No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 293 2 ND BEST POLICY RECOMMENDATIONS So what should we do to minimize inflation and the boom/bust cycle? The best solution would be to get politics out of the provision of money—after all, we see markets doing a pretty good job in everything else. Historically, free banking was stable and successful. Economists George Selgin and Larry White have shown that central banks are not needed, even with fiat money. But given the overwhelming reality that sovereigns are going to be in the money business, how can we constrain their behavior? This raises the question of rules vs. discretion . There is a continuing debate among economists as well as policy makers as to whether central banks should follow strict and simple rules, or have flexibility to “manage” the economy. A fixed rule might be to go back to a gold standard, or to commit to a certain rate of growth of a monetary aggregate, or to target a particular rate of inflation. The point of rules is to constrain the monetary authority’s hands in advance so that she will not be able to submit to political pressure. The general view of those who support fixed rules is that discretionary monetary policy is much more likely to lead to problems than to solve them. Supporters of fixed rules will point to the Great Depression and the Great Contraction, as well as the inflationary 1970s to support constraining the Fed. Alternatively, other economists and policy makers basically see the economy as unstable, and they believe the monetary authority must have the flexibility to deal with problems as they arise. While supporters of fixed rules see the Great Depression and the current Great Contraction a result of poor monetary and fiscal policy, supporters of monetary discretion see these downturns as the result of natural market processes (i.e., “animal spirits”). They see markets as needing constraint, not policy makers. They will point to reduced volatility of the business cycle since the Great Depression (until the recent Great Contraction!). What the best rule might be is beyond the scope of this book; but it is important that you understand the different philosophies supporting both rules and discretion. You will see advocacy for both positions in political discussions of monetary policy. IT’S A WRAP! This completes our introduction to money. You are now aware of the intersection of politics and economics with a very political institution, the Federal Reserve, affecting much of our daily lives by their policies. In the next two chapters we will explore the political part of political economy. We’ll begin in chapter 13 by addressing the rationale for government involvement in the economy—to address so-called “market failure. Rules vs. discretion: a debate over how the central bank should conduct monetary policy (i.e., should the central bank be mandated to follow a fixed rule that will guarantee stability, or should the central bank be allowed flexibility in implementing policy to deal with unforeseeable contingencies?).