Anthony J. Evans is Associate Professor of Economics at ESCP Europe Business School, and a member of the Institute of Economics Affairs and Sunday Times’ Shadow Monetary Policy Committee.
Should we expect policymakers to be any more successful at planning the monetary system than they are at planning other parts of the economy?
Many economists fail to consider this question, so it should be little surprise that elected MPs, civil servants, and the general public have a blind spot on the issue. But the 2008 financial crisis has made matters of monetary policy highly pertinent, and there is plenty of room for improvement.
Today the Adam Smith Institute have published my new policy paper, “Sound Money: An Austrian proposal for free banking, NGDP targets, and OMO reforms”. It is a comprehensive plea for more radical thinking at the Bank of England.
By the end of his career even Milton Friedman, the ‘Godfather of Monetarism’ and one of the economics professions most decorated and respected figures, came around to the conclusion that central banks cause more damage than they prevent, and we may well be better off without them.
When Friedman passed away in 2006, the global economy was on the verge of a stunning meltdown, and he would have struggled to imagine the scale and scope of interventions that policymakers have made to the banking system.
It has been propped up at all costs, with little regard for the rule or law or alternative schools of thought. We saved the system but the economy crashed.
In 2009 the Bank of England adopted Quantitative Easing, and this was followed by the introduction of Forward Guidance. Both of these tools have been tacked onto the prevailing regime of using interest rates to target inflation.
Switching from the price of central bank reserves to the quantity is not all that radical, and given that central banks gain their power from their ability to control the monetary base (i.e. cash and reserves) perhaps this should remain their focus. Unfortunately the way that QE has been administered has been ad hoc and signalled panic.
QE would be more effective if it were: tied to a specific nominal target; punitive (rather than a subsidy); open access; standalone; and as neutral as possible. Instead of a distinction between conventional and emergency monetary policy, we could have a coherent framework that is known and used before a crisis strikes.
In addition to experimenting with a myriad of alternative (and sometimes conflicting) monetary policy tools, there is also uncertainty around the target. We live in a bizarre world where inflation continually misses the two per cent target rate and yet the Chancellor lauds this as being beneficial.
The Bank of England are right to “see through” mild deflation when it is caused by beneficial supply shocks, and indeed the Bank of England should have seen through the inflation spikes of 2008 that were caused by adverse supply shocks. But when good monetary policy requires you to ignore your inflation target, it’s time for a change.
Targeting the combined growth rate of inflation and real GDP (i.e. a nominal GDP target) would have reduced the severity of downturn and would respond better to supply shocks going forward. It is better able to ensure that money supply responds to changes in the demand for money, and thus leads to a neutral monetary policy.
When advocating a specific target there’s a trade-off to be made in terms of data availability, political feasibility and the ease of communication. My preference is for the Bank of England to use reformed QE to ensure that NGDP expectations grow at an average of two per cent per year (over a five year rolling period).
This should be long enough to serve as a de factor level target (and thus people will expect that any short falls in NGDP will be caught up in later periods), whilst short enough to ensure political accountability.
Despite the significant advantages that would come from reforming the current monetary policy tools and target, central bankers would still face insurmountable knowledge and incentive problems. Therefore, in ‘Sound Money’ I argue that the ultimate goal should be a banking system where private firms face low barriers to entry and are able to compete with each other to issue whatever forms of money the public wish to use – in short, “free banking”.
Since FA Hayek pioneered the idea in the 1970s there has been important theoretical and empirical contributions by the likes of Kevin Dowd, Lawrence H White, and George Selgin, and they deserve wider attention and deeper consideration.
Free banks wouldn’t lead to unconstrained credit creation; aren’t prone to bank runs; and would help macroeconomic stabilisation. As radical as it may seem to abolish central banks, they are not natural consequences of the market and are not necessary components of a monetary system.
At an event to pay tribute to Milton Friedman the then Governor of the Federal Reserve, Ben Bernanke, said the following:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Alas they did, and they will continue to do so unless we reform the system.
Those who favour free markets generally should not be blasé about the monetary mishaps that central banks cause. Planning committees are the antithesis of rational economic calculation and we should strive to eliminate them.
But we also have to play with the cards we’ve been dealt. Whilst QE reforms and NGDP targets aren’t perfect, they are an improvement on the status quo and – critically – they can be viewed as part of a coherent strategy to start moving in the right direction. It is time for sound money