Published in GoldMoney Analysis, 6th July 2011
Under fully fiat monetary systems such as ours, a limit on the quantity of money is essential for maintaining the purchasing power of the currency. This constraint has to be set, rather than being automatic as it was under commodity backed standards such as the gold standard. With no constraint, monetary history shows how governments have managed to lean on central banks to finance persistent deficits. This has led to discretionary monetary policies, inflation and to a fall in the value of money. There is a wide consensus in academia on the need to limit monetary expansion. However, experts disagree on the best way to do it. On the one hand, some economists of the so-called Austrian School tradition propose the abolition of central banks and placing legal limits on commercial banks’ ability to create money (by expanding deposits). On the other hand, mainstream economists (the so-called Neoclassical school), do not call for the abolition of central banking, but instead emphasise the need for effective means to prevent central banks from issuing excessive amounts of money.
First of all, the concept of monetary rules is not clear-cut, and thus requires a proper definition. A monetary rule consists of the formal announcement of (1) the tasks of the CB, (2) the time horizon for achieving the tasks, (3) the elements of the decision-making process (including the macro model and the information set) that will be followed and (4) the communication/explanation of the decisions made. Accordingly, by its definition, the rule clearly sets ex ante the monetary conditions that will prevail in the economy for a time period. One way or another, adopting a rule is just a mechanism (a “golden chain” under the gold standard years, and now purely fiduciary limits) to reduce the range of manoeuvre of the central bank.
A monetary rule does not imply fixing money conditions for once and for all, but rather the central bank’s commitment to achieving the announced goals according to a public decision-making process. As Kydland and Prescott showed in their 1977 report Rules Rather than Discretion: The Inconsistency of Optimal Plans, adopting a rule promotes the central bank’s credibility and helps it achieve its targets. Consequently, market expectations will be anchored in line with central bank targets.
There are many different types of rules. Depending on the variables included in the decision-making process, we can distinguish two main types: money-based non-reactive rules (or monetarist rules) and neokeynesian active rules.
Money-based rules constrain the range of manoeuvre of central banks quite significantly. Milton Friedman’s “k percent rule” is the best-known example of them. With this rule, the central bank fixes money rate of growth according to the expected growth of the economy. In this case, the bank is committed to financing non-inflationary economic growth.
In contrast, neokeynesians support a more active role for central banks. Along with price stability, they emphasise price stabilisation over the course of cycle. To do so, central bank intervention is prescribed to correct deviations from inflation target and also as a means of responding to deviations of output gaps – or the difference between current output and the long run or equilibrium level of output of the economy. Following this rationale, a positive output gap reveals excessive output growth and inflationary pressures. Surprisingly enough, money growth is not targeted, nor does it play any explicit role in the decision-making process of central banks. The absence of monetary aggregates confirms the adoption of a neokeynesian explanation of inflation in the short run, determined by inflation expectations and excessive aggregate demand.
The well-known “Taylor rule” lies under this category. In its forward-looking version, the “Taylor rule” prescribes active central bank interventions to correct in advance expected inflation deviations from its target, as well as output gap stabilisation. Even though not officially adopted by any central bank, this rule provides a good description of the Fed’s monetary policy since the late 1970s. Moreover, this rule fits very well with the institutional arrangements of the US Federal Reserve; it is a highly discretionary central bank, with a “plural mandate” to preserve not only price stability, but long term interest rate stability as well as output growth.
The case of the ECB is quite different and indeed unique. Since it is a new central bank, created within an unsettled institutional framework, it was not free to choose a discretionary policy. Instead, the ECB was clearly mandated to preserve price stability. To do so, from 1999 to 2003 it continued the monetarist rule successfully followed by one of its predecessors, the Bundesbank. However, in 2003 the ECB changed its monetary strategy: it stopped publishing the reference value for broad money growth (M3) compatible with price stability and thus the link between the reference value for money growth and the target for inflation was weakened. From 2003 on, broad money growth expanded notably (reaching more than 10% rates of annual growth). This produced a rate of credit growth that was a contributory factor in the first collapse of the world’s financial system since the 1930s.
The recent crisis has revealed a poor performance of central banks’ monopolies. More competition in the money market will be needed to discipline money issuers. In the meantime, the ECB should conduct monetary policy as if there were such a more competitive-open market. In this vein, the ECB should reform its monetary rule in order to get more moderates rates of money growth and to maintain the purchasing power of the euro. In my view, it will require a broader analysis of what price stability means (not only in terms of a basket of consumption goods and services) and a distinctive role of broad money growth measures.
Author: Juan Castañeda