Market Monetarism is not Really Free Market

Or at least not in its current incarnation. (And why market monetarists are a lot more like Milton Friedman, who actually influenced policy and intellectual development in a profound way, than Murray Rothbard who is snubbed as a neo-confederate pariah).

Because many monetarists like Scott Sumner, Lars Christensen, etc. have very pronounced market sympathies, they occasionally get defensive about their support for nominal income targeting. Most recently, Christensen went out of his way to argue that easy money is not a bailout. I’m a fan of a nominal income target, and I’m also generally a fan of “free minds and free markets“. And while market monetarism is a shining example of the latter former, I don’t think it hits the former latter. Here’s why.

Regulation:

If there’s one thing classical liberals and libertarians hate more than taxes, it’s regulation. But it is frankly absurd to think monetary policy should be used to smooth the business cycle without smart rules in place. Without any regulation, under such a regime, a housing bubble would force the central bank to increase rates and pummel the economy into recession. This hardly sounds fair to the job creator entrepreneur in Silicon Valley that can’t get funding for his new idea because the animal spirits on Wall Street have been on a credit binge. I’m not sure where monetarists like Sumner fall on necessity of deposit insurance, but with such deeply ingrained federal institutions, it is ridiculous to think a nominal target would be tolerated without sound regulation.

Monetary policy is a hammer, not a scalpel. That means if we’re using it aggressively, we better wear safety goggles.

Inflation…

…is a capital tax, and Sumner agrees:

After all, when prices rise, incomes usually rise as well. Instead, many economists would argue that high inflation is a sort of tax on capital: Our tax system punishes savers during high-inflation periods like the 1970s, as people must pay taxes on capital earnings that merely reflect price increases driven by inflation. The result is reduced saving and investment.

Anyone who reads his blog knows that Sumner is no fan of an inflation target. And reasonably so: a supply-shock under this policy would force deflation on other goods and services. Considering the nominal rigidity of wages, this would be a particularly tricky and dangerous situation. However, in periods of stagnation like today, a nominal target can be sustained only with more inflation, that is a higher effective target to close the gap from current nominal income to trend.

Using a central bank to spur consumption and devalue savings is functionally similar to a tax-and-spend fiscal policy. Now, unless money is directly deposited everyone’s checking account, rent seeking is a problem, too. The discount window gives bankers free money which are then invested in riskier assets. The inflation is socialized and the benefits are, well, privatized.

To be fair, this is actually an exception to the rule. If central banks never let nominal expenditures fall in the way they did, above-trend inflation would never be necessary (unless real, long-term growth permanently falls).

Free Banking:

Austrians are notorious for thinking a gold standard is a good idea. But perhaps their most charming idea is the idea of competitive banks each issuing notes which would be traded on the open market. Today, the government has absolute monopoly on the issue and transaction of currency.

And like any other monopolist, setting the price – the interest rate – is the sole provenance of our central bank. Again, to be fair, if NGDP was targeted via a futures market, it’s fair to say the power of each member of the FOMC is significantly reduced. (As Sumner recently put it to Noah Smith, this would be liked increasing the FOMC size to millions, where good votes are incentivized and bad ones penalized).

However, I think a NGDP target should be executed more conservatively. Market efficiency is predicated on selfish, profit-maximizing agents, that would vote/trade based on the best information available. Is it not possible that those with asymmetric information and huge market power (TBTF banks) can manipulate the interest rate, somehow? Maybe my logic here is flawed, but it leads me to my final point…

Theory of the Second Best

In 1956, Richard Lipsey and Kelvin Lancaster proved that if one of many conditions of optimality cannot be satisfied, it is possible that the next-best alternative involves changing other conditions from what was otherwise optimal. In their words:

The general theorem for the second-best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable.

By having a government, and by modern extension a central bank, we violate one of the many classically liberal optimality conditions. Once we have centralized governance, it is not at all clear that, except in specific cases (such as a too-high income tax), a linear movement towards free markets is desirable. This brings me in full circle to regulation. We have a set of institutions based on our social contract to protect small savings (FDIC) and provide for the needy. As our welfare state continues to grow due to social pressures, the linear movement in certain sectors towards libertarianism seems ever more imprudent.

I say this, reading Scott Sumner’s remarks on free banking (he’s sympathetic) and Lars Christensen’s argument that a nominal target is on the way to privatizing the Fed. (Shh! Don’t tell the lefties). As our system of money, government, and social contract becomes more complicated by the day, I cannot believe that free banking is our next best alternative.

A standard, non-futures market, target broadly asserts the currency monopoly. As a supporter, I clearly believe that monetary policy is at its best when calming the nominal business cycle. But it is difficult to see how this intervention is philosophically different from fiscal policy. It might be economically more efficient, but many libertarians – including market monetarists – frame opposition to Keynesian spending on moral grounds. This is wrong.

It is important to remember that Sumner, Christensen, and MMs in general support easier money and a nominal target ipso facto. While they would prefer a futures market, it is not a precondition for the policy. Somewhat similarly, I might prefer a consumption tax to finance government expenditures, this is not a precondition for my belief. (I’m okay with deficits and/or more income taxes, at least morally if not economically).

Remember, none of this is a criticism of market monetarism in general, or nominal targeting in specific.  But I take issue that some of the more progressive monetarists believe their policy is by the fact more libertarian than fiscal policy, and I think that is indefensible on moral grounds. Atop, I mentioned something about Milton Friedman. Because, unlike Austrian neo-confederates at the Ludwig von Mises Institute, he had remarkable influence from Christensen, to Sumner, to Larry Summers. His advocacy for a negative income tax is the bedrock for one of America’s most successful welfare programs, the Earned Income Tax Credit (as progressive economist Brad DeLong forcefully argues).

The echoes of Scott Sumner’s work is heard across the world, and across the political spectrum. It has earned a New York Times op-ed from Christina Romer, discussion at the Federal Reserve, and rapid acceptance across the blogosphere.

This is because the work is fundamentally pragmatic, sensible, and forceful. There are libertarians and “true” free marketers out there. And they are irrelevant. Monetarists can defend their policy on the grounds of potential success (it has never been tried before, after all) rather than market virtues.

Market Pragmatists, perhaps?

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12 comments
  1. ‘Today, the government has absolute monopoly on the issue and transaction of currency.

    ‘And like any other monopolist, setting the price – the interest rate – is the sole provenance of our central bank.’

    Interest rates are not ‘the price’ of currency. You and David Stockman need to familiarize yourselves with that.

  2. James in London said:

    I am not really sure what you are trying to say. It seems as if you are merely falling on one side of the old, old debate amongst Libertarians (echoed by the debates between Marxists, and in fact any group who share the same political ideas): do you try and help your enemies run their policies better? Or do you leave them to fail so you can take power and do it right? For Libertarians it takes the form of whether to offer the statists advice to make the state run better?

    “Collaboration” is a dirty word, but that is what you are doing. And sometimes it’s rational, to prevent worse outcomes over the short term. It’s also poltics. It’s perfectly fair to remain aloof, pure, hard line etc over at the von Mises Institute and it may well influence the world more than you think. Such purity inspires younger generations, who may then grow up and realise life is messy, but you need the purity of vision to do the inspiration in the first place.

    Those who start out as trimmers, collaborators and politicoes rarely make any difference at all to the real world. As Keynes rightly said, “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist”.

    Ashok, you sound as if you started out with the purity thing, but have got a bit frustrated with your old friends. That’s inevitable, but dissing them like this is just a bit silly. Just as saying the MM’ers want “easy money”. They want it now, but have very clearly said they would have wanted “tight money” in the 1970s.

    And, the free banking set like George Selgin and others seem to be market monetarists and seem to easily see it actually as the working model of free market money providers. You just need to look at the history of private money and use your imagination a bit more. And, in the meantime, all us Libertarian MM’ers can suggest a better policy for the monopoly central bank to use. There is no contradiction as long as you don’t lose sight of your roots.

    • James, I’m definitely not a “purist” when it comes to markets. I would fall way to the left of Austrians, but also market monetarists like Scott Sumner (i.e. I think fiscal policy is necessary, if for nothing else but to provide immediate relief to the most vulnerable members of society).

      I don’t know where you think I’m dissing them. I have a lot of respect for sensible libertarian thinking, just not revisionist history about how Abraham Lincoln is the devil etc.

      So me and you probably have very different “roots”. I see libertarianism as a beautiful idea (or maybe classical liberalism is the better word – Adam Smith’s work is powerful) that won’t work. I was never a purist. This post was more trying to reconcile MM ideas with a (modern) liberal point of view, than to criticize Austrians. Perhaps I should not read Lew Rockwell before writing about libertarians.

      • James in London said:

        You’d enjoy David Friedman, a hardcore, but “pragmatic” libertarian, and a brilliant (micro)economist. Perhaps you know him already, but if not:

        http://daviddfriedman.blogspot.co.uk/

        (and, yes is
        and all the guys here:

        http://www.freebanking.org/

        There is a strong, “left-wing” Libertarian stream, quite as poweful and influential as their cousins (brothers?) at the von Mises Institute. At the end of the day almost all should have rallied around Gary Johnson for President at the end of the day!

        I had puzzled for years why Rothbard stopped his history of the Great Depression in 1931, I reckon it was the same sort of reason as Hayek stopped writing about it. They didn’t really like the answer. And then along came Milton Friedman who clearly had the right answer, and he was a classical liberal. And that was a problem. But I think a combination of Sumner and the Free Banking crowd can square that circle. The history of private banking has many examples of private money providers adding liquidity in the face of demand and supply shocks, without ending up with hyper-inflation like you can get with those often badly-run public money providers.

        In many ways the “hard money” men of the von Mises Institute remind me of the Inflation Targeting old (and young) guard who attack NGDP targeting. They were all brought up in the 1970s and are still fighting old battles, and worrying about their cash values, blindly ignoring the lesson of Cyprus.

        And, by the way, there is no need for fiscal policy. Taxes for welfare are just a form of charity at the end of the day.Just forced charity. And using force never produces the best results, as any left wing libertarian can pragmatically prove. It’s a nice coincidence that it fits with the von Mises Institute crowd’s prejudices too.

        (ps there is something funny about the way your blog font shows up on my browser, makes it faint, almost italic and quite hard to read)

  3. So I agree with everything starting with “Free Banking,” but I have responses to the two prior points:

    Re: regulation – why would a housing bubble constrict credit availability elsewhere under NGDPLT? There’s no evidence that a large and rapid increase in housing prices increases core CPI:

    http://research.stlouisfed.org/fred2/graph/?g=hMj

    Or causes rapid NGDP growth:

    http://research.stlouisfed.org/fred2/graph/?g=hMk

    So if a “job creator entrepreneur in Silicon Valley” wants funding what is to prevent anyone from investing if their expected returns exceed the cost of funds?

    Also, re “inflation:”

    “However, in periods of stagnation like today, a nominal target can be sustained only with more inflation, that is a higher effective target to close the gap from current nominal income to trend.”

    I don’t think that’s necessarily the case. NGDPLT works (at least in theory) by spurring real grwoth by threatening inflation. It’s true that to credibly threaten above-trend inflation you may have to occasionally induce it, but a) that will only tend to be in response to a period of below-trend inflation and b) it’s not hard to convince people that the instutition with the power to create infinity money can create some inflation if it wants to. Therefore if the central bank can credibly commit to a NGDPLT regime then (again in theory) we should rarely if ever experience above-trend inflation.

  4. So I agree with everything starting with “Free Banking,” but I have responses to the two prior points:

    Re: regulation – why would a housing bubble constrict credit availability elsewhere under NGDPLT? There’s no evidence that a large and rapid increase in housing prices increases core CPI:

    http://research.stlouisfed.org/fred2/graph/?g=hMj

    Or causes rapid NGDP growth:

    http://research.stlouisfed.org/fred2/graph/?g=hMk

    So if a “job creator entrepreneur in Silicon Valley” wants funding what is to prevent anyone from investing if their expected returns exceed the cost of funds?

    Also, re “inflation:”

    “However, in periods of stagnation like today, a nominal target can be sustained only with more inflation, that is a higher effective target to close the gap from current nominal income to trend.”

    I don’t think that’s necessarily the case. NGDPLT works (at least in theory) by spurring real grwoth by threatening inflation. It’s true that to credibly threaten above-trend inflation you may have to occasionally induce it, but a) that will only tend to be in response to a period of below-trend inflation and b) it’s not hard to convince people that the instutition with the power to create infinity money can create some inflation if it wants to. Therefore if the central bank can credibly commit to a NGDPLT regime then (again in theory) we should rarely if ever experience above-trend inflation.

    • David Friedman would definitely be an improvement over Brian Arthur for Ashok. In fact, in his Price Theory text there is an explanation of why interest rates are not the ‘price of money’. And, you don’t have to buy it, because it’s up on the web;

      http://www.daviddfriedman.com/Academic/Price_Theory/PThy_1st_Edn_Ch22/PThy_1st_Edn_Chap_22.html

      ‘The distinction between the price of money and the cost of holding money–what we might also describe as the rent on money–is crucial to understanding how the general price level is determined, and confusion between the two is at the root of many of the more common economic mistakes. The price of money is what you must give up to get money; the higher the general price level (the amount of money you must give up to get something else), the lower the price of money. The cost of holding money (more precisely, the cost of holding money measured in money, the number of dollars per year you give up for each dollar you hold) is the nominal interest rate.’

  5. John S said:

    “perhaps [Austrians'] most charming idea is the idea of competitive banks each issuing notes which would be traded on the open market.”

    May I ask if you are familiar with the Free Banking literature (Lawrence White, George Selgin)? Admittedly, FB sounds like a crazy idea at first, but if we look at the most studied historical cases (Canada, Scotland), we find that the system actually worked in practice, and in fact all banknotes traded at par with one another. Other surprisingly sophisticated arrangements developed, such as interbank clearinghouses evolving into private lenders of last resort.

    Here’s a great talk by White on Free Banking: http://www.youtube.com/watch?v=Dd-UHqibj5c

    Free Banking may be a radical idea, but it isn’t an untried one. If nothing else, the literature and history are fascinating in their own right.

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