Archive for the 'Henry Simons' Category

The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A         Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B         Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

            C         Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

Pedantry and Mastery in Following Rules

From George Polya’s classic How to Solve It (p. 148).

To apply a rule to the letter, rigidly, unquestioningly, in cases where it fits and cases where it does not fit, is pedantry. Some pedants are poor fools; they never did understand the rule which they apply so conscientiously and so indiscriminately. Some pedants are quite successful; they understood their rule, at least in the beginning (before they became pedants), and chose a good one that fits in many cases and fails only occasionally.

To apply a rule with natural ease, with judgment, noticing the cases where it fits, and without ever letting the words of the rule obscure the purpose of the action or the opportunities of the situation, is mastery.

Polya, of course, was distinguishing between pedantry and mastery in applying rules for problem solving, but his distinction can be applied more generally: a distinction between following rules using judgment (aka discretion) and following rules mechanically without exercising judgment (i.e., without using discretion). Following rules by rote need not be dangerous when circumstances are more or less those envisioned when the rules were originally articulated, but, when unforeseen circumstances arise,  making the rule unsuitable to the new circumstances, following rules mindlessly can lead to really bad outcomes.

In the real world, the rules that we live by have to be revised and reinterpreted constantly in the light of experience and of new circumstances and changing values. Rules are supposed to conform to deeper principles, but the specific rules that we try to articulate to guide our actions are in need of periodic revision and adjustment to changing circumstances.

In deciding cases, judges change the legal rules that they apply by recognizing subtle — and relevant — distinctions that need to be taken into account in rendering decisions. They do not adjust rules willfully and arbitrarily. Instead, relying on deeper principles of justice and humanity, they adjust or bend the rules to temper the injustices that would from a mechanical and unthinking application of the rules. By exercising judgment — in other words, by doing what judges are supposed to do — they uphold, rather than subvert, the rule of law in the process of modifying the existing rules. The modern fetish for depriving judges of the discretion to exercise judgment in rendering decisions is antithetical to the concept of the rule of law.

A similar fetish for rules-based monetary policy, i.e., a monetary system requiring the monetary authority to mechanically follow some numerical rule, is an equally outlandish misapplication of the idea that law is nothing more than a system of rules and that judges should do more than select the relevant rule to be applied and render a decision based on that rule without considering whether the decision is consistent with the deeper underlying principles of justice on which the legal system as a whole is based.

Because judges exercise coercive power over the lives and property of individuals, the rule of law requires their decisions to be justified in terms of the explicit rules and implicit and explicit principles of the legal system judges apply. And litigants have a right to appeal judgments rendered if they can argue that the judge misapplied the relevant legal rules. Having no coercive power over the lives or property of individuals, the monetary authority need not be bound by the kind of legal constraints to which judges are subject in rendering decisions that directly affect the lives and property of individuals.

The apotheosis of the fetish for blindly following rules in monetary policy was the ideal expressed by Henry Simons in his famous essay “Rules versus Authorities in Monetary Policy” in which he pleaded for a monetary rule that “would work mechanically, with the chips falling where they may. We need to design and establish a system good enough so that, hereafter, we may hold to it unrationally — on faith — as a religion, if you please.”

However, Simons, recovering from this momentary lapse into irrationality, quickly conceded that his plea for a monetary system good enough to be held on faith was impractical, abandoning it in favor of the more modest goal of stabilizing the price level. However, Simons’s student Milton Friedman, surpassed his teacher in pedantry, invented what came to be known as his k-percent rule, under which the Federal Reserve was to be required to make the total quantity of  money in the economy increase continuously at an annual rate of growth equal to k percent. Friedman actually believed that his rule could be implemented by a computer, so that he confidently — and foolishly — recommended abolishing the Fed.

Eventually, after erroneously forecasting the return of double-digit inflation for nearly two decades, Friedman, a fervent ideologue but also a superb empirical economist, reluctantly allowed his ideological predispositions to give way in the face of contradictory empirical evidence and abandoned his k-percent rule. That was a good, if long overdue, call on Friedman’s part, and it should serve as a lesson and a warning to advocates of imposing overly rigid rules on the monetary authorities.

A Draft of my Paper on Rules versus Discretion Is Now Available on SSRN

My paper “Rules versus Discretion in Monetary Policy Historically Contemplated” which I spoke about last September at the Mercatus Center Conference on rules for a post-crisis world has been accepted by the Journal of Macroeconomics. I posted a draft of the concluding section of the paper on this blog several weeks ago. An abstract, and a complete draft, of the paper are available on the journal website, but only the abstract is ungated.

I have posted a draft of the paper on SSRN where it may now be downloaded. Here is the abstract of the paper.

Monetary-policy rules are attempts to cope with the implications of having a medium of exchange whose value exceeds its cost of production. Two classes of monetary rules can be identified: (1) price rules that target the value of money in terms of a real commodity, e.g., gold, or in terms of some index of prices, and (2) quantity rules that target the quantity of money in circulation. Historically, price rules, e.g. the gold standard, have predominated, but the Bank Charter Act of 1844 imposed a quantity rule as an adjunct to the gold standard, because the gold standard had performed unsatisfactorily after being restored in Britain at the close of the Napoleonic Wars. A quantity rule was not proposed independently of a price rule until Henry Simons proposed a constant money supply consisting of government-issued fiat currency and deposits issued by banks operating on a 100-percent reserve basis. Simons argued that such a plan would be ideal if it could be implemented because it would deprive the monetary authority of any discretionary decision-making power. Nevertheless, Simons concluded that such a plan was impractical and supported a price rule to stabilized the price level. Simons’s student Milton Friedman revived Simons’s argument against discretion and modified Simons plan for 100-percent reserve banking and a constant money supply into his k-percent rule for monetary growth. This paper examines the doctrinal and ideological origins and background that lay behind the rules versus discretion distinction.

Rules vs. Discretion Historically Contemplated

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.

Larry White on the Gold Standard and Me

A little over three months ago on a brutally hot day in Washington DC, I gave a talk about a not yet completed paper at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World. The title of my paper was (and still is) “Rules versus Discretion Historically Contemplated.” I hope to post a draft of the paper soon on SSRN.

One of the attendees at the conference was Larry White who started his graduate training at UCLA just after I had left. When I wrote a post about my talk, Larry responded with a post of his own in which he took issue with some of what I had to say about the gold standard, which I described as the first formal attempt at a legislated monetary rule. Actually, in my talk and my paper, my intention was not as much to criticize the gold standard as it was to criticize the idea, which originated after the gold standard had already been adopted in England, of imposing a fixed numerical rule in addition to the gold standard to control the quantity of banknotes or the total stock of money. The fixed mechanical rule was imposed by an act of Parliament, the Bank Charter Act of 1844. The rule, intended to avoid financial crises such as those experienced in 1825 and 1836, actually led to further crises in 1847, 1857 and 1866 and the latter crises were quelled only after the British government suspended those provisions of the Act preventing the Bank of England from increasing the quantity of banknotes in circulation. So my first point was that the fixed quantitative rule made the gold standard less stable than it would otherwise have been.

My second point was that, in the depths of the Great Depression, a fixed rule freezing the nominal quantity of money was proposed as an alternative rule to the gold standard. It was this rule that one of its originators, Henry Simons, had in mind when he introduced his famous distinction between rules and discretion. Simons had many other reasons for opposing the gold standard, but he introduced the famous rules-discretion dichotomy as a way of convincing those supporters of the gold standard who considered it a necessary bulwark against comprehensive government control over the economy to recognize that his fixed quantity rule would be a far more effective barrier than the gold standard against arbitrary government meddling and intervention in the private sector, because the gold standard, far from constraining the conduct of central banks, granted them broad discretionary authority. The gold standard was an ineffective rule, because it specified only the target pursued by the monetary authority, but not the means of achieving the target. In Simons view, giving the monetary authority to exercise discretion over the instruments used to achieve its target granted the monetary authority far too much discretion for independent unconstrained decision making.

My third point was that Henry Simons himself recognized that the strict quantity rule that he would have liked to introduce could only be made operational effectively if the entire financial system were radically restructured, an outcome that he reluctantly concluded was unattainable. However, his student Milton Friedman convinced himself that a variant of the Simons rule could actually be implemented quite easily, and he therefore argued over the course of almost his entire career that opponents of discretion ought to favor the quantity rule that he favored instead of continuing to support a restoration of the gold standard. However, Friedman was badly mistaken in assuming that his modified quantity rule eliminated discretion in the manner that Simons had wanted, because his quantity rule was defined in terms of a magnitude, the total money stock in the hands of the public, which was a target, not, as he insisted, an instrument, the quantity of money held by the public being dependent on choices made by the public, not just on choices made by the monetary authority.

So my criticism of quantity rules can be read as at least a partial defense of the gold standard against the attacks of those who criticized the gold standard for being insufficiently rigorous in controlling the conduct of central banks.

Let me now respond to some of Larry’s specific comments and criticisms of my post.

[Glasner] suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. . . .  He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks.

It’s hard to write a short description of a system that covers all possible permutations in the system. While I think Larry is correct in noting the difference between the commitment made by any single bank to convert – on demand — its obligations into gold and the legal commitment imposed on an entire system to maintain convertibility into gold, the historical process was rather complicated, because both silver and gold coins circulating in Britain. So the historical fact that British banks were making their obligations convertible into gold was the result of prior decisions that had been made about the legal exchange rate between gold and silver coins, decisions which overvalued gold and undervalued silver, causing full bodied silver coins to disappear from circulation. Given a monetary framework shaped by the legal gold/silver parity established by the British mint, it was inevitable that British banks operating within that framework would make their banknotes convertible into gold not silver.

Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

I agree that introducing a central bank into the picture creates the possibility that the actions of the central bank will have a destabilizing effect. But that does not necessarily mean that the actions of the central bank could not also have a stabilizing effect compared to how a pure free-banking system would operate under a gold standard.

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

But in my book, I did acknowledge that there inherent instabilities associated with a gold standard. That’s why I proposed a system that would aim at stabilizing the average wage level. Almost thirty years on, I have to admit to having my doubts whether that would be the right target to aim for. And those doubts make me more skeptical than I once was about adopting any rigid monetary rule. When it comes to monetary rules, I fear that the best is the enemy of the good.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

Actually I didn’t mean to blame anyone for the crises of 1825 and 1836. All I meant to do was a) blame the Currency School for agitating for a strict quantitative rule governing the total quantity of banknotes in circulation to be imposed on top of the gold standard, b) point out that the rule that was enacted when Parliament passed the Bank Charter Act of 1844 failed to prevent subsequent crises in 1847, 1857 and 1866, and c) that the crises ended only after the provisions of the Bank Charter Act limiting the issue of banknotes by the Bank of England had been suspended.

My own view is that, because the monopoly Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

Here, I think, we do arrive at a basic theoretical disagreement, because I don’t accept that the price-specie-flow mechanism played any significant role in the international adjustment process. National price levels under the gold standard were positively correlated to a high degree, not negatively correlated, as implied by the price-specie-flow mechanism. Moreover, the Bank Charter Act imposed a fixed quantitative limit on the note issue of all British banks and the Bank of England in particular, so the overissue of banknotes by the Bank of England could not have been the cause of the post-1844 financial crises. If there was excessive credit expansion, it was happening through deposit creation by a great number of competing deposit-creating banks, not the overissue of banknotes by the Bank of England.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

And my view is that Free Bankers like Larry White overestimate the importance of note issue in a banking system in which deposits were rapidly overtaking banknotes as the primary means by which banks extended credit. As Henry Simons, himself, recognized this shift from banknotes to bank deposits was itself stimulated, at least in part, by the Bank Charter Act, which made the extension of credit via banknotes prohibitively costly relative to expansion by deposit creation.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

1 While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.

2 The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.

Larry makes two good points, but I doubt that they are very important in practice. The problem with the value of gold is that there is a very long time lag before the adjustment in the rate of output of new gold will cause the value of gold to revert back to its normal level. The annual output of gold is only about 3 percent of the total stock of gold. If the monetary demand for gold is large relative to the total stock and that demand is unstable, the swing in the overall demand for gold can easily dominate the small resulting change in the annual rate of output. So I do not have much confidence that the mean-reversion characteristic of the purchasing power of gold to be of much help in the short or even the medium term. I also agree with Larry that the Canadian and Scottish banking systems exhibited a lot more stability than the neighboring US and English banking systems. That is an important point, but I don’t think it is decisive. It’s true that there were no bank failures in Canada in the Great Depression. But the absence of bank failures, while certainly a great benefit, did not prevent Canada from suffering a downturn of about the same depth and duration as the US did between 1929 and 1933. The main cause of the Great Depression was the deflation caused by the appreciation of the value of gold. The deflation caused bank failures when banks were small and unstable and did not cause bank failures when banks were large and diversified. But the deflation  was still wreaking havoc on the rest of the economy even though banks weren’t failing.

Cluelessness about Strategy, Tactics and Discretion

In his op-ed in the weekend Wall Street Journal, John Taylor restates his confused opposition to what Ben Bernanke calls the policy of constrained discretion followed by the Federal Reserve during his tenure at the Fed, as vice-chairman under Alan Greenspan from 2003 to 2005 and as Chairman from 2005 to 2013. Taylor has been arguing for the Fed to adopt what he calls the “rules-based monetary policy” supposedly practiced by the Fed while Paul Volcker was chairman (at least from 1981 onwards) and for most of Alan Greenspan’s tenure until 2003 when, according to Taylor, the Fed abandoned the “rules-based monetary rule” that it had followed since 1981. In a recent post, I explained why Taylor’s description of Fed policy under Volcker was historically inaccurate and why his critique of recent Fed policy is both historically inaccurate and conceptually incoherent.

Taylor denies that his steady refrain calling for a “rules-based policy” (i.e., the implementation of some version of his beloved Taylor Rule) is intended “to chain the Fed to an algebraic formula;” he just thinks that the Fed needs “an explicit strategy for setting the instruments” of monetary policy. Now I agree that one ought not to set a policy goal without a strategy for achieving the goal, but Taylor is saying that he wants to go far beyond a strategy for achieving a policy goal; he wants a strategy for setting instruments of monetary policy, which seems like an obvious confusion between strategy and tactics, ends and means.

Instruments are the means by which a policy is implemented. Setting a policy goal can be considered a strategic decision; setting a policy instrument a tactical decision. But Taylor is saying that the Fed should have a strategy for setting the instruments with which it implements its strategic policy.  (OED, “instrument – 1. A thing used in or for performing an action: a means. . . . 5. A tool, an implement, esp. one used for delicate or scientific work.”) This is very confused.

Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?

It is worth noting that the practice of defining a rule in terms of a policy instrument rather than in terms of a policy goal did not originate with John Taylor; it goes back to Milton Friedman who somehow convinced a generation of monetary economists that the optimal policy for the Fed would be to target the rate of growth of the money supply at a k-percent annual rate. I have devoted other posts to explaining the absurdity of Friedman’s rule, but the point that I want to emphasize now is that Friedman, for complicated reasons which I think (but am not sure) that I understand, convinced himself that (classical) liberal principles require that governments and government agencies exercise their powers only in accordance with explicit and general rules that preclude or minimize the exercise of discretion by the relevant authorities.

Friedman’s confusions about his k-percent rule were deep and comprehensive, as a quick perusal of Friedman’s chapter 3 in Capitalism and Freedom, “The Control of Money,” amply demonstrates. In practice, the historical gold standard was a mixture of gold coins and privately issued banknotes and deposits as well as government banknotes that did not function particularly well, requiring frequent and significant government intervention. Unlike, a pure gold currency in which, given the high cost of extracting gold from the ground, the quantity of gold money would change only gradually, a mixed system of gold coin and banknotes and deposits was subject to large and destabilizing fluctuations in quantity. So, in Friedman’s estimation, the liberal solution was to design a monetary system such that the quantity of money would expand at a slow and steady rate, providing the best of all possible worlds: the stability of a pure gold standard and the minimal resource cost of a paper currency. In making this argument, as I have shown in an earlier post, Friedman displayed a basic misunderstanding of what constituted the gold standard as it was historically practiced, especially during its heyday from about 1880 to the outbreak of World War I, believing that the crucial characteristic of the gold standard was the limitation that it imposed on the quantity of money, when in fact the key characteristic of the gold standard is that it forces the value of money – regardless of its material content — to be equal to the value of a specified quantity of gold. (This misunderstanding – the focus on control of the quantity of money as the key task of monetary policy — led to Friedman’s policy instrumentalism – i.e., setting a policy rule in terms of the quantity of money.)

Because Friedman wanted to convince his friends in the Mont Pelerin Society (his egregious paper “Real and Pseudo Gold Standards” was originally presented at a meeting of the Mont Pelerin Society), who largely favored the gold standard, that (classical) liberal principles did not necessarily entail restoration of the gold standard, he emphasized a distinction between what he called the objectives of monetary policy and the instruments of monetary policy. In fact, in the classical discussion of the issue by Friedman’s teacher at Chicago, Henry Simons, in an essay called “Rules versus Authorities in Monetary Policy,” Simons also tried to formulate a rule that would be entirely automatic, operating insofar as possible in a mechanical fashion, even considering the option of stabilizing the quantity of money. But Simons correctly understood that any operational definition of money is necessarily arbitrary, meaning that there will always be a bright line between what is money under the definition and what is not money, even though the practical difference between what is on one side of the line and what is on the other will be slight. Thus, the existence of near-moneys would make control of any monetary aggregate a futile exercise. Simons therefore defined a monetary rule in terms of an objective of monetary policy: stabilizing the price level. Friedman did not want to settle for such a rule, because he understood that stabilizing the price level has its own ambiguities, there being many ways to measure the price level as well as theoretical problems in constructing index numbers (the composition and weights assigned to components of the index being subject to constant change) that make any price index inexact. Given Friedman’s objective — demonstrating that there is a preferable alternative to the gold standard evaluated in terms of (classical) liberal principles – a price-level rule lacked the automatism that Friedman felt was necessary to trump the gold standard as a monetary rule.

Friedman therefore made his case for a monetary rule in terms of the quantity of money, ignoring Simons powerful arguments against trying to control the quantity of money, stating the rule in general terms and treating the selection of an operational definition of money as a mere detail. Here is how Friedman put it:

If a rule is to be legislated, what rule should it be? The rule that has most frequently been suggested by people of a generally liberal persuasion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of a rule [my emphasis]. It is the wrong kind of a rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway.

As an aside, I note that Friedman provided no explanation of why such a rule would disperse responsibilities. Who besides the monetary authority did Friedman think would have responsibility for controlling the price level under such a rule? Whether such a rule would give the monetary authorities “too much leeway” is of course an entirely different question.

There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities. (p. 53)

Friedman continues:

In the present state of our knowledge, it seems to me desirable to state the rule in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System shall see to it [Friedman’s being really specific there, isn’t he?] that the total stock of money so defined rises month by month, and indeed, so far as possible day by day, at an annual rate of X per cent, where X is some number between 3 and 5. (p. 54)

Friedman, of course, deliberately ignored, or, more likely, simply did not understand, that the quantity of deposits created by the banking system, under whatever definition, is no more under the control of the Fed than the price level. So the whole premise of Friedman’s money supply rule – that it was formulated in terms of an instrument under the immediate control of the monetary authority — was based on the fallacy that quantity of money is an instrument that the monetary authority is able to control at will.

I therefore note, as a further aside, that in his latest Wall Street Journal op-ed, Taylor responded to Bernanke’s observation that the Taylor rule becomes inoperative when the rule implies an interest-rate target below zero. Taylor disagrees:

The zero bound is not a new problem. Policy rule design research took that into account decades ago. The default was to move to a stable money growth regime not to massive asset purchases.

Taylor may regard the stable money growth regime as an acceptable default rule when the Taylor rule is sidelined at the zero lower bound. But if so, he is caught in a trap of his own making, because, whether he admits it or not, the quantity of money, unlike the Fed Funds rate, is not an instrument under the direct control of the Fed. If Taylor rejects an inflation target as a monetary rule, because it grants too much discretion to the monetary authority, then he must also reject a stable money growth rule, because it allows at least as much discretion as does an inflation target. Indeed, if the past 35 years have shown us anything it is that the Fed has much more control over the price level and the rate of inflation than it has over the quantity of money, however defined.

This post is already too long, but I think that it’s important to say something about discretion, which was such a bugaboo for Friedman, and remains one for Taylor. But the concept of discretion is not as simple as it is often made out to be, especially by Friedman and Taylor, and if you are careful to pay attention to what the word means in ordinary usage, you will see that discretion does not necessarily, or usually, refer to an unchecked authority to act as one pleases. Rather it suggests that a certain authority to make a decision is being granted to a person or an official, but the decision is to be made in light of certain criteria or principles that, while not fully explicit, still inform and constrain the decision.

The best analysis of what is meant by discretion that I know of is by Ronald Dworkin in his classic essay “Is Law a System of Rules?” Dworkin discusses the meaning of discretion in the context of a judge deciding a “hard case,” a case in which conflicting rules of law seem to be applicable, or a case in which none of the relevant rules seems to fit the facts of the case. Such a judge is said to exercise discretion, because his decision is not straightforwardly determined by the existing set of legal rules. Legal positivists, against whom Dworkin was arguing, would say that the judge is able, and called upon, to exercise his discretion in deciding the case, meaning, that by deciding the case, the judge is simply imposing his will. It is something like the positivist view that underlies Friedman’s intolerance for discretion.

Countering the positivist view, Dworkin considers the example of a sergeant ordered by his lieutenant to take his five most experienced soldiers on patrol, and reflects on how to interpret an observer’s statement about the orders: “the orders left the sergeant a great deal of discretion.” It is clear that, in carrying out his orders, the sergeant is called upon to exercise his judgment, because he is not given a metric for measuring the experience of his soldiers. But that does not mean that when he chooses five soldiers to go on patrol, he is engaging in an exercise of will. The decision can be carried out with good judgment or with bad judgment, but it is an exercise of judgment, not will, just as a judge, in deciding a hard case, is exercising his judgment, on a more sophisticated level to be sure than the sergeant choosing soldiers, not just indulging his preferences.

If the Fed is committed to an inflation target, then, by choosing a setting for its instrumental target, the Fed Funds rate, the Fed is exercising judgment in light of its policy goals. That exercise of judgment in pursuit of a policy goal is very different from the arbitrary behavior of the Fed in the 1970s when its decisions were taken with no clear price-level or inflation target and with no clear responsibility for hitting the target.

Ben Bernanke has described the monetary regime in which the Fed’s decisions are governed by an explicit inflation target and a subordinate commitment to full employment as one of “constrained discretion.” When using this term, Taylor always encloses it in quotations markets, apparently to suggest that the term is an oxymoron. But that is yet another mistake; “constrained discretion” is no oxymoron. Indeed, it is a pleonasm, the exercise of discretion usually being understood to mean not an unconstrained exercise of will, but an exercise of judgment in the light of relevant goals, policies, and principles.

PS I apologize for not having responded to comments recently. I will try to catch up later this week.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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