. The rule would minimize harm and provide a stable background. He did not believe that monetary policy was capable of increasing the economic growth rate. That depended on "those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth" (Friedman 1968:17).

Friedman's awareness of the knowledge problem and his adoption of policy rules as a solution to it predate his AEA presidential address or even his work on money. "Friedman was already advocating rules ... before his monetarist theoretical position came to fruition. But Friedman's case for rules did rely on a strong theoretical motivation: in particular, the possibility that stabilization policies might give rise to destabilization of the economy" (Nelson 2015: 204). The conviction that, in a world of uncertainty, stabilization policies might actually destabilize the economy is what most united Hayek and Friedman. Both the Great Depression and the Great Recession exemplify that dynamic--stabilization policies destabilizing the economy.

Other monetary economists followed in the Hayek-Friedman mold of emphasizing uncertainty in policymaking. Karl Brunner and Allan Meltzer are notable examples, and Meltzer (2015) reprises their contribution. Axel Leijonhufvud (1981) emphasized the role of information in economic coordination. These monetary economists all had a UCLA connection, which is where Chicago and Vienna intersected. Other, nonmonetary UCLA economists who contributed to the economics of uncertainty were Armen Alchian (1969) and Thomas Sowell ([1980] 1996). Today, John Taylor's work follows closely in that tradition. The Monetary Policy Rule website provides a useful compendium of recent articles (Taylor 2016a).

Fed Governance: Bureaucracy and Incentives

Conti-Brown (2016) is highly critical of the Fed's structure, which he views as causing governance problems and a lack of democratic accountability. He recommends changing it by eliminating the private-component resident in the reserve banks from monetary policymaking. Reserve banks are private institutions and their presidents are not political appointees. According to Conti-Brown, the Fed's structure is a mistake and it needs to be fixed.

Decades earlier, Kane (1980) looked at the same reality and found the "murky lines of internal authority" serve identifiable political goals. "Once the Fed is viewed as a policy scapegoat for elected officials, these developments emerge as intelligible adaptations to recurring political pressures" (Kane 1980: 210). (4) In Kane's analysis, if macroeconomic outcomes are good, politicians can claim credit for them. If outcomes are bad, politicians can blame the Fed. Central bank discretion and "independence" benefit both sides. Fed officials are not bound by rules and thus enjoy the sense of power that comes with discretion. Politicians are happy to grant that discretion because it allows them to scapegoat the central bank. If the Fed were effectively rule-bound, then politicians could only blame themselves for choosing the rule.

The last thing politicians want is to have the buck stop at their desk. So they tolerate ambiguity in Fed governance, nontransparency in policymaking, and long tenure for Fed officials. These features provide plausible deniability for both the administration and Congress. Fed officials, in turn, get power and prestige, which are valuable nonpecuniary returns. There is symbiotic rent seeking by Fed officials and politicians. The two sides feed off each other to their mutual benefit.

Conti-Brown (2016: 109) is particularly critical of the Reserve Bank structure because it impedes democratic accountability. In a public-choice analysis, however, the last thing politicians crave is accountability. With respect to fiscal policy, politicians love to spend without levying taxes to pay for the spending. So future, unspecified taxes (debt finance) are preferred to present taxes. If taxes are levied, nontransparent taxes are preferred. The corporate income tax is an example.

The preference for...