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I've just been reading Arie Arnon's superb Monetary Theory and Policy from Hume and Smith to Wicksell. And what is striking is how little these debates have changed over the past 200 years.

Ricardo and the Bullionists at the end of the Napoleonic Wars, and Torrens, Lord Overstone and the Banking School in the 1830s and 1840s, all made the same argumetns for a fixed rule to be followed by the central bank. The 1844 Bank Act was fundamentally the same as what NPP are proposing, justified on the same kinds of grounds. It's not just an American thing. As long as there have been central banks, there have been deep misgivings about giving them discretion.

Oops, I mean Currency School. The Banking School were the pro-discretion side.

So, 2% forever? Do you think that is the definitive response?
I think that with higher indebtness and falling assets, better a higher inflation target.

JW: Yep! The rules vs discretion debate will probably continue forever! But some things do change:

I think Kydland and Prescott changed the debate, by at least clarifying the underlying motivation for rules, even if the central bank is acting in the public interest.

I think that the sort of rules that are proposed have changed a lot over time. Gold Standard, a commitment to "full employment", the k% rule for M, inflation targeting, and now NGDP targeting.

But the currency school vs banking school is especially interesting to this particular debate, because both agreed (IIRC) on the gold standard target rule, but disagreed on the instrument policy to best hit it. Currency School wanted Peel's 1844 Bank Act, where dM=dGold reserves. Banking School were more discretionary, but also wanted something like the Real Bills Doctrine, which was a sort of instrument rule.

Miguel: If we keep to an inflation target, I think 3% might be better than 2%, to avoid the ZLB (not because of higher indebtedness or "falling assets". But a 5% NGDP level path target would be better.

But yes, we can never predict whether new research and new data will suggest we have chosen the wrong target. "I wish I had never promised to do X, because I did not foresee Y!" But we don't break promises on a whim. Maybe we only make them for definite periods in advance. Even constitutions get changed, but not lightly.

Here's what discretion gets you, Nick: (Quoted from the Financial post)

“We went through the crisis almost as soon as governor Carney took office,” Mr. Poloz told the CBC. “He was Johnny-on-the-spot, if you like. Very knowledgeable, street-savvy type. That helped us enormously to get through that. Canada did better than most other countries through those dire developments.” At the time, he said, there was a sense that, “Wayne Gretzky’s retired, now I get to go in and play in Wayne Gretzky’s position.”

Does that look reasonable to you, Nick? That central bankers are compared to top performing athletes? Now, imagine if Mark Carney had stayed and further cultivated his Gretzky-like status and then suppose he started to read the tea leaves wrong. Suppose he badly missed the target but claimed that it wasn't his fault, that forces beyond his control were at work. You see, it was an unexpected slumping of Chinese demand, not me, we were using the right instrument all along and we will continue to do so. Who will dare question the great Gretzky of central banking? How much damage will result before we finally change tactics? Cults of personality contributed greatly to the Great Depression, with the death of Benjamin Strong in the late 1920s. If behavioural economics has taught us anything, it's the dangers of group think from a strong personality, in small settings (like senior decision makers at the central bank).

Steve is almost certainly talking about the ABCP crisis, and about the Bank's role as lender of last resort, rather than about monetary policy in the narrower sense. Mark was one of the very few people who fully understood that crisis, and was personally involved in resolving it.

With that distinction understood, your example and point is very well-taken. There is a world of difference between the Bank's:

1. Monetary policy in the narrow sense, of setting a rate of interest to target 2% inflation, where all is rules, accountability, and transparency. Any bright high school student can spend a couple of hours on the bank's website and figure out what the Bank is doing and how the Bank thinks it works. And our CD Howe Monetary Policy Council ends up recommending doing something very similar to what the Bank does. Personalities do not matter, as long as they have the reasonably good judgement and background knowledge to listen to all the sources of information and advice, like a good judge implementing the law.

2. Lender of last resort in a financial crisis. Where it is the exact opposite. There are no rules. Go on the Bank's website, and try to figure out who it would bail out, and how, and under what circumstances, and why. You can't.

And on monetary policy in the narrow sense, the difference between the Bank of Canada and the Fed is massive. Expert Fed-watchers know less about the Fed than any bright high school kid can figure out about the Bank. And Deputy Governors at the Bank may have their own opinions about whether targeting 2% inflation is best, but they do not announce them in public every couple of months. They almost always start every speech by repeating the 2% inflation target screed. Because that is the rule, and they follow that rule. And any change in that rule gets considered only every 5 years, and if there is a change it will be announced in advance. The Bank does not publish its minutes, but it doesn't need to. Because everybody knows they are targeting 2% inflation. Compare that to the wacko speeches by Fed regional governors.

I have blogged about this before, both the monetary policy in the narrow sense vs lender of last resort distinction at the Bank, and the Bank vs the Fed on monetary policy in the narrow sense. Both distinctions are rules vs discretion distinctions.

My old post on the Bank vs the Fed, rules vs discretion

I can't find my old post on rules vs discretion, monetary policy vs lender of last resort, at the Bank.

There is one instrument rule (or class of instrument rules) I would take seriously: instead of targeting the Bank's internal forecast of inflation (or NGDP, or whatever), target the market forecast. That's what Scott Sumner wants. You replace the Bank's judgement with the market's judgement. Both beat mechanical rules, because both can look at mechanical rules as a source of advice, but can look at other things too.

"Could we state a law for monetary policy that would be contingent on all possible future results for all possible future theoretical and applied research in monetary policy? Of course not."

My God. This should all be so obvious.

As obvious as observing that the gold standard came and went.

It’s all inherent in the existence of (relatively) free capital and money markets.

Did somebody get a Nobel Prize for denying this?

JKH: trouble is, when you write down a model of the economy, it is very hard to see that obvious thing. Because you are (provisionally) assuming your model is the whole truth about the economy. And you can solve that model to see what rule works best. Popper once said something related, IIRC. Something about our inability to forecast the future of society, because of human learning.

Good post, In a paper I did back in the 1990s I said something to the effect; "You only change the target when there is new theoretical information about the relationship between observable macro aggregates and the unobservable social welfare function."

Thanks Scott!

As obvious as observing that the gold standard came and went.

And yet the thing about the gold standard is how persistent it was. The link to gold has existed for most of the history of modern capitalism, and people went to great lengths to maintain the link between gold and the money and credit system. So what seems obvious, is that the impossibility of a fixed rule is not obvious at all. Saying "everyone was just wrong" doesn't get you very far. The interesting question is why this idea has such a powerful attraction.

"Why don't they get the distinction between target rules and instrument rules?"

Because everybody knows that monetary policy is about setting interest rates, right?

Nick, you write:

"There is one instrument rule (or class of instrument rules) I would take seriously: instead of targeting the Bank's internal forecast of inflation (or NGDP, or whatever), target the market forecast. That's what Scott Sumner wants."

OK, I'll reveal my ignorance yet again: would an example of what "Scott wants" here be using TIPS spreads? If that's the case, then yesterday Scott asked for and received one piece of evidence that it might be possible for the central bank's internal forecast of inflation to be improved such that it is substantially better than forecasts based on TIPS spreads (5x better than TIPS spreads was the conclusion of the quick analysis provided)... provided of course the CB adopted the new method proposed. And I'm sure more analysis would be required before making any changes!

Here's Scott's question:


The rest of the thread, including Scott's response to the analysis is below.

Also, what do you mean by "1776 and all that?" Do you mean the colonial revolutionaries emphasizing the "rule of law?"


"But in that case, why bother with the central bank at all? Why not just have the lawmakers set interest rates every month?"

If government (lawmakers) are net borrowers, then having them set the interest rate at which they borrow and the quantity of bonds that are sold is a bit of strong arming. The roles, however, could be reversed. Central bank could determine quantity of bonds that may be sold, and government could set interest rate.

If government (lawmakers) are non-borrowers, then it is conceivable that government could replace the central bank as an interest rate determiner for interbank lending.

You are right in your reference to 1776, in that the U. S. government was founded on the principle of decentralized power (Legislative Branch, Executive Branch, Judicial Branch). The same thing applies to interest rates / government bonds. One body sets price of bonds (interest rate). Second body sets quantity of bonds.

Ok, I see. That seems reasonable, but I think that rule has not been able to prevent the bubble and subsequent crisis. And the bubble is the problem, not annual inflation.
I'm afraid that the rule played a decisive role masking the very bubble that was ballooning at the same time that inflation was so modest.
The problem is that we have one instrument to monitoring two sectors: the real and the financial one. And only if you believe that financial markets are efficient (or have similar efficiency that real markets) you can say that a rule about a real variable (inflation, NGDP...) can be sufficient.
But, I don't believe any more in the efficiency of financial markets.

Agree: Taylor rule proponents could well have the causality backwards. Instability leads the CB to break stead with the Taylor rule.

Funny how aficionados of a "free market" are very keen on tight central control of the value of money.


"Funny how aficionados of a free market are very keen on tight central control of the value of money."

Agreed. Question for free market supporters out there - which is more important?

1. Central bank independent of government influence
2. Government independent of central bank influence

Free market supporters in general see the virtues of #1 without recognizing the virtues of #2.

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