Jun 14, 2021

Daniel Smith and Alexander Salter on *Money and the Rule of Law: Generality and Predictability in Monetary Institutions*

The macroeconomic and political case for the increased use of monetary policy rules.
David Beckworth Senior Research Fellow , Alex Salter, Daniel Smith

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Dan Smith is an associate professor of economics at Middle Tennessee State University and directs the Political Economy Research Institute at MTSU. Alex Salter is an associate professor of economics at Texas Tech University. Dan and Alex join David on a special live episode of Macro Musings to discuss their new book, Money and the Rule of Law: Generality and Predictability in Monetary Institutions. Specifically, they discuss knowledge and incentive problems in setting monetary policy, what is meant by “rule of law,” how to make monetary policy accountable, centralized versus decentralized forms of digital currencies, thoughts on free banking, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Dan and Alex, welcome to the show.

Alex Salter: Thank you. It's really good to be here.

Dan Smith: Thank you very much. We're very excited to be with you today.

Beckworth: Well, I'm excited to have you on. I have to confess I was a part of this book, a small part of this book. You guys wrote the book. And then you had a review session where you sent out early drafts, I got to comment on it. So I was looking forward to his release. And I'm excited to have you on the show to talk about it today. And I'm just curious, what is the executive bird's eye view summary of the book before we get into the specific chapters and the nuances of it?

Salter: Sure. So the executive summary is if we want monetary policy to be macroeconomically effective, and democratically justifiable, you need to have a strict monetary rule in place. That's the book in a single sentence. And so we think that viewed correctly, there's actually not a tradeoff between these things, we think that you can equally have good aggregate demand management on the one hand, and democratic justifiability on the other hand, and this is reconciled through a true binding monetary rule.

We think that you can equally have good aggregate demand management on the one hand, and democratic justifiability on the other hand, and this is reconciled through a true binding monetary rule.

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Beckworth: It's a great point, we'll get into it more. But I do think this is an increasingly important issue, legitimacy of central banking as we get into an increasingly polarized world, in a world where central banks are asked to do more and more and more, and that does raise questions of legitimacy, democracy, rule of law and all those things. What motivated you to write this book, because it began before the pandemic, well, before the pandemic? So what's the story behind it? How did the two of you plus Peter Boettke get together and decided this book was needed?

Smith: So for me, at least, it started in 2011, just finished up my dissertation and was waiting for graduation at the Buchanan House and Peter Boettke, after a conference said, "What do you think about the Fed?" And that led to a conversation because Mark Pennington's book, Robust Political Economy had just come out in 2011. And he had idea to apply it to our monetary institutions. Why not design monetary institutions that were robust to real world knowledge, and incentive problems at the foundation of our monetary institutions?

Smith: So that just started a series of papers and research and Alex joined in as well on some of those important early papers, and then that just bloomed and we kept going. Right? We just kept, here's another piece of an argument. Here's another piece. And before we knew it, we think we had stumbled onto to a unique perspective that money should be treated as a property right of citizens, not a prerogative of the central bankers.

Beckworth: What about you, Alex?

Salter: It really started with my PhD dissertation, because one of my chapters in that dissertation was about monetary constitutions, and specifically the question of whether there could be a self enforcing monetary constitution, right, one that didn't rely on extraordinary assumptions about the knowledge or incentives that policymakers face. And so that project started in 2012. And I branched out from there, writing more about the political economy of central banking.

Salter: And so eventually, I linked up with Dan and Pete and we decided, you know what, there's really a common narrative throughout all these papers. And what we're really doing is building on the classically liberal tradition and monetary policy and monetary scholarship. A lot of times you get this view that those of a classical liberal bent deny the importance of aggregate demand driven recessions and diminish the importance of monetary factors.

Salter: And that couldn't be further from the truth. If you look at scholars like Buchanan, like Friedman, like Hayek, they turn their significant attention to these topics. And I thought that especially given the direction that monetary policy is going these days, that perspective deserved another hearing.

Beckworth: All right. Now, I imagine part of the history, in addition to what you've just shared, is the great recession, living through that and all the jarring moments. It doesn't seem so radical now looking back, but at a time, some very radical different, I mean, a lot of change, which is now a normal part of monetary policy, but a lot of conversations back then. So I imagine that also kind of helps spark this conversation you have. And I want to read an excerpt from your book that speaks to this period, or at least I think it does, and you can correct me if I'm wrong, but you start out your introduction with a story from the Federal Reserve. And I'm going to read it and then you can explain what exactly you meant.

Beckworth: You say on November 8, 2002, Ben Bernanke, then a member of the Federal Reserve Board of Governors gave a speech at a conference honoring Milton Friedman. Along with Anna Schwartz, Friedman's scholarship on monetary history of the United States was crucial in drawing the economics profession's attention to how monetary mismanagement helped put the ‘great’ in Great Depression. Bernanke ended his speech with an institutional Mia culpa. And an important promise, this is Bernanke, "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna, regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." And then you two chime in, say, oh, but the Fed did do it again. So how does that help motivate your book?

Smith: It was really interesting when we started writing this, the big motivating factor was the great financial crisis. Of course, things even crazier than that have happened since and we can talk about that in a little bit. But we found it particularly interesting that even with Bernanke, who is a top tier monetary economist, a top tier academic economist, who has elite credentials, just really, really smart, really talented, really dedicated guy could make this statement in the early 2000s about finally getting it about the money supply and the importance of the monetary transmission mechanisms. And then not very long after that, could helm the Fed when they really dropped the ball and combating the downturn following the 2008 financial crisis.

Smith: So we actually indict the Fed for being a little bit too loose before the crisis. Of course, that was before Bernanke's tenure as chairman of the Fed. But then we also indict them for being too tight for engaging the interest on excess reserves policy that prevented the newly created liquidity from stabilizing nominal expenditures. And we see that as a large part of the story for why the economy tanked so far after the financial bubble burst and recovered so slowly.

Smith: So you got it going before, and you got it going after. And we think that that illustrates a very important point. Hardly anyone can claim to be more qualified than Bernanke to do the job of Fed chair: he understood the monetary policy, he understood the science, and yet his Fed dropped the ball. If that's not an argument for minimizing policy discretion, I don't know what it is, we really need to take seriously that when we're actually in the moment, and confronted by an incipient panic, and things are falling out below us, we really need to take seriously this idea that although it might be tempting to throw away the rules and do whatever we need to do to stabilize the financial system, that almost always comes with some really nasty, unintended consequences.

Hardly anyone can claim to be more qualified than Bernanke to do the job of Fed chair: he understood the monetary policy, he understood the science, and yet his Fed dropped the ball. If that's not an argument for minimizing policy discretion, I don't know what it is.

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Smith: It doesn't do a good job of credibly conveying to market actors what the policy response is going to be, it doesn't do a good job of committing the Federal Reserve to a responsible monetary policy course. So if even then, and what seems like the dream team at the Federal Reserve could not stop the malaise, the fall off from the financial bubble, we really need to think about getting these rules in place that can force the outcomes that we need to keep the economy stabilized for all our sakes.

Beckworth: Well, let me ask you to flesh out your argument there, because I think many people understand the claim that you're making that the Fed contributed to the housing boom, a lot of things were going on. But the Fed's monetary policy was easy. And I think, a lot of people made this argument, John Taylor, others. So that may not be very surprising or new to many people. But your claim that monetary policy was too tight, or did not help matters during 2008. I'm sympathetic to that. In fact, I've written about that, as you know, so I am on board. But for many listeners, this may be strange or foreign. So help us understand, how did the Fed contribute to the collapse in 2008?

Salter: Sure. So David, I think you and I see largely eye to eye on this in the sense that it's about NGDP. It's about aggregate demand. And so the way that I wanted to think about this is, the immediate policy response by the Federal Reserve was to shore up banks’ balance sheets, swapping bad assets for good assets, the monetary base, right. But then, because they were also worried about inflation getting out of hand, given the massive monetary stimulus that was necessary to shore up banks balance sheets, they started paying interest on excess reserves, reserves above the minimum necessary based on the statutory requirements for reserves that are set by the Federal Reserve Board of Governors.

Salter: And so because of that, all that new liquidity did not end up circulating throughout the financial system. It basically sat in banks accounts held at the Fed. And so yes, that did a great job of shoring up banks balance sheets, and yes, it absolutely did a great job of preventing inflation. The problem with that is it also did a great job of preventing that liquidity from circulating throughout the economy, to fight against the increase in money demand. In retrospect, I think that we can see that that policy prevented from happening what we would need to happen to keep nominal income on stable path, which was, yeah, I created a bunch of liquidity, but it didn't do any economic work.

Salter: And so because of that, we had to have an entire series of costly wage and price adjustments, we had to grow up our way to this new equilibrium that took a really long time. And I don't think that any of that was necessary. If the Federal Reserve had committed to a responsible rules-based policy, they wouldn't have needed to worry about the suppose a tradeoff between banks balance sheets and the integrity of the financial system on the one hand, and inflation on the other. A policy rule to stabilize something like nominal expenditures would have solved that problem.

Salter: Now, I don't want to make the claim that we're arguing more than we are. In the book, we do not argue for an NGDP target, specifically, we argue for the importance of rules as such, because we think it's important to argue for the importance of rules in general, before we get into the weeds and start arguing about the pros and cons of any particular rule.

Beckworth: You going to add anything to that, Dan?

Smith: He said it well.

Beckworth: Let me provide my first pushback on that particular crisis. I agree with you. I think that the Fed did not fulfill its mandate properly during that period, it set on 2% interest rates from April to October, it was worried about inflation. I mean, part of the reason it didn't do anything is because there wasn't inflation spike in 2008. And the Fed is an inflation targeting bank.

Beckworth: And so let me provide this pushback given that point, could it be interpreted that the Fed was sticking too much to a rule, an inflation targeting rule? In other words, the Fed was so concerned about inflation during that period, it took his eyes off the other part of its mandate or off of nominal spending, as you said. And if you go back to the housing boom period, right, the Fed kept rates really low contributed into the housing boom.

Beckworth: The reason it did that, because there was a temporary productivity boom during this period, which lowered inflation again, the Fed was worried about low inflation, the early to mid 2000s, so didn't tighten policy as quickly. So could you make the case that if anything, the Fed was almost too adherent to an inflation targeting rule versus not having a rule?

Smith: That's a good question. So I understand the perspective from which that question is coming. But I'm not entirely sure I'm persuaded of the argument. And there are two main reasons that I think that I would push back on the push back. The first of which is that the Federal Reserve's 2% inflation target was voluntarily chosen. So it's something that it could deviate from based on its own discretion and its own judgment. And I think that that was a situation where, especially when you got a lot of the early experiments in quantitative easing, that there was a veering off in terms of non traditional monetary policy tools, when I think sticking to more traditional monetary policy tools would have done the job. So even if you want to make the argument that they were very concerned about inflation, and I think they were, I still think it's nonetheless the case that their hands were not tied strongly enough.

Smith: The other argument that I would make has to do with the role of the Federal Reserve in cementing expectations, I don't think that they've done a very good job of that. And I think that a lot of the pain could have been avoided if their commitment to some sort of a nominal anchor had been more credible, both before, during and in the immediate aftermath of the crisis.

Smith: And I think that one of the reasons that their commitment just wasn't credible is because people understand that a self-imposed constraint isn't much of a constraint. And so those would be my immediate thoughts.

Beckworth: Well, let's move into your next chapter. And this chapter is on the knowledge problem. And you make the case that there is a big knowledge problem and monetary policy. So maybe you can explain that to us. Dan, you want to take a stab at that?

The Knowledge Problem in Monetary Policy

Smith: Yeah, I'd be delighted to. And actually, what we really wanted to do with this chapter is split out technical problems, which we define as problems that complicate monetary policy, but are theoretically solvable with refined data collection and if we calibrate our models better, we want to separate that from true monetary policy problems which we define as rendering discretionary central bank means and inconsistent, that due to the lack of knowledge, central bankers do not have the capacity to actually achieve their own ends as stated.

Smith: So, the technical problems. We split these up into four different categories: objectives, targets, instruments and calibration. For objectives, for instance, you can say, well, we all know the objective function of central banks, right? It's to maximize employment subject to long term price stability. But there's a lot of fuzziness there. There's a lot of short-term tradeoffs in achieving that goal. I think there's a lot of, there's even inconsistent remarks from, for instance, Yellen and Bernanke, on what those tradeoffs are.

Smith: Sometimes they say the weights on those are equal, they both get 50%. But at other times, they argue, well, at this time, this one takes precedent over the others. And actually I think central bankers preferred that they're unspecified, because that gives them a lot more discretion. And it also allows them to add an unofficial objectives. So we know inequality, climate change, financial stability, exchange rate stabilization, those have all been factors that have at times entered into the central bank's reaction function.

Smith: It's done so, like I said, in unofficial capacities. And I think that creates a lot of issues. And if you go back through, and what we do is we pull out some FOMC meeting minutes, where there's genuine uncertainty. Okay, what's the actual objective here? Most people I think, would be surprised that that's actually takes up time, had those meetings, and it does. And go down the list, targets. Yeah, it was Fed funds rate and now interest on excess reserves. But it could be term structure of interest rates. It could be inflation, it could be NGDP targeting, and even average inflation targeting. What's the allowable range? What's the timeframe over which the average is calculated? How quickly are we going to get back to the average, if there's a deviation?

Smith: There's a lot of fuzziness there that I think makes it more difficult for central bankers than we oftentimes have met. Instruments. We know the traditional tools. But obviously, with the financial crisis and COVID-19, in particular, we've seen a lot of unconventional monetary policy tools, tools that, we actually didn't really fully understand. We didn't know how they interacted with the other tools. And really, I mean, I almost frame our response to COVID-19 is throwing spaghetti at the wall and seeing what stuck, right.

Smith: I mean, it is a lot of different tools and a lot of different directions, in the magnitude and timing of those instruments creates a lot of uncertainty as well. And then just calibration of the models. I mean, measuring the economy as is currently before you intervene in the economy, and then sticking your dips again later on to see how to calibrate your models and see how well you've done. There's a wide range of different things that you could use to measure the state of the economy. The obvious ones are GDP or interest rates.

Smith: But Greenspan famously looked at men's underwear sales at points, people have looked at conference attendance, gold, dry cleaning, there's so many different metrics. And even if you dig into one of the metrics, like the labor market, which measure of the labor market are you going to use? Are you going to use hiring rates, job openings? There's a lot of discretion, Yellen reportedly had a labor market board with nine different measurements in there. So that adds to the uncertainty, right, if they're going in different directions.

Smith: And you can start to see why these technical problems make central banking more art than science. While, when we talk about the formal models, it's very clean and precise. But there's a lot of fuzziness in the objectives, targets, instruments and calibration, that makes central banking very, very difficult. And those we wanted to separate from the true knowledge problems. And the knowledge problem is that it's fiat currency, someone has to adjust the supply of currency. There's no automatic adjustment mechanism as there is with like gold standard or competitive currency just for comparison.

You can start to see why these technical problems make central banking more art than science. While, when we talk about the formal models, it's very clean and precise. But there's a lot of fuzziness in the objectives, targets, instruments and calibration, that makes central banking very, very difficult.

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Smith: So problems emerge in terms of forecasting the demand for money, because there's new financial regulations coming out, there's new financial products, even sweep accounts, those look pretty mild compared to our financial instruments that we have today with cryptocurrency and non-fungible tokens, those through the Fed off its course and fooled it and misled its policy. So imagine trying to deal with that.

Smith: And then I mean, the regulatory and fiscal policy changes that occur also affect the demand for money as well as demographics, inflation, inequality, there's so many factors that affect it. And then the final argument, and you're well aware of this as an advocate for NGDP targeting is the supply shock problem when it comes to inflation targeting that the Federal Reserve will actually engage in the wrong direction, whenever there's a positive or negative productivity shock from what they should be doing, and those are sometimes hard to forecast, they affect different sectors of the economy.

Smith: Price stickiness can affect how quickly they make their way through the economy. So that we argue, renders the task of central banking because there's no automatic adjustment process. There's no way as the monopoly supplier that they know what the optimal supply of money should be, given what the demand for money is, in real time. Sure, we can calculate a long term average of the demand for money. But we commissioned central bankers operate and to mitigate the short and medium run fluctuations, especially during the times that aren't ordinary, right, and that's when your long run money demand estimates are going to be no good.

Beckworth: I can think of several examples to maybe illustrate this just recently. I mean, right now, inflation is up. And some of that, maybe a large part of that is due to supply bottlenecks. I mean, the price of lumber, gas, all these things are up and I just saw an article today that a number of futures are going down, the markets correcting itself, but yet there's calls for the Fed to tighten, because people are seeing this.

Beckworth: So there is this knowledge problem in real time. I also think of the repo crisis in September 2019, the Fed wanted to shrink its balance sheet just enough, so it could stay in a four ample reserve operating system, but it kind of fell back unexpectedly into a corridor, create all kinds of problems in the money market. I want to take those observations and switch into a deeper question about what is this knowledge problem?

Beckworth: And that is, what if the central bank did have great knowledge, even complete knowledge? And so I'm thinking right now, China, the Central Bank of China is releasing its own central bank digital currency, and unlike other countries, it's actually using it to monitor its citizens, which is troubling in its own right. But the Central Bank of China can say, "Aha, now we know velocity of money perfectly, we know spending perfectly, we know prices perfectly." So putting aside the civil libertarian concerns about their currency, could they still be able to master and run a great monetary policy, given all the knowledge they have? Or is there still a knowledge problem even in that setting?

Smith: I would certainly argue that there's still a knowledge problem, I compare it to the Soviet Union. Yes, with all the advancements they had in design to essentially plan the economy, perhaps if you stop all innovation and keep the economy as is like a very farming society, very simple. Eventually, you're going to be able to centrally plan somewhat. But the fact is, if you have an open economy, and you allow innovation, and you also have the political factor with new regulations coming in, how the demand for money is going to manifest itself and change as demographic changes as we have a global pandemic, I think is impossible for a central banker to know any real time sense.

Beckworth: So even if we get great improvements in real time data, and we're knowing real time information, throw in some artificial intelligence, evolving Taylor rule based on some smart computer algorithm, we're still going to have knowledge problems is what you're saying is.

Smith: You know why, I think, because when you increase the complexity, you add AI, you use quantum computing, you increase the complexity at the bottom, too. So it's not just like we have this new technology that we can put over top of people. It's the people at the bottom have that technology too, and we don't know how they're going to use it, and how that's going to affect their demand for money.

When you increase the complexity, you add AI, you use quantum computing, you increase the complexity at the bottom, too. So it's not just like we have this new technology that we can put over top of people. It's the people at the bottom have that technology too, and we don't know how they're going to use it, and how that's going to affect their demand for money.

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Beckworth: Well, Alex, let me ask you this question. So you bring up in this chapter, the story of AOC questioning Chair Powell, and she got him to admit that he did not really have a good grasp on the natural rate of unemployment or what is the true speed limit of economy. He acknowledged that the Fed had over estimated over the past decade, because it kept going down their estimate of it. And you mentioned also his speech, Navigating by the Stars, where Jay Powell comes out and says, "Look, we don't know what the natural rate of unemployment is, we don't know the equilibrium real interest rate."

Beckworth: So he came out with some humility. And one could argue the Fed's new framework is a result of that humility. Because what the Fed is doing, you mentioned this earlier, average inflation targeting, the Fed is saying we're not going to try to predict when inflation is going to go up, we're going to wait till it actually shows itself, because we don't have a good working theory, may have theories, but they haven't worked. And I think the Fed's new framework is an implicit acknowledgment that they have not done a good job forecasting inflation. So, put that game to a aside, let inflation manifest itself and then respond. So is that a step in the right direction or not?

Salter: That's a great question. So I think the place to start is to focus on the unique economic problem posed by money, which is something that we actually rely very heavily on in the book. Money is one half of all exchange. We want the medium of exchange to facilitate transactions, but we don't want money to impinge on the pricing process, right, we don't want monetary disequilibria to result in systematic errors in the market price and process of goods and services.

Salter: Because if you're using money, then one half of all transactions are in money. If you're planning the dollar price of pizza, you're also planning the pizza price of dollars, etc. And so from that starting point, I think that that's why these knowledge problems are never fully going to go away. Because as long as you're trying to engineer monetary equilibrium from the top down, you're just facing a central planner problem, just the reciprocal side of it.

Salter: So that being said, there are better or worse attempts, getting some feedback here. There are better and worse attempts to deal with it. I think, at the margin, the move to an average inflation target is something that looks pretty good on paper. So I'm cautiously optimistic about it. I like the idea of pinning down the long term price level in terms of we can be reasonably sure about over correcting tomorrow if we under correct today, so we can make sure that the growth rate of the price level is whatever it needs to be to hit that moving target. So I like that.

Salter: I am worried though that in a world of information and incentive imperfections, the real world of central bankers are well-intended, they're fallible human beings, whether we're introducing too much noise in the pricing process in the short run, because the long term precision that we get also comes with some short term wiggle room, right? Because we can always say, well, why did you deviate from the average inflation target? You can always say, well, our deviation now was necessary to make sure that we get back to the growth path.

I think, at the margin, the move to an average inflation target is something that looks pretty good on paper. So I'm cautiously optimistic about it...I am worried though that in a world of information and incentive imperfections, the real world of central bankers are well-intended, they're fallible human beings, whether we're introducing too much noise in the pricing process in the short run, because the long term precision that we get also comes with some short term wiggle room.

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Salter: And maybe that's going to be less of a problem once we actually figure out where the growth path is, right, once we figure out where the start date is, what we're looking at going forward. And so I think that, even though this is something that we don't explicitly touch in the book, I do think that there are many theoretical merits to average inflation targeting. I like it better than just the 2% year inflation target that the Federal Reserve previously had, its previous 2% self-chosen target. And I like that better, of course, because it persistently failed to hit it for the better part of a decade.

Salter: And so now that we're doubling down a little bit and recommitting to a better understanding of the nominal anchor, which I like. But I don't think that that solves any of the fundamental problems that Dan and Pete and I point out, that I don't think that it obviates the case for a true monetary rule, which is something that we would still like to see, in terms of getting the Federal Reserve to live up to the monetary mandate. We don't really touch the regulatory mandate in this book, although as you can probably guess, we have thoughts about that as well.

Beckworth: Sure. Well, let's move to the next chapter. In the next chapter, you talk about incentives. And you say, central bankers don't have great incentives. So walk us through. What's the problem here?

Incentive Problems in Monetary Policy

Smith: So we argued that central bankers face two sets of problems. One is internal pressure, and one is external pressures. So the internal pressures, the Federal Reserve is a bureaucracy and it suffers the same tendencies as every other bureaucracy, self preservation, budget maximization, inertia group think, that Bernanke he quote, where he admits that the Federal Reserve made an error with the Great Depression. That was 70 years after the Great Depression. Right. It takes a long time.

Smith: And I know, David, you've pointed this out in some of your work, when we switched in the financial crisis from a corridor operating system to a floor operating system. We stuck with that. And I don't think there are good arguments for sticking with it, and yet we continue to move on. So there's that a lot of inertia.

Smith: There's also a very concerning influence on the economics profession. So it's no secret that this central bank, especially the Federal Reserve is one of the major employers of monetary economist and the sponsor of economic research. And there's been accounts of people that have been at the Fed coming out and saying there's is suppression to some extent. Alan Blinder, reportedly had his tenure at the Fed cut short because he wasn't conforming. Paul Krugman reportedly has been uninvited from a conference for criticizing the Fed.

Smith: There's something that we should worry about when a large institution employs so many monetary economists, which is, are we creating groupthink? But I think the more concerning pressures are the external pressures. And we split these up into three different categories: debt accommodation, political influence, both legislative and executive, and then the special interest group pressure.

There's something that we should worry about when a large institution employs so many monetary economists, which is, are we creating groupthink?

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Smith: So debt accommodation is, I think, fairly simple. When the Federal government engages in, puts out a lot of debt, if the central bank is just trying to even keep things constant, it's got to adjust this policy for that increase in debt. And I think we've seen this, especially with the new operating framework under Trump, his fiscal policies did cause the Federal Reserve to adjust its interest rate policies.

Smith: And I think we'd see more of this if we see something like what's advanced under the rubric of modern monetary theory, or the Fed now accounts were initially in the stimulus bill, like some type of more of a helicopter type drop, those type of things, I think, would even cause more concern. And I think, more fundamentally, and Alex and I were just talking about this, one of my biggest concerns about the Federal Reserve right now is it's walking perfectly in step with the Treasury. And now we even have a former chairperson of the Fed as the Secretary of the Treasury. That's very concerning.

Smith: And in all the academic research, most of it talks about the need for coordination. It's almost as if the 1951 Treasury-Fed Accord never occurred. So that's a big concern. I think, political influence is... We just got done with Trump's tweets towards the Federal Reserve. I'm actually more concerned about the meetings like with Greenspan and Clinton that we're... I’m jumping all over the place, but we have the Burn's tapes, Arthur Burns, and Richard Nixon tapes, where he's sitting Burns down and saying, "The Fed's not independent." Laughing and telling them get interest rates down.

Smith: Those concerning. But I think the more concerning one is the Greenspan Clinton type relationship, where it was weekly meetings, and there was bargaining going on, if you do this, we won't do this. So there's a lot of ways both officially and unofficially, for politicians to exert control over the Federal Reserve. I think, Sarah Binder and Mark Spindel do a great job in the myth of Fed independence and talking about how Congress has threatened the Federal Reserve at times in order to push it in certain directions.

One of my biggest concerns about the Federal Reserve right now is it's walking perfectly in step with the Treasury. And now we even have a former chairperson of the Fed as the Secretary of the Treasury. That's very concerning... There's a lot of ways both officially and unofficially, for politicians to exert control over the Federal Reserve. I think, Sarah Binder and Mark Spindel do a great job in the myth of Fed independence and talking about how Congress has threatened the Federal Reserve at times in order to push it in certain directions.

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Smith: And then the last one, special interest group influence. The major concern right now is just the revolving door between the major financial institutions and the Federal Reserve and the Treasury. It's clear that policy is being undertaken, especially in times of crisis in order to benefit those institutions. And it's clear, one of the factors driving is that revolving door, the Carmen Segarra tapes, I think, make this clear, that's on the regulatory side.

Smith: But I think it reflects a culture at the Federal Reserve of willingness to walk in step with these industries. And you can go back historically to other special interest groups, like farmers getting into the trackers and surrounding the Fed, or construction workers sending in two by fours and stuff like that. But I think the major thing there is actually the major financial institutions.

Beckworth: Do you add anything, Alex?

Salter: I think Dan hit it perfectly.

Beckworth: Fantastic. Well, I want to jump in to the chapter on the rule of law, because this book is about the rule of law, monetary policy is a key part of your argument. And you talk about real monetary policy rules versus pseudo monetary policy rules. And I guess just the general idea, what is the rule of law? Why should we care about it? And then how do we apply it to central banks?

What We Mean By ‘Rule of Law’

Salter: Great question, because that really does get at the heart of the book. And it's one of the main reasons that we wrote it. So as we understand the rule of law, we're borrowing heavily from scholars like Hayek and Buchanan on this. It's not just procedural, although procedure is very important. There is also some minimal content standard there, you want rules that are general, predictable and non-discriminatory.

Salter: You want them to apply to citizens, quasi-citizens, you want them to not impose undue obligations on some certain subset of the population to redistribute benefits to the other part of the population, and you want people to be able to reasonably understand and anticipate what the rule is and how it should apply. Now, when we think of the rule of law, we think of it as applying to legislation like tax policy, or who gets that subsidy or who doesn't.

Salter: We don't very often think about it as applied to monetary policy and central bankers, but we should. Money is a basic social institution that underpins the commercial society. If anything, it should apply even more strongly to our monetary affairs than it does to tertiary things like taxation policy. And so we don't see monetary policy as a thing like a DA with prosecutorial discretion or something like that, that's an area where you actually might prefer a local magistrate to have some room to meet the exigencies of time and place.

Salter: But because money is such an important basic social institution, and because we understand the unique economic problem posed by money, we're not persuaded that really any degree of discretion in monetary policy is something that's desirable from the perspective of maintaining short run economic stability. And so when we're talking about democratic justifiability, we need these institutions to be acceptable by the citizens. We need monetary policy to work for the benefit of all, not just large financial institutions that are judged too big to fail. And then we ask the taxpayer to put those risks on their balance sheets when things go bad.

Because money is such an important basic social institution, and because we understand the unique economic problem posed by money, we're not persuaded that really any degree of discretion in monetary policy is something that's desirable from the perspective of maintaining short run economic stability...money isn't special. It's another public institution of basic importance and our post enlightenment jurisprudence norms about what is good and what is not acceptable in terms of public institutions and justifiability should apply equally to money.

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Salter: And so we think for all those reasons, we really need to take seriously this idea that to make monetary policy lawful, to make sure it has these general predictable and non-discriminatory components, we really need to restrict the goals of monetary policy to a nominal anchor, although we don't make that nominal anchor point specifically in the book. We do insist that we judge monetary institutions by the same justificatory standards, that we judge other standards of public institutions in a liberal democracy; money isn't special. It's another public institution of basic importance and our post enlightenment jurisprudence norms about what is good and what is not acceptable in terms of public institutions and justifiability should apply equally to money.

Beckworth: What's the difference between a pseudo monetary policy rule and a real rule? Bring out this distinction.

Smith: So a pseudo rule is a rule where you give discretion to central bankers to actually deviate from the rule as they see fit. That's not really a binding rule, it's not strictly binding, and there's no enforcement mechanism, there's no punishment if they do deviate. A real rule is actually going to be both binding, and there's an enforcement mechanism, there's a punishment for deviating from that rule.

Smith: And that's why we firmly come out in favor of a strictly binding rule. Because as we've seen, constrained discretion. We've had this whole debate of rules versus discretion. And Alex and I argued, the rules won that debate. And then somehow it's turned into, we slowly eroded that. And now it's constrained discretion. And we've seen that that has failed to keep central bankers in line, especially in a crisis situation, when there's clamoring from special interest groups or politicians for drastic action.

A pseudo rule is a rule where you give discretion to central bankers to actually deviate from the rule as they see fit. That's not really a binding rule, it's not strictly binding, and there's no enforcement mechanism, there's no punishment if they do deviate. A real rule is actually going to be both binding, and there's an enforcement mechanism, there's a punishment for deviating from that rule. And that's why we firmly come out in favor of a strictly binding rule.

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Smith: It would be much better if they were constrained, and that would help with expectations, because people would know, okay, they're constrained, this is how they're going to operate. We know what's going to happen. I think that would be far better and more conducive to recovery from a crisis than what we're currently seeing.

Salter: It's worth pointing out that we have a perfect example of a pseudo rule, the Fed's 2% inflation target. Right? They had as 2% inflation target within year, right. So every year, they're supposed to hit about 2%. And far more often than not, they didn't hit it, they undershot. And from our perspective, you might think that we're inflation hawks, we're not necessarily inflation hawks, what we want is inflation predictability, right, getting back to that rule of law criterion.

Salter: So what were the penalties for the Fed undershooting its inflation target for so long? It's not that there were any, what were the enforcement mechanisms? None. Maybe Congress yells at them every so often. But that's not really all that terrible. So when it gets back to this really just basic issue of making public credible commitments, we don't think that that can be done except for adopting this rule of law perspective, and embracing true monetary rules rather than pseudo monetary rules.

Beckworth: That's an interesting observation that the Fed broke its rule or didn't live up to its rule by undershooting its target for close to a decade. Going forward, however, I think the concern is in the other direction, right, that the Fed won't step in and stop inflation from running high. Given all the fiscal packages and things that are going on. I don't think that's actually going to be a concern. But let's say that it does manifest itself.

Beckworth: So what concrete steps could Congress take me, I mean, should we tie the wages of the FOMC to outcomes? I mean, in New Zealand, I don't believe this rule has been enforced in New Zealand, the head of the central bank can be removed if they don't live up to their mandate. So are you thinking something like that or something else?

Making Monetary Policy Accountable

Smith: I wouldn't be thinking something like what New Zealand has I have no problem giving central bankers a bonus if they do a specially good job at hitting their target. I think that that would be an interesting idea. But I do think that there needs to be a way for policymakers to hold central bankers accountable up to an including the revocation of their position. So in terms of what I would like to see, I'm actually not a fan of the current dual mandate for monetary stability and employment stability.

Smith: First of all, it's technically a triple mandate. Nobody ever talks about the third part of that act of Congress, which is moderate long term interest rates. And we've sort of just agreed to let that fall by the wayside because the advancement in macroeconomic understanding is that well, over any reasonable time horizon interest rates are beyond the control or competency of the monetary authority.

First of all, it's technically a triple mandate. Nobody ever talks about the third part of that act of Congress, which is moderate long term interest rates. And we've sort of just agreed to let that fall by the wayside because the advancement in macroeconomic understanding is that well, over any reasonable time horizon interest rates are beyond the control or competency of the monetary authority.

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Smith: It's great. I agree with that insight that we've come to it. But at the same time, it also highlights the challenges of getting this rule of law perspective into monetary policy. Because there's a pretty delicate balancing act that has to happen here, right? Statutorily, who is going to discipline the Fed? It has to be Congress, there's nobody else who can do it. At the same time, we don't want politicians on short term election cycles to have too much say over what's going on in terms of day to day monetary policy.

Smith: So I definitely understand that fear, we don't want politicians interfering with the printing press, so to speak. But I think sometimes that argument is used as a shield to insulate the monetary authority from any meaningful criticism by the people's representatives. Congress enacted the Fed, the Federal Reserve Act was passed by Congress, Congress has modified it many times. It's ultimately, it has to be Congress that conducts this oversight authority. And if we're going to have any meaningful discipline on the monetary authority, we're going to have to actually deliberate this in the halls of Congress.

If we're going to have any meaningful discipline on the monetary authority, we're going to have to actually deliberate this in the halls of Congress.

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Smith: I know that that's not popular right now, many people perceive that Congress is A, dysfunctional, and B, more than happy to outsource as much of its powers can to non explicitly partisan entities to take the heat off themselves. And be that as it may, if we want to actually have this rule of law enforcement process, it's going to need to be something that Congress takes seriously again.

Q&A from the Live Audience

Beckworth: This has been a great conversation. I do want to turn to the audience and to the online folks who are watching and take some questions from them. So if you have any, please do so now.

Audience Member #1: Our first question is society is going more digital in the future. If the first concern is the choice of operational architecture, should the payment system rely on trusted central authority like a central bank to ensure integrity? Or could it be based on decentralized governance system where the validity of the payment is built upon its network participants?

Beckworth: So that sounds like a cryptocurrency fan out there. Right? And so should we move towards some kind of cryptocurrency payment system monetary system?

Centralized vs. Decentralized Digital Currencies

Smith: I think it's very clear that the private sector can provide those mechanisms. And if the private sector can do it and do it well, I see no reason for the Federal Reserve to step into the game and try to provide that market.

Salter: I agree with Dan, I've viewed with suspicion the proposal is to create a central bank digital currency, the helicopter drop accounts that Dan was alluding to previously. I've systematically under-predicted the success of cryptocurrencies like Bitcoin, so I'm by no means a credible authority on cryptocurrencies. I like that it's there. I really like that it's providing this alternative mechanism for payments, which can serve as a way for consumers to switch if and when things are going at the current governance system just don't look so hot.

Salter: That being said, I'm really not comfortable with the Federal Reserve. Even more getting out of its lane to regulate cryptocurrencies, to move to a digital payment system beyond what it's already doing, I would be much more comfortable with reforming the monetary mandate, and then allowing innovative solutions and currency and payments to emerge in the private sector.

Beckworth: Well, I guess one of the questions I have and I'd love to hear your response about cryptocurrency is it's largely being used as an investment store of value. It's not really widely used as a means of payment. You still got to pay with dollars or turn your crypto back into dollars. Some places do take it, but for the most part, it's more of a speculative asset than it is a medium of exchange. So do you see a future for cryptocurrency as a true medium of exchange?

Salter: A medium of exchange, possibly, the dominant medium of exchange, I'm skeptical. The whole point of these media of exchange networks is that you have these really strong network effects. And so I don't think that the dollar is going anywhere, anytime soon. I think it's really great that we have entrepreneurs who are willing to invest in and create these new alternatives.

Salter: And occasionally, you get some pretty cool headlines out of them. Right. Elon Musk has said SpaceX is going to do a Dogecoin mission to the moon, financed with Dogecoin. So that's pretty fun, right? That's interesting that you have serious private sector people who are willing to do [with cryptocurrencies] like that. At the same time, it's not really getting at the heart of the monetary network itself, right? It's sort of being used for these alternative purposes rather than the medium of exchange function as money. And so my personal take Is that something really catastrophic would have to happen to the dollar, in order to nudge us away from that current equilibrium. And I think that it's not a good thing to wish for that to happen. I'd prefer things don't go that bad, that quick to get us off to that network.

That's interesting that you have serious private sector people who are willing to do [with cryptocurrencies]. At the same time, it's not really getting at the heart of the monetary network itself, right? It's sort of being used for these alternative purposes rather than the medium of exchange function as money.

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Beckworth: If that happens, we got bigger fish to fry.

Salter: Much bigger fish to fry.

Beckworth: If that happens, but I do think there is room for FinTechs to innovate. They are innovating. I mean, just a couple of weeks ago, the Federal Reserve opened up its site for comments on a new proposal that allows non bank financial firms to have access to its balance sheet for these firms to have better accounts, better master accounts. And I think there's an argument to allow like Venmo, and PayPal, firms that don't do maturity transformation, that don't make loans, but simply are just the means of payment to have their own accounts at the Fed. And then they can innovate on their end. Are there any questions here? Anyone have any questions here? We'll go back to the online questions.

Audience Member #2: Looking at some of the problems faced by the Fed, and the fact that it's still more efficient in discharging its mandates than central banks in Africa, for example, do you have any advice for better central banking in Africa?

Central Banking in Developing Nations

Salter: That's a tough question. I don't have any particular expertise in that area of the world. My recommendation would be to stick with what the hard one macroeconomic knowledge is on what central banks can and cannot do. If you're looking to get control over the price level, if you're looking to base policy on some sort of a nominal anchor to create greater predictability in the market economy, yeah, central banks can do that, we have a pretty good idea of how that works.

Salter: There are some other tertiary functions that I'm less comfortable with. But nonetheless, you can make an argument that are a part of central banking best practices like acting as a lender of last resort. So that might be something that you would incorporate there as well. But beyond that, I would really caution any central bank to resist the urge to get involved with the fiscal financing process, to resist the urge to pick winners and losers in the marketplace, right?

Salter: The maxim that we all think of is ‘with great power comes great responsibility,’ well, monopoly on base money is a pretty great power. And so that gives you a lot of ability to affect change for good if you're willing to set the basic rules of the game in terms of the nominal anchor. But anything more than that, and things can go pretty bad pretty quickly.

Smith: So it kind of makes me think of Click’s paper on seigniorage in a cross section of countries. And it's oftentimes the developing nations that rely most extensively on seigniorage for revenue. So I think the case for a rule of law is even stronger for developing nations. But I also think the ability to actually enforce the rule of law could be more difficult in developing nations as well.

Smith: So it's a real tough problem. But of course, there's always exploiting central banking, right, you dollarize or you adopt a foreign currency, instead of trying to do it yourself is always an option. But if there is the capacity there at the foundational level, to adopt the rule of law and be able to actually enforce it, I think that's the best path forward.

Beckworth: You've provided a nice segue to one of the questions I had for you, it's tied to this, it's tied to emerging market, places where you mentioned, it may be harder to do the rule of law. And that is, is price stability about a rule per se, or about a deeper institutional commitment to price stability? So we criticize the Fed for not hitting 2% over the past decade, well hitting one and a half percent. So it's half a percent over the whole decade.

Beckworth: And yes, you could say that leads to a price level path different than expected. But that was a period where I think you would argue a lot of discretion. They did a lot of discretionary stuff, we had incredible low inflation. The gold standard, it's a rule that helped bring about price stability during the classical gold standard. But it's also a rule that could be broken easily. I mean, underlying, I guess these regimes, is it the rule so much, or is it this deeper commitment by the body politic to price stability?

Beckworth: So the Fed may try, crazy operating systems may try this rule, that rule, but the end of the day, it's constrained by what the public wants. And maybe in some places, there's competing interest. So what is the real deeper heart of price stability?

Smith: I mean, we use New Zealand as an example, and I think they've adjusted their range of inflation targeting several times since implementing it. So they have this enforcement mechanism, but they never have to use it because they keep adjusting the ranges. So I think we do make the case for formal explicit rules. But I think you are right that there has to be a culture just like a constitution that appreciates, respects and adheres to those. In the book talking about James Scott seeing like a state. And we argue rather than seeing like a state when it comes to our monetary institutions, what we should, which is its openly technocratic, it's rationalistic.

Smith: What we are argue is you got to see like a citizen and appreciate money as a property right of citizens. And therefore, that leads to the appreciation for the rule of law, when you actually say, okay, this is money in the pockets of people. What was our fiduciary responsibility as a monopoly supplier of currency? Well, we argue that you have to be general, predictable and non-discriminatory.

Beckworth: All right. Another question.

Thoughts on Free Banking

Audience Member #3: What are your thoughts on a free banking system and the abolishment of the Fed?

Salter: Should I start?

Smith: Please.

Salter: I think that this is one that we're both going to want to take. I am persuaded that a free banking system would work. I am persuaded that we do not need a monopoly issue or a fiat currency, I would be perfectly happy to have something like a gold standard. I think many of the criticisms levied against it are just frankly wrong if you look at the historical data. That being said, I'm personally more interested in responsible reforms to the institutions that we have.

Salter: I certainly think that if we were to make a concerted effort to get rid of the Federal Reserve System to go back to some alternative system, maybe even to freeze the monetary base, and then just say, this is the new monetary base banks conducting financial intermediation on top of that, and that's going to be the new system. All well, and good. I think it would work. I don't think that it would be any worse than what we have.

Salter: That being said, I would personally be more interested in seeing reforms to the existing operating framework that would do a reasonably good job of approximating that sort of a system, because the political transaction costs of a complete change are just going to be astronomically high. And if I'm being frank, there's just no political coalition for it. Right. There's nobody in the political arena who's going to get behind that because the interest in that is not sufficiently high.

Salter: And like you just said a minute ago, right? The ultimate rule has to be invested than the people themselves. Rules are a necessary but not sufficient condition for good governance. Right. If the populace isn't on board, then in a democratic society, you're just not going to have it happen.

Beckworth: All right, Dan?

Smith: I completely agree with Alex. I think the practicality of it going up against entrenched, well established and respected bureaucracy is incredibly difficult. The more we do move towards rule frameworks, average inflation targeting, NGDP targeting, I think that obviates the need for that large of a bureaucracy. Because if you're saying, okay, now we're committing to this rule, well, maybe we don't need as many research economists, maybe we don't need all these staff economists at hand. That I think could be a natural way to kind of wind down the Fed. But I just don't see in the range of political possibility of saying, hey, we're going to end the Fed, and move to competing currencies as much as I think it would work.

Beckworth: Well, maybe Elon Musk can set up a free banking system on Mars, when the colony is established. But I wanted to flesh this out for the listeners of macro musings, because maybe some of them haven't heard of free banking. So I agree with you guys. I don't think it's a hill most people want to die on because it's just politically not going to happen. But for the listeners who don't know about the free banking history, tell us about it, Scotland, Canada. How in the world is it that a banking system exists without a central bank? What about financial panics? Can you shed some light on that?

Salter: Absolutely. So because most people are usually a little more familiar with US macroeconomic history, they have this understanding that banking is something that's inherently unstable because US banking and monetary history was notoriously unstable. But if you take a broader view, you realize that that was the exception rather than the rule. You brought up Canada in the 19th century, Scotland until the banking reforms in 1844, I believe.

Salter: The way that this works is if you have the same rules governing money and banking as you do other sectors of the economy, just the general law of property, contracts and torts in a common law legal system, you actually get the evolution of robust institutions, banking, clearing houses, and things like that, that sort of ameliorate a lot of these macroeconomic problems by facilitating clearings between banks during emergencies, sometimes even acting as a proto lender of last resort.

Salter: And so if you look at the broader banking history, you see nations that are on some sort of a commodity standard, with banks that are free to conduct financial intermediation on top of that, those bank liabilities tend to be what people actually use as money day to day. And then when there are big spikes and liquidity demand, those institutions are able to meet that by relying on the clearing house, by relying on transactions between other financial intermediaries.

Salter: And so going back to the US experience for a little bit, the reason that the US was notoriously unstable is that we had all these statutory laws on the books that made the money supply quite inelastic to the needs of commerce. Right. So you had these restrictions on the money supply that banks could issue because you had to have a certain fraction of your assets posted as a collateral bond with the state comptroller, before you could increase the money supply.

Salter: Well, that might do something for safety in the short run, whenever there's a big and unexpected spike in money demand, you can no longer meet that spike in money demand with an easy offsetting increase in money supply. And so now we're going to have some nasty balance sheets effects, right? You had all these restrictions on branch banking in the United States, which overly forced US banks to be exposed to geographic specific risk. And that's something that you didn't see in Canada, or Sweden or Scotland, right?

Salter: If you can branch across the country, it's going to be much easier to not be overly exposed to say, I'm a bank, and I'm loaning to farmers. And now there's a bad crop. And so all the farmers that I loaned to can't pay me back. And now my bank's going to go under, that means that everybody's savings are gone. So they're in trouble. And then you get this sort of cascading failure process.

Salter: And so if you look at the history of money and banking, especially from the 17th, 18th and 19th centuries, what you really do see is the "free banking system" where perhaps the only special restriction that applies to banking is a system of extended liability, double or triple liability for shareholders.

Salter: Aside from that, you don't need any banking specific regulations, the system works well on its own, the market mechanism can actually govern money in banking arrangements. And oftentimes that works significantly better.

If you look at the history of money and banking, especially from the 17th, 18th and 19th centuries, what you really do see is the "free banking system" where perhaps the only special restriction that applies to banking is a system of extended liability, double or triple liability for shareholders. Aside from that, you don't need any banking specific regulations, the system works well on its own, the market mechanism can actually govern money in banking arrangements. And oftentimes that works significantly better.

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Beckworth: So just to summarize, the banking system in Canada, if I recall correctly, the central bank comes onto the scene in 1935, I believe in Canada. And before that, there was no central bank. And they actually had zero bank closures during the Great Depression compared to US had 9000. So Canada had a relatively robust banking system, even without a central bank. And then the free banking experience in Scotland, did that run about 100 years or so?

Salter: Ish.

Beckworth: Ish, close to 100 years, and it did not have financial panics. It didn't have the problems we see modern day. Now, again, this is an interesting case study from the past, it's not something that I think all of us up here would think it's politically feasible, but we want to at least acknowledge it, that it's there, it's possible in the past, and then it should maybe use as a benchmark when we think about banking reforms.

Beckworth: Okay. We have run to the end of the hour for the show. I want to thank Dan Smith and Alex Salter for joining us. Their book is titled Money and the Rule of Law: Generality and Predictability in Monetary Institutions. So go get your copy, it's available now online. Thank you, gentlemen, for joining us today.

Salter: Thank you, David. This is great.

Photo by Martin Bureau via Getty Images

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