A dilemma for libertarians: Should central banks be strong or weak?
By Scott Sumner
Over at TheMoneyIllusion I have a post looking at the Fed’s ability to engage in policies such as QE and negative interest on reserves. What are the limits to the Fed’s ability to do these policies, and should there be limits?
Here I’d like to take a broader view of the issues. Let me start off with an analogy. Should libertarians favor a strong or a weak police force? One the one hand, a weak police force might lead to mob rule, and the loss of property rights. On the other hand, police at every street corner might lead to a sort of police state, where people lose their freedoms. Of course it’s far more complicated, on both sides of the issue. Under anarchy, private police might step in. Alternatively, perhaps having lots of police need not restrict our freedom. But I do think there is a somewhat ambiguous relationship between libertarianism and law enforcement, based on what I have read.
I see something similar with central banks. Many libertarians favor free banking. If we are operating under a gold standard, then I’m persuaded by experts like Larry White and George Selgin that we’d probably be better off without any central bank at all. While it’s true that their claims represent a sort of fringe opinion within the macroeconomics community, it’s an opinion that’s actually better informed than the views you’d find in textbooks, or from educational materials from the Federal Reserve. (That’s different from Austrian business cycle theory as a whole, where advocates are generally not any better informed than mainstream business cycle theorists like Bernanke and Romer, or monetarists like Friedman and Meltzer (and I?))
So I see the gold standard case as a pretty easy call for libertarians. Free banking sounds good if you are suspicious of big government, and it probably is good if you are on the gold standard. But fiat money is much trickier.
Libertarians are often suspicious of fiat money, but I’m not persuaded by their arguments. In any case, let’s say we do have a fiat money regime, and we are trying to make the best of a bad situation. Do we want a strong or a weak central bank?
Weak might sound good to libertarians, as they’d be able to do less harm. But in the end I’d argue exactly the opposite. Indeed I fear that a weak central bank is much more likely to make major policy errors. That is, they’ll have enough power to create monetary disequilibrium, but not enough power to repair the damage that they inadvertently caused.
If we are going to have a fiat money regime, then we at least ought to try to adhere to some sort of monetary rule that insures monetary stability, however defined. I define monetary stability as stable NGDP growth (perhaps per capita or per worker.) But there are other plausible definitions, such as price stability. In any case, whatever target they choose, it is essential that the central bank actually hit its target.
In 2008-09, the Fed clearly did not hit their target, and over at MoneyIllusion I argue that one reason was that they perceived there to be limits as to the size of their balance sheet. It’s actually not clear that their are limits, but when it comes to monetary policy, perceptions can easily become reality. If the Fed is going to target inflation at 2%, or NGDP growth at 4%, then it is essential that they have the tools to hit that target. That means we need a strong central bank.
To summarize, with a gold standard regime, libertarians should advocate the complete abolition of central banks. But I think it’s a mistake for libertarians to advocate a gold standard, as it might end up resulting in unstable NGDP, due to gold demand shocks. Don’t bother leaving comments about how NGDP performed under the actual gold standard, because we lack good data from that period, and it’s not even clear the data we do have would be relevant for today, as the world is far different. For instance, the volatility of real gold prices depends to some extent on how many countries adopt the gold standard. And wages are stickier. My worry is that if the gold standard didn’t work out well, and if libertarians had been its strongest advocates, it would tend to unfairly discredit all of libertarianism.
NGDP targeting is the safer route to market-friendly policies. And that means that if we give the central bank a monopoly on the production of fiat money, we’d better make sure that they have enough power to achieve their targets.
One final point. It would be possible to combine free banking and NGDP targeting, if we took away the Fed’s monopoly on currency issue. Perhaps we should do so, but this post is looking at the question of how much power the Fed should have if we assume that it continues to monopolize the issuance of currency and bank reserves.