I recently got reminded of an excellent quote from John Stuart Mill (The Principles of Political Economy with Some of Their Applications to Social Philosophy, 1848):
“There cannot . . . be a more intrinsically insignificant thing, in the economy of society, than money: . . . It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.”
So what is Mill saying? The story essentially is that as long as monetary policy “works” everybody basically forgets about monetary policy. Hence, as long as the monetary regime does not distort relative prices and mess up the economic system nobody will pay attention to the monetary system. It is only when the machinery for some reason breaks down that people are starting to notice and discuss monetary policy matters.
This is why most economists during the Great Moderation showed little interest in monetary policy matters. After all, what impact did monetary policy have? Well, it have great impact in the sense that we in generally from the mid-1980s and until 2008 in the Western world had fairly well-functioning monetary policy and a regime that in general did not distort relative prices. The monetary regime ensured stable and predictable growth in nominal spending and low and stable inflation.
The is no optimal monetary regime, but there is an “optimal purpose”
I have often thought about why two so prominent thinkers as Milton Friedman and F.A. Hayek did not consistently advocate the same monetary policy regime through their lives. Instead both of them at times argued in favour of some kind of commodity standard, both at certain times seemed to have advocated full reserve banking, Friedman famously also argued for a fixed monetary supply growth rate, but later argued for a “frozen” money base. Both to some degree at some point also favoured Free Banking.
So while both Friedman and Hayek’s monetary thinking didn’t change much over the years they both nonetheless ended up again and again changing their preferred monetary policy regime.
I don’t think that this illustrates some kind of inconsistency in their thinking. Rather I believe that it illustrates that there is no such thing as an “optimal” monetary regime. What is “optimal” changes over time and is also different from country to country.
Just think of the US and Iceland. The US is the largest economy in the world and nobody questions the US’ ability to maintain the dollar. On the other hand a very small country like Iceland might not rationally be big enough to maintain a currency of its own.
Similarly we can easily argue for nominal GDP targeting in the US. But how about NGDP targeting for Zimbabwe? Would we trust that the NGDP data for Zimbabwe is good and timely enough for us to conduct monetary policy based on it?
And finally what is or is not an “Optimal Currency Area” today might not maintain that status in the future – just think of institutional and legal changes, technological development etc. Normally we for example say that labour mobility is key to different countries sharing a currency, but what if the technological development means that we in the future will be able to do most of our work from home?
I believe that these examples illustrate that there we should not expect that there is a “one size fits all” monetary policy regime. That is also why while I am happy to advocate NGDP level targeting for the US or the euro zone, but is much less inclined to advocate it for Iceland or Angola.
Instead I think it is helpful instead of starting out with discussing monetary rules we should start out discussing what we want our monetary machine to produce. Furthermore, we also want to discuss what the monetary machine cannot produce.
And here I think the answer is pretty clear. To me the monetary machine should basically ensure “neutrality” – not in the traditional textbook form of money neutrality – but rather in the normative form of the word. Neutrality in my definition means a monetary policy that does not distort relative prices in the economy.
Or as Hayek at length explains in Prices and Production (1931):
“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ”frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance. But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy.”
The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”
So what Hayek is telling us is that any monetary policy rule should be based on its ability to ensure neutrality in the sense of ensuring that there will be no distortion of relative prices. But Hayek is also telling us that it might not be possible to find the “perfect” monetary policy rule among other things because of institutional factors such as price rigidities and contracts.
Therefore when we discuss actual monetary reform rather than just talk on a purely theoretical basis institutional factors come into play.
If it ain’t broke, don’t fix it
Since we cannot in practical terms talk about an “optimal” monetary regime we are in that – for the revolutionary-minded monetary reformer (like myself) – unpleasant situation that we essentially have to choose between different imperfect regimes.
For example imagine that we have a system that most of the time provides a stable monetary machinery with a high degree of nominal stability and little distortion of relative prices, but every 7-8 years something goes wrong and we get a mid-size recession or a asset bubble and every 30 years we get a nasty “Great Recession” or a “Great Inflation”.
So the Machine is certainly not perfect, but for most of the time it works well and most importantly the system is not questioned by policy makers in general and therefore is to a very large extent rule based.
Maybe this is how we should think of the gold standard or inflation targeting. Both are regimes that have worked fairly well during fairly long periods of times, but then in the case of the gold standard finally broke down in the 1930s and presently we might be in a process of abandoning inflation targeting.
One could of course argue that somebody should have ended the gold standard before or reformed it before it collapsed, but that would have meant opening the door for a discussion of alternative monetary regimes that would be much less rule based and potentially would provide even less monetary stability.
What I here is trying to articulate is that there might be a trade-off between the wish for a well-functioning monetary machine (nominal stability, no distortion of relative prices) and the wish for a “robust” monetary machine in the sense that the machine cannot be “high-jacked” by crazy policy makers of some kind.
An example that comes to mind is Canada’s inflation targeting regime. Overall, if we look at the economic performance of the Canadian economy since the early 1990s when the present regime was introduced the regime has been a huge success.
However, we all also know that theoretically at least the system could be improved if we moved from inflation targeting to nominal GDP targeting as there is an in-build tendency for inflation targeting central banks to react to supply shock and hence distort relative prices, which should be a no-go for any central bank.
However, should the Canadians throw out a regime that overall has worked fairly to experiment with another regime – such as NGDP targeting? By opening the door for change one would maybe in the process change the political perception of the regime and thereby make the regime less robust. And not sure about the answer, but I do believe that sometimes we should accept what we have and maybe go for gradual reform of the regime rather than risk making “regime choice” something we make every 3-4 years.
Many ways to nominal stability
I finally want to say sorry to my readers for this post probably not being the best organised post I – I wrote over a number of days and frankly speaking this is mostly part of my “thinking process” regarding the question of how to choose a monetary regime. I am sure I soon will return to the topic and I hope I haven’t been wasting your time to get to the conclusion – nominal stability can be relatively clearly defined, but there are many ways that can lead us to nominal stability.