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The nature of central banking and the importance of a monetary constitution

September 28, 2015

In my previous posts, I argued that it is imperative to secure a monetary policy regime that adheres to the rule of law.  In this post, I will extend the argument further: truly lawful money requires a monetary constitution of some kind.

There is actually considerable sympathy to rules-based monetary policy contemporary macroeconomics.  However, not all monetary rules meet the requirements of a monetary constitution.  Many who favor monetary rules want central banks to adopt voluntarily a rule such as an inflation target or a nominal income target.  Among other requirements, monetary constitutions demand more than this—they require that the central follow a predetermined rule, and that the central bank cannot change the rule in the course of ordinary operations.  The monetary rule must operate at a ‘higher level;’ it is not a rule for central bank behavior, but a meta-rule.

Why is this level of strictness necessary?  Can’t central bankers, who are experts in monetary theory and policy, be trusted to pick a suitable rule, or change the rule as circumstances require?  Unfortunately, they cannot.  There are many reasons for this, but here I want to focus on one in particular: central banking, as an institution, is a filter that selects for certain economists and screens out others.

Frank Knight, a prominent Old Chicago School economist, made the following observation on how political institutions select for the kinds of people who seek out political power: “The probability of the people in power being individuals who would dislike the possession and exercise of power is on a level with the probability that an extremely tender-hearted person would get the job of whipping master in a slave plantation.”  This is an extreme example, but one that points toward an important truth.  Economists who do not believe in central banking probably will not themselves become central bankers.  This is not to say that they will not study central banking or monetary policy.  Milton Friedman never held a job as a central banker.  But by the nature of the work, individuals who believe that central banks must take active steps to steward the macroeconomy are much, much more likely to become central bankers.

Notice what this implies: Even if economists, as a whole, had neutral positions on central banking, all those who ended up as central bankers would believe in central banking.  The institution selects for the outcome.  This means that, irrespective of the truth value of the claim, “Macroeconomic wellbeing requires active stewardship by central bankers,” central bankers will favor active stewardship.  Macroeconomic activism is better able to compete on margins other than the factual validity of the paradigm.

(This is not a conspiracy theory of central banking, because there are no conspirators.  A conspiracy requires active coordination; here there is none.  I have no doubt that today’s central bankers, as individuals, have high personal integrity and truly believe their actions are in the best interests of society.  Modern central banking, from the classical liberal perspective, is thus a high-profile example of a ‘bad’ spontaneous order.)

This is only one part of the argument for a monetary constitution, but it is an important part.  If central banking, in and of itself, promotes for central bank activism, then central bankers cannot be trusted to forsake activism in favor of restraint when the situation calls for it.  Something must bind their hands, and only a genuine monetary constitution—not a self-imposed rule—can do that.