Henry Simons, one of the early pillars of the Chicago School of Economics and a student of Frank Knight’s, emphasised monetary rules as opposed to monetary discretion. Milton Friedman, a more recent Chicago School economist, argued that the Fed would do a better job of managing monetary policy if it were required to increase the money supply by some defined percentage, say 3% per year. Both of these gentlemen feared the power of a central bank being able to act in discretionary fashion.
Friedman expressed the problem thusly:
The power to determine the quantity of money… is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power… Any system which gives so much power and so much discretion to a few men, [so] that mistakes – excusable or not – can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – this is the key political argument against an independent central bank.
Doug Noland writes about this problem in the context of our times (emboldening mine):
Henry Simons Was Right:
“The establishment of definite, stable, legislative rules of the game as to money, or in other words, the creation of a national monetary system, are of paramount importance to the survival of a system based on freedom of enterprise.” Henry Simons, 1936
Listening to Chairman Bernanke’s Wednesday press conference, I was reminded of the long-standing but forgotten “rules vs. discretion” debate with respect to monetary policy. Dr. Bernanke is an impressive public servant. He is extremely intelligent and a man of integrity. I do believe our chairman seeks to do the right thing, and he would prefer to shoot straight with people. I appreciate all of that, although I have come to the conclusion that the system would be at less risk these days if the Fed were being governed by a less capable, less trusted and less doctrinaire official. We’ve somehow gone from the cult of “The Maestro” to “Genius Professor.” Federal Reserve performance is deserving of significantly less discretion.
I remain deeply troubled both by Dr. Bernanke’s analytical framework and by the institutional structure of the Federal Reserve System. We are in desperate need of some fixed and definite rules of the game. The backdrop beckons for a cautious approach. Instead, the great monetary experiment runs unabated – an experiment that evolves without serious scrutiny only because our central bank is judged these days largely by its capacity to inflate equities and risk markets. “No questions asked,” as long as the markets are strong. There were no questions Wednesday regarding the relationship of Fed policy and asset Bubbles – past or present.
Our Fed Chairman did adeptly respond to questions on important topics including inflation, commodities prices, and the dollar. One was left feeling comfortable that inflation was low and under the Fed’s control. Commodities price effects will likely prove “transitory.” The dollar, well, it’s just not a problem. Besides, Fed policies will spur a strong economy and resulting foreign capital inflows, all consistent with the view that “a strong dollar is in the best interest of the United States.” The Chairman noted that the dollar’s big rally back in 2008 confirmed the retention of our safe-haven status. It all sounded reasonable and hopeful. In reality, Washington policymaking is corroding long-term confidence in our currency, a non-transitory predicament that will invariably lead to uncertainty, instability and inflation issues. The best we can hope for is another dollar “short squeeze.”
Mr. Simons’ above comment was from a classic article written during the Great Depression. Throughout that period, many questioned the role the Federal Reserve had played in the breakdown of the monetary system and economic collapse. And, importantly, the focal point in contemporaneous analysis was not an incompetent Fed that had failed to act forcefully following the stock market crash. No, most leading economic thinkers at the time pointed blame directly at the Federal Reserve for failing to adequately regulate Credit and protect the financial system and economy from profligate lending, rampant speculation and general financial excess – all during the preceding boom.
The collapse in confidence was the consequence of cumulative (“Roaring Twenties”) financial and economic excess. It was recognized at the time that the Fed had steered badly off course; had succumbed to “New Era” thinking; and had abrogated its responsibility for maintaining stable Credit. The powerful president of the New York Fed, Benjamin Strong, was faulted for his predilection for intervening in support of the markets, while turning a blind eye to speculative excess and Bubble Dynamics.
Wednesday, Chairman Bernanke was asked about a main theme from Carmen Reinhart’s and Ken Rogoff’s book, “This Time is Different:” that historical experience demonstrates that systems require long periods to recover from deep financial crises. Bernanke’s response: “…Certainly part of it has to do with the problems in credit markets. And my own research when I was in academia focused a great deal on the effects of problems in credit markets on recoveries. Other aspects would include the effects of credit problems on areas like housing and so on. And we’re seeing all that, of course, in our economy. But that said, another possible explanation for the slow recovery from financial crises might be that policy responses were not adequate – that they, that the recapitalization of the banking system, the restoration of credit flows and monetary and fiscal policies were not sufficient to get as quick a recovery as might otherwise have been possible. And so, you know, we haven’t allowed that, that historical fact, to dissuade us from doing all we can to support a strong recovery.”
I certainly have no issue with Dr. Bernanke’s analytical focus on “problems in the Credit markets.” From my study of history (including “This Time is Different”), it has often required decades to recovery from Credit system collapse. In my reading of the incredible experience of John Law’s “Mississippi Bubble” (the introduction of paper currency to France around 1720), I recall one author noting that it was almost a century before the French people again fully trusted banks.
Fundamentally, great care and intense focus must be taken to ensure the soundness and stability of a system’s Credit mechanisms and underlying instruments. This should go without saying, yet our policymaking framework is incredibly deficient in this regard. Indeed, today’s “activist” policy approach sees an extended period of near-zero rates, double-digit-to-GDP deficits, and massive central bank monetization as a prudent course of action. Chairman Bernanke professes that current policy is “not that different from other monetary policy” – when it is clearly unlike anything prescribed in the long history of central banking. He can speak confidently that the Fed has “lots of experience” with this type of policy, when they are actually deep into uncharted waters.
I take strong exception with Bernanke’s framework. His analytical focus rests upon the policy response to a crisis, while the lessons of history point rather directly to uncontrolled Credit expansion and attendant speculative excess as the root cause of major financial crises. It is crucial to have a framework – a doctrine of clearly defined “rules of the game” – that protects the integrity of the system against the type of excesses that risk a crisis of confidence and systemic collapse (such as massive federal deficits and a ballooning central bank balance sheet). This is foreign to current Federal Reserve doctrine.
The danger with discretionary monetary policy – noted by proponents of a rules-based system over the years – is that policy errors have a propensity for inciting only bigger blunders. I argued against aggressive “Keynesian” stimulus back in 2002. Central to my thesis was that policymakers’ so-called “post-Bubble” response was in reality bolstering powerful ongoing Credit Bubble Dynamics and excess. I took exception with the likes of Messrs. Bernanke, Dudley, McCulley and others. Dr. Bernanke’s early Fed speeches, in particular, espoused a radical monetary response to systemic stress. The danger of such an approach was not indiscernible at the time – and definitely shouldn’t be today. In hindsight, it should be clear that misplaced Federal Reserve stimulus was instrumental in fueling the mortgage finance Bubble and deep structural maladjustment
When questioned on inflation, the Fed Chairman repeatedly referred to “well-anchored inflation expectations.” Gold jumped $21 Wednesday to surpass $1,525. Watching the markets bid up the prices for gold, silver, crude and commodities, one is hard-pressed to dismiss the notion that inflationary forces are nowadays especially untethered. The press conference also did little to dismiss the notion that a weak dollar is an important facet of Dr. Bernanke’s reflationary policymaking. It is simply not credible to claim that inflation is contained, while faith and the price of our currency decline on an almost daily basis.
The markets were quite satisfied by the event. The Fed Chairman conveyed that the Fed is in no hurry to remove extraordinary monetary accommodation. He went so far as to state that any rundown of the Fed’s balance sheet (specifically from not reinvesting maturing securities) would “constitute a policy tightening.” This suggested that, after the conclusion of Q2, the Fed plans on strictly maintaining the current size of its holdings. And when “extended period” is eventually dropped from the Fed’s statement, there will be at least a couple meetings before “tightening” commences – and this so-called tightening might begin with a period of slow rundown in the Fed’s balance sheet. Bernanke made it clear that the Fed will err on the side of caution all the way through this process. Especially considering underlying structural deficiencies and fragilities, the markets are content to presume that true “tightening” – returning rates to a more normalized level – is likely years away.
Returning to “rules vs. discretion,” Dr. Bernanke’s highly-discretionary policy has been communicated to the markets with great transparency. Never mind the fact that signaling an extended period of aggressive monetary accommodation directly to a highly speculative marketplace was instrumental in fueling past Bubbles.
We’re in need of some rules. We need rules that would ensure that the Fed never again accommodates a doubling of mortgage Credit in about six years. We need rules that ensure that the Fed is not complicit in double-digit-to-GDP federal deficits – and a doubling of federal debt in less than four years. We need some rules that ensure that savers don’t receive a pittance on their savings while speculators enjoy a historic windfall.
We need rules to ensure that the Fed judiciously monitors financial conditions from a broad perspective. We need rules that would impose discipline when our economy runs persistently large Current Account and fiscal deficits. We need rules to ensure that emergency monetary policy measures have defined durations – helping to limit the structural impact from artificially low interest rates. We need to have rules to ensure that intervening in the marketplace is not commonplace. We need rules to ensure that the Fed doesn’t use the manipulation of financial markets as a mechanism to bolster the economy. We need rules to ensure a policy focus on underlying Credit conditions rather than asset prices. We need rules to ensure monetary policy does not nurture speculative excess. These rules would incentivize the speculators to bet on the system gravitating toward stability – as opposed to these days where the sophisticated speculating community wagers confidently that excess will beget only greater excess.
We need rules to ensure that Federal Reserve policymaking does not dictate the (re)distribution of wealth throughout our society. We need rules that would ensure that the public and financial markets do not expect too much from monetary policy. We need rules that would forbid the Fed from monetizing debt, ballooning its holdings, and massively inflating system liquidity – at its discretion. Rules are needed to ensure that monetary policy doesn’t dictate decision-making throughout the entire economy.
And we so need a framework of rules that would work toward ensuring that the stability of our monetary system is beyond repute – that society need not fear that policymakers will devalue their savings or jeopardize the Creditworthiness of our nation’s obligations and financial system. And we need rules to ensure that the ideology of a single appointed central banker cannot have a profound impact on the nature of monetary policy, asset prices, debt structures, speculative dynamics, financial flows and resource allocation. The risks of indiscretion are much too great, and Henry Simons was absolutely right.
Now we are in the pickle that both Simon and Friedman warned about. We have, perhaps a well-meaning man, directing the fate of the nation based on an economic ideology that never worked.