Scott Sumner and other Market Monetarists including myself have been greatly frustrated with the behaviour of central bankers – especially the the Federal Reserve and the ECB. According to Market Monetarists the Great Depression was caused by overly tight monetary policies on both sides of the Atlantic and therefore central banks could long ago have taken us out of the crisis by having eased monetary policy. I have often been asked the question “Lars, if it is so easy why don’t central banks just not do what you suggest?” Scott has an answer to this question:

 I’m inclined to discount most public choice explanations of monetary policy failure, and fall back on the “It’s the stupidity, stupid.” explanation.

I totally disagree. Yes, sure enough I have met central bankers who might be considered to be “stupid”, but the majority of central bankers I have encountered in my career have been well-educated and clever people and they certainly could not be described as stupid. Some of them might have had an different economic model in their head than the model that guides Scott’s and my own thinking, but that does not qualify for stupidity. Not even Scott would seriously argue that Ben Bernanke is stupid. Yes, wrong on monetary policy, but stupid? Certainly not. In the same way nobody would seriously argue that Milton Friedman’s old mentor Arthur Burns was stupid, but despite of that he was the main “architect” of the Great Inflation.

Rather I think we should analyze the conduct of the central bankers with the same tools that we use to analyze the conduct of other economic agents. Scott always forcefully (and rightly!) argues that rational expectations and the Efficient Market Hypothesis are useful tools in analyzing financial market pricing. Scott, how can we argue that investors are not stupid herd following idiots and then at the same time argue that central bankers are just stupid fools? I don’t buy that explanation. Central bankers are utility maximizing individuals like any other bureaucrats. Don’t tell me that the Argentine central bank governor does not believe that when she is printing money at the same speed as Gideon Gono it will not lead to hyperinflation. Of course she knows that.

I therefore strongly believe that if we want to explain the true reason for monetary policy mistakes we need to look at a public choice explanation for the policy mistakes. That said, I think that most public choice explanations of the behavior of central bankers have been extremely simplified and as a result often lead to very mistaken conclusions.

The traditional public choice “model” assumes that the purpose of central banks is to function as a agent of the government and just print money to fund a ever expanding public sector. I find this model highly problematic as it basically assumes that governments and central banks would pursue a policy that would not be in their own self-interest.  The “revenue maximizing” monetary policy is not one of high inflation. Furthermore, governments and central banks full well know that they can not “play” the Phillips curve to maximize the support for the governing political party. Hence, the problem with the “fiscal agent” theory of the central bank is the same as with the first naive models of the political business cycle – it simply assumes too much irrationality (might I say stupidity) among policy makers and also generally a wrong (Keynesian) model of the economy. Therefore, the fiscal agent model (my expression) is really as naive as Scott’s stupidity model. It should be noted that there is of course no real public choice model of central bank behavior, but rather what I call a model is the way public choice oriented economists like Pete Boettke or James Buchanan tend to view central bank behaviour.

A common critique of central bankers is that the behavior of central banks is bias towards inflation. However, that does not square well with the empirical facts. The fiscal agent model can not explain the Great Depression nor can it explain the Great Recession. How come the Greek central bank happily is accepting deflationary pressures in Greece or what how about nearly two decades of deflation in Japan?

If we want to explain the behaviour of central bankers we of course need a rational choice based model. Central bankers are rational individuals. As a consequence we should not expect them to try to maximize “social welfare” (whatever that is…). They will try to maximize their own utility and that might or might not lead to maximization of “social welfare” dependent on the institutional framework.

So while we certainly need a public choice model to explain central bank we need a model that can explain both deflationary and inflationary overshoots. Therefore the fiscal agent model is not a good model. In my view the most suitable model is probably William Niskanen’s Bureaucrat model – as least at a starting point.

The difference between a (proper) public choice based model of central bank behaviour and Scott’s stupidity model is also having that crucial implication that Scott would put more emphasis on convincing central banks to do the “right thing”  (monetary stimulus) while I would put a lot more emphasis on taking away central banks’ room to do the wrong thing. I fully well know that my big hero Scott is in favour of limiting the discretionary powers, but often he will put more emphasis on “doing the right thing” than on the institutional framework. That is sometimes useful, but I believe that it is increasingly important to discuss the institutional framework for monetary policy rather than to discuss whether the Fed should do QE3 or not.

If Market Monetarists fail to acknowledge that central bankers are driven by self-interest rather by than stupidity we are likely just to waste our time. The implication of this is of course that Pete Boettke and Daniel Smith have a point when they argue that we need to debate the institutional framework for monetary policy at least as much as we debate what central banks should do. The two things does not rule out each other, but I think the he real battle is about ensuring the right institutional structures for the monetary regime – whether that is NGDP level targeting or Free Banking. In fact arguments for monetary “stimulus” without a debate about the institutional structures about monetary policy are likely to be at best completely fruitless and at the worst counterproductive.

If you think I sound like Pete Boettke then you are probably not completely wrong. Where Pete is wrong is to use a far too simple model of central bank behavior – central banks are not always biased in an inflationist direction. Pete is also wrong when he is fearful about monetary easing in the US at the same time. So I certainly agree with Scott about the fact that more monetary easing is needed in the US, but I would just like to ensure the success of such policies by doing it within a proper institutional framework.