11 (Author at Cato Institute) https://www.cato.org/ en 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 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 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="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="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 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="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 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="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="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>. <br /></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"> <p><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="https://www.cato.org/sites/cato.org/files/styles/pubs/public/wp-content/uploads/a68b0215bb50a0e9da397f9eee4086ad.jpg?itok=Av90Frhz" alt="Media Name: a68b0215bb50a0e9da397f9eee4086ad.jpg" typeof="Image" class="component-image" /></p></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. <br /><br /><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. <br /><br /><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.” <br /><br /><br /> Other protected rights include: <br /></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> </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). <br /><br /><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 /><br /><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. <br /><br /><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. <br /><br /><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. <br /><br /><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. <br /><br /><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. <br /><br /><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. <br /><br /><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. <br /><br /><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). <br /><br /><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. </p> <p>&#13;<br /></p> <hr /><br /><br /><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). <br /><p>&#13;<br /><br /><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.” <br /></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 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="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 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="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 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="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.libertyfund.org/titles/liggio-literature-of-liberty-winter-1982-vol-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​.chi​na​.org​.cn/​c​h​i​n​a​/​t​h​i​r​d​_​p​l​e​n​a​r​y​_​s​e​s​s​i​o​n​/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 Irving Fisher’s Search for Stable Money: What We Can Learn https://www.cato.org/blog/irving-fishers-search-stable-money-what-we-can-learn James A. Dorn <p>Irving Fisher’s classic treatise, <em>The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises</em> (1911), still offers valuable insights regarding monetary reform. This post examines some of Fisher’s insights and draws some lessons for Fed policy.&#13;<br /> &#13;</p> <h4>The Importance of Stable Money</h4> <p>Fisher recognized “the evils of monetary instability”—that is, “periodic changes in the level of prices, producing alternate crises and depressions of trade.”  He argued that “only by knowledge, both of the principles and of the facts involved, can such fluctuations . . . be prevented or mitigated, and only by such knowledge can the losses which they entail be avoided or reduced” (Fisher 1912: ix). <a name="_ftnref1" href="#_ftn1" id="_ftnref1">[1]</a>&#13;<br /> &#13;<br /> The main principles that guided Fisher’s work were embodied in the quantity theory of money and the theory of monetary disequilibrium.  The former held that, ceteris paribus, the purchasing power of money (the reciprocal of the price level) depends on the quantity of money relative to real output (trade).  If the economy is at full employment and the velocity of money is stable, then the purchasing power of money will be inversely related to the stock of money.  If money moves in line with trade and velocity is stable, then monetary equilibrium will prevail and the value of money will also be stable (see Fisher 1912: 320).&#13;<br /> &#13;<br /> When Fisher wrote <em>The Purchasing Power of Money</em>, the United States was still on the classical gold standard; there was no central bank.  In his book, he defined money as “<em>what is generally acceptable in exchange for goods</em>” (p. 8).  He recognized that “money never bears interest except in the sense of creating convenience in the process of exchange” and that “this convenience is the special service of money and offsets the apparent loss of interest involved in keeping it in one’s pocket instead of investing” (p. 9).&#13;<br /> &#13;<br /> Fisher also importantly recognized that “money itself belongs to a general class of property rights” known as “currency” or “circulating media.”  More specifically, “currency includes any type of property right which, whether generally acceptable or not, does actually, for its chief purpose and use, serve as a means of exchange” (p. 10).  While Fisher classified bank notes as money <em>and</em> circulating media, he viewed checkable bank deposits as currency, not money in the strict sense (p. 11).&#13;<br /> &#13;<br /> “Primary money” referred to commodity money (gold coin at the time), while “fiduciary money” (notably bank notes) referred to money whose value depended “on the confidence that the owner can exchange it for other goods” (ibid.).  “The chief quality of fiduciary money,” wrote Fisher, “is its redeemability in primary money, or else its imposed character of legal tender” (p. 12).&#13;<br /> &#13;<br /> Fisher refined the quantity theory of money to take account of monetary disequilibrium and used statistical methods to test the theory against historical data.  Like his contemporaries, he understood that the fundamental cause of business fluctuations was erratic money.&#13;<br /> &#13;</p> <h4><strong>The Theory of Monetary Disequilibrium </strong></h4> <p>The main tenets of the theory of monetary disequilibrium were well known to Fisher and Harry Gunnison Brown, who assisted in writing <em>The Purchasing Power of Money</em> (see chap. 4). Clark Warburton summarized those tenets in his monumental book, <em>Depression, Inflation, and Monetary Policy</em> (1966).  They are listed in Table 1.&#13;<br /> &#13;</p> <table> <tbody> <tr> <td><em>TABLE 1</em><em><strong>Assumptions of the Theory of Monetary Disequilibrium</strong></em></td> </p> </tr> <tr> <td><em>1. A change in the level of prices is a process which takes a period of time, and affects prices of various items sequentially rather than simultaneously.</em></td> </p> </tr> <tr> <td><em>2. Some prices are greatly influenced by custom or contract and move less readily than other prices; specifically, wages and contractual elements in business costs tend to be sluggish relative to price of output.</em></td> </p> </tr> <tr> <td><em>3. These differential movements of prices and also prospective further changes in prices have significant effects upon business profits and prospects and hence upon business plans, especially with respect to investment decisions and to holdings of cash relative to receipts and expenditures.</em></td> </p> </tr> <tr> <td><em>4. The economy is not static; more specifically, we live in a world where population is growing, technological developments are increasing production per worker, and other developments tend to increase the volume of transactions (in quantity terms) relative to the output of final products.</em></td> </p> </tr> <tr> <td><em>5. As a result of the foregoing and of the stability of customs (such as the periodicity of income payments) which affect the rate of circulation of money, the economy needs for equilibrium a continuous increase in the quantity of money.</em></td> </p> </tr> <tr> <td><em>6. It is theoretically possible for monetary disequilibrium to persist for months or years, and observations indicate that many such situations have occurred.</em></td> </p> </tr> <tr> <td><em>7. The actual quantity of money reflects primarily the behavior of banks or of a government treasury issuing circulating medium; and the nature of banks is such that they have a tendency to carry forward the expansion of money to the limit permitted by interbank relationships and the laws under which they operate.</em></td> </p> </tr> <tr> <td><em>8. In the United States, subsequent to establishment of the national banking system, the chief restraint on the banks, limiting their expansion and occasionally necessitating contraction, is the amount of legal reserves.</em></td> </p> </tr> <tr> <td><em>9. The impact of monetary disequilibrium is intensified by sequential changes in the rate of circulation of money [i.e., the velocity of money].</em></td> </p> </tr> <tr> <td><em>10. Changes in the quantity of money which are not consonant with the rate of expansion needed for equilibrium also change the amount of funds available in the money loan market; thus they constitute the force which produces a departure of the market rate of interest from the equilibrium rate, and consequently disturbs property values and mutual adjustment of saving and investment decisions.</em></td> </p> </tr> <tr> <td><em>11. If the force impinging on the quantity of money, such as the state of bank reserves, can be observed ahead of change in the quantity of money, or is itself of such character as to have a direct effect on the securities market, the disturbance to property values and to investment decisions may begin ahead of the monetary disequilibrium as </em><em>observed in statistical data.</em></td> </p> </tr> </tbody> </table> <p>Source: Warburton (1966: 28–29).&#13;<br /> &#13;<br /> Propositions 10 and 11 in Table 1 were of particular importance to Fisher. He argued that, while “it is generally recognized that the collapse of bank credit brought about by loss of confidence is the essential fact of every crisis,” it “is not generally recognized . . . that this loss of confidence . . . is a consequence of a belated adjustment in the interest rate” (p. 66). His purpose in writing <em>The Purchasing Power of Money</em> was to emphasize that “the monetary causes [of crises] are the most important <em>when taken in connection with the maladjustments in the rate of interest</em>. The other factors often emphasized are merely effects of this maladjustment” (ibid.).&#13;<br /> &#13;<br /> In seeing monetary instability as the chief factor in business fluctuations, Fisher was following the tradition going back to David Hume whereby classical economic theory consisted of two parts: (1) a theory of equilibrium whereby market forces would restore relative wages and prices to their equilibrium levels, and (2) a theory of disequilibrium in which there is either an excess demand for, or supply of, money.  Although the theory of monetary disequilibrium—also known as the “dynamic theory of money”—was widely recognized and developed by the first quarter of the 20th century, the ascent of Keynesian economics diverted attention from that body of knowledge.<a name="_ftnref2" href="#_ftn2" id="_ftnref2"><sup>[2]</sup></a>&#13;<br /> &#13;<br /> Fisher argued that an excess supply of money will not immediately be reflected in a proportionate rise in the price level. The corresponding rise in the supply of bank credit will lower the rate of interest in the short run until inflation is fully anticipated, at which point the nominal interest rate will rise and the expected profitability of investment fall. During the transition to a new equilibrium, bankruptcies will occur and unemployment rise (because of sluggish adjustment of relative wages and prices).<a name="_ftnref3" href="#_ftn3" id="_ftnref3"><sup>[3]</sup></a>&#13;<br /> &#13;<br /> In looking at the case of “overinvestment,” Fisher notes:&#13;<br /> &#13;</p> <blockquote><p>The stockholder and enterpriser generally are beguiled by a vain reliance on the stability of the rate of interest, and so they overinvest. It is true that for a time they are gaining what the bondholder is losing and are therefore justified in both spending and investing more than if prices were not rising; and at first they prosper. But sooner or later the rate of interest rises above what they had reckoned on, and they awake to the fact that they have embarked on enterprises which cannot pay these high rates [p. 66].</p> </blockquote> <p>He goes on to explain that “a curious thing happens: borrowers, unable to get easy loans, blame the high rate of interest for conditions which were really due to the fact that <em>the previous rate of interest was not high enough</em>. Had the previous rate been high enough, the borrowers never would have overinvested (p. 67, emphasis added).&#13;<br /> &#13;<br /> In sum, the importance of erratic money in Fisher’s theory of business fluctuations and his recognition that transition periods could last a considerable time make his theory part and parcel of the dynamic theory of money (see Warburton 1966: 4–5).  Fisher held that, in studying business fluctuations, one cannot ignore variations in the quantity of money relative to output. That is why he chose those variations as the  “chief factor” in his study of commercial crises (Fisher 1911: 55).  Moreover, he argued that “periods of transition are the rule and those of equilibrium the exception, [so that] the mechanism of exchange is almost always in a dynamic rather than a static condition” (p. 71). One of his major contributions was a rigorous discussion of “maladjustments in the rate of interest” in the process of adjustment to a new equilibrium by distinguishing between nominal and real rates of interest.&#13;<br /> &#13;</p> <h4><strong>Proposed Reforms and Method of Persuasion</strong></h4> <p>Fisher considered a number of reforms designed to stabilize the long-run price level, and thus maintain the purchasing power of money. They included changes in monetary law to:&#13;<br /> &#13;</p> <ul> <li>“Make inconvertible paper the standard money, and to regulate its quantity.”</li> <li>“Regulate the supply of metallic money by a varying seigniorage charge.”</li> <li>“Issue paper money, redeemable on demand, not in fixed amounts of the basic precious metal, but in varying amounts, so calculated as to keep the level of prices unvarying.”<a name="_ftnref4" href="#_ftn4" id="_ftnref4">[4]</a></li> <li>“Adopt the gold-exchange standard combined with a tabular standard” [p. 348].<a name="_ftnref5" href="#_ftn5" id="_ftnref5">[5]</a></li> <p>&#13; </p> </ul> <p>In proposing any monetary reform designed to safeguard the long-run value of money, Fisher believed that “the first step” should be “to persuade the public, and especially the business public, to study the problem of monetary stability” (ibid.) When the time is ripe for reform, the intellectual groundwork will be ready for policymakers and the public to take the appropriate action. The fact that certain monetary reforms may not be politically feasible at the moment should not dissuade scholars from contemplating reforms that may improve the monetary arrangement and benefit society.  As Fisher wrote,&#13;<br /> &#13;</p> <blockquote><p>The necessary education once under way, it will then be time to consider schemes for regulating the purchasing power of money in the light of public and economic conditions of the time. All this, however, is in the future. For the present there seems nothing to do but to state the problem and the principles of its solution in the hope that what is now an academic question may, in due course, become a burning issue [ibid.].</p> </blockquote> <p>As noted earlier, Fisher saw “the problem of stability and dependability in the purchasing power of money” as “the most serious problem” (p. 321).  Variations in the price level can occur due to (1) “transitional periods constituting credit cycles” and (2)  “secular variations” due to “incidents of industrial changes.”  Both those disturbances can be mitigated, according to Fisher, by increasing “knowledge as to prospective price levels.”  If the public <em>anticipates</em> changes in the price level, then those changes will be reflected in nominal interest rates: “a foreknown change in price levels might be so taken into account in the rate of interest as to neutralize its evils” (ibid.).&#13;<br /> &#13;<br /> Fisher summed up by writing:&#13;<br /> &#13;</p> <blockquote><p>While we cannot expect our knowledge of the future ever to become so perfect as to reach this ideal, viz. compensations for every price fluctuation by corresponding adjustments in the rate of interest—nevertheless every increase in our knowledge carries us a little nearer that remote ideal [ibid.].</p> </blockquote> <p>Giving people better information, however, may not change their behavior if they have a vested interest in maintaining the status quo. Thus, Fisher observes:&#13;<br /> &#13;</p> <blockquote><p>The prejudice of business men against the variability of, and especially against a rise of the rate of interest, probably stands in the way of prompt adjustment in that rate and helps to aggravate the far more harmful variability in the level of prices and its reciprocal, the purchasing power of money [p. 322].</p> </blockquote> <p>Nevertheless, Fisher thought that “while there is much to be hoped for from a greater foreknowledge of price [level] changes, a lessening of the price changes themselves would be still more desirable” (p. 323).&#13;<br /> &#13;</p> <h4><strong>The Search for Stable Money</strong></h4> <p>The quantity theory of money attributes price-level changes mainly to “changes in money and trade.”  As Fisher remarks,&#13;<br /> &#13;</p> <blockquote><p>There has been for centuries, and promises to be for centuries to come, a race between money and trade. On the results of that race depends to some extent the fate of every business man. The commercial world has become more and more committed to the gold standard through a series of historical events having little if any connection with the fitness of that or any other metal to serve as a <em>stable</em> standard. So far as the question of monetary stability is concerned, it is not too much to say that we have hit upon the gold standard by accident [pp. 323–24].</p> </blockquote> <p><a name="_ftn1" href="https://www.alt-m.org/2019/01/17/irving-fishers-search-for-stable-money-what-we-can-learn/#_ftnref1" id="_ftn1"></a>While there is little support for a gold standard at present, that monetary regime was taken as a given in 1911, and there seemed to be little chance of replacing it:&#13;<br /> &#13;</p> <blockquote><p>Now that we have adopted a gold standard, it is almost as difficult to substitute another as it would be to establish the Russian railway gauge or the duodecimal system of numeration. And the fact that the question of a monetary standard is today so much an international question makes it all the more difficult” [p. 324].</p> </blockquote> <p>What is of interest here is that Fisher did “not attempt to offer any <em>immediate </em>solution of this great world problem of finding a substitute for gold.”   Rather, he reasoned that “before a substitute for gold can be found, there must be much investigation and education of the public” (ibid.).  His strategy was&#13;<br /> &#13;</p> <blockquote><p>to call attention to the necessity for this investigation and education, to examine such solutions as have been already proposed and, very tentatively, to make a suggestion which may possibly be acted upon at some future time, when, through the diffusion of knowledge, better statistics, and better government, the time shall become ripe [ibid.].</p> </blockquote> <p>Fisher reviews a number of proposals for fundamental monetary reform in chapter 13, including “honest government regulation of the money supply” aimed at price-level stability. A simple scheme would be for the monetary authority to issue  “inconvertible paper money in quantities so proportioned to increase of business that the <em>total amount of currency in circulation, multiplied by its rapidity</em>, would have the same relation to the total business at one time as at any other time.” He argued that, “if the confidence of citizens were preserved, and this relation were kept, the problem [of achieving a stable price level] would need no further solution” (p. 329, emphasis added).&#13;<br /> &#13;<br /> However, Fisher rejects this proposed monetary rule, because “sad experience teaches that irredeemable paper money, while theoretically capable of steadying prices, is apt in practice to be so manipulated as to produce instability” (ibid.) His preferred reform was to introduce a “gold-exchange standard combined with a tabular standard.”<a name="_ftnref6" href="#_ftn6" id="_ftnref6">[6]</a> He recognized that, a tabular standard alone, which could be introduced by private contractual parties without any government action, would not suffice to bring about monetary and price-level stability (see pp. 334–37).  But it should be pointed out that his mixed system also has problems: it is not a real gold standard, it is open to speculative attacks, and it depends on an unsustainable degree of central bank cooperation.&#13;<br /> &#13;<br /> We now turn to lessons for the Fed and monetary reform from the insights of Fisher.&#13;<br /> &#13;</p> <h4><strong>Lessons for the Fed and Monetary Reform</strong><strong>   </strong></h4> <p>Irving Fisher’s examination of monetary theory and history led him to refine the quantity theory of money and to offer various proposals for monetary reform.  He took a comparative institutions approach to reforming the monetary regime.  He did not expect immediate results, but emphasized the importance of laying the groundwork for future reform so that when the time was ripe he could offer well-developed alternatives to the existing system. He sought to improve the chances for price-level stability and lessen the chances for crises due to erratic money.&#13;<br /> &#13;<br /> Fisher’s emphasis on the discoordination generated by monetary disequilibrium is still relevant today, but has been lost sight of in macroeconomic models devoid of money. His emphasis on a stable and predictable value of the dollar is useful as a guide to monetary policy, but ignores problems with a price-level target as opposed to targeting nominal spending. Instead of maintaining a constant inflation rate, a nominal GDP target would allow the rate of inflation to vary with changes in the growth rate of real output, declining in times of relatively rapid output growth, and rising in times of slower growth. As New Zealand economist Allan G. B. Fisher noted, “If prices are not allowed to fall in proportion to improvements in the efficiency of production, misleading indications will be given to producers as to the directions in which it is desirable to retard or accelerate the flow of capital; and the errors thus encouraged are likely to cause dislocation throughout the whole economic structure.”<a name="_ftnref7" href="#_ftn7" id="_ftnref7">[7]</a>&#13;<br /> &#13;<br /> Fisher’s attention to transition periods and especially to the “maladjustments in the rate of interest,” caused by an excess supply of money, is relevant for helping understand financial crises. His analysis of financial booms and busts led to the idea that interest rates can be kept too low for too long and that “had the previous rate [of interest] been high enough, the borrowers never would have overinvested” (p. 67). This idea is evident in John Taylor’s and Anna Schwartz’s critique of Fed policy prior to the 2008 financial crisis and the Great Recession.<a name="_ftnref8" href="#_ftn8" id="_ftnref8">[8]</a>&#13;<br /> &#13;<br /> The 2008 financial crisis revealed the flaws in the current discretionary government fiat money system with a central bank that kept its policy rate too low for too long.  Although there were nonmonetary factors contributing to the 2008 crisis, especially misguided housing policy, the monetary policy mistakes were of critical importance.&#13;<br /> &#13;<br /> John Taylor, in his reassessment of the 2008 financial crisis after 10 years, concluded:&#13;<br /> &#13;</p> <blockquote><p>There was a significant deviation in 2003–2005 from the more rules-based monetary policy strategy [the Taylor rule] that had worked well in the two prior decades. The resulting extra low policy interest rates were a factor leading to a search for yield, excessive risk taking, a boom and bust in the housing market, and eventually the financial crisis and recession. . . . These actions spread internationally as central banks tended to follow each other in setting their policy interest rate” [<a href="https://www.hoover.org/sites/default/files/research/docs/govt_as_cause_of_crisis-a_reassement_10.pdf" rel="noopener" target="_blank">Taylor 2018</a>: 2].</p> </blockquote> <p>To support his monetary theory of the 2008 crisis, Taylor used an econometric model to simulate what the housing market would have looked like if the Fed had followed the Taylor rule in setting its policy rate.  He found that “the [housing] boom and the bust disappeared”; and that, “if the Fed had not held rates too low, there would have been less search for yield, less risk-taking and fewer problems on the banks’ balance sheets” (pp. 3–4).<a name="_ftnref9" href="#_ftn9" id="_ftnref9">[9]</a>&#13;<br /> &#13;<br /> Taylor’s “real concern” is with “preventing central banks from causing asset bubbles” by keeping rates too low for too long (p. 4). A rules-based monetary policy would help in that regard.  Moreover, “a rules-based monetary policy is an essential part of a well-functioning market economy” (p. 24).&#13;<br /> &#13;<br /><a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2009/1/cj29n1-2.pdf" rel="noopener" target="_blank">Anna J. Schwartz</a> also argued that “if monetary policy had been more restrictive, the asset price boom in housing could have been avoided.” She criticized Alan Greenspan for not seeing this fact (Schwartz 2009: 22–23). In Fisherian fashion, Schwartz (p. 19) stated:&#13;<br /> &#13;</p> <blockquote><p>The basic groundwork to the disruption of credit flows can be traced to the asset price bubble of the housing price boom. It has become a cliché to refer to an asset boom as a mania. The cliché, however, obscures why ordinary folk become avid buyers of whatever object has become the target of desire. An asset boom is propagated by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset.</p> </blockquote> <p>Schwartz then laid out the sequence of monetary policy steps that helped fuel the housing boom:&#13;<br /> &#13;</p> <blockquote><p>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 cuts that began on August 10, 2007, and escalated in an unprecedented 75 basis point reduction on January 22, 2008, was announced at an unscheduled video conference meeting a week before a scheduled FOMC meeting. The rate increases in 2004 were too little and ended too soon [pp. 19–20].</p> </blockquote> <p>The Fed’s unconventional monetary policies, characterized by near zero interest rates, large-scale asset purchases (i.e., “quantitative easing”), and forward guidance (keeping rates “lower for longer”) were designed to revive the economy after the panic of 2008.  There is no doubt that those policies boosted asset prices and had a wealth effect, but they increased risk taking, incentivized leverage, and misallocated capital. Raising rates is more difficult than lowering them—as Fed Chairman Powell is experiencing from President Trump’s harsh criticism and the market’s reaction.  When rates do normalize the wealth created by unconventional policies may well turn out to be a pseudo wealth effect rather than a real one; after all, “easy money” can’t <em>permanently</em> increase real economic growth.&#13;<br /> &#13;<br /> Nevertheless, the Fed seems determined to keep unconventional monetary policy tools available in case of another recession, reverting once again to quantitative easing if the effective fed funds rate reaches the zero lower bound (i.e., a zero nominal rate).  In the meantime, there is the danger of drifting toward a higher inflation target to push nominal interest rates up and thus have more room to decrease the policy rate in case of a recession. Such interest-rate manipulation is part and parcel of our government fiat money regime.&#13;<br /> &#13;<br /> The <em>main lesson</em> from Fisher’s work is that there needs to be a thorough study of the current discretionary regime and an examination of alternatives that would reduce regime uncertainty and mitigate monetary-induced business fluctuations.  Possible alternatives include a price level rule, nominal GDP targeting, Fisher’s compensated dollar plan, and Hayek’s free-market money proposal. The return to a commodity-based regime, in which there is no central bank and the supply of money is market determined, should also be part of the debate over the future of money, as should the use of cryptocurrencies.<a name="_ftnref10" href="#_ftn10" id="_ftnref10">[10]</a>&#13;<br /> &#13;<br /> The Fed plans to host a conference later this year at the Chicago Fed to discuss its dual mandate and strategies to achieve full employment and price stability.  Hopefully, that discussion will include a close examination of the current operating procedure by which the Fed uses interest on excess reserves (IOER) and the overnight reverse repo rate (ONRRP) to set the range for its policy rate.  Paying IOER to banks above the opportunity cost of holding those reserves at the Fed plugs up the monetary transmission mechanism, increases the demand for reserves, and reduces the impact of changes in the monetary base on broader monetary aggregates—and thus on nominal GDP. Moving away from the “floor system” to a “corridor system” and reducing the size of the Fed’s balance sheet are necessary steps for normalizing policy.<a name="_ftnref11" href="#_ftn11" id="_ftnref11">[11]</a>&#13;<br /> &#13;<br /> The Fed conference is a step in the right direction for increasing public debate over the role of the central bank, but it is insufficient.  Congress, in its constitutional duty of safeguarding the value of money, needs to take that responsibility seriously and establish the <a href="https://www.congress.gov/bill/115th-congress/house-bill/10" rel="noopener" target="_blank">Centennial Monetary Commission</a> that was proposed under the Financial CHOICE Act of 2017 (Title X, Sec. 1011) to examine the Fed’s performance since its creation in 1913, and to consider various reforms. In doing so, it should not neglect the importance of restoring constitutional money and understanding how alternative monetary regimes affect uncertainty.&#13;<br /> &#13;</p> <h4><strong>Conclusion</strong></h4> <p>In thinking about monetary alternatives, there is no better place to start then a review of Irving Fisher’s work, especially <em>The Purchasing Power of Money</em>.  His insights can guide all those interested in improving the current government fiat money regime and in avoiding the mistakes of the past.  The Fed, in particular, ought to listen to what Fisher had to say about sound money—that is, money of stable purchasing power.  There is no perfect monetary system, but one needs to understand what a “good system” would look like in order to move in the right direction.  A deep knowledge of monetary theory, monetary alternatives, and monetary history are essential in order to improve the present monetary regime.&#13;<br /> &#13;<br /> Fisher (1911: 329) sought to avoid those reforms that “would be subject to the danger of <em>unwise or dishonest political manipulation.</em>” That is wise advice.  We cannot assume that public officials have perfect information or will act in “the public interest.”  That is why James Madison, the chief architect of the Constitution, wrote:&#13;<br /> &#13;</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; <em>but what is to ensure the inflexible adherence of the Legislative Ensurers to their own principles and purposes?</em> [Madison 1831, “Letter to Mr. Teachle,” Montpelier, March 15, emphasis added].</p> </blockquote> <p><a name="_ftn1" href="#_ftnref1" id="_ftn1"></a>Fisher recognized that, even under the gold standard, the price level would vary in the short run; indeed, it had to in order to maintain stability over the long run. By anchoring the price level under the price-specie-flow mechanism, interest rates stayed low for long periods and governments could issue long-dated bonds (consols).  Fiscal rectitude accompanied monetary stability.&#13;<br /> &#13;<br /> In the search for stable money, reform proposals that may seem farfetched today may become feasible in the future.  Those who lived under the classical gold standard would be shocked to learn of its demise and replacement with a central bank having a balance sheet of more than $4 trillion and the power to engage in large-scale asset purchases, including mortgage-backed securities.  It’s time for an audit of the Fed: not just its books, but its structure, conduct, and performance.  Revisiting the works of  great monetary thinkers like Fisher is not a bad place to start.&#13;<br /> &#13;</p> <hr /><a name="_ftn1" href="#_ftnref1" id="_ftn1"> [1]</a> All quotes are from the 1912 reprint of <em>The Purchasing Power of Money</em> (Macmillan). The 1922 edition can be found at <a href="https://www.econlib.org/library/YPDBooks/Fisher/fshPPM.html">https://www.econlib.org/library/YPDBooks/Fisher/fshPPM.html</a>.&#13;<br /> &#13;<br /><a name="_ftn2" href="#_ftnref2" id="_ftn2">[2]</a> See Warburton (1966: chaps. 1 and 4).  Also see Leland B. Yeager, <em>The Fluttering Veil: Essays on Monetary Disequilibrium</em>, Part 3 (Liberty Fund, 1997).&#13;<br /> &#13;<br /><a name="_ftn3" href="#_ftnref3" id="_ftn3">[3]</a> See Fisher (2012: chap. 4).&#13;<br /> &#13;<br /><a name="_ftn4" href="#_ftnref4" id="_ftn4">[4]</a> Under this so-called compensated dollar plan, “the amount of gold obtainable for a paper dollar would vary inversely with its purchasing power per ounce as compared with commodities, the total purchasing power of the dollar being always the same.”  In such a system, “the supply of money in circulation would regulate itself automatically” (Fisher 1911: 331). For a more thorough discussion of Fisher’s compensated dollar plan, see Don Patinkin, <a href="https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_quarterly/1993/summer/pdf/patinkin.pdf">“Irving Fisher and His Compensated Dollar Plan,”</a> Federal Reserve Bank of Richmond <em>Economic Quarterly</em> (79/3, Summer 1993):1–33. Also see Chapter 6, “The Quantity Theory Alternative,” in Thomas M. Humphrey and Richard H. Timberlake’s forthcoming book, <em>Gold, The Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922–1938 </em>(Cato Institute, 2019).&#13;<br /> &#13;<br /><a name="_ftn5" href="#_ftnref5" id="_ftn5">[5]</a> A gold-exchange system would provide for a country not on the gold standard to exchange its currency at par with a country whose currency is linked to gold.  A tabular standard uses a price index to ensure that creditors are paid back in dollars of constant purchasing power.&#13;<br /> &#13;<br /><a name="_ftn6" href="#_ftnref6" id="_ftn6">[6]</a> For a discussion of the operation of this standard, see Fisher (1911: 337–47).&#13;<br /> &#13;<br /><a name="_ftn7" href="#_ftnref7" id="_ftn7">[7]</a> Allan G. B. Fisher, “Does an Increase in Volume of Production Call for a Corresponding Increase in Volume of Money?” <em>American Economic Review</em> 25/2 (June 1935): 197. Also see George Selgin’s <em>Less than Zero: The Case for a Falling Price Level in a Growing Economy</em> (Cato Institute, 2017).&#13;<br /> &#13;<br /><a name="_ftn8" href="#_ftnref8" id="_ftn8">[8]</a> It is important to note, however, that the Taylor Rule is not the same as Fisher’s compensated dollar rule. Unlike Taylor’s rule, Fisher’s allows for no feedback from the state of output or employment. It is a price level or inflation rule pure and simple. It is also a general inflation rather core inflation rule. As such, it would have called for more tightening than Taylor’s rule, and even more than the Fed engaged in, during 2008. I am indebted to George Selgin for this point.&#13;<br /> &#13;<br /><a name="_ftn9" href="#_ftnref9" id="_ftn9">[9]</a> In a study of 18 OECD countries from 1920 to 2011, <a href="https://www.nber.org/papers/w19585">Bordo and Landon-Lane</a> (2013) found that “‘loose’ monetary policy—that is, having an interest rate below the target rate or having a growth rate of money above the target growth rate—does positively impact asset prices and this correspondence is heightened during periods when asset prices grew quickly and then subsequently suffered a significant correction.”&#13;<br /> &#13;<br /><a name="_ftn10" href="#_ftnref10" id="_ftn10">[10]</a> For a discussion of alternative monetary rules, see <a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2018/2/cato-journal-v38n1-chapter-5.pdf-updated-3.pdf">Dorn</a> (2018).&#13;<br /> &#13;<br /><a name="_ftn11" href="#_ftnref11" id="_ftn11">[11]</a> For a detailed analysis of the pre- and post-crisis operating system, see Selgin (2018): <em>Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession</em>.&#13;<br /> &#13;<br /> [<a href="https://www.alt-m.org/2019/01/17/irving-fishers-search-for-stable-money-what-we-can-learn/">Cross-posted from Alt-M.org</a>]<br /> </p> Thu, 17 Jan 2019 09:31:28 -0500 James A. Dorn https://www.cato.org/blog/irving-fishers-search-stable-money-what-we-can-learn After 40 Years China Still Needs to “Emancipate the Mind” https://www.cato.org/blog/after-40-years-china-still-needs-emancipate-mind James A. Dorn <p>This week marks the 40th anniversary of China’s opening to the outside world, announced at the Third Plenum of the Eleventh Party Congress in1978. After Mao Zedong’s disastrous Cultural Revolution and the failure of central planning, the nation was ready to embark on a new path of development. Individuals were to be given greater economic and political freedom under the leadership of Deng Xiaoping.   &#13;<br /> &#13;<br /> How successful was that new path in the long run? Today, China’s paramount leader Xi Jinping expresses his desire for a “socialist rule of law” and supports the “principle of letting a hundred flowers bloom and a hundred schools of thought contend.” Yet what we see is increasing constraints on freedom of thought.&#13;<br /> &#13;<br /> Xi and Deng had similar backgrounds, as both were at one point victimized and elevated by the Communist Party. During the Cultural Revolution, Deng was labelled a “capitalist roader” and his son was crippled by the Red Guards. Those events left an indelible mark and opened Deng’s mind to new thinking about how best to organize the economy and allow people to prosper. He thought that China’s leaders “ought to study the successful experiences of capitalist countries and bring them back to China.” That view contrasted sharply with Chairman Mao’s condemnation of private enterprise and his view of capitalists as criminals.&#13;<br /> &#13;</p> <p>Deng announced a change of tone at the Third Plenum, two years after Mao’s death. Although he paid lip service to Mao, he rejected the idea of “class struggle” and made economic development the chief goal of the Chinese Communist Party (CCP).&#13;<br /> &#13;<br /> In his speech, Deng argued that “the primary task is to emancipate our minds.”  He criticized the rigid thinking of many Party members, which he blamed on “historical conditions.” He was reluctant to openly blame Mao, so he pointed to Lin Biao, whom Mao had appointed vice chairman in 1966, and the Gang of Four, which included Mao’s wife Jiang Qing. Under the masquerade of “Party interests,” people were subject to Party control and oppressed. “Many important issues were often decided by one or two persons,” said Deng. Consequently, “there wasn’t much point in thinking things out for yourself.” He went on to say that “no clear distinction was made between right and wrong,” and that “people were naturally reluctant to use their brains.”  The simply adjusted “their words and actions according to whichever way the wind [was] blowing.”&#13;<br /> &#13;<br /> In closing, Deng warned: “When everything has to be done by the book, when thinking turns rigid and blind faith is the fashion, it is impossible for a party or a nation to make progress. Its life will cease, and that party or nation will perish.” &#13;<br /> &#13;<br /> After the Third Plenum, Deng advocated greater freedom of thought and supported the “Democracy (Xidan) Wall,” which served as a place to post criticism of Maoist thought, including the “Two Whatevers”: whatever Mao said should be taken as the truth, and whatever examples he set should be adhered to. Nevertheless, as China’s paramount leader, Deng was unwilling to accept large protests that could threaten the power of the CCP. The infamous Tiananmen Square incident occurred under his leadership.&#13;<br /> &#13;<br /> Yet, despite the contradiction, Deng led China to a significantly freer path than the one Mao had set it upon. Can we say the same of Xi Jinping?&#13;<br /> &#13;<br /> Since he came to power in 2013, Xi has cracked down on officials who deviate from CCP dogma, institutionalized “Xi Jinping Thought”— a 14-point manifesto to ensure CCP “leadership over all forms of work”—in the PRC Constitution, ended Deng’s collectivist governance by being “elected” president for life, launched a “social credit system” that could seriously erode personal freedom, and silenced leading liberal intellectuals such as Mao Yushi, whose Unirule Institute has seen its website shutdown and its office shuttered. Academic freedom suffers from the presence of propaganda departments at all universities, and there is a strong feeling that “the door to a free market in ideas is nearly shut.”&#13;<br /> &#13;<br /> Although China has accomplished much in its 40 years of reform and opening to the outside world, it has a long way to go in terms of both economic and political freedom. At this point, it needs a Deng—someone who actually advances liberal ideas—rather than a Xi—someone who pays lip service, at best.&#13;<br /> &#13;<br /> Most important, China needs a free market for ideas, as well as a free market for goods and services. Silencing the voices of Chinese liberals—and blocking the transmission of Western ideas of limited government, separation of powers, and freedom under a just rule of law—will not “emancipate the mind” or create a harmonious society.  </p> <p></p> Thu, 20 Dec 2018 09:49:31 -0500 James A. Dorn https://www.cato.org/blog/after-40-years-china-still-needs-emancipate-mind 36th Anonetary Conference: Panel 2: Unconventional Monetary Interest Rates, and Asset Prices https://www.cato.org/multimedia/events/36th-anonetary-conference-panel-2-unconventional-monetary-interest-rates-asset James A. Dorn, Tobias Adrian, Vincent R. Reinhart, Lawrence H. White <p>Ten years after the 2008 financial crisis, we are again facing the possibility of economic turmoil as the Fed and other central banks exit their unconventional monetary policies. Although central banks will move gradually, unforeseen circumstances could trigger a&nbsp;flight to safety and a&nbsp;collapse of asset prices.</p> Thu, 15 Nov 2018 14:59:00 -0500 James A. Dorn, Tobias Adrian, Vincent R. Reinhart, Lawrence H. White https://www.cato.org/multimedia/events/36th-anonetary-conference-panel-2-unconventional-monetary-interest-rates-asset Leland B. Yeager: Market Grandmaster https://www.cato.org/cato-journal/fall-2018/leland-b-yeager-market-grandmaster James A. Dorn <div class="lead text-default"> <p class="BodyTextTop" id="ch9_para001">When Leland Yeager (1924 – 2018) passed away on April 23, at the age of 93, the world lost a&nbsp;brilliant mind, a&nbsp;devoted teacher, a&nbsp;dedicated scholar, and a&nbsp;man of integrity. I&nbsp;had the privilege of having Leland as a&nbsp;professor at the University of Virginia during my graduate studies in economics in the late 1960s, and later working closely with him as editor of the <em>Cato Journal</em> and director of Cato’s annual monetary conference. Of course, I&nbsp;didn’t need to edit his beautifully crafted papers and I&nbsp;studiously avoided sending his papers to a&nbsp;copyeditor! When he retired from the University of Virginia as the Paul Goodloe McIntire Professor of Economics, he left a&nbsp;legacy of excellence, as well as a&nbsp;host of stories about his legendary persona. All of his students know about “the yardstick” and “the stare.”<sup><a href="#ch9_note001">1</a></sup></p> </div> , <div class="text-default"> <p> </p><div data-embed-button="image" data-entity-embed-display="view_mode:media.full" data-entity-type="media" data-entity-uuid="923bc16c-314f-4a01-b467-a25bceb2a159" data-langcode="en" class="embedded-entity"> <img width="530" height="412" alt="Media Name: cjv38n3-ch09-fig001.jpg" class="lozad component-image lozad" data-srcset="/sites/cato.org/files/styles/pubs/public/images/cato-journal/fall-2018/cjv38n3-ch09-fig001.jpg?itok=R5l8l4L8 1x, /sites/cato.org/files/styles/pubs_2x/public/images/cato-journal/fall-2018/cjv38n3-ch09-fig001.jpg?itok=UOwyySQY 1.5x" data-src="/sites/cato.org/files/styles/pubs/public/images/cato-journal/fall-2018/cjv38n3-ch09-fig001.jpg?itok=R5l8l4L8" typeof="Image" /></div> <p>In this memorial essay, I wish to paint a picture of Leland as a “market grandmaster,” in the sense of his keen understanding of markets and prices along with the role of money in facilitating exchange, and the importance of property rights in shaping incentives and behavior. Along with James Buchanan, Gordon Tullock, Ronald Coase, G. Warren Nutter, Roland McKean, and others, he was an important member of the Virginia School of Political Economy.</p> <h2>The Centrality of Market Exchange and Coordination</h2> <p>James Buchanan, who was instrumental in bringing Leland to the University of Virginia from the University of Maryland (<a href="#ch9_ref11">Koppl 2006</a>: 7), held that “economists should be ‘market economists’” — that is, “they should concentrate on market or exchange institutions . . . in the widest possible sense” (<a href="#ch9_ref02">Buchanan [1964] 1979</a>: 36). Buchanan also argued that the “most important social role [of economists] is that of teaching students,” and “the most important central principle in economics is . . . that of the spontaneous coordination which the market achieves” — namely, “the principle of spontaneous order” (<a href="#ch9_ref03">Buchanan [1976] 1979</a>: 81–82).</p> <p>Leland excelled in the tasks that Buchanan thought most important. He was an outstanding teacher who placed market exchange and coordination at the center of his lectures. He wanted us to understand how the voluntary actions of individuals, guided by free-market prices and limited government, would lead to mutually beneficial exchanges and a harmonious market order in which people were free to choose. He also wanted us to recognize the significance of money in facilitating exchange and what happens when monetary disorder upsets the market system by distorting relative prices.</p> <p>In the realm of public policy, he took a principled approach and sought to trace out the long-run effects of alternative policies, whether in the field of international trade or monetary policy. In his presidential address, “Economics and Principles,” at the 1975 meetings of the Southern Economic Association, he reiterated what his students knew well:</p> </div> , <blockquote class="blockquote"> <div> <p>The principled approach to economic policy recognizes that the task of the policymaker is <em>not</em> to maximize social welfare, somehow conceived, and <em>not</em> to achieve specific patterns of outputs, prices, and incomes. It is concerned, instead, with a&nbsp;framework of institutions and rules within which people can effectively cooperate in pursuing their own diverse ends through decentralized coordination of their activities. In the macroeconomic field, it shuns activist “fine‐​tuning” and aims instead at a&nbsp;steady monetary framework [<a href="#ch9_ref18">Yeager 1976a</a>: 560].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>Leland espoused “the principle of limited government” and argued that “even when no disadvantages are obvious, there is a&nbsp;presumption (defensible, to be sure) against a&nbsp;new or expanded government activity” (ibid., 562). He hoped that voters “might come to appreciate the value of avoiding myriad interventions and of orienting economic policies, instead, toward legal and monetary <em>frameworks</em> within which decentralized decisions are coordinated by market processes” — but he was not optimistic that voters “might come to judge policies and candidates in the light of the principle of limited government” (ibid., 565).</p> <p>Yeager, nevertheless, saw it as his duty to “help explain the value of respecting principles not only in the realm of economic policy but also in other interactions among human beings” (ibid.). In thinking about “relevant strands of economic theory,” he pointed to the liberal concept of “results of human action but not of human design,” which F. A&nbsp;Hayek (<a href="#ch9_ref08">1973</a>: chap. 6) popularized, as well as</p> </div> , <blockquote class="blockquote"> <div> <p>the importance, for a&nbsp;functioning society, of people’s having some basis for predicting each other’s actions; the inevitable imperfection, incompleteness, dispersion, and costliness of knowledge; the costs of making transactions and of negotiating, monitoring, and enforcing agreements, and the consequent usefulness of tacit agreements and informally enforced rules; applications of methodological individualism and of property‐​rights theory to analysis of nonmarket institutions and activities; concepts of externalities and collective goods and the supposed free‐​rider problem; and the principle of interdependence [<a href="#ch9_ref18">Yeager 1976a</a>: 565].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>Like Buchanan, Leland was a&nbsp;fellow traveler of the Austrian School of Economics. Indeed, after he left the University of Virginia, he took a&nbsp;position at Auburn University as the Ludwig von Mises Distinguished Professor of Economics. Although he neither subscribed to the radical subjectivism of some Austrians nor fully accepted the Austrian theory of the business cycle, he noted the significance of thinking in terms of individuals, not aggregates; viewed competition as a&nbsp;market process; recognized the subjective nature of value; and understood the importance of sound monetary institutions and private property rights for maintaining a&nbsp;vibrant market system.</p> <p>In his advanced price theory class, Yeager took time to review the socialist calculation debate and the absurdity of adhering to gross output targets, which would lead to the production of large nails that were useless. When he gave this example of the experience under Soviet central planning, Professor Yeager stopped in the middle of his lecture to leave the room because his face turned red with laughter at the absurdities that resulted from the lack of a&nbsp;real price system. However, he soon regained his composure and returned to carry on his lecture.</p> <p class="BodyText" id="ch9_para002">Throughout his career as a&nbsp;teacher and scholar, Leland always returned to fundamentals. In his keynote address at a&nbsp;meeting of the Chesapeake Association of Economic Educators, which I&nbsp;helped organize in 1979, he began by saying, “The economic ignorance that is so painfully evident in public‐​policy discussions is ignorance not of the subtleties of technicalities but of the basic truths. Economists should make an effort to communicate these basics, and not only to their students but also to a&nbsp;wider audience” (<a href="#ch9_ref20">Yeager 1979</a>).<sup><a href="#ch9_note002">2</a></sup> Moreover, “in our teaching we ought to point out not only truths but also ancient fallacies that keep being rediscovered in new guises with an air of triumphant novelty, e.g., [the] real‐​bills doctrine.”</p> <p>Some of the basics Leland thought should be emphasized include:</p> </div> , <blockquote class="blockquote"> <div> <p>Scarcity, rivalry among uses of resources, opportunity cost, the need for choice, choices made in the light of perceived costs and benefits (prices), the laws of supply and demand, specialization, decentralization, the general interdependence of economic activities, the coordination problem and the way that a&nbsp;market price‐​and‐​profit system handles it, the role of money in facilitating the operation of such a&nbsp;system (facilitating the fundamental exchanges of goods and services against goods and services), and the snarl that occurs when the quantity or growth rate of money changes erratically (here is the chief point of intersection between micro and macroeconomics [ibid.].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>Finally, Yeager argued that, “in understanding how the economic system and the individuals that compose it behave, it is important to understand the opportunities open to individuals and the signals and incentives that impinge on them. This holds true not only of consumers, workers, and businessmen but also of people in government — politicians, economic regulators, and so forth.” He also warned, wisely, that:</p> </div> , <blockquote class="blockquote"> <div> <p>Failure to appreciate the roles of prices and profits is tied up with failure to appreciate the problems of mobilizing knowledge, of coordinating decentralized activities, and of coping with obstacles to carrying out transactions. There is a&nbsp;tendency, perhaps found even more among high‐​powered theorists than among laymen, to regard the imaginary extreme case of pure and perfect competition as a&nbsp;standard for judging the real world. Relevant information is assumed to be automatically at hand; information and transactions costs tend to be forgotten. Hard facts of reality — including aspects of scarcity, the fact that resources have to be used in acquiring and transmitting knowledge and in conducting transactions — are seen as “imperfections” of our particular economic system. Reality is blamed for being real. Well, we should beware of planting any such misconceptions in the minds of our students [ibid.].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p class="Body">Because Leland was an authority on monetary economics and international monetary relations, as well as on alternatives to our present system of discretionary government fiat money, I&nbsp;now turn to those topics.</p> <h2>Money Is the Centerpiece of Macroeconomics</h2> <p>In his Chesapeake lecture, Leland called money “the centerpiece of macroeconomics.” He then went on to explain why. I&nbsp;will give a&nbsp;brief overview of some of Leland’s fundamental thoughts about the role of money in a&nbsp;market system.</p> <h3>Say’s Law Is Fundamentally Right</h3> <p>According to Yeager (<a href="#ch9_ref20">1979</a>), “There has been too much aggregation in macroeconomics, theoretical and applied — too much of the notion of aggregate demand confronting aggregate supply. Fundamentally, Say’s Law is right: supply of some goods and services <em>constitutes</em> demand for other goods and services; fundamentally there can be no problem of deficiency of aggregate demand.” However, “the exchange of goods and services against goods and services takes place through money.” When the supply of and demand for money do not mesh, monetary disequilibrium can upset the smooth operation of the market mechanism and Say’s Law must be qualified. This is especially true when price and resource adjustments are sluggish.</p> <p>Consequently, Yeager emphasized that students need “to understand the tremendous importance of money in facilitating exchange and thus in facilitating the division of labor in producing the goods to be exchanged.” In particular, they need to recognize that “money facilitates economic calculation and the comparison of costs and benefits and the signaling function of price and profit” (ibid.).</p> <p>Yeager goes on to argue that it is “precisely because money is so important to the working of the economic system [that] monetary disorders can have fateful consequences.” Thus, there is a “hitch in Say’s Law: Although ‘fundamentally’ goods and services exchange against goods and services, money is the intermediary in this process; and if the demand for and supply of money get out of balance, these fundamental exchanges are impeded” (ibid.).</p> <p>Yeager elaborated on this idea elsewhere, explaining that an</p> </div> , <blockquote class="blockquote"> <div> <p>imbalance between the actual quantity of money and the total of desired cash balances cannot readily be forestalled or corrected through adjustment of the price of money on the market for money because money, in contrast with all other things, does not have a&nbsp;single price and single market of its own. Monetary imbalance has to be corrected through the roundabout and sluggish process of adjusting the prices of a&nbsp;great many individual goods and services (and securities). Because prices do not immediately absorb the full impact of the supply and demand imbalances for individual goods and services that are the counterpart of an overall monetary imbalance, quantities traded and produced are affected also. Thus, the deflationary process associated with an excess demand for money, in particular, can be painful [<a href="#ch9_ref21">Yeager 1983</a>: 307].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p class="Body">It is to this theory of monetary disequilibrium that I&nbsp;now turn.</p> <h3>Monetary Disorder</h3> <p class="BodyText" id="ch9_para003">Leland was influenced by the work of Clark Warburton and was put in charge of Warburton’s papers after his death. Those papers are now housed in the special collections at George Mason University.<sup><a href="#ch9_note003">3</a></sup> Like Warburton (<a href="#ch9_ref14">1966</a>), Yeager (<a href="#ch9_ref20">1979</a>) understood monetary disorder as “erratic disturbances to the relation between the actual quantity of money and the demand for money balances.” Those disturbances mean</p> </div> , <blockquote class="blockquote"> <div> <p>not only wrong relative prices but also a&nbsp;wrong price level or purchasing power of the dollar, in relation to the quantity of money, [which] can snarl up exchanges. Anything that snarls up exchanges snarls up the production of goods to be exchanged, with <em>cumulative</em> consequences. Anything that undercuts the reliability of the dollar as a&nbsp;unit of account snarls up the accuracy of economic calculation, with fateful consequences [<a href="#ch9_ref20">Yeager 1979</a>].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>This “theory of monetary disequilibrium” or “erratic money” has a&nbsp;long history that Warburton (<a href="#ch9_ref14">1966</a>: 1 – 35) resurrected (see <a href="#ch9_ref06">Dorn 1987b</a>: chap. 1). In his empirical studies after 1945, he emphasized “an erratic money supply as the chief originating factor in business recessions and not merely an intensifying force in the case of severe depressions” (<a href="#ch9_ref14">Warburton 1966</a>: 9). In May 1945, Warburton (ibid., 257) argued that “the theoretical developments since publication of Lord Keynes’s <em>General Theory</em> … have shifted attention away from the policies which produced the Great Depression and other cases of large departure from full employment, and have laboriously diverted the energies of economists into fruitless directions.”</p> <p>Yeager followed Warburton’s lead and wrote an important article on “The Keynesian Diversion” (<a href="#ch9_ref17">1973</a>) and another on “The Significance of Monetary Disequilibrium” (<a href="#ch9_ref22">1986</a>), both of which are reprinted in <em>The Fluttering Veil: Essays on Monetary Disequilibrium</em> (<a href="#ch9_ref23">Yeager 1997</a>).</p> <h3>Money and Freedom: In Search of a&nbsp;Monetary Constitution</h3> <p>Leland was a&nbsp;member of the Mont Pelerin Society and a&nbsp;libertarian; he was a&nbsp;proponent of limited government and economic freedom, which he viewed as part of personal freedom. He was interested in examining a&nbsp;broad range of monetary alternatives to advance monetary theory and offer ideas for fundamental reform. In the fall of 1960, he organized an innovative conference for the Thomas Jefferson Center for Studies in Political Economy at the University of Virginia, which produced a&nbsp;book titled <em>In Search of a&nbsp;Monetary Constitution</em>, published by Harvard University Press in 1962.</p> <p>That book has had a&nbsp;major influence in thinking about monetary reform from a&nbsp;constitutional perspective. In April 2012, to mark the book’s 50th anniversary, the Liberty Fund held a&nbsp;symposium in Freiburg‐​im‐​Breisgau, Germany, which was organized by Lawrence H. White, Viktor Vanberg, and Ekkehard Köhler — who acted as editors for <em>Renewing the Search for a&nbsp;Monetary Constitution</em> (2015). Leland, who could not attend the conference due to health issues, contributed a&nbsp;paper titled “The Continuing Search for a&nbsp;Monetary Constitution” (<a href="#ch9_ref24">Yeager 2015</a>).</p> <p>By “constitution” Leland meant “rules of the game” in a&nbsp;broad sense — that is, both formal and informal rules that would lend predictability to human interactions and help bring about social and economic order. With respect to a&nbsp;monetary constitution, he was critical of the lack of a&nbsp;rules‐​based monetary policy and what he called “our preposterous dollar”:</p> <p class="blockquotef">On reflection, our existing monetary system [discretionary government fiat money] must seem preposterous. It is not difficult to understand how individually plausible steps over years and centuries have brought us to where we now are, but the cumulative result remains preposterous nevertheless. Our unit of account — our pervasively used measure of value, analogous to units of weight and length — is whatever value supply and demand fleetingly accord to the dollar of fiat money</p> <p class="blockquotel">If balance between demand for and supply of this fiat medium of exchange is not maintained by clever manipulation of its nominal quantity at a&nbsp;stable equilibrium value of the money unit, then any correction of this supply‐​and‐​demand imbalance must occur through growth or shrinkage of the unit itself. Money’s purchasing power — the general price level — must change. This change does not occur swiftly and smoothly. Money’s value must change, when it does, through a&nbsp;long‐​drawn‐​out, roundabout process involving millions of separately determined, though interdependent, prices and wage rates. Meanwhile, until the monetary disequilibrium has been finally corrected in this circuitous way, we suffer the pains of an excess demand for or excess supply of money [<a href="#ch9_ref21">Yeager 1983</a>: 305 – 6].</p> <p>Leland argued that “some properties of actual monetary systems are illuminated by contrasting them with imaginary systems” (ibid., 305). He was interested in nongovernmental approaches to correcting deficiencies in the present monetary system. As he stated, “proposals for nongovernmental remedies intrigue me more” than “remedies within the realm of government money” (ibid., 308 – 9). In discussing “private money,” Yeager wrote:</p> </div> , <blockquote class="blockquote"> <div> <p>As a&nbsp;libertarian, I&nbsp;favor allowing free banking — the competitive private issue of notes and deposits redeemable, presumably, in gold. Notes and deposits would be backed by merely fractional reserves, for efforts to enforce 100 percent banking in the face of contrary incentives and private ingenuity would require unacceptably extreme government interference [ibid., 318].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>His preferred scheme, which was designed to eliminate or greatly reduce monetary disorder, was tentatively called the “BFH system,” after Fischer Black, Eugene Fama, and Robert Hall whose writings influenced Yeager and his coauthor Robert Greenfield (see <a href="#ch9_ref07">Greenfield and Yeager 1983</a>). Their proposed system is rather complex and is best summarized by Leland in his 1983 <em>Cato Journal</em> article:</p> </div> , <blockquote class="blockquote"> <div> <p>Like the reform proposed by Hayek [<a href="#ch9_ref09">1976</a>, <a href="#ch9_ref10">1978</a>], [the BFH system] would almost completely depoliticize money and banking. By the manner of [the state’s] withdrawal from its . . . domination of our current system, the government would give a&nbsp;noncoercive nudge in favor of the new system. It would help launch a&nbsp;stable unit of account free of the absurdity of being the supply‐​and‐​demand‐​determined value of the unit of the medium of exchange. The government would define the new unit, just as it defines units of weights and measures. The definition would run in terms of a&nbsp;bundle of commodities so comprehensive that the unit’s value would remain nearly stable against goods and services in general. The government would conduct its own accounting and transactions in the new unit. Thanks to this governmental nudge, the public‐​goods or who‐​goes‐​first problem of getting a&nbsp;new unit adopted would largely be sidestepped. The government would be barred from issuing money. Private enterprise, probably in the form of institutions combining the features of today’s banks, money‐​market mutual funds, and stock mutual funds, would offer convenient media of exchange. Separation of a&nbsp;unit of account of defined purchasing power from the medium — or rather media — of exchange, whose quantity would be appropriately determined largely on the demand side, would go far toward avoiding macroeconomic disorders and facilitating stable prosperity. Lacking any base money, whether gold or government‐​issued money, on which ordinary money would be pyramided on a&nbsp;fractional‐​reserve basis, the BFH system would not share the precariousness and vulnerability of ordinary monetary systems [<a href="#ch9_ref21">Yeager 1983</a>: 323 – 24].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p class="BodyText" id="ch9_para004">The question inherent in the Yeager‐​Greenfield proposal is, Why would the government “give a&nbsp;noncoercive nudge in favor of the new system?”<sup><a href="#ch9_note004">4</a></sup> Perhaps Leland would think that question irrelevant, because his aim was to imagine a&nbsp;totally different type of system and to advance monetary theory — not to think that his idealized system would ever emerge, given the political economy/​public‐​choice problems involved.</p> <p>Leland did not believe the BFH system was the sole or best path to privatization; it was not intended to be “a definitive proposal.” Rather, it was to serve “as an example of one route to privatization” (<a href="#ch9_ref24">Yeager 2015</a>: 12). He offered four reasons for studying private alternatives to government money, even if they may not yet be politically feasible:</p> </div> , <blockquote class="blockquote"> <div> <p>First, what is politically realistic can evolve. Second, although horrible to contemplate, a&nbsp;collapse of the government dollar would call for drastic reform. Third, keeping the government (or its agent, the Federal Reserve) from printing money will impose some discipline on its fiscal policies.… Fourth, considering how private money might work provides opportunities for progress in monetary theory [ibid., 9 – 10].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p class="Body">Yeager concludes by returning to a&nbsp;general theme, namely:</p> </div> , <blockquote class="blockquote"> <div> <p>It is preposterous to try to remedy economic discoordination without even understanding coordinating processes in the first place and without understanding what obstacles and inhibitions sometimes impede productive transactions. Evident ignorance of economics, even at the highest levels of government, must itself sap the business and consumer confidence necessary for business recovery [ibid., 19].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <h2>Economics and Government</h2> <p>In his Chesapeake lecture, Yeager points to the importance of the economic way of thinking and methodological individualism in helping us recognize why government tends to overexpand:</p> </div> , <blockquote class="blockquote"> <div> <p>The failure to appreciate the fact that decisions are made by individuals pursuing purposes of their own is perhaps worst when it comes to government.… The government, instead of being a&nbsp;philosopher‐​king, is a&nbsp;congeries of persons — politicians, legislators, bureaucrats, judges, and, once in a&nbsp;while, voters — all pursuing purposes of their own and operating with the fragmentary information that comes to their attention. Furthermore, nothing in government corresponds to the market process of spontaneous coordination of decentralized decisions. Nothing corresponds to the market’s way of bringing even remote considerations to the attention of each decentralized decision‐​maker in the form of prices. Knowledge, authority, incentives, and responsibility are largely fragmented and uncoordinated in the political and governmental process. Far‐​reaching and long‐​run consequences of government decision‐​making receive scant attention. There are reasons for thinking that these characteristics of government result in too much government — too much taxing and spending and regulation [<a href="#ch9_ref20">Yeager 1979</a>].</p> </div> </blockquote> <cite> </cite> , <div class="text-default"> <p>Leland goes on to argue that the free‐​market system allows for great diversity, which he deems a&nbsp;good thing. The voluntary nature of the market system provides for myriad opportunities for exchanges that reflect the diverse preferences of millions of traders. As he puts it, “A subjectivist and individualistic approach appreciates the diversity of people’s personalities and tastes and the attendant diversity of consumption and work patterns and of lifestyles generally. If we value the uniqueness of each human being, we are led to value a&nbsp;system that caters to diversity” (ibid.). He cautions, however that “recognizing the legitimacy of self‐​interest does not mean … approving of any and all self‐​interested behavior. It doesn’t justify lying, cheating, and stealing.”</p> <p>Leland’s understanding of the free‐​market system made him a&nbsp;strong proponent of limited government and wary of government interventions under the guise of serving the “public interest.”</p> <h2>International Monetary Relations and the Necessity for Choice</h2> <p class="BodyText" id="ch9_para005">In Yeager’s magnum opus, <em>International Monetary Relations: Theory, History, and Policy</em>,<sup><a href="#ch9_note005">5</a></sup> he notes: “It would seem odd that economists have not yet reached near‐​unanimity on the need, in framing international monetary policy, to sacrifice one or more individually desirable things. The necessity for choice is, after all, the most fundamental principle of economics” (<a href="#ch9_ref19">Yeager 1976b</a>: 651).</p> <p>To illustrate the need for choice, Yeager (ibid.) turns to the “Doctrine of Alternative Stability,” which posits that among three desirable alternatives only two can be fully obtained. The three alternatives are (1) “freedom for each country to pursue an independent monetary and fiscal policy for full employment without inflation” (internal stability); (2) “freedom of international trade and investment from controls wielded to force equilibrium in balances of payments” (capital freedom/​external balance without controls); and (3) “fixed exchange rates.” If a&nbsp;country chooses capital freedom (i.e., open capital markets), it “can maintain a&nbsp;fixed exchange rate only by sacrificing its monetary independence and allowing its domestic business conditions and price level to keep in step with foreign developments.”</p> <p>Yeager goes on to say, “If countries do not openly choose which one to sacrifice among monetary independence, external balance without controls, and fixed exchanges, the choice gets made unintentionally.” For example, “in the early years after World War II — the ‘transition period’ of the IMF Charter — freedom from controls was sacrificed to national pursuit of full employment. Since then, the choice has become fuzzier as countries seek a&nbsp;compromise in the merely partial sacrifice of each of the three objectives” (ibid., 652).</p> <p>China is a&nbsp;textbook case in this regard: policymakers have made the renminbi convertible for current account transactions and have been slowly opening the capital account, while making the exchange rate more flexible and using domestic monetary policy to spur the economy. If China is to establish a&nbsp;world‐​class capital market, it needs the free flow of capital, which means policymakers will have to choose either monetary independence under a&nbsp;floating rate system or a&nbsp;genuine fixed‐​rate system. Because China is a&nbsp;large player in the global trading system, it would make sense for Beijing to float the renminbi and remove capital controls, using domestic monetary policy to stabilize nominal GDP and maintain long‐​run price stability. However, in a&nbsp;political system dominated by the Chinese Communist Party, lacking both a&nbsp;genuine rule of law and a&nbsp;free market in ideas, there is little incentive to make the fundamental choice in favor of capital (and personal) freedom. That is why Eswar Prasad (<a href="#ch9_ref13">2017</a>) does not think the renminbi will become a “safe haven” currency for some time.</p> <p>In sum, “historical evidence illustrates … the logically inexorable need to sacrifice one of the three objectives forthrightly or two or three of them in part” (Yeager 1976: 652).</p> <h2>Conclusion</h2> <p class="BodyText" id="ch9_para006">Leland Yeager never lost sight of the logic of the market price system, the benefits of limited government and private property rights, the dignity of the individual, and the beauty of the market process and its spontaneous order. Like Buchanan, he understood that the order of the market emerges from the <em>process</em> of voluntary exchange, and that such a&nbsp;result depends crucially on the institutions supporting and framing a&nbsp;free‐​market system.<sup><a href="#ch9_note006">6</a></sup></p> <p>One institution that is of the utmost importance is sound money — that is, money with a&nbsp;predictable and stable purchasing power. Yeager’s emphasis on how monetary disorder (monetary disequilibrium) can disrupt relative prices and their coordinating function, and make economic calculation more difficult, made him deeply interested in examining alternatives to discretionary government fiat money, including privatization. He was searching for a “monetary constitution” that would anchor expectations about the future value of money and thus help facilitate exchange — widening the scope of markets and thus the range of options open to individuals.</p> <h2>References</h2> <p><a id="ch9_ref01"></a>Breit, W.; Elzinga, K. G., and Willett, T. D. (1996) “The Yeager Mystique: The Polymath as Teacher, Scholar and Colleague.” <em>Eastern Economic Journal</em> 22 (2): 215 – 29.</p> <p><a id="ch9_ref02"></a>Buchanan, J. M. ([1964] 1979) “What Should Economists Do?” In <em>What Should Economists Do?</em> chap. 1. Indianapolis: Liberty Press.</p> <p><a id="ch9_ref03"></a>__________ ([1976] 1979) “General Implications of Subjectivism in Economics.” In <em>What Should Economists Do?</em> chap. 4. Indianapolis: Liberty Press.</p> <p><a id="ch9_ref04"></a>__________ (1982) “Order Defined in the Process of Its Emergence.” <em>Literature of Liberty</em> 5 (4): 5.&nbsp;A&nbsp;note stimulated by reading Norman Barry, “The Tradition of Spontaneous Order,” <em>Literature of Liberty</em> 5 (4): 7 – 58.</p> <p><a id="ch9_ref05"></a>Dorn, J. A. (1987a) “The Warburton Collection at George Mason.” <em>History of Economics Society Bulletin</em> 8 (Winter): 41 – 48.</p> <p><a id="ch9_ref06"></a>__________ (1987b) “The Search for Stable Money: A&nbsp;Historical Perspective.” In J. A. Dorn and A. J. Schwartz (eds.) <em>The Search for Stable Money</em>, chap. 1. Chicago: University of Chicago Press.</p> <p><a id="ch9_ref07"></a>Greenfield, R. L., and Yeager, L. B. (1983) “A Laissez‐​Faire Approach to Monetary Stability.” <em>Journal of Money, Credit, and Banking</em> 15 (August): 302 – 15.</p> <p><a id="ch9_ref08"></a>Hayek, F. A. (1973) <em>Rules and Order</em>, vol. 1&nbsp;of <em>Law, Legislation and Liberty</em>. Chicago: University of Chicago Press.</p> <p><a id="ch9_ref09"></a>__________ (1976) <em>Choice in Currency</em>. Occasional Paper 48. London: Institute of Economic Affairs.</p> <p><a id="ch9_ref10"></a>__________ (1978) <em>Denationalisation of Money</em>, Hobart Paper Special 70, 2nd ed. London: Institute of Economic Affairs.</p> <p><a id="ch9_ref11"></a>Koppl, R. (2006) “A Zeal for Truth.” In R. Koppl (ed.) <em>Money and Markets: Essays in Honor of Leland B. Yeager</em>, chap. 1. New York: Routledge.</p> <p><a id="ch9_ref12"></a>O’Driscoll Jr., G. P. (1983) “A Free‐​Market Money: Comment on Yeager.” <em>Cato Journal</em> 3 (1): 327 – 33.</p> <p><a id="ch9_ref13"></a>Prasad, E. S. (2017) <em>Gaining Currency: The Rise of the Renminbi</em>. New York: Oxford University Press.</p> <p><a id="ch9_ref14"></a>Warburton, C. (1966) <em>Depression, Inflation, and Monetary Policy: Selected Papers, 1945 – 1953.</em> Baltimore: The Johns Hopkins Press.</p> <p><a id="ch9_ref15"></a>White, L. H.; Vanberg, V. J.; and Köhler, E. A., eds. (2015) <em>Renewing the Search for a&nbsp;Monetary Constitution: Reforming Government’s Role in the Monetary System.</em> Washington: Cato Institute.</p> <p><a id="ch9_ref16"></a>Yeager, L. B., ed. (1962) <em>In Search of a&nbsp;Monetary Constitution</em>. Cambridge, Mass.: Harvard University Press.</p> <p><a id="ch9_ref17"></a>Yeager, L. B. (1973) “The Keynesian Diversion.” <em>Western Economic Journal</em> 11 (June): 150 – 63.</p> <p><a id="ch9_ref18"></a>__________ (1976a) “Economics and Principles.” <em>Southern Economic Journal</em> 42 (4): 559 – 71.</p> <p><a id="ch9_ref19"></a>__________ (1976b) <em>International Monetary Relations: Theory, History, and Policy</em>, 2nd ed. New York: Harper and Row. (First edition printed in 1966.)</p> <p><a id="ch9_ref20"></a>__________ (1979) Keynote Address at the meeting of the Chesapeake Association of Economic Educators, University of Baltimore, December 7; from Leland Yeager’s unpublished note cards.</p> <p><a id="ch9_ref21"></a>__________ (1983) “Stable Money and Free‐​Market Currencies.” <em>Cato Journal</em> 3 (1): 305 – 26. Reprinted in J. A. Dorn and A. J. Schwartz (eds.) <em>The Search for Stable Money</em>, chap. 14. Chicago: University of Chicago Press, 1987.</p> <p><a id="ch9_ref22"></a>__________ (1986) “The Significance of Monetary Disequilibrium.” <em>Cato Journal</em> 6 (2): 369 – 95.</p> <p><a id="ch9_ref23"></a>__________ (1997) <em>The Fluttering Veil: Essays on Monetary Disequilibrium</em>. Edited with an introduction by G. Selgin. Indianapolis: Liberty Fund.</p> <p><a id="ch9_ref24"></a>__________ (2015) “The Continuing Search for a&nbsp;Monetary Constitution.” In White, Vanberg, and Köhler (2015: chap. 1).</p> <p><a id="ch9_note001"></a><sup><a href="#ch9_para001">1</a></sup> See “The Yeager Mystique” by William Breit, Kenneth Elzinga, and Thomas Willett (<a href="#ch9_ref01">1996</a>). The first two authors were Leland’s colleagues at Virginia, and the third was a&nbsp;former student. Yeager often brought a&nbsp;yardstick to class to draw complex diagrams. He sometimes stood on a&nbsp;chair and extended the graph onto the cinder blocks to get it perfectly to scale. (I am the safe‐​keeper of “the yardstick,” which I&nbsp;received from Ed Olsen when I&nbsp;hosted a&nbsp;retirement party for Leland at Cato.) “The stare” refers to Yeager’s penchant for avoiding small talk and simply staring at you intensely until you made a&nbsp;fool of yourself and departed his office totally embarrassed. As one graduate student recalled, “From the moment you entered his office you knew you were in trouble. Your simple question like ‘Will you be offering International Trade in the fall?’ was met by this stunned look of disbelief and a&nbsp;penetrating look straight into your eyes” (ibid., 222). Yet, those who got to know Leland found that he was an engaging conversationalist, a&nbsp;considerate mentor, and an excellent dinner host who enjoyed fine wines and knew their provenance (ibid., 224 – 25).</p> <p><a id="ch9_note002"></a><sup><a href="#ch9_para002">2</a></sup> Although his speech, which was given at the University of Baltimore on December 7, 1979, was never published, he prepared note cards that were neatly typed and, jointly, read like an article. The quotes are from those cards, which were preserved in my files.</p> <p><a id="ch9_note003"></a><sup><a href="#ch9_para003">3</a></sup> For a&nbsp;summary of the Warburton collection, see Dorn (<a href="#ch9_ref05">1987a</a>).</p> <p><a id="ch9_note004"></a><sup><a href="#ch9_para004">4</a></sup> Gerald P. O’Driscoll Jr. (<a href="#ch9_ref12">1983</a>) points to this and other problems with the BFH system.</p> <p><a id="ch9_note005"></a><sup><a href="#ch9_para005">5</a></sup> This book first appeared in 1966; the second edition was published in 1976. Quotes in the text come from the 1976 edition.</p> <p><a id="ch9_note006"></a><sup><a href="#ch9_para006">6</a></sup> According to Buchanan (<a href="#ch9_ref04">1982</a>), “The ‘order’ of the market emerges <em>only</em> from the <em>process</em> of voluntary exchange among the participating individuals. The ‘order’ is, itself, defined as the outcome of the <em>process</em> that generates it.”</p> </div> Mon, 24 Sep 2018 09:54:00 -0400 James A. Dorn https://www.cato.org/cato-journal/fall-2018/leland-b-yeager-market-grandmaster Abusing the “National Defense” Card https://www.cato.org/publications/commentary/abusing-national-defense-card James A. Dorn <div class="lead text-default"> <p>Economic policies and relations are an integral part of any bilateral relationship, especially in the case of U.S.-China relations. Both the U.S. and China have benefited from China’s integration into the global economy after 1978 and its policy of “peaceful development.” Tariff and nontariff barriers were significantly lowered by Beijing in its effort to join the World Trade Organization (WTO) in 2001; those reforms helped set the stage for China to become the world’s top trading country and second largest economy.</p> </div> , <div class="text-default"> <p>The expansion of U.S.-China trade has increased consumption possibilities for millions of people in both countries. No country in history has seen the massive reduction in poverty that has occurred in China during the last 40&nbsp;years. The specialization and division of labor that is constantly evolving in a&nbsp;dynamic global economy would suffer severely if there was a&nbsp;prolonged trade war between the U.S. and China.</p> <p>The Trump administration hopes to push China to the negotiating table by imposing, or threating to impose, high tariffs on a&nbsp;broad array of imports. In part to justify this protectionist strategy, the administration has turned to the age‐​old argument based on “national security.” While a&nbsp;case can be made for selective use of&nbsp;<a href="https://www.commerce.gov/news/fact-sheets/2017/04/fact-sheet-section-232-investigations-effect-imports-national-security" target="_blank">Section 232 of the Trade Expansion Act of 1962</a>, which permits the use of tariff and nontariff measures for national defense reasons and is recognized by the WTO; those reasons should be significant and not merely a&nbsp;ploy to protect special interests. The main risk in implementing protectionist policies based on these security considerations is that the “national defense card” will likely be overplayed, curbing legitimate trade and investment in the name of safety.</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>A regime based on shared rules to guide foreign trade and investment is far superior to a&nbsp;purely discretionary regime, with stop‐​go policies exercised through presidential tweets. </p> </div> </div> </aside> , <div class="text-default"> <p>The global economy is much more integrated today than it was before the information revolution. Complex supply chains span the world, with China being the predominant production platform. When links in that chain are broken, everyone suffers. That fact alone should deter anyone against upsetting the global economic order by instigating a&nbsp;trade war. A&nbsp;rules‐​based international order confers net benefits on the global economy by reducing uncertainty and risk. History has taught us that free trade promotes peace and prosperity, while protectionism does the opposite.</p> <p>President Donald Trump may think he can get a&nbsp;better deal from President Xi Jinping by using the protectionist stick, but so far that tactic has backfired as China has retaliated by increasing tariffs on imports from the United States in an escalating tit‐​for‐​tat strategy.</p> <p>A regime based on shared rules to guide foreign trade and investment is far superior to a&nbsp;purely discretionary regime, with stop‐​go policies exercised through presidential tweets. Trade wars lead to a&nbsp;rise in “economic nationalism” — that is, the use of industrial policy to build “national champions.” In the heat of such wars, leaders and the public too often ignore the opportunity costs of closing markets to foreign competition and ideas.</p> <p>The recent enactment of the&nbsp;<a href="https://www.lawfareblog.com/foreign-investment-risk-review-modernization-act-2018" target="_blank">Foreign Investment Risk Review Modernization Act</a>&nbsp;(FIRRMA), which is part of the National Defense Authorization Act (signed by President Trump on August 13), gives the Committee on Foreign Investment in the United States (<a href="https://www.treasury.gov/resource-center/international/Pages/Committee-on-Foreign-Investment-in-US.aspx" target="_blank">CFIUS</a>) greater scope to monitor inbound investments to make sure they do not jeopardize critical infrastructure or national security.</p> <p>Under the new law, which does not take effect until fiscal year 2019, the CFIUS review process will become longer and costlier. The hope is that the new process will make the U.S. more secure. However, it could also discourage cross‐​border capital flows that benefit high‐​tech startup firms, which are unlikely to pose a&nbsp;security threat. Although FIRRMA applies to all foreign countries, it is specifically designed to address Chinese investment in U.S. firms specializing in information technology, robotics, and other high‐​tech areas.</p> <p>In 2015, President Xi launched&nbsp;<a href="https://www.washingtonpost.com/news/monkey-cage/wp/2018/05/03/what-is-made-in-china-2025-and-why-is-it-a-threat-to-trumps-trade-goals/?noredirect=on&amp;utm_term=.c7c425f77d8d" target="_blank">“Made in China 2025,”</a>&nbsp;with the goal of making China a&nbsp;leader in global technology. The easiest way to accomplish that goal is to acquire high‐​tech startups in the U.S. and other major innovative countries. In September 2017, CFIUS blocked the acquisition of&nbsp;<a href="https://www.politico.com/story/2018/05/22/china-us-tech-companies-cfius-572413" target="_blank">Lattice</a>, a&nbsp;U.S. semiconductor maker, by a&nbsp;Chinese‐​backed investor. A&nbsp;few months later,&nbsp;<a href="https://www.usatoday.com/story/tech/news/2018/01/03/u-s-blocks-alibaba-affiliate-ant-financials-1-2-b-bid-moneygram/999126001/" target="_blank">Ant Financial,</a>&nbsp;an affiliate of Alibaba, had its bid for Moneygram blocked because of concerns over data privacy. The CFIUS caseload is sure to increase under the new legislation, especially as U.S.-China tensions escalate.</p> <p>China has also turned to national defense as a&nbsp;justification for restricting access to its own “strategic” industries such as energy, transportation, and finance. New laws have been enacted that restrict imports of information and communications technology (ICT) products and components by requiring that they be “<a href="https://www.wsj.com/articles/china-to-start-security-checks-on-technology-companies-in-june-1493799352" target="_blank">secure and controllable</a>” —a vague criterion that allows decision makers great discretion, increases uncertainty, and imposes heavy costs on U.S. firms seeking to enter China’s rapidly emerging ICT market.</p> <p>While President Trump’s protectionist strategy may exact some concessions from China (e.g., increasing China’s purchases of U.S. goods to reduce the trade deficit), it is unlikely to immediately improve market access in key sectors (e.g., telecommunications and banking), secure intellectual property rights, or end the practice of requiring foreign firms to share their proprietary information. Beijing has long promised to make those policy changes, but the current political environment in China means real reform will continue to be sluggish.</p> <p>Overextending the national security argument for protectionism is fraught with danger, as it could escalate economic nationalism and forgo the benefits of mutually beneficial trade under a&nbsp;rules‐​based regime. The U.S. and China should work together to strengthen the global economy by keeping the international supply chain open and by recognizing that even a&nbsp;small delinking of U.S.-China trade can have a&nbsp;large ripple effect.</p> </div> Fri, 07 Sep 2018 09:08:00 -0400 James A. Dorn https://www.cato.org/publications/commentary/abusing-national-defense-card Why Xi Jinping Thought Is a Threat to China’s Future https://www.cato.org/publications/commentary/why-xi-jinping-thought-threat-chinas-future James A. Dorn <div class="lead text-default"> <p>This year marks the 40th anniversary of China’s opening to the outside world in 1978. Following the disastrous Cultural Revolution and Mao Zedong’s death in 1976, economic development, not class struggle, became the primary aim of the Chinese Communist Party (CCP). Deng Xiaoping allowed experimentation with market‐​based alternatives to central planning, and for a&nbsp;while it appeared that economic liberalization would help create a&nbsp;free market in ideas with greater debate on political as well as economic issues. That hope is rapidly disappearing with the rising power of China’s president for life, Xi Jinping.</p> </div> , <div class="text-default"> <p>A new “little red” book,&nbsp;<em>Thirty Chapters about Xi Jinping Thought on Socialism with Chinese Characteristics for a&nbsp;New Era,</em>&nbsp;compiled by the Publicity Department of the CCP’s Central Committee, presents the politically correct view on Chinese‐​style socialism. The book is being widely distributed within China, but there is little room for serious debate. As the&nbsp;<em>China Daily</em>&nbsp;notes, the book “explains that Xi Jinping Thought is the guiding thought that the Party and the country&nbsp;<em>must</em>&nbsp;follow in the long run.”</p> <p>Xi Jinping Thought is a&nbsp;14‐​point manifesto to ensure CCP “leadership over all forms of work.”&nbsp;It promises “continuation of ‘comprehensive deepening of reforms’&nbsp;”; propagates the long‐​held myth that under “socialism with Chinese characteristics,” the “people” are “the masters of the country”; asserts that China should be governed by “the rule of law”; reinforces the post‐​Maoist idea that “the primary goal of development” is to improve “people’s livelihood and well‐​being”; and advocates creating “a peaceful international environment.”</p> <p>In March 2018, the National People’s Congress, by a&nbsp;vote of 2,958 to 2 (with 3&nbsp;abstentions), added “Xi Jinping Thought” to the Preamble of the PRC’s Constitution, alongside “Marxism‐​Leninism, Mao Zedong Thought, and Deng Xiaoping Theory.”&nbsp;At the same time, the NPC amended Article 1&nbsp;by adding: “The defining feature of socialism with Chinese characteristics is the leadership of the Communist Party of 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>China’s institutional infrastructure is weaker than it might appear at first glance.</p> </div> </div> </aside> , <div class="text-default"> <p>If President Xi actually allowed the common people to be “masters of the country,” adopted a&nbsp;genuine rule of law to limit the power of government and safeguard persons and property — including freedom of thought — then he would truly transform China. Yet his actions and growing power do not instill much confidence that the Middle Kingdom will couple economic freedom with limited government and protect basic human rights. Indeed, since Xi took over as paramount leader, economic reform has stalled or even regressed, and suppression of human rights has worsened.</p> <p>Liu Xiaobo’s dream for “a future free China” looks dim. As a&nbsp;signatory to Charter 08, he was imprisoned and not allowed to receive the 2010 Nobel Peace Prize in person, and his wife, Liu Xia, was put under house arrest for eight years. The empty seat at the Nobel ceremony was a&nbsp;stark reminder that although China is the largest trading nation in the world, it ranks near the bottom in terms of a&nbsp;free market for ideas.</p> <p>Without open debate and competition in a&nbsp;free market for ideas, the probability of big errors increases dramatically. China learned that lesson under Mao’s central planning and control. That is why Article 45 of the PRC’s 1978 Constitution guaranteed individuals “the right to speak out freely, air their views fully, hold great debates and write big‐​character posters.”</p> <p>Those “four big rights” were ended in 1980, and no longer appear in the Constitution. They ended because the CCP has a&nbsp;monopoly of power and to maintain that power the ruling elite must not let liberalization in the market for goods and services spillover to the market for ideas. All individual rights in China are suppressed by the power of the state, as represented by the vanguard of the CCP.</p> <p>Today, the PRC Constitution declares: “Citizens of the People’s Republic of China enjoy freedom of speech, of the press, of assembly, of association, of procession and of demonstration” (Article 35). It also states that “freedom of the person of citizens … is inviolable” (Article 37). Yet the reality is much different.</p> <p>The CCP’s Constitution continues to hold that&nbsp;“the highest ideal and ultimate goal of the Party” is “the realization of communism.” In truth, the Party’s monopoly on power is maintained through the suppression of a&nbsp;free market in ideas. Any criticism of the CCP is dealt with swiftly with no effective due process and no independent judiciary. In a&nbsp;country without a&nbsp;just rule of law and the free flow of information, there is little trust in government and much fear with regard to one’s security. Those cracks in the institutional infrastructure will put a&nbsp;drag on China’s future development and cause untold misery.</p> </div> Tue, 14 Aug 2018 10:16:00 -0400 James A. Dorn https://www.cato.org/publications/commentary/why-xi-jinping-thought-threat-chinas-future