Three views on Fed independence

While reading an excellent new book by Peter Conti-Brown, I came across this interesting observation:

Liberals like Tobin, Galbraith, and Harris weren’t the only ones who thought a policy separation problematic. Milton Friedman, the great monetary theorist on the right, thought central bank independence much less desirable than a straightforward monetary policy rule that increased the money supply at an agreed-on rate.

I’d never quite thought of things that way.  He suggests that back in the 1960s, many liberal economists favored a supportive Fed.  Let’s think about three ways the Fed could have interacted with the fiscal authorities during the Kennedy/Johnson fiscal expansion:

1.  The Fed could have supported the fiscal authorities by holding interest rates at a low level, despite the fiscal stimulus.

2.  The Fed could have maintained a neutral policy, with a 4% money supply growth rule.

3.  The Fed could have sabotaged fiscal stimulus with a 2% inflation target.

Policy #1 would be the most expansionary.  The second option would also be somewhat expansionary, as fiscal stimulus would push up nominal interest rates, and also velocity.

Under option #3, however, monetary policy would be not at all stimulative, and would essentially neutralize the impact of fiscal stimulus.  And I find that to be a rather odd way of looking at things.  In this framework, Milton Friedman’s monetarism is the “moderate” position.  (Quite a contrast to the rules vs. discretion debate, where Friedman took an extreme position.)  Even more surprisingly, you find Keynesians at each extreme.  The older 1960s Keynesians favored a supportive monetary policy, and the new Keynesians of the 1990s wanted monetary policy to sabotage fiscal policy, in order to keep inflation at 2%.

Once I started looking at things this way, I noticed an uncanny similarity to the three ways that one could categorize monetary policy interrelationships under an international gold standard.  In my book on the Great Depression, I did not look at the interaction of monetary and fiscal policy, but rather the way various central banks reacted to moves at the dominant central bank.  For instance, in the late 1800s the Bank of England was dominant.  Other central banks could be supportive, neutral, or sabotage discretionary actions by the BoE.  In 1930, Keynes argued that they tended to be supportive:

During the latter half of the nineteenth century the influence of London on credit conditions throughout the world was so predominant that the Bank of England could almost have claimed to be the conductor of the international orchestra. By modifying the terms on which she was prepared to lend, aided by her own readiness to vary the volume of her gold reserves and the unreadiness of other central banks to vary the volumes of theirs, she could to a large extent determine the credit conditions prevailing elsewhere. (1930 [1953], II, pp. 306–07, emphasis added)

Here’s how I interpreted this issue in my book on the Depression:

If Keynes were correct then the Bank of England would have had enormous leverage over the world’s money supply.[1] For example, assume the Bank of England doubled its gold reserve ratio. This would represent a contractionary policy, which would then lead to a gold inflow to Britain. If other countries wished to avoid an outflow of gold they would have had to adopt equally contractionary monetary policies. In that case the change in the Bank of England’s gold reserve ratio would have generated a proportional shift in the world gold reserve ratio.

Although it is unreasonable to assume that foreign gold stocks were not allowed to change at all, during the interwar period some countries did not allow significant fluctuations in their monetary gold stocks.[1] Other central banks may have varied their gold holdings, but not in response to discretionary policy decisions taken by the Bank of England. Thus it is quite possible that the estimates in Table 13.5 significantly understate the ability of central banks to engage in discretionary monetary policies.

An alternative form of interdependence occurs when countries refuse to allow gold flows to influence their domestic money supplies. If one country reduces its gold reserve ratio, other countries can offset or “sterilize” this policy by raising their own gold reserve ratios. Complete sterilization would occur if the other countries raised their gold reserve ratios enough to prevent any change in the world money supply.

If central bank policies are interdependent, then there are a variety of ways in which a change in one country’s gold reserve ratio might impact the world gold reserve ratio:

1. d(ln r)/d(ln r_i) = 0 (the complete sterilization case)
2. d(ln r)/d(ln r_i) = G_i/G (the policy independence case)
3. d(ln r)/d(ln r_i) = 1 (the extreme Keynesian case)

In Table 13.5 the estimated impact of central bank policy changes was computed under the “policy independence” assumption (i.e., that a change in one country’s gold reserve ratio had no impact on gold reserve ratios in other countries).

[1] There also may have been an asymmetrical response, with central banks being more reluctant to allow gold outflows than gold inflows. Note that the unwillingness of central banks to vary their gold holdings does not necessarily imply an unwillingness to freely exchange currency for gold. They could set their discount rate at a level to prevent gold flows.

[1] McCloskey and Zecher (1976) criticized Keynes’s assertion by noting that the Bank of England held a gold stock equal to only 0.5 percent of total world reserves. This would seem too small to allow the Bank of England any significant influence over the world money supply (or price level). There are several problems with their criticism. They have assumed that central banks were indifferent between holding gold or Bank of England notes as reserves. Yet many countries placed great importance on their gold stocks, and in some cases laws specified a minimum gold reserve ratio. Thus the relevant size variable is the ratio of England’s monetary gold stock to the world’s monetary gold stock, not the ratio of England’s gold stock to total world reserves. More importantly, McCloskey and Zecher ignored Keynes’s assumption that other central banks were unwilling to vary their reserves of gold (as the rules of the game required).

These three cases offer an interesting parallel to the three types of fiscal/monetary coordination discussed above.  The “extreme Keynesian case” (relying on his 1930 hypothesis) is equivalent to the supportive central bank preferred by 1960s Keynesians.  The policy independence case occurs if countries follow the “rules of the game”, i.e. they must allow their money supplies to move in proportion to their monetary gold stocks.  This case is obviously similar to Friedman’s money supply rule.  And the complete sterilization case is equivalent to a central bank that sabotages fiscal actions. Indeed another term I could have used for “monetary offset” is “monetary sterilization of fiscal policy”.

PS.  This post is rather tangential to the main thrust of the Conti-Brown book.  I also have a new post on his book at Econlog, which gives a better sense of the book’s focus.

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This entry was posted on July 07th, 2016 and is filed under Fiscal policy, Monetary History, Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.