The Marginal Utility of Central Banking

Economists often discuss the marginal utility of goods and services.  For instance, your second donut is less satisfying than the first and by the fifth donut the value of one additional donut is slim.  With each passing donut the marginal value of another donut is small.  The question we now pose is does monetary policy and by extension all central banking have a marginal utility curve, and if so what is the optimal amount?

On one extreme you get the popular mantra “Abolish the Fed”.  Free market advocates often side here explaining that central bankers have a terrible track record throughout history and most often make the problem worse.   The Nobel Prize winner Milton Freidman was an advocate for this style of monetary policy well before it was in fashion.  He went on record saying we should do away with the Federal Reserve and instead tie interest rates to inflation.  One of the primary strengths of this strategy is that excesses are quickly cleared from the system often through deflation and liquidation.  Famed investor Jim Rogers explains simply that recessions are like small forest fires that clean out the system of excess.  If the fire is prevented the kindling accumulates until a larger crisis occurs.

The major downside of a Fed-free model is that the economy and asset prices become extremely volatile.  In fact, the process that often clears out excesses is an increase in either inflation, deflation, or both.  These periodic shocks make corporate planning very difficult, which in turn would create a higher reluctance to hiring, leading to higher unemployment.  Moreover, a more volatile economy would likely lead to corporations holding more cash (like we have now), which leads to underinvestment and sub-optimal efficiencies.

The other extreme view is that the skilled hand of the federal bankers is a critical part of stability and crisis mitigation.  When shocks occur the Federal Reserve can step in to provide liquidity.  Perhaps the most famous advocate of this view is Paul Krugman, the Nobel Prize winning economist who frequently defends larger government action across the board.  This strategy appears to be what central banks around the world have adopted, as explained in our piece It’s the Economy Stupid.  The benefits of this strategy are transparent.  The government has the ability to create liquidity, change the price of credit, or even become the buyer of last resort.  These benefits, overall, promote price stability and more full employment.   But the benefits of central banking can quickly become perverse.

In Naill Ferguson’s book The Ascent of Money:  A financial history of the world, professor Ferguson explains how at the height of money printing in the Weimer republic it was a nightly event to see tens of thousands of youths gather into some sort of parade selling their bodies.  Inflation was so high that “anyone with anything of value was happy to get rid of it before it was worthless, and anyone without any assets were willing to sell anything they had, including their bodies to gain something of value.”  Similarly, Japan “engineered” a soft landing when the economy turned in the late 1980’s.  Unfortunately, this soft landing has turned into a 25 year long runway.  Central banking may add stability in the short run but can create massive instability if left unchecked.  Today, we are starting to see cracks in high levels of central banking in Europe, Japan, China, and even the United States with quantitative easing becoming the norm and global interest rates racing to zero.  So, one has to ask, is there an optimal amount of central banking?

I agree with Milton Friedman’s view that interest rates should generally be tied to some type of metric.  Unfortunately, finding meaningful inflation data is difficult because of how it is measured. keeps data comparing the old way the CPI was calculated (prior to 1981) and the way it is calculated now, and the discrepancies are huge (currently they show the old CPI at near 11%).  For this reason, I recommend tying interest rates to a basket of commodities such as the Rogers commodity index.  However, during times of duress it makes sense to give central banks some freedom to act.  I would suggest a set standard deviation from the index where the Federal Reserve would be allowed to act if the board agreed.  Moreover, allocating Central Banks a PREDEFINED amount of money they can use to create liquidity in emergency situations would add a certain level of price stability without giving seven men carte blanch over our fiscal wellbeing.

A system like that discussed above would keep many of the benefits of having a central bank but would keep their power within reason.  Today’s system promotes stability over resilience (ability to come back from massive shocks).  Limiting the power of central banks would create a system that is both stable and resilient.