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 ri) = 0 (the complete sterilization case)
  2. d(ln r)/d(ln ri) = Gi/G (the policy independence case)
  3. d(ln r)/d(ln ri) = 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.



11 Responses to “Three views on Fed independence”

  1. Gravatar of Ray Lopez Ray Lopez
    7. July 2016 at 15:00

    From the Amazon blurb on the cited book: “Challenging the notion that the Fed Chair controls the organization as an all-powerful technocrat, he explains how institutions and individuals–within and outside of government–shape Fed policy. ” – does Sumner think the Fed is ‘all-powerful’? Or is money largely neutral and the Fed follows the market? Even in the TARP program the Fed was buying junk paper at a premium to what the market was asking, if you believe “Joe” from the David Beckworth interview. Put another way: if the Fed follows the market, could it mean the Fed really has no power over the market, and must follow the market? Apparently our host is somewhat coming around to that view, if you read his post between the lines. And indeed, Ben S. Bernanke’s 2002 FAVAR paper says Fed policy shocks (which by definition were not foreseen by the market) only account for 3.2% to 13.2% of any change in any economic variable (out of a 100% change), which while statistically significant is nearly trivial. In short: “money is neutral”.

  2. Gravatar of Benjamin Cole Benjamin Cole
    7. July 2016 at 16:33

    Scott Sumner’s book is essential reading.

    However, the most important (and way best) central banker of the Great Depression was Takahashi Korekiyo.

    Japan largely sidestepped the Great Depression.

    For Ray Woepez: money is neutral blah, blah, blah. But is not dodging the Great Depression a worthy result of a good monetary policy?

  3. Gravatar of TravisV TravisV
    7. July 2016 at 20:26

    Fascinating new post by David Glasner on Mervyn King’s new book!

  4. Gravatar of Ray Lopez Ray Lopez
    8. July 2016 at 01:38

    @Ben Cole – JP did survive the GD by invasion of Manchuria. Here is the second link from Google: “Japan’s prosperous economy and new government structure did not continue into the next decade. Japan, an island nation with few natural resources, relied on foreign trade. When the Great Depression hit the world in the early 1930’s, counties no longer imported Japanese luxuries such as silk. The value of Japanese exports dropped by 50% between 1929 and 1931 (p 686, Beers). Many people blamed the government for Japan’s economic crisis. After Japan agreed to keep its navy very small at the London Naval Conference in 1930, the military and nationalists became fed up with the government (p 686, Beers). Since Japan lacked natural resources and building space, the military invaded the area of Manchuria in northeastern China in September 1931.”

    Money is neutral.

  5. Gravatar of rayward rayward
    8. July 2016 at 03:25

    Of course, the “Kennedy tax cut” (as it was called) was intended as fiscal stimulus, but the fiscal expansion Sumner mentions was primarily the result of the Vietnam War (and Johnson’s policy of so-called “guns and butter”, or deficit spending to fund both the war and the great society programs). What Sumner et al. have chronicled is that monetary policy and fiscal policy often are at cross-purposes, not because of a desired equilibrium effect but because of politics dictating policy. Indeed, politics sometimes can drive the economy over the cliff, and not by accident. There’s general agreement among economists that today (and for the past several years) the economy needs more fiscal stimulus and, perhaps, less reliance on monetary stimulus, but the former is a non-starter for political reasons not policy. And recall that 15 years ago large fiscal stimulus (in the form of tax cuts) was promoted, first, to avoid government surpluses, and then, within months, was promoted to increase economic growth; in other words, tax cuts as policy regardless of the economic conditions. The question, then, is whether an independent Fed is essential to offset a dependent (on politics) Congress and Executive. The problem is that the Fed can’t be “independent”, not in the sense of crafting a monetary policy that stands on its own because all too often the monetary policy implemented is exaggerated in order to offset the wrong (for the time) fiscal policy that is dictated by politics. So we end up with the wrong fiscal policy and an exaggerated monetary policy. Do two wrongs make a right in economics? What Sumner seems to promote (and what Friedman promoted) was monetary policy standing on its own rather than as a response to an often misguided fiscal policy.

  6. Gravatar of bill bill
    8. July 2016 at 03:58

    I would modify #3 by adding to it.
    The Fed could have sabotaged fiscal stimulus with a 2% inflation target that it also sabotages so that markets end up thinking it’s a 2% inflation ceiling.

  7. Gravatar of Off Topic Off Topic
    8. July 2016 at 05:27

    More China trade stuff:

  8. Gravatar of flow5 flow5
    8. July 2016 at 07:59

    “And the complete sterilization case is equivalent to a central bank that sabotages fiscal actions.”

    ? How does monetary sterilization negate fiscal actions?

    “the economy needs more fiscal stimulus”

    No, rayward, the buget needs cut.

    What needs to happen to correct our prolonged economic contracttion (which began in 1965), is to get the CBs out of the savings business. There are 9 trillion dollars of savings impounded within the confines of the CB system. I.e., from a System’s standpoint, the CBs do not loan out existing deposits, saved or otherwise.

    By forcing savings through non-bank conduits, there is a non-inflationary increase in the supply of loan-funds (and a decrease in long-term interest rates).

    And money flowing thru the NBs doesn’t change the money stock (there’s just a change in ownership/title)- so no change in the volume of CB earning assets, nor the income received by the system, etc.

    This is the crux of the world-wide economic malice, i.e., the Gurley-Shaw thesis.

  9. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2016 at 09:56

    Ray Woepez: Yes, because the Japanese invaded Manchuria, money is neutral.

  10. Gravatar of ssumner ssumner
    8. July 2016 at 10:48

    Thanks Travis.

    Rayward, You said:

    “There’s general agreement among economists that today (and for the past several years) the economy needs more fiscal stimulus and, perhaps, less reliance on monetary stimulus, but the former is a non-starter for political reasons not policy.”

    God help us if that is true, as it’s a recipe for slower growth and bigger budget deficits.

    You said:

    “What Sumner seems to promote (and what Friedman promoted) was monetary policy standing on its own rather than as a response to an often misguided fiscal policy.”

    No, I don’t agree with Friedman. I want monetary policy to offset misguided fiscal policy.

  11. Gravatar of Ray Lopez Ray Lopez
    8. July 2016 at 10:59

    @Ben Cole – who says: “Ray Woepez: Yes, because the Japanese invaded Manchuria, money is neutral.” – no, that’s not it. Read the blurb I gave you. JP did suffer in the Great Depression, but arguably the fiscal (not monetary) stimulus from Manchuria war production boosted their GDP. Recall the meme about WWII ‘ending’ the Great Depression in the USA.

    BTW, you’re pretty ignorant about economics, your supposed specialty. Did you read my rebuttal of your erroneous but common claim that New World silver caused a boom in Spanish GDP in the 16th century? It’s wrong: real GDP per capita declined in Spain from before 1492 until 1800 (citing data from Alvarez-Nogal & de la Escosura 2013). Nominal GDP means nothing. There’s no money illusion and money is neutral.

    What else don’t you know?

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