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During the 1970s a key debate keynesians and monetarists was about the causality in macroeconomic models or more specifically about whether changes in the money supply caused changes in nominal spending or whether nominal spending changed caused changes in the money supply. Both sides of the argument produced endless numbers of econometric studies to show that they were right. This together equally large amount of studies of the interest rate elasticity of money demand got to be the biggest waste of time in the history of the economic profession.
This is Bloomberg today:
The best news of the week might have been the publication of September's Chinese money supply data. Since 2010 Chinese money supply growth has been slowing, but there might now be signs that money supply growth is now reaccelerating.
Recently Peter Boettke in a blog post basically argued that Market Monetarists ignored what I have called the Iron Law of Public Choice theory when we are discussing monetary policy. I have ready responded to Pete's post. However, Pete's blog post have made me think more about the issue of understanding monetary policy through the eye of the Public Choice theorist. Or rather it is an issue that I have been thinking about for a while, but Pete has inspired me to return to the topic.
The message we get from Public Choice theory is that we should not only model the behaviour of investors, consumers, labour unions etc., but we should equally model the behavior of policy makers and we should assume the policy makers are not benevolent dictators, but rather act in their own self-interest in the exact same way as the consumer or the investor. I have always strongly believe in the fundamental truth in Public Choice theory and I therefore also find it completely natural that when we discuss monetary reform and discusses these issues.
The problem - There is no Public Choice model of central banking
However, while I certainly think that Public Choice theory is highly relevant for understanding the actual conduct of monetary policy - rather than what would be the preferable monetary policy policy I also think that nobody so far has come up with any good model for understanding monetary policy from a Public Choice perspective.
In fact it seems to be that very few Public Choice theorists have had any clever to say about monetary policy issues and those who have tried to say anything in this regard have utilized extremely simplified models, which fits actual monetary very badly.
Overall, I think we can identify two different (quasi) Public Choice models of central banking. In that these is not really models in a strict theoretical sense, but rather ad hoc postulates on the motives and actions of central bankers, but they nonetheless seem indicative for how Public Choice theorists have been thinking about monetary policy.
The first type of "model" is what we could call the "Bankers' Conspiracy" model. This model is basically saying that commercial banks control the central bank and that it is in the interest rate of commercial banks that the central bank keeps interest rates artificially low. The model really has its origin in US southern agrarian populist thinking. Thomas Jefferson was an early proponent of this view and today many Austrian economists seem to believe in this model. A version of the Bankers' Conspiracy model can also be found in Murray Rothbard's book "The Case Against the Fed".
The second type of "model" we could call the "Sugar daddy" model. The assumption is this model is that the government is in control of the central bank and the sole purpose of the central banks is to finance government budget deficits.
Both the Bankers' Conspiracy and the Sugar daddy models predict an central banks should have an inflationary bias. That might of course have sound appealing if you want to explain what happened in 1970s or the hyperinflation of Zimbabwe in 2008-9. However, the fact is that historically we cannot generally say that central banks have had an inflationary bias. Neither of the models can hence explain the biggest monetary policy mistake in world history - the Great Depression. Nor can they explain 15 years of Japanese deflation or the overly tight monetary policies in the euro zone and the US during the Great Recession.
Central bankers as budget maximizing bureaucrats
I have earlier suggested that we instead need to model central bank behaviour within a Niskanen style budget maximizing bureaucrat framework. In Niskanen's bureaucrat model an institution - for example a central bank - will use asymmetrical information to maximize its budget.
Obviously we can easily incorporate both the "Bankers' Conspiracy" model and "Sugar daddy" model into the "central bankers as bureaucrats" model. Christopher Adolph has for example suggested that central bankers will pay attention to the possibility of securing lucrative jobs in commercial banks once they retire from central banking. That according to Adolph gives the central bank bureaucrats a bias towards implementing policies to support commercial banks.
Similarly one can easily imagine a situation where a budget maximizing central bank bureaucrat would find it in his or her interest to fund a government's budget deficit - basically to protect the central bank's operational independence from political attacks. Just think of Zimbabwean central bank governor Gideon Gono or Argentine central bank governor del Pont.
However, I think neither of this examples can be generalized. What I, however, think can be generalized is central bankers reluctance to tie their own hands and introduce a rule-based monetary policy. From the perspective of a budget maximizing central bank too transparent monetary policy rules reduces the central bank bureaucrat's informational advantage. Hence, if the central bank don't have a clear monetary target if will never miss the target and hence will be able to claim that it doing the job perfectly good. On the other with clear targets the central bank can be held accountable.
Concluding, I believe that if we want to understand actual central bank behaviour our starting point should be William Niskanen's bureaucrat theory ....
Partisan central banker theory
Partisan central bank theory
It is official - Larry Summers is now favorite to become the next Federal Reserve chairman at least according to the latest odds from the Irish bookmaker Paddy Power. Just have a look at the odds here.
This morning I did a presentation for Danske Bank clients about US monetary policy and who will be the next Fed chairman.
Market Montarists are tireless in arguing in favour of NGDP level targeting. However, we normally do not spend much time on how such a target should practically be implemented. Scott Sumner obviously has argued that an NGDP target should be implemented with the use of NGDP futures. I love Scott's suggestion, but it might not convince everybody and it might therefore be worthwhile looking at other possibilities.
Market Monetarists have long argued that governments should issue bond linked to the development in nominal GDP. The main argument has been that NGDP-linked bond would be a very good indication of monetary policy conditions.
Since the collapse of Cyprus' economic and financial system earlier this year everybody have been looking for the next euro zone country to get in trouble. In fast became clear that the next country in line could very well be Slovenia and the country's Prime Minister Alenka Bratušek has been fighting to save her country from disaster in the last couple of months.