Abstract
A self-enforcing monetary constitution has rules that agents acting within the system will uphold even in the presence of deviations from ideal knowledge and complete benevolence. It thus does not require external enforcement. What would such a constitution look like? I show that two regimes—a version of nominal gross domestic product targeting that relies on market implementation of monetary policy, and free banking—meet these requirements for self-enforcing monetary constitutions. The analysis draws insights from political economy, and from constitutional political economy in particular.
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Notes
Boettke and Luther (2009) argue that these two positions are reconcilable.
Horwitz (2011) argues that market forces can devise a stable and predictable monetary order. I will revisit this claim in a subsequent section.
Anna Schwartz (1987: 391) defines a monetary constitution as any established rule for monetary policy, which may or may not be formally embodied in a written document. This is how “monetary constitution” ought to be understood in this paper.
The necessity of an explicit constitutional provision for gold was deemed necessary due to the central banks’ history of suspending redemption (Jonung 1984: 368).
This obviously does not definitively show the inferiority of commodity standards in terms of insularity from political forces. But it does show that explicit constitutionalization is not a sufficient condition for insulation from these forces.
Treaty on the Functioning of the European Union, Article 127(1).
Inflation is measured by the Harmonized Index of Consumer prices (HICP), data for which is also available at the ECB’s website.
The range of inflation above the 2 % target begins in December 2010 and continues today, although the most recent data shows falling inflation. As of this writing, the most recent estimate is 2.2 %.
Technically, the ECB’s constitution mandates price stability without mentioning a specific inflation rate. However, it is clear the ECB’s governing council interprets price stability as 2 % inflation or less (European Central Bank 2011).
This issue is inherent in all questions that fall within the scope of constitutional political economy (e.g. Brennan and Buchanan 2000).
As an example, the Fed during its earliest years resembled a club environment, albeit imperfectly. The Federal Reserve System was originally intended to be a formalization of the interbank clearing mechanism. Individual reserve banks faced a quasi-budget constraint, operated in a decentralized environment with each reserve bank conducting open market operations based off of local conditions, and individual member banks could self-sort by choosing whether to be a part of the system. A true club-like scenario would feature even more decentralization and privatization, but the early Fed still came much closer to this standard than it does currently.
Whether this is true net of switching costs is a question I relegate to a later section of the paper.
Buchanan (1962), writing before the development of the robust political economy literature, argues for predictability as a chief criterion of a monetary constitution.
See also Greenfield and Yeager (1983) for another take on institutional arrangements that yield stable money.
Of course, this increase in purchasing power overlies many changes in relative prices, based on the productivity gains in specific sectors at the micro level.
It is important to note that agents concerned with maintaining their money’s purchasing power would still be able to engage in post-constitutional contractual arrangements, such as purchasing inflation-indexed securities, to maintain that purchasing power. A monetary order that did not institutionalize monetary neutrality would be much more disruptive, and render such contracting much more difficult (costly). This is another argument for placing monetary equilibrium at a higher level of importance than stable purchasing power.
The financial crisis has seen central banks adopt untraditional measures to combat deflation and unemployment, but the underlying paradigm remains the same. The theoretical justification for interest rates as the implementation mechanism is given in Woodford (2003).
This is extraordinarily unlikely due to the fact individuals change their behavior in response to changing policy environments; the constants aren’t so constant after all (Lucas 1976).
This is a signal-extraction problem akin to the one made famous by Lucas (1972).
In addition, Mankiw also counsels skepticism regarding the extent to which the rules versus discretion debate has influenced central banking in practice. “[T]he institutional changes we have observed are at best loosely connected to the issues raised in the theoretical literature” (Mankiw 2006: 16).
See also Boettke and Smith (2012).
Proponents of a Taylor Rule will be pleased to discover that a generalized version of this rule is a special case of NGDP targeting (Koenig 2012).
Hendrickson’s (2012) view that NGDP targeting can be viewed as a “technology” for achieving monetary equilibrium is characteristic of Market Monetarism. However, insights from Hayek’s (1948) work on knowledge and the price mechanism suggest that the process by which NGDP is generated and sustained matters, and as such NGDP as a choice variable for a central bank is not the same thing as NGDP as the emergent outcome of market processes. This distinction has been noted elsewhere (Salter 2013a) but will not receive further treatment here.
See also Sumner (1989, 2006).
This may be some fraction of NGDP. As of the time of writing, U.S. NGDP is approximately $16 trillion. The initial price of each contract could be, say, one one-billionth of this value, adjusted for the particular form of the desired NGDP target. Even simpler, at the start of the regime, NGDP could be normalized to one, with subsequent values decided by the desired percentage growth of target NGDP. Also, it is assumed throughout that the monetary authority is the monopoly provider of base money, and can near-costlessly create or destroy additional balances, akin to the Fed’s actions when conducting open market operations by electronically altering banks’ account balances held at the Fed.
This payment scheme is what leads Dowd (1994: 829) to refer to the contracts as Quasi-Futures Contracts (QFCs). In “real” futures contracts, payment is made at the time of maturity. In this case, payment at the time of the bargain is necessary to anchor the underlying variable which is being targeted.
Because monetary policy is actually implemented by market actors, this scheme avoids the “circularity problem” outlined by Bernanke and Woodford (1997). However, the “first mover” problem discussed by Garrison and White (1997) is still a potential issue. Sumner (2006: 17–22) discusses ways this problem can be ameliorated.
The evolution of free banking systems shows a remarkable degree of homogeneity across time and space. See the essays in Dowd (1992) for specific historical cases.
Cf. White (1989: 231): “Eventually all the banks within an economy will be connected through one or a small number of clearinghouses … [t]he histories of the best-known early clearinghouses, in London, Edinburgh, and New York, all conform to this general pattern…”.
This response is especially noteworthy, given the U.S. system at the time was constrained by regulations that rendered the money supply extremely inelastic to changes in money demand (Smith 1990: Ch. 5).
See also White (1995: 27–29) for a description of how the Edinburgh clearinghouse prevented the failure of the Ayr Bank from crashing Scotland’s free banking system.
That a specific monetary constitution is unnecessary does not imply that the general constitution need not have provisions preventing government interference with the monetary order. Cf. Horwitz (2011: 332): “A constitution might expressly prohibit the state from playing such a role, much as the First Amendment to the US Constitution does with respect to speech.”
A third possibility may exist: instead of “scrapping” the Fed, the monetary base can be frozen at its current level and serve as the medium of redemption upon which banks can issue their own liabilities. This is basically free banking with Federal Reserve notes, rather than gold, serving as the monetary base. The Fed would be reduced to just one bank among many, forced to compete to survive (Selgin 1985). This would economize on switching costs, but there is some worry that, by preserving any of the Fed’s institutional structure, it would then be less costly for politicians to restore the Fed’s monopoly status. This is the same problem that plagues the NGDP targeting regime described above.
Cf Brennan and Buchanan (2000: 4): “What advice can we offer ourselves in our own societies, standing as we do with the benefits of cooperation and the prospects of conflict on either hand? What aspects of our social life should we discard? Where are there "rules of social order"—institutional arrangements governing our interactions—that lead us to affect one another adversely? Where are there forces for harmony that can be mobilized? What rules—and what institutions—should we be struggling to preserve?… These questions represent the area of inquiry we term "constitutional political economy" (in the spirit of the classical political economists, for whom such questions were also central).”
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Salter, A.W. Is there a self-enforcing monetary constitution?. Const Polit Econ 25, 280–300 (2014). https://doi.org/10.1007/s10602-014-9163-1
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DOI: https://doi.org/10.1007/s10602-014-9163-1
Keywords
- Central banking
- Constitutional political economy
- Free banking
- Monetary constitution
- NGDP targeting
- Robust political economy