Modern Central Banking as Technocracy

Modern monetary institutions are a far cry from those that prevailed during the age of monetary cosmopolitanism. Today’s monetary regimes can be classified as variants of monetary nationalism. This isn’t to say discretionary central banks — the overwhelmingly dominant monetary institution in existence — are narrowly and chauvinistically advancing domestic political interests at the expense of international cooperation. Instead, central banks see themselves as stewards and managers of the domestic economy who play a crucial role in maintaining the health of the domestic economy through judicious application of monetary policy.

Modern central banking is a form of technocracy. The theories and empirical findings in the monetary-economics literature are overwhelmingly oriented toward understanding and improving the practice of central banking. Academics devise models, calibrate them, and test them empirically. Central bankers then use the best results to inform their thinking about what the stance for monetary policy ought to be. It’s a top-down, expert-driven enterprise, with the boundary between theory and practice blurred, given the significant role modern central banks, and in particular the Federal Reserve, play in contemporary scholarship.

The chief problem with modern central banking is that it’s discretionary: there are no hard-and-fast rules dictating what central bankers can do, nor how they should do it. In the case of the United States, much is often made of the Fed’s dual mandate, according to which Congress instructs the Fed to undertake the necessary actions to achieve full employment and price stability. But this is so vague a mandate that it does not really constrain central bankers. Central bankers have a large degree of authority to act according to what they perceive as the exigencies of the moment. This does not mean central bankers can do whatever they want, of course. Such an objection would invoke a straw man. The problem is that because there is no hard-and-fast rule for how monetary policy ought to be conducted, market actors often are forced into a guessing game with the central bank, with central banks trying to surprise markets and markets trying not to be surprised. This in turn weakens the macroeconomy in a number of ways, rather than strengthening it as central banks are supposed to do.

In my next few posts, I will explore several of these problems with discretionary central banking. I will argue that discretionary central banking, which includes “constrained discretion” and other pseudo-rules that do not actually bind, confronts informational and incentive problems that make it a virtual certainty that central bankers cannot achieve macroeconomic stability. I will also argue that central banks have been a source of macroeconomic instability throughout their history, with the run-up to and immediate aftermath of the 2007–8 financial crisis as the most recent example. Lastly, I will argue we have good reason to expect that a truly constrained monetary regime, bound by the rule of law, can beat discretionary central banking at its own game by better delivering macroeconomic stability.