What determines central bank decisions? Why do they do what they do? The literature on this question is enormous. But much of it, as Will Luther and I argue in a recent paper, is misguided. Too often we focus on the intentions or motivations of central bankers. Instead we should look for patterns of behavior that have adaptive value within the context of the various political institutions we refer to as central banking.
The great price theorist Armen Alchian argued that the best way to understand objective functions, such as profit maximization by firms, is as a constraint placed upon the agent or organization by the nature of the competitive environment. We model firms as profit maximizers not because they’re consciously trying to squeeze out every last penny of profit they can, but because the market, as a competitive environment, rewards firms that make profits and punishes firms that incur losses. The key insight is an evolutionary one: the environment serves as a filter, promoting some behaviors and discouraging others.
Will and I apply this insight to central banking. We begin with a pretty straightforward question: what kinds of policies will the institutions of central banking select for? Our answer is that central banking and the network of supporting institutions within the policy and academic worlds select for not only policies but paradigms that promote active monetary management of the economy. Central banking itself serves as a filter that rewards pro–central bank behavior and discourages anti–central bank behavior, regardless of whether central banking contributes to its objective of macroeconomic stability. In other words, there are margins unrelated to truth on which paradigms conducive to active and discretionary monetary policy outcompete rival paradigms.
We use this insight to offer alternative explanations of three important results of central banking, at least in the United States: long-term debasement of the currency, the surrounding intellectual environment of monetary economics and macroeconomics, and the Fed’s extraordinary—and from the standpoint of orthodox lender-of-last-resort theory, downright bizarre—actions during the 2007–8 financial crisis. In each case, we can explain the central bank policies that resulted in these outcomes either in terms of motivations or in terms of adaptive value. We contend the latter is more compatible with the economic way of thinking.
Modern central banking is a durable and effective institution—effective, that is, at promoting its own interests. We need to think seriously about how to cope with lawless monetary institutions in a world where ideas and persuasion are, at most, loosely binding constraints. Perhaps the reason we’ve had little success at constraining central banks is because we’ve been focusing on the wrong margins.