On this week’s episode of the Governance Podcast, our Assistant Director Dr. Bryan Cheang interviews Prof. Daniel Smith from Middle Tennessee State University. This episode features his latest book Money and the Rule of Law, published by Cambridge University Press and co-authored with Alexander Salter and Peter Boettke. Drawing on a wide body of scholarship, this volume presents a novel argument in favor of embedding monetary institutions into a rule of law framework. The authors argue for general, predictable rules to provide a sturdier foundation for economic growth and prosperity. The authors argue that a rule of law approach to monetary policy would remedy the flaws that resulted in misguided monetary responses to the 2007-8 financial crisis and the COVID-19 pandemic.
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The Guest
Daniel J. Smith is the Director of the Political Economy Research Institute and Professor of Economics in the Jones College of Business at Middle Tennessee State University. He serves as the North American Co-editor of The Review of Austrian Economics and is the President-elect of the Society for the Development of Austrian Economics. His academic research and policy work uses Austrian and public choice economics to analyze private and public governance institutions.
Transcript
Bryan Cheang
Welcome to the Governance Podcast by the Centre for the Study of Governance and Society at King’s College London. I’m Bryan Cheang and the Assistant Director of this organisation. Today we’re very pleased to have with us Professor Daniel Smith. Daniel Smith is the Director of the Political Economy Research Institute and Professor of Economics in the Jones College of Business at Middle Tennessee State University. His academic research and policy work uses Austrian and public choice economics to analyse private and public governance institutions. Today we’ll be discussing Daniel, his new book, co-authored with Peter Becky and Alexander Salter, with Cambridge University Press title, ‘Money and the Rule of Law: Generality and Predictability in Monetary Institutions’. Daniel, thanks for joining us on an episode of the podcast.
Daniel Smith
Thank you, Bryan, it’s great to be with you. Thanks for the invitation.
Bryan Cheang
Perhaps we can start off the discussion by asking you why you decided to write a book connecting monetary policy institutions with the rule of law? What is the problem that you see right now that you’re trying to identify and put your finger on?
Daniel Smith
Yeah, so we’re looking at the rule of law and its application across a wide range of government programmes. And it’s something that classical liberals appreciate and have a deep respect for. It’s one of the things that drives economic growth, prosperity around the world. And we noticed that the rule of law did not did not get applied to central banking, which is a real puzzle, because sound money is one of the most core components of economic freedom and one of the drivers of economic prosperity around the world. And the undermining of sound money has been at the the catalyst for some of the worst and most catastrophic events in human history, the fall of the Roman Empire, the French Revolution, Hitler’s rise to power, the Great Depression, the financial crisis. And it’s just odd that we never applied the rule of law, especially because if you go back to the academic literature, there was a debate among academic economist about money and the rule of law, like should we have rules or discretion, and rules won that debate, hands down, but in practice, discretion, won that debate.
So essentially, we’re looking at a set of central banking institutions around the world that are largely conducted by unelected and oftentimes unaccountable officials, essentially given complete discretion. So it’s an EPA stock receipt, that does not have democratic justifiability in terms of being connected to the people and driven and conducted on their behalf. So rather than money being seen as a property right of citizens, citizens that need to be protected and defended. It is oftentimes seen as a prerogative of central banks and all the influences that they received from major financial players and politicians.
Bryan Cheang
So when we discuss applying the rule of law in the area of monetary policy, what do we mean by this? You know, some people may think of simply inflation targeting, right, setting a certain rate for policymakers to aim at. But it seems that you are recommending something deeper than that. It’s about institutional and constitutional arrangements. Right. So what do we mean by applying the rule of law in this case?
Daniel Smith
Yeah, that’s a great question. Certainly inflation targeting could be construed as one rule. But in practice it is often a very weak rule, either one that’s informally followed, like at the Federal Reserve, where they’re allowed to deviate from it as they see fit. And they’re the ones that decided that they were the ones going to pursue that rule. And there’s no punishment mechanism for deviating from that rule, or bonuses for hitting it. So what we argue for is a true monetary rule, not a pseudo rule that isn’t actually enforced a true binding monetary rule that actually set constraints with central bankers are allowed to do, no matter how heavy the political pressure or pressure they get from from big financial institutions, they have a strict rule they have to adhere to, and they’re given rewards for following it. And they’re punished for deviating from that rule. And that creates generality and predictability and money which is fundamental, especially during times of crisis for entrepreneurs out there making all the decisions reallocating capital to have general and predictable money is essential for economic growth and prosperity.
Bryan Cheang
I was just wondering, we look at the world today. Are there certain countries or case studies that you think are worth emulating? Any experiments with such rules that you think, you know, worth copying?
Daniel Smith?
Yeah, so we identified three different types of rules that we think fit. Under this criteria of praying generality and predictability in monetary institutions, we don’t think the discussion is limited to those three, we just think those are the best three at this time. And we don’t, you know, we don’t take a side on any of those. But those are one to create a strictly binding rule like Ngdp targeting, which has received a lot of attention in the academic literature, and we find very intriguing. Second, and this is from James Buchanan is to constitutionalize money. So if money is a fundamental right of citizens then put it in the Constitution, right next to other rights, like the freedom of speech. And that at least protects, it gives another layer of protection against politicians and special interest groups. The third would be free banking, which is the most radical idea; this was the one proposed by FA Hayek and would actually allow private banks to issue currency in competition with the government or just eliminate central banks altogether and allow money to become a privately provided commodity.
But we find those as the three most interesting, we do look into a survey of other types of rules that have been implemented around the world since, such as inflation targeting. And they’ve even been implemented with punishment mechanisms like the Bank of New Zealand, or the European Union, there were some explicit punishment mechanisms. The thing is that they’re, they’re rarely if ever used. And the other problem with inflation targeting rules is that whenever they didn’t hit those targets, they changed the rules, they changed the range of the inflation target, to suit the circumstances rather than stick to the rules, when it was hard to do the right thing. So by and large, the rules that central bankers have adopted themselves and tried to enforce have failed. We need a stricter binding rule that comes from a legislative authority that really curtails and constrains what central bankers are allowed to do.
Bryan Cheang
Thank you. Before we delve deeper on some of these recommendations and prescriptions that you’ve suggested, I’ll like to take a step back and focus a little bit more about the analysis that you conduct in the book itself. And I refer specifically to page 15. I think this is very interesting. You wrote in this picture that readers familiar with mainstream monetary economics, and macro economics may find our methods and arguments unusual. We will not construct any mathematical models or not test econometric theory, any hypotheses. Instead, you’ll be using simple verbal logic grounded in an economic way of thinking, why we believe constrained discretion cannot be adopted by central banks, if their goal is economic stability. So perhaps could you share with us why you say that these methods have been unusual? And why do you think this move is justified? You know, in your analysis in this book?
David Smith
Well, I think there’s two things underlying our decision to go that route and why we think that’s the best case. One is, it’s really hard when you’re dealing with issues of political philosophy, to put it into the mainstream preferred methodology, which is technical models. Usually, they smuggle in some political philosophy somehow as an assumption into those models, or its underlying it. There’s the you know, the implications of the model is there is some political philosophy notion at play, but the political philosophy isn’t brought to the forefront and actually articulated and critiqued and scrutinised as it should be. So what we’re doing is we’re taking all these underlying assumptions about the proper scope and size of government as it pertains to central banking, and bringing them out in the open, say, let’s have it let’s have an honest debate about the political philosophy of central banking.
The second is we’re looking at, you know, the underlying concern behind this entire project. And why I started upon it was Mark Pennington’s book, Robust Political Economy. And in that book, he argues that we need to design institutions that are robust to knowledge and incentive problems. And we really wanted to take that project and apply it to central banking. So fundamentally, what we want to do is start from scratch and say, how do we design central banking institutions that are robust to real world knowledge and incentive problems?
Bryan Cheang
And on page 16, you really focus on the importance of institutions. And I think this is, this is really an important move that you make because many times of returnable policies or problems, people look on the surface and they don’t delve into the fundamental institutional arrangements surrounding them. And you wrote here, our takeaway message is that if monetary economists and macroeconomists would want to make lasting contributions to request for economic stability in a self governing society, they must think constitutionally, calibrating formal models and studying policy effects economic friendly or valuable of secondary pondense, fundamental institutional considerations come first. So I think on this note, you know, do you think what do you think this is about in mainstream economics, the kind of research that we do and really the importance of looking back to the institutional underpinnings?
Daniel Smith
Yeah, that would make us think of this as we actually were analysing the progression of Milton Friedman’s ideas on central banking over time. Initially, Milton Friedman was, you know, going on about how we just have to get the right people, meaning academics in charge of central banks, and equip them with the right technical models. And Hayek was actually like this at the beginning of his career as well. You know, let’s refine our technical models, let’s get better empirical, get, you know better better at gathering empirical data, and we can improve central banking, but both Nobel laureates by the end of their careers actually switched tunes, they became frustrated that they even when they got the right people in position. So even Milton Friedman, Arthur Burns has his you know, who he worked closely with, with, he wrote a an op ed, praising it, like, finally, we got a good academic scholar, central banking is now going to be set on the right path, I think is like only eight months later, he wrote another op ed saying, it didn’t matter. They’re still doing the same shenanigans that they’ve been doing. They’ve violated the rule of law, not enacting sound policy. And it’s that frustrating that even when you get good academics, such as Ben Bernanke, he was arguably the best person to be at the helm of the Federal Reserve when a financial crisis is occurring. He’s a scholar of the Great Depression. He’s got good practice practitioner experience in central banking, as a governor beforehand. You know, he’s who you want the best and brightest from the economics profession, well intentioned, and yet, even he, when it came to the financial crisis, we argue, undermine the rule of law in money and enacted policies that we think undermine sound money and made the economy worse off. So the frustration that we were struggling with is not about getting the right people in position. It’s not about refining the data, that’s important to a degree, don’t get us wrong, we’re we’re big, favourite big fans of that. But on the margin, there’s far more return for studying the underlying institutions that drive that behaviour, and provide the structure of incentives and the flow of information that these actors receive in their roles as central bankers.
Bryan Cheang
And this brings us to the discussion of robust political economy analysis, right, which we at the Centre for Study Governance and Society care a lot about, and robust political economy released about evaluating alternative institutions based on whether or not they cope with knowledge and incentive problems. So you spend a chapter each discussing these. Perhaps you could go, you know, one at a time, and firstly, talk about the incentive problems. And particularly, I’m curious whether or not this area of monetary policy is more susceptible to these problems than in other policy areas.
David Smith
Yeah, I’d be happy to discuss that. So we break up the incentive problems at traditional central banks into two types of pressures. One is internal pressures. And the second is external pressures. So internal pressures, these are central banks, just like any other government bureaucracy are pure bureaucratic bureaucracies, right? They had the same tendencies to maximise their budgets, self preservation, inertia and groupthink. Just an example of this Ben Bernanke, when he was a governor, I believe it was in 2002. At Milton Friedman’s 90th birthday, he made an institutional policy apology on behalf of the Federal Reserve saying, You’re right, Milton Friedman, we caused the Great Depression. Thanks to you, we won’t do it again.
So this was 70 years after the event occurred, you know, after the profession had already been won over to realise that yeah, the Federal Reserve caused the Great Depression, and made it more severe and lengthened it. That’s how long it took the Federal Reserve to actually admit that, which is pretty impressive.
And then there’s other examples that we provide of inertia. And examples of, you know, when central banks are the primary employer of monetary economists around the world, that creates a huge perverse incentive for the profession to engage in groupthink. And there’s even examples that we offer where central banks such as the Federal Reserve, have cut people off from attending their conferences, or you know, people have been pushed out and examples of suppression of research that was critical in the Federal Reserve within the system. But that’s not the most important pressure. The more important pressure that is exerted on central banks that we argue is the external pressures. And there’s a couple debt accommodation, political influence and special interest groups. So debt accommodation, this is pretty straightforward when the government issues a lot of debt, it’s necessarily going to have an impact on underlying market conditions, it’s going to affect interest rates. So if a central bank simply just wants, even if they don’t want to accommodate that debt, if they just want to keep markets, even keel, they have to adjust the policy and necessarily support that debt regardless. And we saw examples of this under the Federal Reserve, when they switch to a new operating system. And I don’t want to get too technical, they switch from a quarter operating system to a floor operating system. And when Trump initiated some fiscal policies, the Federal Reserve measurably had to adjust its policies in order to just keep things constant.
But certainly other policies currently under discussion, such as, you know, individual accounts at the Federal Reserve or other central banks to allow direct stimulus would create more pressures on this in this regard. And certainly, modern monetary theory would create more pressures in this regard. The other pressures, political influence, this includes pressure from the executive branch and legislative branch. The executive branch has the power of appointment and the legislative branch, the Senate, at least in the United States has the appointment to approve those appointments. But there’s also pressure beyond that. There’s the testimonies, there’s the quid pro quo quo going okay, we will, we will pursue this economic policy if you don’t do this. You know, there’s been close relationships, we identify, like between Alan Greenspan and Bill Clinton. President Trump getting on Twitter is another example of a more modern, you know, exerting pressure on the central banks to get interest rates down.Richard Nixon in his recorded tapes, with Arthur Burns, he’s laughing in the White House in the oval office saying, yeah, the Federal Reserve is independent, like, really just get those interest rates down, or else there’ll be ramifications.
And then the final one is special interest group groups. These are major financial institutions like Goldman Sachs that have undue influence on monetary decision making. And this is due to two factors. One is the revolving door between these major financial institutions and the Treasury in the Federal Reserve. So it’s people that are buddies and friends with each other, rotating back and forth between those positions. The second is, more practical, that when a crisis situation occurs, getting real time information, because of all the uncertainty is really hard. So central bankers rely on the key players, they call them up frequently, and say, Hey, what’s going on. But that creates an avenue of potential bias that allows these major financial institutions to do that, to exaggerate the problem and therefore justify policy that would be more conducive to advancing their own interest.
Bryan Cheang
And this discussion of incentive problems is interesting, because the focus is on the incentive structure of the institutional environment. It is not about how well intentioned in a sense the monetary policy maker is, right, which means that we can put in place the most well intentioned individual, yet these institutional constraints still influence the individual’s behaviour. Right. Is that the point you’re making?
Daniel Smith
Yes. And in fact, in some research, independently with Alex Salter, on that we briefly mentioned in this book, if we trace out we go through Ben Bernanke Key, Alan Greenspan and Arthur Burn’s writings, before being at the Federal Reserve, and after being at the Federal Reserve, we find a noticeable shift in the policies that they advocate for simply switching between the institution of the academy to move into being a policymaker in a role at a central bank, cause an institutional shift and their incentives that cause them to advocate for different policies.
Bryan Cheang
So once again, institutions of fundamental importance in influencing behaviour of people in different environments, and by themselves can move on to the knowledge problem. You know, what, what is this? And do you think perhaps it is more or less severe than the incentive problem in monetary policy?
Daniel Smith
So I’ll actually start with that second part of that question. We viewed the knowledge problem as enabling the incentive problem. So if there’s genuine uncertainty about what you should be doing in the economy as a monetary authority, then that opens the door to be pressured by special interest groups or politicians because you honestly don’t know what the right thing to do is. And we do make the case that monetary authorities do suffer from severe knowledge problems. We separate these into two things. One is technical problems. Technical problems make central banking inherently difficult, but not impossible. And then we also argue there are severe knowledge problems that actually make central banking inconsistent, that you cannot actually achieve the ends of central banking due to these severe knowledge problems.
So I’ll start with the technical problems.These involve the setting of objectives, targets, instruments and calibrating models. So the objectives of monetary policy, we typically assume that, you know, they’re set in stone, you know, it’s maximising employment subject to long term price stability. But the thing is, there’s a lot more grey area in there, the short term trade offs, what’s the weight that you give to each of these, we have actually statements from Bernanke and Yellen that we go over where they actually place different weights at different times to these objectives. And we think there’s actually a reason to do that central bankers actually prefer to keep these unspecified because that gives them more discretion. And it also allows them to introduce unofficial arguments into the equation such as Fed Funds, rate smoothing, financial stability, exchange rate stabilisation, ability of housing, even climate change and inequality have recently entered central banking discourse as potential goals that they should pursue or at least account for in setting policy targets. So the Fed, you know, traditionally, central banks look at the short term, inner, you know, the overnight lending rate. In America, the Fed funds rate, the term structure of interest inflation, could be Ngdp targeting. So there’s a wide range of targets that they could focus on, and even calculating these, you know, such as average inflation targeting, well, how long are you taking the average? How quickly will you get back to the average if there’s a deviation, so that there’s a lot of grey area there. And also, recently, at least for the Federal Reserve, it transitioned from its primary target being the federal funds rate to interest on excess reserves. There was very little discussion about that.
So once again, it makes it really difficult when you actually don’t know what the target is, or the target could potentially be moving over time. The instruments themselves. So these are the tools that the central bank actually uses to implement monetary policy. Traditionally, it’s been buying and selling treasuries, the required reserve ratio and a penalty rate for when banks are forced to borrow from from from them when they can’t get that overnight lending to meet the reserve requirements for private institutions. But now, central banks in the financial crisis, and especially now, in COVID-19, have resorted to some unconventional monetary policy instruments such as interest on excess reserves, direct lending, large scale asset purchases, maturity, extensions. So, we’ve seen a wide range of different types of instruments employed. And there’s oftentimes with little consideration a lot of the tools employed during COVID-19, were not employed, even in the financial crisis. And so we don’t have a real good understanding of what the implications are, how they operate, where you know, what their sweet spot is, or how they interact with other instruments that we have. And then the final technical problem is calibrating the model itself. So after a central bank intervenes, let’s put the dipstick in to the economy and see how it’s doing to judge our how well we have done well, there’s a wide range of metrics for trying to measure the economy central banks, if used interest rates, labour market, housing market, you know, Ben Bernanke, he said that he even used men’s underwear sales and gold at times to try to measure the state of the economy. And even something like the labour market. There’s a lot of different metrics on employment, the labour force participation, hiring rights, job opening rates. So there’s a lot of different metrics that could potentially be used to calibrate models, lots of different ways to even measure GDP. In fact, in the United States, there’s two different central banks that issue conflicting GDP estimates.
But that’s not the true knowledge problem. Those are just technical difficulties that make conducting monetary policy extremely difficult. But we argue that making central banking impossible is the same argument that makes central planning of the economy impossible. And that is that as a Fiat supplier of currency, they have to adjust the supply of currency in response to changes in the demand for currency. And in a monopoly system, there is no feedback net automatic adjustment mechanism, like there would be in the market to automatically give our central bankers the knowledge of what the demand for money is and how it’s changing, and then the incentives for them to actually address it. So basically, just to kind of restate that, I think in a clear fashion, economists could come up with long term estimates of what the demand for money is. But we commissioned central bankers specifically to mitigate short run and medium run fluctuations. That’s the whole justification for discretionary central banking, and it’s in the short and medium run, that the demand for money can change in ways that we can’t predict, especially during a crisis situation. And new technologies such as an FTS and cryptocurrency new ways that demand for money can manifest itself, because fundamentally affect that demand for money, demographics, fiscal policy, regulatory policy, you know, a whole range of different metrics influence that demand for money in very unpredictable ways. And we argued that’s the true knowledge problem that that a central bank supplier faces, and so they will always be over supplying or under supplying the currency and thus thereby creating monetary disequilibrium, and therefore, undermining the validity and power of the price system in a free enterprise system to encourage entrepreneurship, innovation, and servicing consumers.
Bryan Cheang
And thinking about further knowledge problems that we just discussed. Do you think that in this specific area of monetary policy, there may be a sudden sense of asymmetric information, given the very technical and complex nature of this policy area, as compared to you know, health care policy or fiscal policy is something that, you know, ordinary citizens, and even perhaps elected officials, you don’t have a problem but fully understanding? Could this perhaps give some room for monetary policymakers specifically to engage in some level of unaccountability?
Daniel Smith
Yeah, that’s the primary justification for having essentially the EPA stock recei, or high priestess central banking that we currently have, that ordinary citizens don’t understand this, even politicians, many politicians don’t understand this. And even if they did, they wouldn’t have the right incentives. So therefore, we need to give these experts a lot of discretion and leeway in order to tailor monetary policy to certain circumstances, and thus do it in a way that would, you know, exceed what would happen if we did it more democratically. We reject this, you know, our rule by experts has fundamentally failed. When we look at the historical literature comparing the Federal Reserve to institutions before that. It’s very clear, the Federal Reserve has not improved macro economic stability, it still led to the Great Depression, the financial crisis, and not just not just allow those to happen. We fundamentally argue with the literature that central banking actually was the catalyst that caused and prolonged both of those catastrophic events.
So rather than try to entrust unelected and unaccountable experts to have discretion, we argue for creating those binding rules on monetary policy authorities so that we have generality and predictability and money that’s far superior to allowing us discretion that so often has been used inappropriately throughout history.
Bryan Cheang
What then would you say to the argument that sometimes, you know, we need a level of discretion, especially when it comes to emergency situations? You know, we need policymakers to have this flexibility to engage in discretionary actions, including monetary policy, or do you think there is totally no scope for discretion? Perhaps it’s a certain continuum? Where do you draw the line here?
Daniel Smith
Yeah, so that’s that, we tackle that directly in one of our chapters. We think that particularly during a time of crisis is precisely when you need rules the most because during a time of crisis is when the knowledge problems are going to be the most severe. You have the fog of war, so to speak, and monetary experts, just like the regular citizens, don’t know what’s going on. A good example of this is COVID-19. Right now. There’s all sorts of supply constraints going on. And it’s really hard, these monetary authorities are really struggling with, should we engage in easy or loose monetary policy right now, it’s, it’s hard. And I, when we are you are unknowable. And then of course, incentive problems are also the most severe during the correct engineering crisis situations, because especially politicians want to, you know, use the crisis opportunity to advance, you know, agendas that they have.
And to increase the scope and size of government, you also have special interest groups that are clamouring for, you know, bailouts and policy that’s gonna, in particular benefit them. So, at the time of crisis is when a rule bound central bank would actually provide the most benefits and the most predictability. You need entrepreneurs in the economy to be able to predict what that did to reliably predict there’s going to be sound money, so that it can reallocate capital to help adjust the economy out of that recession, rather than adding monetary uncertainty on top of all the other uncertainty that entrepreneurs face and trying to get out of a recession.
Bryan Cheang
Speaking about the use of discretion during emergency situations, you know, let’s perhaps think a little bit about COVID-19. And how that may have really affected monetary policy and the increased use of discretion. My understanding is that since last is short term interest rates, which were already very low, in most advanced economies were quickly cut around the world, reaching around zero and all advanced economies, and even some emerging market economies. You know, how do you see, you know, COVID-19, is having an impact on monetary policy? And do you think that, you know, it’s, it’s different, you know, in terms of impacts, compared to, you know, the Great Recession of 2008?
Daniel Smith
So that’s a really good question. So when we look at what happened with COVID-19, and the policies implemented by central banks around the world, one of the most noticeable things is, after the financial crisis, a lot of central banks, like the Federal Reserve, didn’t ever unwind their balance sheets. So they didn’t have a lot of dry powder, so to speak, to actually engage traditional tools, interest rates were really low, they had, you know, large asset balances on their portfolios.There wasn’t much they could do in terms of traditional tools. And there were, of course, several advocates prior to that saying, hey, you know, every 1015 years, we can expect a recession, nobody could have predicted a global pandemic, certainly. But we know, you know, every once in a while there are recessions. And we should have been more prepared by creating a lean and mean central bank that didn’t have such a large impact on the economy during a regular normal time, because that enabled the central bank to engage its traditional tools more effectively when a true recession occurred.
But after that, so me, you know, pretty immediately, central banks engaged all the traditional tools to the max. And then they started to resort to some of the unconventional policies resorted to during the financial crisis, and even invented do programmes. And some of these programmes, I think, are of deep concern for those who care about a classical liberal society, and robust political economy. For instance, in the United States, the Federal Reserve implemented programmes that bailed out state local governments creating this potential moral hazard problem, very similar to the moral hazard problem that the European Union faced with, you know, Portugal, Italy, Spain, in terms of if you have a monetary union, but individual fiscal sovereignty, that provides the incentives for local level governments to engage in reckless fiscal policies, and expect to be bailed out. And that’s exactly what this type of system enables. There’s also intervention in you know, the Federal Reserve directly intervened in the bond market, which is unprecedented, there’s no bank run problem in the bond market. So there’s no theoretical justification for a central bank, actually bailing out the bond market.
So that was pretty extraordinary. And it also opened the door to politicians being able to say, hey, if we’re gonna intervene in the bond market and help out these corporations, can’t we legislate or can we implement a $15 minimum wage? Can’t we implement environmental policies, those may be important objectives, but they should run through the proper legislative channels, not through the backdoor by the Federal Reserve owning bonds and corporate, you know, controlling and bailing out bonds, and thus mandating those to the back door. Other policies, I think, that are kind of notable are the direct lending to main street businesses. So traditionally, central banks around the world have refused. And this goes back to Walter Walter Badgett, right, this was fine general liquidity, never actually picking winners and losers who’s getting the who’s getting the money. And that’s exactly what the Federal Reserve did. They stepped into the economy and said, Okay, we’re gonna identify certain businesses and give loans to them, rather than just providing general liquidity to the market and allowing the banks to make that using private criteria. So I think, and that’s just a couple of the programmes. I think there’s a wide range of other programmes as well, that create potential fissures in the economy. If they become conventional tools that the central bank employs, every time there is a crisis. And that there, we have no reason to suspect they will use several of the tools used in the financial crisis that were just one time things were brought back during COVID-19.
Bryan Cheang
Well, hence, we can now discuss the solutions that you’ve recommended in the book, particularly the constitutional solution inspired by the work of James Buchanan as well as free banking. Let’s start with the first set. Let’s think about you know, how have the ideas of Buchanan influenced your work here? And how feasible Do you think this approach is?
Daniel Smith
Yeah, so you can start with James M. Buchanan, who I was actually an undergraduate at Middle Tennessee State University, and then was a professor of mine at George Mason. You know, he sorted the field of public choice, which first, you know, examined the incentive problems in government. And part of his research also looked at monetary institutions. But the second field that he created was constitutional political economy. As a solution to that first problem, let’s find ways to craft rules to govern our rule makers to prevent them from engaging in discretionary activity that is not general and is discriminatory. So you wanted to create a constitution that creates general and non discriminatory rules.So we apply that concept, as he did to to monetary institutions in arguing that one way to ensure generality and predictability of money, and to move it out of the hands of politicians and special interest groups is to actually create a constitutional rule that provides protections, constitutional protections to sound money.
There are problems with that, and that is they, you know, politicians can ignore constitutional provisions as they have done occasionally in the past. And they can also change the constitution, but at least it creates a barrier that makes it much harder to do that. The more interesting idea, at least for myself, I won’t speak for my co authors is the idea of free banking. And this was advanced by FA Hayek, later on in his career. And it’s the simple observation that in world history, and even around the world today, there are some societies that allow private banks to issue currency in competition with one another. And what’s really interesting about allowing the market to provide currency is you don’t have the knowledge incentive problems. And that is because if a bank is issuing currency, and it’s backed by gold or silver, and they inflate that currency, so they issue too much, well, if you’re holding that currency or light, you’re realising, hey, this is worth less now, I’m going to take it back and redeem it for the golden silver, and then go grab a different currency to exchange with. So the bank automatically starts losing gold and silver reserves and realises Oh, we’ve made a mistake, we can no longer float our currency. And they’re going to be forced to bring back their currency levels down to the optimal in accordance with monetary demand.
So they have both the knowledge and the incentives to actually provide the optimal amount of currency. And you don’t have to read the tea leaves with monetary experts, just leave it up to the market to do that. It sounds crazy and radical. And there are legitimate scholars in this area studying this. And it’s, we consider one of the more viable ideas that we advance for crane, generality and predictability in money.
Bryan Cheang
How do you think the rise of cryptocurrency fits into this solution of free banking that you just advocated and I’m also curious about where do you stand on the debate between advocates of hot commodity money like gold and silver? And on the other hand cryptocurrency?
Daniel Smith
Yeah, so I’m fascinated by cryptocurrency. So I’m glad you asked. I, you know, I’m a big fan of everything going on. And I love that there’s competition out there. I do think that governments, by threatening legislation, are hampering some developments in cryptocurrency and it’s, you know, its extension and its ability to become more of a commonly used medium of exchange. You know, at least in the United States, the Federal Reserve and other government agencies are trying to find ways to regulate cryptocurrency in certain capacities that I think would undermine its potential. I also think legal tender laws prohibit cryptocurrency from being fully what it should be. And what I mean by legal tender laws is when governments have a centralised monopoly supplier of currency, they make it illegal for anyone else to create a competing private currency. So if we just remove those laws and allow competition to emerge, whether it be in the banking sector banks issuing their own private currency or in the crypto sector, you know it you know, I’m a big fan, just letting the market decide.
I don’t know which one to get to your other question, which one is going to be superior? Privately issued, money backed by gold and silver, or cryptocurrency or maybe even privately issued currency backed by cryptocurrency? All sorts of innovations could be unleashed if we would simply allow entrepreneurs to work on solving that problem in creating a medium of exchange that people saw value in, rather than hampering those efforts simply so the government can control the commanding heights of the economy through central banks.
Bryan Cheang
And lastly, to end off our discussion, I’d like to ask you a final question. Looking at current events today, you know, and the way that monetary policy has evolved recently, are you more optimistic or pessimistic about how, you know, this is gonna turn out in the near future? So are you at the end of the day an optimist or pessimist? And also what would be your final takeaway message to our listeners today?
Daniel Smith
Yeah, so that’s a really good question. It seems to be on that day. Some days, I wake up very optimistic. Some days I wake up pessimistic. It’s really hard for me to see how going forward, we can make radical changes to central banks around the world. They’re entrenched bureaucracies, you know, a special interest group that benefits from the system, they have a lot of prestige and influence. So it’s really hard to see how, you know, especially some of the more radical solutions, such as free brain banking would ever be implemented. However, you know, we did write the book, right, if we took the time to write the book, because we think, now if you can make the case that we could convince people that this is a really important area, and that we should think creatively about finding institutional solutions to creating better monetary institutions, even if they aren’t the ones that we kind of rest our head on. I’m optimistic, I think and that I think we can convince people, and that it’s becoming increasingly obvious that central banks are deviating from their original mission, and taking on all sorts of additional responsibilities. And I think the most noticeable thing that is catching on is climate change and inequality. People are like raising eyebrows, like, even if those are important issues. And I think they are, they shouldn’t be done by a central bank. So to the extent that that happens, I think we can make a case to constrain the Federal Reserve on the possibility of N GDP targeting as a rule that central banks should follow. And I think that would obviate the need for having such a large bureaucracy. It’s such a large bureaucracy, because if you’re following a standard rule, it’s very simple, very simple to follow. Well, you don’t need hundreds upon hundreds of staff economists to be trying to predict which way the economy is going. So you can kind of unwind the Federal Reserve without actually bringing in the radical idea of free banking yet and get people used to the idea of a much smaller central banking footprint on the economy.
Bryan Cheang
Thank you very much! Professor Daniel Smith’ Money and the Rule of Law, published by Cambridge University Press.
Daniel Smith
Thank you, Bryan. It was a pleasure to be with you!
