| Perspectives on Monetary Policy |
| From before the time of Adam Smith, nations have sought to manipulate money supplies to achieve certain goals. Whether it be simple fractional reserve banking to increase the availability of loanable funds to printing of unbacked fiat money, monetary policy has been an integral part of national economic policy across the globe. Not surprisingly, economists disagree as to what a proper approach to monetary policy is. However, the diverse views on the subject may be categorized in to three groups. First, there is the “free market” money school. This group tends to favor a metallic monetary standard (primarily because that is what historically developed before monetary intervention became extreme) and 100% reserve banking. Money would be a product of the free market, and would be produced according to free market principles. This policy is inspired (or at least supported) by the belief that interventionism of any sort in the market for money causes the boom-bust cycle. Second, there is the “monetary stability” school. Generally, this group favors a constant rate of growth in the money supply and 100% reserve banking. This policy is inspired by the idea that consistent money growth will stabilize prices, which decreases uncertainty. Monetary growth that is “too fast” breeds price inflation, while monetary collapse (which is possible with fractional reserve banking) produces deflation and economic collapse. Finally, there is the “active manipulation” school. This school seeks to use discretionary monetary policy to achieve various economic goals, from price stability to full employment. By examining and comparing each of these schools from a theoretical and practical perspective, one may decide which of these stories is most credible, and is most useful for the formulation of future monetary policies. The “free market” money school (typified by the Austrian economists) emphasizes the effects of monetary policy on the boom-bust cycle. “Saving gets us genuine growth; credit expansion gets us boom and bust.” (Garrison 1996) Saving, because it reflects true preferences, is sustainable, and therefore need not cause a boom-bust. However, credit expansion (which is synonymous with an easy monetary policy) causes an artificial decline in the interest rate, which separates the levels of true saving and investment. In Garrison’s words, “The low bank rate of interest has stimulated growth in the absence of any new saving. The credit-induced artificial boom is inherently unsustainable and is followed inevitably by a bust, as investment falls back into line with saving.” (Garrison 1996) The reason for this inevitable bust is derived from the Austrian view of the production structure and its relationship to the interest rate. Production takes time. The interest rate is, simply, the “price of time”. Therefore, “The interest rate governs the intertemporal pattern of resource allocation.” (Garrison 1996) In short, the interest rate is a major determinate in how long production may take, and therefore how many resources are allocated at each stage of production. If interest rates are low, that is a signal that time is of little value, and people are willing to wait for production. From a practical perspective, this means that businesses may invest in longer time, more productive capital structures. If interest rates are high, that is a signal that time is of great value, and people are not willing to wait for production. So, businesses, in order to satisfy their consumers, must invest in more immediately productive capital, despite the fact that productivity may be lower. The difficulty is that “[t]he shift of capital away from final output—and hence the shift of output towards the more remote future—can also be induced by credit creation. However, the credit-induced decrease in the rate of interest engenders a disconformity between intertemporal resource usage and intertemporal consumption preferences.” (Garrison 1996) So, by using an easy money policy, the central bank may drive down interest rates below the market level, causing longer production structures than are backed by consumer preferences. Based on a purely numbers game, this may not appear to be a bad thing at first. Investment has increased, which will increase production in time. However, after this investment has occurred, “the owners of the original factors, with their increased money income, naturally hasten to spend their new money.” (Rothbard 2001, 856) Then, in their spending, consumers will seek to restore the old saving-spending ratio, and “the rate of interest will return to its free market magnitude. As a result, the prices at the higher stages of production will fall drastically, and the prices at the lower stages will rise again, and the entire new investment at the higher stages will have to be abandoned or sacrificed.” (Rothbard 2001, 857) This collapse in investment is the bust. According to the “free market” money theory, this is a necessary consequence of credit expansion. The policy consequence of this theory is obvious enough: monetary injection must not occur. To keep this from happening, the State must not be the producer of money, either through direct printing or through the allowance of fractional reserve banking. Both of these policies must be abandoned to avoid the business cycle, and the market will provide money in whatever form people prefer. The “monetary stability” school (typified by Friedmanite monetarists) is, in many ways, cousin to the “free market” school. In non-monetary policy, they generally agree that the market is the best rationing mechanism for goods, and provides maximum economic well-being. However, they believe “that monetary policy can prevent money itself from being a major source of economic disturbance.” (Friedman 1968, 12) Despite the fact that monetary policy is incapable of ensuring a specific level of unemployment or a specific interest rate, it can provide the money that the economy requires at a specific time. Friedman admits that, at first glance, this seems like a negative responsibility, much like the Hippocratic oath to “do no harm.” However, Friedman notes that money has been a cause of economic disturbance even before there was a strong central bank in the United States (the crisis of 1907 is an example). “There is therefore a positive and important task for the monetary authority—to suggest improvements in the machine that will reduce the chances of it getting out of order, and to use its own powers so as to keep the machine in good working order.” (Friedman 1968, 13) Friedman goes on to explain that a part of the monetary authority’s responsibility should be to aid in the process of economic calculation by aiding in providing a generally stable overall price level with flexibility in individual prices. In the past, the gold standard did well in providing something along the lines of this stability. However, “there is scarce a country in the world that is prepared to let the gold standard reign unchecked.” (Friedman 1968, 13) Therefore, the monetary authority must commit itself to a policy that will ensure monetary stability. Finally, Friedman states that the monetary authority is capable of holding inflationary pressures in check, though he admits the difficulty of this act, since it is often difficult to recognize these pressures when they first arise. In the end, Friedman takes his philosophy of accepting the limitations and benefits of a monetary authority in giving us some specific monetary rules. His most important rule is that “the monetary authority go all the way in avoiding swings by adopting publicly the policy of achieving a steady rate of growth in a specific monetary total.” (Friedman 1968, 16) By committing itself to such a policy, the central bank will remove temptation to “adjust” the money supply, which too often results in error. As Friedman states concerning discretionary monetary rules, “any system that gives so much power and so much discretion to a few men that mistakes—excusable or not—can have such far-reaching effects is a bad system.” (Friedman 2002, 50) Friedman also supports a 100% reserve on demand deposits and regular savings accounts. (Friedman 1959) While there are some other, less central elements to his plan, these two capture the nature of Friedman’s goal. He seeks to ensure monetary stability. By supporting a stable monetary growth target and a 100% reserve on the most liquid accounts, Friedman ensures that the money supply will grow at a constant, predictable rate. Monetary stability will then remove money as being the root of economic disturbance. The final school of thought supports active manipulation of the money supply, raising it and lowering it to reach certain goals in employment, price inflation or stability, and economic growth. This is the legacy of John Maynard Keynes, who supported using fiscal policy in addition to monetary policy in pursuit of these objectives (focusing on employment). “The argument for using monetary policy is usually expressed in terms of the ‘flexibility’ of monetary policy, by which is often meant no more than that monetary policy can be changed quickly.” (Johnson 1962, 368) While many of the manipulation school would claim that fiscal policy is more effective than monetary policy, they often point out how long the fiscal process is. So, to at least some degree, “monetary policy can be helpful in tempering the essentially moderate fluctuations that occur under normal conditions.” (Smith 1956, 606) However, there is the difficulty of knowing precisely how to balance the conflicting goals of economic policy. “Recognition of several objectives of economic policy introduces the possibility of a conflict of objectives requiring resolution by a compromise.” (Johnson 1962, 367) Indeed, mainstream economic theory tends to suggest that there is an inherent conflict between price stability and employment/economic growth. This idea is the root of the idea of the non-accelerating inflation rate of unemployment. “This concept flows naturally from any theory that says that changes in monetary policy, and aggregate demand more generally, push unemployment and inflation in opposite directions in the short run.” (Ball 2002, 115) This relationship is built partially on Keynes’s theory of employment, which states that as inflation occurs, employment goes up because employees react to the higher money wages being offered and provide more labor, while employers react to the lower real wages and provide more jobs. “With a given organization, equipment, and technique, real wages and the volume of output (and hence employment) are uniquely correlated so that, in general, an increase in employment can only occur to the accompaniment of a decline in the rate of wages.” (Keynes 1964, 17) The active manipulation school then has a difficulty. Should it pursue a monetary policy that is consistent with high employment? Or, should it pursue a monetary policy leading to price stability? The answer is (often proudly) ad hoc. A group of economists, at the end of an article describing a model to solve this particular problem state “we do not seriously propose this model as a substitute for the ad hoc models that still constitute most monetary theory.” (Krugman 1985, 694) So, the active manipulation supports the setup of the Federal Reserve System with discretionary authority to pursue those policies which seem best at the moment. Each of these schools has certain merits to its position, and certain detriments as well. By examining each of them from a critical perspective, rather than the descriptive perspective that has been used to this point, a rational choice may be made as to which approach is strongest both in terms of theory and in terms of policy. The free market monetary school presents us with a logical argument for how moments of monetary inflation will lead to malinvestment and the insolvency that comes from malinvestment. A momentary increase in the money supply will, under most theories, drive the interest rate down, increasing the amount of investment in marginally profitable enterprises. Once this artificial additional supply disappears, the interest rate will necessarily increase, ceteris paribus, and marginally profitable enterprises will be abandoned. Also, having a free market money (probably a precious metal) will ensure that the “proper” quantity of money is provided. (Since individual firms seek profit, and profit is a sign of providing social value, private money providers will provide more money as long as it is socially valuable.) The monetary stability school also presents us with a good logical argument for how monetary instability will breed economic disturbance. Much of this theory is in agreement with the free market school, though from a different semantic perspective. A decrease in the money supply means that there is “less grease” in the economy, so it stops moving as fluidly. This results in decreased economic activity as the friction in the system slows it down (in the 30s to a near halt). Generally, this occurs because an easy monetary policy breeds inflation that demands a hard money policy. As the economy slows, some banks will be victim of the slowdown, causing a monetary decline (like that experienced in the early years of the Great Depression) as the flaw of fractional reserve banking is revealed and people run the banks. Based on this believable theory, a strict monetary growth rule and 100% reserve banking is a proper policy. It will ensure that sufficient “grease” will be in the economic machine so things move fluidly. The least satisfying is the active manipulation school. The logic of the inflation-unemployment trade-off is questionable. Empirically, the period of stagflation in the 1970s provides an excellent example of how this theory does not seem to hold water in the real world. On a theoretical level, even, Keynes seems to be ignoring the supply side of the labor market. Even though more jobs will be offered if real wages fall, ceteris paribus, fewer workers will offer their labor services. Keynes wants to assume that employers are rational and that employees are not. This is clearly intellectually unsatisfying. The lack of clarity as to how policy should be used is a brilliant move on their part, because it makes their position so unclear that it is impossible to attack solidly. Those that attack from a price stabilizing perspective are met with the answer “monetary policy should be used for price stabilization”. Those that attack from an employment perspective are told “monetary policy should be used for achieving full employment”. At the same time, lack of clarity is, in itself, grounds for attack. By necessity, regardless of whether the monetary policy du jour is hard or easy, it will lead to inflationary pressure or unemployment, and monetary policy is incapable of attaining at least one of what active manipulators would have be its goals. The active manipulators are forced to abandon, to some degree, at least one of their goals. A policy that is necessarily incapable of actually achieving its goals requires adjustment. Either the policy itself or at least one of the goals must be abandoned. Attempting to achieve goals with a policy that cannot achieve them is senseless. In the end, we are left with the free market money school and the monetary stability school. Choosing between them based on theory is difficult. The monetary stability school could accept the idea of a free money market without abandoning their basic principles. Generally, the monetary stability school accepts the market’s ability to provide for the needs of the economy. Also, the monetary stability school’s policy seems to solve for the free market money school’s concern with the business cycle. By growing the money supply at a constant rate, there is never a fall in supply that would result in an interest rate spike and subsequent bust. Based on this analysis, either policy recommendation could provide the solution to the major practical concern (preventing recession or bust). In the end, the decision between these two policies must be made on some other grounds. I would contend that the monetary stability school offers a system that may be more easily implemented, as it is nearer to the system that is currently in place. The abandonment of fiat money would cause a great shock throughout the economy as all common monetary forms would become essentially worthless. The monetary stability school avoids that by maintaining the same money, and simply disposing with the discretionary authority that causes the real problem. Of course, a system that is more easily converted one direction is generally more easily converted the other direction as well. So, even though the transition from active manipulation to monetary stability would not be overly difficult, the transition the other direction would, likewise, not be overly difficult. However, history has shown that even a free market money regime can turn fiat in time. So, even though a free market policy would make the process more difficult, it would not prevent it completely. In the end, the decision is primarily a matter of political acceptability, and politics generally demands gradual change. By examining the three primary monetary policy schools in theory and in practice, the benefits and disadvantages of each have been made clear. In the end, we find that active manipulation proves theoretically and practically unsatisfying, while free market money and monetary stability are both reasonable, and mostly compatible theoretically. Our decision, following all policy decisions, is bound by political limitations, and therefore, monetary stability was selected as being the most feasible alternative procuring the benefits of either of these policies. |
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