11 (Author at Cato Institute) https://www.cato.org/ en Editor’s Note https://www.cato.org/cato-journal/spring/summer-2020/editors-note Thu, 28 May 2020 12:00:00 -0400 James A. Dorn https://www.cato.org/cato-journal/spring/summer-2020/editors-note The Fed’s Corporate Lending Facilities: A Case of Pseudo Markets https://www.cato.org/blog/feds-corporate-lending-facilities-case-pseudo-markets James A. Dorn <p>When the <a href="https://www.cnn.com/2020/03/23/business/federal-reserve-emergency-recession/index.html" rel="nofollow external noopener noreferrer" target="_blank">Federal Reserve</a> announced on March 23 that it would purchase eligible corporate debt, syndicated loans, and exchange-traded funds (ETFs) via a special purpose vehicle (SPV), backstopped by the Treasury, <a href="https://www.cnn.com/2020/05/04/investing/fed-junk-bonds-etfs-debt/index.html" rel="nofollow external noopener noreferrer" target="_blank">moribund markets jumped.</a> Highly leveraged companies like Carnival, Ford, and Boeing, which were unable to obtain funds in the bond market, suddenly found themselves able to borrow at rates that discounted the true credit risks. <a href="https://www.bloomberg.com/news/articles/2020-05-04/new-york-fed-says-it-will-begin-buying-etfs-in-early-may" rel="nofollow external noopener noreferrer" target="_blank">BlackRock</a>, which will be managing the SPV, recorded a record inflow of nearly $4 billion to its iShares iBoxx High Yield Corporate Bond ETF in April, and also attracted investors to its iShares U.S. Investment-Grade Corporate Bond ETF.</p> <h4><strong>Real versus Pseudo Credit Markets</strong></h4> <p>Although the Fed's intent is to provide temporary liquidity to large U.S. firms, the promise of supporting corporate bond prices and making loans to highly leveraged companies undermines corrective market forces: real markets are supplanted by pseudo markets in which the central bank will be subsidizing distressed companies and politicizing the allocation of capital. Initially private investors may purchase more corporate debt, but if corporations use that credit to pay off existing debt, and do not invest in productive capital, losses may continue. Private investors then will have an incentive to offload their holdings to the SPV, effectively socializing those losses. Moreover, the Fed's financing of those purchases will further expand its balance sheet and make it difficult to exit the corporate debt market without creating additional financial turmoil. Perhaps that is why the <a href="https://www.nytimes.com/2020/05/18/business/economy/economic-stimulus-treasury-fed-risk.html" rel="nofollow external noopener noreferrer" target="_blank">Fed has been slow</a> to roll out the SPV.</p> <p>Those who value private, free markets recognize that the Fed's promise to revitalize corporate debt markets is, in reality, a step toward market socialism. In a dynamic market economy, private investors have many options and will take prudent risks based on expected future profits. If investors decide to buy bonds rather than stocks, they will do so only if the interest rate offered exceeds the opportunity cost of tying up their capital in one use relative to their next best alternative. With millions of investors and constantly changing circumstances, market interest rates will adjust to new information: some investors will gain, others will lose. That is the logic of the market.</p> <p>Freely competitive markets ensure that relative prices reflect opportunity costs and that capital is allocated according to consumer preferences. Whenever governments or central banks interfere with that free-market process, the allocation of capital will diverge from that preferred by consumers—and there will be a loss of economic and individual freedom.</p> <h4><strong>Section 13(3) on Steroids</strong></h4> <p>The COVID-19 pandemic and the government-mandated lockdowns sharply reduced output and employment while increasing the demand for money. The Fed quickly reacted by reducing its policy rate to near zero, using forward guidance, and reigniting its large-scale asset purchase program (also known as quantitative easing or QE). In addition, the Fed, in conjunction with the Treasury, used its emergency lending authority under <a href="https://www.federalreserve.gov/aboutthefed/section13.htm" rel="nofollow external noopener noreferrer" target="_blank">Section 13(3)</a> of the Federal Reserve Act to set up a number of off-balance sheet SPVs.<a href="#_edn1" name="_ednref1" id="_ednref1">[1]</a></p> <p>Although the Federal Reserve Act prohibits the Fed from buying corporate bonds, the Fed circumvented that restriction by having the Treasury authorize a SPV with two corporate credit facilities (CCFs): a Primary Market CCF to directly purchase newly issued investment-grade bonds of large corporations with maturities up to four years, as well as the bonds of "fallen angels" (i.e., corporations whose debt was downgraded to junk after March 22); and a Secondary Market CCF authorized to buy existing, investment-grade corporate bonds with maturities up to five years, as well as some debt from "fallen angels" and ETFs that specialize in corporate debt (see <a href="https://www.newyorkfed.org/markets/primary-and-secondary-market-faq/corporate-credit-facility-faq" rel="nofollow external noopener noreferrer" target="_blank">New York Fed</a>, <a href="https://www.bloomberg.com/news/articles/2020-05-14/fed-is-all-in-here-are-the-key-features-of-its-lending-programs" rel="nofollow external noopener noreferrer" target="_blank">Condon</a>, <a href="https://www.reuters.com/article/usa-fed-etfs/update-1-federal-reserve-will-begin-purchasing-exchange-traded-funds-on-tuesday-idUSL1N2CU02T" rel="nofollow external noopener noreferrer" target="_blank">Marte</a>, and <a href="https://www.cnn.com/2020/05/04/investing/fed-junk-bonds-etfs-debt/index.html" rel="nofollow external noopener noreferrer" target="_blank">Egan</a>).</p> <p>The Primary Market facility, expected to open later this month, will be backstopped by the Treasury's $50 billion equity investment, which the Fed can leverage up to $500 billion. The bonds will be held by the SPV (off the Fed's balance sheet), but the Fed's loans to the facility will show up on its balance sheet. The Secondary Market facility, which began purchasing ETFs on May 12, is backstopped by the Treasury's $25 billion equity investment. Thus, the Treasury's overall investment in the CCFs amounts to $75 billion. Those funds were appropriated by Congress as part of the $2.3 trillion CARES (Coronavirus Aid, Relief, and Economic Security) Act (see <a href="https://www.bloomberg.com/news/articles/2020-05-14/fed-is-all-in-here-are-the-key-features-of-its-lending-programs" rel="nofollow external noopener noreferrer" target="_blank">Condon</a>).</p> <p>Instead of Congress directly providing credit to the corporate sector via fiscal policy, the decision was made to let the Fed do the heavy lifting and extend its lending authority via a loose interpretation of Section 13 (3). It is instructional to understand how the Fed sets up the CCFs by examining the <a href="https://www.newyorkfed.org/medialibrary/media/markets/SMCCF_Investment_Management_Agreement.pdf" rel="nofollow external noopener noreferrer" target="_blank">"Investment Management Agreement"</a> for the Secondary Market CCF, dated May 11, 2020.<a href="#_edn2" name="_ednref2" id="_ednref2">[2]</a></p> <p>That Agreement states, that, after receiving approval by the Secretary of the Treasury, the Federal Reserve's Board of Governors established the Secondary Market CCF, and the New York Fed then set up a limited liability company in Delaware called "Corporate Credit Facilities LLC." The company's obligations to the New York Fed ("as lender") are specified in a Credit Agreement. Loans are to be "secured by all of the assets of the Company." Finally, the asset manager, BlackRock Financial Markets Advisory, "shall not exercise such authority with any purpose or design of favoring or discriminating against any sector of the economy or region of the country."</p> <p>The Fed initially will use BlackRock Financial Markets Advisory as the sole investment manager for the CCFs, and the New York Fed will impose investment guidelines to ensure that the objectives of the SPV are implemented. The CCFs are supposed to end operations by September 30, 2020, unless otherwise instructed by the Board of Governors and the Treasury. However, "the New York Fed will continue to fund the CCFs after such date until the CCF's holdings either mature or are sold" (<a href="https://www.newyorkfed.org/markets/primary-and-secondary-market-faq/corporate-credit-facility-faq" rel="nofollow external noopener noreferrer" target="_blank">New York Fed)</a>.</p> <h4><strong>Subsidizing Corporate Credit Does Not Eliminate Risk</strong></h4> <p>Setting up the SPV with Treasury backing takes some risk off the table for the Fed, but if the failure rate is higher than expected, the Treasury will have to acquire more funds from Congress to indemnify the Fed. The great uncertainty surrounding the pandemic and lockdown makes it very difficult to predict which firms will survive and which will fail, thus making the Fed's job of deciding how to allocate its credit a guessing game. There is no reason experts at the Fed will have better information than the market. BlackRock can supply its expertise, but there is no guarantee of success—especially in light of the nondiscrimination requirement. Indeed, the whole purpose of private, free markets is to discriminate in order to get an efficient allocation of scarce capital. When that mechanism is thwarted by central bank intervention, debt markets become politicized—and both the credibility and independence of the monetary authority becomes compromised. Taxpayers are also put at risk when emergency lending fails (see <a href="https://businesslawtoday.org/2019/03/revised-section-133-federal-reserve-act/" rel="nofollow external noopener noreferrer" target="_blank">Long</a>).</p> <p>Narayana <a href="https://www.bloomberg.com/opinion/articles/2020-03-30/coronavirus-fed-s-lax-lending-terms-to-companies-invite-trouble" rel="nofollow external noopener noreferrer" target="_blank">Kocherlakota</a>, former president of the Federal Reserve Bank of Minneapolis, and now at the University of Rochester, has recognized the danger of allowing companies "to borrow at interest rates that are not reflective of their true risks." Recessions naturally cause private investors to demand a risk premium because of the increased probability of defaults on corporate debt. That risk does not disappear when the Fed and Treasury step in to create a SPV to subsidize it. It is merely shifted elsewhere—most likely to future taxpayers.</p> <h4><strong>Conclusion</strong></h4> <p>The Fed is ill-equipped to engage in corporate lending. Congress made the Federal Reserve a "monetary authority"—but now wants it to be a "national investment authority" as well.<a href="#_edn3" name="_ednref3" id="_ednref3">[3]</a> In the process, the Fed's credibility and independence will be tested. The line between monetary and fiscal policy is quickly vanishing as the Fed gains more and more power, in the hope that it will save the real economy. However, restoring economic growth requires revitalizing real markets, not creating pseudo markets.</p> <p>*********</p> <p><a href="#_ednref1" name="_edn1" id="_edn1">[1]</a> Section 13(3) of the Federal Reserve Act arose out of the Banking Act of 1932, otherwise known as the first Glass-Steagall Act, and became law on July 21, 1932, when Senator Glass added it as an amendment to the Emergency Relief and Construction Act. It is interesting to note that Glass, the founder of the Federal Reserve System, and Fed Board member Charles Hamlin were concerned that the Reconstruction Finance Corporation (RFC) might crowd out lending by the Fed, and convinced President Hoover to veto a bill designed to increase the RFC's lending authority.</p> <p>Initially Section 13(3) was very restrictive and the Fed only approved a few Section 13(3) loans during the Great Depression. In 1991, Congress eliminated the constraint that the Fed could only discount "the same type of paper that was otherwise eligible for discount at a Federal Reserve Bank." The Fed used the expanded powers under Section 13(3) to help bail out Bear Stearns and AIG, and to set up the Term Securities Lending Facility, Term Asset-Backed Securities Loan Facility, and Commercial Paper Funding Facility during the 2007–2009 financial crisis. The Dodd-Frank Act amended Section 13(3) by requiring that Fed loans only go to a "program or facility with broad-based eligibility" and by prohibiting the Fed to "aid a failing financial company" or "borrowers that are insolvent." Also, all facilities established under Section 13(3) now require prior approval by the Secretary of the Treasury. This summary draws from <a href="https://businesslawtoday.org/2019/03/revised-section-133-federal-reserve-act/" rel="nofollow external noopener noreferrer" target="_blank">Arthur S. Long</a>, a partner at Gibson, Dunn &amp; Crutcher.</p> <p><a href="#_ednref2" name="_edn2" id="_edn2">[2]</a> The Primary Market CCF Investment Management Agreement has not yet been published.</p> <p><a href="#_ednref3" name="_edn3" id="_edn3">[3]</a> Lev Menand distinguishes between a monetary authority and an investment authority: "Whereas a monetary authority strives to manage the money supply in a neutral way that encourages sustainable economic growth and price stability, an investment authority is necessarily non-neutral. Its investments affect relative prices and make some projects more attractive and cheaper to finance and other projects more expensive and difficult to finance" (p. 25). <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2939309" rel="nofollow external noopener noreferrer" target="_blank">Hockett and Omarova</a> make the case for a national investment authority.</p> <p>[<a href="https://www.alt-m.org/2020/05/25/the-feds-corporate-lending-facilities-a-case-of-pseudo-markets/">Cross-posted from Alt-M.org</a>]</p> <p></p> Tue, 26 May 2020 08:40:55 -0400 James A. Dorn https://www.cato.org/blog/feds-corporate-lending-facilities-case-pseudo-markets Slippery Slope Ahead for RBA’s Yield Management Strategy https://www.cato.org/publications/commentary/slippery-slope-ahead-rbas-yield-management-strategy James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Federal Reserve officials are fond of touting the importance of independence in the conduct of monetary policy. In theory, they want to avoid politicisation and maintain a&nbsp;firm boundary line between monetary and fiscal policy in pursuing their dual mandate of full employment and price stability.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>In reality, however, the Fed is an agent of Congress — or more precisely, a&nbsp;fiscal agent — and, in a&nbsp;crisis, is subservient to the Treasury.</p> <p>During World War II, for example, the Fed supported the prices of US securities and pegged interest rates at artificially low levels to finance government deficits. The pegged rate system didn’t end until 1953, even though the Treasury‐​Fed Accord was announced in 1951.</p> <p>Today, in response to COVID-19, <a href="https://www.afr.com/link/follow-20180101-p54q61">the Fed has once again become a&nbsp;major player in funding massive increases in government deficits.</a> It has promised to more than double the size of its balance sheet by engaging in large‐​scale asset purchases of Treasuries and mortgage‐​backed securities.</p> <p>The Fed also has created off‐​balance sheet entities — special purpose vehicles — backstopped by the US Treasury with funds appropriated by Congress under the CARES Act (Coronavirus Aid Relief and Economic Security Act).</p> <p>Congress has provided the Treasury with $US454 billion ($700 billion) to cover potential losses from the Fed’s emergency lending programs. That backstop will allow the Fed to lend as much as $US4.54 trillion.</p> <p>Although the Fed — unlike the Bank of Japan and, more recently, the Reserve Bank of Australia — has not officially pegged interest rates on government debt, there has been talk of establishing “yield curve control”. The idea is to have the Fed commit to buy longer‐​terms bonds to support their prices, and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury.</p> <p>Although the Fed may see this as a&nbsp;way to stimulate the economy, it could also be a&nbsp;way to fund fiscal deficits at an artificially low rate.</p> <p>According to <a href="https://www.brookings.edu/blog/up-front/2019/08/14/what-is-yield-curve-control/">Sage Belz and David Wessel</a>, of the Brookings Institution, “a major risk associated with yield‐​curve policies is that they put the central bank’s credibility on the line” — that is, if the Fed promises to peg rates, it runs the risk of straying from its inflation target.</p> <p>In the case of Australia, the central bank has set a&nbsp;0.25 per cent target for the yield on three‐​year government bonds, which meshes with the cut in its cash rate target.</p> <p>The Reserve Bank distinguishes its<a href="https://www.afr.com/link/follow-20180101-p54lom"> yield control</a> approach from quantitative easing. Rather than announce a&nbsp;target for the quantity of bonds it plans to buy, it says it will buy an unlimited quantity of government bonds to keep the bond yield at its targeted low rate.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>The real economy has a&nbsp;mind of its own and central bank forecasts have a&nbsp;poor track record.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Governor Philip Lowe has also promised that the board “will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band”.</p> <p>He expects the cash rate “will remain at its current level for some years”. The problem is, central bankers don’t have perfect information. Consequently, forward guidance has not worked very well.</p> <p>The real economy has a&nbsp;mind of its own and central bank forecasts have a&nbsp;poor track record.</p> <p>When central banks peg rates and try to control the yield curve, they may reduce the quantity of bonds they need to purchase in the short run, if the central bank has credibility, but investors will be incentivised to search for yield by moving to longer‐​term securities.</p> <p>This shift increases duration risk — that is, when the economy starts to recover and interest rates rise, holders of longer‐​term securities will suffer large losses.</p> <p>By engineering lower rates and promising to keep them low for several years, the central bank encourages politicians to continue to run fiscal deficits.</p> <p>Pegged rates also distort the allocation of credit by diminishing the role of private markets. Placing legal ceilings on interest rates (i.e. not allowing them to rise above the maximum rate targeted by the authorities) — and thus supporting bond prices — is not a&nbsp;panacea for creating a&nbsp;robust economy.</p> <p>Most importantly, once rates are pegged at artificially low levels, they can be difficult to exit.</p> <p>Politicisation of central bank policy will diminish independence and harm credibility. If inflation increases, there is always the danger of wage‐​price controls and a&nbsp;loss of economic freedom. Future economic growth will suffer.</p> <p>Those adverse consequences of pegged rates should not be lost sight of in fighting the COVID-19 pandemic.</p> <p>The pandemic was not the fault of central banks, nor was the political decision to lock down the economy and put millions of people out of work. In such a&nbsp;situation, the <a href="https://www.afr.com/link/follow-20180101-p54p5g">Fed and other central banks had to act quickly and decisively to provide liquidity -</a> to prevent financial instability from leading to further deterioration of the real economy.</p> <p>Yet unconventional monetary policies are meant to be temporary, not permanent. Ensuring long‐​run economic growth necessary to restore economic wellbeing will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favoured groups.</p> </div> Wed, 13 May 2020 09:36:35 -0400 James A. Dorn https://www.cato.org/publications/commentary/slippery-slope-ahead-rbas-yield-management-strategy COVID-19: Implications for Monetary Policy and Fed Independence https://www.cato.org/blog/covid-19-implications-monetary-policy-fed-independence James A. Dorn <p>One year ago the U.S. economy was robust with unemployment at historically low levels and real incomes rising. No one would have predicted that a year later the economy would come to a halt and more than 20 million people would be applying for unemployment benefits. This reversal was not due to monetary instability, which has been the primary cause of most recessions, but rather to a decision by government officials to mandate business closures to battle a pandemic. The initial sharp supply-side effect of COVID-19 quickly turned into a strong demand for cash and a corresponding decline in the velocity of money.</p> <h4><strong>Fed's Response to the Pandemic</strong></h4> <p>The Fed responded rapidly and dramatically to keep the U.S. economy from descending into depression. Monetary policymakers reduced the benchmark fed funds rate to near zero; promised to more than double the size of the Fed's balance sheet by engaging in large-scale asset purchases of Treasuries and mortgage-backed securities, with the intent of reducing longer-run interest rates; and restarted or created a number of special purpose vehicles (SPVs), which are off the Fed's balance sheet, to stabilize a broad array of financial markets.<a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_edn1" name="_ednref1" id="_ednref1">[1]</a><span> </span>The U.S. Treasury has worked closely with the Fed to backstop lending and increase leverage, providing $454 billion to cover potential losses from the Fed's lending programs to private firms under the<span> </span><a href="https://www.congress.gov/bill/116th-congress/house-bill/748/text" rel="nofollow external noopener noreferrer" target="_blank">CARES Act</a><span> </span>(an acronym for Coronavirus Aid Relief and Economic Security). With leverage estimated at 10 to 1, the Fed may lend as much as $4.54 trillion—none of which would show up as part of the federal deficit (see<span> </span><a href="https://www.wsj.com/articles/the-feds-emergence-as-a-power-player-poses-new-risks-to-its-independence-11586559527" rel="nofollow external noopener noreferrer" target="_blank">Ip</a><span> </span>and<span> </span><a href="https://www.bloomberg.com/news/articles/2020-03-25/fed-s-anti-virus-lending-firepower-could-reach-4-5-trillion" rel="nofollow external noopener noreferrer" target="_blank">Torres</a>).</p> <h4><strong>Risks to Monetary Control and Independence</strong></h4> <p>By monetizing much of the new federal debt and engaging in credit allocation, the Fed risks sacrificing monetary control and its independence. Of course, the Board of Governors could increase the rate of interest it pays on excess reserves to keep inflation at bay. However, in so doing, it would deprive the Treasury of revenue to help reduce budget deficits.</p> <p>The more serious issue for the Fed's credibility and independence is the drift into fiscal space. As Charles Plosser, former CEO and president of the Federal Reserve Bank of Philadelphia has warned: "Independence is drifting away and after this [Covid-19] crisis it will be easier and easier for politicians to seek Fed participation in off-budget fiscal actions."<a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_edn2" name="_ednref2" id="_ednref2">[2]</a></p> <p>The Fed's decision to set up SPVs to purchase corporate and municipal debt opens the door for all sorts of mischief (see<span> </span><a href="https://www.morningstar.com/news/dow-jones/2020040911708/fed-announces-new-facilities-to-support-23-trillion-in-lending-3rd-update" rel="nofollow external noopener noreferrer" target="_blank">Timiraos</a>). Likewise, the Term Asset-Backed Securities Loan Facility (TALF) now accepts more risky assets, including commercial mortgage securities and collateralized loan obligations. As such, the Fed will be buying "the worst shopping malls in the country and some of the most indebted companies." Consequently, "the opportunities for losses will be that much greater," according to an editorial in the<span> </span><a href="https://www.wsj.com/articles/the-feds-main-street-mistake-11586474912" rel="nofollow external noopener noreferrer" target="_blank"><em>Wall Street Journal</em></a>.</p> <p>In 2001,<span> </span><a href="https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/2001/winter/pdf/broaddus.pdf" rel="nofollow external noopener noreferrer" target="_blank">J. Alfred Broaddus and Marvin Goodfriend,</a><span> </span>warned that expanding the Fed's portfolio beyond Treasuries poses risks to the Fed's credibility and independence:</p> <blockquote><p>The Fed's asset acquisition policies should support monetary policy by protecting the Fed's independence. . . . First, the Fed's asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed's involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed's independence and the effectiveness of monetary policy.</p> </blockquote> <p>The Fed's decision to pay interest on excess reserves, in October 2008, means it can separate its balance sheet size from the stance of monetary policy. As<span> </span><a href="https://www.researchgate.net/publication/226650622_Central_Banking_in_the_Credit_Turmoil_An_Assessment_of_Federal_Reserve_Practice" rel="nofollow external noopener noreferrer" target="_blank">Goodfriend</a><span> </span>explains:</p> <blockquote><p>Central banking is understood in terms of the fiscal features of monetary, credit, and interest on reserves policies. Monetary policy—expanding reserves by buying Treasuries—transfers all revenue from money creation directly to the fiscal authorities. Credit policy—selling Treasuries to fund loans or acquire non-Treasury securities—is debt-financed fiscal policy. Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy.</p> </blockquote> <p>He argues that "An ambiguous boundary of responsibilities between the Fed and the fiscal authorities contributed to economic collapse in fall 2008."</p> <p>Charles Plosser made a similar argument in his 2018 article,<span> </span><a href="https://www.hoover.org/sites/default/files/research/docs/ch01a_section1_cochrane_9780817921347.pdf" rel="nofollow external noopener noreferrer" target="_blank">"The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy"</a>:</p> <blockquote><p>A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation.</p> </blockquote> <p>The Fed's response to COVID-19 has increased the chances that the Fed's balance sheet will stay immense for a long time. Returning to "normal" would require shrinking the balance sheet and returning to a<span> </span><a href="https://www.cato.org/cato-journal/springsummer-2019/feds-operating-framework-how-does-it-work-how-will-it-change" rel="nofollow external noopener noreferrer" target="_blank">corridor-type operating system</a><span> </span>that restores the link between the balance sheet and monetary policy (see<span> </span><a href="https://www.amazon.com/Floored-Misguided-Experiment-Prolonged-Recession/dp/1948647087" rel="nofollow external noopener noreferrer" target="_blank">Selgin</a>).</p> <h4><strong>Insulating Monetary Policy from Credit Policy</strong></h4> <p>Long ago,<span> </span><a href="https://www.amazon.com/Depression-Inflation-Monetary-Selected-1945-1953/dp/0801806550" rel="nofollow external noopener noreferrer" target="_blank">Clark Warburton</a><span> </span>saw the inherent danger in "too close a linkage of monetary expansion and contraction with expansion and contraction of indebtedness" (p. 301).<a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_edn3" name="_ednref3" id="_ednref3">[3]</a><span> </span>From the experience of World War II, he warned: "Whenever the federal government wishes to borrow money in large amounts, the Federal Reserve Board ceases to be an independent agency" (p. 309). He attributed that to</p> <blockquote><p>the combination of (a) emphasis on the accommodation of borrowers rather than maintenance of a suitable quantity of money in the economy, and (b) a specific provision that, in case of any apparent conflict between the powers of the Board and those of the Secretary of the Treasury, the Board shall exercise such powers under the supervision of the Secretary of the Treasury [ibid.].</p> </blockquote> <p>Warburton wrote that passage in December 1946, prior to the<span> </span><a href="https://www.federalreservehistory.org/essays/treasury_fed_accord" rel="nofollow external noopener noreferrer" target="_blank">Treasury-Federal Reserve Accord</a><span> </span>in 1951, which led to the end of the Fed's obligation to support the prices of government securities, by pegging interest rates at artificially low levels, in 1953. The "specific provision" he was referring to still exists in the Federal Reserve Act and is relevant for the current war on COVID-19. <span> </span><a href="https://www.federalreserve.gov/aboutthefed/section10.htm" rel="nofollow external noopener noreferrer" target="_blank">Section 10 of the Act</a><span> </span>states:</p> <blockquote><p>Nothing in this chapter . . . shall be construed as taking away any powers heretofore vested by law in the Secretary of the Treasury which relate to the supervision, management, and control of the Treasury Department and bureaus under such department, and wherever any power vested by this chapter in the Board of Governors of the Federal Reserve System or the Federal Reserve agent appears to conflict with the powers of the Secretary of the Treasury, such powers shall be exercised<span> </span><em>subject to the supervision and control of the Secretary</em><span> </span>[italics added].<a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_edn4" name="_ednref4" id="_ednref4">[4]</a></p> </blockquote> <p>Today, we are in danger of returning to a state of affairs before the famous Accord. Indeed, there has been discussion at the Fed about pegging longer-term interest rates under a program called "yield curve control" (YCC). The idea is to have the Fed commit to buy longer-term bonds to support their prices and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury. Although the Fed may see this as a way to "stimulate" the economy, it could also be a way to fund fiscal deficits at an artificially low rate.<span> </span><a href="https://www.brookings.edu/blog/up-front/2019/08/14/what-is-yield-curve-control/" rel="nofollow external noopener noreferrer" target="_blank">Sage Belz and David Wessel</a><span> </span>of the Brookings Institution have examined the YCC proposal's benefits as well as its downsides. With respect to the latter, they write:</p> <blockquote><p>Like other unconventional monetary policies, a major risk associated with yield-curve policies is that they put the central bank's credibility on the line. They require that the central bank commit to keep interest rates low over some future horizon; this is exactly why they can help encourage spending and investment, but it also means that the central bank runs the risk of letting inflation overheat while holding to its promise. If the Fed, for example, were to commit to a 2-year peg, they would be betting on the fact that inflation will not run well above its 2 percent target in that period. If it does, the Fed may have to choose between abandoning its promise about the peg or not holding to its stated inflation objective—both bad options in terms of its credibility with the public.</p> </blockquote> <p>The odds are that, given large fiscal deficits and high unemployment, there would be strong pressure by the Treasury to maintain the peg and have the Fed accept a higher inflation rate—at least in the short run. Section 10 would give the Treasury the authority to do so. There is no doubt that the credibility and independence of the Fed would suffer in the process.</p> <p>Under the CARES Act, Congress appropriated nearly $500 billion for the Treasury to cover potential losses from the Fed's lending programs—designed to support businesses, households, states, and municipalities. Consequently, Fed independence is already compromised.</p> <p>Warburton wanted to insulate<span> </span><em>monetary policy</em><span> </span>from<span> </span><em>credit policy</em>. He recognized that the goal of the Fed should be to provide for monetary stability and allow markets to determine the allocation of capital via freely determined interest rates, which are relative prices indicating preferences for current versus future consumption, as well as the productivity of capital. In a free enterprise system and monetary equilibrium, the natural rate of interest will coordinate the plans of millions of savers and investors, bringing about a voluntary allocation of resources between capital goods and consumer goods. Because time preferences and capital productivity are normally positive, the natural rate of interest should also be positive.</p> <p>Writing in 1948, Warburton (p. 290) argued:</p> <blockquote><p>The rate of interest must be free to respond to real changes in the demand and supply of loan funds, in order to avoid producing monetary maladjustment, and there is no method of judging accurately the "correct" level of interest rates except when monetary maladjustment is avoided.</p> </blockquote> <p>By not having a monetary rule aimed at a stable, noninflationary growth of nominal income and instead trying to use interest rates to guide monetary policy, the Fed has followed what Warburton called "upside-down" monetary policy. In his opinion, this practice is a "fatal error." As Warburton (p. 233) explained in his June 1947 article in the<span> </span><em>Journal of Political Economy</em>:</p> <blockquote><p>Interest-rate regulation came into vogue as the chief instrument, and later as the objective, of monetary policy. The latter was a fatal error—for it turned the quantity-of-money interest-rate relationship upside down. Central banks tried to use variations in the interest rate both as a technique and as a guide for the provision of a suitable quantity of money in the economy, whereas they should have used provision of a suitable quantity of money as a technique for achieving price-level stability and freedom of the rate of interest.</p> </blockquote> <p>He goes on to say, "This upside-down monetary policy, under the circumstances of the late 1920's and early 1930's, proved to be as disastrous as an attempt to build a sky-scraper's foundation from the architect's plans for its tower."</p> <p>When the Federal Reserve was established in December 1913, it adhered to the "convertibility principle" of monetary control. That principle no longer applies, but the Fed has never adopted what Warburton calls the "responsibility principle" of monetary control, which applies to a pure fiat money regime. Under such a principle, there would be a rules-based regime aimed at safeguarding the value of money and avoiding what Warburton called "erratic money"—that is, variations in the quantity of money that are either excessive or deficient, bringing about inflation or depression. Warburton thought "the most suitable guide for the exercise of monetary power" would be to maintain "a rate of growth in the money supply equal to the combined rates of growth in population and production of final products per capita, adjusted for trend in the circuit velocity of money" (p. 396). Based on historical data, he suggested a growth rate of 5 percent per annum (pp. 358–59).</p> <p>Warburton (p. 316) criticized the state of monetary law in the United States, arguing that it is "ambiguous and chaotic, does not contain a suitable principle for the exercise of the monetary power held by the Federal Reserve System, and has caused confusion in the development of Federal Reserve policy." He distinguished between "monetary control" and "loan control," with the former dealing with "the creation of money" and the latter with "the borrowing of money already in existence" (p. 298). The proper function of the Fed, according to Warburton (p. 401), is to "regulate the supply of money and leave interest rates on various types of loans, including United States government obligations, to be determined by the forces of supply and demand impinging upon the market where money is borrowed."</p> <p>Warburton's historical insights are worth considering in thinking about the future path of monetary policy and Fed independence. The wide discretion and power the Fed has been given is a far cry from that envisioned at its founding. The financial crisis led to unconventional monetary policies that were to be "normalized" after the crisis. Yet the sudden onset of the COVID-19 crisis has compounded those policies and added new powers. The case for monetary control is still relevant, even though the proper monetary rule is debatable. Given the size of the Fed's balance sheet and the fiscal deficit, it will be hard for the Fed to limit its credit policies and let market forces determine interest rates. Thus, its independence is likely to remain compromised for some time, just as it was during World War II until the Accord.</p> <p>Broaddus and Goodfriend would agree with Warburton. Monetary policy must be kept separate from fiscal policy. "To formulate and carry out monetary policy effectively, the Fed must maintain a high level of independence within the government, and its asset acquisition practices must support and reinforce that independence." That means "precluding the use of the Fed's off-budget status to allocate credit across various sectors of the economy" and insulating "the Fed from political entanglements that could undermine its independence." Those objectives would be realized if the Fed restricted "its asset portfolio to Treasury securities." The authors warn that straying from a Treasuries only policy "would present significant risks to the integrity of fiscal policy and to the Fed's independence, and hence to the quality of U.S. monetary policy."</p> <p>The Fed, of course, has moved in the opposite direction. Turning back may be very difficult and politically untenable, so long as there is little fiscal rectitude and interest rates must be kept near zero to fund massive government debt. Knowing that the Fed will "do whatever it takes" to prop up asset prices and keep rates low, there will be a continued reach for yield, an increase in risk taking, and a fleecing of risk-adverse savers. Capital formation will suffer and prospects for economic growth will diminish. The desired wealth effects from "easy money" will end up being a mirage. Taxpayers will ultimately bear the burden of the debt—either through higher future taxes or inflation. There is no free lunch.</p> <h4><strong>Conclusion</strong></h4> <p>The COVID-19 pandemic has led to an unprecedented expansion of Fed power and discretion. It has led to the transfer of fiscal responsibility to the Fed and weakened the Fed's independence. The drift into fiscal policy and credit allocation—as opposed to pure monetary policy (i.e., allowing the size of the balance sheet to influence money, prices, and nominal GDP)—places the Fed in a precarious position. The lack of a rules-based monetary regime increases uncertainty and opens the Fed to further politicization. Too much is asked of monetary policy and too little responsibility is placed on Congress for difficult fiscal decisions.</p> <p>After the 2007–09 financial crisis, the Fed failed to fully normalize its balance sheet and, in setting its policy rate, it stuck with the<span> </span><a href="https://bpi.com/wp-content/uploads/2018/11/Understanding_the_Fed%E2%80%99s_implementation_framework_debate_Review05.pdf" rel="nofollow external noopener noreferrer" target="_blank">"floor system"</a><span> </span>that was first instituted in October 2008. That system has allowed the Fed to respond to COVID-19 by massively expanding its balance sheet without fueling inflation. Meanwhile, the Fed's off-balance sheet lending programs, created under the authority of<span> </span><a href="https://www.federalreserve.gov/aboutthefed/section13.htm" rel="nofollow external noopener noreferrer" target="_blank">Section 13 (3)</a><span> </span>of the Federal Reserve Act, have been dramatically expanded in response to the pandemic.</p> <p>The challenge, in the wake of COVID-19, will be to limit the Fed to its proper role of providing monetary stability, while allowing competitive capital markets to freely set interest rates and allocate funds. To meet that challenge, according to<span> </span><a href="https://www.hoover.org/sites/default/files/research/docs/ch01a_section1_cochrane_9780817921347.pdf" rel="nofollow external noopener noreferrer" target="_blank">Plosser</a>, means:</p> <blockquote><p>The Fed should not be allowed to engage in fiscal policy actions that rightly belong to the fiscal authorities. Without carefully established constraints on the size and composition of the Fed's balance sheet, credit allocation and off-budget fiscal policy represent discretionary opportunities ripe for abuses that would undermine the case for political independence. Such authorities are likely to prove detrimental to our institutions and the economy.</p> </blockquote> <p>In a world of scarcity and uncertainty, tradeoffs are inevitable. The pandemic was not the Fed's fault, nor was the political decision to lockdown the economy and put millions of people out of work. In such a situation, the Fed had to act quickly and decisively to provide liquidity to prevent financial instability from leading to further deterioration of the real economy. But the Fed's actions are meant to be temporary, not permanent. Ensuring long-run economic growth necessary to restore economic well-being will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favored groups.</p> <p>Several fundamental issues will need to be addressed when the pandemic ends: Will the Fed be able to downsize along with the government? Will fiscal policy continue to dominate monetary policy? Will interest rates continue to be pegged at low levels to finance ever growing fiscal deficits? The answers to those and related questions will determine both the path of economic life and the scope of personal freedom. They are too important to be left solely to policymakers.</p> <p>******</p> <p><a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_ednref1" name="_edn1" id="_edn1">[1]</a><span> </span>For a detailed discussion of the Fed's SPVs, see<span> </span><a href="https://finance.yahoo.com/news/glossary-federal-reserves-emergency-measures-coronavirus-bazookas-120337473.html" rel="nofollow external noopener noreferrer" target="_blank">Cheung</a>.</p> <p><a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_ednref2" name="_edn2" id="_edn2">[2]</a><span> </span>Correspondence with author, April 18, 2020.</p> <p><a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_ednref3" name="_edn3" id="_edn3">[3]</a><span> </span>All text references are to Warburton's 1966 book:<span> </span><em>Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953<span> </span></em>(Baltimore: The Johns Hopkins Press). Page numbers are indicated.<span> </span><em> </em></p> <p><a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/#_ednref4" name="_edn4" id="_edn4">[4]</a><span> </span>See 12 USC 246.</p> <p>[<a href="https://www.alt-m.org/2020/04/20/covid-19-implications-for-monetary-policy-and-fed-independence/">Cross-posted from Alt-M.org</a>]</p> <p></p> Mon, 20 Apr 2020 09:00:31 -0400 James A. Dorn https://www.cato.org/blog/covid-19-implications-monetary-policy-fed-independence The Classical Gold Standard Can Inform Monetary Policy https://www.cato.org/blog/classical-gold-standard-can-inform-monetary-policy James A. Dorn <p>Watching the frenzy surrounding Judy Shelton's<span> </span><a href="https://www.banking.senate.gov/hearings/02/03/2020/nomination-hearing" rel="noopener noreferrer" target="_blank">confirmation hearing</a><span> </span>before the Senate Banking Committee on February 13, one is led to believe that the gold standard is a "nutty" idea, for which no serious economist or monetary policymaker could possibly have a kind word. This post critiques that wholesale refutation of the gold standard. In recent years (as well as in the past), both serious economists and reputable monetary policymakers have recognized the benefits of a gold standard in reducing regime uncertainty and promoting monetary and social order. Whatever one may think of President Trump's recent Fed picks, the gold standard itself deserves more respect than it's been getting.</p> <h4><strong>Misguided Criticisms</strong></h4> <p>All serious persons agree that stable money of some sort is crucially important to social order. But journalists and others commenting on Judy Shelton's views took for granted that a gold standard could not be consistent with such stability.<span> </span><a href="https://www.washingtonpost.com/opinions/yes-trumps-latest-fed-pick-is-that-bad-heres-why/2020/02/10/a13fa1ec-4c44-11ea-9b5c-eac5b16dafaa_story.html" rel="noopener noreferrer" target="_blank">Catherine Rampell</a>, a respected journalist with<span> </span><em>The Washington Post</em>, wrote that "pegging the dollar to gold could restrict liquidity just when the economy needs it most, as happened during the Great Depression," while<span> </span><a href="https://prospect.org/blogs/tap/trumps-latest-crackpot-judy-shelton-federal-reserve/" rel="noopener noreferrer" target="_blank">Robert Kuttner</a>, another widely read journalist, opined:</p> <blockquote><p>As we painfully learned from economic history, a gold standard is profoundly deflationary, because it prevents necessary expansion of the money supply in line with economic growth. No serious person advocates it. …[I]f you want lower interest rates, the last thing you want is a gold standard.</p> </blockquote> <p>In considering these claims, one must first of all distinguish between the "classical" gold standard, which functioned from the 1870s until World War I, and the interwar "gold exchange standard." While some highly respected authorities have good things to say about the classical gold standard, the interwar gold exchange standard has been universally condemned. And it was the breakdown of that interwar standard, which depended much more heavily on cooperation among various central banks than its pre-1914 counterpart, that contributed to the Great Depression.<a href="#_ftn1" name="_ftnref1" rel="noopener noreferrer" target="_blank" id="_ftnref1">[1]</a><span> </span>George<span> </span><a href="https://www.cato.org/sites/cato.org/files/pubs/pdf/pa729_web.pdf" rel="noopener noreferrer" target="_blank">Selgin</a>, Doug<span> </span><a href="https://www.nber.org/papers/w16350.pdf" rel="noopener noreferrer" target="_blank">Irwin</a>, Barry<span> </span><a href="https://www.nber.org/papers/w2198.pdf" rel="noopener noreferrer" target="_blank">Eichengreen</a>, Michael<span> </span><a href="https://files.stlouisfed.org/files/htdocs/publications/review/81/05/Classical_May1981.pdf" rel="noopener noreferrer" target="_blank">Bordo</a> , and Milton<span> </span><a href="https://www.journals.uchicago.edu/doi/abs/10.1086/466571?journalCode=jle" rel="noopener noreferrer" target="_blank">Friedman</a> elaborate on this argument.</p> <p>Furthermore, not even the generally defective gold exchange standard can be blamed for having restricted liquidity in the United States' case. So far as the U.S. was concerned, as Friedman states,</p> <blockquote><p>It was certainly not adherence to any kind of gold standard that caused the [Great Depression]. If anything, it was the lack of adherence that did. Had either we or France adhered to the gold standard, the money supply in the United States, France, and other countries on the gold standard would have increased substantially.</p> </blockquote> <p>Even a constitutional political economist like James<span> </span><a href="https://www.aier.org/research/prospects-for-a-monetary-constitution/" rel="noopener noreferrer" target="_blank">Buchanan</a> can point to the gold standard and see both its benefits and flaws. He writes: "I am not necessarily anti-gold standard. I think gold would be far better than what we have. But I think there might be better regimes."</p> <p>The gold standard is not a panacea. It is only one of many monetary arrangements that might succeed in checking arbitrary government. There are others. And all of them are imperfect. Because no arrangement is ideal, we must choose among realizable, imperfect alternatives—there are always tradeoffs. But it is also important to take a principled approach to thinking about monetary reform and not to simply accept the status quo.</p> <p>That the "gold standard"—or, more accurately, the interwar "gold exchange standard"—contributed to the Great Depression, understood as a<span> </span><em>worldwide</em><span> </span>depression, is something most economic historians accept. Yet the belief that the<span> </span><em>pre-1914 gold</em><span> </span><em>standard</em><span> </span>was responsible for the U.S. economic collapse of the early 1930s is a myth. It was the Federal Reserve's policy mistakes, rather than its commitment to the gold standard, that was the major cause of the Great Depression. That, at least, is what Milton Friedman and Anna J. Schwartz claim in their landmark book,<span> </span><a href="https://www.amazon.com/Monetary-History-United-States-1867-1960/dp/0691003548" rel="noopener noreferrer" target="_blank"><em>A Monetary History of the United States</em>.</a></p> <p>The United States entered the 1930s with massive excess gold reserves. The Fed was not constrained in using those reserves to expand base money, and thus the broader money supply. As Richard<span> </span><a href="https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2008/5/cj28n2-13.pdf" rel="noopener noreferrer" target="_blank">Timberlake</a><span> </span>wrote in 2008:</p> <blockquote><p>By August 1931, Fed gold had reached $3.5 billion (from $3.1 billion in 1929), an amount that was 81 percent of outstanding Fed monetary obligations and more than double the reserves required by the Federal Reserve Act. Even in March 1933 at the nadir of the monetary contraction, Federal Reserve Banks had more than $1 billion of excess gold reserves. …Whether Fed Banks had excess gold reserves or not, all of the Fed Banks' gold holdings were expendable in a crisis. The Federal Reserve Board had statutory authority to suspend all gold reserve requirements for Fed Banks for an indefinite period.</p> </blockquote> <p>More recently, both<span> </span><a href="https://www.amazon.com/Gold-Real-Bills-Doctrine-Fed/dp/1948647559" rel="noopener noreferrer" target="_blank">Timberlake and Thomas Humphrey</a>, in their path-breaking book—<em>Gold, The Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922–1938</em>—identified the real culprit responsible for the Fed's misconduct. Instead of adhering to the rules of the gold standard, Fed officials managed the Fed's policies according to a fallacious theory known as the "Real Bills Doctrine." That doctrine holds that the money supply can be regulated by making only short-term loans based on the output of goods and services. The problem is that adhering to that doctrine would link the nominal value of the money stock to the nominal expected value of real bills, and there would be no anchor for the price level. Lloyd Mints had it right when he argued: "whereas convertibility into a given physical amount of specie [gold or silver]… will limit the quantity of notes… the basing of notes on a given money's worth of any form of wealth… presents the possibility of unlimited expansion of loans."</p> <p>Setting up straw men, misreading economic history, and using ad hominem arguments are no way to conduct a hearing or improve monetary policy. Richard<span> </span><a href="https://www.independent.org/pdf/tir/tir_11_03_01_timberlake.pdf" rel="noopener noreferrer" target="_blank">Timberlake</a><span> </span>is correct in noting that unless policymakers understand the real causes of the Great Depression—namely, the failure of Fed policy to maintain a steady path for nominal GDP and the failure of the Real Bills Doctrine to guide monetary policy in an era that did not have a real gold standard—then they "are forever in danger of repeating past mistakes or inventing new ones."</p> <p>It is true that, during the classical gold standard, mild deflation did occur, but it was generated by robust economic growth and was beneficial, in contrast to the severe deflation that occurred during the Great Depression due to Fed mismanagement of the money supply.</p> <p>In their meticulous study of the link between deflation and depression for 17 countries over more than a century,<span> </span><a href="https://pubs.aeaweb.org/doi/pdfplus/10.1257/0002828041301588" rel="noopener noreferrer" target="_blank">Andrew Atkenson and Patrick J. Kehoe</a><span> </span>find:</p> <blockquote><p>The only episode in which there is evidence of a link between deflation and depression is the Great Depression (1929–1934). We find virtually no evidence of such a link in any other period. …[M]ost of the episodes in the data set that have deflation and no depression occurred under a gold standard.</p> </blockquote> <p>Moreover, under a commodity standard, long-run price stability allowed the British government to issue bonds without a maturity date, called<span> </span><a href="https://en.wikipedia.org/wiki/Consol_(bond)" rel="noopener noreferrer" target="_blank">"consols."</a><span> </span>Interest rates on those securities were relatively low and actually fell, going from 3 percent in 1757 to 2.75 percent in 1888, and 2.5 percent in 1903. The United States issued consols during the classical gold standard, in the 1870s.</p> <h4><strong>The Importance of Thinking about Monetary Alternatives</strong></h4> <p>There are many alternative monetary regimes, ranging from a pure commodity standard to a pure fiat money system. Serious debate over those alternatives is a worthwhile project, which Cato has been involved with for decades (e.g., see<span> </span><a href="https://www.amazon.com/Search-Stable-Money-Essays-Monetary/dp/0226158292" rel="noopener noreferrer" target="_blank"><em>The Search for Stable Money</em></a><span> </span>and<span> </span><a href="https://www.amazon.com/Monetary-Alternatives-Rethinking-Government-Money/dp/194442444X" rel="noopener noreferrer" target="_blank"><em>Monetary Alternatives: Rethinking Government Fiat Money</em></a>).</p> <p>The importance of studying the properties of alternative monetary regimes and their consequences for safeguarding an essential property right—namely, the promise of a monetary unit that maintains a stable purchasing power in both the short- and long-run—cannot be understated. Indeed, we should not forget that Article 1, Section 8, of the U.S. Constitution grants Congress "the power …to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures." That power was given to Congress, not to inflate the money supply, but to safeguard its value under a rule of law. Consequently, sympathy for gold can begin with a strict reading of that constitutional clause, the language of which clearly presupposes a commodity (gold or silver) standard. As<span> </span><a href="https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2014/9/cj34n3-10.pdf" rel="noopener noreferrer" target="_blank">Milton Friedman</a><span> </span>himself told members of Congress, "As I read the original Constitution, it intended to limit Congress to a commodity standard."</p> <p>The "chief architect" of the Constitution, James Madison, was clear that his preference was for a commodity standard, not for a fiat money standard:</p> <blockquote><p>The only adequate guarantee for the uniform and stable value of a paper currency is its convertibility into specie—the least fluctuating and the only universal currency. I am sensible that a value equal to that of specie may be given to paper or any other medium, by making a limited amount necessary for necessary purposes; but what is to ensure the inflexible adherence of the Legislative Ensurers to their own principles and purposes?</p> </blockquote> <p>Maybe such a concern is quaint, but it's hardly nutty. In fact, it's backed by a considerable base of knowledge on the history of money and monetary arrangements. (<a href="https://www.cato.org/sites/cato.org/files/pubs/pdf/bp100.pdf" rel="noopener noreferrer" target="_blank">Lawrence H. White</a><span> </span>provides an admirable bibliography.)</p> <p><a href="https://www.sciencedirect.com/science/article/abs/pii/S0014498385710194" rel="noopener noreferrer" target="_blank">Michael Bordo and Finn Kydland</a><span> </span>highlight the gold standard's ability to solve the time-inconsistency problem: "When an emergency occurred, the abandonment of the [gold] standard would be viewed by all to be a temporary event since, from their [the public's] experience, only gold or gold-backed claims truly served as money."</p> <p><a href="https://www.minneapolisfed.org/research/qr/qr2222.pdf" rel="noopener noreferrer" target="_blank">Arthur J. Rolnick and Warren E. Weber</a>, in their classic study "Money, Inflation, and Output under Fiat and Commodity Standards," find that, "under fiat standards, rates of money growth, inflation, and output growth are all higher than they are under commodity standards." And Nobel Laureate economist James<span> </span><a href="https://www.aier.org/research/prospects-for-a-monetary-constitution/" rel="noopener noreferrer" target="_blank">Buchanan</a>, who favored a rules-based approach to monetary policy, argues:</p> <blockquote><p>The dollar has absolutely no basis in any commodity base, no convertibility. What we have now is a monetary authority [the Fed] that essentially has a monopoly on the issue of fiat money, with no guidelines that amount to anything; an authority that never would have been legislatively approved, that never would have been constitutionally approved, on any kind of rational calculus.</p> </blockquote> <p>The constitutional political economist is interested in thinking about how to shape institutions to limit the power of government and allow free individuals to go about their own affairs. The pre-1914 gold standard provided "rules of the game," in which human creativity flourished—and people could count not only on long-run price stability, but also on stable exchange rates. Finally, most authorities agree that the period from 1880 to 1914, when the classical gold standard prevailed, was one of innovation, wealth creation, free trade, and sound money. Joseph Schumpeter emphasized:</p> <blockquote><p>An "automatic" gold currency is part and parcel of a laissez-faire and free trade economy. It links every nation's money rates and price levels with the money-rates and price levels of all the other nations that are "on gold." It is extremely sensitive to government expenditure and even to attitudes or policies that do not involve expenditure directly, for example, to foreign policy, to certain policies of taxation, and, in general, to precisely all those policies that violate the principles of [classical] liberalism. …It is both the badge and the guarantee of bourgeois freedom—of freedom not simply of the bourgeois<span> </span><em>interest</em>, but of freedom in the bourgeois<span> </span><em>sense</em>. From this standpoint a man may quite rationally fight for it.</p> </blockquote> <p>Even<span> </span><a href="https://www.econlib.org/library/YPDBooks/Keynes/kynsCP.html?chapter_num=3#book-reader">John Maynard Keynes</a><span> </span>recognized the great benefits stemming from the pre-1914 gold standard:</p> <blockquote><p>What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages.</p> </blockquote> <p>It is a legitimate and important role of scholars to think about monetary alternatives—even when they may not appear politically feasible. This is one reason the Cato Institute established a<span> </span><a href="https://www.cato.org/centers/center-monetary-financial-alternatives" rel="noopener noreferrer" target="_blank">Center for Monetary and Financial Alternatives</a>. It's also why each year, our<span> </span><a href="https://www.cato.org/multimedia/media-highlights-radio/james-dorn-discusses-history-monetary-policy-washington-dc-its" rel="noopener noreferrer" target="_blank">Annual Monetary Conference</a><span> </span>brings together the best minds to discuss, in a civil manner, how to improve current policies in order to increase trust in the future value of money and promote financial stability. From constitutional political economists to central bankers, we welcome contributions from across the spectrum in what we consider a crucial ongoing conversation.</p> <h4><strong>What Would Gold Principles Bring to the Fed? </strong></h4> <p>If one is unfit to serve on the Federal Reserve Board because he or she sees the beauty of the classical gold standard, then Alan<span> </span><a href="https://www.constitution.org/mon/greenspan_gold.htm" rel="noopener noreferrer" target="_blank">Greenspan</a><span> </span>also should never have been allowed to serve on the Board. He too was a strong defender of the classical gold standard. In 1966, he wrote:</p> <blockquote><p>An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense—perhaps more clearly and subtly than many consistent defenders of laissez-faire—that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.</p> </blockquote> <p>The operation of the classical gold standard offered many lessons, including the importance of enforceable private contracts under a just rule of law, to how the existing system might be improved. This does not mean we should necessarily return to such a standard. It simply means that we shouldn't dismiss that system as a "nutty idea."<span> </span><a href="https://fraser.stlouisfed.org/files/docs/publications/somc/1987_03_09.pdf" rel="noopener noreferrer" target="_blank">Karl Brunner</a>, the cofounder of the Shadow Open Market Committee, for example, once called for an international "club of financial stability" in which member states would agree to bind themselves to a monetary rule and thereby help reduce the uncertainty inherent in a discretionary government fiat money regime. To return to rules-based monetary policy would, itself, be to honor lessons learned during the era of the gold standard.</p> <p>Although Greenspan lauded the classical gold standard, he realized that, once appointed, he would have to work within the existing legal framework—not advocate a return to the pre-1914 gold standard. Yet, his knowledge of how that system worked to maintain the value of money—and to allow interest rates, not central bankers, to allocate scarce capital—helped inform his approach to monetary policy at the Fed. Even many years after he began his long tenure as Fed chairman,<span> </span><a href="http://www.usagold.com/gildedopinion/greenspangold.html" rel="noopener noreferrer" target="_blank">Greenspan</a><span> </span>stated, at a 2001 congressional hearing: "Mr. Chairman, so long as you have fiat currency, which is a statutory issue, a central bank properly functioning will endeavor to, in many cases, replicate what a gold standard would itself generate."</p> <p>________________________</p> <p><a href="#_ftnref1" name="_ftn1" id="_ftn1">[1]</a><span> </span>The gold exchange standard operated from 1925 to 1931. Under that system, central banks could sterilize gold flows to insulate their domestic money supplies. Moreover, countries (other than the United States and United Kingdom) were allowed to hold their reserves in the form of dollars or pounds, in addition to gold. This system collapsed in 1931, after the UK ended convertibility to stem large outflows of gold and capital (see <a href="https://files.stlouisfed.org/files/htdocs/publications/review/81/05/Classical_May1981.pdf" rel="noopener noreferrer" target="_blank">Bordo</a>).</p> <p>[<a href="https://www.alt-m.org/2020/03/04/the-classical-gold-standard-can-inform-monetary-policy/">Cross-posted from Alt-M.org</a>]</p> <p></p> Wed, 04 Mar 2020 08:38:34 -0500 James A. Dorn https://www.cato.org/blog/classical-gold-standard-can-inform-monetary-policy The Phillips Curve: A Poor Guide for Monetary Policy https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-monetary-policy James A. Dorn <div class="mb-3 spacer--nomargin--last-child text-default"> <blockquote>[The] persistent shortfall in inflation from our target has led some to question the traditional relationship between inflation and the unemployment rate, also known as the Phillips curve.… My view is that the data continue to show a relationship between the overall state of the labor market and the change in inflation over time. That connection has weakened over the past couple of decades, but it still persists, and I believe it continues to be meaningful for monetary policy.<br /><br /> — Fed Chairman Jerome Powell (<a href="#ref039">2018</a>: 6–7)</blockquote> <p>The history of economic thought is replete with examples of economic ideas that are politically attractive and persist even after they have little empirical support or theoretical validity. That has certainly been the case with the Phillips curve.</p> <p>The Federal Reserve continues to incorporate the Phillips curve in its macroeconomic models even though the empirical evidence for a negative relationship between inflation and unemployment is weak at best. In a recent study by the Brookings Institution, the authors note that the Fed still relies on the Phillips curve as a “key factor” in setting its policy rate and as a “tool … to forecast what will happen to inflation when the unemployment rate falls, as it has in recent years” (<a href="#ref031">Ng, Wessel, and Sheiner 2018</a>: 1–2).</p> <p>This article traces the history of the Phillips curve and argues that it is a poor guide for monetary policy. The underlying problem is that the Phillips curve misconstrues a supposed correlation between unemployment and inflation as a causal relation. In fact, it is changes in aggregate demand that cause changes in both unemployment and inflation. The Phillips curve continues to misinform policymakers and lead them astray.</p> <h2>Evolution of the Phillips Curve</h2> <p>In 1958, New Zealand economist A. W. Phillips published a landmark paper showing an inverse relationship between unemployment and the rate of change in money wages in the United Kingdom from 1861 to 1913. He also found that relationship persisted when the data set was extended to 1957 (<a href="#ref037">Phillips 1958</a>).</p> <p>R. G. Lipsey (<a href="#ref024">1960</a>) provided further support for Phillips’s findings, as did Paul Samuelson and Robert Solow (<a href="#ref040">1960</a>), who coined the term “Phillips curve.” In their version of the curve, price inflation (rather than wage inflation) is plotted against unemployment. Using U.S. data for 1934 to 1958, they found a negative relationship between the rate of change in the average level of money prices and the level of unemployment. By viewing the Phillips curve as a “menu of choice[s] between different degrees of unemployment and price stability,” Samuelson and Solow opened the door for policymakers to believe they could fine‐​tune the economy by choosing a socially optimal point on the Phillips curve, at least in the short run (see <a href="#ref019">Humphrey 1986</a>:100–03).</p> <p>Although Samuelson and Solow (<a href="#ref040">1960</a>: 193) stated that their analysis pertained to the short run, and that the shape of the Phillips curve could change in the long run, or the curve could shift, those caveats were largely ignored in the 1960s. There was a strong sense that the Phillips curve was stable and that there was a <em>permanent</em> tradeoff between inflation and unemployment. That belief fostered the idea that mild inflation was beneficial in reducing unemployment. In such an environment, inflation increased from 1.2 percent in 1962 to 5.8 percent in 1970 (see <a href="#ref014">Hall and Hart 2012</a>: 62–64).</p> <p>In his monumental <em>History of the Federal Reserve</em>, Allan Meltzer, paints a succinct picture of the raise of the Phillips curve as a policy guide in the 1960s:</p> <blockquote>The Phillips curve was an empirical relation with no formal foundation, but it had great appeal and moved with remarkable speed from the economics journals to the policy process. Samuelson and Solow (<a href="#ref040">1960</a>) estimated the Phillips curve on data for the United States. Both worked with the new administration before the election and in its early years, Samuelson as an informal, personal adviser to President Kennedy and Solow as a senior staff member of the Council of Economic Advisers. Their paper contained a phrase about the relation of inflation to unemployment that they and others chose to ignore: “A first look at the scatter is discouraging; there are points all over the place” (ibid., 188). They recognized, however, that the shape of the curve, hence the tradeoff, depended on the policies pursued. Almost all discussion ignored the fact that most of the data which Phillips used came when the gold standard tied down expected inflation [<a href="#ref029">Meltzer 2009</a>: 268, fn.3].</blockquote> <p>In a separate study of the Samuelson‐​Solow Phillips curve, Hall and Hart (<a href="#ref014">2012</a>: 63–64) note:</p> <blockquote id="pn1">Samuelson and Solow interpreted their statistical Phillips curve as a structural relationship that had the potential of offering a menu of exploitable tradeoffs between inflation and unemployment. And while they warned that the tradeoff may not be sustainable (that is, warned that the Phillips curve might shift), this message seemed to have been quickly lost on all but a few.… It turns out, however, that the Samuelson–Solow Phillips curve was neither statistical nor structural. Samuelson and Solow provided no empirical estimates of the Phillips curve in their celebrated 1960 paper. Instead, they simply hand‐​drew a line they believed fitted the data for the twenty‐​five year period from 1934 to 1958.<sup><a href="#en1">1</a></sup></blockquote> <p>With high and variable inflation in the 1970s, reaching 13.5 percent in 1980, the Phillips curve lost its luster as both inflation and unemployment soared. Peter Ireland, a member of the Shadow Open Market Committee notes, “Despite the occasional appearance of a statistical Phillips curve relationship between inflation and unemployment in the United States data, the Federal Reserve’s efforts to exploit that Phillips curve led, during the 1970s, not to lower unemployment at the cost of higher inflation but instead to the worst of both worlds: higher unemployment and higher inflation” (<a href="#ref021">Ireland 2019b</a>: 5).</p> <p>The stagflation led Paul Volcker, chairman of the Federal Reserve, to proclaim before the Senate Committee on Banking, Housing, and Urban Affairs in 1981: “I don’t think that we have the choice in current circumstances — the old tradeoff analysis — of buying full employment with a little more inflation. We found out that doesn’t work” (<a href="#ref048">Volcker 1981</a>: 28). Volcker’s war on inflation was not popular with many members of Congress, who continued to think that higher inflation could help reduce unemployment. However, he proved to be correct in arguing that lowering inflation and achieving long‐​run price stability would help calm markets and improve the prospect for growth in employment and output (see <a href="#ref044">Steelman 2011</a>: 3–4).</p> <p>Milton Friedman (<a href="#ref010">1968</a>, <a href="#ref011">1977</a>) and Edmund Phelps (<a href="#ref035">1967</a>) recognized that when inflation expectations are built into the Phillips curve, and individuals fully anticipate inflation, unemployment will settle at its “natural” level as determined by market forces, and the long‐​run Phillips curve will be vertical — that is, there will be no tradeoff between inflation and unemployment.</p> <h3>Three Stages of the Phillips Curve</h3> <p>In his 1976 Nobel lecture, “Inflation and Unemployment,” Milton Friedman (<a href="#ref011">1977</a>) traced out three stages in the evolution of the Phillips curve. The <em>first stage</em> featured the simple curve in <a href="#fig8_1">Figure 1</a>, showing a stable, negative relationship between inflation and unemployment.</p> <p align="center" id="fig8_1"><img data-src="https://www.cato.org/sites/cato.org/files/images/cato-journal/winter-2020/cj-v40n1-8-figure-1.jpg" class=" lozad" /></p> <p id="pn2">The <em>second stage</em> featured Friedman’s “natural rate hypothesis,” which he first described in his 1967 presidential address to the American Economic Association. In this stage, the short‐​run Phillips curve is adjusted for expectations and the long‐​run curve is vertical at the natural rate of unemployment (<a href="#ref010">Friedman 1968</a>). An unexpected increase in inflation initially reduces unemployment. However, once workers and employers fully anticipate higher inflation, they will revise their plans and unemployment will return to its “natural” level consistent with equilibrium real wages and the overall structure of the labor market.<sup><a href="#en2">2</a></sup></p> <p><a href="#fig8_2">Figure 2</a> shows an increase in inflation from 0 percent to I<sub>1</sub> temporarily reduces unemployment below its long‐​run “natural” level U<sub>N</sub> to U<sub>1</sub>, say from 4 percent to 3 percent. (No one knows for certain what the actual “natural rate of unemployment” is; it is not observable.) The movement from point <em>a</em> to point <em>b</em> on the initial Phillips curve (PC<sub>1</sub>) is posited on the assumption that the initial inflation rate is 0 percent. However, once the higher inflation rate is fully recognized by market participants, unemployment will return to U<sub>N</sub> and PC<sub>2</sub> will become the relevant Phillips curve — provided expected inflation remains at I<sub>1</sub>. Points <em>a</em> and <em>c</em> now lie on the long‐​run Phillips curve (LRPC), where each point represents a state of full adjustment between actual and expected inflation. Thus, the long‐​run Phillips curve is vertical. As Meltzer (<a href="#ref029">2009</a>: 287) writes, “The long‐​run Phillips curve must be vertical because inflation is a nominal variable and unemployment is a real variable. Rational behavior require[s] that any influence of nominal variables on real variables last only as long as it takes markets to learn and adjust.”</p> <p align="center" id="fig8_2"><img data-src="https://www.cato.org/sites/cato.org/files/images/cato-journal/winter-2020/cj-v40n1-8-figure-2.jpg" class=" lozad" /></p> <p id="pn3">The concept of “rational expectations,” first developed by John Muth (<a href="#ref030">1961</a>) and later elaborated upon by Robert Lucas (<a href="#ref025">1987</a>) and Thomas Sargent (<a href="#ref041">1986</a>), provided a strong theoretical case that there could be no tradeoffs between inflation and unemployment — even in the short run. Hence, under the rational expectations framework, systematic monetary policy can have no impact on relative prices, output, or employment. However, if wages and/​or prices are sticky and there are costs to acquiring information about job openings, and so on, then activist monetary policies can still have real effects — perhaps for a considerable time (see <a href="#ref019">Humphrey 1986</a>: 126).<sup><a href="#en3">3</a></sup></p> <p id="pn4">The <em>third stage</em> in the evolution of the Phillips curve is the hypothesis that high and variable inflation plants the seeds for higher future unemployment by distorting relative prices and increasing “regime uncertainty,” thus producing a positively sloped long‐​run Phillips curve as shown in <a href="#fig8_3">Figure 3</a> (adapted from <a href="#ref019">Humphrey 1986</a>: 108).<sup><a href="#en4">4</a></sup> As Humphrey explains:</p> <p align="center" id="fig8_3"><img data-src="https://www.cato.org/sites/cato.org/files/images/cato-journal/winter-2020/cj-v40n1-8-figure-3.jpg" class=" lozad" /></p> <blockquote>The long‐​run Phillips curve may become positively sloped in its upper ranges as higher inflation leads to greater inflation variability (volatility, unpredictability) that raises the natural rate of unemployment. Higher and hence more variable and erratic inflation can raise the equilibrium level of unemployment by generating increased uncertainty that inhibits business activity and by introducing noise into market price signals, thus reducing the efficiency of the price system as a coordinating and allocating mechanism [<a href="#ref019">Humphrey 1986</a>: 108].</blockquote> <p>Milton Friedman considered the possibility of a positively sloped Phillips curve, given the stagflation that occurred in the 1970s. Using inflation lagged one‐​half year (n 5 0.5), Friedman (<a href="#ref011">1977</a>: 461, Table 1) found that unemployment averaged 6.1 percent from 1971 through 1975 while inflation averaged 6.7 percent. His “tentative hypothesis” was that the positively sloped Phillips curve may be “a transitional phenomenon that will disappear as economic agents adjust not only their expectations but their institutional and political arrangements to a new reality.” He therefore thought that the natural‐​rate hypothesis would still hold in the very long run, but the “transitional period may well extend over decades” (<a href="#ref011">Friedman 1977</a>: 464–65).</p> <p>Friedman (<a href="#ref011">1977</a>: 467) recognized that, during the transitional period, “increased volatility of inflation” can distort relative price signals and increase unemployment. Moreover, he believed that, “in practice, the distorting effects of uncertainty, rigidity of voluntary long‐​term contracts, and the contamination of price signals will almost certainly be reinforced by legal restrictions on price change” (i.e., wage and price controls).</p> <h3>The Great Moderation</h3> <p>During the Great Moderation, roughly from the mid‐​1980s until 2007, the transition to a more systematic monetary policy that implicitly followed a Taylor‐​type rule reduced the volatility of inflation and output compared to the stop‐​go monetary policy that preceded it (see <a href="#ref013">Hakkio 2013</a>). By anchoring inflation expectations and stabilizing the growth of nominal GDP (NGDP) around a trend rate of about 5 percent per year, the Fed improved its credibility and reduced regime uncertainty.</p> <p>Jerry L. Jordan, former president of the Federal Reserve Bank of Cleveland, described the atmosphere surrounding the Phillips curve during the last two decades of the 20th century:</p> <blockquote>The macroeconomic developments of the final two decades of the 20th century should have ended any further debate about the notion of some tradeoff between inflation and unemployment. Rates of inflation declined in market economies around the world, regardless of the political systems. Most places also experienced declines in unemployment rates, and where unemployment remained high it was almost universally acknowledged to be the result of national labor market rigidities and regulatory policies. Nowhere was the idea put forth that a bit higher inflation would even temporarily lower the unemployment rates. It seemed — for a while at least — that no minister of finance or central banker would dare to suggest that inflation was too low and that a bit more would in any way be a good thing [<a href="#ref022">Jordan 2012</a>: 22].</blockquote> <h3>Global Financial Crisis and Its Aftermath</h3> <p>The global financial crisis of 2008 ended the Great Moderation and ushered in a new wave of uncertainty associated with unconventional monetary policies. After more than a decade, the inflation rate has remained low despite historically low unemployment, a result that challenges those who continue to place faith in the Phillips curve’s credibility as a forecasting tool to guide monetary policy. As St. Louis Fed President James Bullard (<a href="#ref002">2017</a>) has stated, “the idea that unemployment outcomes are a major factor in driving inflation outcomes in the U.S. economy” cannot be substantiated by the data. “A more important determinant” appears to be “inflation expectations.” He goes on to say:</p> <blockquote>Despite the empirical evidence suggesting that the Phillips curve relationship is relatively flat, some still argue in favor of raising the U.S. policy rate in an effort to get ahead of the anticipated surge in inflation. Implicit in that argument is the idea that the relationship is nonlinear, meaning the impact on inflation would be much larger once unemployment reached extremely low levels. However, I am not aware of empirical estimates that have made a convincing case for the nonlinear Phillips curve using recent data. For monetary policy purposes, we should not base our notions of what will happen with inflation solely on ideas related to low unemployment.</blockquote> <p id="pn5">Even in the face of strong evidence for the flattening of the short‐​run Phillips curve (i.e., decreases in unemployment have a much smaller impact on inflation than in earlier periods), central banks are reluctant to omit it from their macroeconomic models.<sup><a href="#en5">5</a></sup> As Fed Chairman Jerome Powell noted in his April 6, 2018, speech at the Economic Club of Chicago, “Almost all of the participants [at the January 2018 Federal Open Market Committee meeting] thought that the Phillips curve remained a useful basis for understanding inflation.” Yet they recognized “that the link between labor market tightness and changes in inflation has become weaker and more difficult to estimate, reflecting in part the extended period of low and stable inflation in the United States and in other advanced economies” (<a href="#ref039">Powell 2018</a>: 6–7).</p> <p>The real problem with the Phillips curve is not that it supposes that inflation and unemployment are related, especially in the short run, but that it misconstrues that relation as involving a direct causal influence of unemployment on inflation, and vice versa, when in fact it is changes in aggregate demand that cause changes in both unemployment and inflation. According to Mickey Levy, chief economist at Berenberg:</p> <blockquote>The Phillips curve, which correctly posits that lower unemployment raises wages, incorrectly presumes that [higher] wages always lead to higher product prices without considering the impact of productivity on production costs, or how nominal aggregate demand influences businesses flexibility to raise product prices. In the 1990s, strong productivity gains were associated with strong gains in real wages, while constraining unit labor costs; that is, the stronger productivity raised the share of nominal GDP that was real. In [the present] expansion, the moderate growth in nominal GDP has constrained wage gains and inflation despite very low unemployment. Not surprisingly, the Phillips curve did not capture either of these dominant trends [<a href="#ref023">Levy 2018</a>].</blockquote> <p>The Phillips curve is a distraction to the main function of a central bank — namely, to “prevent money itself from being a major source of economic disturbance,” as Milton Friedman observed in his 1968 presidential address (<a href="#ref010">Friedman 1968</a>: 12).</p> <h2>How a Broken Theory Is Still Guiding Policy</h2> <p id="pn6">At a press conference following the Fed’s Open Market Committee meeting on June 14, 2017, Janet Yellen remarked: “We continue to feel that, with a strong labor market and a labor market that’s continuing to strengthen, the conditions are in place for inflation to move up” (<a href="#ref051">Yellen 2017</a>). Likewise, Fed Chairman Jerome Powell believes the Phillips curve “continues to be meaningful for monetary policy” even though the strength of the relationship between unemployment and inflation “has weakened” (<a href="#ref039">Powell 2018</a>).<sup><a href="#en6">6</a></sup></p> <p>A few years earlier, in 2015, then president of the Federal Reserve Bank of Atlanta, Dennis Lockhart, in an interview with the <em>Wall Street Journal</em>, stated:</p> <blockquote>I think a policymaker has to act on the view that the basic relationship in the Phillips curve between inflation and [un]employment will assert itself in a reasonable period of time as the economy tightens up, as the resource picture in the economy tightens. I am quite confident that that basic expectation will materialize.… I don’t know if I would quite say that I am resting everything on a model, but I am certainty prepared to get comfortable based on [an] expectation that seems to me to have compelling logic [<a href="#ref018">Hilsenrath 2015</a>, interview with Lockhart].</blockquote> <p>A final example of how the Phillips curve continues to be treated by Fed officials as a useful guide to policy, even in the face of strong evidence during the last 20 years that the degree of unemployment is a poor indicator of inflation, comes from a working paper prepared by the staff of the Federal Reserve Board’s Divisions of Research &amp; Statistics and Monetary Affairs in 2018:</p> <blockquote>While inflation appears to be insensitive to labor market slack, policy needs to take proper account of the prospects for persistently tight labor markets leading to higher inflation, or other imbalances, that could eventually endanger prospects on the employment side of [the Fed’s] policy mandate [<a href="#ref007">Erceg et al. 2018</a>: 18].</blockquote> <p>All of the forgoing examples show that central bankers are not yet willing to discard the Phillips curve as a policy tool, even though the evidence for a downward sloping curve is meager. Indeed, as early as 2002, William Niskanen, a former member of President Ronald Reagan’s Council of Economic Advisers, declared: “The concept of a Phillips curve should be considered empty when most of the variation in the data must be explained by shifts in this presumed relation. In any case, the Phillips curve proved to be a poor basis for forecasting and a worse guide to policy” (<a href="#ref033">Niskanen 2002</a>: 194).</p> <p>Using annual data from 1960 through 2001, Niskanen found that “there is <em>no</em> tradeoff of unemployment and inflation except in the same year,” and that “in the long term, the unemployment rate is a <em>positive</em> function of the inflation rate” (<a href="#ref033">Niskanen 2002</a>: 198). During the 1970s, inflation and unemployment both increased, as the United States experienced stagflation, and since 2009, unemployment has turned sharply lower while inflation has remained low.</p> <p>Nevertheless, the existence of even a transient and loose relation between inflation and unemployment provides policymakers with the illusory hope that they can exploit that relation to achieve desired policy goals. The idea that a little more inflation is desirable in return for a little less unemployment is appealing to both policymakers and politicians, both of whom are inclined to overemphasize the short run and discount the long run. That is why economic fallacies have a tendency to reappear, especially when politicians can win votes by resurrecting them. Protectionist rhetoric is one common example; the idea that a little inflation is a good thing is another.</p> <p>Although the Phillips curve has been discredited, it is not really dead and so distracts from alternative ideas for conducting monetary policy that offer a better chance of achieving long‐​run price stability and promoting economic stability and growth. The still‐​lingering influence of circa. 1965 Keynesianism — with its emphasis on short‐​run remedies for long‐​run problems, its distrust of the market adjustment process, and its dismissal of the quantity theory of money — downplays the point, clearly recognized by F. A Hayek in 1960, that “the stimulating effect of inflation will … operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity” (<a href="#ref015">Hayek 1960</a>: 331). Hayek went on to criticize the myopic view of policymakers:</p> <blockquote>The inflationary bias of our day is largely the result of the prevalence of the short‐​term view, which in turn stems from the great difficulty of recognizing the more remote consequences of current measures, and from the inevitable preoccupation of practical men, and particularly politicians, with the immediate problems and the achievement of near goals [<a href="#ref015">Hayek 1960</a>: 333].</blockquote> <p id="pn7">The Phillips curve gives policymakers a justification to try to fine‐​tune the economy, but it is a weak reed on which to base policy — and it fails to recognize the limits of monetary policy.<sup><a href="#en7">7</a></sup></p> <h2>A Better Framework for Monetary Policy</h2> <p id="pn8">Instead of relying on a flawed Phillips curve analysis to guide policy, Fed officials should focus on the underlying causes of both undesired changes in inflation and cyclical fluctuations in unemployment. In turn, the Fed’s dual mandate to achieve maximum employment and price stability, which is flawed by assuming a tradeoff between inflation and unemployment, should be replaced by a single target, preferably keeping NGDP on a level growth path.<sup><a href="#en8">8</a></sup> Doing so would increase the credibility of monetary policy, reduce regime uncertainty, mitigate business fluctuations, and avoid stop‐​go monetary policy. Niskanen (<a href="#ref034">2008</a>: 377) argued that “the intent of Congress would be better served and monetary policy would be more effective if Congress instructed the Federal Reserve to establish a monetary policy that reflects both their concerns in a <em>single</em> target.” He did so because he clearly recognized the failure of forecasting inflation under a Phillips curve framework and, hence, the merits of a nominal income target over an inflation target (with the unemployment rate serving as a poor proxy for likely inflation).<sup><a href="#en9">9</a></sup></p> <p>One benefit of a rule designed to keep nominal income on a steady growth path is that it bypasses the issue of assigning weights under the Fed’s dual mandate to achieve price level stability and maximum employment. All that needs to be done is to set a target path for the growth of nominal spending (i.e., the sum of real output growth and inflation). Market forces will then determine real growth.</p> <p>Peter Ireland nicely summarizes the benefits of NGDP targeting over a problematic reliance on the Phillips curve as a guide to monetary policy:</p> <p class="EXT_F">As the sum of real GDP growth and nominal price inflation, NGDP growth conveniently captures, in a single number, the Fed’s performance in satisfying both sides of its dual mandate for maximum sustainable growth with stable prices. At the same time, however, NGDP, precisely because it is a nominal variable, measured in units of dollars, is under the central bank’s control in the long run.… Moreover, the Fed’s ability to regulate the growth rate of NGDP does not depend on the stability of the Phillips curve.… [I]n the current environment, where various nonmonetary forces may well be causing the very low rate of measured unemployment to overstate the true degree of resource utilization in the U.S. economy, focusing instead on the real component of NGDP growth guards against one of the risks alluded to in Powell’s remarks: a policy stance that becomes inappropriately restrictive out of concern for inflationary pressures working through a misperceived Phillips curve.</p> <p class="EXT_TXT">Finally, as noted by Tobin (<a href="#ref047">1983</a>) and McCallum (<a href="#ref026">1985</a>), the equation of exchange MV5PY identifies nominal income (PY) as a measure of the money supply (M) that gets adjusted automatically for shifts in velocity (V). Thus, analyses based on the behavior of NGDP growth provide a monetarist cross‐​check against mainstream Keynesian approaches, like Powell’s, organized around the Phillips curve instead. According to this monetarist view, interactions between trends in M, reflecting monetary policy actions that affect the money supply, and V, interpreted following Friedman (<a href="#ref009">1956</a>) with reference to the determinants of money demand, replace those between the actual and natural rates of unemployment as the key mechanisms determining inflation [<a href="#ref020">Ireland 2019a</a>: 52–53].</p> <p>Congress should put the Phillips curve to bed and consider the case for a nominal GDP (or domestic final sales) target. One step toward that goal would be to add nominal GDP growth to the Fed’s Summary of Economic Projections, a proposal first made by Jeffrey Frankel (<a href="#ref008">2019</a>: 461–70).</p> <h2>Conclusion</h2> <p>Instead of continuing to hold onto the discredited presumption of a tradeoff between inflation and unemployment, policymakers should focus on the misallocative and distributive effects of activist monetary policy. The Fed needs to recognize that the Phillips curve is not a reliable policy compass. A monetary policy based on short‐​run activism, such as that implied by a “data‐​dependent” Fed, is not a good substitute for one based on a transparent, long‐​run strategy guided by a robust monetary rule. Policymakers should heed the advice of Hayek, who in 1975 wrote:</p> <p class="EXT_F">What we must now be clear about is that our aim must be, not the maximum of employment that can be achieved in the short run, but a “high and stable level of employment.” We can achieve this, however, only through the reestablishment of a properly functioning market which, by the free play of prices and wages, establishes the correspondence of supply and demand for each sector.</p> <p class="EXT_TXT">Though monetary policy must prevent wide fluctuations in the quantity of money or in the volume of the income stream, the effect on employment must not be its dominating consideration. <em>The primary aim must again become the stability of the value of money.</em> The currency authorities must again be effectively protected against the political pressure that today forces them so often to take measures that are politically advantageous in the short run but harmful to the community in the long run [<a href="#ref016">Hayek (1975) 1979</a>: 17].</p> <p id="pn10">It has been more than 40 years since Hayek made those recommendations for changes in the framework for monetary policy, yet we are still in search of a monetary constitution.<sup><a href="#en10">10</a></sup></p> <p>The Phillips curve has diverted attention from the search for a monetary constitution and a rules‐​based regime by promoting the idea that central banks can use expansionary monetary policy to lower unemployment — and, hence, that discretionary policy is to be preferred to a rules‐​based regime. Macroeconomic models used by the world’s central banks still rely on the Phillips curve as a tool for their inflation forecasts, even though those forecasts have been unreliable.</p> <p>Today, the United States has historically low unemployment while inflation has stayed at less than 2 percent for more than a decade. Those facts alone should convince policymakers that the Phillips curve is a poor guide for monetary policy.</p> <h2>References</h2> <p class="REF_F" id="ref001">Beckworth, D. (2017) “The Knowledge Problem in Monetary Policy: The Case for Nominal GDP Targeting.” Mercatus on Policy Series (July 18). Mercatus Center, George Mason University.</p> <p class="REF" id="ref002">Bullard, J. (2017) “Does Low Unemployment Signal a Meaningful Rise in Inflation?” Federal Reserve Bank of St. Louis <em>Regional Economist</em> (Third Quarter).</p> <p class="REF" id="ref003">Dorn, J. A. (1987) “The Search for Stable Money: A Historical Perspective.” In J. A. Dorn and Anna J. Schwartz (eds.), <em>The Search for Stable Money: Essays on Monetary Reform</em>, 1–28. Chicago: University of Chicago Press.</p> <p class="REF" id="ref004">_________ (2001) “The Limits of Monetary Policy.” <em>Cato Handbook for Congress</em>, 108th Congress, 247–56. Washington: Cato Institute.</p> <p class="REF" id="ref005">_________ (2018) “Monetary Policy in an Uncertain World: The Case for Rules.” <em>Cato Journal</em> 38 (1): 81–108.</p> <p class="REF" id="ref006">_________ (2019) “Myopic Monetary Policy and Presidential Power: Why Rules Matter.” <em>Cato Journal</em> 39 (3): 577–95.</p> <p class="REF" id="ref007">Erceg, C.; Hebden, J.; Kiley, M.; López‐​Salido, D.; and Tetlow, R. (2018) “Some Implications of Uncertainty and Misperception for Monetary Policy.” Finance and Economics Discussion Series 2018-059. Washington: Board of Governors of the Federal Reserve System.</p> <p class="REF" id="ref008">Frankel, J. (2019) “Should the Fed Be Constrained?” <em>Cato Journal</em> 39 (2): 461–70.</p> <p class="REF" id="ref009">Friedman, M. (1956) “The Quantity Theory of Money: A Restatement.” In <em>Studies in the Quantity Theory of Money</em>, 3–21. Chicago: University of Chicago Press.</p> <p class="REF" id="ref010">_________ (1968) “The Role of Monetary Policy.” <em>American Economic Review</em> 58 (1): 1–17.</p> <p class="REF" id="ref011">_________ (1977) “Nobel Lecture: Inflation and Unemployment.” <em>Journal of</em> <em>Political Economy</em> 85 (3): 451–72.</p> <p class="REF" id="ref012">Gordon, R. J. (1985) “The Conduct of Domestic Monetary Policy.” In A. Ando et al. (eds.), <em>Monetary Policy in Our Times</em>. Cambridge, Mass.: MIT Press.</p> <p class="REF" id="ref013">Hakkio, C. S. (2013) “The Great Moderation.” Federal Reserve History blog (November 22): <a href="http://www.federalreservehistory.org/essays/great_moderation">www​.fed​er​al​re​serve​his​to​ry​.org/​e​s​s​a​y​s​/​g​r​e​a​t​_​m​o​d​e​r​ation</a>.</p> <p class="REF" id="ref014">Hall, T. E., and Hart, W. R. (2012) “The Samuelson–Solow Phillips Curve and the Great Inflation.” <em>History of Economics Review</em> 55 (Winter): 62–72.</p> <p class="REF" id="ref015">Hayek, F. A. (1960) <em>The Constitution of Liberty</em>. Chicago: University of Chicago Press.</p> <p class="REF" id="ref016">_________ ([1975] 1979) <em>Unemployment and Monetary Policy: Government as Generator of the Business Cycle.</em> San Francisco<em>:</em> Cato Institute. Revised edition of <em>Full Employment at Any Price?</em> London: Institute of Economic Affairs (1975).</p> <p class="REF" id="ref017">Higgs, R. (1997) “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.” <em>The Independent Review</em> 1 (4): 561–90.</p> <p class="REF" id="ref018">Hilsenrath, J. (2015) “Excerpts from Atlanta Fed’s Lockhart Interview.” <em>Wall Street Journal</em> (August 4).</p> <p class="REF" id="ref019">Humphrey, T. M. (1986) <em>Essays on Inflation</em>, 5th ed. Richmond, Va.: Federal Reserve Bank of Richmond.</p> <p class="REF" id="ref020">Ireland, P. N. (2019a) “Economic Conditions and Policy Strategies: A Monetarist View.” <em>Cato Journal</em> 39 (1): 51–63.</p> <p class="REF" id="ref021">_________ (2019b) “Independence and Accountability via Inflation Targeting: Strengthening the Foundations for Successful Monetary Policymaking.” Paper presented at the Cato Institute’s 37th Annual Monetary Conference, Washington, D.C., November 14.</p> <p class="REF" id="ref022">Jordan, J. L. (2012) “Friedman and the Phillips Curve.” In <em>Sound Money: Why It Matters, How to Have It</em>, 9–29. Ottawa, Ontario: Macdonald‐​Laurier Institute.</p> <p class="REF" id="ref023">Levy, M. D. (2018) “U.S. Nominal GDP Acceleration: Pay More Attention to It.” Economics Macro News, Berenberg Capital Markets (August 6).</p> <p class="REF" id="ref024">Lipsey, R. G. (1960) “The Relation between Unemployment and the Rate of Change in Money Wages in the United Kingdom, 1862–1957: A Further Analysis.” <em>Economica</em> 27 (105): 1–31.</p> <p class="REF" id="ref025">Lucas, R. E. Jr. (1987) <em>Models of Business Cycles.</em> Oxford: Basil Blackwell.</p> <p class="REF" id="ref026">McCallum, B. T. (1985) “On Consequences and Criticisms of Monetary Targeting.” <em>Journal of Money, Credit, and Banking</em> 17 (November, Part 2): 570–97.</p> <p class="REF" id="ref027">_________ (1989) <em>Monetary Economics: Theory and Policy.</em> New York: Macmillan.</p> <p class="REF" id="ref028">Meltzer, A. H. (1989) “On Monetary Stability and Monetary Reform.” In J. A. Dorn and W. A. Niskanen (eds.) <em>Dollars, Deficits, and Trade</em>, 63–85. Boston: Kluwer.</p> <p class="REF" id="ref029">_________ (2009) <em>A History of the Federal Reserve: Volume 2, Book 1, 1951–1969.</em> Chicago: University of Chicago Press.</p> <p class="REF" id="ref030">Muth, J. A. (1961) “Rational Expectations and the Theory of Price Movements.” <em>Econometrica</em> 29 (6): 315–35.</p> <p class="REF" id="ref031">Ng, M.; Wessel, D.; and Sheiner, L. (2018) “The Hutchins Center Explains: The Phillips Curve.” Brookings <em>Up Front</em> (August 21). Available at <a href="http://www.brookings.edu/blog/up-front/2018/08/21/the-hutchins-center-explains-the-phillips-curve">www​.brook​ings​.edu/​b​l​o​g​/​u​p​-​f​r​o​n​t​/​2​0​1​8​/​0​8​/​2​1​/​t​h​e​-​h​u​t​c​h​i​n​s​-​c​e​n​t​e​r​-​e​x​p​l​a​i​n​s​-​t​h​e​-​p​h​i​l​l​i​p​s​-​curve</a>.</p> <p class="REF" id="ref032">Niskanen, W. A. (1992) “Political Guidance on Monetary Policy.” <em>Cato Journal</em> 12 (1): 281–86.</p> <p class="REF" id="ref033">_________ (2002) “On the Death of the Phillips Curve.” <em>Cato Journal</em> 22 (2): 193–98.</p> <p class="REF" id="ref034">_________ (2008) “Monetary Policy and Financial Regulation.” <em>Cato</em> <em>Handbook for Policymakers</em>, 7th ed., 377–84. Washington: Cato Institute,</p> <p class="REF" id="ref035">Phelps, E. S. (1967) “Phillips Curves, Expectations of Inflation, and Optimal Unemployment over Time.” <em>Economica</em> 34 (135): 254–81.</p> <p class="REF" id="ref036">_________ (1968) “Money‐​Wage Dynamics and Labor‐​Market Equilibrium.” <em>Journal of Political Economy</em> 76 (July‐​August): 678–711.</p> <p class="REF" id="ref037">Phillips, A. W. (1958) “The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957.” <em>Economica</em> 25 (100): 283–99.</p> <p class="REF" id="ref038">Plosser, C. I. (2014) “A Limited Central Bank.” <em>Cato Journal</em> 34 (2): 201–11.</p> <p class="REF" id="ref039">Powell, J. H. (2018) “The Outlook for the U.S. Economy.” Speech given at the Economics Club of Chicago (April 6).</p> <p class="REF" id="ref040">Samuelson, P. A., and Solow, R. M. (1960) “Analytical Aspects of Anti‐​Inflation Policy.” <em>American Economic Review</em> (<em>Papers and Proceedings</em>) 50 (2): 177–94.</p> <p class="REF" id="ref041">Sargent, T. J. (1986) <em>Rational Expectations and Inflation.</em> New York: Harper &amp; Row.</p> <p class="REF" id="ref042">Selgin, G. (2017) “Bill Niskanen: Monetary Policy Radical.” <em>Alt‐​M</em> (December 21).</p> <p class="REF" id="ref043">Selgin, G.; Beckworth, D.; and Bahadir, B. (2015) “The Productivity Gap: Monetary Policy, the Subprime Boom, and the Post‐​2001 Productivity Surge.” <em>Journal of Policy Modeling</em> 37 (2): 189–207.</p> <p class="REF" id="ref044">Steelman, A. (2011) “The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea.” Federal Reserve Bank of Richmond <em>Economic Brief</em> (December).</p> <p class="REF" id="ref045">Stock, J. H., and Watson, M. W. (2019) “Slack and Cyclically Sensitive Inflation.” NBER Working Paper No. 25987 (June).</p> <p class="REF" id="ref046">Sumner, S. B. (2014) “Nominal GDP Targeting: A Simple Rule to Improve Fed Performance.” <em>Cato Journal</em> 34 (2): 315–37.</p> <p class="REF" id="ref047">Tobin, J. (1983) “Monetary Policy: Rules, Targets, and Shocks.” <em>Journal of Money, Credit, and Banking</em> 15 (November): 506–18.</p> <p class="REF" id="ref048">Volcker, P. (1981) <em>Federal Reserve’s First Monetary Policy Report for 1981</em>. Hearings before the U.S. Senate Committee on Banking, Housing, and Urban Affairs (February 25 and March 4). Washington: U.S. Government Printing Office.</p> <p class="REF" id="ref049">White, L. H.; Vanberg, V. J.; and Köhler, E. A. (eds.) (2015) <em>Renewing the Search for a Monetary Constitution</em>. Washington: Cato Institute.</p> <p class="REF" id="ref050">Yeager, L. B. (ed.) (1962) <em>In Search of a Monetary Constitution</em>. Cambridge, Mass.: Harvard University Press.</p> <p class="REF" id="ref051">Yellen, J. (2017) “Transcript of Chair Yellen’s Press Conference” (June 14). Available at <a href="http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170614.pdf">www​.fed​er​al​re​serve​.gov/​m​e​d​i​a​c​e​n​t​e​r​/​f​i​l​e​s​/​F​O​M​C​p​r​e​s​c​o​n​f​2​0​1​7​0​6​1​4.pdf</a>.</p> <p class="FTN" id="en1"><sup><a href="#pn1">1</a></sup> In an endnote, the authors suggest: “The diagrams for the sub‐​periods in Phillips’s paper might also have alerted Samuelson and Solow to the fact that the Phillips curve relation only seemed to be stable under fixed exchange rates which helped to anchor inflation expectations” (<a href="#ref014">Hall and Hart 2012</a>: 69, n.7).</p> <p class="FTN1" id="en2"><sup><a href="#pn2">2</a></sup> For a more detailed description of the adjustment process from an unanticipated increase in nominal aggregate demand, see Friedman (<a href="#ref010">1968</a>: 100–11; <a href="#ref011">1977</a>: 456–57). Friedman gives credit to Edmund S. Phelps for his groundbreaking work in developing the natural rate hypothesis, for which he received the Nobel Memorial Prize in Economic Sciences in 2016 (see <a href="#ref035">Phelps 1967</a>, <a href="#ref036">1968</a>).</p> <p class="FTN1" id="en3"><sup><a href="#pn3">3</a></sup> Friedman (<a href="#ref010">1968</a>: 11) estimated “that the initial effects of a higher and unanticipated rate of inflation last for something like two to five years; that this initial effect then begins to be reversed; and that a full adjustment to the new rate of inflation takes … a couple of decades.” The adjustment process would be faster, he said, in countries experiencing “more sizable changes” in the rate of inflation.</p> <p class="FTN1" id="en4"><sup><a href="#pn4">4</a></sup> Robert Higgs (<a href="#ref017">1997</a>) coined the term “regime uncertainty,” which he used to refer to the uncertainty caused by fiscal and regulatory policies that attenuated private property rights by decreasing expected returns on capital. In the case of a discretionary government fiat money regime, moving to a monetary rule would help reduce uncertainty about the future value of money and improve the climate for making private investment decisions (<a href="#ref005">Dorn 2018</a>, <a href="#ref006">2019</a>).</p> <p class="FTN1" id="en5"><sup><a href="#pn5">5</a></sup> Stock and Watson (<a href="#ref045">2019</a>: 1) find that the slope of the Phillips curve (measured by the change in inflation relative to the change in the unemployment gap), has gone from 20.48 in 1960–83 to 20.26 in 1984–99, and to 20.03 in 2000–2019Q1, which is not statistically different from zero.</p> <p class="FTN1" id="en6"><sup><a href="#pn6">6</a></sup> By “weakened,” Powell means the slope of the Phillips curve has flattened: large decreases in unemployment have not had much impact on inflation. The rate of unemployment has gone from 10 percent in October 2009 to less than 4 percent today, while inflation has remained relatively low at less than 2 percent per year.</p> <p class="FTN1" id="en7"><sup><a href="#pn7">7</a></sup> On the limits of monetary policy, see Friedman (<a href="#ref010">1968</a>), Plosser (<a href="#ref038">2014</a>), and Dorn (<a href="#ref004">2001</a>).</p> <p class="FTN1" id="en8"><sup><a href="#pn8">8</a></sup> On the case for an NGDP target, see Sumner (<a href="#ref046">2014</a>); Selgin, Beckworth, and Bahadir (<a href="#ref043">2015</a>); and Beckworth (<a href="#ref001">2017</a>). Earlier proponents include Gordon (<a href="#ref012">1985</a>), McCallum (<a href="#ref027">1989</a>: chap. 16), and Meltzer <a href="#ref028">1989</a>). Niskanen (<a href="#ref032">1992</a>: 284) favors targeting nominal domestic final sales (NDFS) and argues that keeping nominal demand on a stable growth path is superior to a “price rule” and a “money rule.” Unlike a price rule (e.g., inflation targeting), “a demand rule.… does not lead to adverse monetary policy in response to unexpected … changes in supply conditions.” Even more important, a demand rule, unlike a money rule, “accommodates unexpected changes in the demand for money” (i.e., in the velocity of money). See also Frankel (<a href="#ref008">2019</a>: 464–65).</p> <p class="FTN1" id="en9"><sup><a href="#pn8">9</a></sup> On Niskanen’s ideas for reforming the monetary framework, see Selgin (<a href="#ref042">2017</a>).</p> <p class="FTN1" id="en10"><sup><a href="#pn10">10</a></sup> On the search for a monetary constitution and stable money, see Yeager (<a href="#ref050">1962</a>); Dorn (<a href="#ref003">1987</a>); and White, Vanberg, and Köhler (<a href="#ref049">2015</a>).</p> </div> Wed, 05 Feb 2020 03:00:00 -0500 James A. Dorn https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-monetary-policy James A. Dorn discusses the economy on Phoenix TV https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-economy-phoenix-tv Thu, 14 Nov 2019 10:48:15 -0500 James A. Dorn https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-economy-phoenix-tv 37th Annual Monetary Conference — Welcoming Remarks and Keynote Address https://www.cato.org/multimedia/events/37th-annual-monetary-conference-welcoming-remarks-keynote-address James A. Dorn, Richard H. Clarida <p>Full event: <a href="https://www.cato.org/events/37th-annual-monetary-conference" rel="noopener noreferrer" target="_blank">37<sup>th</sup> Annual Monetary Conference</a></p> <p>Shadowing the Fed’s strategic review, Cato’s 37th Annual Monetary Conference explores a&nbsp;broad array of recommendations for improving the monetary framework — and goes beyond the narrow scope of the Fed’s agenda to share a&nbsp;vision for a&nbsp;monetary system best suited for a&nbsp;free society.</p> Thu, 14 Nov 2019 09:54:18 -0500 James A. Dorn, Richard H. Clarida https://www.cato.org/multimedia/events/37th-annual-monetary-conference-welcoming-remarks-keynote-address Cato’s 37th Annual Monetary Conference: A Shadow Review of Fed Policy https://www.cato.org/blog/catos-37th-annual-monetary-conference-shadow-review-fed-policy James A. Dorn <h4>Improving the Monetary System</h4> <p>Since 1983, the Cato Institute’s Annual Monetary Conference has brought together leading scholars and policymakers to discuss important issues in the conduct of monetary policy and steps that might be taken to improve the existing system. The conferences have also considered ideas for more fundamental reform by examining alternatives to a discretionary government fiat money regime.<a href="#_edn1" id="_ednref1" name="_ednref1" rel="noopener noreferrer" target="_blank">[1]</a></p> <p>Karl Brunner, who participated in the first conference—<a href="https://www.cato.org/cato-journal/springsummer-1983" rel="noopener noreferrer" target="_blank">The Search for Stable Money</a>—in January 1983, was deeply concerned about the institutional uncertainty created by a lack of a transparent and enforceable monetary rule. In 1980, he advocated a strategy for monetary policy that he thought would reduce uncertainty and help promote economic stability:</p> <blockquote> <p>We suffer neither under total ignorance nor do we enjoy full knowledge. Our life moves in a grey zone of partial knowledge and partial ignorance. More particularly, the products emerging from our professional work reveal a wide range of diffuse uncertainty about the detailed response structure of the economy.… A nonactivist [rules‐​based] regime emerges under the circumstances … as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties … on the market place.<a href="#_edn2" id="_ednref2" name="_ednref2" rel="noopener noreferrer" target="_blank">[2]</a></p> </blockquote> <h4>The Fed’s Review</h4> <p>Nearly four decades later, and after a severe financial crisis in 2008-09, the Federal Reserve has undertaken <a href="https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications.htm" rel="noopener noreferrer" target="_blank">“a broad review of the strategy, tools, and communication practices</a> it uses to pursue the monetary policy goals established by the Congress: maximum employment and price stability.”<a href="#_edn3" id="_ednref3" name="_ednref3" rel="noopener noreferrer" target="_blank">[3]</a> Fed Chairman <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20181115a.htm" rel="noopener noreferrer" target="_blank">Jerome H. Powell</a> believes that, “With labor market conditions close to maximum employment and inflation near our 2 percent objective, now is a good time to take stock of how we formulate, conduct, and communicate monetary policy.”<a href="#_edn4" id="_ednref4" name="_ednref4" rel="noopener noreferrer" target="_blank">[4]</a> The full review will appear in a report to be released by the Fed next year.</p> <p>The fact that the Fed now wants “to step back and consider whether the U.S. monetary policy framework can be improved to better meet future challenges” is a good sign.<a href="#_edn5" id="_ednref5" name="_ednref5" rel="noopener noreferrer" target="_blank">[5]</a> Cato’s Annual Monetary Conference has been doing that for 36 years, and the papers have been published in the <em>Cato Journal</em>. Many Fed officials, including Alan Greenspan and Ben Bernanke, have spoken at Cato’s monetary conferences. The discussion has always taken place with the hope that the policy regime could be improved—so that the market system could work more smoothly and people could enjoy a higher standard of living.</p> <p>The Fed’s review takes the dual mandate as given and assumes that the 2 percent inflation target is consistent with long‐​run price stability. Thus far this year, there have been a number of events hosted by Federal Reserve Banks, including a major conference at the Chicago Fed in June to “consider whether the Federal Reserve can best meet its dual‐​mandate objectives with its existing monetary policy strategy, whether the existing monetary policy tools are adequate to achieve and maintain the dual mandate, and whether the communications about the policy strategy and tools can be improved.”<a href="#_edn6" id="_ednref6" name="_ednref6" rel="noopener noreferrer" target="_blank">[6]</a></p> <p>Many of the events have taken the form of town hall meetings under a program called <a href="https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-fed-listens-events.htm" rel="noopener noreferrer" target="_blank">“Fed Listens.” </a> The goal is to have Fed officials absorb viewpoints from many different sectors of society to make the public feel part of the process of reviewing and improving monetary policy. However, monetary policy is a complex topic, especially under the new operating system.</p> <h4>Cato’s Shadow Review</h4> <p>What is really important is for the Fed to listen to new ideas for reform that may not fit neatly within the parameters of the Fed’s review. Cato’s 37th Annual Monetary Conference—<a href="https://www.cato.org/events/37th-annual-monetary-conference" rel="noopener noreferrer" target="_blank">Fed Policy: A Shadow Review</a>—will do precisely that by bringing together leading policymakers and scholars to offer constructive recommendations for improving the monetary framework. Fed Vice Chairman Richard H. Clarida, who has been instrumental in the review process, will give the keynote address, while Sir Paul Tucker, author of <a href="https://press.princeton.edu/books/hardcover/9780691176734/unelected-power" rel="noopener noreferrer" target="_blank"><em>Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State</em>,</a> and a former Deputy Governor of the Bank of England, will give the luncheon address.</p> <p><strong>Keynote Speakers</strong></p> <table><tbody><tr><td> <figure role="group" class="filter-caption"><div data-embed-button="image" data-entity-embed-display="view_mode:media.blog_post" data-entity-type="media" data-entity-uuid="c42517d9-9a00-4a8d-9029-d0088b7dc96e" data-langcode="en" class="embedded-entity"> <img width="520" height="520" alt="Richard H. Clarida " typeof="Image" class="component-image lozad" data-src="https://www.cato.org/sites/cato.org/files/styles/pubs/public/2019-11/Clarida_0.jpg?itok=CzbJOQze" data-srcset="/sites/cato.org/files/styles/pubs/public/2019-11/Clarida_0.jpg?itok=CzbJOQze 1x, /sites/cato.org/files/styles/pubs_2x/public/2019-11/Clarida_0.jpg?itok=UnKb_rIr 1.5x" /></div> <figcaption><div class="figure-caption text-sans-alternate">Richard H. Clarida </div> </figcaption></figure></td> <td> <figure role="group" class="filter-caption"><div data-embed-button="image" data-entity-embed-display="view_mode:media.blog_post" data-entity-type="media" data-entity-uuid="c7355eb8-5722-4cfa-a9bf-5543e16f01f3" data-langcode="en" class="embedded-entity"> <img width="520" height="520" alt="Sir Paul Tucker" typeof="Image" class="component-image lozad" data-src="https://www.cato.org/sites/cato.org/files/styles/pubs/public/2019-11/Tucker.jpg?itok=hidNv576" data-srcset="/sites/cato.org/files/styles/pubs/public/2019-11/Tucker.jpg?itok=hidNv576 1x, /sites/cato.org/files/styles/pubs_2x/public/2019-11/Tucker.jpg?itok=w6gLrL7v 1.5x" /></div> <figcaption><div class="figure-caption text-sans-alternate">Sir Paul Tucker </div> </figcaption></figure></td> </tr></tbody></table><p>Panel topics include:</p> <ul><li><strong>Targets and Mandates</strong></li> <li><strong>The Operating Framework</strong></li> <li><strong>Central Banks and the Rule of Law</strong></li> <li><strong>Communication Practices: Transparency and Forward Guidance</strong></li> <li><strong>Creating an Optimal Monetary System for a Free Society</strong></li> </ul><p></p> <p>Please join our distinguished speakers on <strong>Thursday, November 14</strong>, as we shadow the Fed’s review and explore a variety of recommendations for improving our monetary system. We hope the Fed will be listening.</p> <span class="hs-cta-wrapper" id="hs-cta-wrapper-e8a58884-0735-4f93-b434-360246bcf6d5"><span class="hs-cta-node hs-cta-e8a58884-0735-4f93-b434-360246bcf6d5" id="hs-cta-e8a58884-0735-4f93-b434-360246bcf6d5"><a href="https://cta-redirect.hubspot.com/cta/redirect/4957480/e8a58884-0735-4f93-b434-360246bcf6d5"><img class="hs-cta-img lozad" id="hs-cta-img-e8a58884-0735-4f93-b434-360246bcf6d5" alt="Details and Registration" data-src="https://no-cache.hubspot.com/cta/default/4957480/e8a58884-0735-4f93-b434-360246bcf6d5.png" /></a></span> //--&gt; //--&gt; //--&gt; </span> <hr /><p><a href="#_ednref1" id="_edn1" name="_edn1">[1]</a> For a history of Cato’s Annual Monetary Conference, see James A. Dorn, “History of Monetary Policy in Washington, D.C. and Its Future,” <a href="https://www.cato.org/multimedia/media-highlights-radio/james-dorn-discusses-history-monetary-policy-washington-dc-its" rel="noopener noreferrer" target="_blank"><em>Macro Musings with David Beckworth</em></a>, September 30, 2019.</p> <p><a href="#_ednref2" id="_edn2" name="_edn2">[2]</a> Karl Brunner,<a href="http://www.bostonfed.org/-/media/Documents/conference/23/conf23a.pdf?la=en" rel="noopener noreferrer" target="_blank">“The Control of Monetary Aggregates,”</a> in <em>Controlling Monetary Aggregates III</em>, 61. Boston: Federal Reserve Bank of Boston, 1980.</p> <p><a href="#_ednref3" id="_edn3" name="_edn3">[3]</a> Federal Reserve Board, <a href="https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications.htm" rel="noopener noreferrer" target="_blank">“Review of Monetary Policy Strategy, Tools, and Communications.” </a> See “Overview” section. Washington: Federal Reserve Board, 2019.</p> <p><a href="#_ednref4" id="_edn4" name="_edn4">[4]</a> Jerome H. Powell, quoted in <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20181115a.htm" rel="noopener noreferrer" target="_blank">Federal Reserve Board Press Release</a>, “Federal Reserve to Review Strategies, Tools, and Communication Practices It Uses to Pursue Its Mandate of Maximum Employment and Price Stability,” November 15, 2018.</p> <p><a href="#_ednref5" id="_edn5" name="_edn5">[5]</a> Federal Reserve Board, “Review of Monetary Policy,” Overview, p. 1.</p> <p><a href="#_ednref6" id="_edn6" name="_edn6">[6]</a> Ibid.</p> <p>[<a href="https://www.alt-m.org/2019/11/01/catos-37th-annual-monetary-conference-a-shadow-review-of-fed-policy/">Cross‐​posted from Alt​-​M​.org</a>]</p> Fri, 01 Nov 2019 08:41:56 -0400 James A. Dorn https://www.cato.org/blog/catos-37th-annual-monetary-conference-shadow-review-fed-policy Myopic Monetary Policy and Presidential Power: Why Rules Matter https://www.cato.org/cato-journal/fall-2019/myopic-monetary-policy-presidential-power-why-rules-matter James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>This article examines the relationship between Fed policy and presidential power in a&nbsp;fiat money regime in which Congress has delegated significant power and discretion to the Fed. By making the Fed responsible, but not accountable, for achieving full employment and price stability, Congress can shift blame to the Fed when it fails to meet those objectives. As the Fed reviews its strategy and communications this year, it should not forget two important points: (1) independence is necessary for the Fed to do its stabilization job well, free of presidential meddling; and (2) specific monetary rules are an absolutely necessary condition to assure achievement of such independence. Ultimately, the Fed must be bound by a&nbsp;constitution that protects the value of money and safeguards individual freedom under a&nbsp;rule of law. The current monetary regime is far from that ideal.</p> </div> Tue, 01 Oct 2019 09:30:00 -0400 James A. Dorn https://www.cato.org/cato-journal/fall-2019/myopic-monetary-policy-presidential-power-why-rules-matter James A. Dorn discusses the history of monetary policy in Washington D.C. and its future on Macro Musings with David Beckworth https://www.cato.org/multimedia/media-highlights-radio/james-dorn-discusses-history-monetary-policy-washington-dc-its Mon, 30 Sep 2019 10:55:43 -0400 James A. Dorn https://www.cato.org/multimedia/media-highlights-radio/james-dorn-discusses-history-monetary-policy-washington-dc-its Why China at 70 Needs to Listen to the Voices of Those It Silenced https://www.cato.org/publications/commentary/why-china-70-needs-listen-voices-those-it-silenced James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>On October 1, 1949, Mao Zedong proclaimed the founding of the People’s Republic of China before a&nbsp;huge crowd in Tiananmen Square. After three years of gruelling civil war with the Nationalists under the command of Chiang Kai‐​shek, Mao had emerged as the victorious head of the world’s largest communist country. During his tenure as chairman of the Communist Party, until his death in 1976, Mao ruled with an iron fist.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>He imitated the Soviet system of central planning, outlawed capitalism and private property, collectivised agriculture, destroyed family life by mandating large‐​scale communes, and placed the party/​state above the people in all aspects of life.</p> <p>The model of state‐​led development, which Mao supported, was one that favoured autarky over open markets and international trade, depriving China’s people of the advantages of specialisation according to comparative advantage, and stripping them of the benefits of free trade.</p> <p>The absence of competitive markets for resources, goods, and ideas severely handicapped China’s development.</p> <p>While Mao concentrated on increasing the power of the state and suppressing individual freedom, Deng Xiaoping began China’s economic liberalisation movement under “socialism with Chinese characteristics”.</p> </div> , <aside class="aside--right aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>China’s future will depend to a&nbsp;large extent on reopening the market for ideas and ending the party’s monopoly on power by adopting a&nbsp;genuine rule of law to protect persons and property.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>The pragmatist Deng recognised that China’s future prosperity depended on reform and opening up to the outside world. By experimenting with new forms of ownership, and creating special economic zones, Deng facilitated the rebirth of entrepreneurial activity and the growth of the non‐​state sector. Peaceful development was more important to Deng than class struggle.</p> <p>China prospered greatly under Deng’s leadership, until the Tiananmen uprising in 1989, at which time Zhao Ziyang, a&nbsp;key figure in the reform movement, was ousted as general secretary of the Communist Party and put under house arrest for opposing the use of force to&nbsp;end the occupation of Tiananmen Square.</p> <p>From 1980 to ’87, Zhao had helped guide economic policy as China’s premier. In September 1988, following a&nbsp;conference in Shanghai organised by the Cato Institute and Fudan University, renowned US economist Milton Friedman met Zhao in Beijing. Zhao told Friedman, “Our biggest problem is that everything is owned by the state.”</p> <p>In his&nbsp;secret memoirs, recorded while under house arrest, Zhao recognised the importance of international trade, the value of market prices (admitting that he regretted his failure to institute price reform), and the need for political as well as economic reform.</p> <p>He thought that the best system of government, and one that China should aspire towards, was a “Western parliamentary democratic system”.</p> <p>According to Zhao, “If a&nbsp;country wishes to modernise, not only should it implement a&nbsp;market economy, it must also adopt a&nbsp;parliamentary democracy as its political system. Otherwise, this nation will not be able to have a&nbsp;market economy that is healthy and modern, nor can it become a&nbsp;modern society with a&nbsp;rule of law.”</p> <p>To reach that goal, argued Zhao, “two breakthroughs” were necessary: one, the ruling Communist Party needed to allow competing parties to emerge along with freedom of the press, and two, the party needed to “use democratic means to reform itself”.</p> <p>Most importantly, he wrote, “the existence of legitimate differences of opinion must be allowed within the party”, and “the reform of the legal system and an independent judiciary should take precedence”.</p> <p>Zhao&nbsp;<a data-v-f8b97894 href="https://www.scmp.com/news/china/article/1680976/zhao-ziyangs-family-proud-his-tiananmen-legacy-says-son-10-years-after"><span data-v-f8b97894>passed away</span></a> in 2005. His journal was published in 2009. Today, Xi Jinping, China’s “president for life”, is moving in the opposite direction to the one that Zhao advocated. </p><p>Although Xi has called for free trade in goods and services, and the party has championed “emancipation of the mind”, the reality is that China has backtracked on its economic liberalisation initiatives and is cracking down on the free market for ideas.</p> <p>The <a data-v-f8b97894 href="https://www.scmp.com/comment/opinion/article/3026307/why-china-and-us-need-worry-about-war-think-tanks-and-free-thought"><span data-v-f8b97894>recent closure</span></a> of the Unirule Institute in Beijing — a&nbsp;leading advocate for free markets, limited government, and the rule of law — is a&nbsp;strong sign that China under Xi will not tolerate even the slightest deviation from party rule. </p><p>Indeed, in his address at the Communist Party’s 95th anniversary (July 1, 2016), President Xi <a data-v-f8b97894 href="https://www.scmp.com/news/china/policies-politics/article/2143841/new-class-struggle-chinese-party-members-get-back"><span data-v-f8b97894>stated</span></a> : “Turning our backs or abandoning Marxism means that our party would lose its soul and direction.” </p><p>In 1978, Article 45 of the Constitution of the People’s Republic guaranteed individuals “four big rights”: the right to “speak out freely”; “air their views fully”; hold “great debates”; and “write big‐​character posters”. <a data-v-f8b97894 href="http://www.chaos.umd.edu/history/part5" rel="noFollow" target="_blank"><span data-v-f8b97894> </span></a> </p><p>Those rights were quickly reversed in 1980, in order to protect the party’s monopoly on power and close the market for ideas. China’s future will depend to a&nbsp;large extent on reopening the market for ideas and ending the party’s monopoly on power by adopting a&nbsp;genuine rule of law to protect persons and property.</p> <p>China’s challenge, as Premier Li Keqiang has stated, will be “to get the relationship right between the government and the market” and to boost the “vitality of the market”.</p> <p>The 70th birthday of the People’s Republic of China should be a&nbsp;time for&nbsp;<a data-v-f8b97894 href="https://www.scmp.com/week-asia/opinion/article/3030489/china-70-has-much-celebrate-its-biggest-challenges-lie-ahead"><span data-v-f8b97894>celebrating the progress</span></a> China has made, primarily since the reform movement began in 1978.</p> <p>But it should also be a&nbsp;time for looking forward and making sure that the voices of Zhao Ziyang — and many others who have been silenced by the state — are heard once more.</p> </div> Mon, 30 Sep 2019 09:58:31 -0400 James A. Dorn https://www.cato.org/publications/commentary/why-china-70-needs-listen-voices-those-it-silenced The State Strikes Back: The End of Economic Reform in China? by Nicholas R. Lardy https://www.cato.org/publications/cato-journal/state-strikes-back-end-economic-reform-china-nicholas-r-lardy James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The fast‐​paced, uncertain relationship between the United States and China makes it difficult for anyone to write a&nbsp;book depicting how that relationship will evolve, even in the short run. In 2014, Nicholas Lardy, one of America’s top experts on China’s economic liberalization since 1978, was optimistic about the rise of China’s private sector; today he is less so.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>In his 2014 book, <em>Markets over Mao: The Rise of Private Business in China</em>, Lardy saw a&nbsp;vibrant private sector gaining on a&nbsp;largely stagnant state sector, especially in terms of returns on capital. The market, not the state, was on the rise. Consequently, private‐​sector firms accounted for nearly 70 percent of GDP by 2012.</p> <p>That picture changed dramatically after Xi Jinping took power in late 2012 as head of the Chinese Communist Party (CCP) and became president in 2013. While preaching reform, Xi has consolidated his authority by being crowned “president for life,” promoted industrial policies under the banner of “Made in China 2025,” and energized the CCP in the task of “building socialism with Chinese characteristics.” This drift away from economic liberalization is reflected in the title of Lardy’s new book, <em>The State Strikes Back: The End of Economic Reform in China?</em></p> <p>No one knows the Chinese economic data better than Lardy. So when he concludes that, “absent significant further economic reform … China’s growth is likely to slow, casting a&nbsp;shadow over its future prospects,” one should take his prediction seriously.</p> <p>The book is divided into five chapters, each filled with extensive data to support the author’s arguments. Chapter 1&nbsp;explores the reasons for China’s slowing economic growth since the 2008-09 global financial crisis. One key reason, as Lardy explains, is that President Xi failed to implement the pro‐​market reform agenda introduced in the Third Plenum of the 18th CCP Congress, which was held in the fall of 2013. As such, market‐​led development has given way to state‐​led development, economic life has become more politicized and state‐​owned enterprises (SOEs) more protected, while resource allocation has become less efficient. Indeed, Lardy notes that, “beginning in 2012, [state‐​owned] banks directed a&nbsp;larger share of credit to state firms, essentially crowding out private investment,” which was “a stark reversal of the earlier trend” Lardy had lauded in <em>Markets over Mao</em>.</p> <p>Chapter 2&nbsp;focuses on the potential for convergence between SOEs with low returns on capital and private firms with much higher returns. Lardy argues that, if SOEs and state‐​owned banks could become more market‐​oriented, their performance would improve and spur economic growth. However, the soft budget constraints that face socialist enterprises and banks, along with their lack of any credible bankruptcy threat thanks to state‐​ownership, make them ripe for corruption. “Too big to fail” is endemic in China, as loss‐​making SOEs turn to state‐​owned banks for support, and banks favor SOEs in the allocation of credit under pressure from both central and local officials. Because SOEs are seen as less risky than private firms due to their government backstop, they have access to cheaper credit — even though they are much less efficient than private firms.</p> <p>In competitive capital markets, with private enterprises and effective bankruptcy laws, rates of return tend to converge as capital is put to its highest‐​valued uses. China’s basic problem is a&nbsp;lack of strong private property rights protected by a&nbsp;genuine rule of law and an independent judiciary. To realize the convergence potential that Lardy desires, China will have to undergo a&nbsp;major transformation from “building socialism with Chinese characteristics” to safeguarding property rights and allowing the free flow of both capital and information. Yet, under Xi Jinping, China is moving in the opposite direction, dimming its chances for realizing the potential gains from all‐​around privatization.</p> <p>The assets of nonfinancial firms in the state sector increased nearly fourfold between 2008 and 2016, according to Lardy, while their rates of return declined. In particular, the return on assets of state industrial firms reached 1.9 percent in 2015, while the return for private firms stood at 10.6 percent. By failing to reform SOEs, China lost the opportunity to greatly increase the value that a&nbsp;more efficient allocation of resources would have produced.</p> <p>Chapter 3&nbsp;tells the story of China’s failed strategy to reform SOEs. Corporatization (i.e., turning SOEs into limited liability entities with the state as the majority owner), top‐​down mergers (directed by the state, not the market), mixed ownership, debt‐​to‐​equity swaps, governance reforms, and financial window dressing all count as half‐​hearted attempts at reform. As such, they have not been sufficient to end state control of enterprises. There are still too many “zombie” SOEs cluttering the economic landscape and sucking up resources that the private sector could have used to increase the wealth of the nation. The idea that SOEs can be made viable and act like private firms — without a&nbsp;hard budget constraint and well‐​defined private property rights — is an illusion.</p> <p>In Chapter 4, Lardy makes the case for returning to market‐​oriented economic reform and away from state‐​led development. The reforms Lardy prescribes include reducing barriers to entry, promoting mergers and acquisitions, ending “too big to fail” by enacting effective bankruptcy laws, opening the financial sector to competitive pressure, and improving corporate governance. If China were to return to a&nbsp;market‐​led development strategy, argues Lardy, economic growth would likely increase “from the recent range of 6&nbsp;to 7&nbsp;percent to an average of 8&nbsp;percent or possibly slightly more,” and be sustained. However, that’s a&nbsp;big “if” — and many experts predict much lower growth rates. For example, the IMF predicts China’s economic growth rate will decline to 5.5 percent by 2023. Moreover, Chinese growth statistics are often suspect and might overestimate actual growth rates.</p> <p>Finally, in Chapter 5, Lardy considers the prospects for further economic reform. Although he examines the obstacles standing in the way of SOE reform, he also lists reasons to be optimistic. If Lardy were writing this chapter today, however, I&nbsp;believe he would be much less optimistic, given the rising tensions between the United States and China (especially evidenced by the current “trade war” and the U.S. Treasury’s decision to label China a “currency manipulator”). Just because Xi Jinping touts free trade, and espouses the goal of realizing the “Chinese Dream of national rejuvenation,” doesn’t mean he will embark on the path to a&nbsp;freer market and respect human rights. Indeed, his crackdown on dissent is incompatible with a&nbsp;free market for ideas, which is essential for meaningful reform.</p> <p>Listing reforms is the easy part; getting them implemented will require a&nbsp;new way of thinking about the relationship between the state and the market — that is, between the individual and the state. As long as the CCP retains its monopoly on power and President Xi does not tolerate criticism, there is little likelihood of China adopting limited government and a&nbsp;genuine rule of law, which are necessary conditions for an efficient free‐​market system. Hence, the potential for convergence and the benefits to be gained are unlikely to be realized. As Lardy concludes, “China cannot credibly advocate for further globalization, which depends on free and open markets, when its domestic policies continue to move in the opposite direction.”</p> <p>In sum, Lardy recognizes that the main impediment to reform is Xi’s “view of himself as the commander in chief of the Chinese economic state,” but hopes that Xi will bow to pressure to reform in order to restore more rapid growth and avoid social instability. That possibility, however, is fading as Beijing relies on a&nbsp;repressive legal regime — rather than turning to markets and a&nbsp;genuine rule of law — to bring about social and economic harmony.</p> </div> Mon, 30 Sep 2019 03:00:00 -0400 James A. Dorn https://www.cato.org/publications/cato-journal/state-strikes-back-end-economic-reform-china-nicholas-r-lardy Why the Fed Needs a Monetary Rule to Protect Its Independence https://www.cato.org/blog/why-fed-needs-monetary-rule-protect-its-independence James A. Dorn <p>As the 2020 presidential election season heats up, Federal Reserve Chairman Jerome Powell is being pushed from all sides. <a href="https://www.msn.com/en-us/news/politics/trump-slams-fed-chief-who-is-our-biggest-enemy-jay-powell-or-chairman-xi/ar-AAGejHt" rel="noopener noreferrer" target="_blank">President Trump</a> has castigated him for overly tight monetary policy and has implied that Powell is a “bigger enemy” than Xi Jinping.  Meanwhile, <a href="https://www.bloomberg.com/opinion/articles/2019-08-27/the-fed-shouldn-t-enable-donald-trump" rel="noopener noreferrer" target="_blank">William Dudley</a>, who recently headed the Federal Reserve Bank of New York, the most important reserve bank in the system, boldly called for Powell to enter the political fray against Trump and use a tighter monetary policy to help defeat him in 2020.&#13;<br /> &#13;<br /> We’ve seen this pattern before—only this time, it’s more extreme. President Trump, like many executives before him, wants the Fed to sacrifice its independence in favor of more accommodative monetary policies, while Dudley, on the other hand, is willing to sacrifice the Fed’s independence in the short run.&#13;<br /> &#13;<br /> The real problem is that, in our purely discretionary fiat money system, there is no rule to provide long-run guidance to monetary policymakers. This allows Congress to delegate too much power to the Fed and expect too much from it in return.  In conducting monetary policy, the Fed needs to be accountable to political institutions, yet independent of political pressures to finance budget deficits or use the printing press to satisfy special interests (whether those interests take the form of a border wall or a “Green New Deal”).&#13;<br /> &#13;<br /> Only a rule—about how to track economic stability and how and when to respond to changes in that stability—can provide that independence.<a name="_ednref1" href="https://www.cato.org/#_edn1" id="_ednref1">[1]</a>&#13;<br /> &#13;</p> <p>In a recent <em><a href="https://www.wsj.com/articles/america-needs-an-independent-fed-11565045308" rel="noopener noreferrer" target="_blank">Wall Street Journal article</a></em>, Paul Volcker, Alan Greenspan, Ben Bernanke, and Janet Yellen called for “nonpolitical” monetary policy “based on analysis of the longer-run economic interests of U.S. citizens rather than being motivated by short-run political advantage.”  They also called for “a robust public debate” to help “make monetary policy better.”&#13;<br /> &#13;<br /> That debate is indeed necessary. And a significant part of it should focus on the relationship between Fed independence and a monetary rule—that is, whether the depoliticization of the Fed is more likely to occur under a regime of pure discretion or a rules-based regime. The answer seems clear. As <a href="https://www.wsj.com/articles/central-bankers-in-glass-houses-11565910399" rel="noopener noreferrer" target="_blank">Charles Calomiris</a>, a member of the Shadow Open Market Committee, notes: “There are many levers that politicians can, and do, employ to influence monetary policy. True independence comes from making it harder for politicians to pull those levers.”&#13;<br /> &#13;<br /> But the Fed has never managed yet to achieve genuine independence from politics.<a name="_ednref2" href="#_edn2" id="_ednref2">[2]</a> When Alan Greenspan followed an implicit Taylor Rule (adjusting the fed funds, or interbank lending, rate in order to achieve steady nominal GDP growth), the economy flourished under a period now known as “the Great Moderation.” Politicization of the Fed was low and Fed independence was high. But when the Greenspan Fed departed from that rule in mid-2003, it erred by keeping interest rates too low for too long. Those low rates helped fuel the housing bubble and the growing subprime mortgage crisis.<a name="_ednref3" href="#_edn3" id="_ednref3">[3]</a>&#13;<br /> &#13;<br /> More recently, the Fed may have catered to pressures to favor housing finance by accumulating massive amounts of mortgage-backed securities. This meant the Fed began playing a major part in the allocation of credit as opposed to using pure monetary policy to achieve its inflation and employment goals.&#13;<br /> &#13;<br /> Its continued reliance on unconventional monetary policy to offset the 2008 financial crisis finally resulted in a new operating framework in which the Fed sets its policy interest rate administratively and uses forward guidance to signal where the Fed thinks rates should go. But that guidance has been—and, in a free market, will always be—erratic as the Fed attempts to measure and respond to day-to-day changes in economic data and to financial markets.&#13;<br /> &#13;<br /> Powell’s “pivot” after last December’s rate hike is a case in point.  The markets tanked and Powell immediately called for <a href="https://www.cnbc.com/2019/01/30/fed-leaves-rates-unchanged.html" rel="noopener noreferrer" target="_blank">“patience,”</a> followed by the first rate decrease since 2008. There is likely to be another rate cut this month, but not enough to satisfy President Trump, so the political pressure for easy money will continue.  Moreover, with growing budget deficits, the Fed will be expected to maintain a low interest rate policy.&#13;<br /> &#13;<br /> The Fed’s so-called independence has always been tested by political pressures (see <a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2013/9/cjv33n3-9.pdf" rel="noopener noreferrer" target="_blank">Cargill and O’Driscoll</a> 2013), but those pressures became super-charged with the 2008 financial crisis, and have gained steam with President Trump’s tweeting storm and Dudley’s call for politicization. As the Fed reviews its strategy and communications this year, it should not forget two important points: (1) independence is necessary for the Fed to do its stabilization job well, free of presidential meddling; and (2) specific monetary rules may be the only sure means by which it can achieve such independence.&#13;<br /> &#13;<br /> Just what sort of rule might protect the Fed’s independence while also being consistent with its mandate is of course another question that must also be addressed. Any rule can be shown to be inferior to some ideal of discretionary central banking. But it hardly follows that all monetary rules are inferior to discretion as actually practiced by the Fed, let alone as it might be practiced by central bankers who favor the use of discretion for avowedly political ends.&#13;<br /> &#13;<br /> The problem is how to induce the Fed to trade off its discretionary powers and adopt a monetary rule that will decrease the uncertainty that now plagues the present system.  Congress has the authority to make the Fed accountable for following a rule, but thus far has not been able to even commence a national monetary commission to evaluate the Fed’s performance and recommend reforms.&#13;<br /> &#13;<br /> This is a critical first step. Until then, it is imperative that we continue to examine alternative monetary rules so that, when the time is ripe, an effective rule-based monetary regime can be adopted to limit the power of the central bank, insulate it against political opportunism, and safeguard citizens’ right to sound money.&#13;<br /> &#13;<br /> _____________________________________________________________________&#13;<br /> &#13;<br /><a name="_edn1" href="#_ednref1" id="_edn1">[1]</a> See J. A. Dorn, “Myopic Monetary Policy and Presidential Power: Why Rules Matter.” <em>Cato Journal</em> 39 (3), forthcoming Fall 2019.&#13;<br /> &#13;<br /><a name="_edn2" href="#_ednref2" id="_edn2">[2]</a> See S. Binder and M. Spindel, <em>The Myth of Independence: How Congress Governs the Federal Reserve</em>.  Princeton, N.J.: Princeton University Press.&#13;<br /> &#13;<br /><a name="_edn3" href="#_ednref3" id="_edn3">[3]</a> See John B. Taylor, <em>Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis</em>.  Stanford, Calif.: Hoover Institution Press.&#13;<br /> &#13;<br /> [<a href="https://www.alt-m.org/2019/09/04/why-the-fed-needs-a-monetary-rule-to-protect-its-independence/">Cross-posted from Alt-M.org</a>]</p> <p></p> Wed, 04 Sep 2019 09:20:00 -0400 James A. Dorn https://www.cato.org/blog/why-fed-needs-monetary-rule-protect-its-independence James A. Dorn discusses recession signals on Hearst Television https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-recession-signals-hearst-television Thu, 15 Aug 2019 12:28:00 -0400 James A. Dorn https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-recession-signals-hearst-television James A. Dorn discusses China and the Yuan on CNBC’s The Exchange https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-china-yuan-cnbcs-exchange Tue, 13 Aug 2019 13:56:00 -0400 James A. Dorn https://www.cato.org/multimedia/media-highlights-tv/james-dorn-discusses-china-yuan-cnbcs-exchange If Protesters Want to Protect Hong Kong’s Way of Life, They Must Win the War of Ideas https://www.cato.org/publications/commentary/protesters-want-protect-hong-kongs-way-life-they-must-win-war-ideas James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The massive demonstrations in Hong Kong against the <a href="https://www.scmp.com/news/hong-kong/politics/article/3010273/hong-kong-extradition-bill-chaos-and-confusion-reigns-how" target="_blank">proposed extradition bill</a> have revealed the moral rectitude of citizens to protect their way of life and freedom from communist China. On June 9, hundreds of thousands exercised their right to peacefully contest the legislation supported by Chief Executive Carrie Lam Cheng Yuet‐​ngor. By putting moral and political pressure on government, the people succeeded in reversing the course of the bill, which was <a href="https://www.scmp.com/news/hong-kong/politics/article/3014732/when-suspending-hong-kongs-extradition-bill-versus" target="_blank">suspended</a> on June 15 and declared “<a href="https://www.scmp.com/news/hong-kong/politics/article/3017795/hong-kong-leader-carrie-lam-says-extradition-bill-dead" target="_blank">dead</a>” on July 9. Yet, the bill has not been fully withdrawn — and the <a href="https://www.scmp.com/news/hong-kong/law-and-crime/article/3020802/gun-toting-officer-was-fear-his-life-hong-kong-police" target="_blank">protests continue</a>.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Protesters are concerned that, if a&nbsp;bill allowing extradition to the mainland were enacted, Hong Kong would risk losing its unique status as a&nbsp;guardian of the rule of law, limited government, economic freedom and human rights. The possibility of being subjected to China’s draconian penal system would increase uncertainty and result in self‐​censorship — undermining the free market in ideas that is Hong Kong’s trademark. The resulting outflow of human and financial capital would have <a href="https://www.scmp.com/news/hong-kong/hong-kong-economy/article/3017580/political-unrest-hitting-hong-kong-where-it-hurts" target="_blank">dire consequences</a> for both Hong Kong and China.</p> <p></p> </div> , <aside class="aside--right aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>To win the war of ideas, Hong Kong needs to remain an open society and fight the mainland –and those who sympathise with Beijing –with ideas.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>It was to <a href="https://www.scmp.com/news/hong-kong/politics/article/3013758/why-did-hundreds-thousands-hongkongers-take-streets-protest" target="_blank">protect their way of life</a> that the protesters marched and stopped the pulse of everyday life in the world’s freest economy. But on June 12, the protests turned violent, as a&nbsp;small minority <a href="https://www.scmp.com/news/hong-kong/politics/article/3016575/hong-kong-government-told-failure-launch-independent" target="_blank">clashed with police</a>, and called for immediate withdrawal of the bill and the ouster of the chief executive. More recently, protesters have <a href="https://www.scmp.com/news/hong-kong/politics/article/3016839/protesters-storm-and-vandalise-legislative-council-anarchy" target="_blank">broken into</a> the Legislative Council building, <a href="https://www.scmp.com/comment/opinion/article/3020102/when-bad-ideas-happen-hong-kong-protesters-and-beijing" target="_blank">defaced</a> the Chinese national emblem and <a href="https://www.scmp.com/news/hong-kong/politics/article/3019669/how-marauding-gang-struck-fear-yuen-long-leaving-pregnant">thugs</a> have beaten pro‐​democracy demonstrators.</p> <p>One young demonstrator expressed their sentiment by saying: “Protesting is the only way we can make our voices heard in the absence of democracy.”</p> <p>It would have been more correct to say “one of the few ways” because, unlike the People’s Republic of China, Hong Kong has a&nbsp;genuine rule of law that respects basic human rights. Article 27 of the Basic Law states: “Hong Kong residents shall have freedom of speech, of the press and of publication; freedom of association, of assembly, of procession and of demonstration.”</p> <p>The grounding of rights in individuals, <a href="https://www.scmp.com/comment/insight-opinion/hong-kong/article/2158137/how-chinas-constitution-ensured-basic-law-remains" target="_blank">not the state</a>, contrasts sharply with the top‐​down approach to rights in China, where basic rights stated in the constitution are merely “paper rights” and the rule of law is a&nbsp;rule designed to “build socialism” — not a&nbsp;meta‐​legal principle to defend life, liberty, and property. That is why ethnic Chinese in Hong Kong mostly see themselves as “Hongkongers,” not as national citizens of the People’s Republic.</p> <p>The “<a href="https://www.scmp.com/video/hong-kong/2100413/what-does-one-country-two-systems-mean" target="_blank">one country, two systems</a>” doctrine embedded in the Basic Law will end in 2047; what happens in the next 28&nbsp;years will define the future of Hong Kong.</p> <p>If Hong Kong can export its system of limited government and individual freedom to the mainland — by showing that a&nbsp;free market in ideas is far superior to “<a href="https://www.scmp.com/news/china/politics/article/2169151/simple-guide-xi-jinping-thought-heres-how-chinas-official-media" target="_blank">socialism with Chinese characteristics</a>” — then there is hope that China may eventually move from a&nbsp;model based on “building socialism” to one that recognises the principle of spontaneous order under what Friedrich Hayek called a “constitution of liberty”.</p> <p>Unlike in the mainland, everyone in Hong Kong has a&nbsp;voice in a&nbsp;free market for ideas and an opportunity to criticise the state, including Beijing. The evils of the 1989 <a href="https://www.scmp.com/topics/tiananmen-square-crackdown" target="_blank">Tiananmen crackdown</a> have <a href="https://www.scmp.com/news/hong-kong/politics/article/3013115/hong-kong-keeps-tiananmen-crackdown-memory-alive-record" target="_blank">not been forgotten</a>.</p> <p><a href="https://www.scmp.com/news/china/politics/article/3011892/generation-amnesia-why-chinas-youth-dont-talk-about-tiananmen" target="_blank">Why China’s youth don’t talk about Tiananmen </a></p> <p>The moral force of the voices of freedom and limited government should not be underestimated. Just as free trade in goods and services increases the wealth of a&nbsp;nation, so does free trade in ideas.</p> <p>Social media has been widely used to “<a href="https://www.scmp.com/news/hong-kong/politics/article/3015627/be-water-my-friend-protesters-take-bruce-lees-wise-saying" target="_blank">spontaneously</a>” organise the protests. But when young demonstrators think taking to the streets is the “only way” to make their voices heard, they risk taking a&nbsp;tactical approach to reform that could backfire as protests become violent or disruptive.</p> <p>What is needed is a&nbsp;long‐​term strategy that relies on the strength of Hong Kong’s ethos of liberty and adherence to limited government. China has <a href="https://www.scmp.com/news/hong-kong/politics/article/2131848/china-still-needs-hong-kong-its-development-says-no-3-leader" target="_blank">certainly benefited</a> from allowing Hong Kong to maintain its free‐​market trading system since 1997, but that system could not have survived without a&nbsp;corresponding free market in ideas.</p> <p>The protests against the extradition bill have succeeded in killing the legislation for now, and Hong Kong leaders who favoured the bill have <a href="https://www.scmp.com/news/hong-kong/politics/article/3014737/nearly-2-million-people-take-streets-forcing-public-apology" target="_blank">lost face</a> — but not their official status. Without competitive, free elections, Hongkongers are handicapped but not totally ineffective in shaping the political landscape and confronting Beijing with the stark reality of two systems: one in which there is still a&nbsp;free market in ideas and the other in which a “<a href="https://www.scmp.com/week-asia/opinion/article/2136255/president-life-xi-risks-repeat-chinas-mao-era-mistakes" target="_blank">president for life</a>” is intent on suppressing all criticism.</p> <p>To win the war of ideas, Hong Kong needs to remain an open society and fight the mainland — and those who sympathise with Beijing — with ideas. Key to that battle is the idea that limited government and a&nbsp;free market in ideas are better means to enable individuals to pursue happiness than state control.</p> </div> Fri, 02 Aug 2019 15:06:00 -0400 James A. Dorn https://www.cato.org/publications/commentary/protesters-want-protect-hong-kongs-way-life-they-must-win-war-ideas Hong Kong Needs to Leverage Its Free Market in Ideas https://www.cato.org/blog/hong-kong-needs-leverage-its-free-market-ideas James A. Dorn <p>The massive demonstrations in Hong Kong against the proposed <a href="https://en.wikipedia.org/wiki/2019_Hong_Kong_extradition_bill">extradition bill</a> revealed the moral rectitude of citizens to protect their way of life and freedom from Communist China.  On June 9, hundreds of thousands of individuals exercised their right to peacefully contest the extradition legislation supported by Chief Executive Carrie Lam.  By putting moral and political pressure on government officials, the people succeeded in reversing the course of the bill, which was suspended on June 15 and declared “dead” on July 9.      Yet the bill has not been fully withdrawn and could be reintroduced in the future—and the <a href="https://www.bbc.com/news/world-asia-china-49143207">protests continue</a>.&#13;<br /> &#13;</p> <p> </p><div data-embed-button="image" data-entity-embed-display="view_mode:media.blog_post" data-entity-type="media" data-entity-uuid="ce79d577-3d8c-47f0-bb66-1b695bdceca9" data-langcode="und" class="embedded-entity"> <img srcset="/sites/cato.org/files/styles/pubs/public/wp-content/uploads/a68b0215bb50a0e9da397f9eee4086ad.jpg?itok=Av90Frhz 1x, /sites/cato.org/files/styles/pubs_2x/public/wp-content/uploads/a68b0215bb50a0e9da397f9eee4086ad.jpg?itok=d7dJODeU 1.5x" width="700" height="392" src="/sites/cato.org/files/styles/pubs/public/wp-content/uploads/a68b0215bb50a0e9da397f9eee4086ad.jpg?itok=Av90Frhz" alt="Media Name: a68b0215bb50a0e9da397f9eee4086ad.jpg" typeof="Image" class="component-image" /></div> <p><em>Photo Credit: The Asian Age </em></p> <p>Protesters are concerned that, if a bill allowing extradition to the Mainland were enacted, Hong Kong would risk losing its unique status as a guardian of the rule of law, limited government, economic freedom, and human rights. The possibility of being convicted of a crime against the Mainland, extradited, and subjected to China’s draconian penal system would increase uncertainty and result in self-censorship— undermining the free market in ideas that is Hong Kong’s trademark. The resulting outflow of human and financial capital would have dire consequences for both Hong Kong and China.&#13;<br /> &#13;<br />  It was to protect their way of life that the protesters marched and stopped the pulse of everyday life in the world’s freest economy.  But on June 12, the protests turned violent as a small minority broke into the Legislative Council’s building, clashed with police, and called for immediate withdrawal of the bill and the ouster of the chief executive.  More recently, protesters have defaced the Chinese national emblem and thugs have beaten pro-democracy demonstrators. &#13;<br /> &#13;<br /> One protester, 29-year-old <a href="https://www.wsj.com/articles/a-crackdown-in-hong-kong-11563838262">Sandy Chan</a>, expressed the sentiment behind the protest movement by saying, “protesting is the only way we can make our voices heard in the absence of democracy.”  It would have been more correct to say “one of the few ways” because, unlike the People’s Republic of China (PRC), Hong Kong has a genuine rule of law that respects basic human rights.  Article 27 of the <a href="https://www.basiclaw.gov.hk/en/basiclawtext/chapter_3.html">Basic Law</a>, which was promulgated in 1997, states: “Hong Kong residents shall have freedom of speech, of the press and of publication; freedom of association, of assembly, of procession and of demonstration.” &#13;<br /> &#13;<br />             Other protected rights include:&#13;<br /> &#13;</p> <ul><li>“The freedom of the person of Hong Kong residents shall be inviolable” (Article 28).</li> <li>“The homes and other premises of Hong Kong residents shall be inviolable” (Article 29).</li> <li>“Hong Kong residents shall have freedom of conscience” and “freedom of religious belief” (Article 32).</li> <p>&#13; </p> </ul><p>Those freedoms are not granted by the state; they pre-exist government and are the natural rights of all citizens. The grounding of rights in individuals, not the state, contrasts sharply with the top-down approach to rights in China, where basic rights stated in the PRC Constitution are merely “paper rights” and the rule of law is a rule designed to “build socialism”—not a meta-legal principle to defend life, liberty, and property.<a name="_ednref1" href="///C:/Users/sbryant/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/F7BXPE2P/Cato%20at%20Liberty%20(8).docx#_edn1" id="_ednref1">[i]</a> That is why ethnic Chinese in Hong Kong mostly see themselves as “Hong Kongers,” with only 11 percent identifying themselves as “Chinese”—that is, as national citizens of the PRC (see <a href="https://www.bbc.com/news/world-asia-china-48607723">Cheung and Hughes</a>, BBC News, 2019: 4).&#13;<br /> &#13;<br /> Yet, the “one country, two systems” doctrine embedded in the Basic Law will end in 2047, only an instant in China’s long history.  What happens in the next 28 years will define the future of Hong Kong.  If Hong Kong can export its system of limited government and individual freedom to the Mainland—by showing that a free market in ideas is far superior to “socialism with Chinese characteristics”—then there is hope that China may eventually move from a model based on “building socialism” to one that recognizes the principle of spontaneous order<a name="_ednref2" href="///C:/Users/sbryant/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/F7BXPE2P/Cato%20at%20Liberty%20(8).docx#_edn2" id="_ednref2">[ii]</a> under what F. A. Hayek called a <a href="https://the-eye.eu/public/concen.org/Conspiracy%20Theory%20eBooks%20Collection%20part%203%20%5BPDF%5D-OMNiSCiENT/Hayek%2C%20F.%20A.%20-%20The%20Constitution%20of%20Liberty%2C%20The%20Definitive%20Edition%20%282011%29.pdf">“constitution of liberty.”</a>&#13;<br /> &#13;<br /> Unlike the Mainland, everyone in Hong Kong has a voice in a free market for ideas and an opportunity to criticize the state, including Beijing.  The evils of the 1989 Tiananmen crackdown have not been forgotten as Hong Kongers gather each year to commemorate all those who lost their lives fighting for freedom and democracy.&#13;<br /> &#13;<br /> To maintain their own freedom and move toward democracy, the Hong Kong people need to leverage the free market in ideas.  The moral force of the voices of freedom and limited government should not be underestimated. Just as free trade in goods and services increases the wealth of a nation so does free trade in ideas. &#13;<br /> &#13;<br /> Social media has been widely used to “spontaneously” organize the protests.  But when young demonstrators like Sandy Chan think that taking to the streets is the “only way” to make their voices heard, they risk taking a tactical approach to reform that could backfire as protests become violent or disruptive.&#13;<br /> &#13;<br /> What is needed is a long-run strategy that relies on the strength of Hong Kong’s ethos of liberty and adherence to limited government, which is even more important than democratic rule. As Hayek has noted, “The benefits of freedom are . . . not confined to the free”—“unfree societies benefit from what they obtain and learn from free societies” (<em>The Constitution of Liberty</em>, 1960: 32). China has certainly benefited from allowing Hong Kong to maintain its free-market trading system since 1997, and that system could not have survived without a corresponding free market in ideas.&#13;<br /> &#13;<br /> In December 2003, Premier <a href="http://www.chinadaily.com.cn/en/doc/2003-12/11/content_289494.htm">Wen Jiabo</a> expressed optimism regarding China’s future and argued that, in “building socialism with Chinese characteristics,” Beijing needs to “respect and protect the freedom of the Chinese people to pursue happiness.”  The means to attain that end, however, are better supplied by Hong Kong’s open society than by China’s repressive system.&#13;<br /> &#13;<br /> Sandy Chan and other protesters need to recognize that Hong Kong’s institutional infrastructure, characterized by limited government and a genuine rule of law, gives them great <em>moral</em> leverage over Beijing. If the youth in Hong Kong are to win the war of ideas, they need to have a firm grasp of the uniqueness and power of the ideas underlying Hong Kong’s success—namely, that individual rights to life, liberty, and property are sacred, and that the only <em>legitimate</em> role of government is to protect those rights. &#13;<br /> &#13;<br /> The protests against the extradition bill have succeeded in killing the legislation for now, and Hong Kong leaders who favored the bill have lost face—but not their official status.  Without competitive, free elections, Hong Kongers are handicapped but not totally ineffective in shaping the political landscape and confronting Beijing with the stark reality of two systems: one in which there is still a free market in ideas and the other in which a “president for life” is intent on suppressing all criticism.&#13;<br /> &#13;<br /> One of China’s best-known reformers, Professor Wu Jinglian, has argued that “only by matching the rule of law with the market economy can we achieve total success.” But while the Chinese Communist Party (CCP) has pledged to “further emancipate the mind” and President Xi, in his October 2017 report at the CCP’s 19th National Congress, advocated following “the principle of letting a hundred flowers bloom and a hundred schools of thought contend,” those promises remain empty in a system where dissent is outlawed by a powerful one-party state (see <a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2019/2/cj-v39n1-10.pdf">Dorn</a>, 2019: 173–74). &#13;<br /> &#13;<br /> To win the war of ideas, Hong Kong needs to remain an open society and fight the Mainland—and those who sympathize with Beijing—with ideas. Key to that battle is the idea that limited government and a free market in ideas are better means to enable individuals to pursue happiness than state control.&#13;</p> <div>&#13;<br /> &#13; <hr /><div id="edn1">&#13;<br /> &#13;<br /><a name="_edn1" href="///C:/Users/sbryant/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/F7BXPE2P/Cato%20at%20Liberty%20(8).docx#_ednref1" id="_edn1">[i]</a>  The PRC Constitution contains “a general defeasance clause” (Article 51), which states: “Citizens of the People’s Republic of China, in exercising their freedoms and rights, may not infringe upon the interests of the state, of society, or of the collective.”  As my colleague Roger Pilon has noted, this means that “any claims that individuals might have <em>against</em> the state can always be trumped <em>as a matter of constitutional</em> <em>law” </em>(in <a href="https://object.cato.org/sites/cato.org/files/articles/constitutionoflibertyforchina.pdf">Dorn</a>, 1998: 336).   &#13;<br /> &#13; </div> <div id="edn2">&#13;<br /> &#13;<br /><a name="_edn2" href="///C:/Users/sbryant/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/F7BXPE2P/Cato%20at%20Liberty%20(8).docx#_ednref2" id="_edn2">[ii]</a> J. M. Buchanan has called the “principle of spontaneous order” the “most important central principle in economics” (Buchanan 1979, “General Implications of Subjectivism in Economics,” in H. G. Brennan and R. D. Tollison, eds., <em>What Should Economists Do?</em> Indianapolis: Liberty Press). The idea that a harmonious economic and social order can emerge spontaneously from individual action—provided government enforces just rules that protect individual rights to life, liberty, and property—is central both to liberalism and to the case for limited government. As Hayek (1967: 162) states, “Under the enforcement of universal rules of just conduct, protecting a recognizable private domain of individuals, a spontaneous order of human activities of much greater complexity will form itself than could ever be produced by deliberate arrangement, and . . . in consequence the coercive activities of government should be limited to the enforcement of such rules” (“The Principles of a Liberal Social Order,” in <em>Studies in Philosophy, Politics, and Economics</em>, Chicago: University of Chicago Press). See <a href="https://www.independent.org/pdf/tir/tir_07_4_dorn.pdf">Dorn</a>, “The Primacy of Property in a Liberal Constitutional Order.”&#13;<br /> &#13; </div> <p>&#13; </p> </div> <p></p> Mon, 29 Jul 2019 15:19:00 -0400 James A. Dorn https://www.cato.org/blog/hong-kong-needs-leverage-its-free-market-ideas A Benevolent Central Bank https://www.cato.org/blog/benevolent-central-bank James A. Dorn <p>It has become clear that Fed Chairman Jerome Powell will do whatever it takes to keep the expansion going.  In early January, the stock markets rallied after Mr. Powell softened his rhetoric and promised <a href="https://www.wsj.com/articles/fed-chairman-powell-sees-flexibility-on-rates-this-year-11546616769">“patience”</a> in setting the federal funds target range.  Initially, the Fed was to be on “autopilot” and proceed with two rate hikes this year.  That promise was called off because of slowing global growth and the fear that higher rates would cause a sharp fall in asset prices. &#13;<br /> &#13;<br /> Now the chairman has excited markets by announcing at the <a href="https://www.reuters.com/article/us-usa-fed-powell/powell-to-open-chicago-conference-as-rate-cut-talk-intensifies-idUSKCN1T5166">Chicago Fed conference</a> that “we will act as appropriate to sustain the expansion”—meaning that a rate cut could be in the cards possibly as early as July.  That sentiment was expressed earlier by St. Louis Fed President <a href="https://www.cnbc.com/2019/06/03/feds-bullard-says-a-rate-cut-may-be-warranted-soon.html">James Bullard</a>. &#13;<br /> &#13;<br /> Currently, the effective fed funds rate is <em>above</em> the 10-year Treasury rate of 2.07 percent—and the yield curve is inverted, normally a sign of impending recession.  To restore a positive slope to the yield curve, the Fed would have to pencil in two 25 basis point cuts in its policy rate target range, which now stands at 2.25 to 2.50 percent.&#13;<br /> &#13;<br /> But what if the decline in long-term rates reflects a growing uncertainty about the impact of trade wars on productivity and growth, which is driving investors worldwide to hold U.S. government bonds as a safe haven?  When the demand for U.S. bonds increases, their prices rise and yields fall.  By lowering the fed funds target, the U.S. central bank would divert attention from the trade conflict and the uncertainty it generates.&#13;<br /> &#13;</p> <p>The Fed would simply restore the yield curve to its normal positive slope, and pretend that its “lower-for-longer” interest rate policy can create a permanent wealth effect.  The Fed also seems ready to return to large-scale asset purchases (quantitative easing) if short-run nominal rates approach zero.&#13;<br /> &#13;<br /> It is true that core inflation, as measured by the price index for personal consumption expenditures, is low. But asset price inflation is not low. It has been fanned by the Fed’s policy of holding <em>real</em> rates close to zero or even negative.  Should the key policy of the central bank be to encourage risk taking by suppressing interest rates?  There is nothing in the <a href="https://www.federalreserve.gov/aboutthefed/section2a.htm">Federal Reserve Act</a> that says so.&#13;<br /> &#13;<br /> Moreover, as <a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2019/5/cj-v39n2-7.pdf">Vincent Reinhart</a>, chief economist at Mellon Investments Corp., writes in the current issue of the <em>Cato Journal</em>: “How can we expect traders and investors to react reliably to shocks in the future if their past is one in which they have been protected by a benevolent central bank?”&#13;<br /> &#13;<br /> If the Fed followed a credible monetary rule, such as keeping nominal GDP on a level growth path and making up for misses, total spending would be a better guide to the stance of monetary policy than interest rates.  Interest rates are key intertemporal relative prices that should be allowed to adjust freely according to market forces—not be set by a small group of “experts” at the Fed. &#13;<br /> &#13;<br /> The Fed is rapidly losing its independence by catering to financial markets and seemingly to the White House.  If the Fed were subject to a nominal GDP rule, say a 5 percent growth target, financial market volatility would lessen.  Last December the Fed made a mistake by raising its policy rate target range and stock prices tanked.  That volatility could have been avoided if nominal GDP had been the target, because total spending was growing at about 5 percent.&#13;<br /> &#13;<br /> By doing whatever it takes to keep the expansion going, the Fed risks further inflating asset prices while fleecing seniors who depend on interest income from their savings.  The Fed’s backstopping of stock markets and big government, by pegging   interest rates at low levels, will also further politicize monetary policy and encourage protectionist trade policy.&#13;<br /> &#13;<br /> If the Fed could actually stimulate real economic growth by financial repression (i.e., by engineering negative real interest rates), then Congress would have little to do except to make sure the monetary printing presses were operating at maximum capacity.&#13;<br /> &#13;<br /> The real problem today is not that there is too little inflation but that there is too much discretion in both monetary and fiscal policy.  Moving to a rules-based monetary regime, reducing the size and scope of government, allowing markets not the Fed to allocate credit, and addressing structural issues would help set the basis for long-run economic growth and prosperity.  Turning over all policy levers to the Fed is not a viable solution.</p> <p></p> Wed, 05 Jun 2019 10:42:00 -0400 James A. Dorn https://www.cato.org/blog/benevolent-central-bank Editor’s Note https://www.cato.org/cato-journal/springsummer-2019/editors-note James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The articles in this issue of the <em>Cato Journal</em> stem from the Cato Institute’s 36th Annual Monetary Conference — <strong>Monetary Policy 10 Years after the Crisis</strong> — which was held in Washington on November 15, 2018. Leading scholars and policymakers discussed changes in the Fed’s operating framework, the impact of Fed policy on interest rates and asset prices, the lessons learned from unconventional monetary policy, and the case for a&nbsp;rules‐​based monetary regime.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>The Fed’s new operating system became fully operational in 2015. Under the new system, the Fed uses interest on excess reserves (IOER) and overnight reverse repos (ON RRPs) to administratively set a&nbsp;range for the fed funds rate. By doing so, it divorces the size of its balance sheet from its policy rate target. Prior to October 2008, banks had little incentive to hold excess reserves rather than lend them out. However, when the Fed began to pay IOER, which was greater than the opportunity cost of holding those reserves at the Fed, banks rapidly increased their balances at the Fed. The strong demand for reserves weakened the normal monetary transmission mechanism. Hence, the Fed’s large‐​scale asset purchases (also known as “quantitative easing” or QE) increased the monetary base but did not lead to a&nbsp;corresponding expansion of monetary aggregates or runaway inflation.</p> <p>Today, there is no longer any substantial interbank lending on the fed funds market and the Federal Reserve continues to hold a&nbsp;large portfolio of longer‐​term Treasuries and mortgage‐​backed securities. By engaging in credit policy, the Fed politicized the allocation of capital; and by engaging in QE and forward guidance (promising to hold rates “lower for longer”), the Fed encouraged excessive risk taking and helped inflate asset prices. Moreover, the Fed appears willing to relax the stance of monetary policy whenever the stock market begins to tumble.</p> <p>Without any stable long‐​run rule to guide monetary policymakers, there is still much uncertainty about future policy. Another crisis could mean a&nbsp;new round of large‐​scale asset purchases by the Fed and thus further intervention in credit markets — and lower, even negative, interest rates. Meanwhile, the Fed’s new operating system provides a&nbsp;backstop for the Fed to absorb government debt without any apparent short‐​run consequence in terms of inflation, tempting Congress to delegate fiscal authority to the Fed.</p> <p>The authors in this volume present an in‐​depth view of the Fed’s new operating system, assess global financial stability and the role of central banks, consider the lessons learned from the past decade of monetary experiments, and suggest how the monetary regime could be improved and financial systems made more stable.</p> <p>I thank the authors for their assistance in bringing this special issue of the <em>Cato Journal</em> to fruition and the George Edward Durell Foundation for its continuing support of Cato’s Annual Monetary Conference. An understanding of the role of trust, the rule of law, and free markets in creating sound money and credit is essential to avoid policy mistakes that favor special interests and increase uncertainty. By studying the Fed’s experiment with unconventional monetary policies, lessons can be learned on how to reform the monetary regime and mitigate business fluctuations caused by the monetary mischief inherent in our current unconstrained discretionary monetary policy arrangements.</p> </div> Mon, 13 May 2019 03:00:00 -0400 James A. Dorn https://www.cato.org/cato-journal/springsummer-2019/editors-note Time for a Reasoned Debate over Monetary Policy https://www.cato.org/blog/time-reasoned-debate-over-monetary-policy James A. Dorn <p><em>The following letter was sent to the editors of the Wall Street Journal in response to a&nbsp;April 22<sup>nd</sup> opinion piece by Judy Shelton entitled “<a href="https://www.wsj.com/articles/the-case-for-monetary-regime-change-11555873621">The Case for Monetary Regime Change</a>.”</em> <br> </p> <blockquote><p>Judy Shelton, a&nbsp;long‐​time participant at Cato’s Annual Monetary Conference, may be nominated for one of the open seats on the Federal Reserve Board.&nbsp;In her recent <em>Wall Street Journal</em> op‐​ed, <a href="https://www.wsj.com/articles/the-case-for-monetary-regime-change-11555873621">“The Case for Monetary Regime Change”</a> (April 22), Shelton recognizes the limits of monetary policy and the case for a&nbsp;rules‐​based monetary regime in place of the present system of discretionary government fiat money.&nbsp;If she is nominated by President Trump and confirmed by the Senate, she will be a&nbsp;strong voice for sound money and for considering fundamental reform (see, e.g., <a href="https://www.cato.org/cato-journal/springsummer-2018/case-new-international-monetary-system">https://​www​.cato​.org/​c​a​t​o​-​j​o​u​r​n​a​l​/​s​p​r​i​n​g​s​u​m​m​e​r​-​2​0​1​8​/​c​a​s​e​-​n​e​w​-​i​n​t​e​r​n​a​t​i​o​n​a​l​-​m​o​n​e​t​a​r​y​-​s​ystem</a>). Indeed, in her WSJ article, she suggests that “intellectually fair‐​minded people should be able to debate the pros and cons of alternative monetary approaches without rancor.”&nbsp;I&nbsp;hope the White House, Congress, and Federal Reserve are listening.&nbsp;She concludes by welcoming “the Fed’s newfound ‘patience’ in appraising economic and financial developments.”&nbsp;However, she could strengthen her argument by noting that “patience” is not a&nbsp;substitute for a&nbsp;credible, long‐​run monetary rule in bringing about macroeconomic stability and reducing regime uncertainty. <br><br /> <br> James A. Dorn <br> Vice President for Monetary Studies <br> Cato Institute</p> </blockquote> Wed, 01 May 2019 12:52:19 -0400 James A. Dorn https://www.cato.org/blog/time-reasoned-debate-over-monetary-policy James A. Dorn’s article, “Allan H. Meltzer: A Life Well Lived (1928–2017),” is cited on Bloomberg TV’s The Fed Decides https://www.cato.org/multimedia/media-highlights-tv/james-dorns-article-allan-h-meltzer-life-well-lived-1928-2017-cited Wed, 01 May 2019 12:46:00 -0400 James A. Dorn https://www.cato.org/multimedia/media-highlights-tv/james-dorns-article-allan-h-meltzer-life-well-lived-1928-2017-cited Powell’s “Patience” Is No Substitute for a Sound Monetary Rule https://www.cato.org/blog/powells-patience-no-substitute-sound-monetary-rule James A. Dorn <p>Fed Chairman Jerome Powell’s decision in December to raise the federal funds target by 25 basis points, to 2.25–2.50 percent, and to continue raising rates at least twice in the new year, upset financial markets. The Dow and S&amp;P each dropped at least <a href="https://www.cnbc.com/2018/12/31/stock-market-wall-street-stocks-eye-us-china-trade-talks.html" rel="noopener noreferrer" target="_blank">8.7 percent</a>, logging their worst December declines since 1931.&#13;<br /> &#13;<br /> It looked like the “Powell put” was about to end. However, as criticism of the Fed’s tighter money policy mounted, Powell surprised markets early in the new year.  On January 4, he told several thousand economists at the <a href="https://www.reuters.com/article/us-usa-fed-powell-risks/feds-powell-pledges-patience-sensitivity-to-risks-in-markets-idUSKCN1OY1HY?feedType=RSS&amp;feedName=topNews&amp;utm_source=feedburner&amp;utm_medium=feed&amp;utm_campaign=Feed%3A+reuters%2FtopNews+%28News+%2F+US+%2F+Top+News%29&amp;utm_content=Google+Feedfetcher" rel="noopener noreferrer" target="_blank">American Economic Association meeting</a> in Atlanta, “We will be patient [in raising rates and reducing the Fed’s $4 trillion balance sheet] as we watch to see how the economy evolves.”&#13;<br /> &#13;<br /> The call for “patience” was put into action on March 20th when the Federal Open Market Committee <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20190320a.htm" rel="noopener noreferrer" target="_blank">voted unanimously</a> to maintain the Fed’s 2.25–2.50 target, while signaling that <a href="https://www.foxbusiness.com/economy/federal-reserve-signals-no-interest-rate-hikes-in-2019" rel="noopener noreferrer" target="_blank">2019 would see no rate increases</a>.  Moreover, details emerged on the Fed’s plan to <a href="https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm" rel="noopener noreferrer" target="_blank">halt its balance sheet unwind</a>.&#13;<br /> &#13;<br /> Given this backdrop, several issues need special attention as the Fed reviews its formulation, conduct, and communication of monetary policy throughout 2019. The major conference at the Chicago Fed this June is just the place to be asking whether patience, reliance on the “dot plot” as a communication tool, and paying interest on excess reserves are the best we can do in trying to create macroeconomic stability.<a name="_ftnref1" href="#_ftn1" id="_ftnref1">[1]</a>&#13;<br /> &#13;</p> <p>Without any credible long-run rule to guide monetary policymakers, there is still much uncertainty about future policy. Another crisis could prompt a new round of large-scale asset purchases by the Fed, further intervention in credit markets, and lower— even negative—interest rates. Meanwhile, the Fed’s new operating system provides a backstop for the <a href="https://www.cato.org/publications/commentary/federal-reserve-could-once-push-back-against-big-spending-projects-green-new" rel="noopener noreferrer" target="_blank">Fed to absorb government debt</a> without any apparent short-run inflation consequence, tempting Congress to delegate fiscal authority to the Fed.&#13;<br /> &#13;<br /> To understand why inflation has remained low and stable, even as the Fed experimented with near-zero policy rates and three rounds of quantitative easing (i.e., large-scale asset purchases), requires knowledge of the new operating system, which became fully operational in 2015.<a name="_ftnref2" href="#_ftn2" id="_ftnref2">[2]</a>  Under the new system, the Fed uses interest on excess reserves and overnight reverse repos to administratively set a range for the fed funds rate. In doing so, the Fed has divorced the size of its balance sheet from its policy interest rate target.&#13;<br /> &#13;<br /> Prior to 2008 banks had little incentive to hold excess reserves rather than lend them out. However, when the Fed began to pay interest on excess reserves, in October 2008, banks rapidly increased their balances at the Fed—especially when the interest rate on reserves exceeded the opportunity cost of holding those reserves at the Fed. The strong demand for reserves stymied the normal monetary transmission mechanism that had operated up to then. Hence, the Fed’s large-scale asset purchases increased the monetary base but did not lead to an excessive growth of broader monetary aggregates or runaway inflation.&#13;<br /> &#13;<br /> Today, the Fed continues to hold a large portfolio of longer-term Treasuries and mortgage-backed securities, and interest rates are still low historically. In 2000, the real (i.e., inflation adjusted) fed funds rate was 4 percent, now it is 0.25 percent.  In this sense, the “stance of monetary policy is extremely stimulative,” according to Greg Ip.<a name="_ftnref3" href="#_ftn3" id="_ftnref3">[3]</a>       By promising to hold rates “lower for longer” and to maintain the size of its massive balance sheet, the Fed continues to signal that a primary goal of policy is to support asset prices and encourage risk taking. Yet neither objective is found in <a href="https://www.federalreserve.gov/aboutthefed/section2a.htm" rel="noopener noreferrer" target="_blank">Section 2A</a> of the Federal Reserve Act, which states:&#13;<br /> &#13;</p> <blockquote><p>The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.</p> </blockquote> <p>Fed officials need to consider what Vincent Reinhart, chief economist and macro strategist at Mellon Investments, calls “the normative issue of the appropriateness of a large and lingering Fed footprint in markets.” In a forthcoming article in the <em>Cato Journal</em>, he argues:&#13;<br /> &#13;</p> <blockquote><p>The revealed preference of policymakers is that they do not have sufficient confidence in market mechanisms or respect for the role of risk in directing the efficient allocation of resources. A healthier respect for both would place stricter limits on the extent to which a central bank leans against financial market volatility than was the case.  The problem is that the precedent lowers the bar for future intervention and leaves the Fed operating under too large an ambit in our market economy.<a name="_ftnref4" href="#_ftn4" id="_ftnref4">[4]</a></p> </blockquote> <p>A promise of “patience” is not a substitute for a credible, long-run monetary rule in bringing about macroeconomic stability and reducing regime uncertainty. Policymakers need to recognize the limits of monetary policy in generating economic growth, protect the long-run purchasing power of the dollar, and let markets determine the allocation of credit.&#13;<br /> &#13;<br /> The lack of any systematic policy rule to guide long-run decisions has increased regime uncertainty.<a name="_ftnref5" href="#_ftn5" id="_ftnref5">[5]</a> Policymakers err by paying too much attention to short-run remedies and too little attention to the long-run consequences of current decisions.  A rules-based approach to monetary policymaking needs to be part of the discussion at the Fed’s June meeting.&#13;<br /> &#13;<br /> The case for rules versus discretion in the conduct of money policy was well stated by Karl Brunner, a cofounder of the Shadow Open Market Committee, in 1980:&#13;<br /> &#13;</p> <blockquote><p>We suffer neither under total ignorance nor do we enjoy full knowledge. Our life moves in a grey zone of partial knowledge and partial ignorance. [Consequently], a nonactivist [rules-based] regime emerges . . . as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties . . . on the market place.<a name="_ftnref6" href="#_ftn6" id="_ftnref6">[6]</a></p> </blockquote> <p>When Chairman Powell meets with his colleagues in June he should recall Brunner’s advice and consider that, while patience is a good virtue when roaming in the dark, it is not a good rule to reduce regime uncertainty.&#13;<br /> &#13;<br /> ______________________________________________________________________&#13;<br /> &#13;<br /><a name="_ftn1" href="#_ftnref1" id="_ftn1">[1]</a> The Fed’s “dot plot,” which is part of the Summary of Economic Projections (SEP) issued at each FOMC meeting since October 2007, has been highly unreliable.   Because of its subjective nature and the misunderstanding of its intended use, there is a strong case for removing it from the SEP.  See <a href="https://www.marketwatch.com/story/powells-fed-seems-to-be-ready-to-junk-the-dot-plot-2019-03-19" rel="noopener noreferrer" target="_blank">Melissa Tagg and Ed Yardeni</a>, “Powell’s Fed Seems to Be Ready to Junk the Dot Plot,” <em>MarketWatch</em>, March 19, 2019.&#13;<br /> &#13;<br /><a name="_ftn2" href="#_ftnref2" id="_ftn2">[2]</a> For an in-depth analysis of the new system, see George Selgin, <em>Floored!</em> <em>How a Misguided Fed Experiment Deepened and Prolonged the Great Recession</em>.  Washington: Cato Institute, 2018.&#13;<br /> &#13;<br /><a name="_ftn3" href="#_ftnref3" id="_ftn3">[3]</a> Greg Ip, “Fed’s ‘Normal’ Is Anything But, and That Is Cause for Worry,” <em>Wall Street Journal</em>, March 21, 2019.&#13;<br /> &#13;<br /><a name="_ftn4" href="#_ftnref4" id="_ftn4">[4]</a> Vincent Reinhart, “An Unconventional Assessment of Unconventional Monetary Policy,” <em>Cato Journal</em> 39 (Spring/Summer 2019), forthcoming.&#13;<br /> &#13;<br /><a name="_ftn5" href="#_ftnref5" id="_ftn5">[5]</a> See James A. Dorn, <a href="https://www.cato.org/cato-journal/winter-2018/monetary-policy-uncertain-world-case-rules">“Monetary Policy in an Uncertain World: The Case for Rules,”</a> <em>Cato Journal</em> 38 (Winter 2018).&#13;<br /> &#13;<br /><a name="_ftn6" href="#_ftnref6" id="_ftn6">[6]</a> Karl Brunner, “The Control of Monetary Aggregates.” In <em>Controlling Monetary Aggregates III</em>, p. 61.  Boston: Federal Reserve Bank of Boston, 1980.&#13;<br /> &#13;<br /> [<a href="https://www.alt-m.org/2019/04/01/powells-patience-is-no-substitute-for-a-sound-monetary-rule/">Cross-posted from Alt-M.org</a>]</p> <p></p> Mon, 01 Apr 2019 09:23:00 -0400 James A. Dorn https://www.cato.org/blog/powells-patience-no-substitute-sound-monetary-rule Myopic Monetary Policy and Presidential Power: Why Rules Matter https://www.cato.org/publications/cato-journal/modern-monetary-policy-presidential-power-why-rules-matter James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <blockquote>Independence is central to the Federal Reserve’s ability to choose policy actions that achieve price stability. Sacrificing much of its independence, as the Fed often has, permits others to pressure the Fed to achieve other objectives, usually short‐​term objectives. That is one reason that the Fed responds to short‐​term events often at the cost of failing to achieve longer‐​term objectives.</blockquote> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p align="right">— Allan H. Meltzer (<a href="#ch05_ref22">2013</a>: 405)</p> <h2>The Fed’s Vulnerability to Political Pressure</h2> <p>In the absence of a&nbsp;monetary rule, a&nbsp;central bank is vulnerable to politicization. In the case of the United States, Congress delegated monetary authority to the Federal Reserve in 1913 and has increased the scope of that authority over time, especially following crises. However, Congress has never enacted an explicit rule to guide Fed policy, and it has used the Fed as a&nbsp;scapegoat when things go awry.</p> <p id="note-1">By law, the Federal Reserve has a&nbsp;triple mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long‐​term interest rates.” In doing so, the Federal Open Market Committee (FOMC) is instructed to “maintain long‐​run growth of the monetary and credit aggregates commensurate with the economy’s long‐​run potential to increase production” (Section 2A, Federal Reserve Act).<sup><a href="#fn05-1">1</a></sup> That congressional mandate, however, is a&nbsp;weak reed upon which to rest sound monetary policy in a&nbsp;world of government fiat money not subject to any enforceable monetary rule.</p> <p id="note-2">In 1978, the Humphrey‐​Hawkins Act required the Fed to set targets for monetary aggregates and report those benchmarks to Congress twice a&nbsp;year. There was no penalty if the FOMC failed to hit its targets, but the Fed would have to explain why (P.L. 95–523, Sec. 108 (a)). The reporting requirements expired in May 2000 and the Fed no longer pays much attention to the money supply. Instead, the Fed’s main policy instrument since the mid‐​1980s has been the fed funds rate (i.e., the overnight rate at which member banks lend to each other).<sup><a href="#fn05-2">2</a></sup></p> <p>This article examines the relationship between Fed policy and presidential power in a&nbsp;fiat money regime in which Congress has delegated significant power and discretion to the Fed. By making the Fed responsible, but not accountable, for achieving full employment and price stability, Congress can shift blame to the Fed when it fails to meet those objectives. In their study of the political history of the relationship between the Fed and Congress, Binder and Spindel (<a href="#ch05_ref01">2017</a>) argue that the relationship is one of “interdependence” and that Fed independence is a “myth.”</p> <p>The fact that Congress has given the Fed increased power and discretion means that Congress is evading its constitutional duty to safeguard the value of money and, at the same time, opening the door for presidential jawboning. As Robert Weintraub, staff director for the House Subcommittee on Domestic Monetary Policy from 1976 to 1980, argued: By sanctioning “short‐​run money market myopia” — that is, lowering the short‐​run policy rate by expanding the money supply — “Congress weakened its own hand in supervising monetary policy and strengthened the hand of the Executive.” Moreover, “money market myopia fitted harmoniously with administration concerns about financing the government’s deficits” (<a href="#ch05_ref39">Weintraub 1978</a>: 359). He concluded that, without a&nbsp;credible monetary rule, “the President’s objectives and plans will continue to be the dominant input in the conduct of monetary policy” (ibid.: 360).</p> <p>Consequently, in the absence of a&nbsp;credible/​enforceable rule, money supply targets are insufficient to overcome presidential ambitions to push for accommodative monetary policy, keeping rates low to finance deficits and stimulate production, at least in the short run. Of course, a&nbsp;strong leader in the White House could push for sound money, as did President Eisenhower; and a&nbsp;strong leader at the Fed, such as Paul Volcker, could do likewise.</p> <p>For the last 25&nbsp;years, from President Clinton through President Obama, criticism of Fed policy has usually been in private. But there has been a&nbsp;sea change with President Trump, who has been highly critical of Fed Chairman Jerome Powell for raising rates in 2018, especially the December increase in the target range by 25 basis points to 2.25–2.50 percent (see <a href="#ch05_ref33">Smialek 2019</a>). With tensions rising between the White House and the Fed, and with the Fed examining its strategy, tools, and communication practices, it is a&nbsp;good time to take another look at Fed “independence,” the relationship between the Fed and president, and the case for a&nbsp;monetary rule to guide Fed policy and reduce the uncertainty inherent in a&nbsp;discretionary government fiat money regime.</p> <p>Legally, the Fed is independent, but in practice that independence is continuously tested by political pressures for using accommodative monetary policy and credit allocation to win votes. An examination of the evidence reveals that presidents tend to get the monetary policy they desire. The adoption of a&nbsp;rules‐​based monetary regime could help limit interference in the conduct of monetary policy and improve economic performance.</p> <h2>Fed Policy and Presidential Power: An Uneasy Relationship</h2> <p>In considering the relationship between the government and the Fed, Allan Sproul (<a href="#ch05_ref34">1948</a>), then president of the New York Federal Reserve Bank, distinguished between “independence from government and independence from political influence.” Most people, he said, accept the idea that the Fed should be held accountable by the government/​Congress. However, from a&nbsp;narrow political viewpoint, “The powers of the central banking system should not be a&nbsp;pawn of any group or faction or party, or even any particular administration” (quoted in <a href="#ch05_ref18">Meltzer 2003</a>: 738).</p> <p>That sentiment was recently endorsed by Fed Chairman Jerome Powell when he stated:</p> <blockquote>The Fed is insulated from short‐​term political pressures — what is often referred to as our “independence.” Congress chose to insulate the Fed this way because it had seen the damage that often arises when policy bends to short‐​term political interests. Central banks in major democracies around the world have similar independence [Powell <a href="#ch05_ref25">2019</a>: 1].</blockquote> <p>History, however, does not bear out this view of Fed “independence.” The fact is that, in a&nbsp;purely discretionary fiat money regime, with little congressional guidance, the door is open for presidential power/​jawboning to influence Fed policy. We have seen that in the past and see it now.</p> <p>In his monumental <em>History of the Federal Reserve</em>, Meltzer (<a href="#ch05_ref18">2003</a>, <a href="#ch05_ref20">2010a</a>, <a href="#ch05_ref21">2010b</a>) provides ample evidence that monetary policy is not free from political influence. Likewise, Cargill and O’Driscoll, in their review of that history, and based on Ferrell’s (<a href="#ch05_ref09">2010</a>) diary of Arthur F. Burns, conclude:</p> <blockquote>The Fed was appropriately constrained by fiscal dominance in both great wars. It was independent under the modified gold standard in the 1920s because of a&nbsp;rule. It gained operational independence after the 1951 Accord, but lost that independence starting with William McChesney Martin in the early 1960s and especially Burns in the 1970s. Paul Volcker and Alan Greenspan reestablished de facto independence in terms of focusing on price stability with an implicit adoption of the Taylor Rule. It has surely lost any meaningful independence under Ben Bernanke [<a href="#ch05_ref03">Cargill and O’Driscoll 2013</a>: 431].</blockquote> <p>It is well known that President Truman continued to pressure the Fed for low interest rates after the 1951 Accord. He disliked Fed Chairman Thomas B. McCabe, who was adamant about ending the pegging of U.S. bond rates and was pressured to step down shortly after the Accord was signed (<a href="#ch05_ref18">Meltzer 2003</a>: 712). His replacement, William McChesney Martin, became the longest serving Fed chairman (1951–1970). He believed in Fed independence and survived in office under five presidents by largely following their preferences. For example under President Dwight D. Eisenhower, the Fed pursued a&nbsp;stable money policy with low inflation and moderate long‐​term interest rates. But under President Lyndon B. Johnson, the Fed was pressured to pump up money growth and achieve lower short‐​run interest rates.</p> <p id="note-3">In October 1955, Martin gave his famous “punch bowl speech,” in which he argued that the job of the Fed was to take away the punch bowl (i.e., slow money growth and raise interest rates) when the economy was at peak performance.<sup><a href="#fn05-3">3</a></sup> In that speech, he emphasized the importance of an independent central bank and the limits of monetary policy.</p> <blockquote>In framing the Federal Reserve Act great care was taken to safeguard this money management from improper interference by either private or political interests. That is why we talk about the over‐​riding importance of maintaining our independence.… While money policy can do a&nbsp;great deal, it is by no means all powerful.… If we ask too much of monetary policy we will not only fail but we will also discredit this useful, and indeed indispensable, tool for shaping our economic development [<a href="#ch05_ref16">Martin 1955</a>: 3–4].</blockquote> <p>As Fed chairman under Eisenhower, Martin spoke out against central planning and price controls. He supported free enterprise and monetary stability:</p> <blockquote>The answers we sought to the massive problems of the 1930s increasingly emphasized an enlarging role for Government in our economic life. That role was greatly extended again in the 1940s when the emergency of World War II led to direct controls over wages, prices, and the distribution of goods ranging from sugar to steel. That experience led to growing concern over the effect of a&nbsp;straitjacket of controls on the economy’s productive capacity, and the price that would be exacted in terms of individual liberty if the harness of wartime economic controls were carried over into the postwar years. Such a&nbsp;strait jacketing of the economy is wholly inconsistent with our political institutions and our private enterprise system. The history of despotic rule, of authoritarian rule, not merely in this century but throughout the ages is acutely repugnant to us. It has taken a&nbsp;frightful toll in human misery and degradation.</blockquote> <blockquote>… The advantages of a&nbsp;system where supply capacities and demand wants and needs are matched in open markets cannot be measured in economic terms alone. In addition to the advantages of efficiency in the use of economic resources, there are vast gains in terms of personal liberty. Powers of decision are dispersed among the millions affected instead of being centralized in a&nbsp;few persons in authority [ibid.: 4–5].</blockquote> <p>On the idea that a&nbsp;little inflation is the path to lower unemployment, Martin was clear:</p> <blockquote>Allan Sproul, president of the Federal Reserve Bank of New York, put his finger on the fallacy in this contention in testifying before a&nbsp;congressional committee earlier this year when he said: “Those who would seek to promote ‘full employment’ by creeping inflation, induced by credit policy, are trying to correct structural maladjustments, which are inevitable in a&nbsp;highly dynamic economy, by debasing the savings of the people” [ibid.: 8].</blockquote> <p>While monetary policy during the Eisenhower administration (1953–61) was characterized by low inflation, the Johnson administration (1963–69) leaned heavily on Martin to keep rates low and maintain the economic expansion via adequate money growth. President Johnson warned that “it would be self‐​defeating to cancel the stimulus of tax reduction by tightening money” <a href="#ch05_ref06">(<em>Economic Report</em> 1964</a>: 11).</p> <p id="note-4_5">However, Martin increased the discount rate in December 1965 against the president’s wishes and Johnson lashed out at him when they met at LBJ’s ranch, even pushing Martin around (<a href="#ch05_ref11">Granville 2017</a>). With continued growth in the money supply relative to real output, the Martin Fed helped usher in the Great Inflation (1965–84).<sup><a href="#fn05-4">4</a></sup> As Meltzer (<a href="#ch05_ref19">2005</a>: 168) points out, “Martin’s acceptance of policy coordination with the [Johnson] administration prevented the Federal Reserve from taking timely actions and contributed to more expansive policies than were consistent with price stability.“<sup><a href="#fn05-5">5</a></sup></p> <p>When Martin’s term ended on January 31, 1970, President Nixon nominated Arthur Burns who served as Fed chairman until 1978. From 1971 to 1973, inflationary pressures grew as Burns accommodated Nixon’s demands for lower interest rates and expansionary money growth. In August 1971, President Nixon instituted wage and price controls by executive order in an attempt to contain rising inflation, and he put Burns in charge of the Committee on Interest and Dividends (CID). The primary purpose of CID was to maintain low interest rates. With the cap on wages and prices, Burns could use the Fed’s power to create base money to pump up the money supply while not worrying about inflation, and give Nixon the low interest rates he wanted to help him win the election in 1972. Weintraub (<a href="#ch05_ref39">1978</a>: 356) correctly calls the combination of wage‐​price controls and CID “an invitation to disaster.”</p> <p>The gears shifted in 1974 when President Gerald Ford called for tighter monetary policy. But in 1977, President Carter thought inflation was much less an issue than unemployment and called for Burns to shift to easy money once more. It was not Congress that pressured the Fed to accelerate M1 growth in 1977; it was the administration. As Weintraub (<a href="#ch05_ref39">1978</a>: 358) argues, “It is not unfair to conclude that the Federal Reserve accelerated M1 growth in 1977 above its own target range because it perceived its ‘assignment’ in the new administration’s economic game plan be to resist upward pressures on short‐​term rates.”</p> <p>It was left to Paul Volcker, whom Carter nominated in 1979 and who remained as Fed chairman until 1987, to restore Fed independence and crack down hard on inflation by raising rates and slowing money growth. In October 1979, Volcker met with the FOMC and changed the Fed’s operating system. Instead of managing the day‐​to‐​day fed funds rate, Volcker decided to focus on controlling the volume of bank reserves directly, which meant that there would be more variability in the funds rate but better control of the money supply. He stood his ground and pushed the Fed funds rate to a&nbsp;peak of 20 percent in late 1980. Money growth slowed and by 1983 inflation came down from double digits to less than 4&nbsp;percent (<a href="#ch05_ref17">Medley 2013</a>).</p> <p>Alan Greenspan became Fed chairman in 1987 and followed in Volcker’s footsteps, adding credibility to the Fed. When President George H. W. Bush failed to get the Fed to accommodate his wishes for an expansionary monetary policy, he blamed Greenspan for his defeat in the 1992 election, saying: “I think that if the interest rates had been lowered more dramatically that I&nbsp;would have been re‐​elected president because the [economic] recovery that we were in would have been more visible.… I&nbsp;reappointed him, and he disappointed me” (<a href="#ch05_ref37"><em>Wall Street Journal</em> 1998</a>).</p> <p id="note-6">Greenspan prolonged the “Great Moderation,” which began under Volcker in 1983 and lasted until 2003. It was a&nbsp;period of relative macroeconomic stability in which the variability of both inflation and output decreased. John B. Taylor (<a href="#ch05_ref35">2009</a>) attributed that stability to Fed policy that approximated the Taylor rule.<sup><a href="#fn05-6">6</a></sup> When the Greenspan Fed departed from that rule in mid‐​2003, the fed funds rate fell to 1&nbsp;percent and remained at that level until mid‐​2004, far below the rate prescribed by the Taylor rule (see <a href="#ch05_ref35">Taylor 2009</a>: 3, Fig. 1). Although the Greenspan Fed increased the fed funds rate, it continued to be below the Taylor‐​rule rate until 2006. Consequently, Taylor (<a href="#ch05_ref35">2009</a>) argued that, by holding rates too low for too long, the Greenspan Fed encouraged risk taking and helped fuel the housing bubble.</p> <p>Likewise, Anna Schwartz (<a href="#ch05_ref30">2009</a>: 19–20) has argued:</p> <blockquote>The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006.… The rate increases in 2004 were too little and ended too soon. This was the monetary policy setting for the housing price boom.</blockquote> <p>Schwartz (ibid.: 23) concludes that, “if monetary policy had been more restrictive, the asset price boom in housing could have been avoided.”</p> <p>Greenspan’s policy reversal could have been influenced by the need to accommodate President George W. Bush’s 2001 tax cut and the deficit that followed. Identifying whether he did it for political reasons under pressure from the administration, however, is difficult.</p> <p id="note-7">The global financial crisis greatly increased the power and discretion of the Fed and other central banks. Ben Bernanke, who took over as Fed chairman in 2006, worked closely with the G. W. Bush administration, especially Treasury Secretary Hank Paulson, to restore financial stability and stimulate the economy by unconventional monetary policy — including lowering the fed funds rate to near zero, engaging in large‐​scale asset purchases (credit allocation), and using forward guidance to encourage risk taking and prop up asset prices. Monetary policy drifted into fiscal policy as the Fed bought trillions of dollars of U.S. debt and mortgage‐​backed securities. The policy coordination that was evident under Arthur Burns was super‐​charged under Bernanke.<sup><a href="#fn05-7">7</a></sup> The Fed, of course, had an obligation to provide liquidity to the banking/​financial system, but its emergency lending programs and bailouts stretched its powers considerably. The rule of law gave way to the rule of central bankers (<a href="#ch05_ref40">White 2010</a>; see also <a href="#ch05_ref13">Humphrey 2010</a>).</p> <p>In light of the available evidence, it is fair to say that without a&nbsp;credible rule monetary policy is likely to be more myopic and open to politicization than would be the case with either an implicit or explicit rule. As Cargill and O’Driscoll (<a href="#ch05_ref03">2013</a>: 429) observe:</p> <blockquote>Central bank independence is intimately tied to rules that constrain the central bank to focus on price stability, preferably a&nbsp;legislated rule. Focus on the short term inevitably leads the central bank into the political thicket and the loss of de facto independence. Central bank independence is more easily lost than restored.</blockquote> <p>President Trump is demanding an accommodative monetary policy from the Fed to keep the expansion going and asset prices rising. He has called Fed policy “very destructive” and wants a&nbsp;cut in the fed funds rate (<a href="#ch05_ref27">Salama 2019</a>). The Trump administration’s tax cuts have had positive effects on private investment and real economic growth. However, with large increases in spending and no long‐​run solution to slow entitlement spending, fiscal deficits are mushrooming. Financing those deficits at higher interest rates would be very costly. Thus, the White House is urging Fed Chairman Jerome Powell to keep rates lower for longer and not engage in quantitative tightening by reducing the size of the Fed’s still massive balance sheet. So far Powell has maintained his distance from the White House but perhaps not from Wall Street. However, even if Powell acts in the direction wanted by the president that decision doesn’t necessarily mean a&nbsp;loss of independence if the policy move is correct — that is, consistent with the Fed’s independent pursuit of its mandate.</p> <p>From our brief review of the politics of Fed behavior, it seems safe to say that the Fed is neither independent within government nor outside the fray of day‐​to‐​day politics. It is also questionable whether, as Weintraub (<a href="#ch05_ref39">1978</a>: 349) contends, “the dominant guiding force behind monetary policy is the President.” Congress may only play a “watchdog role,” but presidents don’t always get the monetary policies they want. More important, without a&nbsp;guiding monetary rule, and with multiple mandates, both the White House and the Fed will be more focused on the short run than the long run, and politics will play an oversized role.</p> <h2>Reducing Monetary Uncertainty: Toward a&nbsp;Rule‐​Guided Regime</h2> <p>Monetary rules matter because they help focus monetary authorities on what they can do — influence nominal spending and the price level in the long run — not on what they can’t do — permanently raise the level of real income. Without the guidance of a&nbsp;credible rule, monetary authorities face two major problems, as pointed out by Meltzer (<a href="#ch05_ref22">2013</a>: 406, 411–12): (1) “Excessive concern for short‐​term changes causes the Fed to respond to events over which it has little control and largely ignore longer‐​term changes that it can influence”; and (2) “Excessive attention to short‐​term changes neglects the distinction between permanent and temporary changes that is central to standard economic analysis.”</p> <p>The introduction of money‐​growth targets for a&nbsp;brief period in the late 1970s and early 1980s set some limits on the Fed, but they were not sufficiently implemented as a&nbsp;long‐​term constraint to depoliticize the Fed. Although the Federal Reserve Reform Act of 1977 required the Fed to set targets for “the ranges of growth or diminution of monetary and credit aggregates” and report those ranges to Congress, the legislation lacked real teeth to enforce a&nbsp;monetary growth rule:</p> <blockquote>Nothing in this Act shall be interpreted to require that such ranges of growth or diminution be achieved if the Board of Governors and the Federal Open Market Committee determine that they cannot or should not be achieved because of changing conditions [P.L. 95–188, Sec. 2A].</blockquote> <p>Nonetheless, setting a&nbsp;framework for the conduct of monetary policy (e.g., by requiring the Fed to report money supply targets) helped provide information that allowed fiscal policymakers to better plan their budgets. For example, in July 1977, pursuant to House Concurrent Resolution 133, which was adopted in March 1975 to require the Fed to report money growth targets, Rep. Parren J. Mitchell (D-MD), chairman of the House Subcommittee on Domestic Monetary Policy, held hearings to inquire why the Fed had let money growth exceed the announced target ranges. In questioning Fed Governor J. Charles Partee, Mitchell stated:</p> <blockquote>What we have done in this Congress in an effort to get a&nbsp;handle on Government spending is to establish a&nbsp;Committee on the Budget which works in concert with Ways and Means, Appropriations, and all the other major committees. Key to that working relationship is the understanding of monetary policy established early in the year.</blockquote> <blockquote>… If there is a&nbsp;commonly agreed on monetary growth policy at the beginning of the year, then all of us — banking, budget, all of Congress — operate roughly within those guidelines established by you and accepted by the Congress. To the extent and degree that you move away from those guidelines, you throw this whole delicate balance out of whack.</blockquote> <blockquote>… This is, indeed, in my opinion, disruptive to the fiscal policy planning process and to business and consumer planning as well [<a href="#ch05_ref36">U.S. Congress 1977</a>: 50–51; quoted in <a href="#ch05_ref39">Weintraub 1978</a>: 357–58].</blockquote> <p>The 1983–2003 experiment with a&nbsp;Taylor rule helped guide Fed policy under Volcker and Greenspan and gave the Fed more space from the White House and more confidence in its independence. But we can do better. Formal adoption of a&nbsp;legislated rule and effective implementation of a&nbsp;rule would further separate day‐​to‐​day politics from monetary policy. The failure of Congress to legislate a&nbsp;rule‐​based monetary regime, or for Congress or the president to establish a&nbsp;commission to examine Fed performance and alternative monetary rules, is disappointing but not surprising.</p> <p>The Fed has little incentive to bind itself to a&nbsp;rule and lose discretionary power. Congress and the executive branch, meanwhile, have little incentive to put the Fed on auto pilot and deprive themselves of influencing monetary policy or placing blame for economic instability on the Fed. An example suffices to illustrate the difficulty of reforming the monetary regime or even taking the first step by establishing a&nbsp;presidential commission to consider alternatives to the present discretionary government fiat money regime.</p> <p>After Ronald Reagan was elected president in 1980, Martin Anderson, a&nbsp;key member of Reagan’s campaign staff and later appointed as chief domestic policy advisor, reached out to several influential economists for ideas on what policy actions President Reagan should take during his first 100&nbsp;days in office. One of those contacted was James M. Buchanan, a&nbsp;pioneer in public choice and constitutional economics, who recommended that Reagan “appoint a&nbsp;presidential commission that would look into the whole structure of our monetary authority” (<a href="#ch05_ref02">Buchanan 1988</a>: 32–33).</p> <p>As Buchanan observed:</p> <blockquote>What we have now is a&nbsp;monetary authority that essentially has a&nbsp;monopoly on the issue of fiat money, with no guidelines to amount to anything; an authority that never would have been legislatively approved, that never would have been constitutionally approved, on any kind of rational calculus, no matter what political system. We have an authority that just happened to get there and happened to be in place when we demonetized gold totally and completely over this half century. So I&nbsp;thought it was a&nbsp;good idea to use that presidential commission‐​type device to get a&nbsp;little publicity, to get a&nbsp;discussion going about the legitimacy of this authority [ibid.: 33].</blockquote> <p>After sending Anderson a&nbsp;letter in early December, Buchanan heard back from Reagan’s “Kitchen Cabinet” expressing interest in the idea for a&nbsp;presidential commission and asking Buchanan to consider chairing it. He then wrote a “position paper” that he sent to the Western White House, but he never heard anything back (ibid.: 33–34). Here’s the way Buchanan described it:</p> <blockquote>Nothing happened. Absolutely nothing happened. I&nbsp;never heard a&nbsp;word, not one word, from them. I&nbsp;found out months later, that they did seriously consider the idea, but Arthur Burns shot it down. Arthur Burns totally and completely rejected it, and would not have anything to do with any proposal that would challenge the authority of the central banking structure — you don’t even question, you don’t even raise it as an issue to be discussed [ibid.: 34].</blockquote> <p>In other words, Burns, a&nbsp;former chairman of the Fed, “had taken it as his mission to defend the institution as it is, independently of any question. It became a&nbsp;sacrosanct institution to Arthur Burns, and he prevailed in the Reagan councils” (ibid.).</p> <p id="note-8">Official resistance to establishing a&nbsp;commission to explore alternative monetary regimes persists to this day, as attested by the fact that Congress failed to enact the Centennial Monetary Commission Act of 2013 (H.R. 1176), introduced by Rep. Kevin Brady (R-TX).<sup><a href="#fn05-8">8</a></sup></p> <p>Without a&nbsp;transparent and credible rule to guide monetary policy, there is much uncertainty about the Fed’s next move in setting interest rates, as witnessed by the unexpected turnaround after last December’s rate hike. Initially, Fed Chairman Jerome Powell led markets to believe there would be two rate hikes in 2019, but quickly changed his mind when the stock market tanked in December 2018. He then called for “patience” in setting the policy rate and in shrinking the Fed’s massive balance sheet (<a href="#ch05_ref29">Schneider and Spicer 2019</a>).</p> <p>A rule‐​guided monetary policy would help depoliticize the Fed, shift resources to more productive uses than “Fed watching,” and reduce regime uncertainty by concentrating on long‐​run stability of nominal income and the price level rather than trying to fine‐​tune the economy or cater to Wall Street. Moreover, a “hard” rather than “soft” rule (i.e., one fudgeable by the Fed) would end the “ambiguous and chaotic” state of monetary law that Clark Warburton referred to when noting that “Monetary law in the United States … does not contain a&nbsp;suitable principle for the exercise of the monetary power held by the Federal Reserve System, and has caused confusion in the development of Federal Reserve policy” (<a href="#ch05_ref38">Warburton 1966</a>: 316).</p> <p>The Federal Reserve Act of 1913 sought to provide “an elastic currency” and to have reserve banks set discount rates “with a&nbsp;view of accommodating commerce and business.” Those were vague guidelines, however. The Fed failed to provide a&nbsp;quantity of money sufficient to maintain monetary equilibrium in the early 1930s, as Friedman and Schwarz (<a href="#ch05_ref10">1963</a>) and Warburton (<a href="#ch05_ref38">1966</a>) have shown. Weintraub (<a href="#ch05_ref39">1978</a>: 341–42) sums up the situation nicely:</p> <blockquote id="note-9">In the crucible of reality, the [1913] Act was found wanting. It contained no meaningful operational standard for the conduct of monetary policy. Aside from the constraints imposed by the gold standard and the gold backing requirement on Federal Reserve notes and deposits, the Federal Reserve was free to do as it wanted, when it wanted, for whatever reasons it might have.<sup><a href="#fn05-9">9</a></sup> </blockquote> <p id="note-10">The myopic nature of monetary policy stems from the lack of a&nbsp;rules‐​based monetary regime that would give credence to Section 2A of the Federal Reserve Act. As we have seen, the Fed never really adhered to a&nbsp;money supply target regime, and the link between money, income, and prices was severed by financial innovation beginning in the 1990s (see <a href="#ch05_ref15">Labonte and Makinen 2008</a>).<sup><a href="#fn05-10">10</a></sup> Thus, in July 1991, at a&nbsp;congressional hearing, Fed Chairman Alan Greenspan noted:</p> <blockquote>The historical relationships between money and income, and between money and the price level, have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a&nbsp;reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place [<a href="#ch05_ref08">Federal Reserve Bank of New York 2008</a>: 2].</blockquote> <p>Since the 2008 financial crisis, the Fed’s balance sheet has exploded, and, with the payment of interest on excess reserves (IOER) since October 2008, the increased demand for reserves has mitigated the monetary transmission mechanism whereby an increase in base money leads to a&nbsp;multiple increase in money and credit, and boosts nominal income (see <a href="#ch05_ref32">Selgin 2018</a>).</p> <p>By separating its balance sheet from administering interest rates under the so‐​called floor system, the Fed has been able to avoid runaway inflation even as it suppresses interest rates — and it is more open to political manipulation. Indeed, the floor system allows for more administrative and congressional abuse of the Fed’s balance sheet (<a href="#ch05_ref31">Selgin 2017</a>). As former Philadelphia Fed President Charles Plosser (<a href="#ch05_ref24">2018</a>: 15) argues, “A large balance sheet untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed’s balance sheet to conduct off budget fiscal policy and credit allocation.” Nevertheless, the Fed’s new operating system need not expose the Fed to any greater tendency to set its rate targets according to presidential whims.</p> <p id="note-11">The Fed has sought to use “forward guidance” to steer monetary policy, but as seen from Chairman Powell’s “pivot” after the FOMC increased rates last December, there is little certainty about the future course of monetary policy. Forecasting the macroeconomy and interest rates is notoriously difficult. Demands on forecasts could be significantly reduced by moving to a&nbsp;rule‐​based monetary regime. There are many rules to choose from, including ones based on convertibility of the dollar into some commodity or basket of commodities, a&nbsp;constant money growth rule, an inflation or price level rule, a&nbsp;nominal GDP rule designed to keep total spending on a&nbsp;steady path, a&nbsp;Taylor rule, and so on.<sup><a href="#fn05-11">11</a></sup></p> <h2>Conclusion</h2> <p>As the Fed reviews its strategy and communications this year, it should not forget two important points: (1) independence is necessary for the Fed to do its stabilization job well, free of presidential meddling; and (2) specific monetary rules are an absolutely necessary condition to assure achievement of such independence. Moreover, the Fed needs to be open to a&nbsp;rational discussion of alternative monetary rules in attempting to improve the monetary regime. The problem is not too little inflation but too much discretion.</p> <p>There needs to be a&nbsp;better understanding of why rules matter in reducing myopic monetary policy and in insulating the Fed from presidential power and day‐​to‐​day politics. Ultimately, the Fed must be bound by a&nbsp;constitution that protects the value of money and safeguards individual freedom under a&nbsp;rule of law. The current monetary regime is far from that ideal.</p> <p>Creating a&nbsp;monetary commission to evaluate the Fed’s performance and consider alternatives to the current discretionary fiat money regime would be a&nbsp;step in the direction of securing sound money.</p> <h2>References</h2> <p><a id="ch05_ref01"></a>Binder, S., and Spindel, M. (2017) <em>The Myth of Independence: How Congress Governs the Federal Reserve.</em> Princeton, N.J.: Princeton University Press.</p> <p><a id="ch05_ref02"></a>Buchanan, J. M. (1988) “Comment by Dr. Buchanan.” <em>Economic Education Bulletin</em> 28 (6): 32–35. Special issue on “Prospects for a&nbsp;Monetary Constitution,” Proceedings of the Progress Foundation’s International Monetary Conference, Lugano, Switzerland, May 27, 1988.</p> <p><a id="ch05_ref03"></a>Cargill, T. F., and O’Driscoll, G. P. Jr. (2013) “Federal Reserve Independence: Reality or Myth?” <em>Cato Journal</em> 33 (3): 417–35.</p> <p><a id="ch05_ref04"></a>Dorn, J. A. (2017) <em>Monetary Alternatives: Rethinking Government Fiat Money</em>. Washington: Cato Institute.</p> <p><a id="ch05_ref05"></a>__________ (2018) “Monetary Policy in an Uncertain World: The Case for Rules.” In J. A. Dorn (ed.), <em>Monetary Policy in an Uncertain World: Ten Years after the Crisis</em>, 179–206. Washington: Cato Institute.</p> <p><a id="ch05_ref06"></a><em>Economic Report of the President</em> (1964) Available at <a href="https://fraser.stlouisfed.org/title/45/item/8135">https://​fras​er​.stlou​is​fed​.org/​t​i​t​l​e​/​4​5​/​i​t​e​m​/8135</a>.</p> <p><a id="ch05_ref07"></a>__________ (1965) Available at <a href="https://fraser.stlouisfed.org/files/docs/publications/ERP/1965/ERP_1965.pdf">https://​fras​er​.stlou​is​fed​.org/​f​i​l​e​s​/​d​o​c​s​/​p​u​b​l​i​c​a​t​i​o​n​s​/​E​R​P​/​1​9​6​5​/​E​R​P​_​1​9​6​5.pdf</a>.</p> <p><a id="ch05_ref08"></a>Federal Reserve Bank of New York (2008) “The Money Supply.” Available at <a href="http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html">www​.newyork​fed​.org/​a​b​o​u​t​t​h​e​f​e​d​/​f​e​d​p​o​i​n​t​/​f​e​d​4​9​.html</a> (July 2008).</p> <p><a id="ch05_ref09"></a>Ferrell, R. H., ed. (2010) <em>Inside the Nixon Administration: The Secret Diary of Arthur Burns, 1969–1974</em>. St. Lawrence, Kans.: University Press of Kansas.</p> <p><a id="ch05_ref10"></a>Friedman, M. and Schwartz, A. J. (1963) <em>A&nbsp;Monetary History of the United States, 1867–1960</em>. Princeton, N.J.: Princeton University Press for the National Bureau of Economic Research.</p> <p><a id="ch05_ref11"></a>Granville, K. (2017) “A President at War with His Fed Chief, 5&nbsp;Decades before Trump.” <em>New York Times</em> (June 13).</p> <p><a id="ch05_ref12"></a>Hanke, S. (2018) “The Fed’s Misleading Money Supply Measure.” <em>Forbes​.com</em> (October 21).</p> <p><a id="ch05_ref13"></a>Humphrey, T. M. (2010) “Lender of Last Resort: What It Is, Whence It Came, and Why the Fed Isn’t It.” <em>Cato Journal</em> 30 (2): 333–64.</p> <p><a id="ch05_ref14"></a>Humphrey, T. M., and Timberlake, R. H. (2019) <em>Gold, The Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922–1938</em>. Washington: Cato Institute.</p> <p><a id="ch05_ref15"></a>Labonte, M., and Makinen, G. E. (2008) “Monetary Policy and the Federal Reserve: Current Policy and Conditions.” <em>CRS Report for Congress</em>. Washington: Congressional Research Service (April 30).</p> <p><a id="ch05_ref16"></a>Martin, W. M. (1955) “Address before the New York Group of the Investment Bankers Association of America” (October 19). Available at <a href="https://fraser.stlouisfed.org/title/448/item/7800">https://​fras​er​.stlou​is​fed​.org/​t​i​t​l​e​/​4​4​8​/​i​t​e​m​/7800</a>.</p> <p><a id="ch05_ref17"></a>Medley, B. (2013) “Volcker’s Announcement of Anti‐​Inflation Measures.” <em>Federal Reserve History</em> (October). Available at <a href="http://www.federalreservehistory.org/essays/anti_inflation_measures">www​.fed​er​al​re​serve​his​to​ry​.org/​e​s​s​a​y​s​/​a​n​t​i​_​i​n​f​l​a​t​i​o​n​_​m​e​a​sures</a>.</p> <p><a id="ch05_ref18"></a>Meltzer, A. H. (2003) <em>A&nbsp;History of the Federal Reserve: Vol. 1: 1913–1951</em>. Chicago: University of Chicago Press.</p> <p><a id="ch05_ref19"></a>__________ (2005) “Origins of the Great Inflation.” Federal Reserve Bank of St. Louis <em>Review</em> 87 (2, Part 2): 145–75.</p> <p><a id="ch05_ref20"></a>__________ (2010a) <em>A&nbsp;History of the Federal Reserve: Vol. 2, Book 1: 1951–1969</em>. Chicago: University of Chicago Press.</p> <p><a id="ch05_ref21"></a>__________ (2010b) <em>A&nbsp;History of the Federal Reserve: Vol. 2, Book 2: 1970–1986</em>. Chicago: University of Chicago Press.</p> <p><a id="ch05_ref22"></a>__________ (2013) “What’s Wrong with the Fed? What Would Restore Independence?” <em>Cato Journal</em> 33 (3): 401–16.</p> <p><a id="ch05_ref23"></a>Niskanen, W. N. (2001) “A Test of the Demand Rule.” <em>Cato Journal</em> 21 (2): 205–09.</p> <p><a id="ch05_ref24"></a>Plosser, C. (2018) “The Risks of a&nbsp;Fed Balance Sheet Unconstrained by Monetary Policy.” In M. D. Bordo, J. H. Cochrane, and A. Seru (eds.), <em>The Structural Foundations of Monetary Policy</em>, 1–16. Stanford, Calif.: Hoover Institution Press.</p> <p><a id="ch05_ref25"></a>Powell, J. H. (2019) “Economic Outlook and Monetary Policy Review.” Speech at the Council on Foreign Relations, New York (June 25).</p> <p><a id="ch05_ref26"></a>Ramage, J. C. (1968) “The Gold Cover.” <em>Federal Reserve Bank of Richmond Monthly Review</em> (July): 8–10.</p> <p><a id="ch05_ref27"></a>Salama, V. (2019) “Trump Says Fed Policy Makers Have Become ‘Very Disruptive.’ ” <em>Wall Street Journal</em> (June 10).</p> <p><a id="ch05_ref28"></a>Salter, A. W. (2017) “Some Political Economy of Monetary Rules.” <em>The Independent Review</em> 21 (3): 443–64.</p> <p><a id="ch05_ref29"></a>Schneider, H., and Spicer, J. (2019) “Powell Tells Markets Fed Is Flexible and Aware of Risks.” <em><a href="http://Investing.com">Invest​ing​.com</a></em> (January 4).</p> <p><a id="ch05_ref30"></a>Schwartz, A. J. (2009) “Origins of the Financial Market Crisis of 2008.” <em>Cato Journal</em> 29 (1): 19–23.</p> <p><a id="ch05_ref31"></a>Selgin, G. (2017) “Interest on Reserves: A&nbsp;Secret Fiscal Weapon We’re Better Off Without.” <em>Alt‐​M</em> (January 25).</p> <p><a id="ch05_ref32"></a>__________ (2018) <em>Floored! How a&nbsp;Misguided Fed Experiment Deepened and Prolonged the Great Recession</em>. Washington: Cato Institute.</p> <p><a id="ch05_ref33"></a>Smialek, J. (2019) “Trump’s Feud with the Fed Is Rooted in Presidential History.” <em>New York Times</em> (June 25).</p> <p><a id="ch05_ref34"></a>Sproul, A. (1948) “Letter to Robert R. Bowie” (September 1). Files of Allan Sproul, Box 2, “Memorandums and Drafts.” Federal Reserve Bank of New York.</p> <p><a id="ch05_ref35"></a>Taylor, J. B. (2009) <em>Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis</em>. Stanford, Calif.: Hoover Institution Press.</p> <p><a id="ch05_ref36"></a>U.S. Congress, Subcommittee on Domestic Monetary Policy (1977) “Recent Monetary Developments and Future Economic Performance.” Hearings, 95th Cong., 1st sess. (July).</p> <p><a id="ch05_ref37"></a><em>Wall Street Journal</em> (1998) “Bush Pins 1992 Election Loss on Fed Chair Alan Greenspan.” <em>Wall Street Journal</em> (August 25).</p> <p><a id="ch05_ref38"></a>Warburton, C. (1966) <em>Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953</em>. Baltimore: The Johns Hopkins University Press.</p> <p><a id="ch05_ref39"></a>Weintraub, R. E. (1978) “Congressional Supervision of Monetary Policy.” <em>Journal of Monetary Economics</em> 4: 341–62.</p> <p><a id="ch05_ref40"></a>White, L. H. (2010) “The Rule of Law or the Rule of Central Bankers?” <em>Cato Journal</em> 30 (3): 451–63.</p> <p><sup><a id="fn05-1">1</a></sup> See <a href="http://www.federalreserve.gov/aboutthefed/section2a.htm">www​.fed​er​al​re​serve​.gov/​a​b​o​u​t​t​h​e​f​e​d​/​s​e​c​t​i​o​n​2​a.htm</a>.</p> <p><sup><a id="fn05-2">2</a></sup> The Fed now sets a&nbsp;target range for the fed funds rate, using interest on excess reserves as the upper limit and the Fed’s overnight reverse repo rate as the lower limit. For a&nbsp;discussion of the Fed’s new operating system, see Federal Reserve Bank of New York (<a href="#ch05_ref08">2008</a>) and Selgin (<a href="#ch05_ref32">2018</a>).</p> <p><sup><a id="fn05-3">3</a></sup> The “punch bowl” line was really taken from another writer whom Martin doesn’t identify. The exact quote is: “The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up” (<a href="#ch05_ref16">Martin 1955</a>: 12).</p> <p><sup><a id="fn05-4">4</a></sup> It should be noted that, in January 1965, Johnson urged Congress “to eliminate the arbitrary requirement that the Federal Reserve Banks maintain a&nbsp;gold certificate reserve against their deposit liabilities” (<a href="#ch05_ref07"><em>Economic Report</em> 1965</a>: 12). As Robert Weintraub (<a href="#ch05_ref39">1978</a>: 355) notes, removing that constraint would allow domestic monetary policy to be more accommodative, providing cover for Johnson’s Great Society programs and the Vietnam War. Congress obliged by passing a&nbsp;bill in March 1965 eliminating the gold requirement for deposits/​reserves held at the Federal Reserve Banks, and in March 1968 removed the gold requirement for Federal Reserve notes (<a href="#ch05_ref26">Ramage 1968</a>: 8). When President Nixon closed the gold window in August 1971, the last vestige of the gold standard was gone.</p> <p><sup><a id="fn05-5">5</a></sup> Meltzer (<a href="#ch05_ref19">2005</a>: 145) blames the persistence of inflation on “political choices, analytic errors, and the entrenched belief that inflation would continue.” He notes that, under the sway of simple Keynesian models, those calling for policy coordination accepted the practice of monetizing the debt — that is, having the Fed help finance fiscal deficits (ibid.).</p> <p><sup><a id="fn05-6">6</a></sup> William Niskanen (<a href="#ch05_ref23">2001</a>) found that the Greenspan Fed adhered to a&nbsp;de facto demand rule from early 1992 to early 1998 by keeping total spending on a&nbsp;steady growth path of about 5.5 percent per year.</p> <p><sup><a id="fn05-7">7</a></sup> The president and CEO of the Federal Reserve Bank of New York, Timothy Geithner, was also a&nbsp;key player in the policy coordination process.</p> <p><sup><a id="fn05-8">8</a></sup> See <a href="http://www.govtrack.us/congress/bills/113/hr1176/text">www​.gov​track​.us/​c​o​n​g​r​e​s​s​/​b​i​l​l​s​/​1​1​3​/​h​r​1​1​7​6​/text</a>.</p> <p><sup><a id="fn05-9">9</a></sup> Humphrey and Timberlake (<a href="#ch05_ref14">2019</a>) argue that the Fed’s adherence to the Real Bills Doctrine led it to misdiagnose the causes of the Great Contraction. The idea that limiting the discount window to commercial paper would bring about an optimal quantity of money was proven to be a&nbsp;poor guide to stable money and prices.</p> <p><sup><a id="fn05-10">10</a></sup> Meltzer (<a href="#ch05_ref22">2013</a>: 410) has questioned the breakdown in the money‐​nominal income linkage: “The Federal Reserve rejects use of any monetary aggregate by claiming that monetary velocity is unstable. This conclusion comes from tests based on quarterly data. This is another example of the dominant role of myopia.… For the United States, annual data on monetary base velocity and a&nbsp;bond rate for nearly 80&nbsp;years show reasonable stability.” Using a&nbsp;Divisia (weighted) measure of the broad money supply (M4) also shows that money matters in shaping the path of income and prices (see <a href="#ch05_ref12">Hanke 2018</a>).</p> <p><sup><a id="fn05-11">11</a></sup> On alternative monetary rules, see Dorn (<a href="#ch05_ref04">2017</a>) and Salter (<a href="#ch05_ref28">2017</a>). For a&nbsp;summary of the literature on the case for rules versus discretion, see Dorn (<a href="#ch05_ref05">2018</a>).</p> </div> Sat, 30 Mar 2019 03:00:00 -0400 James A. Dorn https://www.cato.org/publications/cato-journal/modern-monetary-policy-presidential-power-why-rules-matter China’s Future Development: Challenges and Opportunities https://www.cato.org/cato-journal/winter-2019/chinas-future-development-challenges-opportunities James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>China’s journey from central planning to market socialism since 1978 has been erratic, with many interruptions along the way. The end result, however, has been eye opening: the Middle Kingdom has become the world’s largest trading nation, the second largest economy, and more than 500 million people have lifted themselves out of poverty as economic liberalization removed barriers to trade.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>One of the enduring lessons from China’s rise as an economic giant is that once people are given greater economic freedom, more autonomy, and stronger property rights, they will have a&nbsp;better chance of creating a&nbsp;harmonious and prosperous society (see <a href="#ref011">Dorn 2019</a>).</p> <p>Nevertheless, China faces major challenges to its future development. There is still no genuine rule of law that effectively limits the power of government, no independent judiciary to enforce the rights promised in the nation’s constitution, no free market for ideas that is essential for innovation and for avoiding major policy errors, no competitive political system that fosters a&nbsp;diversity of views, and a&nbsp;large state sector that stifles private initiative and breeds corruption. China’s slowing growth rate, its increasing debt burden, environmental problems, and the increasing tension in U.S.-China relations compound the challenges facing Beijing.</p> <p>President Xi Jinping, the most powerful leader since Mao Zedong, has used the rhetoric of free trade for the market in both goods and ideas. At the 2017 World Economic Forum in Davos, he stated: “We must remain committed to developing global free trade … and say no to protectionism” (<a href="#ref034">Xi 2017a</a>). Meanwhile, in his October 2017 report at the 19th National Congress of the Chinese Communist Party (CCP), he told his comrades: “We should follow the principle of letting a&nbsp;hundred flowers bloom and a&nbsp;hundred schools of thought contend” (<a href="#ref035">Xi 2017b</a>: 36–37).</p> <p id="ch10_Dorn-REF001">While President Xi’s rhetoric is notable, the reality is that China continues to protect its state‐​run monopolies, restricts entry to financial and other markets, violates intellectual property rights, and severely restricts free speech (see <a href="#ref017">Lardy 2019</a>). Indeed, the 2018 World Press Freedom Index, compiled by Reporters without Borders, ranked China 176th out of 180 countries — only four ranks above North Korea.<sup><a href="#ch10_Dorn-ref001">1</a></sup></p> <p>The CCP (<a href="#ref006">2013</a>) pledges to “further emancipate the mind,” and the Chinese Constitution states that citizens “enjoy freedom of speech, of the press, of assembly, of association” (Art. 35), and that “freedom of the person … is inviolable” (Art. 37). Yet those promises are empty in a&nbsp;powerful one‐​party state.</p> <p>The closing of virtual private networks and the silencing of those who advocate a&nbsp;just rule of law and limited/​constitutional government — such as Mao Yushi at the liberal Unirule Institute, whose website was shut down and office shuttered (<a href="#ref003">Buckley 2018</a>) — reflect a&nbsp;growing anti‐​liberal sentiment under Xi Jinping, who is now “President for life.”</p> <p>Sheng Hong, the director of Unirule, has argued that if China is to advance, the authorities must understand “the intrinsic tie between free trade and free expression.” The logic is simple: “Free trade refers to the free exchange of commodities, and free expression refers to the free exchange of ideas. As ideas are more valuable than commodities, anyone that truly defends the freedom to trade will defend the freedom of expression” (<a href="#ref025">Sheng 2017</a>).</p> <p>Premier Li Keqiang has argued that, if China is to reach its full potential, it must “get the relationship right between the government and the market” and boost the “vitality of the market’ (<a href="#ref018">Li 2015</a>). Allowing a&nbsp;greater scope for the market, however, means reducing the scope of government and diminishing the power of the CCP. Moreover, improving the “vitality of the market” means strengthening the institutional infrastructure that supports a&nbsp;free‐​market system, including the protection of private property rights broadly defined to include a&nbsp;free market in ideas.</p> <p>In thinking about the relationship between government and the market — or more fundamentally, between the individual and the state — it is important to recognize that the modus operandi of the state is <em>coercion</em>, while that of the market is <em>consent</em>. The basic issue is how to balance state and market so that individuals are free to choose while ensuring that government is limited to safeguarding life, liberty, and property.</p> <p>One of the most powerful ideas in social and economic thought is that of a “spontaneous order” arising from the interaction of free individuals under a&nbsp;just rule of law. In 1776, Adam Smith argued that, if “all systems either of preference or of restraint” were “completely taken away,” a “simple system of natural liberty” would evolve “of its own accord.” Each individual would then be “left perfectly free to pursue his own interest in his own way, and to bring both his industry and capital into competition with those of any other man, or group of men,” provided “he does not violate the laws of justice” (<a href="#ref026">Smith [1776] 1937</a>: 651).</p> <p>President Xi Jinping has said that China needs “to make good use of both the invisible hand and the visible hand” (<a href="#ref033">Xi 2015</a>). The problem is that the invisible hand doesn’t work well without the freedom that stems from widespread private property and limited government. That is why Wu Jinglian, one of China’s most respected economists and reformers, declared: “Only by matching the rule of law with the market economy can we achieve total success” (quoted in <a href="#ref012">Fu 2005</a>).</p> <p>In this article, I&nbsp;discuss the major challenges confronting China as it marches ahead on the path to creating a&nbsp;harmonious and prosperous society, and the opportunities that will appear if those challenges are met. In doing so, I&nbsp;consider the importance of getting the relationship right between the individual and the state, and the need for developing a&nbsp;free market in ideas.</p> <h2>Challenges to China’s Future Development</h2> <p>In December 2003, Premier Wen Jiabao gave an important speech at Harvard. He expressed optimism regarding China’s future and remarked that the Middle Kingdom had “found the right path of development” — namely, “building socialism with Chinese characteristics.” The essential nature of that path, he said, “is to mobilize all positive factors, emancipate and develop the productive forces, and respect and protect the freedom of the Chinese people to pursue happiness” (<a href="#ref030">Wen 2003</a>). Pointing to China’s successful economic liberalization since 1978, he noted:</p> <p>With deepening restructuring toward the socialist market economy … , there was gradual lifting of the former improper restrictions, visible and invisible, on people’s freedom in choice of occupation, mobility, enterprise, investment, information, travel, faith, and lifestyles. This has brought extensive and profound changes never seen before in China’s history [<a href="#ref030">Wen 2003</a>].</p> <p>Wen attributed that success “to the freedom‐​inspired creativity of the Chinese people.” However, he argued that to ensure future development, workers would need more capital, and that to attract sufficient capital, China would need more secure property rights: “Without effective protection of the citizens’ right to property, it will be difficult to attract and accumulate valuable capital” (<a href="#ref030">Wen 2003</a>).</p> <p>The 2008 global financial crisis put a&nbsp;brake on Wen’s vision as Beijing engineered a&nbsp;massive “stimulus” program that favored large state‐​owned enterprises (SOEs). China’s financial sector continues to be characterized by state‐​led credit allocation and financial repression. The lack of capital freedom and barriers to the free flow of information reduce the likelihood of having the renminbi (RMB) become a&nbsp;widely accepted reserve currency (see <a href="#ref023">Prasad 2017</a>). Meanwhile, Hong Kong — with its currency board, high degree of economic freedom, and sound rule of law — continues to have a&nbsp;substantial comparative advantage in the financial sector.</p> <p>In November 2012, Xi Jinping became general secretary of the CCP and chairman of China’s Central Military Commission, and in March 2013, he was “elected” president of the People’s Republic of China (PRC). His avowed goals, as stated in his closing speech at the First Session of the 12th National People’s Congress (March 17, 2013), are to “push forward the great cause of socialism with Chinese characteristics” and “achieve the Chinese dream of great rejuvenation of the Chinese nation” (<a href="#ref032">Xi 2013</a>).</p> <p id="ch10_Dorn-REF002">The first sign of progress came in November 2013, following the Third Plenary Session of the CCP’s 18th Central Committee, headed by Xi Jinping, when it announced the “Decision on Major Issues Concerning Comprehensively Deepening Reforms” (<a href="#ref006">CCP 2013</a>). The 60‐​point road map calls for reform on a&nbsp;broad front but with a&nbsp;focus on economic reform: “Economic system reform is the focus of deepening the reform comprehensively. The underlying issue is how to strike a&nbsp;balance between the role of the government and that of the market, and let the market play the decisive role in allocating resources and let the government play its functions better.”<sup><a href="#ch10_Dorn-ref002">2</a></sup> Resource allocation is to be improved by adhering to “market rules, market prices and market competition.” Officials should “encourage, support and guide the development of the non‐​public sector, and stimulate its dynamism and creativity” (<a href="#ref006">CCP 2013</a>).</p> <p>The new road map for reform also emphasized the importance of property rights: “Property rights are the core of ownership. We need to improve the modern property rights system with clear ownership, clear‐​cut rights and obligations, [and] strict protection.” In that regard, SOEs will be allowed “to develop into mixed enterprises,” and “a rural property rights transfer market” will be established to help ensure “the open, fair and procedure‐​based operation of rural property rights transfer.” The <em>hukou</em> system will also be reformed by allowing “the eligible population to move away from agriculture and become urban residents.” Finally, there will be further efforts to “improve the mechanism for market‐​based renminbi exchange rate formation, accelerate interest‐​rate liberalization, and … promote the opening of the capital market” (<a href="#ref006">CCP 2013</a>).</p> <p>While the Central Committee’s road map is promising, the reality is that “if people are not allowed to freely debate how to reform the political system, then it will be impossible to develop the right ideas to implement this roadmap” (<a href="#ref037">Zhang 2015</a>: 38).</p> <p>Although President Xi has called for further economic liberalization, he has done little to advance privatization, the rule of law, or limited government. Instead, he has focused on cracking down on any attempts to create a&nbsp;free market in ideas and seeks to strengthen large SOEs — by requiring that they operate on a&nbsp;commercial basis (an old socialist dream) — and plans to retain them as the heart of China’s socialist market economy (see <a href="#ref029">Wei 2015</a>).</p> <p>At the 19th Party Congress in October 2017, President Xi linked the Chinese Dream of “great rejuvenation” to peaceful development:</p> <p>The dream of the Chinese people is closely connected with the dreams of the peoples of other countries; the Chinese Dream can be realized only in a&nbsp;peaceful international environment and under a&nbsp;stable international order. We must keep in mind both our internal and international imperatives, stay on the path of peaceful development, and continue to pursue a&nbsp;mutually beneficial strategy of opening up [<a href="#ref035">Xi 2017b</a>: 22].</p> <p id="ch10_Dorn-REF003">At the same meeting, he also declared: “Our efforts to build a&nbsp;country, government, and society based on the rule of law have been mutually reinforcing; the system of distinctively Chinese socialist rule of law has been steadily improved; and public awareness of the rule of law has risen markedly” (<a href="#ref035">Xi 2017b</a>: 3).<sup><a href="#ch10_Dorn-ref003">3</a></sup> The “socialist rule of law,” however, is far removed from a&nbsp;liberal rule of law that protects persons and property from the heavy hand of the state. China has a&nbsp;dismal record in building a&nbsp;legal system that uses law to advance human freedom rather than suppress it.</p> <p>The real challenge for China is to turn rhetoric into reality by allowing free expression. A&nbsp;competitive market in ideas would benefit Chinese culture by drawing on many minds — from both East and West. History has shown the failure of central planning and control in both the market for goods and the market for ideas. Silencing the voices of Chinese liberals — and blocking the transmission of Western ideas of limited government, separation of powers, and freedom under a&nbsp;just rule of law — will not “emancipate the mind” or create a&nbsp;harmonious society.</p> <p>If Xi Jinping and the CCP were really interested in emancipating the mind and letting “a hundred schools of thought contend,” they could begin by recognizing that, long before Adam Smith, Lao Tzu recognized the importance of the principle of noninterference (<em>wu wei</em>) and the idea of spontaneous order. In Lao Tzu’s classic <em>Tao Te Ching</em> (chap. 57), the sage‐​ruler says: “Through my non‐​action, people are spontaneously transformed.… Through my non‐​interfering, people spontaneously increase their wealth” (<a href="#ref004">Chang 1975</a>: 143).</p> <p>Chuang Tzu (Zhuangzi or Master Zhuang) also adhered to the idea that harmony is best achieved by leaving people alone to pursue their own interests. He believed that each individual is unique, seeks a&nbsp;better life, and is naturally inclined toward peace and order. He opposed forced order and adhered to the principle of freedom (<a href="#ref013">Fung 1952</a>: chap. 10). As Fung Yu‐​lan (<a href="#ref013">1952</a>: 229) writes, “Since good order is generally desired, one need only let things alone, and good order will result spontaneously. Thus Chuang Tzu, like Lao Tzu, advocated government through non‐​government.”</p> <p>The Taoist view of freedom and order is in sharp contrast to Xi Jinping’s notion that “freedom is the purpose of order” (<a href="#ref033">Xi 2015</a>). Lao Tzu and Chuang Tzu’s views are consistent with western views of market liberalism, in which freedom is the essential means to an emergent or spontaneous order — not the purpose of order. Nobel laureate economist James M. Buchanan best expressed that idea when he wrote: “The ‘order’ of the market emerges only from the process of voluntary exchange among the participating individuals” (<a href="#ref002">Buchanan 1982</a>: 5).</p> <p>If freedom is to result in order as opposed to chaos, there needs to be what F. A. Hayek called “rules of just conduct”:</p> <p>Under the enforcement of universal rules of just conduct, protecting a&nbsp;recognizable private domain of individuals, a&nbsp;spontaneous order of human activities of much greater complexity will form itself than could ever be produced by deliberate arrangement, and in consequence the coercive activities of government should be limited to the enforcement of such rules [<a href="#ref015">Hayek 1967</a>: 162].</p> <p id="ch10_Dorn-REF004">Like Hayek, the great legalist scholar Han Fei Tzu (3rd century, B.C.), thought that “order without direction” required firm rules to guide individual behavior. He accepted the Taoist notion of spontaneous order but emphasized that, given the nature of man, rules are necessary to make sure freedom leads to socially beneficial results by limiting the power of the state and ensuring equality under the law. Hence, he understood that without a&nbsp;genuine rule of law, China could not create a&nbsp;truly harmonious society.<sup><a href="#ch10_Dorn-ref004">4</a></sup></p> <p id="ch10_Dorn-REF005">Xi Jinping draws on the Legalist School to justify using the force of law to rule people. In doing so, he ignores the fact that Han Fei Tzu sought to integrate Taoism with a&nbsp;<em>liberal</em> legalism and viewed law as an instrument for enhancing — not repressing — freedom.<sup><a href="#ch10_Dorn-ref005">5</a></sup> It is therefore important to distinguish between “socialist rule of law” and Hayek’s “rules of just conduct,” which are designed to prevent injustice and support the emergence of a&nbsp;spontaneous order.</p> <p>China’s challenge is to move from market socialism to market liberalism, or what I&nbsp;call “market Taoism” (<a href="#ref008">Dorn 1998</a>). China needs to return to its ancient culture and cultivate the liberal ideas of thinkers such as Meng Tzu (Mencius), Lao Tzu, Chuang Tzu, and Han Fei Tzu — all of whom recognized the importance of freedom in promoting a&nbsp;harmonious social order.</p> <h2>New Opportunities in a&nbsp;Freer China</h2> <p>Opening to the outside world in 1978 has made both China and her trading partners better off. Replacing ideological struggle with peaceful development has created new opportunities for mutually beneficial exchanges. Individuals have much more personal freedom than under the disastrous policies of Mao Zedong. Nevertheless, economic reform has not resulted in a&nbsp;free market for ideas.</p> <p>In response to the suppression of personal liberties during the Mao era, the 1978 Constitution of the People’s Republic of China (PRC) guaranteed individuals “four big rights”: “Speak out freely, air their views fully, hold great debates, and write big‐​character posters” (Art. 45). However, those rights were removed from the PRC Constitution in 1980. The constitution has been amended since that time to recognize the right to private property and pay lip service to human rights. It continues to be the case that all rights are granted and controlled by the state; there are no inalienable rights.</p> <p>The absence of what Hayek (<a href="#ref014">1960</a>) called a “constitution of liberty” in China means there is still much uncertainty regarding the security of persons and property (see <a href="#ref022">Pilon 1998</a>). Removing that uncertainty would open new opportunities for the Chinese people. Indeed, if China embraced a&nbsp;genuine rule of law — that effectively limited the power of government, safeguarded private property rights broadly interpreted, and depoliticized economic relations — opportunities for mutually beneficial trade and investment would dramatically improve.</p> <p id="ch10_Dorn-REF006">Innovation and entrepreneurial activity would flourish in a&nbsp;system of well‐​defined and protected property rights, and financial markets would deepen in an atmosphere of trust and the free flow of information — just as they have in Hong Kong. In such an environment, the RMB would no doubt become a&nbsp;major reserve currency and even reach a “safe haven” status.<sup><a href="#ch10_Dorn-ref006">6</a></sup></p> <p>Whether those opportunities fully emerge will depend on political as well as economic reform. Both China and the United States need to support a&nbsp;rules‐​based international trading regime and respect the principle of nondiscrimination. A&nbsp;big first step would be for China to actualize the personal freedoms that are promised in its Constitution, beginning with a&nbsp;free market in ideas.</p> <h2>Why China Needs a&nbsp;Free Market for Ideas</h2> <p id="ch10_Dorn-REF007">In 1825, James Madison, the chief architect of the U.S. Constitution, wrote, “The diffusion of knowledge is the only guardian of true liberty.”<sup><a href="#ch10_Dorn-ref007">7</a></sup> Nearly a&nbsp;century later, Supreme Court Justice Oliver Wendell Holmes, in his dissenting opinion in <em>Abrams v. United States</em> (1919), argued for “free trade in ideas” and wrote: “The best test of truth is the power of the thought to get itself accepted in the competition of the market.” In 2012, Ronald Coase and Ning Wang introduced the term “market for ideas” (<em>sixian shichang</em>) to the Chinese. They argued:</p> <p>The lack of a&nbsp;free market for ideas … has become the most restrictive bottleneck in China’s economic and social development. Ever since the start of economic reform, the Chinese government has been persistently calling for the “emancipation of the mind,” but nothing is more effective than an active market for ideas in freeing people’s minds [<a href="#ref007">Coase and Wang 2012</a>: 199].</p> <p>A country that does not allow its people to speak freely loses legitimacy and trust. People cannot be confident that the discretionary power of government will not be used against them for even the slightest criticism of the regime. When the ruling party has a&nbsp;monopoly of power and there is no opportunity for honest feedback from the people or press, then the probability of permanent errors is high. That is why Ning Wang (<a href="#ref028">2017</a>: 149) writes: “The ultimate success of China’s search for economic prosperity, cultural renaissance, and a ‘peaceful rise’ depends, in large part, on whether a&nbsp;free market for ideas can reemerge and flourish in China.”</p> <p>Zhang Weiying, a&nbsp;professor of economics at the National School of Development at Peking University, has argued that in order to understand institutional change, one must go beyond simple self‐​interest models and examine the role of ideas and leadership (<a href="#ref037">Zhang 2015</a>: 4). In the case of China, Zhang (<a href="#ref037">2015</a>: 15) notes: “Without the right ideas and strong leadership, it would have been impossible for the openness policy to succeed.” He gives many examples of the role of ideas and leadership since 1978, and he points to “six traps of wrong ideas” that must be rectified if China is to become “a liberal society.”</p> <p>One of those traps is to think that “economic liberalization can continue without political reform.” That idea is wrong because it ignores the fact that, “as people have wealth to protect and innovation becomes crucial for growth, the rule of law becomes a&nbsp;necessity.” Moreover, after 40&nbsp;years of economic reform but little political reform, “the Chinese government needs new legitimacy for ruling the country.” In particular, “If the government cannot protect people’s basic human rights, including the freedom of speech, press, and religion, its legitimacy will be seriously challenged” (<a href="#ref037">Zhang 2015</a>: 30–31).</p> <p>Another wrong idea is that “the status quo is good for vested interests.” That may be true in the short run, according to Zhang, but not in the long run. The reason is evident:</p> <p>While the vested interests enjoy privileges, they lack the basic human rights such as free speech and personal security, just like other ordinary people. Even though privileges give them better opportunities to be wealthy and powerful for the time being, the lack of human rights implies that they are always at political risk — neither their personal freedom nor their property is secure. Under the current system, anyone can be arrested without going through a&nbsp;legal procedure, regardless of seniority [<a href="#ref037">Zhang 2015</a>: 31–32].</p> <p id="ch10_Dorn-REF008">China’s future will depend on replacing wrong ideas with correct ideas — that is, those that are consistent with the pursuit of happiness under a&nbsp;just rule of law that limits the power of the state and protects individual rights.<sup><a href="#ch10_Dorn-ref008">8</a></sup> There are many good ideas in the road map laid out at the Third Plenum of the CCP’s 18th National Congress. However, as Zhang (<a href="#ref037">2015</a>: 38) notes: “If people are not allowed to freely debate how to reform the political system, then it will be impossible to develop the right ideas to implement this roadmap.” By cracking down on the market for ideas, President Xi is missing the opportunity for real reform.</p> <p>The value of free speech is that it allows people to improve institutions by pointing out weaknesses, which can then lead to improvements: “Transparency of public institutions, the right to free expression, and an unfettered media are all necessary for building confidence. They do this not by emphasizing strengths, but by making weaknesses and faults in the system obvious” (<a href="#ref023">Prasad 2017</a>: 156). Chen Zhiwu, a&nbsp;professor of finance at the University of Hong Kong, agrees: “A free press can not only provide independent information, but also act as a&nbsp;corrective mechanism for the economy in a&nbsp;way that the government cannot. Thus, media freedom is not only politically necessary, but also good for growth and job creation” (<a href="#ref005">Chen 2005</a>).</p> <p>The free flow of information is particularly important in the service sector, which deals with intangibles and requires complex contracts that rely on timely, accurate, and diverse information. Without an open market for ideas, the development of financial and other services will be hampered. Confidence and trust are important elements in any transaction but particularly so in financial transactions. As Chen (<a href="#ref005">2005</a>) argues,</p> <p>Press freedom facilitates service development by reducing information asymmetries among transacting parties, bringing confidence to the marketplace. Unbiased information enhances trust, which is fundamental to the deepening of a&nbsp;service market.… Censorship limits the supply of useful information and distorts the information available in the marketplace, thereby hindering the development of markets — especially financial markets.</p> <p>China benefits from having access to Hong Kong’s financial markets based on the rule of law, an independent judiciary, and a&nbsp;free market in ideas. If China is to advance its own service sector, it would do well to learn from Hong Kong.</p> <p>A free market for ideas is important for economic development but even more important for human progress. In the words of Nobel laureate Liu Xiaobo: “Freedom of expression is the foundation of human rights, the source of humanity, and the mother of truth. To strangle freedom of speech is to trample on human rights, stifle humanity and suppress truth” (<a href="#ref019">Liu 2009</a>).</p> <h2>Conclusion</h2> <p>China has accomplished much in its 40&nbsp;years of reform and opening to the outside world, but it has a&nbsp;long way to go in terms of both economic and political freedom. Beijing and the CCP have placed stability above freedom, but without freedom there can be no lasting stability. The lack of limited government under a&nbsp;genuine rule of law and the absence of a&nbsp;free market in ideas endanger China’s future development.</p> <p>The challenges facing China include hostility over its trade policies, which restrict market access, favor SOEs, and compromise intellectual property rights; a&nbsp;weak legal system that favors special interests and is dominated by the CCP; slowing growth and rising debt; and a&nbsp;constitution that makes empty promises to safeguard human rights and free expression.</p> <p id="ch10_Dorn-REF009">Overcoming those and related challenges will determine the range of opportunities open to the Chinese people. Especially important will be whether China relaxes its strict controls on the free flow of information and creates a&nbsp;free market for ideas.<sup><a href="#ch10_Dorn-ref009">9</a></sup> The crackdown on think tanks like the Unirule Institute, which stands for limited government and the rule of law, is in stark contrast to Hong Kong, which supports a&nbsp;free market in both goods and ideas. That is why Hong Kong, with its big market and small government, is out‐​competing the mainland in the provision of financial services.</p> <p>The main lesson for China’s future development is clear: “When the market for goods and the market for ideas are together in full swing — each supporting, augmenting and strengthening the other — human creativity and happiness stand the best chance to prevail” (<a href="#ref007">Coase and Wang 2012</a>: 207).</p> <p>President Xi has argued that China</p> <p>must have the determination to get rid of all outdated thinking and ideas and all institutional ailments, and to break through the blockades of vested interests. We should draw on the achievements of other civilizations, develop a&nbsp;set of institutions that are well conceived, fully built, procedure based, and efficiently functioning, and do full justice to the strengths of China’s socialist system [<a href="#ref035">Xi 2017b</a>: 18].</p> <p>He has also said, “We need to make use of the great wisdom accumulated by the Chinese nation over the last 5,000&nbsp;years” (cited in Page 2015).</p> <p>Opening the door to the study of Western and Chinese liberalism — especially the ideas of spontaneous order, limited government, and the rule of law — would be a&nbsp;giant step toward ensuring “peaceful development” and realizing the “Chinese dream” of social and economic harmony.</p> <h2>References</h2> <p id="ref001">Ang, Y. Y. (2016) <em>How China Escaped the Poverty Trap</em>. Ithaca, N.Y.: Cornell University Press.</p> <p id="ref002">Buchanan, J. M. (1982) “Order Defined in the Process of Its Emergence.” <em>Literature of Liberty</em> 5 (4): 5–18. Available at <a href="http://oll.libertyfund.org/titles/liggio-literature-of-liberty-winter-1982-vol-5-no-4">http://​oll​.lib​er​ty​fund​.org/​t​i​t​l​e​s​/​l​i​g​g​i​o​-​l​i​t​e​r​a​t​u​r​e​-​o​f​-​l​i​b​e​r​t​y​-​w​i​n​t​e​r​-​1​9​8​2​-​v​o​l​-​5​-no-4</a>.</p> <p id="ref003">Buckley, C. (2018) “In Beijing, Doors Shut on a&nbsp;Bastion of Independent Ideas.” <em>New York Times</em> (July 11).</p> <p id="ref004">Chang, C. Y. (1975) <em>Tao: A&nbsp;New Way of Thinking.</em> A&nbsp;Translation of the <em>Tao Te Ching</em> with an Introduction and Commentaries. New York: Perennial Library/​Harper and Row.</p> <p id="ref005">Chen, Z. W. (2005) “A Free Press Could Help China’s Economy.” <em>Financial Times</em> (September 20).</p> <p id="ref006">Chinese Communist Party (CCP) Central Committee (2013) “Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform.” Adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China (November 12): <a href="http://www.china.org.cn/china/third_plenary_session/2014-01/16/content_31212602.htm">www.china.org.cn/china/third_plenary_session/2014–01/16/content_31212602.htm</a>.</p> <p id="ref007">Coase, R., and Wang, N. (2012) <em>How China Became Capitalist</em>. New York: Palgrave Macmillan.</p> <p id="ref008">Dorn, J. A. (1998) “China’s Future: Market Socialism or Market Taoism?” <em>Cato Journal</em> 18 (1): 131–46.</p> <p id="ref009">__________ (2015) “Ideal Was ‘Great Good Government.’” <em>Financial Times</em> (August 24): 10.</p> <p id="ref010">__________ (2016) “China’s Challenge: Expanding the Market, Limiting the State.” <em>Man and the Economy</em> 3 (1): 23–41.</p> <p id="ref011">__________ (2019) “The Genesis and Evolution of China’s Economic Liberation.” In B. Powell (ed.) <em>Economic Freedom and Prosperity: The Origins and Maintenance of Liberalization,</em> 170–96. New York: Routledge.</p> <p id="ref012">Fu, J. (2005) “Economists Honoured for Role in Reform.” <em>China Daily</em> (March 24).</p> <p id="ref013">Fung, Y. L. (1952) <em>A&nbsp;History of Chinese Philosophy.</em> <em>Vol. 1: The Period of the Philosophers</em>, 2nd ed. Translated by D. Bodde. Princeton, N.J.: Princeton University Press. Originally published in Chinese in 1931 by the Shen Chou Publishing Company, Shanghai.</p> <p id="ref014">Hayek, F. A. (1960) <em>The Constitution of Liberty</em>. Chicago: University of Chicago Press.</p> <p id="ref015">__________ (1967) “The Principles of a&nbsp;Liberal Social Order.” In <em>Studies in Philosophy, Politics, and Economics</em>, pp. 160–77. Chicago: University of Chicago Press.</p> <p id="ref016">Hilton, I. (2015) “Ancient Origins of Xi’s Harsh Brand of Justice.” <em>Financial Times</em> (August 17): 7.</p> <p id="ref017">Lardy, N. R. (2019) <em>The State Strikes Back: The End of Economic Reform in China</em>? Washington: Peterson Institute for International Economics.</p> <p id="ref018">Li, K. Q. (2015) “Full Transcript of Premier’s Press Conference.” Available at <a href="http://english.gov.cn/premier/news/2015/03/15/content_281475071837425.htm">http://​eng​lish​.gov​.cn/​p​r​e​m​i​e​r​/​n​e​w​s​/​2​0​1​5​/​0​3​/​1​5​/​c​o​n​t​e​n​t​_​2​8​1​4​7​5​0​7​1​8​3​7​4​2​5.htm</a>. The press conference followed the Third Session of the 12th National People’s Congress, March 15, 2015.</p> <p id="ref019">Liu, X. B. (2009) “I Have No Enemies: My Final Statement” (December 23). Also see “Nobel Lecture in Absentia” (December 10, 2010): <a href="http://www.nobelprize.org/prizes/peace/2010/xiaobo/lecture">www​.nobel​prize​.org/​p​r​i​z​e​s​/​p​e​a​c​e​/​2​0​1​0​/​x​i​a​o​b​o​/​l​e​cture</a>.</p> <p id="ref020">Padover, S. K., ed. (1953) <em>The Complete Madison: His Basic Writings</em>. New York: Harper &amp;&nbsp;Brothers.</p> <p id="ref021">Page, J. (2015) “In China Confucius Makes a&nbsp;Comeback.” <em>Wall Street Journal</em> (September 21): A1.</p> <p id="ref022">Pilon, R. (1998) “A Constitution of Liberty for China.” In J. A. Dorn (ed.) <em>China in the New Millennium: Market Reforms and Social Development</em>, 333–53. Washington: Cato Institute.</p> <p id="ref023">Prasad, E. (2017) <em>Gaining Currency: The Rise of the Renminbi.</em> New York: Oxford University Press.</p> <p id="ref024">Schwartz, B. I. (1985) <em>The World of Thought in Ancient China.</em> Cambridge, Mass.: Belknap/​Harvard University Press.</p> <p id="ref025">Sheng, H. (2017) “Unirule Announcement on the Website Incident.” Unirule Memorandum (January 24). Available at <a href="http://www.atlasnetwork.org/assets/uploads/misc/20170124_Unirule_announcement_on_website_incident.pdf">www​.atlas​net​work​.org/​a​s​s​e​t​s​/​u​p​l​o​a​d​s​/​m​i​s​c​/​2​0​1​7​0​1​2​4​_​U​n​i​r​u​l​e​_​a​n​n​o​u​n​c​e​m​e​n​t​_​o​n​_​w​e​b​s​i​t​e​_​i​n​c​i​d​e​n​t.pdf</a>.</p> <p id="ref026">Smith, A. ([1776] 1937) <em>The Wealth of Nations</em>. Edited by E. Cannan. New York: The Modern Library (Random House).</p> <p id="ref027">Tatlow, D. K. (2014) “Xi Jinping on Exceptionalism with Chinese Characteristics.” <em>New York Times</em> (October 14). Available at <a href="http://sinosphere.blogs.nytimes.com/2014/10/14/xi-jinping-on-exceptionalism-with-chinese-characteristics">http://​sinos​phere​.blogs​.nytimes​.com/​2​0​1​4​/​1​0​/​1​4​/​x​i​-​j​i​n​p​i​n​g​-​o​n​-​e​x​c​e​p​t​i​o​n​a​l​i​s​m​-​w​i​t​h​-​c​h​i​n​e​s​e​-​c​h​a​r​a​c​t​e​r​i​stics</a>.</p> <p id="ref028">Wang, N. (2017) “China’s Future and the Determining Role of the Market for Ideas.” <em>Cato Journal</em> 37 (1): 149–65.</p> <p id="ref029">Wei, L. L. (2015) “China to Overhaul State Sector.” <em>Wall Street Journal</em> (September 14): A1.</p> <p id="ref030">Wen, J. B. (2003) “Full Text of Premier Wen’s Speech at Harvard.” <em>People’s Daily</em> (December 12). Available at <a href="http://en.people.cn/200312/12/eng20031212_130267.shtml">http://​en​.peo​ple​.cn/​2​0​0​3​1​2​/​1​2​/​e​n​g​2​0​0​3​1​2​1​2​_​1​3​0​2​6​7​.​shtml</a>.</p> <p id="ref031">Wu, J. L. (2005) <em>Understanding and Interpreting Chinese Economic Reform</em>. Boston: Thompson/​South‐​Western.</p> <p id="ref032">Xi, J. P. (2013) Keynote Speech at the First Session of the 12th National People’s Congress (March 17). See H. Whiteman, “China Leaders Vow Fairness, Frugality as Nation Strives for ‘Chinese Dream.’” CNN (March 17): <a href="http://www.cnn.com/2013/03/17/world/asia/china-xi-li-npc-address/index.html">www​.cnn​.com/​2​0​1​3​/​0​3​/​1​7​/​w​o​r​l​d​/​a​s​i​a​/​c​h​i​n​a​-​x​i​-​l​i​-​n​p​c​-​a​d​d​r​e​s​s​/​i​n​d​e​x​.html</a>.</p> <p id="ref033">__________ (2015) “In Rare Interview, Xi Discusses Ties with the U.S.” <em>Wall Street Journal</em> (September 22): A11.</p> <p id="ref034">__________ (2017a) “Jointly Shoulder Responsibility of Our Times, Promote Global Growth.” Keynote Speech, Opening Session, 2017 World Economic Forum Annual Meeting, Davos, Switzerland (January 17). Available at <a href="https://america.cgtn.com/2017/01/17/full-text-of-xi-jinping-keynote-at-the-world-economic-forum">https://​amer​i​ca​.cgtn​.com/​2​0​1​7​/​0​1​/​1​7​/​f​u​l​l​-​t​e​x​t​-​o​f​-​x​i​-​j​i​n​p​i​n​g​-​k​e​y​n​o​t​e​-​a​t​-​t​h​e​-​w​o​r​l​d​-​e​c​o​n​o​m​i​c​-​forum</a>.</p> <p id="ref035">__________ (2017b) “Secure a&nbsp;Decisive Victory in Building a&nbsp;Moderately Prosperous Society in All Respects and Strive for the Great Success of Socialism with Chinese Characteristics for a&nbsp;New Era.” Speech delivered at the 19th National Congress of the Communist Party of China (October 18): <a href="http://www.xinhuanet.com/english/download/Xi_Jinping’s_report_at_19th_CPC_National_Congress.pdf">www.xinhuanet.com/english/download/Xi_Jinping’s_report_at_19th_CPC_National_Congress.pdf</a>.</p> <p id="ref036">__________ (2017c) <em>The Law‐​Based Governance of China</em>. Beijing: Central Compilation and Translation Press.</p> <p id="ref037">Zhang, W. Y. (2015) “The Power of Ideas and Leadership in China’s Transition to a&nbsp;Liberal Society.” <em>Cato Journal</em> 35 (1): 1–40.</p> <p></p> <p><a id="ch10_Dorn-ref001" href="#ch10_Dorn-REF001"><sup>1</sup></a>See <a href="https://rsf.org/en/ranking">https://​rsf​.org/​e​n​/​r​a​nking</a>.</p> <p><a id="ch10_Dorn-ref002" href="#ch10_Dorn-REF002"><sup>2</sup></a>As early as 1956, Gu Zhun, an economist working at the Chinese Academy of Sciences, recognized that, if China was to improve the allocation of its scarce resources, the market pricing system would have to supplant central planning (<a href="#ref031">Wu 2005</a>: 37–38).</p> <p><a id="ch10_Dorn-ref003" href="#ch10_Dorn-REF003"><sup>3</sup></a>For a&nbsp;detailed examination of Xi Jinping’s views on a&nbsp;socialist rule of law for China, see Xi (<a href="#ref036">2017c</a>).</p> <p><a id="ch10_Dorn-ref004" href="#ch10_Dorn-REF004"><sup>4</sup></a>For a&nbsp;discussion of Han Fei’s ideas and how they relate to “Great Good Government,” see Dorn (<a href="#ref010">2016</a>: 34–36, and the references therein). Also, see Schwartz (<a href="#ref024">1985</a>: 332–33, 341–45).</p> <p><a id="ch10_Dorn-ref005" href="#ch10_Dorn-REF005"><sup>5</sup></a>Han Fei Tzu is often wrongly viewed as an authoritarian of the Legalist School rather than an advocate of market liberalism under a&nbsp;rule of law that prevents injustice. For example, Didi Kirsten Tatlow (<a href="#ref027">2014</a>), in an article in the <em>New York Times</em>, writes: “Mr. Xi has drawn on the teachings of Han Fei, the Legalist philosopher who advocated rule with an iron fist.” Also see Hilton (<a href="#ref016">2015</a>), who argues that Han Fei “saw the law not as a&nbsp;guarantee of justice but as a&nbsp;coercive instrument in a&nbsp;state in which the moral standards of the ruler were irrelevant.” For a&nbsp;counterargument, see Dorn (<a href="#ref009">2015</a>).</p> <p><a id="ch10_Dorn-ref006" href="#ch10_Dorn-REF006"><sup>6</sup></a>Eswar Prasad (<a href="#ref023">2017</a>: chap. 7) has argued that, given China’s current institutions, the goal of making the RMB a&nbsp;safe haven currency is a “mirage.”</p> <p><a id="ch10_Dorn-ref007" href="#ch10_Dorn-REF007"><sup>7</sup></a>Letter to George Thompson, June 30, 1825 (see <a href="#ref020">Padover 1953</a>: 337).</p> <p><a id="ch10_Dorn-ref008" href="#ch10_Dorn-REF008"><sup>8</sup></a>Zhang (<a href="#ref037">2015</a>: 36) states: “The future of China’s reform will depend on the kind of ideas and leadership the new leaders, particularly General Secretary Xi Jinping, have. To succeed in a&nbsp;peaceful transition to a&nbsp;liberal society, China must get rid of the wrong ideas.” To do so, China needs “to create a&nbsp;marketplace for ideas. It is the free competition in the academic market and the debate of different opinions, beliefs, theories, and ideologies that produce new and right ideas.”</p> <p><a id="ch10_Dorn-ref009" href="#ch10_Dorn-REF009"><sup>9</sup></a>Yuen Yuen Ang (<a href="#ref001">2016</a>: 249) has argued that “China needs to find new sources of adaptability and innovation” to realize “the immense creative potential of Chinese society” — and that “academic freedom is a&nbsp;clear place to start.”</p> </div> Tue, 26 Feb 2019 03:00:00 -0500 James A. Dorn https://www.cato.org/cato-journal/winter-2019/chinas-future-development-challenges-opportunities