Pete Boettke, Dan Smith, and I make several arguments against discretionary central banking in our forthcoming book. One argument is that monetary policy is plagued by incentive problems. These problems are exacerbated by discretion.
Central banking is political. It always has been. Too often writers on economics and finance treat those who work at the Federal Reserve as disinterested technocrats, whose sole concern is stabilizing markets. This is wrong. As a political bureaucracy, the Fed both exerts political pressure and has political pressure exerted upon it. This creates a host of incentive problems in monetary policy. The only way to avoid these problems is to bind the Fed with a monetary rule.
The Fed is not politically independent. In fact, it is among the least politically independent central banks in the world. De jure, the Fed answers to Congress, and members of both the House and Senate are not shy about interfering. For example, in the darkest days of the Covid-19 crisis, politicians tried to get the Fed to expand the list of parties eligible to receive funds under the Fed’s special program for municipal lending. Is this because elected officials had genuine concerns about the smooth operation of markets for local government debt? Of course not. It was done to benefit political supporters.
De facto, the President also heavily influences the Fed. That President Nixon strong-armed Chairman Arthur Burns is well known. Less well known is that virtually all presidents try to force their will upon the Fed. Even President Reagan, despite his strong public anti-inflation stance, encouraged the Fed to loosen its monetary policy in the runup to the 1982 midterm elections. Presidents pressuring central bankers is as American as apple pie.
Political pressure can also originate within the Fed. Remember, the central bank is a bureaucracy. Incentives abound for maximizing inputs (costs) while minimizing outputs (economic stability). A natural consequence is mandate creep. Somehow, the answer to every economic problem is more power for the Fed. Just look at the extraordinary powers the Fed acquired to fight Covid-19. Never before has the Fed engaged in direct lending to large corporations and local governments. Congress was in the driver’s seat, but the Fed was cheering them on.
One reason the Fed’s powers grow over time is asymmetric incentives. Monetary policymakers have good reasons to err on the side of excessive policy responses. No central banker wants to be remembered as presiding over Great Depression 2.0 due to inaction. The incentives are to go big and fast with policy interventions. Of course, these are precisely the responses that permanently weaken the financial system. They create moral hazard. Financial executives know the Fed will always be there to break their fall, so why not shoot for the moon?
Incentive problems with discretionary monetary policy are not psychological in origin. By that, I mean they do not stem from what monetary policymakers are thinking. Conscious awareness of their political environment is unnecessary. The problems are institutional. The various rules and procedures associated with central banking select for pro-intervention, pro-discretionary policymakers. These preexisting traits are reinforced by the filtering process that weeds out restraint.
Filtering exists in institutions, both commercial and governmental. But they manifest very differently. Whereas markets select for profits, politics–yes, even when done by egghead economists–select for power. Ideas don’t necessarily compete on a level playing field, and within the network of political institutions that affect the Fed, activist ideas outcompete the others.
Can we eliminate the incentive problems of discretionary central banking? No. Discretion is the problem. The only way to win is not to play the game.
A firm monetary rule that binds central bankers’ hands is the only way to overcome incentive problems. Pick a rule, and force the Fed to hit it. If they don’t, make sure there are professional penalties. Obviously the content of the rule matters for economic well-being. But, to fix incentive problems, the chosen rule must be ironclad.
Discretionary central banking creates bad incentives. To overcome bad incentives, we must take away the discretion. The Fed, so long as it exists, should follow a rule.