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In his later years Friedman also endorsed free banking.

Great post, Pete. That Hayek quote is great. In order not to sound "conspiratorial" and to be taken as a serious economist, yes we end up spending our time arguing about exit strategies and money multipliers. But in reality I am quite sure that Bernanke's specific decisions are driven by his personal benefits from steering billions of dollars into the hands of the world's richest and most powerful people. Why aren't we allowed to even bring that up? Surely it's relevant.

Bob, I question what personal benefit Bernanke would receive from his decision to bailout the banking institutions. Would you please elaborate?

Pete, let's say we all agree that we should abolish the Fed (I agree with that). The question is, what should the Fed be doing right now? I recall Steve arguing in his first book that there are cases to be made for both rules and discretion, and he called for discretion so that the Fed can adjust reserves should the demand for money change, in an attempt to bring about monetary equilibrium. The problem is, I'm not sure that argument is consistent with not only the public choice problems, but also with the knowledge problem argument.

So, given that we have the Fed, and will have it at least for the next few years, does Steve's general call for discretion -- perhaps especially in times like this -- fall into the robust political economy that Pete favors? I think not. I side with Pete on this issue.

Nice post.

In the Hayek quote, notice how we cannot swap Menger in for Smith.

Why would any of you expect the Fed to stick to a rule in any case? Do you imagine a Constitutional amendment? What exactly is the rule they should stick to and what enforcement mechanism is there?

Seems to me neither option is "robust." And if so, and if the Fed is just going to make it up as it goes along anyway, why not point out that good monetary theory says it should have done X in situation Y?

Why not point out? We point out the value of free markets, too, but those in power don't listen.

I do understand the dilemma, Steve. If the rule doesn't stick, it isn't a rule, no matter what the rule is. But the alternative is unending discretion which will always face public choice and knowledge problems and cannot help but create a kind of fundamental uncertainty that cannot be helpful in the long run. What to do? What to do?

You have to go down the decision tree, as it were, with your interlocutors. When discussing monetary issues you have to show them how the monetary authorities could and should act under various contingencies. Doing so does not overturn arguments that we cannot expect such good behavior from the authorities given their cognitive and moral limits.

Indeed, isn't that part of the free banking story? Free banking gives you results that approximate, or even exceed, what you would get from a superhuman monetary authority.

I think that means I side with Dave on the discretion issue even while recognizing that Steve should articulate how discretion should properly be exercised when it exists. Does that make sense?

In defense of the CatoUnbound exchange, Peter, let me suggest that the dichotomy you suggest concerning "technical discussions" of monetary policy on one hand and "political economy" of policy on the other is perhaps too strict. Bear in mind that, whatever the merits of a commodity standard, there can be no question of any return to such a standard unless the government were to either actively promote such, in which case it would probably muck things up. Nor would a unilaterally adopted commodity money standard be desirable. In any event the transition to a new standard is likely to be very costly. So there are good reasons for assuming that we must continue to rely on the present fiat standard. But because the scarcity of fiat money is a contrived scarcity only, the political economy question is then how to contrive it, and do so in a manner conducive to stability, without letting politics (or sheer ignorance) get in the way. Arguments favoring monetary rules are at bottom attempts to address this question of political economy. And at least some rules (e.g., "dollarize," "freeze the monetary base," "set up an orthodox currency board," as well as "restore gold convertibility") themselves embody radical departures from orthodox central banking.

I see Scott's NGDP futures targeting scheme as the basis for another such radical departure. After all, if stable nominal GDP growth is really the desideratum of sound fiat-money policy (and I think the case for this is compelling), then Scott's idea amounts to a market-based device for helping to achieve it. As you know, and as I argued on the blog, I think that free banking is another device, and that the two devices together would be better than either alone. The idea in either case is to make central _bankers_, if not central banks themselves (understood simply as sources of national base monies), redundant; and trying to do that is, I should think, taking the political economy of money very seriously!

Finally, I must say that, having spent much of the last week pouring over the FOMC minutes for 2003, politics don't seem to have much obvious bearing on what goes on in the Fed's monetary policy deliberations. The real problems seem to be bad theories and plain old ignorance--most of it quite unavoidable--of the true state of the economy.

Steve, would you favor what we might call the Horwitz Rule: the Fed should always adjust the Ms to changes in Md so as to achieve a continuous monetary equilibrium? (Not that it is unique to you, but I use your name to incline you to adopt a rule-based approach.)

Having said that, I would be inclined to favor the Horwitz Rule only if I can be assured that there are no variable lags and other knowledge problem-related issues and that the Fed, even under minimal knowledge problems, has the incentive to make adjustments in a timely way.

Come to think of it, I think you've already argued for the Horwitz Rule. Maybe it can be considered a kind of discretionary rule. Anyway, what's your thoughts on the knowledge and incentive issues?

The "Horwitz Rule." Like the name. But as stated it's really too vague: consider, for starters, that in principle even with rigid prices and wages you can have equality of Md and Ms with _any_ trend for nominal variables generally. (The noise level changes, of course.)

But if I understand what Steve really wants to accomplish by his rule--and I think I may presume to do so--it is precisely what Scott's NGDP targeting and my free banking proposals would accomplish.

George, it is indeed clear that free banking would accomplish that, making it the first-best solution. The Horwitz Rule is only second best from, I better say, a first-best Austrian economist.

And as a follow up to George's concern: Steve, don't leave us hanging. You should clarify your Horwitz Rule. The only difficulty is, the more persuasive rules tend to be articulated in a single sentence. So try to restrict it to one sentence.

We should distinguish between monetary rules and institutional arrangements for (imperfectly) enforcing them. Doing so allows us to see rules and institutional reforms as potential complements rather than as alternatives to one another.

Sorry folks, was at a doctor's appointment, so I missed the christening of my Rule. :)

George's presumption is correct. I think my "rule" is simply a pithy if vague way of phrasing either of the two options George mentions.

And Dave, I agree that the Fed's incentives to follow any version of these guidelines aren't ideal. If George's reading of the FOMC minutes are right, then perhaps there's hope if one can get a seachange in what they consider to be the right theories.

In the end, though, it's always a comparative question, no? What's your preferred alternative for the central bank? What should they do/have done, Dave? Even a Friedman rule has its costs, and the question is whether they are larger or smaller than the "Horwitz Rule."

In my view what should the Fed do now? I am inclined, though not comfortable at all, with Pete's normative claim that it should hold Ms constant. At least that is a "predictable" policy. But I am very uncomfortable with that. I'd be much more comfortable with the Horwitz Rule if I thought the Fed can measure and control the Ms and see or predict timely changes in Md.

Note that my argument or thoughts here are not based on a libertarian vision, but on economic consequences for the longer run.


In Hume's discussion he clearly states how the knave assumption is NOT a statement of empirical reality, but nevertheless is critical for building the institutions of governance. And note Steve and others, that a commitment to "robustness" means that you build institutions that DO NOT concentrate on what good men can do when circumstances demand right action, but in preventing bad men from doing bad things when given the opportunity. Bad men but least harm is the institutional effort.

To Dan -- yes Dan, Hume and Smith are at the core of the political economy project --- I agree.


Understood Pete. Which is why we need free banking. But why shouldn't we expect to find ourselves on the horns of a dilemma when we're in the world of the second best? Central banks weren't designed with Hume's perspective in mind, so to now claim one central bank policy (rules) is more in line with that dictum than another seems somewhat strange.

For Pete and Dave: this all still comes down to a series of empirical claims, including the political economy ones you raise. For example: do you think central banks should *always* hold the MS constant, no matter the state of the economy? If so, that rule will allow central bankers to do much harm through errors of omission, especially in unusual times such as those we've been through. Would you have said that in 1930? Would you have said that in 1987?

And better yet: wouldn't you actually NOW recommend that they shrink the base? Isn't that the whole point of your fears of inflation? What they should have done a year ago is one thing. What should they do *today*? Doesn't your own logic say they should shrink it? If so, doesn't that require discretion? Or are you going to go with the freezing the base at its current level? :)

Bottom line: the Fed HAS discretion and in the situation we found ourselves last fall, my *judgment* is that it should have used it in a particular way.

I do understand Hume's argument, Peter. What's more, I agree with it entirely, which is why I favor institutional reform, and as radical as you like it.

Perhaps you are responding to my idle remarks about the lack of evidence of "politics" influencing the FOMC's deliberations. Believe me, I didn't at all intend, in pointing that out, to suggest that we should therefore not see any problem with "the rule of men" over money! If I were inclined to assume that only knaves could wreck the economy, my views would be quite different from what they are.

In other words: Hey, Pete, wake up! It's me--George. You know: the free banking guy. Why you're shaking and positively soaked with sweat! No wonder: I think you fell asleep while reading my boring CatoUnbound contributions, and have been having a bad dream in which I turned into a derivative-taking Fed apologist who thought we just needed to tweak the Taylor rule a wee bit to make everything peachy keen.

There, there, Peter. Everything's OK now--THIS is reality, I promise. Now go and get some real rest.

But that's the thing, Steve... can we count on the Fed to its discretion in a particular, and more importantly, a correct way?

We always find ourselves in a situation of what the Fed just did. Your approach seems to be: given that the Fed has done this, now it should do that; given that the Fed has done that, now it should do this, given that the Fed has done those, now it should do these. It creates an unending coil of uncertainty.

How much uncertainty is there really if the Fed tries to follow a NGDP growth rule? Again, assuming they can actually DO so (knowledge/incentives), this is not an uncertainty generator as such a rule has pretty clear implications for the Fed's action.

Again, as George says above, this is all world of the second-best stuff. It will be far from perfect, but I simply think the net benefits of following such a rule are greater than the alternatives for the central bank.

George and Steve,

Please do note that in my original post I do say I am being "unfair" to you guys. And I do think the question of MV=PQ is important and understanding the issues involved in that relationship are critical. BUT, I also wonder how much the essential issues of knowledge problem and political opportunism have to be incorporated into the fundamental theory of economics let alone public policy analysis. To me, the behavioral assumptions of omniscience and benevolence have the theoretical consequence of de-emphasizing the role of comparative institutions in our analysis. The behavioral assumptions, in other words, work so strongly that comparative institutions lose their comparative importance.

When Pete and I submitted our robustness paper around to journals several years ago we got the same reaction we got from George. Yes, that is a good point. But we all knkow it, so why are you saying it. Again I agree we all know it, but do we incorporate it consistently and persistently in to our analysis. When I used to talk about assumptions and "only if" as it related to my sports career, my Dad used to say to me "if my aunt had b***, she would be my uncle", followed usually by 'get over it, it is what it is'. I also think about that when I think about economic models and so much of blackboard economics. I want to endogenize those behavioral issues of limited knowledge and private interst poliics. As Hayek says "the constitutional limits" to man's knowledge and interests. So while everyone understands the point, I wonder how many understand the full implications of the point for the way we do our economics.

I am being unfair to George and Steve, but in the interest of trying to push you both further. Perhaps the only way to play this policy game is to not play at all. The optimal monetary policy for the Fed isn't to engage as if it would do what a free banking system would do, but to restrict it by a rule so that it doesn't nothing. Freeze the monetary base, and let the market adjust around that. Why isn't that discussed?

Once we ask the Fed to use discretion to respond, why do we believe it will ever return to a monetary rule?

Well, Pete, it depends on what you consider "discretion," and what you consider to be close enough to having the (reformed) Fed "do nothing." There's a fine line here. A frozen base, where you actually disband the FOMC, surely is safely on one side of it. But Scott's NGDP futures targeting plan is consistent with doing away with the FOMC and replacing it and the rest of the Fed monetary-policy administration with a skeleton crew whose sole task is to administer the target. The new arrangement could and should be fully privatized--that is, with no government input of any sort. Think of the reconstituted Fed--call it the "Monetary Base Maintenance Association," becoming like the NYSE, or a big private clearinghouse. Traditional US private clearinghouses managed banks' reserves, but generally didn't augment them, except in emergencies like those of 1893 and 1907. Well, think of them agreeing to follow Scott's rule as an alternative to adjusting reserves on an ad-hoc emergency basis. (Steve may want to chime in on this.) Indeed, I suppose Scott himself understands that the Fed as presently constituted can never be expected to stick to a monetary rule--his or any other. Hell, they can't even bring themselves to stick to the Taylor rule, the principle virtue of which is precisely that it comes closest to reflecting what the the Fed is inclined to do when it isn't rule-bound.

I also think that free banking with a frozen base would be an improvement on the status quo. But free banking with Scott's plan has the advantage of being better able to guarantee stability by allowing adjustments of the base in response to such things as a change in real equilibrium interest rates or a change in the ratio of total to income transactions. For this reason FB with NGDP futures is an easier sell than FB with a frozen base. Should the latter prove adequate, the NGDP futures market will just be moribund. If, on the other hand, the NGDP futures market remains active, it will be so because a frozen base isn't sufficient to keep spending stable.

Finally, I hope that, in engaging Scott's views as I did, I may have brought us closer together, not only by recognizing the advantages of his scheme, but by nudging him a little closer to my own. Should Scott ultimately recognize virtues in FB akin to those I see in NGDP futures targeting, I for one will consider it a big victory for "us" Humeans!


Is freezing the monetary base doing nothing? I am not so sure. It seems to me that freezing the monetary base is doing something -- prohibiting competitors from issuing money.

Is there anywhere I can get a in-plain-English explanation of Scott Sumner's NGDP futures targeting idea? I am intrigued, but confess to not understanding the principle.

Can anyone help me out?

Scott Sumner wrote about this a long time ago in the Cato journal:


"Central banks weren't designed with Hume's perspective in mind, so to now claim one central bank policy (rules) is more in line with that dictum than another seems somewhat strange." --Mlle. Horwitz (yeah, you're an unmarried young French girl from now on...deal with it)

We might say that it does follow it in the sense that the scholastics would call per accidens. It doesn't arise out of the nature or the intentions of the action but it's there all the same. The Egyptians knew less about biology than the Greeks but produced better doctors on faultier theories. In other words, by accident, they acted more in line with what a correct knowledge of human biological characteristics would have instructed them to do.

The financial crisis and deep U.S. recession have prompted concerns about a sustained reduction in the economy's growth potential (the growth rate of potential supply, rather than demand), perhaps to as low as 2% per year. We take a more positive stance.

thanks for sharing about it.

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