Monetary policy: reforming the rules

The relative merits of directing monetary policy by following set rules or by the use of discretion has engaged economists since first discussed by Henry Simons in a seminal paper published contemporaneously with Keynes’s General Theory in 1936. Although Simons cites neither of the two rivals, his antipathy to Maynard Keynes and his empathy with Friedrich Hayek can be inferred from respective references to (i) ‘the stupid schemes of plausible reformers’ and (ii) the neutral money concept as ‘the most stimulating contribution to recent discussion’.

For Keynes (and Keynesians), monetary policy is an instrument for managing output and employment. For Hayek (and classical liberals) monetary policy should be benign (vide, neutral money) and in practice used only to counter general price rigidities. Hence Simons: ‘[w]ith adequate price flexibility, we could get along under almost any financial system; with extreme rigidities (reflecting widespread partial monopoly), the most drastic monetary and financial reform … could not protect us from serious disturbances of production and employment.’

Price and wage flexibility are effective means to adjust to ever-changing demands and production technologies. However, to ease the frictions of negotiated contracts and resistance to nominal wage reductions, inflation targeting at a modest level has merit. It is then apposite for workers in contracting sectors to experience a fall in real wages (a ‘cost of living crisis’) to give the incentive for their redeployment to expanding sectors.

Simons was far-sighted in noting that short-term business financing is potentially catastrophic. By the provision of effective money-substitutes (i.e., new bank credit) in a cyclical upturn, commercial banking ‘acquires in effect the prerogative of currency issue and places the government under the practical necessity of giving the private obligations virtually the status of public debts’. Then, in precipitating liquidations to keep ahead of preferential creditors in a cyclical downturn, banks risk system-wide insolvencies that require government intervention. Features noted by Simon as adding further to financial uncertainties, were the low ratio of owner equity to liabilities and the sheer volume of unsecured lending. Plus ça change.

Simons emphatically favoured automatic adjustments ‘under a definite monetary constitution’ but, given the likelihood ‘that many different rules would serve about equally as well’, he argued that the precise form would be less relevant that ‘the difficulties of transition’. The crucial requirement is for agents to understand what the central bank is doing, which is at the root of Mark Carney’s objection to nominal GDP targeting, as currently endorsed by Samuel Brittan. Quite simply, it is ‘too complicated to communicate’. For that reason, if for no other, the UK regime is likely to remain (loosely) that of inflation targeting with (flexible) forward guidance.

The merit of more radical reform can be inferred from Simons’s implicit acknowledgement of the advantages of Islamic finance. If all property were ‘held in a residual-equity or common stock form’, then ‘no one would be in a position either to create effective money-substitutes…or to force enterprises into wholesale efforts at liquidation’. Although such change might be long in coming, the resilience of Islamic banking in the aftermath of the sub-prime crisis attracts attention. Currently, the UK is host to over twenty banks offering Islamic financial products and services, which is more than in any other Western nation. Nor is it without significance that London recently became the first non-Muslim city to host the World Islamic Economic Forum. In addressing delegates, the Prime Minister announced plans for a new Islamic index on the London Stock Exchange as as part of a broader strategy to make London the hub for Islamic finance in the West.

Oak trees from acorns grow…