What can Niskanan teach us about central bank bureaucrats?

 Numerous studies have shown that prediction markets performs remarkably well. For example prediction markets consistently beats opinion polls in predicting the outcome of elections. In general the wisdom of crowds is an extremely powerful tool for forecasting and there no doubt the markets are the best aggregators of information known to man.

Market Monetarists advocate using the power of prediction markets to guide monetary policy. Scott Sumner of course is advocating using NGDP futures in the implementation of monetary policy (as do I). Furthermore, I have advocated that central banks replace their internal macroeconomic forecasts with prediction markets and also that central banks could use Robin Hanson-style prediction markets to choose between different policy instruments in the implementation of monetary policy.

The advantages of using prediction markets are in my view so obvious that one can only wonder why prediction markets are not used more by policy makers – not only in monetary policy, but just think about the endless discussions about “climate change”. Why have policy makers not set-up prediction markets for the outcome of different “climate initiatives”? I think the explanation have to be found in public choice theory.

William Niskanen argues forcefully in his classic book on “Bureaucracy and Representative Government” (1971) that bureaucrats are no different from the rest of us – their actions are determined by what is in their own self-interest. Niskanen claims – and I think he is more or less right (I used to be civil servant) – that that implies that bureaucrats are maximizing budgets.

So how do bureaucrats maximize their department budgets? Well, it’s really simply – they use asymmetrical information. Take what is now called the Department of Homeland Security in the US. The job of the Department of Homeland Security’s is to monitor the risk of terror attacks on the US and implement policies to reduce the threat against “homeland security” (whatever that is…). If the Department of Homeland Security can convince the US taxpayers that the US faces a massive terror threat then the department is more likely to get allocated more funds. So if the Department of Homeland Security bureaucrats want to maximize their budget then it just have to convince the American public that the US faces a very large terror threat.

The average US taxpayer does not really have a large incentive to go out and find out how big the terror threat really is and remember as Bryan Caplan tells us that voters tend to be rationally irrational (they don’t really have an incentive to be rational in terms of political issues) and as a consequence the average US taxpayer would happily accept any assessment made by the Department of Homeland Security about the level of the terror threat. Hence, if the Department of Homeland Security overestimates the terror threat it will be able to increase its budget and as the Department has superior knowledge of the real threat level it can easily to do so. This of course is just an example and I have no clue whether the authorities are overestimating the terror threat (I am sure my US readers will be happy to tell me if this is the case).

Hence, a bureaucrat can according to Niskanen’s theory maximize its budgets by using asymmetrical information. However, there is a way around this and reduce the power of bureaucrats. It is really simple – we just introduce prediction markets.

Lets say that we set up one prediction market asking the following question: “Will more people die in terror attacks than in will die in drowning accidents in the US in 2012?”  – Then this “terror/drowning”-prediction could be used to allocate funds to the Department of Homeland Security. My guess is that we would be looking at major budget cuts at the Department of Homeland Security. What do you think?

Anyway, my concern is not really the Department of Homeland Security, but rather monetary policy. If you think that the bureaucrats at the US Department of Homeland Security would use asymmetrical information to increase their budgets what do you think central banks around the world would do? Why would you expect central bank’s to pursue any given economic target in the conduct of monetary policy? And why would you trust the central banks to produce unbiased forecasts etc.?

Why is it for example that the Federal Reserve is so reluctant to formulate a clear nominal target? Could it be that it would not be in the bureaucratic interest of the institution? Could it be that central bank bureaucrats are afraid that they would be held accountable if they miss their target?

I don’t know if it is so, but if not then why not just formulate a clear and measurable nominal target? For example a target to increase nominal GDP by 10% by the end of 2013? And why not then use the opportunity to set up a NGDP futures markets? And why not let prediction markets take care of the Fed’s forecasts?

I am not saying that Ben Bernanke and his colleagues are Niskanen style bureaucrats, but if they want to prove that they are not then I am sure that Scott Sumner or Robin Hanson will be happy to advise them on setting up a NGDP futures market (or any other prediction market).

Of course the US Congress (or whoever is in charge) could also just regulate the FOMC member’s salaries based on their ability to hit a given target…

PS The so-called Policy Analysis Market (PAM) actually was meant to be used to among other thing assess the global terror threat. The project was shot down after political criticism of the project.

PPS our friend Scott Sumner is not all about monetary policy – he has also done research on how to use Prediction Markets to Guide Global Warming Policy.

PPS George Selgin would of course tell us that there is an even better solution to the “central-bankers-as-budget-maximizing-bureaucrats”-problem…

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Robin Hanson’s brilliant idea for central bank decision-making

George Mason University professor Robin Hanson in my view is one of the most thought-provoking and innovative thinkers in the world. I often read Hanson’s blog Overcoming Bias and I always find my own views challenged and even though Hanson’s views often seem outrageous they surely make you think and personally I often conclude that Hanson is right.

One of Robin Hanson’s most provocative ideas is his suggestion to replace democracy with what he calls Futarchy. Hanson first presented this idea in his paper “Shall We Vote on Values, But Bet on Outcome?” originally from 2000 (and revised in 2007). Hanson’s view is that democracies often fail to aggregate information and different forms of bias – well known from the Public Choice literature – plague democracy, while the market mechanism is a much better aggregator of information that should be utilised in the decision making process.

Hanson thinks that democratically elected officials should vote on what objectives (“Values”) to pursue, but not on how to achieve these objectives.  Hanson instead suggest using Decision Markets to make decisions instead of voting on different proposals.

Most people will find Hanson’s suggestion outrageous and I am not advocating Futarchy as a general form of government, but I do think that Hanson’s idea have lot of merit in regard to the conduct of central banking (assuming that we want to have central banks in the first place…)

Today most “modern” central banks have some more or less clearly stated objective (“values” in Hanson’s terminology). For example the Swedish Riksbank, the New Zealand Reserve Bank or the Polish central bank all have relatively clearly defined inflation targets, while the ECB as objective has to ensure “price stability” (in praxis defined as an inflation target of 2%) and the Federal Reserve has the (in)famous “dual mandate” (price stability and a high level of employment). Market Monetarists of course are advocating NGDP level targeting.

Central banks around the world are relatively clear on what they want to achieve – at least on paper. However, when it comes to the question of how to achieve these objectives it is often a lot less clear. A reason for that is that economists often disagree on what model best describes the economy. Furthermore, often disagreement in what really should be the objective of the central bank blurs policy discussions. I have previously argued that central banks should utilise prediction markets to do macroeconomic forecasting, but why not take this one step further and listen to Robin Hanson and introduce Futarchy as the basis for decision-making in monetary policy? (Please note here that I am “just” thinking out loud here. I have no clue whether this is a good idea, but if we don’t play around with ideas we will never make progress…)

Today the decision-making process in most central banks follows a pretty well-defined “industry standard”, where policy decisions often are made on a monthly basis by what is often termed something like monetary policy committee (MPC). In the US this of course is the FOMC. Policy decisions are then made by a “democratic” method where the MPC members vote on different policy proposals – for example to cut or hike interest rates or to engage in asset buying and open market operations etc. The central bank’s research department will often play a key role in the decision making process as the research department will present scenario analysis based on different proposals. There are of course variations from country to country but I think this is pretty close to the “real-life” praxis in for example the Bank of England, the ECB and the Federal Reserve. The Bank of Israel is an interesting exemption. Here BoI governor Stanley Fischer is “monetary dictator” as he alone – at least on paper – makes decisions on monetary policy.

A monetary policy making process based on Futarchy would change that decision-making process in a significantly more transparent direction. Here is a simple illustrative “proposal” (I stress again that I am thinking out loud).

I imagine a four-step procedure. First, the MPC would vote on what objective to pursue – for example a NGDP level target and a target for the growth path of NGDP. Most likely that objective would be reaffirmed very month.

Second, each member of the MPC would be allowed to suggest a proposal for how to achieve the agreed policy objective. To make things simple the MPC would be asked to decide on from all the suggestions on three different suggestions based on the gross list of proposals. It would be conditioned that these proposals where clearly defined in terms of timing and execution – for example the central bank will buy X dollars (or whatever currency) of foreign currency every month in the coming 6 months or the central bank will increase the overnight rate by 25bp every quarter in the coming year. Compared to today’s policy-making process this would be much more transparent and clear to market participants.

Third, the central bank would set-up “policy markets” for each of the three policy proposals. These markets then will give an implicit estimate on the probability that each of the proposals will be successful in achieving the stated policy goal.  I imagine the markets are opened the day after the MPC decision and then be open initially for a week.

Forth, the one of the three policy proposals the market judges to have the highest probability of succeeding in achieving the policy objective is put into action. The two other policy markets would be closed down again and the investors in these markets would get their money back. This will happen one week after the three markets have been opened. Obviously the price of the chosen proposal would jump once it becomes clear that it will be put into action. This market will then automatically give a market based forecast on the likely outcome in terms of the overall policy objective of the chosen policy instrument.

Lets relate this to the present US monetary policy and lets assume the Fed has decided that it would target a return of NGDP to the pre-crisis trend by the end of 2014. The FOMC agrees on three alternative policy proposals to achieve this policy objective. 1) Ben’s solution: The Fed will keep interest rates at basically zero until late 2014. 2) Scott’s solution: The Fed will issue NGDP futures and target a level for the futures, which is compatible with the overall policy objective.  3) Irving’s solution: A modified version of the compensated dollar plan – the Fed will buy unlimited amounts of commodities until NGDP reaches the target level.

I wonder how the markets would price these three proposals, but it doesn’t really matter because if you believe in the wisdom of the crowds then you will trust the markets will choose the policy that best ensures the overall objective. Furthermore, a complete commitment to the overall set-up would probably ensure that the markets would do a lot of the lifting on its own.

But yes, let me just say that I am still just thinking out loud, but I am looking forward to hear what my readers think of this “minor” institutional reform idea.

PS George Selgin would of course say that we should just get rid of central banks all together and Scott Sumner would say why not just implement NGDP futures? I would not argue with George and Scott, but for now we just want people to start thinking serious about monetary policy. And there is of course no conflict between a Hansonian monetary system and Scott’s ideas (which on it own could be seen as a privatisation strategy)

PPS In Hanson’s Futarchy paper he in fact briefly discusses monetary policy and decision markets.

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