Constitutional catallaxy

April, 2019

Most liberal constitutional theorising, as exemplified by Buchanan (1975) and Rawls (1971), operates with a two-level scheme of analysis. The first level entails agreement on the rules through which a polity is constituted; the second level entails self-interested action inside that framework of rules. Within this framework a polity is constituted through agreement on the rules that frame political action. In this paper, we explore how this scheme of analysis might be relaxed by recognising that acquiescence is not agreement. Hence, people can acquiesce in some framework of governance without truly accepting it. In this alternative framework, agreement on rules is always incomplete, for two sets of reasons. One is the limited and divided quality of knowledge (Hayek, 1937; 1945). The other is the persistent presence of antagonism within society, as conveyed by Carl Schmitt's (1932) distinction between friends and enemies, and with that distinction present as well in William Riker's (1962) theory of political coalitions.

Decentralize Financial Regulation

Wednesday, November 22, 2017

The 2007–2008 financial crisis upended conventional wisdom for financial companies, government regulatory bodies, and economists. We are still feeling the effects a decade later, as post-recession growth has been meager by historical standards. Moreover, as our new research shows, many assumptions about what caused the financial crisis are mistaken — making a repeat more likely.

Both sides of the political aisle are responsible for the inaccurate narrative. The Left tends to highlight lenders’ alleged greed in exploiting “subprime” borrowers, while the Right has focused on the “moral hazard” created by government bailouts and the bad investment caused by government subsidies. Such explanations are at best incomplete. The truth is more complex — and more disturbing — than these morality tales let on.

A well-functioning financial sector requires firms to assess and manage the risk of their actions accurately and carefully. In reality, these companies’ worst-case scenarios have turned out to be naively optimistic. The truth is that just about everyone was taken by surprise in 2008, not only by the crash, but also by its sheer magnitude. No one — including financial firms — anticipated that things could get as bad as they did.

In fact, the financial system is too complex for anyone to understand all its intricacies and dangers. Thus securing financial stability requires acknowledging this complexity as a starting point. Admitting what we don’t know is more productive than pretending to understand more than we do know.

Economists have paid too little attention to the problem of fragmented and incomplete knowledge, especially on the part of regulators trying to engineer stability. As a consequence, economists and regulators rally around technocratic solutions to financial instability that are ill-equipped to accommodate unanticipated change.

Take the current fascination with “macroprudential” regulation. This approach focuses on systemic risk within the entire financial system. In practice, it’s the same old regulatory dance to a slightly jazzed-up tune: Economists and regulators claim they can keep the financial system safe by keeping an eye on system-wide variables such as asset structures and credit ratios. The problem is that, at best, these variables provide a bird’s-eye view of an incredibly complex process. Ultimately, macroprudential regulation amounts to increased regulatory discretion by would-be financial czars who — despite their expertise — will inevitably make some human errors.

Good intentions aside, such policies threaten to make an already brittle system even less resilient. A system is fragile if it works well only when the people in charge are benevolent and have all the information they could possibly need.

That describes our current, highly regulated financial system precisely. To work properly, it requires too much knowledge, generosity, and rationality on the part of everyone involved — whether in the private or public sectors. Even fairly small departures from the assumptions of omniscience and benevolence can create large-scale problems. 

A more promising way to achieve financial stability lies in the concept of “institutional resilience,” developed by 2009 Nobel Laureate Elinor Ostrom. In Ostrom’s system, an institution is robust if it continues to perform well even when powerful players are selfish and ignorant. A resilient system of this sort punishes or offers corrections for errors of judgment, gaps in knowledge, and irresponsible behavior before they unfold into a full-blown financial crisis. 

Is this type of analysis useful beyond diagnosing institutional problems? That is, how can we correct our current institutions or even design better ones? 

One of Ostrom’s other insights is the concept of “polycentricity.” She points outthat because institutional design is so difficult and rife with uncertainties, systems must be allowed to evolve by embracing market-like features with numerous players and independent rule-making authorities. This is the opposite of what currently prevails in our financial system, which is regulated in a top-down fashion.

Because they are decentralized and allow solutions to emerge and spread organically, polycentric systems have some important advantages. First, problems generally remain relatively contained at small scales. Second, when problems occur, one part of the system is able to absorb some of the turbulence occurring in others. Third, experimentation can discover “best practices” that can be shared or even generalized. 

Historically, the financial-banking system that comes closest to being polycentric is what is known as “free banking.” This is a bit of a misnomer, as free banking does not mean that the system is unregulated. Rather, such systems eschew top-down federal regulation, relying instead on a combination of formal and informal rules that promote resilience, many of which are enforced by bankers themselves. 

The backbone of a free-banking regime is a system of private clubs. Historically, the most important clubs were the private clearinghouses created by banks for the purpose of settling liabilities. As they evolved, the clearinghouses created safety-promoting rules, such as minimum reserve requirements, and monitored banking activities to ensure members were not behaving irresponsibly. Unfortunately, this system was gradually eliminated by the creation of modern central banks and government financial regulators.

Polycentricity suggests a solution to our own fragile financial system: Governmental authorities should make some room for financial institutions to self-govern. Doing so would require a judicious repeal of much existing regulation, in a manner that allows private networks of exchange and regulation among banks to emerge once again.

The need for stability in the financial system remains one of the most significant public policy challenges today. Worryingly, policymakers and regulators appear to be doubling down on the same tried-and-failed strategies of centralization and micromanagement by government regulators. A better approach would be to embrace a genuinely polycentric financial system, which could more readily absorb the shock — and perhaps even reduce the likelihood — of future financial crises. 

Governing the Financial System

November 8, 2017

The 2008 financial crisis has sparked a renewed discussion of ways to combat financial instability. Alexander W. Salter and Vlad Tarko argue that a system of multiple, interlocking financial regulatory institutions—a polycentric system—could be a more effective policy tool for combating potential instability of financial and banking systems, which are largely governed today by top-down regulatory institutions (a monocentric system).

Lessons from Free Banking Systems

Institutional resilience is key to stable governance and is defined by robustness (the ability to absorb and recover from shocks) and adaptability. Contrary to their reputation for instability, banking systems in which banks issued their own money and operated without oversight from a central bank (free banking systems) were remarkably resilient, in large part because of three nested mechanisms:

  • The distinction between the medium of redemption and the medium of exchange. Today, money created by the central bank is the medium of redemption, but it can also be spent in the economy as the medium of exchange. In a free banking system, each bank printed its own currency but held the medium of redemption (historically, gold or silver) in its vault. Since an inability to fulfill withdrawal (redemption) requests would require a bank to sell its assets to meet demand, this encouraged banks to maintain adequate liabilities in circulation to meet the needs of trade.
  • The interbank clearinghouse enforced minimum-quality standards, cleared liabilities, and provided emergency loans to minimize transactions costs.
  • The hard budget constraint, or the fact that the amount of money in circulation was finite, was the result of extended liability, which made the owners of banks liable if banks couldn’t meet their obligations. These mechanisms provided strong incentives to banks to avoid taking on too many risky assets.

Using Design Principles to Understand Robust Governance

Whether or not a transition to a fully polycentric banking system is plausible or contemplated, lessons from free banking can improve understanding of what makes polycentric financial regulation resilient, which, in turn, can provide guidance for more effective financial regulation.

Salter and Tarko build upon the broader literature on polycentric governance and institutional resilience, and adapt the Nobel laureate Elinor Ostrom’s “design principles” for robust governance institutions to the problem of financial stability. Accordingly, they argue that in a successful system,

  • Boundaries are clearly defined, such as those established by clearinghouses and financial exchanges.
  • The price system and bankruptcy match benefits with costs as banks compete for customers by offering lower prices, but will remain in business only if they can earn enough to cover their costs.
  • Those affected by the rules have the ability to change them. In free banking systems the banks were self-regulating, whereas currently they do not play a direct role in rulemaking.
  • Those who monitor and enforce the rules are accountable, such as through members contesting the actions of clearinghouses.
  • The price system and the rules for settling property and contract disputes under the common law provide gradually increasing penalties for breaking the rules.
  • Low-cost options for dispute resolution encourage banks to solve disputes without costly legal battles under free banking.
  • Outside authority respects the rulemaking rights of the community, a major challenge for a financial system with a single, external regulator.
  • Responsibility for governing the system is dispersed through nested levels of governance through the entire system, allowing free banking systems to accommodate the wide variety of services offered in the financial system in a way that is difficult for top-down regulation.

Money as Meta-Rule

September, 2018

This paper explores James Buchanan’s contributions to monetary economics and argues these contributions form the foundation of a robust monetary economics paradigm. While often not recognized for his contributions to monetary economics, Buchanan’s scholarship offers important insights for current debates. We argue that the post-2007 crisis milieu creates a unique opportunity to recognize, as Buchanan did, the vital role that money plays in the market as the ‘grammar of commerce.’ That recognition makes the need for more fundamental reform of our monetary regimes at the constitutional level more apparent, making Buchanan’s work on monetary constitutions more relevant than ever before.

Space Debris: A Law and Economics Analysis of the Orbital Commons

September 23, 2015

The dawn of the space age began in 1957 with the launch of Sputnik 1, and ever since, debris from man-made objects launched into space has increased at a significant rate. This debris creates difficulties similar to those typically associated with goods and resources that are available for use by anyone at any time, known as public goods or common pool resources. Orbits have become cluttered as those launching objects into space have little incentive to mitigate or remove debris.

A new paper for the Mercatus Center at George Mason University conducts an economically rigorous analysis of the problems posed by space debris and concludes that the problem is significantly more legally, institutionally, and economically complicated than some may believe. 

Past studies of space debris have too quickly assumed that the space debris problem resembles the tragedy of the commons and concluded that public sector action is therefore justifiable. While a public policy response is reasonable, including a role for the public sector better specify the “rules of the game,” previous academic analyses have been too hasty and casual in arriving at their conclusions. In order to find a solution, policymakers must pay attention to the economics and institutional factors involved in the space debris problem.


Today, there are more than 21,000 known pieces of large space debris, an estimated 500,000 pieces of medium-sized debris, and more than 100 million pieces of small debris. The large debris is tracked with sufficient accuracy to maneuver around it, and the small debris is small enough for a spacecraft to withstand impact. It is the medium-sized debris (between 1 cm and 10 cm) that poses a great risk to the future of outer space commerce.

The amount of debris in space has increased significantly over time, often from accidental collisions but also from the intentional destruction of satellites. See the figure on the next page for more information on the rise of various types of space debris.

Three countries are responsible for a large percentage of the debris: China (42 percent), the United States (27.5 percent), and Russia (25.5 percent). Current efforts to mitigate space debris are under the purview of each nation’s space agencies and other administrative bodies, which issue their own guidelines and regulations to public and private organizations. To date, there is little international cooperation to mitigate or remove space debris, and some treaties signed by spacefaring nations may even prohibit any one nation or party from removing debris created by another.


Current policy debates usually assume that space debris must be reduced without giving serious consideration to economic efficiency or international legal considerations. This creates a gap in knowledge by failing to address the specific problems that must be solved involving incentives, property rights, and international law.

  • Outer space resembles a common pool resource. The space debris problem has much in common with textbook common pool resource problems and public goods problems. No single entity controls the resource that is outer space and therefore, no one has an incentive to take care of it at the current time.
  • Defining private property rights is likely not feasible. Defining and enforcing private property rights, which is a standard solution to this sort of problem, is probably not feasible because defining property rights in outer space would be significantly more costly than it is worth.
  • As more debris is created, the use of outer space becomes more challenging. The Kessler syndrome describes the potential for debris to collide and snowball, cluttering the orbit to the point of rendering its use extremely difficult and costly. If the problem progresses to this degree, the costs of dealing with space debris in the future will be high. The more cluttered orbital access and specific orbits become, the higher the costs the private sector must incur to protect against damage. And as collisions become more likely, insurance will be less effective.
  • Other solutions, such as taxes, have their own significant issues. One proposed solution is to impose taxes on those that launch objects into space, which could force them to take into account the costs they impose on others. These taxes are intended to offset externalities by allocating resources more efficiently, but regulators would have difficulty setting the optimal tax rate, and it is unclear how governments would use taxes to solve the problem.
  • New international legal framework. Solving the space debris problem by reducing debris must involve a clearer international legal framework that explicates the “rules of the game” for launches that create debris. This will necessarily involve bargains among nation-state actors that, unfortunately, have incentives to bargain strategically in their own interest.


Space debris is a serious problem that threatens the viability of outer space commerce, a growing industry that could potentially create enough wealth to raise standards of living. There needs to be a better international legal framework to deal with the mitigation and removal of space debris, or else outer space commerce may become significantly more challenging and expensive.

Singapore's Lee Kuan Yew Showed Good Governance Is Good Business

Monday, March 30, 2015

A “true giant of history who will be remembered for generations to come” has passed away. This portrayal of Singapore's founding father by President Barack Obama came shortly after Lee Kuan Yew died last week at the age of 91. As the world looks back on Lee's legacy, we should pay special attention to his contributions on responsible and effective governance over a three-decade reign as the city-state's prime minister.

In the post-financial crisis world, when many in the West are dissatisfied with their governments – a Pew Research Center poll conducted in February 2014 shows 75 percent of Americans mistrust the government at least some of the time, for example – Lee’s bold political experimentation in aligning governors’ incentives with the welfare of the governed deserves recognition.

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Repealing Banking Regulations Is the Best Path to Financial Stability

Monday, January 5, 2015

Many people blame the recent financial crisis on a lack of regulation and fraud in the financial system. However, the Federal Reserve appears to have been a significant contributor to the crisis in terms of both its poor monetary policy and faulty regulation of the financial system.

In contrast to the current approach of regulators attempting to outsmart the bankers, increasing competition by reducing the restrictions on banking activities and ending the special protections granted to privileged financial institutions will help increase financial intermediation and improve monetary stability. The best path to financial stability is to free the banking system from the current burden of inefficient and costly regulations.

Free and unregulated banking systems provide the financial intermediation consumers want while simultaneously reducing banks’ incentives to take risk. These benefits can be captured in spite of – indeed, because of – a lack of government intervention in the financial system. In a free banking system, banks are allowed to issue their own banknotes. These notes act as liabilities against each bank’s assets. Anyone who holds the banknote can redeem it or “cash it in” for a particular asset specified in advance, such as a regular U.S. dollar or possibly for a commodity such as gold.

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Why the Fed Should Follow Rules

Thursday, December 18, 2014

How should monetary policy be conducted? What previously was a question of interest only for a subset of economists has exploded into popular debate since the 2008 financial crisis. This, no doubt, is due to the Federal Reserve's unprecedented activities during the crisis. Some, such as Stanford's John Taylor, have accused the Fed of fueling a speculative boom by keeping interest rates "too low for too long" in the years running up to the crisis. Others, such as monetary-economics blogger Scott Sumner, argue instead the Fed was responsible for not acting swiftly and decisively enough when the trouble in asset markets became apparent. Whatever the reason, many believe that the Fed bears some of the responsibility for putting the "Great" in Great Recession, and that its activities must be scrutinized to discover how its operating framework can be changed to avoid such a calamity in the future.

Monetary policy can be defined as changing the supply of money in order to achieve some predetermined macroeconomic goal. In this case, the organization doing the changing is the Fed, and the macroeconomic goal is nominal stability -- preventing large and unexpected changes in aggregate demand. Typically this can be thought of as trying to offset changes in the demand to hold money with changes in its supply.

Money is the one good in the economy that does not have a market of its own in which it is independently priced. As such, if the demand to hold money changes, the only way markets can fully adjust is if relative prices across the entire economy change. Since prices, and especially wages, are costly to change, the adjustment at first is highly imperfect, which may result in a misallocation of resources. Ideally, the Fed prevents the need for such costly price adjustments by increasing the money supply if demand to hold it rises, and vice versa. This keeps the money market as close to equilibrium as possible.

A significant debate within monetary economics is whether the monetary authority should act according to a predetermined rule, or whether it should be allowed discretion to act as the circumstances require. The financial crisis seems to suggest the latter. After all, how can crises be avoided if the rule the Fed is bound to follow prevents it from taking decisive action when necessary?

However, this line of thought gets it backwards. A stable and predictable rule is necessary to anchor market actors' expectations by reducing uncertainty over the future stance of policy. This enables market actors to better coordinate their trading activity, increasing welfare by enlarging the gains from exchange. So long as market actors perceive the rules-based regime to be credible, the expectation of stability afforded by the rule will prevent market actors from engaging in the panicked behavior that can precipitate crises in the first place.

Rules are preferable to discretion for three chief reasons. The first is the famous (at least within economics) time inconsistency problem. This basically says that without something tying the Fed's hands, the public will rationally expect the Fed to engage in more money printing than is optimal, resulting in too much inflation. The Fed can credibly commit to lower inflation, and hence increase public welfare, by binding itself to a rule on which it cannot go back. The second lies in the fact that the Fed often lacks the knowledge to fine-tune a system as complex as the U.S. economy. Given this complexity, providing a stable framework is the best the Fed can do. Lastly, we must also remember the Fed is a bureaucracy that is not accountable to market actors. It is subject to status quo bias, as Harvard's Greg Mankiw argues, like all bureaucracies. Therefore, what is best for the Fed may not be what is best for the economy.

Realizing that a rule is preferable to discretion is only the first step toward reforming monetary policy. We must still decide which rule, from the multitude that economists have proposed over the years, ought to be adopted. Perhaps a strict inflation target, similar to that in the charter of the European Central Bank, is preferable. Perhaps Scott Sumner's proposed regime of using nominal gross domestic product (NGDP) targeting has the best chance of offering stability. More sweeping still, perhaps the Fed should be jettisoned in favor of a return to a gold standard, or some other commodity standard. While this last option may seem fantastic, recent research suggests the Fed has not outperformed the classical gold standard in delivering monetary stability, and may in fact have made things worse.

Reasonable people can disagree over what rule a central bank should adopt, or whether we ought to have a central bank at all. It is clear, however, that the current discretionary regime is not in the public interest. Whichever way forward is chosen, we must remember that any reform, if it is to be effective, must not limit itself to monetary theory narrowly conceived, but must incorporate political economy considerations as well.

An Introduction to Monetary Policy Rules

December 4, 2014

As policymakers seek to prevent another financial crisis, they are scrutinizing the role the Federal Reserve (Fed) played before and during the 2008 crisis. The Fed currently exercises a great deal of discretion in monetary policy. A key point of debate is whether requiring the Fed to follow a specific rule would be preferable to the Fed’s current broad discretion.

In a new study for the Mercatus Center at George Mason University, scholar Alexander William Salter examines several different proposed rules that the Fed could follow. Salter provides a framework to help policymakers better understand how incentives and information can affect monetary policy and discusses discretion-based and rule-based approaches to monetary policy. He concludes that a rule-based approach is superior and may have been able to prevent the 2008–2009 financial crisis. While Salter does not advocate a particular rule in his study, he presents a framework for policymakers to use as they strive to choose the best monetary policy rule.


Monetary policy seeks to offset changes in the demand for money by changing the supply of money. Monetary policy that effectively manages the money supply helps ensure that prices for goods and services accurately reflect changes in supply or demand for those goods and services. The Fed currently adjusts the money supply by buying and selling government bonds and other assets, such as mortgage-backed securities.


Academics and policymakers debate whether central banks should follow a predetermined, fixed rule or should have discretion in monetary policy. Proponents of central bank discretion argue that a simple monetary policy rule is incompatible with the complexity of the US economy. A closer look, however, suggests that a rules-based approach is superior.

  • A good monetary policy rule specifies a plan of action which the central bank cannot later ignore, while discretion allows central bankers to react—and often overreact—to economic indicators as they see fit.
  • The rules-based approach has been criticized for being too rigid, but it provides certainty in the market that the central bank will not sacrifice long-term stability for short-term gain.
  • While discretion affords central bankers the flexibility to respond to the economy’s complexity, they lack the perfect knowledge and untainted motives that would enable them to exercise this discretion appropriately. Central banks are bureaucracies, and bureaucracies are not adept at processing new information and making changes to policies in response.
  • In sum, a simple and easily communicated rule is better able to manage the complexity of the economy than a central bank operating with discretion.


Having established the superiority of a rules-based approach, the study looks at the pros and cons of several popular proposed rules. The proposed rules are divided into two categories: targeting rules and market-based proposals.

Targeting Rules

A number of scholars recommend a rule that includes a particular target. Among these are the following:

  • Friedman’s k-percent rule. This rule would increase the supply of money by a certain fixed percentage per time period, which cannot be changed by the central bank. One of the problems with this rule is its inability to adjust to sudden and unexpected swings in the economy, especially changes in money demand. The result may be abrupt “shocks” to income and employment.
  • Taylor’s interest rate rule. This rule would set a target for the short-run interest rate. Whenever inflation or output in the economy is above the desired rates, the monetary authority would raise the target rate by contracting the supply of money. If inflation and output are below desired levels, the monetary authority would increase the supply of loanable funds, thus lowering the interest rate.
  • McCallum’s feedback rule. This rule takes Friedman’s rule and attempts to apply macroeconomic variables, such as changes in employment and income, to determine the target rate for the monetary authority. However, similarly to the above rules, McCallum’s rule is costly in that it would require the accurate and timely measurement of such variables.
  • Inflation targeting rule. This rule would set an inflation target—for example, 2 percent—and adjust the money supply every predetermined time period by 2 percent. This does not require the same measurement as the other rules, but could destabilize the economy if income and employment are reduced due to other factors in the economy, thus increasing inflation at a faster rate than the target. This would raise prices of goods and services without a corresponding increase in the quantity of money.

Market-Based Proposals

The following three market-based proposals are “institutional” changes that could lead to greater stability in the market than either discretion or the rules discussed above.

  • Market-based nominal income targeting. This proposal would restrict the central bank to buying and selling an unlimited amount of a derivative financial instrument. Its market value would be dependent on the actual level of nominal income, set in advance, controlling the actual price at which the monetary authority would buy or sell the contract. This rule would harness the diffuse knowledge of the market and the profit-seeking incentives of individuals.
  • Commodity standards. This proposal would make money take the form of a commodity, such as gold, with all prices of other goods and services listed in units of that commodity. The political and institutional inertia against returning to a commodity standard may be too high of a cost to overcome, however, despite the self-correcting and stabilizing nature of a commodity standard.
  • Free banking. In this system, anyone could open a bank and issue notes and checkable deposits. These would serve as liabilities against the bank’s assets, which historically were backed by gold held by the bank. A bank would have a financial incentive to regulate itself by issuing notes relative to the demand for money by customers. This would create a stabilizing force similar to what nominal income targeting would create. However, despite its appeal from a macroeconomic stability standpoint, it is unclear whether the benefits of moving toward such a system would be worth the transition costs.


The correct way of thinking about issues in monetary theory and policy is not to work within these fields only, but to include broader political-economy considerations as well. Abstract monetary theory is both good and necessary, but without engaging issues of political economy little can be said about whether a particular monetary policy is desirable. When considering monetary policy, it is important to remember that central bankers are self-interested and lack access to perfect information. Because policymakers cannot know everything about the economy at one time and their incentives as public actors remain the same as their incentives as private actors, establishing rules for their decision-making is preferable to prolonging the current discretion-based policymaking at the Fed.