Knowledge Problem in Central Banking – Part II

The previous post presented Hayek’s knowledge problem in the context of the economic calculation debate under socialism. We discussed the distinction (sometimes overlooked) between information and knowledge. To sum up, information is objective data such as quantities and prices. As a qualitative concept, information can be complete or incomplete. Knowledge is subjective data interpretation. As a qualitative concept, it is neither complete nor incomplete. This distinction is not only key to understanding the Mises-Hayek argument against socialism, but it is also important in understanding where the central banking knowledge problem falls. Socialism deals with both information and knowledge problems, but central banks deals mainly with knowledge problems, including lack of competition, the big player effect, and the rule of law vs. the rule of experts.

Lack of competition in a competitive money and banking regime (free banking), competition among convertible banknotes supplies information, through adverse clearing settlement (if banks are issuing too much or too little money). Money supply follows money demand spontaneously, maintaining monetary equilibrium. Central banks, especially in the case of fiat money, do not have this source of information. The piece of information that is going to be used as a substitute depends on the knowledge of policy-makers. By far the most common one is price level stability. But since productivity can also change, a stable price level is not a synonym of monetary equilibrium. Another option is a stable nominal income, where money supply changes maintain monetary equilibrium. In this case, the price level is allowed to change inversely with respect to changes in productivity. Other options exist as well, but the point is that these are not minor differences. What is being questioned is what the right proxy of monetary equilibrium is, which is not a small issue for the monopoly of money supply. For the central bank, the issue is not so much having access to market information as it is, (1) choosing the right variables to inform the stance of monetary policy and (2) knowing how to read them correctly. As has been pointed out by a number of scholars, the U.S. Federal Reserve mistakenly thought that the low inflation in the years after the 2001 crisis showed that their monetary policy was on the right track.

Big Player effect on top of the preceding problem, central banks also have to deal with being Big Players. A Big Player is an economic agent whose decisions can push other players to change strategies. The execution of a certain policy changes the market condition that informs which policy to take on in the first place. This can become an issue if a key monetary variable is changed in the process. For instance, the decision by the Board of Governors to start paying interest on reserves pushed banks to hoard reserves, worsening the 2008 crisis. In the middle of the crisis, the Fed started to pay to banks to not extend credit. The experts in charge of the Fed seemed to underestimate how sensitive banks would react to interest payment on reserves. This issue becomes more problematic when a Big Player decision triggers a reaction by another Big Player. In these situations predicting market conditions becomes even harder. It could be argued that the major central banks’ reactions to the Fed’s loose monetary policy after 2001 helped mislead the status of U.S. monetary policy.

Rule of law vs rule of experts Lastly, market order depends on following the rule of law. Among other reasons, the rule of law allows for predictability in economic agents’ behavior, fulfillment of contracts, etc. Central banks, however, do not follow the rule of law; the alternative is the rule of experts. Experts may be well informed and hold the best intentions and still be wrong. Their mistakes can be very expensive since they are not constrained by the rule of law, but by their “expert knowledge.” To mention that central banks do not follow a rule of law does not mean that policy-makers cannot be held accountable for breaking the law, or that central banks do not have their own regulatory framework. It means that central banks have regulatory power over other economic agents. In that sense, central banks are above the law of other economic agents, and that requires them to rely on expert knowledge. As we saw in the 2008 crisis, some of this expert knowledge can lead to determining which institutions are too big to fail and how credit should be allocated in financial portfolios. A principle of constitutional constraints under the rule of law, however, is that the more damage an institution can do (a President, or a central bank), the more limited their behavior should be. Rules are more important than experts.  

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