Reading Hayek -- Or Why I Think Monetary Policy Based on Monetary Equilibrium Theory Might Run Into Problems in a World of Central Banking

|Peter Boettke|

Monetary Equilibrium Theory is a beautiful theory, but in a world of central banking I wonder if it can ever be implemented effectively.  And if it cannot, does it then run the risk of being discredited?  There are two impediments -- (1) inability to sort out in real time the difference between "good" and "bad" deflation, and (2) the political consequences of inflation and deflation being such as they are that there is a bias in political actors to avoid deflation at all costs.

In turns out, Hayek identified this problem: "the chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable.  But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation." (Constitution of Liberty, 1960, p. 330)

I have begun working on a paper with Dan Smith, which building on the idea of "robust political economy" that Pete Leeson and I developed, we are looking at the search for rules and institutions for monetary policy by the three leading classical liberal political economists of the 20th century: Hayek, Friedman, and Buchanan.  Each thought hard throughout their respective careers to find the appropriate monetary rule that would effectively bind the monetary authority.  Each were frustrated with earlier answers and this led them to continue their search.  In his 90s, James Buchanan is still searching for the appropriate monetary constitution.

Comments

[Bill Woolsey]

Pete:

The "mainstream" policy approach for the last 30 years has been to target a low inflation rate--usually 2%. The main reason is to avoid deflation at all costs.

So, I guess Hayek was more correct than he knew! No one is even playing lip service to price level stability.

[Mike Sproul]

Pete:
"Each thought hard throughout their respective careers to find the appropriate monetary rule that would effectively bind the monetary authority"

I expect there were probably old Soviet wheat commissars who thought hard about rules that would effectively set national wheat output at the appropriate level and 'bind the wheat authority'.

They didn't need rules. They needed to get rid of the commissars and let markets work. Economists seem to think that the 'fiat' nature of modern money makes it special, and in need of regulation. That misconception disappears once you recognize that there is no such thing as fiat money. All money is backed by the assets of its issuer, and money's value is determined in the same way as any other financial security.

[Current]

I agree with Pete.

I think an important problem is technological changes altering the demand for money. Imagine if we are using an productivity norm rule and someone invents a new means of eliminating the need for money by widening the use of cancellation. How would this be centrally recognised?

[Jerry O'Driscoll]

Friedman and Schwartz were emphatic that the bias against price deflation is not supported by the data. The confusion among economists is the failure to distinguish between good and bad deflation.

If there is any doubt about the existence of an inflation bias, look at the progression of the price level since 1913. The data are available in tabular and graphic form at the website of the St. Louis Fed.

[Lee Kelly]

Accomodating changes in money demand with an appropriate quantity of money is achieved reflexively in a private market; particular issuers merely register fluxuations in the redempetion rate of their liabilities. Perhaps an institutional arrangment can be created in which the function of the clearing house, and the check it imposes upon private money issuers, can be emulated for central banks.

I don't know what institutions would achieve this, but I assume that an adequate solution would probably take this form.

[Current]

"Perhaps an institutional arrangment can be created in which the function of the clearing house, and the check it imposes upon private money issuers, can be emulated for central banks."

I discussed this with Scott Sumner on Money Illusion once. The problem in the US is the widespread use of cash, it makes up a large part of the money stock and the money demand. Though it may be possible to track demand directly for bank account money it is much more difficult for cash.

[Mario Rizzo]

There is an excellent article by Michael Bordo and John Landon Lane in Friday's Financial Times. It is a historical analysis of Fed policy regarding when it has decided to tighten credit after a recession. The upshot, relevant for today's purposes, is that when unemployment is slow to fall the Fed usually tightens too late and thus there is inflation.

http://www.ft.com/cms/s/0/41d9fba0-224a-11df-9a72-00144feab49a.html

[Lawrence H. White]

Pete, I don't think George or any other modern free-banking-type proponent of what you call "monetary equilibrium theory" would disagree. (Not sure about Sumner.) A first-best free banking system means no central bank, hence no need for a second-best rule for constraining the central bank. "Market" beats "best rule for constraining a government planner" every time.

[Lawrence H. White]

"Perhaps an institutional arrangment can be created in which the function of the clearing house, and the check it imposes upon private money issuers, can be emulated for central banks.

I don't know what institutions would achieve this, but I assume that an adequate solution would probably take this form."

It was called the classical gold standard. Central bankers didn't like the constraint it imposed, and sabotaged it.

[Doc Merlin]

The classical gold standard sans central bank did the job.
Another option would be competition in currency.

[Doc Merlin]

@ Lawrence H. White:

Scott Sumner is pro-having-a-central bank.
He just wants the bank constrained by an NGPD futures exchange system.

[Lee Kelly]

"It was called the classical gold standard" - Lawrence White

This had occurred to me, but I was not confident enough with my understanding of the classical gold standard to suggest it.

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