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August 20, 2006
What market failure does a central bank address?
And does it succeed? Better then other (private, market-based) alternatives?
This post certainly cannot answer such momentous questions. I would, however, like to use these questions as a focal point for thinking about one of the hot topics on the economics blogs. I think a lesson that comes out of this (are you listening, grad students?) is that monetary policy questions can have very deep roots in fundamental questions about the nature of money and markets. Recently, Greg Mankiw posted a letter from Milton Friedman on his blog. The final thrust of the letter was as follows. Quoting Friedman:
Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.
Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level.
A wonderful round of comments ensued. Among them was Divison of Labour's Lawrence White. White actually wrote two posts. Quoting from the earlier of the two,
Do we need to keep the Fed around because the money multiplier might collapse again? Mankiw is right that the money multiplier declined sharply in the 1930s, but why did it? The proximate cause of the collapse in the 1930s was bank runs and fear of more bank runs. The underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs and no money-multiplier collapse in Canada in the 1930s, which had neither restriction. Fortunately we no longer have the geographic restrictions in the US. We still have note-issue restrictions. Friedman’s brief letter neglected to mention an important adjunct to his base-freeze proposal that he has elsewhere mentioned, which is that shifts in the public’s demand to hold currency could be accommodated by letting commercial banks freely issue currency redeemable for base money. With well-diversified note-issuing banks, a collapse of the money multiplier would not occur.
Over at Marginal Revolution, Tyler Cowen enters the fray.
Greg counters that the lender of last resort function of the central bank may interfere with a fixed monetary rule. Fair enough (in fact I think the earlier Milton admitted this point, although the later Milton may agree with Larry White's comment on Greg), but my objection is more day-to-day. Hardly anyone is willing to live with the consequences of a strict rule for the monetary base.
In particular, the resulting short-term interest rate volatility would be much higher than, prior to experience, most people had expected. Liquidity is quite scarce. The demand for funds goes up and sometimes, in the absence of Fed smoothing, the supply just isn't there. Price has to adjust. No, interest rate volatility is not the end of the world but few people believe this makes for a better marketplace. That is why hardly anyone in the world of central banking defends monetary base targeting these days, even though the idea was fairly popular twenty-five or thirty years ago.
In a modestly growing economy, holding the money supply absolutely constant will approximate a "Friedman Rule". Students of macroeconomics will recognize the Friedman Rule as the well-known result that in a certain type of cash-in-advance model the optimal policy is to have deflation equal to the rate of time preference. This also results in a zero nominal interest rate.
In practice, with output varying around a long run trend, fixing the money supply would anchor the long-term interest rate only. Short term rates would vary depending on the shocks to output (and, importantly, changes in expectations of future output). For example, if output is expected to increase at a faster rate, borrowing will increase and the short-term rate will rise.
One of the successes of modern central banking is certainly the ability to smooth the short-term interest rate fluctuations. The directives of the FOMC, such as the most recent one that provoked so much debate, are instructions to carry out open market operations aimed at keeping the short-term interest rate at a certain level for the next six weeks. This aspect of the task is mechanical and is familiar to students in principles of macro. Without the Fed performing this function, long-term rates may be well achored, but short-term rate will fluctuate per Cowen's analysis.
Indeed one of the thorny puzzles for the Fed of late has concerned the short vs. long term rates. It was Greenspan's "conundrum"--how the long term rate could stay so low even as the short rate was rising so steadily and consistently. But this is a non-issue under a Friedman Rule. Even if we do not go quite that far, a credible commitment to low inflation should bring about increased stability at the long end of the yield curve. But to maintain that credibility in the long run, you might have to sacrifice a little bit of control at the short end. That is, you might have to let the short rate rise (or fall) in response to changes in expectations. The policymaker cannot have it both ways. You can't target both the money supply and (short-term) interest rates.
But what if, as White suggests, we allowed banks to issue private notes and traded those notes in financial markets. Suppose output is temporarily high. With a fixed supply of government supplied money, the price level would tend to fall as money becomes more precious. There is a need for more liquidity. As holders of highpowered money, banks could create the liquidity by issuing notes that would circulate until the need for liquidity subsides. These notes could be presented to settle debts between banks and between firms. If such notes were traded on an exchange, it would be immediately apparent whether there were too few or too many in circulation and adjustments could be made quickly.
Such an arrangement sounds like a 21st century version of 19th century free banking (the latter, not coincidentally being an area of interest for White). The thought of an institution or an exchange for clearing the notes reminds me (at least in a very general sort of way) of the Suffolk Banking System. I refer interested readers to a number of papers on the subject by Arthur Rolnick and Warren Weber (papers can be found at their websites). Along with the late Bruce Smith, they wrote a particularly concise and informative introduction to the subject in the Minneapolis Fed Quarterly Review. They conclude that the Suffolk Banking System, a clearinghouse for bank notes that existed in the early 19th century, was a natural monopoly. One piece of evidence in favor of this was that Suffolk's rival that eventually drove them out of business, the Bank of Mutual Redemption (BMR), may have engaged in predatory pricing. Clearninghouses such as Suffolk and BMR required participating banks to keep deposits with them (much like the Fed accomplishes clearing of payments by transferring reserves that banks have deposited with the Fed). BMR offered interest on their deposits when they entered the market, but after Suffolk exited, BMR stopped paying interest.
Stories like this are informative because they help illuminate some of the functions of the payment system that we often take for granted. So why do we have a central bank? Is it because clearing payments is a natural monopoly? But one can legitimately ask whether modern financial market technology could accomplish this function. Would this market function freely enough that short term interest rate fluctuations would be optimally smoothed? And if this market functioned well, would we need a lender of last resort?
These are very penetrating questions that cut to the heart of a monetary system. They are fundamental questions that walk the fine line between money and credit. The fact that there is still a demand for an asset bearing a zero nominal interest rate suggests that there is a market friction. Do central banks alleviate that friction or make it worse. My assessment is that they do both from time to time. But a completely private market solution would surely be a bit messy until all the problems were worked out. If we tried another Suffolk Bank today, it might work better, but there is no guarantee that it would work perfectly. Not to mention the fact that I would be slow to give up the Fed's role as lender of last resort (recognizing that this has potential problems for a fixed money supply rule).
But at the same time, if the Fed became truly serious about price stability as its only long-term goal (yes, I'm aware that would require an act of Congress), we should expect financial markets and institutions to take on some of the responsibility for maintaining a smooth functioning system--provided that the law allowed them to do so. After all, one of the functions of currency is to overcome frictions caused by the lack of information. In this, the age of information, we may have our best chance yet of seeing private markets for near money instruments assume at least some of the role for financial market stability that the Fed assumes today. However our experience with the Great Depression makes us cautious of ceding that responsibility--a fact which is at the same time understandable and unfortunate.
Posted by William Polley at August 20, 2006 3:27 PM
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