Thursday, September 20, 2007

Why do we have a Fed?

John Stewart asks the question, and Greg Mankiw echoes it, elevating the question from comedy to serious economics, or at least serious economic pedagogy. The problem, as I argued in the comments section of Greg’s post, is that the question is ambiguous unless you specify what alternative you have in mind. (Part of John Stewart’s comedy technique, it seems to me, is to ask oversimplified questions.) You need to ask, “Why do we have a Fed instead of X?” where X is some specific other possibility. Otherwise (in the words of my commenting self)
you're asking a lot of different questions, and no wonder there is no simple answer: Why do we have money instead of barter? Why do we have a huge, public central bank instead of letting private banks handle the function of "bankers' banking"? Why do we have fiat money instead of a commodity standard? Why do we have a discretionary central bank instead of a merely technical money-creation facility that would follow a set of legislated rules?
And now I will answer those questions.

Why do we have money instead of barter? Because barter is ridiculously inconvenient. Do I really have to go into the economic theory here?

Why do we have a huge, public central bank instead of letting private banks handle the function of "bankers' banking"? Because of economies of scale in central banking and the fact that an efficiently sized private central bank would have too much power. Before the Fed came into existence, the “central” problems in banking were often solved by temporary cartels. The last straw in private central banking was when J.P. Morgan solved a banking panic by essentially declaring himself the leader of an impromptu central banking cartel and demanding, successfully, that the other members do his bidding.

Why do we have fiat money instead of a commodity standard? Greg should be happy with “sticky prices” but I don’t even think we need to mention such theoretically troublesome matters. How about just the risk of hyperdeflation – when the monetary commodity becomes a bubble asset. This is roughly what happened during the early 1930s, and it was solved, separately in various different countries, by abandoning the commodity standard. Granted, sticky prices and wages made the hyperdeflation a lot more painful than it otherwise might have been, but isn’t avoiding hyperdeflation a good enough reason by itself?

Why do we have a discretionary central bank instead of a merely technical money-creation facility that would follow a set of legislated rules? One way to answer this is to say that there is no good reason and to spin some theory of conspiracies or vested interests or self-important macroeconomists standing in the way of progress. But I think there is a good reason. The reason is that our objective function for central banking is so complicated that it would be impractical to put it into a fixed set of rules. The rules would constantly run into problems when we realized that they were missing some detail that circumstances suddenly rendered critical, and Congress would have to have emergency sessions and appoint temporary central bankers to deal with the problems. We want a stable financial system (even though the system is constantly evolving); we want stable prices; we want stable interest rates; we want stable employment; we want this; we want that; … The macroeconomy is like a spoiled child demanding all sorts of subtle and incompatible things. Rather than trying to make the child (who, by the way, isn’t very good at making decisions, since he has to use the democratic process to do it) specify “I’m willing to accept X amount of interest rate variance in exchange for Y amount of inflation variance” and so on, isn’t it better just to appoint a wise and respected nanny to make the necessary compromises?

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16 Comments:

Anonymous Anonymous said...

Knzn,
Your writing about monetary econmics is quite awesome and easily one of the best sources of understanding monetary economics on the internet. Please blog more often.

Fri Sep 21, 01:21:00 PM EDT  
Blogger Laurent GUERBY said...

Unofficial reason: otherwise lots of economists would be unemployed :)

Fri Sep 21, 02:55:00 PM EDT  
Blogger TDDG said...

KNZN: Well said. Don't you sometimes feel as though people who ask such questions never look at why the institution was set up in the first place? As you said, history shows that before we had a central bank, we had a much more volatile economy.

I read once, and I can't remember where, that Greenspan himself once said that he wished we didn't have a Fed, but if we were going to have one, it may as well operate based on Friedman's theories on money. I believe that was in his Ayn Rand years. Anyway, keep up the interesting writing.

Fri Sep 21, 05:01:00 PM EDT  
Blogger Gabriel M. said...

TDDG,
In his essay in Ayn Rand's book he supported the gold standard.
His support for a Friedmanian freeze in the base (or was that long-run k% average?) is more recent.

Knzn,
Central banking creates a lot of power. True. But why is that power better in the hand of B. Bernanke and colleagues than in the hands of J.P. Morgan figures?

Re: commodity money, you can use a broad index as to avoid having your currency move sharply in a direction different form the wider economy.

Re: sticky prices, I wonder how much of today's stickiness comes from expectations of Fed intervention. This sort of thing feed on itself.

Plus, you have to weigh the benefits of addressing sticky prices (successfully?) with the cost of having much power in the hands of government.

As for the spoiled child mentality... First of all, maybe the reasons why we still fail at the basics, at times, in some places, is related to these unlimited desires.

Secondly, if you have a huge concentration of power, soon people will start thinking about ways to take it over and ways in which to demand more of it.

Sat Sep 22, 03:52:00 AM EDT  
Blogger Gabriel M. said...

I would have also liked to see the distinction between why-justification and why-cause drawn more clearly.

Why central banks were created had nothing to do with sticky prices or doing the greater good for the greatest number, I suspect. :-)

Sat Sep 22, 03:55:00 AM EDT  
Blogger knzn said...

why is that power better in the hand of B. Bernanke and colleagues than in the hands of J.P. Morgan figures?

Because a central bank that is a quasi-governmental institution has a responsibility to the public and its members can be chosen as people who will take that responsibility seriously, whereas with J.P. Morgan, you just have to get lucky to have someone who will serve the public interest rather than his own personal interest. (I know appointed central bankers aren't immune to personal interests, but it's a matter of degree. Appointed central bankers are likely to feel more responsibility to the public than someone who just happens to have enough economic power to act like a private central banker.) Also, there's nothing to assure that the private central bank will have attained the efficient scale at the time when it's needed, because the needs are lumpy.

In the case of the Fed's actual founding, the why-cause and the justification for "why do we have a huge, public central bank..." were pretty much identical, I think. I gather that the memory of J.P. Morgan's role in solving a recent banking panic was brought up explicitly as an argument for establishing the Fed. We still had a gold standard at the time, and I don't fiat money was much of an issue.

But for someone asking the question today "Why do we have a Fed?" it could be seen as referring to the fiat money responsibility later conferred on the Fed (and indeed John Stewart's question kind of has that ring to it). And there again, I think the cause for the Fed being given that responsibility stems from the same incidents as the justification that I give: the deflation of the early 1930s. (Although after that, there was Breton Woods, where you had sort of semi-fiat money, and the transition to pure fiat money probably had more to do with Nixon's political concerns than with legitimate concern about sticky prices and potential deflation.)

In the case of rules vs. discretion, the why-cause could just be inertia, since we have never had a fiat money system without a discretionary monetary authority. But I think that point is pretty much implicit in the mention of possible "self-important macroeconomists standing in the way of progress", after which I go on to discuss what is clearly my own justification rather than an actual cause.

Sat Sep 22, 11:16:00 PM EDT  
Anonymous sredni_vashtar said...

For an answer to your last question about the nanny, look here, chapter III.

Sun Sep 23, 06:18:00 AM EDT  
Anonymous Anonymous said...

I hate to point this out, but the FED is not a public entity - it is a private organization owned by various private shareholders who are restricted, by legislation, to only paying themselves 6% dividends on the profits they make from all the money they create out of thin air...

If the FED were public (instead of being private, as it is currently) that would be ONE STEP in the right direction... on a long long long long road back to sound money.

Mon Feb 11, 07:03:00 AM EST  
Blogger ghaws said...

Hi Knzn -- great blog! I have another justification for the following question: "Why do we have fiat money instead of a commodity standard?"

A commodity standard is effectively a government commitment to honor a fixed rate of exchange between the currency and a arbitrarily chosen commodity (usually gold) — it's an exchange rate mechanism wherein the "peg" is a commodity.

This commitment will work well when the market believes that the government has sufficient reserves (à la bank capital requirements) to honor its commitment to maintain such a peg (the "honeymoon effect"). But it can collapse very swiftly when the market loses confidence in the system (a run on the treasury), taking the value of the currency with it. So, I suppose you could say that this would be hyper-INFLATIONARY in that the value of the currency collapses, and prices skyrocket, rather than hyper-deflationary, which is more analogous to Japan's "lost decade" in the 1990's (and the present US credit crisis that will likely lead to similar results).

If the sovereign backing the commitment exercises fiscal restraint, that would prevent such a problem. But we all know how the government loves to go into debt when political expediency demands that politicians fund new programs for their constituencies...

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