In monetary policy, the debate between advocates of rules and advocates of discretion rages on. Supporters of rules argue that discretionary monetary policy falls prey to information and incentive problems. Supporters of discretion argue that strict rules-based policy cannot account for real-world complexities, such as financial innovation, that can make a previously sound rule unsound.
But perhaps there is a feasible middle ground between unanchored discretion and hidebound rules. “Constrained discretion” is an intriguing possibility. In a 2003 speech before he became Fed chairman, Ben Bernanke lauded constrained discretion as “an approach that allows monetary policymakers considerable leeway in responding to economic shocks, financial disturbances, and other unforeseen developments. Importantly, however, this discretion of policymakers is constrained by a strong commitment to keeping inflation low and stable.” This seems to strike a virtuous balance between the expectation-anchoring function of rules and the flexibility of discretion. Is it feasible?
Unfortunately, the answer is no. Constrained discretion is not a third way between rules-based monetary policy and discretionary monetary policy. It is just discretionary monetary policy under a more rhetorically palatable label.
The problem with constrained discretion is that it leaves up to central bankers the decision when to switch from rule-like behavior to discretionary behavior. Nothing binds the hands of monetary policy makers except their own judgment. There is a qualitative difference between being subject to a rule and acting as if one is subject to a rule. The difference may not mean much when the economy is humming along nicely at full employment. But what happens when turmoil arises in financial markets?
The possibility of a financial panic, advocates of constrained discretion would argue, is precisely why the discretionary part of constrained discretion is desirable. By permitting central bankers to intervene sharply to stabilize the financial system, even if it means temporarily ignoring short-run price stability, we can avoid a true financial panic. But this completely overlooks the well-known fact that market actors take the probable stance of monetary policy makers into account when making financial decisions. If private sector financiers know the central bank can and will deviate from rules-like behavior if there is an impending financial panic, then they don’t have much of an incentive to refrain from engaging in excessively risky financial activity. Financiers can bet big on exotic trades and assets. If the coin lands heads, they make extraordinary profits. If the coin lands tails, the central bank will step in to bail them out, which means deviating from rule-like behavior.
In other words, constrained discretion cannot cope with what is perhaps the single biggest problem with our current financial system: moral hazard. The discretionary part of constrained discretion is precisely what incentivizes market actors to behave badly in the first place. Commitment to rules-like behavior is a façade under constrained discretion. If it breaks down when the going gets rough, then it was never robust in the first place.
There is no middle ground, no third way, between rules and discretion. Either we have the rule of law or we have the rule of central bankers. And history shows central bankers are poor stewards of the macroeconomy. We should reject constrained discretion for what it is: discretionary monetary technocracy in disguise. A free society that is also an economically prosperous society should insist on real monetary rules.