Why have a central bank at all?

House Domestic Monetary Policy subcommittee held a hearing recently on Improving the Federal System (HT: John Taylor Blog).

There are very interesting testimonies/papers there. I just read this one from Austrian school economist – Peter Klein. He says the issue is not of reforming Fed, but why have it at all in the first place?

In the remarks below I evaluate the Federal Reserve System—and the institution of central banking more generally—from the perspective of an organizational economist. While I strongly disagree with many of the key policies of the Federal Reserve Board both before and after the Financial Crisis and Great Recession, my argument does not focus on particular actions taken by this or that Chair and Board. The problem is not that the Fed has made some mistakes—perhaps addressed by restating its statutory mandate, scrutinizing its behavior more carefully, and so on—but that the very institution of a central monetary authority is inherently destabilizing and harmful to entrepreneurship and economic growth.

Come to think of it, monetary policy is associated with Friedman’s views of free markets etc. Fiscal Policy is seen as interventionist policies of Keynes. However, central banks are nothing but government agencies/ planning agency to manage money:

The central bank’s job, in short, is to “manage” the monetary system. As such, it is the most important economic planning agency in a modern economy. Money is a universally used good and the loan market, through which newly created money enters the economy, is at the heart of the investment process. Ironically, though economics clearly teaches the impossibility of effi-cient resource allocation under centralized economic planning, as demonstrated (theoretically) in the 1920s and 1930s by economists such as Ludwig von Mises and F. A. Hayek,3 and (empirical-ly) by the universally recognized failure of centrally planned economies throughout the twentieth century, many people think that the monetary system is an exception to the general principle that that free markets are superior to central planning. When it comes to money and banking, in other words, it is essential to have a single decision-making body, protected from competition, without effective oversight, possessing full authority to take almost any action it deems in the best inter-est of the nation. The organization should be run by an elite corps of apolitical technocrats with only the public interest in mind.

The usual experience with such agencies is that they perform badly:

And yet, everything we know about organizations with that kind of authority, without over-sight, or any external check or balance, tells us that they cannot possibly work well. Just as economy-wide central planners lack the incentives and information to direct the allocation of productive resources, monetary planners lack the incentives and information to make efficient decisions about open-market operations, the discount rate, and reserve requirements. The Fed simply does not know the “optimal” supply of money or the “optimal” intervention in the banking system; no one does. Add the standard problems of bureaucracy—waste, corruption, slack, and other forms of inefficiency well known to students of public administration—and it becomes increasingly difficult to justify control of the monetary system by a single bureaucracy. 

This is especially true when the good in question is money, the only good that exchanges against all other goods, meaning the good in which all prices are quoted. Mismanagement of the money supply not only affects the general price level, but distorts the relative prices of different goods and industries, making it more difficult for entrepreneurs to weigh the benefits and costs of various forms of action, leading to malinvestment, waste, and stagnation.

   So though econs have advised that central banks should follow rules, one should not have a central bank in the first place:

Critics of discretionary monetary policy have argued for fixed rules, such as Milton Fried-man’s famous recommendation of a fixed rate of money-supply growth, or Professor Taylor’s more accommodating set of countercyclical rules.5 Others debate whether inflation targeting or nominal-income targeting is a more straightforward and realistic policy for the Fed.6 However, none of these proposals is as effective as eliminating the monetary authority altogether, and rely-ing on the voluntary decisions of market participants to determine the money supply and interest rates. A commodity standard, for example, removes even the possibility of central government intervention in the monetary system. If rules are better than discretion, the best policy is to eliminate all discretion, and to achieve a monetary standard that is wholly independent of political or technocratic interference.

He argues Fed should not have intervened to let the fin instis fail and not provide any financial help.  He goes onto argue how Fed intervention has led to wrong incentives and the huge power of Fed. There is too much discretion involved and one should not be running something that important with so much discretion.

Economist Lawrence Ball produced an interesting paper in February of this year on the psy-chology of the chairman.11 Ball traced the evolution of Bernanke’s thinking between 2000 and 2012, arguing that, since 2008, “the Bernanke Fed has eschewed the policies that Bernanke once supported.” Ball attributes to the change in Bernanke’s thinking to groupthink and to the chair-man’s own personality, which Ball describes as shy, withdrawn, and unassertive.

Without intending to, Ball makes powerful arguments against discretionary monetary policy itself, which relies on a small, elite group of powerful technicians, interest-group representatives, and political advisers to design and implement rules and procedures that affect the lives of mil-lions, that reward some (commercial and investment bankers, homeowners) while punishing oth-ers (savers, renters), that shape the course of world events. Under central banking, there are no rules, only discretion. Do we really want a system in which one person’s personality type has such a huge effect on the global economy?

ME pointed to the Ball paper here. In a nice line he says Fed in run by men, not Gods..

If not CB, then who takes over? No one, just markets will govern the money:

Without a central bank, how can a monetary system work? Don’t we need a central bank to create bank reserves? Isn’t the Fed necessary to maintain stable prices? Don’t we need the gov-ernment to create and regulate money? Actually, the reverse is true. One of the first scientific analyses of the nature and origin of money, Carl Menger’s 1892 es-say “On the Origin of Money,” explains how money—a generally accepted medium of ex-change—emerges from the trading patterns of individual market participants.19 Menger was challenging the then-dominant “state theory of money,” which held that money must be created, ex nihilo, by benevolent central planners.

Rather, as decades of research in monetary theory and history have shown, there is no need whatsoever for government participation in the monetary and financial system. Money—whether a physical commodity like gold or silver or their paper equivalents—is essentially a commodity that is selected and “governed,” so to speak, by the choices of entrepreneurs and consumers in the market. This is as true today, in an era of paper currencies and electronic payments, as it was under the international gold standard. There is no need for a government agency to increase or decrease the supply of money. Indeed, according to the Austrian school, government attempts to control the money supply create distortions in the economy by interfering with relative prices and warping the capital structure, encouraging the bad investments that manifest themselves over the course of the business cycle. Rather, the value of money should be determined on the market, as part of the normal, day-to-day process of ex-changes between money and goods and services. 

What about price stability? Who cares..

How, then, is price stability to be maintained? The answer is that the economy doesn’t need “stable” prices, just market prices. Some of the proposals discussed at this hearing suggest re-moving the Federal Reserve Act’s language about “maximum employment,” keeping just the part about “stable prices.” Eliminating the dual mandate would be a step in the right direction, as it would reduce the Fed’s incentive to increase the money supply when unemployment rates rise beyond some arbitrary threshold. But the requirement of price stability should be removed as well. The idea that a central bank is need to maintain a stable or modestly rising price level—to prevent high levels of inflation, in other words—is based on a misunderstanding of inflation.

In a growing economy, with a stable or slightly growing money supply (as under a commodity stand-ard), prices will tend to fall, as in the US during the 19th century, when the US experienced dra-matic increases in production and living standards. Price levels rise because the real economy is shrinking or—as is almost universally the case in practice—because the money supply is increas-ing faster than the increase in real production. Inflation is not caused by an “overheated” econo-my that the government needs to somehow cool off. Inflation, as Milton Friedman famously put it, is everywhere and always a monetary phenomenon. Central banks don’t fight inflation; they create it.

Superb reading….Though again, too purist a view..

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