Replacing discretion with a sound rule would thus be a major step forward. One possible rule would force the Federal Reserve to freeze the money supply, as Paul recommends. But this rule would require prices and output to fall any time people increased their demand for money balances. Another rule would instruct the Fed to keep the price level constant from year to year. But under that rule the Fed would have to compound the blow from any negative supply shock (a disruption of the oil market, for example) by reducing the money supply. A sudden move to that rule could also cause serious economic dislocation if people were used to a higher inflation rate and had, for example, factored it into long-term debt contracts.
Considerations such as these have led some monetary economists to favor a rule that would commit the monetary authorities to stabilizing the growth of spending. Inflation would be allowed to go up or down in response to productivity shocks, and the money supply would be allowed to go up or down in response to changes in the demand for money balances. Theorists of free banking have generally agreed that if banks were allowed to issue currencies in competition with one another, something like this rule would emerge as a market equilibrium. So a government pursuing this policy would in a sense be mimicking a free-market outcome (although the choice of growth rate and starting point would admittedly have an element of arbitrariness). Scott Sumner, a professor of economics at Bentley University, has made an ingenious proposal to use futures markets to estimate the future course of nominal spending, further reducing the discretion and improving the accuracy of the monetary authority.
We have already had something of a test of this policy. Between 1982 and 2007, the Fed’s conduct of monetary policy led to a fairly consistent 5 percent annual increase in nominal spending even though it was not legally bound to produce one. This period was not the nightmare that Paul portrays but a time of relatively stable growth and low inflation. (Over the last twelve years of the period, inflation averaged 2.6 percent.) In the closing years of the period the Fed allowed nominal-spending growth to rise a bit above the trendline, which may have expanded some asset bubbles. The Fed could have corrected for this excess and then gradually reduced the growth rate of nominal spending to eliminate all long-term inflation.
Instead, starting in mid-2008, it allowed nominal spending to drop at the fastest rate since the depression within a depression of 1937–38. It even discouraged the circulation of money by paying banks interest on their reserves. The consequences of these decisions have been many and horrible. Among them are booming book sales and credibility for a congressman who does not deserve them.
— Ramesh Ponnuru is a senior editor of National Review. This article appears in the February 20, 2012, issue of National Review.