Here is a new concluding section which I have just written for my paper “Rules versus Discretion in Monetary Policy: Historically Contemplated” which I spoke about last September at the Mercatus Confernce on Monetary Rules in a Post-Crisis World. I have been working a lot on the paper over the past month or so and I hope to post a draft soon on SSRN and it is now under review for publication. I apologize for having written very little in past month and for having failed to respond to any comments on my previous posts. I simply have been too busy with work and life to have any energy left for blogging. I look forward to being more involved in the blog over the next few months and expect to be posting some sections of a couple of papers I am going to be writing. But I’m offering no guarantees. It is gratifying to know that people are still visiting the blog and reading some of my old posts.
Although recognition of a need for some rule to govern the conduct of the monetary authority originated in the perceived incentive of the authority to opportunistically abuse its privileged position, the expectations of the public (including that small, but modestly influential, segment consisting of amateur and professional economists) about what monetary rules might actually accomplish have evolved and expanded over the course of the past two centuries. As Laidler (“Economic Ideas, the Monetary Order, and the Uneasy Case for Monetary Rules”) shows, that evolution has been driven by both the evolution of economic and monetary institutions and the evolution of economic and monetary doctrines about how those institutions work.
I distinguish between two types of rules: price rules and quantity rules. The simplest price rule involved setting the price of a commodity – usually gold or silver – in terms of a monetary unit whose supply was controlled by the monetary authority or defining a monetary unit as a specific quantity of a particular commodity. Under the classical gold standard, for example, the monetary authority stood ready to buy or sell gold on demand at legally determined price of gold in terms of the monetary unit. Thus, the fixed price of gold under the gold standard was originally thought to serve as both the policy target of the rule and the operational instrument for implementing the rule.
However, as monetary institutions and theories evolved, it became apparent that there were policy objectives other than simply maintaining the convertibility of the monetary unit into the standard commodity that required the attention of the monetary authority. The first attempt to impose an additional policy goal on a monetary authority was the Bank Charter Act of 1844 which specified a quantity target – the aggregate of banknotes in circulation in Britain – which the monetary authority — the Bank of England – was required to reach by following a simple mechanical rule. By imposing a 100-percent marginal gold-reserve requirement on the notes issued by the Bank of England, the Bank Charter Act made the quantity of banknotes issued by the Bank of England both the target of the quantity rule and the instrument by which the rule was implemented.
Owing to deficiencies in the monetary theory on the basis of which the Act was designed and to the evolution of British monetary practices and institution, the conceptual elegance of the Bank Charter Act was not matched by its efficacy in practice. But despite, or, more likely, because of, the ultimate failure of Bank Charter Act, the gold standard, surviving recurring financial crises in Great Britain in the middle third of the nineteenth century, was eventually adopted by many other countries in the 1870s, becoming the de facto international monetary system from the late 1870s until the start of World War I. Operation of the gold standard was defined by, and depended on, the observance of a single price rule in which the value of a currency was defined by its legal gold content, so that corresponding to each gold-standard currency, there was an official gold price at which the monetary authority was obligated to buy or sell gold on demand.
The value – the purchasing power — of gold was relatively stable in the 35 or so years of the gold standard era, but that stability could not survive the upheavals associated with World War I, and so the problem of reconstructing the postwar monetary system was what kind of monetary rule to adopt to govern the post-war economy. Was it enough merely to restore the old currency parities – perhaps adjusted for differences in the extent of wartime and postwar currency depreciation — that governed the classical gold standard, or was it necessary to take into account other factors, e.g., the purchasing power of gold, in restoring the gold standard? This basic conundrum was never satisfactorily answered, and the failure to do so undoubtedly was a contributing, and perhaps dominant, factor in the economic collapse that began at the end of 1929, ultimately leading to the abandonment of the gold standard.
Searching for a new monetary regime to replace the failed gold standard, but to some extent inspired by the Bank Charter Act of the previous century, Henry Simons and ten fellow University of Chicago economists devised a totally new monetary system based on 100-percent reserve banking. The original Chicago proposal for 100-percent reserve banking proposed a monetary rule for stabilizing the purchasing power of fiat money. The 100-percent banking proposal would give the monetary authority complete control over the quantity of money, thereby enhancing the power of the monetary authority to achieve its price-level target. The Chicago proposal was thus inspired by a desire to increase the likelihood that the monetary authority could successfully implement the desired price rule. The price level was the target, and the quantity of money was the instrument. But as long as private fractional-reserve banks remained in operation, the monetary authority would lack effective control over the instrument. That was the rationale for replacing fractional reserve banks with 100-percent reserve banks.
But Simons eventually decided in his paper (“Rules versus Authorities in Monetary Policy”) that a price-level target was undesirable in principle, because allowing the monetary authority to choose which price level to stabilize, thereby favoring some groups at the expense of others, would grant too much discretion to the monetary authority. Rejecting price-level stabilization as monetary rule, Simons concluded that the exercise of discretion could be avoided only if the quantity of money was the target as well as the instrument of a monetary rule. Simons’s ideal monetary rule was therefore to keep the quantity of money in the economy constant — forever. But having found the ideal rule, Simons immediately rejected it, because he realized that the reforms in the financial and monetary systems necessary to make such a rule viable over the long run would never be adopted. And so he reluctantly and unhappily reverted back to the price-level stabilization rule that he and his Chicago colleagues had proposed in 1933.
Simons’s student Milton Friedman continued to espouse his teacher’s opposition to discretion, and as late as 1959 (A Program for Monetary Stability) he continued to advocate 100-percent reserve banking. But in the early 1960s, he adopted his k-percent rule and gave up his support for 100-percent banking. But despite giving up on 100-percent banking, Friedman continued to argue that the k-percent rule was less discretionary than the gold standard or a price-level rule, because neither the gold standard nor a price-level rule eliminated the exercise of discretion by the monetary authority in its implementation of policy, failing to acknowledge that, under any of the definitions that he used (usually M1 and sometimes M2), the quantity of money was a target, not an instrument. Of course, Friedman did eventually abandon his k-percent rule, but that acknowledgment came at least a decade after almost everyone else had recognized its unsuitability as a guide for conducting monetary policy, let alone as a legally binding rule, and long after Friedman’s repeated predictions that rapid growth of the monetary aggregates in the 1980s presaged the return of near-double-digit inflation.
However, the work of Kydland and Prescott (“Rules Rather than Discretion: The Inconsistency of Optimal Plans”) on time inconsistency has provided an alternative basis on which argue against discretion: that the lack of commitment to a long-run policy would lead to self-defeating short-term attempts to deviate from the optimal long-term policy.[1]
It is now I think generally understood that a monetary authority has available to it four primary instruments in conducting monetary policy, the quantity of base money, the lending rate it charges to banks, the deposit rate it pays banks on reserves, and an exchange rate against some other currency or some asset. A variety of goals remain available as well, nominal goals like inflation, the price level, or nominal income, or even an index of stock prices, as well as real goals like real GDP and employment.
Ever since Friedman and Phelps independently argued that the long-run Phillips Curve is vertical, a consensus has developed that countercyclical monetary policy is basically ineffectual, because the effects of countercyclical policy will be anticipated so that the only long-run effect of countercyclical policy is to raise the average rate of inflation without affecting output and employment in the long run. Because the reasoning that generates this result is essentially that money is neutral in the long run, the reasoning is not as compelling as the professional consensus in its favor would suggest. The monetary neutrality result only applies under the very special assumptions of a comparative static exercise comparing an initial equilibrium with a final equilibrium. But the whole point of countercyclical policy is to speed the adjustment from a disequilbrium with high unemployment back to a low-unemployment equilibrium. A comparative-statics exercise provides no theoretical, much less empirical, support for the proposition that anticipated monetary policy cannot have real effects.
So the range of possible targets and the range of possible instruments now provide considerable latitude to supporters of monetary rules to recommend alternative monetary rules incorporating many different combinations of alternative instruments and alternative targets. As of now, we have arrived at few solid theoretical conclusions about the relative effectiveness of alternative rules and even less empirical evidence about their effectiveness. But at least we know that, to be viable, a monetary rule will almost certainly have to be expressed in terms of one or more targets while allowing the monetary authority at least some discretion to adjust its control over its chosen instruments in order to effectively achieve its target (McCallum 1987, 1988). That does not seem like a great deal of progress to have made in the two centuries since economists began puzzling over how to construct an appropriate rule to govern the behavior of the monetary authority, but it is progress nonetheless. And, if we are so inclined, we can at least take some comfort in knowing that earlier generations have left us a lot of room for improvement.
Footnote:
[1] Friedman in fact recognized the point in his writings, but he emphasized the dangers of allowing discretion in the choice of instruments rather than the time-inconsistency policy, because it was only former argument that provided a basis for preferring his quantity rule over price rules.
Uneasy Money 