Topic: Finance, Banking & Monetary Policy

What Is “Optimal” Monetary Policy?

On Thursday, November 12th, Cato hosts its 33rd Annual Monetary Conference. This year’s conference theme is “Rethinking Monetary Policy.” I will be presenting a paper on “Monetary Policy: The Knowledge Problem.”

The knowledge problem in conducting monetary policy, or any other government policy, is that the required knowledge is simply not available to policymakers. The knowledge is not available in any one place, nor can it be assembled in a form that would enable policymakers to formulate an “optimal” policy.

My paper focuses on Friedrich Hayek because he first formulated the knowledge problem. He argued that knowledge is inherently dispersed and localized across the population of economic agents. It is not possible to assemble the totality of knowledge existing in society in any one mind or place. Moreover, what the totality of individuals knows far exceeds what any policymaker can know, no matter his expertise and wisdom.

In order to formulate an optimal policy, a monetary authority must predict how alternative policy actions will affect the plans of millions of people. That information is unavailable. Assuming it exists in an economic model doesn’t make it so.

It is the conceit of central bankers (or at least most) that they can acquire the knowledge needed to conduct optimal monetary policy. In his Nobel Prize lecture, Hayek called that “The Pretence of Knowledge.”

In my paper, I also detail Milton Friedman’s contribution to the knowledge problem in monetary policy. That contribution has been under-appreciated in the literature.

Some problems cannot be solved. The knowledge problem is one such. But it can be mitigated, and I conclude my paper by discussing how that might happen. I suggest, as did Hayek and Friedman, that a monetary rule works best.

(If you would like to see this paper presented, you can register here. With several central bankers on the distinguished line up, including St. Louis Fed President James Bullard, Richmond Fed President Jeffrey Lacker, and Bank of Mexico Deputy Governor Manuel Sánchez, this year’s conference is a particularly interesting place to discuss the knowledge problem in the context of central banking. If you cannot attend, the conference papers will appear in a forthcoming edition of the Cato Journal).

[Cross-posted from Alt-M.org]

The Monetary Base and Total Reserves: Fed Confusions and Misreporting

The monetary base is the only magnitude that the Fed directly controls. It consists of currency held by the general public (including both Federal Reserve notes and Treasury coin) and the total aggregate reserves of banks and other depositories (whether held in the form of vault cash or deposits at one of the regional Federal Reserve banks).

Some would translate this control over the base into direct Fed control over total reserves, but that is not strictly correct. Even though the Fed initially increases (or decreases) the base by increasing (or decreasing) reserves, the general public and the banks determine how much of the base is ultimately held instead in the form of currency in circulation. Thus, it would seem desirable to have the Fed report the base and its two components accurately. Yet the Fed’s reported measures of total reserves exclude significant amounts of bank vault cash. Even with changes in the Fed’s monthly releases implemented in July 2013, the problem has not been rectified. Moreover, there also remains a minor omission from the total base that while not yet serious could become so in the future. More important, once the Fed began paying interest on reserves in 2008, it dramatically altered the monetary relevance of its base and reserve measures.

The Courage to Refuse

Last week I attended a talk and panel discussion at Brookings, in which Roger Lowenstein discussed his new book on the Fed’s origins. I have much to say about that book, and I eventually plan to say some of it here. But for the moment my concern is with another book, this one concerning, not the Fed’s origins, but its recent conduct. I mean Ben Bernanke’s The Courage to Act.

So why bring up the Brookings event? Because, in the course of that Federal Reserve love-fest, someone made a passing reference to those crazy people who actually want to limit the Fed’s emergency lending powers. Having seen the Fed save the economy from oblivion, such people, one of the panelists observed (I believe it was former Fed Vice Chairman Donald Kohn), are determined to make sure it can never save it again! At this, the audience chuckled approvingly.

Well, mostly it did. My own reaction was more like a bad attack of acid reflux. Is it really possible, I asked myself (as I struggled to keep my gorge from rising), that nobody here takes the moral hazard problem seriously? Do they really suppose that Senators Warren and Vitter and others seeking to limit the Fed’s bailout capacity are doing so because they like financial meltdowns and couldn’t care less if the U.S. economy went to hell in a hand-basket?

A Green Light for Investment Crowdfunding?

There’s big news in the crowdfunding world. The Securities and Exchange Commission (SEC) announced that they are (finally) voting on final rules Friday that would make investment crowdfunding legal.

Other types of crowdfunding — funding a venture with small amounts of money solicited from a large group of people — have been around for a while. The biggest crowdfunding site has even seen its name become a verb – as in “we’re Kickstarting our indie film.” And while one typically thinks of crowdfunding as a creature of the Internet, the concept has a long history. The Statue of Liberty stands in New York Harbor because of a successful crowdfunding effort, although in those days they called it taking subscriptions for donations, and the campaign was done door-to-door and not, of course, online.

But crowdfunding has been limited legally. Organizations raising money through crowdfunding, including for-profit corporations, have been restricted in what they can give in exchange for funds provided through online solicitations. Things like t-shirts have been popular thank-you gifts, while creators of innovative products, like the Pebble Watch, have offered pre-sales of their coveted inventions.

But offering any kind of return on investment, including the opportunity to buy a piece of the company, has been off limits. That’s because securities offered for sale in the U.S. must be registered with the relevant regulators, including the SEC and any state regulator in the states in which the securities will be offered. Any offering that deviates from this rule must fall under one of the laws’ exemptions. For example, there is an exemption that can apply when an issuer sells only to accredited investors (broadly speaking, institutional investors and wealthy individuals). Until now, there hasn’t been an exemption for crowdfunding.

Technology Takes On the Big Problems

Take a look at how markets and technology are taking on some of society’s biggest problems and revolutionizing the way we live. 

Nanotech and clean drinking water 

The World Economic Forum recently reflected on nanotechnology’s potential to improve people’s lives by providing smaller yet more powerful batteries, and by speeding up the purification process for air and water, among other things. Nanotechnology could deliver clean drinking water to millions of people who currently lack it, furthering the current positive trend. Around 10 percent of the global population lacks clean drinking water, down from around 20 percent in 1990.

A Million Homes Taken Since Kelo

It has been just over a decade since the Supreme Court decided in Kelo v. New London that local governments can take private property by eminent domain under a very broad reading of “public use”.  Cato held an event earlier this year to examine the legal impact of Kelo, featuring remarks from George Mason Law Professor Ilya Somin based upon his recent book, The Grasping Hand.  Not only has Kelo spawned widespread public backlash, but its also given birth to renewed interest by legal scholars.  As an economist, I am a little more interested in the direct impact on families.

Unfortunately, I have had no luck finding a database of all U.S. takings.  The American Housing Survey (AHS), conducted by the Census Bureau every two years, does, however, offer some estimates.  For survey respondents who moved within the previous year, the AHS asks respondents the “main reason” for leaving their previous unit.  One option offered is “government displacement”. For the survey years since Kelo, the average has been 109,000 households who state that government action displaced them from their previous home.  If that average holds for non-survey years, then a good estimate is that just over a million households have been displaced by government action since Kelo

A Fed Divided

Markets once again are waiting breathlessly for a decision on short-term interest rates by the FOMC, the Federal Reserve’s monetary policy making arm. All signs point to no change in interest rates. More interesting is a possible change in how members of the FOMC are thinking about the economy.

For years, most members of the FOMC have used the Phillips Curve framework in setting monetary policy. This is done against the backdrop of the Fed’s so-called dual mandate to promote maximum employment and low inflation. The Phillips Curve postulates a negative relationship between unemployment and inflation. Thus, a falling unemployment rate foretells higher inflation in the future.

Now two Fed Governors (members of the FOMC) have questioned the relevance of the Phillips Curve in separate speeches recently. The one-two punch was delivered by Lael Brainard and Daniel Tarullo. In Brainard’s words, “I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation.”

At the Kansas City Fed’s annual Jackson Hole conference last August, two former Fed economists questioned the Phillips Curve. They argued the relationship between inflation and unemployment has never been tight.

The Fed Chair, Janet Yellen, who has been largely absent from public view, remains wedded to the Phillips Curve. It is unusual for two Governors to so publicly deviate not only from the Chair’s policy guidance but also from the policymaking framework. Is Janet Yellen losing control of the FOMC?

In reality, labor markets are not so tight and there is just no sign of higher inflation in the near-term. I made those points in an August 24th op-ed in the Wall Street Journal.

Adding to the dilemma facing the FOMC is that markets are signaling that short-term interest rates should be lower not higher. New issues of short-term Treasury bills have been issued with a zero interest rate (though the most recent auction produced mildly positive interest rates). In secondary markets, bills have traded at mildly negative interest rates. Moreover, short-term interest rates are negative in around 20 countries mostly in the European Union (HT: Walker Todd).

In sum, we have a Fed divided and markets signaling a move down not up in interest rates. That makes for enhanced uncertainty in financial markets.

[Cross-posted from Alt-M.org]