The Central Bank’s Powers Should Be Curtailed, Monetary Expert Argues
By Carl Close • Thursday April 22, 2010 2:52 PM PDT • 13 Comments
Professor Richard Timberlake, an Independent Institute research fellow and an economist who has written several books and dozens of journal articles about Federal Reserve monetary policies, sent us the following note today regarding my Lighthouse write-up of “Central Banks as Sources of Financial Instability,” George Selgin‘s superb article in the Spring 2010 issue of The Independent Review. Here, with Prof. Timberlake’s permission, is the note.
I have just read this issue of “The Lighthouse,” and have also read George Selgin’s article about central bank instability in The Independent Review.
I feel obliged to point out that my book, Monetary Policy in the United States, (Univ. of Chicago Press, 1993) treats the instability of central banking at length. Chapter XVI, especially reviews and summarizes the development of central banking up to WW I, both in England in the United States.
I stress particularly that no central bank should be allowed any discretion. Congress should give the Fed a MANDATE to maintain absolute stability in the price level, and, perforce, in the value of the money unit. The precedent for this action is the policy initiated by Benjamin Strong, President of the NY Fed between 1922 and 1929 (see my article in the TIR, Winter 2007). Fed bureaucrats could perhaps squirm around this Rule, but would have to follow it generally because it is so easily verified — just look at a CPI. This rule would force them to abolish their “bailouts,” “stimulus” and “too big to fail” activities, and anything else that tended to involve them in real variables, such as “employment” or “growth,” about which they can do nothing.
The Stable Price Level Rule (SPLR) is the only way to harness a central bank. If we could get rid of the Fed, say, by a law that freezes the Monetary Base, we could provide a free market monetary system, perhaps with a gold standard as an option. (I cover this possibility in my book, too. See the last Chapter, Ch. 27, “What the Fed Cannot Do; What the Fed Can Do; What the Fed Should Do.”) Given political realities, however, Congress can force a SPRL Rule on the Fed. Alan Greenspan approved the idea while he was Chairman of the Fed Board, when it was initiated in Congress by Rep. Stephen Neal (DEM. N.C.). Several Fed Bank Presidents did, too. So it is politically possible.
I hope you will put this note where it can be read. I think it is important for a general understanding of the Fed, that someone treated these issues professionally. Let me know if you would like more.
This prompts me to ask Beacon readers two questions: (1) What would it take to get Congress to require the Fed to adopt a Stable Price Level Rule, such as the one Prof. Timberlake recommends? (2) What, if any, alternative reform(s) of the Federal Reserve do you believe would produce economic outcomes superior to what Timberlake proposes and would be politically possible?
(Offer your comments below. The person who, in my judgment, posts the most thoughtful answer to both questions by 3PM Pacific Time on Monday, April 26, will receive a free copy of Money and the Nation State, edited by Kevin Dowd and Richard Timberlake, and Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775-1821, by George Selgin. You can still post your comments after then, but that will be the deadline for the contest.)
Tags: Economics, Federal Reserve, Money and Banking, Uncategorized 
The subject of Stable Price Level Rule ties into the fiscal policies of Congress. Before we can have anything like that, spending has to be slashed heavily. Anything else is putting the cart before the horse. Greasing the wheels might be human stories of people hurt by inflation, such as the poor who’s wages don’t always keep up with prices.
The most important thing that can be done is to make the Federal Reserve a system of rules. I envision the Federal Reserve as a network of automated systems, which would expand and contract the money supply based on pre-programmed equations. Economists like John Taylor and Milton Friedman devised numerous equations that would determine how much money is in circulation. People who actually run the Fed can’t be counted on to follow them. Computers, having no biases or stakes in the game, would apply the equations without fail. In brief, the money supply would be run by equations, not human beings.
Tristan Band | Apr 22, 2010 | Reply
Tristan,
Who programs the computers you’re relying on to make the system of rules that will transform the world for the better?
I don’t understand why people can make a distinction between interest rates on one hand and prices for everything else on the other. No one but an unreconstructed Soviet commissar would believe that economic central planning, particularly the cost of borrowing money, could be adequately managed by a room full of bureaucrats, no matter how well-intentioned and intelligent they claim to be.
How many times must we relearn the same painful lesson? Central planning does not work. It cannot work. The result is about to make itself known to millions in the form of impoverishment and despotism.
Steve Hogan | Apr 22, 2010 | Reply
Steve,
“Planning” implies agency, and equations don’t plan; they change in response to incoming data. The Taylor Rule, for example, is the same regardless of who programs it. So are Friedman’s equations What I am proposing is to take the central bank out of the hands of bureaucrats, out of the hands of human agency. Instead of interest rates being set arbitrarily by Ben, it would be automatically adjusted in response to economic indicators.
In terms of who programs it, you raise an interesting point. Perhaps open sourcing the program work would ease your concerns? With a million eyeballs, wrongdoing would be immediately corrected. I’m not an Austrian, nor am I interested in preaching to the choir.
Tristan Band | Apr 23, 2010 | Reply
While I think Professor Timberlake’s price level stability rule is a good idea, one possible fly in the ointment is that the government defines the CPI. Its definition not only can be changed, but has been changed, in significant ways over the years. Two major examples are the move to chain-weighting, and redefinitions in the housing component of the index. I like the idea of the Fed focusing solely on price level stability, but I fear that if this were made into a mandatory rule, tied to a government-defined price index, the index would be redefined to essentially mandate permanent inflation.
Randall Holcombe | Apr 23, 2010 | Reply
Any ideas on how the CPI issue could be resolved?
Tristan Band | Apr 23, 2010 | Reply
No good ideas come to mind, Tristan. One problem is that all price indexes measure the cost of something (for example, the cost of living for the CPI), whereas what you’d really like to measure with regard to Fed performance is the value of money. The difference is that if the opportunity cost of something goes down, you actually do want its price to go down (for example, computers), whereas if the opportunity cost of something goes up, you want its price to go up. Price level stability approximates this, but because of productivity increases, a stable value of the dollar would actually imply a falling price level.
More to the present point, the market basket of goods that makes up the consumer purchases that are measured in the CPI is always changing, and what goes in it is somewhat arbitrary (as changes in the definition of the housing component show). As long as it it just used as a measure of the cost of living, there isn’t too much motivation to manipulate it for political purposes. If it were to become a benchmark for Fed performance, incentives for manipulation appear.
Perhaps there would be a way to create an impartial group to manage the CPI, but I’m not sure how you would insulate it from politics. And perhaps there might be some permanent formula or rule for changing the formula that could be implemented, but that would seem to suffer from the problem of unforeseen consequences in the rule’s design that might, over time, make the CPI a less reliable, or even inappropriate, indicator.
That’s my long answer, Tristan. My short answer is “No.” I’d be happy to hear anyone else’s ideas on this.
Randall Holcombe | Apr 23, 2010 | Reply
Well, we’re both in agreement that rules need to play a bigger role than people. The problems with the unforeseeable consequences means that the Fed’s tasks should be as few as possible, and as simple as possible. Key to keeping politics out is keeping human agency out as much as possible. Rules, rather than the discretion of bankers, go far in accomplishing this.
Tristan Band | Apr 23, 2010 | Reply
Relative to the current monetary arrangements of vast discretion and inconsistency between Chairman Bernanke and the Congress and Treasury, I think Prof. Timberlake’s appeal to establish a “MANDATE to maintain absolute stability in the price level, and, perforce, in the value of the money unit” would be a welcomed improvement. But the issue is relative to what. The present institutional arrangements of the nation’s (world’s?) monetary policy are so unstable that Prof. Timberlake’s proposal would probably produce a substantial improvement. But it’s not preferable. For a pretty detailed and thorough critique of the Fisherian-Friedmanite-Timberlake proposal, see parts one and two of this book.
So long as human life exists in a state of constant change, so too will the value of the monetary unit. What’s most important in my view is to establish a concrete, definite understanding of what the monetary unit is. Once it’s attached to something tangible, then the price system can be the break that allows the system to adjust, rather than attempting to adjust the supply of the units in circulation to some imagined “price level” of all goods and services in different sectors throughout the economy. Prof. Timberlake’s proposal is not capable of attaining the policy ends sought.
Ryan Szabo | Apr 23, 2010 | Reply
It is a near certainty that the United States Congress would never force the Fed’s hand towards a Stable Price Level Rule. There are many reasons for this, however, one of the biggest is housing. To quote Allan Meltzer, “housing is a sacred cow” perhaps the most sacred, in the halls of Congress. In a society in which a house is the largest and most important investment a person makes, Congress has an incentive to promote home ownership, towards unsustainable levels, in an effort to give “the folks” the feeling of prosperity. Such an incentive gives us Fannie, Freddie, the FHA, the (problematic) mortgage-interest deduction, etc. Thus, if there was ever going to be a move towards the SPLR, that originated from Congress, it would take a financial crisis far worse than the one we just went through, and very well may not fully be out of. It would take a shock of such proportion that congressmen could return to their districts and say, “The last crisis was so severe, with such devastating deflation, that we must now pursue a monetary policy of stable prices.” It is highly unlikely that anyone would argue that the kind of crisis to make such a statement palatable to voters could survive a cost-benefit analysis.
To point 2, it is worth asking whether or not we would want to pursue an SPLR were it politically viable. After all it was Hayek who argued that stabilizing prices would not eliminate credit bubbles. With stable prices in an environment of growing output (which we of course always hope for) the central bank would have to inject credit into the economy to keep prices level. This could create another kind of bubble, and Hayek worried that it could be a severe one (though he backed away from these views later in life, it remains a concern worth exploring.) Rather than adopt an SPLR, instead of the current focus on interest rates, a good central bank reform would in terms of rules rather than goals. Attempting to change the role of Fed, or Congress’s power over it, are both political non-starters. However, given the public’s disgust with the reckless actions of the government and some large financial institutions (in combinations of varying degrees) it might be possible to delineate rules, clear and accessible to all citizens, that would prevent the Fed from having policies that allowed the rescue of Bear Sterns creditors in March, and the subsequent failure Lehman. Reasonable people will forever debate the merits and necessity of these decisions. However, it seems beyond question that had there been a system of rules in place that were well understood, in advance of the crisis (that is critical), the process of dealing with failed institutions would have been more manageable, precisely because they would have been more predictable.
In truth, we are never going to get discretion out of the Fed. And there are compelling arguments as to why we would not want to. This is why a great first step towards Fed reform would be to create a set of rules, which we all could understand, that would make dealing with crises easier. After all, it is a crisis that does the most damage, therefore, it makes the most sense to attempt to smooth future crises first. And to borrow from Mr Emanuel, in our current climate, a rules based reform of the central bank just might be possible.
Thomas G. Lacey | Apr 26, 2010 | Reply
Perhaps we could just allow free market money to compete with Federal Reserve Notes, thus encouraging the Fed to moderate its action and/or making it increasingly irrelevant. This could be done through passage of the Free Competition in Currency Act. See here.
Perry Willis | Apr 27, 2010 | Reply
Competition for the managers of the US dollar is the only long-run discipline, but neither the euro nor any other national currency is rising to the challenge. The “Free Competition in Currency Act” goes in the right direction, but not far enough. As Professor Timberlake (and I) have written in the past, denationalizing the gold stock is necessary and legislating “specific performance” must be added to the end of “legal tender.” Finally, payment of tax obligations is something other than the liabilities of a central bank is necessary. All this is set forth in my money paper at the Fraser Institute and here.
The lack of fiscal discipline will test the “fiscal dominance hypothesis” and lead to calls for a new “US Gold Commission.” I served on the first one with Ron Paul and we made a bit of progress, but the next one will need to go much further in answering Hayek’s call for “Denationalizing Money.”
Jerry L. Jordan | Apr 28, 2010 | Reply
Correction: 2nd from last sentence in 1st para. should read “...obligations in something...”
Jerry L. Jordan | Apr 28, 2010 | Reply