The Fed and the Limits of Discretion

A review of Money and the Rule of Law by Peter W. Boettke, Alexander William Salter, and Daniel J. Smith.

I n just over a decade, the Federal Reserve has been called upon to fight a global financial crisis and pandemic. The monetary response to these events represented a radical departure from the status quo. While a great deal has been written about the technical aspects of these policies, there has been little consideration of their political implications. In Money and the Rule of Law: Generality and Predictability in Monetary Institutions, professors Peter W. Boettke, Alexander William Salter, and Daniel J. Smith argue that the lack of consideration for such implications has not only led to greater economic instability, but has also transformed our central bank into an institution unconstrained by the rule of law.

In the United States, the monetary authorities are permitted to pursue short-run objectives in keeping with a pre-announced commitment to low and stable inflation. Proponents of this approach, known as constrained discretion, argue that it represents a middle ground between two undesirable extremes: inflexible rules on the one hand, and unlimited authority on the other. The trouble with this approach, the authors argue, is that it fails to adequately grapple with the knowledge and incentive problems that monetary policymakers face, which, in practice, means the distinction between constrained discretion and discretion is essentially meaningless.

Boettke, Salter, and Smith distinguish between two types of knowledge problems. The first are what the authors refer to as technical problems, which include the choice of appropriate objectives, targets, and instruments of monetary policy. These are problems that could be solved in principle through the continued refinement of theoretical models, data-collection techniques, and empirical tools. However, as the authors note, that these problems are solvable in principle does not mean that these problems have in fact been solved.

The second and, in the authors’ view, larger problem with discretionary monetary policy is that the knowledge necessary to ensure that the supply of money aligns with the public’s demand for it does not exist in a form accessible to the monetary authorities. The context within which central banks operate is devoid of feedback mechanisms that indicate whether the central bank is producing too much, too little, or just enough money. In consequence, relying on the discretion of the monetary authorities to determine the appropriate quantity of money will tend to worsen economic performance.

According to the authors, the incentive problems that plague discretionary central banking stem from two sources. First, the Federal Reserve is a bureaucracy, and as such is subject to a set of incentives that encourage budget-maximizing behavior. Since the Federal Reserve does not receive its funding from Congress, but rather through the income earned from its portfolio of assets, Fed officials have an incentive to increase the size of the central bank’s balance sheet beyond a point consistent with promoting the public interest. Doing so yields additional revenue that can be used finance higher salaries, additional employees, etc.

The second source comes from external pressure on the Federal Reserve by political officials and special interest groups. While monetary policy has little effect on output and unemployment in the long run, the Federal Reserve can influence these variables in the short run, albeit at the expense of economic stability. As such, the authors argue that political officials have an incentive to pressure the central bank for policies that make their reelection more likely. Likewise, special-interest groups can pressure Federal Reserve officials for policies that benefit their particular industry at the expense of the public at large. As the authors document, such pressure is not uncommon.

Boettke, Salter, and Smith argue that the only solution to these problems is to adopt a rules-based approach to monetary policy that binds the hands of our monetary authorities. Their proposal is not uncontroversial. A common argument against strict adherence to a monetary rule is that it prevents monetary policymakers from responding appropriately to financial crises. Monetary rules may be desirable under normal economic conditions, the argument goes, but are incapable of dealing with financial crises and other economic disturbances.

Proponents of this view argue that because such disturbances are difficult to predict and vary in their characteristics, binding the monetary authorities to a specific rule in advance would prevent policymakers from taking the appropriate steps to prevent a financial crisis from wreaking havoc on the entire economy. Boettke, Salter, and Smith respond to this critique by arguing that while an ideally managed central bank with discretion would be preferable to an ideal monetary rule, we do not live in an ideal world.

To illustrate this point, the authors compare the Federal Reserve’s behavior during the 2008 financial crisis to what is considered by many policy-makers to be the ideal policy response to such an event. The ideal policy, formulated by the 19th-century British writer Walter Bagehot, is for the central bank to lend freely on good collateral to solvent banks at a penalty rate high enough to discourage overly risky lending, and that the monetary authorities should announce their intent to follow such a policy in advance.

The authors argue that despite paying lip service to Bagehot’s rules, Federal Reserve officials deviated from the ideal policy during the 2008 financial crisis. In 2012, for example, Ben Bernanke claimed that the Federal Reserve’s response was consistent with Bagehot’s rules, despite the fact that the central bank lent on risky collateral, such as mortgage-backed securities, and lent to insolvent firms such as AIG and Citigroup. Moreover, the Federal Reserve’s policy was not announced in advance, nor was the policy consistently applied, as illustrated by the decision to bailout Bear Stearns but not Lehman Brothers.

The authors are not as concerned with whether the Federal Reserve’s response to the financial crisis averted what would have otherwise been an even more severe downturn, although they note that the case could be made that it did not. Instead, their purpose is to illustrate that the monetary authorities failed to respond to the crisis in a manner consistent with what central bankers themselves regard as ideal policy, and that their failure to have done so has undermined their ability to credibly commit to following Bagehot’s rules in the future, thereby making subsequent financial crises more likely.

In the authors’ view, the underlying reason Federal Reserve officials failed to respond appropriately to the financial crisis is not the result of personal failings of our monetary policy-makers, many of whom, the authors rightly note, are world-class economists. Rather, ideal policy is unlikely to emerge in a discretionary regime given the types of knowledge and incentives produced by the institutional context within which monetary policymakers make decisions. Thus, we are left with a choice between two imperfect alternatives: strict adherence to a monetary rule or ad hoc policymaking.

Boettke, Salter, and Smith contend that modern monetary scholarship has failed to adequately grapple with this choice, focusing instead on strategies and tactics for monetary policy that assume away the problems that plague discretionary policy-making. What is needed, the authors claim, is a robust monetary framework that will work well under less-than-ideal circumstances. Developing such a framework requires tackling the difficult issues of limited knowledge and political incentives directly by explicitly incorporating these factors into the analyses of alternative approaches to monetary policy.

To illustrate the sort of approach they have in mind, the authors discuss the work of three Nobel Laureates who grappled with these issues : F. A. Hayek, Milton Friedman, and James Buchanan. While these scholars disagreed to some extent over how best to improve our monetary institutions, they all came to see the underlying problem with discretionary monetary policy as institutional, and their policy proposals reflected this belief. To varying degrees, all three took the knowledge and incentive problems seriously and sought to incorporate these problems into their policy proposals.

In the authors’ view, modern monetary scholarship has failed to adopt this analysis. One consequence of this failure is that monetary policy as it’s currently practiced in the United States is, the authors contend, inconsistent with the rule of law in that the monetary authorities have acted in ways that are neither general nor predictable. While the actions of Federal Reserve officials over the past decade have, for the most part, been authorized by Congress, such authorization is not sufficient for these actions to be consistent with the rule of law, which, the authors argue, requires generality, predictability, and robustness.

Each of these three features take on special significance in the context of central banking. Generality requires the Federal Reserve not to treat some firms differently because of their political importance. Without generality, not only do firms have an incentive to invest resources towards becoming politically connected, but the potential for special treatment makes risky behavior more likely and thereby destabilizes the financial system. Predictability requires that the central bank’s behavior be predictable under a wide range of circumstances, otherwise the public will be unable to form accurate expectations of the future. Finally, robustness requires that our monetary institutions work well under less-than-ideal circumstances.

According to Boettke, Salter, and Smith, constrained discretion and other policy frameworks that they describe as pseudo-rules fail to meet the standards of generality, predictability, and robustness. Proponents of these frameworks ignore the issue of governance and proceed as if monetary policy is purely technocratic. In the authors’ view, this approach leads to worse economic outcomes and is inconsistent with the tenets of constitutional government.

Boettke, Salter, and Smith have written a book about monetary policy that is different from any other book on this topic. Rather than framing their discussion around specific models, data, and other technical issues, the authors have tried to take a step back from the minutiae of monetary theory in order to see the big picture. Their object is to convince the reader that there are basic questions of governance that have essentially been ignored by both policymakers and academics. In their view, these basic questions cannot be treated as an afterthought, and therefore must be confronted head on rather than ignored.

While this book contains important insights for those trained in monetary theory, the authors’ intended audience is not only other academics. The authors conclude by stressing the importance of balancing the science of monetary theory, and its application to policy, with constitutional considerations. In this sense, the book is about the role that experts, in this case, monetary experts, play in democratic society. As such, it is a book intended to help self-governing citizens weigh the costs and benefits of alternative monetary institutions.