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Monetary Policy: Is There a Prudent Second Best?

It's usually a good thing when representatives of the Von Mises Institute and George Mason ends of the Austrian-economics spectrum agree with each other. But I can't say I found it much to my liking when Joe Salerno and Pete Boettke agreed with each other concerning a CNBC interview I gave a week ago. For both held that, by declaring during that interview that "a case existed" for quantitative easing back in late 2008 and 2009, I seemed to forget my own case for free banking, joining ranks instead with apologists for monetary central planning.

Having defended myself against this particular accusation at the two sites where it came up (and in Joe's follow-up post), I don't intend to repeat my defense here, except to observe again that "a case existed" isn't the same as "a slam-dunk case existed," or something equivalent. I do, however, want to further engage the broader question concerning the pitfalls of the second best. For while I agree that the pitfalls are real, it hardly follows that what might be called the "intransigent first best" strategy, which is to say the strategy that treats second best prescriptions as slippery slopes to be rejected out of hand, is a more prudent alternative.

In considering whether it is, let's not conflate the question at hand with questions concerning the merits of the Fed's actual, recent undertakings. It seems to me relatively easy to find fault with those undertakings, including all three rounds of quantitative easing, even considered merely as second-best means for encouraging recovery, and I have for that reason not found it especially difficult to resist endorsing them. Instead, let's suppose that it is the autumn of 2008, that the wholesale credit market has shut down (thanks in large part, admittedly, to the combined shenanigans of the Fed and the FDIC), and that aggregate demand has consequently begun its downward spiral. Let us also assume (again, for the sake of argument, but also because there is, I believe, plenty of evidence for it) that the collapse of demand, if allowed to go on, is bound to lead to falling sales and unemployment and other sorts of hardship, beyond the hardship made inevitable by the end of any unsustainable boom, in part because prices, and wage rates especially, can only be expected to adjust downward in response to fallen demand very gradually, if at all.* Let's assume, further, that a free banking system would tend automatically to counter the tendency for demand to shrink, even despite a fixed monetary base, by allowing banks to operate on lower reserve ratios as the real demand for their deposits and notes increases. Finally, let's suppose that we are fully aware of the mischief that discretionary central banks can do, and that we are all anxious to avoid making any statement that might be construed as approving of, much less further empowering, such institutions.

The relevant question then is: given the existing, centralized arrangement, what should the Fed do? Suppose the question is asked of you on a popular, live TV broadcast. How to respond prudently?

Will merely insisting on the first-best solution suffice? I don't think so. In the present context that would mean saying something like, "The Fed should freeze the monetary base; but that isn't all: Congress should then wind it up, while allowing other banks complete freedom to meet the public's monetary needs, including the freedom to issue their own notes. This would also require doing away with deposit insurance and…" etc. Even supposing one could elaborate the argument in a few sound bites, or that one could go on for hours, the obvious problem remains that the steps required would take months to accomplish even if they could be instantly and universally agreed upon. The answer, therefore, begs the question, "What should the Fed do in the meantime?" We remain more or less where we began.

Nor, as some commentators (myself included) have noted elsewhere, is saying that the Fed should do "nothing" any better. So long as it exists the Fed is, of necessity, doing "something." So "nothing" here must actually refer to some particular Fed policy. Most often (I gather) it means that the Fed should refrain from any further lending or open-market activities, or from otherwise expanding its balance sheet. It amounts, in other words, to recommending that the Fed maintain a constant monetary base. But is asking the Fed to maintain a constant base really indicating any more principled opposition to monetary central planning than one indicates by calling upon it to alter the base by some particular amount, or by whatever it takes to achieve some particular target? I don't see why. Indeed, what some have wrongly taken to be the more principled of the two alternatives seems to me to be hardly more principled, though rather less prudent, for it calls, not for the avoidance of monetary central planning, but for the implementation of a monetary central plan that is likely, according to "our" theory, to be particularly lousy. Nor will it do to say that the "keep the base constant" alternative is superior in that it might be proposed, not just as a suggestion for the present, but as a hard-and-fast monetary rule, for the same might be said concerning the suggestion that the Fed expand the base only when doing so serves to keep spending stable.

The option of recommending that the central bank "do nothing" is, by the way, precisely the one Hayek chose to take back in the early 1930s when, despite having recognized in print the desirability of a constant "money stream," and despite the fact that the money stream had dried up dramatically, he campaigned against expansionary monetary policy. As he explained many years later, with regrets, Hayek's reason for departing from his own theoretical ideal had to do, not with any slippery-slope considerations, but with his belief that allowing the collapse of demand to go on could be just the thing needed to wrench the British labor market free from labor unions' stranglehold.** Still it is difficult to see why the results would have been any different if, instead of having opposed monetary expansion because he hoped by doing so to help thaw a rigid labor market, he did so on other political-economy grounds. To say that Hayek's strategy backfired is putting it mildly, for it was not labor unions but Hayek's own theoretical legacy that suffered.

Must one, then, simply endorse monetary expansion, setting aside the first-best alternative altogether, while also neglecting those political-economy considerations as point to the inherent dangers of such a compromise? I don't believe so. It seems to me that making a case for monetary expansion is not the same as making one for monetary central planning. It is a matter of choosing one's language carefully. The prudent answer to the interviewer's question may be something like this: "For better or for worse, we are forced to rely on the Fed to prevent such a collapse in demand, so the Fed should do what it is supposed to do. But the Fed is a deeply flawed system and continuing to rely on it is asking for trouble. There are better alternatives, and now is as good a time as any to start taking them seriously."

Perhaps putting it so would still make one an apologist for central banking. In that case, my plea to Pete and Joe is, "guilty as charged." But why settle for that, fellows, when you can throw the whole first-best book at me? After all, I also believe that, until better (free market) alternatives are in place, the USPS ought to deliver my first-class mail, and the FAA ought to keep the airplane I'm flying in from attempting to land on a busy runway.

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*I understand that the Salerno-Austrians will regard these assumptions as proof of my being a "Keynesian" and of my failing to understand Say's Law. In answer I can only observe (1) that if I'm a Keynesian so, too, are Milton Friedman and Leland Yeager, among others; and (2) that my "problem" is not that I don't understand Say's Law; it is, rather, that, like most neoclassical (and some classical) economists, I happen to think that Say erred in assuming that people (or banks) never attempt to accumulate reserves or broader-money balances. I know not how anyone can look at recent statistics regarding banks' (and other firms') accumulations of cash reserves and still treat Say's position as if it were irrefutable.
**See Lawrence H. White, The Clash of Economic Ideas (Cambridge, UK: Cambridge University Press, 2012, p. 95.