Submitted by Alasdair Macleod – FinanceAndEconomics.org
Well, well: who would have believed it. First the Bank for International Settlements comes out with a paper that links credit booms to the boom-bust business cycle, then Britain’s Adam Smith Institute publishes a paper by Anthony Evans that recommends the Bank of England should ditch its powers over monetary policy and move towards free banking. Admittedly, the BIS paper hides its argument behind a mixture of statistical and mathematical analysis, and seems unaware of Austrian Business Cycle Theory, there being no mention of it, or even of Hayek. Is this ignorance, or a reluctance to be associated with loony free-marketeers? Not being a conspiracy theorist, I suspect ignorance.
The Adam Smith Institute’s paper is not so shy, and includes both “sound money” and “Austrian” in the title, though the first comment on the web version of the press release says talking about “Austrian” proposals is unhelpful. So prejudice against Austrian economics is still unfortunately alive and well, even though its conclusions are becoming less so. The Adam Smith Institute actually does some very good work debunking the mainstream neo-classical economics prevalent today, and is to be congratulated for publishing Evans’s paper.
The BIS paper will be the more influential of the two in policy circles, and this is not the first time the BIS has questioned the macroeconomic assumptions behind the actions of the major central banks. The BIS is regarded as the central bankers’ central bank, so just as we lesser mortals look up to the Fed, ECB, BoE or BoJ in the hope they know what they are doing, they presumably take note of the BIS. One wonders if the Fed’s new policy of raising interest rates was influenced by the BIS’s view that zero rates are not delivering a Keynesian recovery, and might only intensify the boom-bust syndrome.
These are straws in the wind perhaps, but surely central bankers are now beginning to suspect that conventional monetary policy is not all it’s cracked up to be. For a possible alternative they could turn to the article by Anthony Evans, published by the Adam Smith Institute. Their hearts will sink, because Evans makes it clear that central banks are best as minimal operations, supplying money through open market operations (OMOs) on a punitive instead of a liberal basis. Instead of targeting inflation, Evans recommends targeting nominal GDP. Evans’s approach is deliberately sound-money-light, on the basis that it is more likely to be accepted than a raw sound-money approach. But he does hold out the hope it will be an interim measure towards sound money proper: initially a Hayekian rather than a Misesian approach.
Targeting nominal GDP is not a perfect answer. As Evans points out, changes in government spending distort it, and by targeting output, there may be less control over inflation, if control was ever the right word. However, my own researches are generally supportive of Evans’s approach to managing the money supply. This is because, logically, nominal GDP, which is impossible to measure accurately by the way, is simply the total amount of money deployed in the part of the economy included in GDP. The reason this must be so is Say’s law, the law of the markets, tells us that we produce to consume, and production is balanced by the sum of consumption and savings. Therefore, if new money or bank credit is introduced into the economy, it will temporarily increase both demand and supply for goods, until the spread of rising prices negates the impact.
In managing the total money supply, a central bank would have to take into account fluctuations in bank credit, and adjust its own operations accordingly. No MPC, no FOMC, and no convoluted analysis of inflation prospects are required. The true Austrian approach is to welcome a corrective crisis as the most efficient and rapid way to unwind malinvestments. Nominal GDP targeting of a few per cent can be expected to soften this process without unduly discouraging it.
While I support the concept of targeting nominal GDP, Evans’s paper is necessarily complicated, written for an audience that dismisses Say’s law. He argues his case on a modified equation of exchange, M+V = P+Y, where M is the growth rate of the money supply, V is the change in its velocity, P is the inflation rate, and Y is the growth rate of output.
My worry is that the faintest suggestion of sound money policies will be blamed for a developing economic crisis, without being adopted at all. Within one month of the Fed raising the Fed Funds rate by a miniscule 0.25%, it seems the whole world is falling apart. The usual market cheerleaders are now on record of expecting a global crisis to develop, the signs being too obvious to ignore. Markets are over-valued relative to deteriorating economic prospects. Collapsed energy and commodity prices tell their own story. Shipping rates and the share prices of US utilities (including rails and freight) are falling. The days of blaming China for a contraction of world trade are over: the downturn is now far larger and more widespread.
Decades of accumulated market distortions appear to be on the brink of a great unwind, most of which can be blamed on expansionary monetary policies. If so, the banking crisis of 2008 was a prelude, rather than the crisis itself. The Fed will almost certainly reduce interest rates back to zero, and will reluctantly have to consider imposing negative rates.
The Keynesians will blame the Fed for a complete policy failure. They will argue in retrospect, as they did following the banking crisis, that the financial and economic crisis of 2016 was made immeasurably worse by the Fed raising the Fed funds rate and not pumping yet more money into the economy at such a crucial time. It’s like saying alcoholics must drink more to be cured. The monetarists will simply say that the Fed got it wrong, and that monetarism was not to blame. They will all blame advocates of inflexible sound money.
The reality is, that by implementing conventional policies on the recommendation of group-thinking macroeconomists, the central banks have dug a hole too deep to escape.
 BIS Working Paper 534: Labour reallocation and productivity dynamics: financial causes, real consequences.
 ASI: Sound money: An Austrian proposal for free banking, NGDP targets, and OMO reforms.