The Bear’s Lair: Central banks must be rule-bound, not independent

Retiring Senator Jeff Flake (R.-AZ), apparently concerned about President Donald Trump’s influence in all areas, wants legislation to make the Fed truly independent – of Congress as well as the President, presumably. However, independent central bankers like Ben Bernanke and Mark Carney have been responsible for most of the truly lousy monetary policy of the last two decades. Rather than mandating Fed independence, therefore, Congress must establish rules, constraining the Fed to observe monetarily responsible behavior.

The fashion for independence in central banking was a product of the 1980s and 1990s. Once Paul; Volcker had worked his magic at the Fed, and observers looked back at the bullying that had occurred between President Johnson and William McChesney Martin and to a lesser extent between President Nixon and Arthur Burns, it became clear that politicians could not be trusted not to inflate the money supply. Central bankers needed to be independent of politics.

Thus in 1998, as one of the first actions of the incoming Blair Labour government, the Bank of England was given full independence on monetary matters. Various emerging market central banks, for example in Brazil, were set up or re-established on the basis that local politicians could not be trusted. In New Zealand not only was the central bank made independent, but the Governor’s salary was set inversely to inflation, so that the higher inflation rose, the lower his salary fell.

In retrospect, the diagnosis of those supporting independent central banks was wrong. Politicians are not necessarily pro-inflation; to the extent that there is a trade-off between inflation and unemployment, they may prefer unemployment to inflation, since inflation affects all their constituents whereas unemployment affects only some of them. You can see this in the EU, where politicians in countries like France and Spain have had very little inflation in recent years, but very high unemployment. The cause of the unemployment is generally excessive size of government and government meddling, but politicians generally love all that.

In any case, whether they are generally pro-inflation or anti-inflation, politicians are subject to frequent election campaigns, and therefore tend to keep the welfare of their constituents high if not uppermost in their minds. The same is not necessarily true of independent central bankers. If they are by profession bankers, they want to maintain good relations with the financial community, possibly with an eye to lucrative opportunities after their central banking service. If (as is more common) they are career central bankers or academics, they crave the respect of the economics profession and the financial media, neither of which constituencies have the welfare of the public much at heart.

The whole “independent central bank” idea implies that central banks have and should have a great power to control our economic destiny. In this, the idea is an example of the Keynesian fallacy that wise government bureaucrats can produce better outcomes than the market. Stated that way, it becomes obvious that a powerful independent central bank is merely another tool of the command economy; it should thus not be expected to work any better than did Gosplan.

Before 1914, central banks, if they existed, had merely a modest role in managing money markets whose movements were dictated by larger economic forces. If a country on the Gold Standard ran a balance of payments deficit persistently, it would run the danger of suffering an outflow of gold, leaving it with an inadequate domestic money supply and producing a liquidity crisis. The only solution to this was for the local central bank to raise interest rates until gold was once more attracted back into the domestic economy by the higher interest rates. This in turn would slow activity in the domestic economy sufficiently to swing the balance of payments back towards surplus. The system was more or less self-correcting; if the central bank botched policy, the liquidity crisis in the domestic economy would be sufficiently severe to cause squawking and ensure that the central bank corrected its mistake.

The system was only a little more complicated if the central banks themselves issued notes. It was discovered by painful experience in 1825 that allowing entities beyond the central bank to issue notes was likely to prove ruinous. Hence the central bank controlled its note issuance in order to manage its own liquidity position, and that in turn ensured that the central bank’s note issue did not distort signals from the gold market. The Bank Charter Act of 1844, which restricted bank note issuance artificially, proved to be both unnecessary and dangerous; because of its lack of flexibility it had to be suspended three times within twenty years, causing bank crises each time.

Translating this nineteenth century experience into modern conditions, and assuming that political factors will not allow us to return to a full Gold Standard, it therefore follows that central banks need to be constrained by rules of sound policy, giving them little scope for Bernanke-esque experimentation. In a word that I coined several years ago, they need to be “Volckerized,” in other words, made to operate as if an immortal Paul Volcker was running them permanently, without ever being replaced by a lesser being.

I take Paul Volcker as the model of the ideal central banker because he was moved neither by short-term popularity, nor by the need to gain favor from economists, politicians or bankers, but only by the need to restore and maintain price stability to the U.S. economy. To that end, he pushed interest rates up to extraordinarily high levels of over 20%, far above even the inflation levels of his early years in office. As a compass, he used the growth rate of broad money supply, although he recognized that monetary policy suffers from the “quantum mechanics” problem – by steering according to a particular measure of monetary growth, you affect that measure and make it less useful as a compass by which to steer.

Naturally, it is impossible to mandate Fed policymakers to operate with the wisdom and sophistication of Paul Volcker himself. Indeed, we should not attempt to do so; by attempting to impose wisdom and sophistication upon monetary policy we would ourselves be entering into the Keynesian bureaucrat fallacy that as designers of complex regulations, we could mimic bureaucrats of infinite wisdom. Instead, we should content ourselves with just a few simple rules that will result in a monetary policy as close as possible to a classical Gold Standard.

The first of those rules should be on interest rates, and it should decree that at each Federal Open Market Committee meeting, the Chairman must certify that the short-term policy interest rates he was setting for the next three months was no lower than the Committee’s estimate of the inflation rate for the next year. In that way, the Committee would be prevented from setting negative real interest rates, which create and stoke asset bubbles. Clearly, if the Committee believed that inflation over the next year would be negative, so that deflation was a problem, there would then be no effective limit on setting any positive or zero policy interest rate. Thus, the Fed will still be able to fight severe deflation if it were to appear.

The second rule, which would not conflict with the first, is that the Fed should conduct its policy in such a way as to achieve an average inflation rate of zero over the medium term, as measured by the GDP deflator or some other broad measure of prices. The current unofficial target inflation rate of 2% allows for far too much fudging and indeed is itself damaging. A gradual erosion of purchasing power in the currency is like the gradual erosion of any other item of weights and measures; it prevents accurate long-term policy on a whole host of matters.

For example, if you allow an average inflation rate of 2% and a capital gains tax of 20%, then taxpayers should have the right to deduct 2% per annum from their capital gains before calculating the tax liability – otherwise, you discriminate against long-term holdings, which is a discrimination you definitely do not want. Aiming at an average inflation rate of zero is aiming at price stability, the outcome that would be provided by a well-functioning Gold Standard.

With those two rules in place, decreed by Congress, and not to be changed except with a two thirds majority of Congress, you could trust Fed chairmen to do their job within those parameters. Any Keynesian fantasies of expanding the money supply to achieve permanent prosperity, or to get a favorite President re-elected, would quickly come up against the constraints of the two governing rules, and thus be quickly ended. Essentially, you would be imposing the judgments of the good, sound economics of the Gold Standard over the fashionable fads that individual Fed chairmen might pursue.

As any good Gold Standard economist would tell you: In monetary policy, rules beat judgement, every time.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)