Kick the ‘wise men’ out of the Bank of England

In today’s City AM, newly-minted ASI fellow Lars Christensen (aka The Market Monetarist) writes on the ‘Carney rule’. The Carney announcement is a tiny step in the right direction, he says, but as long as the ‘wise men’ of the Monetary Policy Committee are running monetary policy, policy will be erratic and unpredictable, preventing adequate planning by firms and adding to market panic in economic downturns. Instead, we should have a strict rules-based system of nominal GDP targeting:

A much better rule would have been to commit to stabilising the level of nominal GDP (NGDP), a measure of aggregate demand, keeping market expectations of NGDP growth on a 4 or 5 per cent growth path. This should be combined with an open-ended commitment to expanding the money base to hit this target. This would avoid the nitty-gritty of the Carney Rule and be clearer and easier to communicate to markets.

Monetary policy based on the discretion of “wise men” leads to market uncertainty and panicky jolts as investors react to tiny changes in central bankers’ pronouncements. Replacing the MPC with rules-based policy would bring discipline and predictability to the Bank of England far beyond what was outlined yesterday.

I would prefer to have no Bank of England at all, with money emerging from the market as outlined by Hayek in 1976. Having said that, perfect is not the enemy of good — replacing the discretion of ‘experts’ with predictable, market-led rules would be a huge step in the right direction. If Carney’s new rule fails, it may come on to the agenda sooner than we think.

A question for market monetarists

Market monetarism, as propagated most prominently by Scott Sumner’s (excellent) blog The Money Illusion, argues that recessions come about due to a collapse in demand. This is a problem because prices cannot adjust downwards quickly. Instead of a costly adjustment period we can simply boost demand by announcing a target and credibly committing to do the necessary quantitative easing (buying gilts to inject money in the system) to achieve that target.

This makes a lot of sense. Markets are finding it hard to clear; we boost AD to put the situation back where it was; now markets find it easier to clear. But lots of the best market monetarists, including Scott, Lars Christensen and many others, argue that right now what we need is more stimulus, because the economy is still in a bad shape, and it is still due to a shortfall of demand.

Last Tuesday Professor George Selgin delivered an extremely interesting lecture at the Adam Smith Institute making the case for productivity driven deflation. He said he agreed with the market monetarists that there is “bad deflation”—the sort that means nominal rigidities stop markets from clearing—but there is also “good deflation”, from productivity improvements—and this is not associated with unemployment, stagnant or falling GDP, or any other cyclical issue.

After the talk I quizzed him on whether he agreed with the market monetarists that even though the ideal is a rule-based system, as opposed to the current discretionary way policy is set, right now the best discretionary policy is more easing, because that’s probably what the ideal rule would require.

Prof. Selgin disagreed, arguing that we didn’t need easier policy, and if you look at the graph above there’s at least apparent reason to agree with him. Nominal GDP—aggregate demand—is not only well above its pre-recession peak in the US, but is growing at an apparently steady rate, roughly in line with its long-term trend. If the high unemployment in the US is down to insufficient demand combined with nominal rigidities then why hasn’t a long period of higher-than-pre-crisis demand brought unemployment back down.

According to Selgin, policy uncertainty and pro-cyclical strictness in enforcing regulations (particularly risk-weighted lending rules that rate Greek bonds as zero but loans to small business at 100%) are holding firms back from investing their cash piles in capital and it is this that is stopping the robust recovery. He made the point very convincingly and despite trying hard to argue against it I couldn’t find a good reason to disagree, except that I hadn’t seen a good measure of the importance of these two factors so it was hard for me to compute how big their influence really was.

But many market monetarists—along with New Keynesians and most others—seem very sure that insufficient demand is the overriding factor holding back recovery, in the US as much as the EU, UK and Japan (where NGDP growth is further below trend). So my very genuine question is: upon what arguments and/or evidence do they rest this belief?

 

Monetary rules vs. central bank discretion

On Monday I attended a conference in Copenhagen on monetary policy regime change with Lars Christensen of Danske Bank, Sam Bowman, research director here, Anthony J Evans, economics professor at ESCP Europe Business School, and Martin Ågerup, president of Danish liberal think-tank CEPOS, among others. The discussions raised a huge number of interesting ideas, among which was the question of rules vs. discretion in monetary policy. We all agreed that a rule-based system would be a major improvement on the existing system.

The current monetary regime in the UK, and many other major economies, is known as flexible inflation targeting. Under flexible inflation targets, a panel of appointed “wise men” is tasked with keeping inflation close to a target rate—in the UK 2% measured by the consumer prices index. They set interest rates (and in exceptional times, asset purchases, known as quantitative easing) to control aggregate demand and through that the price level, and achieve their target. The flexible element of the policy is that they have leeway to decide when achieving the target straight away would cause more harm to the economy than the resultant above target inflation. It is this provision that explains the Bank of England’s monetary policy committee’s decisions not to tighten policy despite 40 successive months of above target consumer price inflation in the UK.

There are many problems with this framework—including looking narrowly at consumer prices, rather than all prices in the economy; targeting a rate instead of a level; and judging performance by actually achieved inflation instead of expected future inflation—but here I wish to focus in on the problems with allowing the MPC to decide when and how much to miss their target.

One obvious problem with discretion, as opposed to rules, is that it can be unclear exactly what rate-setters will do in response to shocks. Firms have to worry not only about unexpected changes in market conditions but also unexpected macroeconomic response to these changes. Hence the feverish market interest in a press conference from Mario Draghi or Ben Bernanke, with intense focus on minute changes in tone or wording of statements. Hence the massive market shifts on central bank policy decisions. Measures of economic policy uncertainty have risen to volatile highs, and such uncertainty is widely believed to stymie investment, arguably the most important constituent of national income for staging an economic recovery.

A perhaps more fundamental problem with discretion as against rules is the huge amount of knowledge it assumes the nine-member MPC can amass and act upon. The optimal response to a supply shock, as Bill Woolsey explains in detail will depend on the demand and supply elasticities in that and other markets, not to mention guessing when and in which markets the shocks will hit. So even if an omniscient and perfectly benevolent despot could set the optimal policy with discretion, a rule-based system could be the best—or least bad—actually possible policy.

Allowing central bankers to decide when to hit their target is just allowing central bankers to decide whatever they think is best, and as Woolsey says, it’s completely unsurprising that they come out generally in favour of the system.

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