The Federal Reserve’s powers have grown enormously in response to COVID-19. Its toolkit now includes a dizzying array of direct credit allocation programs. Chairman Jerome Powell is offering to work directly with the Treasury to support another massive expansion of federal debt. This blurs the line between fiscal policy and monetary policy. The increasingly likely prospect of a Biden administration means we’re looking at an activist Fed for the foreseeable future.
The problem is that the Fed has become lawless. As we argue in our forthcoming book, “Money and the Rule of Law” the only way to make monetary policy lawful is to force the Fed to follow a monetary policy rule.
For central bankers, rules that actually bind their hands are anathema. They strongly prefer “constrained discretion” as an operating framework. Constrained discretion supposedly combines the discipline of rules during ordinary times with the flexibility of discretion during extraordinary times. In reality, constrained discretion is just discretion, because central bankers themselves get to decide when to deviate from rule-like behavior. This violates the first principle of the rule of law: One cannot be a judge of one’s own cause.
Without true rules, central banking falls prey to two classes of problems that inhibit economic prosperity. The first is the information problem. Some information problems are technical, such as discovering the values of policy-relevant variables like the natural rates of unemployment and interest. There are also problems with picking appropriate goals, targets and instruments for monetary policy. Yet technical difficulties pale in comparison to true knowledge problems. These stem from the fact that central bankers have no real-time feedback mechanism to ascertain whether they are providing sufficient liquidity to the economy. Discretionary monetary policy is essentially throwing darts at a moving target while blindfolded.
Discretionary central banking is also plagued by the incentive problem. We greatly err when we treat central bankers as benevolent and disinterested technocrats. Like everyone else, central bankers act in their own interests, which frequently differ from the interests of the public. We must remember that discretionary central banking is inherently political. We often applaud Fed independence, but in truth, the Fed is quite sensitive to politics: It’s among the least politically independent central banks in the world. Every presidential administration pressures the Fed chairman, to say nothing of Congress.
Furthermore, perverse incentives arise from within the Fed, too. The Fed is a bureaucracy, subject to all the pathologies of an organization that bears only a tiny fraction of the costs and benefits associated with its decisions. Groupthink and status quo bias are ever-present features of monetary policy decisions. High-level Fed decision makers are unquestionably well-trained and clever, but this does not insulate them from these biases.
What about financial crises? Wouldn’t binding rules make it much harder to put out financial fires? As it turns out, decades of discretion have turned firefighters into arsonists. Every time an important financial institution has gotten into trouble, the Fed has facilitated a bailout. Moral hazard has become thoroughly institutionalized in our financial system. Indeed, the perverse incentives created by gambling with other people’s money is a large part of the explanation for the 2007-8 crisis. This was exacerbated by the Fed’s misguided policy response. Instead of behaving as a responsible lender of last resort, the Fed broke virtually every rule by lending on questionable collateral, failing to charge penalty interest rates and keeping markets in the dark about their next move while the contagion spread. The truth is, it is even more important for monetary rules to bind during a financial crisis. Unpredictable monetary policy necessarily inhibits comprehensive recovery.
A true monetary rule can fix these problems. By forcing the Fed to provide markets with a predictable nominal anchor, we can overcome information and incentive problems. Rather than trying to micromanage economic stability, a rule creates a strong foundation upon which the economy can stabilize itself. And a Fed whose hands are bound can’t engage in politically questionable emergency lending, or other forms of credit allocation. This also lessens moral hazard, which makes financial crises less likely in the first place. Provided we restrict and reorient the Fed with a monetary policy rule, we can do much better economically than we are now.
Some of the economics profession’s greatest minds have pushed for lawful money. Nobel laureates F. A. Hayek, Milton Friedman and James Buchanan spent a good portion of their scholarly careers thinking about sound monetary policy. All ended up rejecting discretion in favor of binding rules. We should heed their advice.
It’s time to end our misguided experiment with lawless money. We need a true monetary policy rule. The stakes are nothing less than predictable money, a stable investment environment and economic flourishing.
Peter Boettke is a professor of economics and philosophy at George Mason University and director of the F. A. Hayek Program for Advanced Study in Philosophy, Politics at the Mercatus Center at George Mason University. Follow him on Twitter @PeterBoettke. Alexander William Salter is an associate professor of economics in the Rawls College of Business at Texas Tech University, and the Comparative Economics Research Fellow at TTU’s Free Market Institute. Follow him on Twitter @alexwsalter. Daniel Smith is s an associate professor of economics in the Jones College of Business at Middle Tennessee State University and the director of the Political Economy Research Institute. Follow him on Twitter @smithdanj1.