Commentary

Right Federal Reserve Policy Must Be Based on Rule of Law

The debate over Federal Reserve policy and Quantitative Easing has been framed in terms of technical economic issues. More than 50 years ago, Milton Friedman recognized that monetary policy involves broader political and constitutional issues.

If we are to move beyond the debate over QE, we must go back to Friedman’s classical liberal case for a constitutionally constrained Fed.

Friedman is the most well-known proponent of rules in monetary policy, as opposed to discretion. His technical argument centered on the knowledge requirements for implementing discretionary monetary policy.

Effective monetary policy is not a question of having enough economic data. Central bankers are drowning in data. The problem is that even the most up-to-date data are merely recent economic history. They do not reflect the current state of the economy, much less the future.

How do we avoid another Great Recession and thus the apparent need for extraordinary monetary policy?

To determine optimal monetary policy, one must know future economic conditions. Time elapses between the collection of economic data and decision-making by central bankers. The Federal Open Market Committee meets eight times per year with about six weeks between meetings. (Emergency meetings can be held by phone.)

A lot can happen in an economy in six weeks, as we saw repeatedly in 2008. Think of the bailout of Bear Stearns in March; Fannie Mae and Freddie Mac lurching through the summer to conservatorship on Sept. 7; and the bankruptcy of Lehman Brothers on Sept. 15.

To have had the “right” monetary policy in place for the summer of 2008 would have required that the FOMC act earlier in the year on data they did not yet possess. There is a lag (time lapse) between the implementation of monetary policy and its effects. So the correct monetary policy must be in place before events transpire.

If one reads the FOMC minutes for the first half of 2008, Chairman Ben Bernanke’s speeches and the chairman’s testimony to Congress, it is clear that he and other members of the FOMC were clueless about the economic situation they would face in a few short weeks and months.

That is not a cheap shot, but the essence of the argument against discretionary monetary policy. It requires central bankers to predict a future that is inherently unknowable.

Even many critics of Fed policy accept the need for the first QE in November 2008. Actually, the Fed was late to the game. There was a growing liquidity crisis building throughout the summer.

In that period, however, the Fed was sterilizing its lending to troubled financial institutions with offsetting open-market operations. The Fed actually came close to repeating the mistakes of the 1930s. And this happened under the chairmanship of a scholar of the Great Depression.

Once again, my criticism is neither of the man nor even of the institution.

There will be another year like 2008, with different fact patterns, and the Fed will once again make mistakes, though perhaps different ones. The argument for rules is that the sum of such errors will be smaller if the Fed follows a rule rather than engages in discretionary monetary policy.

Friedman also offered a second, political argument on the rule of law. To the argument for a rule, proponents of discretion invariably respond that we can do better than rigid adherence to a rule.

In “Capitalism and Freedom” (1962), Friedman observed that one could with a few word changes make the same argument against the First Amendment and the entire Bill of Rights. “Is it not absurd, one might say, to have a standard proscription to interference with free speech?”

Discretionary proscriptions on speech would create huge uncertainty about what speech is permissible and what is not. It would also violate the very concept of a right. It would be the difference between living in Russia and in the U.S.

Friedman strengthened his rule-of-law argument by noting how much power monetary discretion puts in the hands of a few men. In his words, “it is a bad system to believers in freedom.”

The case for a monetary rule is one with the case for legal and constitutional rules generally. The Madisonian vision is not a political system that enables good men to do great things. It is a system that prevents ordinary men from causing great harm to their fellow citizens.

How does this affect the debate over QE? The evidence for its being beneficial on net is thin. But that is a backward-looking argument. Friedman’s argument is a forward-looking one. How do we avoid another Great Recession and thus the apparent need for extraordinary monetary policy?

In recent years, Stanford University economist John Taylor has been a torch-bearer of the argument for a monetary rule. His work updated and added to Friedman’s work. Thanks to Taylor and others, there is a bill before Congress to implement a rule.

The “Federal Reserve Accountability and Transparency Act of 2014” requires the Fed to follow a rule. The default rule is the eponymous Taylor Rule. The Fed can choose another one, but must follow some rule.

There is any number of alternative rules. The Cato Institute recently established a Center for Monetary and Financial Alternatives to analyze systematically the alternatives. The economic arguments for a rule of some kind are compelling. But so, too, are the political and constitutional ones.

In monetary policy, as elsewhere, the rule of law should govern.

Gerald O’Driscoll is a senior fellow at the Cato Institute and former vice president at the Federal Reserve Bank of Dallas.