Bill Niskanen: Monetary Policy Radical

Bill Niskanen, dual mandate, lender of last resort, monetary policy, Phillips Curve
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Bill Niskanen, dual mandate, lender of last resort, monetary policy, Phillips Curve Several days ago a colleague of mine, referring to the Niskanen Center's recent conspectus, wondered whether Bill Niskanen, the former Chairman of the Cato Institute after whom the Niskanen Center is named, would have agreed with a claim it made. The claim was that promoting sound monetary policy was basically a matter of encouraging "policymakers to support the Federal Reserve's dual-mandate" and of getting "pro-growth" candidates appointed to the Board of Governors.

My short answer to the question was, "No." But it occurs to me that that answer is worth fleshing-out here, because many people may not be familiar with Niskanen's ideas for improving monetary policy, and because those ideas show that he was far from being a cheerleader for the status quo, or for a more "pro-growth" version of the status quo, whatever that might mean.

The Dual Mandate

For one thing, Niskanen was no fan of the dual mandate. That mandate had its roots in the Employment Act of 1946 and was formally established by the 1978 Full Employment and Balanced Growth Act, a.k.a. the Humphrey-Hawkins Act. The latter act originally gave the Fed five years to reduce the overall (16 years or older) unemployment rate to 4 percent, while getting inflation down to 3 percent. The assumption that these goals were perfectly compatible rested, at least implicitly, on legislators' belief in the presence of a stable Phillips Curve, implying a negative relationship between the rate of inflation and the rate of unemployment. Yet that belief had already been discredited by empirical developments by the time the legislation was passed.

It did not take long after the passage of Humphrey-Hawkins for wiser Federal Reserve officials, including Paul Volcker (who became Chair in 1979), to conclude that the "dual mandate," far from defining a new and sustainable approach to monetary policy, was simply a nuisance — something they had to pay lip service to, whilst really concerning themselves with keeping a lid on inflation, so as to undo and avoid repeating the mistakes of the 70s. For the most part they managed this by insisting that, in the long run at least, price stability was itself the best guarantee of "full employment."

Bill Niskanen shared that perspective. Like all monetary economists who take empirical evidence seriously, he knew that the stable Phillips Curve was a myth, while regretting that other "macroeconomists have confused each other, generations of students, and too many policymakers" by pretending otherwise. Indeed, the evidence for the period between 1960 and 2001 suggested a "strong positive relation between the unemployment rate and the inflation rate lagged one or two years." That meant that the best way to achieve a minimum long-run unemployment rate really was to aim at a zero steady state inflation rate.

In short, so far as Niskanen was concerned, the dual mandate was one mandate too many. If anyone doubts it, I invite them to review the opening passages of Niskanen's entry on "Monetary Policy and Financial Regulation" for the 2008 edition of Cato's Handbook for Policymakers. "For the past 30 years," Niskanen observes,

the Full Employment and Balanced Growth Act of 1978 instructed the Board of Governors of the Federal Reserve to establish a monetary policy to maintain long-term economic growth and minimum inflation. As these two goals are sometimes inconsistent, this congressional guidance has not been very effective. The Federal Reserve has had almost full discretion in the conduct of monetary policy, subject only to the balance of current political concerns.

The intent of Congress would be better served and monetary policy would be more effective if Congress instructed the Federal Reserve to establish a monetary policy that reflects both their [i.e. Congress's] concerns in a single target.

A Nominal Spending Target

Yet Niskanen did not favor the single-minded pursuit of zero inflation. Although he preferred a zero steady-state (or long-run) rate of inflation, he believed that that long-run objective was best achieved, not by having the central bank directly target some measure of the price level or inflation rate, but by having it target the growth rate of total spending on goods and services, as measured by the Department of Commerce's statistical series "final sales to domestic purchasers."

A final demand target, Niskanen explained in a 1992 Cato Journal article, is better than a price level or inflation target "because of the different response to changes in supply conditions." Whereas a central bank that stabilizes spending "would not respond to either positive or negative supply shocks," one that endeavored to stabilize the price level at all times would seek to increase the money stock and spending to keep prices from falling in response to a positive supply shock, and would seek to reduce the money stock and spending to keep prices from rising in response to a negative supply shock. While either approach could be consistent with achieving a zero long-run inflation rate, targeting demand reduces the variance of output.

Although Niskanen's choice of a demand measure distinguishes his proposal from those of Scott Sumner and some other Market Monetarists, who would have the Fed stabilize nominal GDP rather than final sales, the difference is one of second-order importance only.[1] Also like some Market Monetarists, and unlike apologists for the monetary status quo, Niskanen favored a monetary rule imposed upon the Fed by Congress, as opposed to unbridled monetary discretion. Congress, he observed in that 1992 article, has delegated its Constitutional authority to "coin money" to the Fed

either without guidance or, more recently, with sufficiently confused, redundant, or contradictory guidance to permit the Fed to chart its own course. We could do worse. The performance of the Federal Reserve has usually been better than that of most other central banks.

I believe we can also do better — much better… .

We could do better, Niskansen said, by having Congress "approve a target path of total demand in the American economy," specifically by passing legislation "that would formally instruct the Fed to follow a specific target path of nominal domestic final sales," and by having "the administration and Congress…monitor the Fed's performance" as often as once every quarter. That monitoring

should focus on the reasons why actual final sales may have differed from the target path in the previous quarter. An increasing difference between the actual and the target final sales over a period as long as two quarters should automatically trigger… a review. There is ample reason to criticize the Fed for an accumulating difference between the actual final sales path and the approved target path. But as long as the Fed maintains a roughly stable level of final sales relative to this path, both the administration and Congress should refrain from criticizing the Fed… .

In his 2008 Cato Handbook chapter, Niskanen offers more specific advice. Congress would be wise, he says,

(1) to specify a target rate of increase of final sales and (2) to instruct the Federal Reserve to minimize the variance around this target rate. The target rate of increase of final sales may best be about 5 percent a year, sufficient to finance a realistic rate of economic growth of 3 percent and an acceptable rate of inflation of about 2 percent.

Niskanen goes on here to accuse the Fed of "creating three 'bubbles' of aggregate demand" — between 1987 and 1991, 1997 and 2000, and 2002-2006 — each of which in turn contributed to bubbles in other markets, followed by recessions. In every instance, Niskanen argues, the Fed appeared to overreact to a previous financial crisis by allowing demand to increase relative to its target path, instead of merely taking steps "to avoid a decline in the growth of demand relative to the target path."

Observe that Niskanen's proposal would place the Fed on a much tighter leash than the one contained in the FORM (Fed Oversight and Modernization) Act, both in its original, 2015 version  and as incorporated in the latest version of the CHOICE Act. Unlike Niskanen's plan, the FORM Act  leaves the choice of a specific monetary rule entirely to the FOMC.

Last Resort Lending

Besides wanting to place strict limits on the Fed's conduct of monetary policy, Niskanen also wanted to curb its emergency lending powers. In particular, he opposed the de facto broadening of those powers that took place during the first months of the most recent financial crisis, observing (again in the Cato Handbook) that

the combination of deposit insurance and access to the [Fed's] discount window created a serious level of moral hazard that reduced the incentive of both depositors and banks to avoid adverse risks. Adding securities firms and the government-sponsored mortgage firms to the list of financial firms eligible for access to the discount window and subject to regulation by the Federal Reserve would only expand the level of moral hazard in the financial system.

Rather than have it permit a permanent broadening of the Fed's lending powers, Niskanen urged Congress to "consider amending the Federal Reserve Act of 1913 to restrict access to the discount window to depository institutions only." Here again, Niskanen goes further than the CHOICE Act, in essentially proposing a complete repeal of the Federal Reserve Act's section 13(3). The CHOICE Act, in contrast, would still allow the Fed to make emergency loans to non-banks, albeit on more strictly regulated terms, and only if the presidents of nine Reserve Banks (along with five members of the Federal Reserve Board and the Treasury Secretary) agree that allowing the firms in question to fail would "pose a threat to the financial stability of the United States.”

Against Central Banking?

The reforms Niskanen favored show that he was far from being a monetary policy conservative, to give that adjective its literal meaning. But was Niskanen really a monetary policy "radical"? Sure, he wanted to limit the Fed's powers. But that hardly means that he questioned the need for a Federal Reserve System, or some other sort of central bank.

Yet question it he did. What's more, he ultimately became convinced that we would, in principle at least, be better off without central banks. I ought to know, because I'm the one who convinced him!

The occasion was the 7th installment of Cato's Annual Monetary Conference, in 1989, at which I presented my paper "Legal Restrictions, Financial Weakening and the Lender of Last Resort." The argument of that paper is, essentially, that financial systems would be robust enough to avoid major crises altogether, and to do so without the help of central banks, were it not for government meddling, including central bank misconduct, that makes them unnaturally fragile.[2]

Niskanen, who was asked to comment on my paper, began his remarks as follows:

May I make a confession. In some areas of public policy I sense that my views are usually radical, in that I am prepared to promise a substantial reduction of the contemporary role of government. In other areas my views are more conservative, more from lack of understanding than from any conviction that the status quo is appropriate.

George Selgin has convinced me that my conservative acquiescence to the contemporary role of central banks has been misplaced. I had long recognized that central banks were the primary agents of both major recessions and sustained inflation, but I had casually accepted the argument that a lender of last resort and a monopoly of note issue were necessary to prevent panics in a fractional-reserve banking system. …[It] is increasingly clear that the conventional arguments for a central bank are second-best arguments that assume the restrictions that have increased the vulnerability of private banks.

To be sure, Niskanen's new-found understanding didn't cause him to propose that the Federal Reserve Act be repealed in its entirety! It merely caused him to believe that an alternative set of arrangements "would be better… if it could be implemented without transition costs." The challenge is to come up with a transition process that would make the change worth it despite its short-run costs.

Of course I, too, would rather we chip away at the Fed's powers than risk raising havoc by trying to "end" it in one fell swoop. The same goes for many of my fellow free bankers. So Niskanen's position is actually no less radical than ours.

In portraying Bill Niskanen as a monetary policy radical, I've limited myself to his views on the Fed and central banking more generally, without venturing to consider what he had to say about other financial regulatory agencies. But readers may rest assured that his views concerning many of these were equally radical. Had Niskanen had his way, Congress would have done away with Fannie and Freddie, the Community Reinvestment Act, and U.S. support for the IMF; and I'm pretty sure that with a little more digging the list could be made much longer. One thing, though, is certain: Niskanen was never one to settle for conventional wisdom. As he himself explained, when he didn't question some aspect of the status quo, more often than not it was because he hadn't yet had a chance to noodle around with other options.

[1] Unlike final sales, nominal GDP includes spending on private inventories and net imports exports.

[2] The thesis is essentially the same as that expounded at greater length by Charles Calomiris and Stephen Haber in their 2014 book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit.