Views on Monetary Policy
Hoskins, W. Lee, Federal Reserve Bank of St. Louis Review
THE IDEAL MONETARY POLICY requires a credible and predictable commitment to maintain the long-term purchasing power of a currency. The performance of central banks, which have traditionally been entrusted with monetary policymaking, is far from this ideal simply because a clear mandate for price-level stability--zero inflation--is absent. In practice, central banks serve as instruments that governments use to pursue multiple objectives that they believe serve their interests. Therefore central banks pursue monetary policies that at best have only a fragile commitment to price stability. Governments are currently pursuing policy coordination or monetary union strategies that are little more than attempts to implement a regime of monetary protectionism in the global economy. The future of monetary policy rests on the continuing struggle between politicians seeking policies that serve their short-term agendas and global financial markets that limit the actions of an individual central bank.
In my remarks I discuss why central banks have been established, their bias toward inflation and the importance of independence and accountability to their effectiveness. I also argue that zero inflation should be the dominant objective of a central bank and that current efforts to coordinate monetary policies are likely to conflict with that objective.
WHY CENTRAL BANKS?
What is the justification for a central bank? Can some configuration of private institutions in a so-called free-banking environment perform the functions of a government-sponsored monetary authority? Are central banks necessary?
In his 1959 Millar Lectures at Fordham University, MIlton Friedman provided a classic statement of the economic rationale for central banks.(1) Friedman's argument appealed fundamentally to the costs inherent in a pure commodity-standard system, for example, a gold-standard system. These costs arise both from pure resource costs and perhaps more significantly from substantial short-run price variability resulting from inertia in the adjustment of commodity-money supply to changes in demand. The inefficiencies these costs represent are a significant disadvantage of commodity-money exchange systems.
As a consequence there is a natural tendency, borne out by history, for pure commodity standards to be superseded by fiat money. But particular aspects of fiat money systems--such as fraudulent banking practices, natural monopoly characteristics and tendencies for localized banking failures to spread to the financial system as a whole--resulted in the active participation of government. We have come to know this active participation as central banking.
Rationales for establishing central banks have not gone unchallenged, not even by Friedman.(2) Disruptions in payments can be costly, but so are the instabilities and inefficiencies caused by the lack of an effective anchor for the price level in fiat money systems. Moreover, theoretical discoveries in finance and monetary economics, closer attention to the lessons of historical banking arrangements and advances in information and financial technologies have contributed to a healthy skepticism about the superiority of central banks and government regulation to alternative market arrangements. For example, some of the financial-backstop functions performed by central banks and banking regulators may have weakened private market incentives to control and protect against risk.(3)
Still, those who argue for alternative monetary structures must at least recognize that their case rests on untested propositions. Yes, it would be wrong to accept unthinkingly our current central banking system as the best alternative for performing the monetary functions of advanced economies, but it would also be wrong to claim that the current central banking system does not reflect society's choice of an institutional arrangement to perform those functions. …