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When central banking becomes central planning

The great thing about the blogosphere is that everything is happening in “real-time”. In economic journals the exchange of ideas and arguments can go on forever without getting to any real conclusion and some debates is never undertaken in the economic journals because of the format of journals.

Such a debate is the discussion about whether central banking is central planning, which has been going on between the one hand Kurt Schuler and on the other hand David Glasner and Bill Woolsey. Frankly speaking, I shouldn’t really get involved in this debate as the three gentlemen all are extreme knowledgeable about exactly this topic and they have all written extensively about Free Banking – something that I frankly has not written much about.

In my day-job central banks are just something we accept as a fact that is not up for debate. Anyway, I want to let me readers know about this interesting debate and maybe add a bit of my humble opinion as we go along. There is, however, no reason to “reprint” every single argument in the debate so here are the key links:

From Glasner:

“Gold and Ideology, continued”

“Central Banking is not Central Planning”

“Hayek on the meaning of planning”

“Central Banking and Central Planning, again”

From Schuler:

“Central Banking is a form of Central Planning”

“Once more: central banking is a form of central planning”

From Woolsey:

“Central Banking is Not Central Planning”

Initially my thinking was, yes, of course central banking is central planning, but Bill Woolsey arguments won the day (Sorry David, the Hayek quotes didn’t convince me…).

Here is Bill Woolsey:

“Comprehensive central planning of the economy is the central direction of the production and consumption of all goods services. How many cars do we want this year? How much steel is needed to produce those cars? How much iron ore is needed to produce the steel?…Trying to do this for every good and service all the time for millions of people producing and consuming is really, really hard. Perhaps impossible is not too strong of a word, though that really means impossible to do very well at all, much less do better than a competitive market system…Central banking is very different. It does involve having a monopoly over a very important good–base money. Early on, governments sold that monopoly to private firms, but later either explicitly nationalized the central banks, or regulated and “taxed” them to a point where any private elements are just window dressing…Schuler’s error is to identify this monopoly on the provision of an important good with comprehensive central planning. Yes, a monopolist must determine how much of its product to produce and what price to charge. The central bank must determine what quantity of base money to produce and what interest rate to pay (or charge) on reserve balances. But that is nothing like determining how much of each and every good is to be produced while making sure that the resources needed to produce them are properly delivered to the correct places at the correct times.”

Bill continues (here its gets really convincing…):

“Suppose electric power was produced as a government monopoly. That is certainly realistic. The inefficiency of multiple sets of transmission lines provides a plausible rationale. The government power monopoly would need to determine some pricing scheme and how much power to generate. And, of course, these decisions would have implications for the overall level of economic activity. Not enough capacity, and blackouts disrupt economic activity. Too much capacity, and the higher rates needed to pay for it deter economic activity…It is hard to conceive of an electric utility centrally directing the economy, but it isn’t impossible. Ration electricity to all firms based upon a comprehensive plan for what they should be doing. Any firm that produces the wrong amount and sends it to the wrong place is cut off.”

Central banking might not be central planning

Hence, there is a crucial difference between central planning and a government monopoly on the production of certain goods (as for example money). One can of course argue that if government produces anything it is socialism and therefore central planning. However, then central planning loses its meaning and will just become synonymous with socialism. Therefore, arguing that central banking is central planning as Schuler does is in my view wrong. It might be a integral part of an socialist economic system that money is monopolized, but that is still not the same thing as to say central banking is central planning.

But increasingly central banking is conducted as central planning

While central banking need not to be central banking it is also clear that during certain periods of history and in certain countries monetary policy has been conducted as if part (or actually being part of) a overall central planning scheme. In fact until the early 1980s most Western European economies and the US had massively regulated financial markets and credit and money were to a large extent allocated with central planning methods by the financial authorities and by the central banks. Furthermore, exchange controls meant that there was not a free flow of capital, which “necessitated” central planning of which companies and institutions should have access to foreign currency. Therefore, central banking during the 1970s for example clearly involved significant amounts of central planning.

However, the liberalization of the financial markets in most Western countries during the 1980s sharply reduced the elements of central planning in central banking around the world.

The Great Recession, however, has lead to a reversal of this trend away from “central bank planning” and central banks are increasingly involved in “micromanagement” and what clear feels and look like central planning.

In the US the Federal Reserve has been highly involved in buying “distressed assets” and hence strongly been influencing the relative prices in financial markets. In Europe the ECB has been actively interfering in the pricing of government bonds by actively buying for example Greek or Italian bonds to “support” the prices of these bonds. This obviously is not central banking, but central planning of financial markets. It is not and should not be the task of central banks to influence the allocation of credit and capital.

With central banks increasingly getting involved in micromanaging financial market prices and trying to decide what is the “right price” (contrary to the market price) the central banks obviously are facing the same challenges as any Soviet time central planning would face.

Mises and Hayek convincing won the Socialist calculation debate back in the 1920s and the collapse of communism once and for all proved the impossibility of a central planned economy. I am, however, afraid that central banks around the world have forgotten that lesson and increasing are acting as if it was not Mises and Hayek who prevailed in the Socialist-calculation debate but rather Lerner and Lange.

Furthermore, the central banks’ focus on micromanaging financial market prices is taking away attention from the actual conduct of monetary policy. This should also be a lesson for Market Monetarists who for example have supported quantitative easing in the US. The fact remains that what have been called QE in the US in fact does not have the purpose of increasing the money supply (to reduce monetary disequilibrium), but rather had the purpose of micromanaging financial market prices. Therefore, Market Monetarists should again and again stress that we support central bank actions to reduce monetary disequilibrium within a rule-based framework, but we object to any suggestion of the use  central planning “tools” in the conduct of monetary policy.

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Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

I always enjoy reading whatever George Selgin has to say about monetary theory and monetary policy and I mostly find myself in agreement with him.

George always is very positive towards the views of Milton Friedman, which is something I true enjoy as longtime Friedmanite. I particular like George’s 2008 paper “Milton Friedman and the Case against Currency Monopoly”, in which he describes Friedman’s transformation over the years from being in favour of activist monetary policy to becoming in favour of a constant growth rule for the money supply and then finally to a basically Free Banking view.

I believe that George’s arguments make a lot of sense I and I always thought of Milton Friedman as a much more radical libertarian than it is normally the perception. In my book (it’s in Danish – who will translate it into English?) on Friedman I make the argument that Friedman is a pragmatic revolutionary.

To radical libertarians like Murray Rothbard Milton Friedman seemed like a “pinko” who was compromising with the evil state. Friedman, however, did never compromise, but rather always presented his views in pragmatic fashion, but his ideas would ultimately have an revolutionary impact.

I there are two obvious examples of this. First Friedman’s proposal for a Negative Income Tax and second his proposal school vouchers. Both ideas have been bashed by Austrian school libertarians for compromising with the enemy and for accepting government involvement in education and “social welfare”. However, there is another way to see both proposals and is as privatization strategies. The first step towards the privatization of the production of educational and welfare services.

Furthermore, Friedman’s proposals also makes people think of the advantages if the freedom of choice and once people realize that school vouchers are preferable to a centrally planned school system then they might also realize that free choice as a general principle might be preferable.

In a similar sense one could argue that Scott Sumner and other Market Monetarists are pragmatic revolutionaries when they argue in favour of nominal GDP targeting.

Why is that? Well, it is a well-known result from the Free Banking literature that a privatization of the money supply will lead to money supply becoming perfectly elastic to changes in money demand. Said, in another way any drop in velocity will be accompanied by an “automatic” increase in the money, which effectively would mean that a Free Banking system would “target” nominal NGDP. Hence, as I have often stated NGDP targeting “emulates” a Free Banking outcome. In that sense Sumner’s proposal for NGDP targeting is similar to Friedman’s proposal for school vouchers. It is a step toward more freedom of choice. Scott therefore in many ways also is a pragmatic revolutionary as Friedman was.

There is, however, one crucial difference between Friedman and Sumner is that, while Friedman was in favour of a total privatization of the school system and just saw school vouchers as a step in that direction Scott does not (necessarily) favour Free Banking. Scott argues in favour of NGDP targeting based on its own merits and not as part of a privatization strategy. This is contrary to the Austrian NGDP targeting proponents like Steve Horwitz who clearly see NGDP targeting as a step towards Free Banking. Whether Scott favours Free Banking or not does, however, not change the fact that it might very well be seen as the first step towards the total privatization of the money supply.

Sumner’s proposal the implementation of NGDP futures could in a in similar fashion be seen as a integral part of the privatization of the money supply.

Friedman famously paraphrased the French Word War I Prime Minister George Clemenceau who said that “war is much too serious matter to be entrusted to the military” to “money is much too serious a mater to be entrusted to central banker”. Scott Sumner’s proposal for NGDP targeting within a NGDP futures framework in my view is the first step to taken away central bankers’ control of the money supply…but don’t tell that to the central bankers then they might never go along with NGDP Tageting in the first place.

For Scott own view of the Free Banking story see: “An idealistic defense of pragmatism” – he of course might as well have said “A revolutionary defense of pragmatism”.

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Update: I just found this fantastic quote from George Selgin (from comment section of Scott’s blog): ‘I only wish…that Scott would draw inspiration from Cato the Elder, andend each of his pleas for replacing current Fed practice with NGDP targeting with: “For the rest, I believe that the Federal Reserve System must ultimately be destroyed.”’

Please help Mr. Simor

He is a challenge for you all.

András Simor is governor of the Hungarian central bank (MNB). Next week he will meet with his colleagues in the MNB’s Monetary Council. They will make announcement on the monetary policy action. Mr. Simor needs your help because he is in a tricky situation.

The MNB’s operates an inflation-targeting regime with a 3% inflation target. It is not a 100% credible and the MNB has a rather unfortunate history of overshooting the inflation target. At the moment inflation continues to be slightly above the inflation target and most forecasts shows that even though inflation is forecasted to come down a bit it will likely stay elevated for some time to come. At the same time Hungarian growth is basically zero and the outlook for the wider European economy is not giving much hope for optimism.

With inflation likely to inch down and growth still very weak some might argue that monetary policy should be eased.

However, there is a reason why Mr. Simor is not likely to do this and that is his worries about the state of the Hungarian financial system. More than half of all household loans are in foreign currency – mostly in Swiss franc. Lately the Hungarian forint has been significantly weakened against the Swiss franc (despite the efforts of the Swiss central bank to stop the strengthening of the franc against the euro) and that is significantly increasing the funding costs for both Hungarian households and companies. Hence, for many the weakening of the forint feels like monetary tightening rather monetary easing and if Mr. Simor was to announce next week that he would be cutting interests to spur growth the funding costs for many households and companies would likely go up rather than down.

Mr. Simor is caught between a rock and a hard. Either he cuts interest rates and allows the forint to weaken further in the hope that can spur growth or he does nothing or even hike interest rates to strengthen the forint and therefore ease the pains of Swiss franc funding households and companies.

Mr. Simor does not have an easy job and unfortunately there is little he can do to make things better. Or maybe you have an idea?

PS The Hungarian government is not intent on helping out Mr. Simor in any way.

PPS When I started this blog I promised be less US centric than the other mainly US based Market Monetarist bloggers – I hope that his post is a reminder that I take that promise serious.

PPPS if you care to know the key policy rate in Hungary is 6%, but as you know interest rates are not really a good indicator of monetary policy “tightness”.

NGDP targeting is not about ”stimulus”

Market Monetarists are often misunderstood to think that monetary policy should “stimulate” growth and that monetary policy is like a joystick that can be used to fine-tune the economic development. Our view is in fact rather the opposite. Most Market Monetarists believe that the economy should be left to its own devises and that the more policy makers stay out of the “game” the better as we in general believe that the market rather than governments ensure the most efficient allocation of resources.

Exactly because we believe more in the market than in fine-tuning and government intervention we stress how important it is for monetary policy to provide a transparent, stable and predictable “nominal anchor”. A nominal GDP target could be such an anchor. A price level target could be another.

Traditional monetarists used to think that central banks should provide a stable nominal anchor through a fixed money supply growth rule. Market Monetarists do not disagree with the fundamental thinking behind this. We, however, are sceptical about money supply targeting because of technical and regulatory develops mean that velocity is not constant and because we from time to time see shocks to money demand – as for example during the Great Recession.

A way to illustrate this is the equation of exchange:

M*V=P*Y

If the traditional monetarist assumption hold and V (velocity) is constant then the traditional monetarist rule of a constant growth rate of M equals the Market Monetarist call for a constant growth rate of nominal GDP (PY). There is another crucial difference and that is that Market Monetarists are in favour of targeting the level of PY, while traditional monetarists favours a target of the growth of M. That means that a NGDP level rule has “memory” – if the target overshots one period then growth in NGDP need to be higher the following period.

In the light in the Great Recession what US based Market Monetarists like Bill Woolsey or Scott Sumner have been calling for is basically that M should be expanded to make up for the drop in V we have seen on the back of the Great Recession and bring PY back to its old level path. This is not “stimulus” in the traditional Keynesian sense. Rather it is about re-establishing the “old” monetary equilibrium.

In some way Market Monetarists are to blame for the misunderstandings themselves as they from time to time are calling for “monetary stimulus” and have supported QE1 and QE2. However, in the Market Monetarists sense “monetary stimulus” basically means to fill the whole created by the drop in velocity and while Market Monetarists have supported QE1 and QE2 they have surely been very critical about how quantitative easing has been conducted in the US by the Federal Reserve.

Another way to address the issue is to say that the task of the central bank is to ensure “monetary neutrality”. Normally economists talk about monetary neutrality in a “positive” sense meaning that monetary policy cannot affect real GDP growth and employment in the long run. However, “monetary neutrality” can also be see in a “normative” sense to mean that monetary policy should not influence the allocation of economic resource. The central bank ensures monetary neutrality in a normative sense by always ensuring that the growth of money supply equals that growth of the money demand.

George Selgin and other Free Banking theorists have shown that in a Free Banking world where the money supply has been privatised the money supply is perfectly elastic to changes in money demand. In a Free Banking world an “automatic” increase in M will compensate for any drop V and visa versa. So in that sense a NGDP level target is basically committing the central bank to emulate the Free Banking (the Free Market) outcome in monetary matters.

The believe in the market rather than in “centralized control mechanisms” is also illustrated by the fact that Market Monetarists advocate using market indicators and preferably NGDP futures in the conduct of monetary policy rather than the central bank’s own subjective forecasts. In a world where monetary policy is linked to NGDP futures (or other market prices) the central bank basically do not need a research department to make forecasts. The market will take care of that. In fact monetary policy monetary policy will be completely automatic in the same way a gold standard or a fixed exchange rate policy is “automatic”.

Therefore Market Monetarists are certainly not Keynesian interventionist, but rather Free Banking Theorists that accept that central banks do exists – for now at least. If one wants to take the argument even further one could argue that NGDP level targeting is the first step toward the total privatisation of the money supply.

 

 

 

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