Most people who say "interest rates should be set by the market and not by government-owned central banks" are confused. But not all who say that are confused.
People who want the government to get out of the money business altogether, and de-nationalise money and central banking, are not confused. They might be right or they might be wrong, but they are not confused. But this post is not about them. Off-topic.
Modern central banks, like the Bank of Canada for example, have an inflation target. And they adjust the overnight rate of interest to try to hit that inflation target. Does this mean that the Bank of Canada, rather than the market, sets that overnight rate of interest? Well, yes and no.
The driver of a car sets the position of the steering wheel. But if the driver has decided to drive along a particular road to get to a particular destination, it is that destination, and the bends in that road, that really determine where the driver must set the position of the steering wheel. If we replaced the conscious decisions of the human driver with a self-driving car, we would see the steering wheel do roughly the same thing. Provided the car stays on the same road in both cases.
The "destination" is the 2% inflation target. The "bends in the road" are the shocks that hit the economy. The "self-driving" car is the market. Just to make the analogy clear.
If the driver and passengers had a clear view of the road ahead, and if all agreed on how cars worked, and if all agreed on the destination, and if the driver were doing a good job of staying on the road, we wouldn't see any back-seat drivers. Some passengers might dislike right turns, and others might dislike left turns, but none would try to persuade the driver to do anything different. They might whinge about the bends in the road, but they wouldn't complain about the driver when the driver turned the wheel to follow those bends.
But if the bends in the road are unclear, or if people disagree about how cars work, or are unsure whether the driver is really trying to stay on the road to get to the agreed destination, we might see a lot of back-seat driving. And it will be very hard for people to separate their personal preferences for right or left turns from their personal judgements about whether right or left turns are needed to keep the car on the road and get to the destination. And even harder if there is no agreed destination.
Paul Krugman gives us a recent example of this. But anyone who has renewed a mortgage can recognise the same feeling in themselves: "I hope the Bank of Canada cuts interest rates!"
If the government owns and ultimately controls the central bank, and if you don't want that to change, then it does not make sense to say that the market should determine everything. The central bank must choose something. It could be an inflation target, or it could be an NGDP target, or it could be a fixed exchange rate target, but there must be something it targets. If the government is in the money business, the government must, logically, set something, and cannot let the market set everything. People who don't get that point are confused.
But if the government-owned central bank sets the destination, there is no reason why we can't let a self-driving car make all the other decisions. Set up some sort of prediction market like Scott Sumner advocates, and hook it up to the steering wheel with a negative feedback mechanism, so if the market thinks that the car is turning too far to the left, the wheel turns automatically to the right.
Then we would have an immediate response to any back seat drivers: "You think the central bank is getting it wrong? OK, put your money where your mouth is, and you should make a profit in the prediction market, if you turn out to be right!"
It's not just about getting monetary policy right to reach the destination. It's about the perceived legitimacy and transparency of the process by which we use our imperfect judgements to try to reach that destination. Juries vs judges as ways to implement the rule of law rather than the rule of man. A prediction market would be like a jury, where anyone could be a member, except if you found the defendant guilty/innocent, and subsequent evidence showed he was innocent/guilty after all, you would have to pay a fine if you were wrong, and get a reward if you were right.
The steering wheel doesn't have to be interest rates. And in my opinion it shouldn't be interest rates. It could be base money, or it could be the nominal price of some real asset. But that's a separate question.
[I hope I die before they force us all to use self-driving cars. But if I had to take the bus, it might as well be a self-driving bus, if they do better than human drivers. Monetary policy is like a bus, because we are all on it together.]
[In Canada, the 2% inflation target destination was jointly agreed on by a democratically elected government and the Bank of Canada, and the governors of the Bank are appointed by the government, so the 2% inflation target destination has legitimacy. It might be the wrong target, and in my opinion it is the wrong target, but it is nevertheless a legitimate target.]