By Daniel J. Smith
According to a 2005 World Bank report, a primary driver of the wealth of nations is the rule of law. The rule of law, as opposed to the discretionary rule of politicians and bureaucrats, enables individuals to coordinate their plans under a predictable and general framework of rules, and is hence a key component of economic and political freedom. To paraphrase L. Fuller in the Morality of Law, the rule of law prevents, among other things, ad hoc decision-making, un-publicised laws, incomprehensible laws, contradictory laws, and laws that change too frequently. Failure to maintain the rule of law can undermine the institutions that drive economic growth and prosperity.
Given its importance for free and prosperous societies, the rule of law has become a bedrock principle of government in contemporary democracies. Taxation, fiscal policy, regulation, courts, the police, and militaries are all beholden to the rule of law to prevent the abuse of public power.
There is one major entity in modern governments, however, that largely operates beyond the rule of law; our monetary institutions: central banks.
Especially during times of crisis, central banks make ad hoc decisions, operate via informal and often opaque, rules, behave in a manner incomprehensible even to legal and monetary scholars, and frequently alter their informal rules and policies.
To be sure, some central banks do follow rules, such as inflation-targeting. But on the whole, central banks around the world operate on the basis of empowering expert technocrats to manipulate the levers of the economy largely as they see fit. Even the explicit objectives of central banking, the pursuit of maximizing employment subject to long-term price stability, enable monetary authorities the discretion to select and change the relative weights on each objective. And, central bankers have had the leeway to introduce new informal objectives, including exchange rate stabilization, inequality, and climate change, without legislative approval.
In Money and the Rule of Law (Cambridge University Press), Alexander W. Salter, Peter J. Boettke, and I argue that discretionary central banking conflicts with the rule of law. Furthermore, central bank policy often becomes nonoperational in the face of real-world knowledge and incentive problems. In other words, discretionary central banking fails the test of robust political economy.
Even droves of Ph.D. economists do not have the real-time knowledge to bring the money supply into balance with money demand. The market’s liquidity preference is inherently unpredictable due to constantly changing economic, demographic, and psychological factors. New financial products, such as cryptocurrency and non-fungible tokens, also affect the demand for money in unpredictable ways. Central bankers are marginally successful at estimating the long-term demand for money during normal times. But the competence central banks have is severely hampered during financial crises. The demand for money becomes most unpredictable during times of crisis when central bankers are most expected to act. Benjamin Bernanke, Timothy F. Geithner, and Henry M. Paulson, Jr., writing about their experience during the Financial Crisis, state that “There was no standard playbook we could consult for guidance, no professional consensus about best practices. We had to feel our way through the fog, sometimes changing our tactics, sometimes changing our minds, with enormous uncertainty about the outcomes.”
The inability of central bankers to appropriately adjust the supply of money in accordance with changes in the demand for money generates persistent monetary disequilibrium. This disequilibrium, in turn, undermines the efficacy of the price system, disrupting the flow of information and the structure of incentives that is the driving force of economic progress. As we saw in the years prior to the 2008 financial crisis, central bank mismanagement of money can also drive speculation and malinvestment with catastrophic consequences for the economy.
Uncertainty is simply an unavoidable reality of central banking, as central bankers Alan Greenspan, Mervyn King, and Jerome Powell can attest to. The same knowledge problems that render central planning inoperable make it impossible for discretionary central banking to achieve its own objectives.
Even if knowledge problems were not a factor, discretionary central bankers would still face incentive problems. Central bankers face both internal and external pressures. Internal pressures emerge from the bureaucratic nature of central banks: they face incentives for inertia, groupthink, budget maximisation, and mission creep. Externally, central bankers are pressured by politicians up for re-election or seeking policy coordination for their platform policies.
Political pressures on central banks escalate during crises. As a result, the size and scope of their policy interventions can drastically expand. Central banks’ footprint on the economy becomes permanently larger. It can also lead to the creation of programs that actually incentivise risky behavior in the future. We saw this on full display during COVID-19, when the Federal Reserve went beyond providing liquidity to the market to engaging in direct credit allocation, including to state and local governments. In other words, the Fed engaged in fiscal policy, not monetary policy. This sets a dangerous precedent.
What would monetary institutions look like if we held them to the same lawful standards as other public institutions? The answer is clear: we need a binding rule on the goals of monetary policy. While modern central banks make occasional pro-rule gestures, they have the discretion to ignore these pseudo-rules when and where they see fit. The Federal Reserve’s departure from their inflation target and the Reserve Bank of New Zealand’s constant changing of their inflation target’s content are two well-known examples. In Money and the Rule of Law we outline three possible avenues for moving towards a truly rule-bound monetary system.
One avenue would be a strictly binding rule, such as an inflation-targeting or nominal income-targeting. These rules would need to incentivise central bankers with rewards and punishments to adhere to the specified rules. Importantly, the rule cannot be chosen by the central bank. It must be imposed by the legislature.
Similarly, we could benefit from formally adopting a restricted last-resort lending policy to combat financial crises. Walter Bagehot’s argument for a crisis policy is still best. We need rules that are binding even during crises because it is during crises the pressure to behave irresponsibly is highest. Monetary generality and predictability are essential for helping the economy readjust and recover. Without rules, those adjustments might never happen.
The second possibility is the constitutionalisation of money. This means formally amending the basic law of the land to specify the proper objectives of monetary . Such a constitutional rule would ensure predictable and non-discriminatory monetary policy from central banks. Monetary constitutionalisation would better establish money as a property right of citizens, alongside other fundamental rights, rather than a prerogative of central bankers.
The last possibility for establishing a rule-bound monetary system would be free banking. This means completely abolishing any legal restrictions on money, banking, and finance, save the general laws of property, contract, and torts. It is a free-enterprise approach to money. This is not as radical as it seems. The argument for free banking is that market competition is a proven method for coordinating complex production processes. Under free banking, profit maximisation by financial firms adjusts the supply of money to offset changes in money demand. This eliminates “monetary policy” and replaces it with the tried-and-true forces of market discipline. As the historical record shows, the results are short-run economic stability and long-run economic growth. While cryptocurrency is an interesting development providing some limited competition in the money space, legal tender laws prevent true banking competition from emerging.
Whatever path is chosen, the key issue remains subjecting monetary institutions to the rule of law. This is our book’s chief contribution. We need real monetary rules. Only lawful monetary institutions can fulfil the promise of human flourishing through peaceful commerce and trade.
About the Author
Professor Daniel J. Smith is the Director of the Political Economy Research Institute at MTSU and a professor of economics in the Jones College of Business. He is a co-author of Money and the Rule of Law (Cambridge University Press). Follow him on Twitter: @smithdanj1