The great Montagu Norman (Bank of England Governor, 1920-46) said when considering Britain’s return to the Gold Standard in 1925 “the merchant, manufacturer, workman, etc, should be considered, but not consulted any more than about the design of a battleship.” It’s quite clear that Fed chairman Ben Bernanke shares Norman’s view. He consults closely with Wall Street, but his pronouncements are issued as obiter dicta to the rest of us. Given the lack of success of both Norman’s and Bernanke’s policies (for more or less opposite reasons) one is forced to ask: if we must have a fiat currency, is it indeed optimal to have its quantity of issue and interest rates determined by such an unrepresentative and eccentric group as central bankers?
 
Norman’s and Bernanke’s monetary policy errors were of opposite types. Norman linked the British pound to gold at an exchange rate which after World War I was clearly about 10% overvalued. As a result Britain, already suffering from an over-unionized workforce (the unions had been given legal immunity by the foolish Benjamin Disraeli in 1875) was unable to squeeze costs out of its economy in the late 1920s and suffered several years of high unemployment until the National Government and Neville Chamberlain abandoned gold in 1931 and put in a modest tariff in 1932, after which there was a considerable economic catch-up. Conversely Bernanke has kept monetary policy notoriously loose, with negative real interest rates, a weak dollar and resurgent inflation.
 
Even though their errors were in opposite directions, Norman and Bernanke arrived at those errors by the same process of consultation with the leading bankers of their day. Bernanke added politicians to that consultation list, while Norman consulted with the leading permanent officials at the Treasury (who undertook the difficult task of guiding Winston Churchill as Chancellor of the Exchequer down the path they had chosen.) However neither man consulted significantly with industrialists, or with international traders, or with the major retail emporia, and both men were famous for their chilly distance from the working man.
 
Thus the opposing conclusions to which Norman and Bernanke came were governed by the different social and economic positions of the bankers of their day. In Norman’s time, banks were primarily havens for depositors, with the leading merchant banks privately owned by third- and fourth- generation men of considerable wealth. Hence the bankers’ attitude was that of the rentier, whom Maynard Keynes famously wished to euthanize. They wanted high interest rates and zero inflation, to allow the growth in value of their savings and those of their depositors. With high real interest rates they were able to make satisfactory returns without excessive risks or leverage; indeed by the standards of later generations the London merchant banks of Norman’s day were woefully under-leveraged.
 
Modern bankers, on the other hand, invest their money in hedge funds, do not themselves own a significant portion of their banks, socialize mostly with hedge fund and private equity magnates, and live largely by trading profits leveraged to the hilt. They want cheap money and lots of it, as much cheap leverage as possible, on and off the balance sheet, bailouts available if their trading strategies go wrong, and not too much scrutiny of the murkier details of how they make their profits. Hence their advice to Bernanke is the exact opposite of the merchant bankers’ advice to Norman.
 
The central bankers’ sources of advice beyond the banking system merely reinforced the advice of the bankers. Norman’s permanent officials were men of the utmost small-c conservatism, and so approved of his tight-money policies. Conversely Bernanke’s advisers are politicians, of a particularly spendthrift generation, who see cheap money as enabling them to run ever larger public deficits without running up against any financing difficulties. Both Norman and Bernanke devised their monetary policies through consultation with an excessively narrow group of people, but as the nature of the people changed, so did the advice they received. Both blinkered sets of advice led to monetary policy failure.

While there are certain aspects of monetary policy that are akin to battleship design, in that they require deep specialist knowledge, the complexity of our actual understanding of monetary matters (as distinct from our politically-driven theorizing) is far less than that of the deep engineering skills employed by designers of a revolutionary battleship such as the 1905 Dreadnought. As non-economists we can be fairly sure of the economic effects of too much or too little money – we see them in our daily lives, and even a modest reading about past economic failures gives us an idea of the various things that go wrong. But a deep knowledge of the precise components of M1, M2, M3, MZM and the monetary base is unnecessary for making recommendations on the broad outlines of a satisfactory monetary policy, whereas knowledge of the precise weight distribution and ballistic capabilities of a 12-inch naval gun was essential to make intelligent comments on Dreadnought design.

There is thus no technical reason why the power structure of monetary policy should be confined to central bankers. A fiat money is in any case an offense against a pure free market system, since mad scientists at the centre of money creation can distort the market in any way they choose. In principle the ideal arbiter of monetary policy would be a purely mechanical system like the demons of James Clerk Maxwell, which were supposed able to open and close an infinitesimal door to allow all the air in a room to collect on one side of it. In the same way, one could imagine an impartial computer-driven monetary system, whereby money was created according to the computer’s observations about economic conditions. Even in this case however, excessive power would be vested in the computer’s programmers, who would instruct the computer to take more notice of type A observations than of type B observations, thus biasing the system.

In the real world, again given that we are not on a Gold Standard, it becomes clear that the most useful decision-makers in monetary policy are those with the most knowledge about local conditions, and the least ideological or political preconception about whether money creation is “good” or “bad” in a given situation. To the greatest extent possible, the decision-makers should be shielded from influence by politicians and the titans of Wall Street, and should be given as much input as possible from the local manufacturers, traders and bankers who form the backbone of the U.S. economy.

It thus becomes painfully obvious that, far from supporting Rep. Barney Frank’s (D.-MA) proposal that the twelve presidents of the regional Federal Reserve Banks should be removed from monetary policy creation, a near-optimal system would in fact include nothing BUT the regional Fed presidents in such deliberations. They are selected, not by Congress or through presidential nomination, but by the regional bank’s Board of Directors, who in turn are selected mostly by the region’s local banks. Most of these local banks are small institutions with little or no connection to Wall Street but considerable understanding of what drives business conditions in their own markets.

Regional Fed presidents are not answerable to Congress or to the President, but to the local banking and business interests which elected them. Being (except for the New York Fed president) located outside both the political nexus of Washington and the financial markets of New York, they are pretty well immune from suborning by the rich and powerful titans of the national stage, and in most cases from realistic ambitions to join those rich and powerful. As a committee of twelve, they could meet in a revised Federal Open Market Committee, with those meetings rotating between the regional Fed offices, so that no central secretariat could subvert their intellectual processes.

On a rough count, four of the current twelve regional Fed presidents (Hoenig of Kansas City, Lacker of Richmond, Fisher of Dallas and Plosser of Philadelphia) are in favor of significantly tighter monetary policy, with another 3-4 undecided. In the current system, in which only five of the regional Fed presidents sit on the FOMC (one of them being the cuckoo in the nest from the New York Fed) that is nowhere near enough to change the outcome of FOMC meetings, especially with the powerful Bernanke, the Washington-based secretariat and the six politically appointed Fed governors in the meeting.)

However with FOMC meetings taking place mostly at remote centers such as the monetarily-oriented St. Louis, no Bernanke, no Governors and no Washington secretariat, it must be clear that, even if the FOMC had initially adopted the loose-money policies of Alan Greenspan and Ben Bernanke after 1995, it would have reined them in on three crucial occasions: in late 1996/early 1997, when it became obvious that a bubble had been created, in 2004, when it became obvious that loose money had caused an alarming explosion in the housing market, and in early 2010, when it became obvious that loose U.S. monetary policies were re-inflating a global commodity and energy bubble, to the great danger of the world economy.

Thus the solution to our current economic travails requires nothing extreme, either in terms of monetary theory or of politics. It simply requires that an existing structure be modestly reformed, to ensure that monetary policy creation is put in the hands of people with detailed knowledge of conditions on the ground and no political or high-finance axes to grind. Norman would have been horrified at the idea, and so no doubt would Bernanke. But monetary policy is too important to be left to mandarins.

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(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.)