By James Anderson
American Banker John A. Allison, in a 2012 paper, provided a pertinent anecdote in which he explained that he had asked a number of members of the Federal Reserve’s Open Market Committee whether they believe that price controls work, to which each central banker stated something along the lines of: “Absolutely not, price controls never work—they are destructive.” Allison then followed up their answer with: “When the Federal Reserve sets interest rates isn’t that really a price control? Isn’t the interest rate perhaps the most important price in the economy?” He then states that “not one of them has given me a credible answer.” (Allison, 2012, p. 271)
Monetary policy is central planning, albeit central planning in a very subtle and roundabout – but nonetheless real and pervasive – way. As Allison said, central banks like the Fed or the Bank of England, are enforcing a price control – and a very important one at that – when they set interest rates. Indeed the interest rate is the most important price in the economy for, through interest rates, individuals, businesses and governments plan and adjust their economic actions both intra- and inter-temporally. Moreover, the method by which central banks adjust interest rates is by adjusting the supply of money (and bank credit) that is in the economy, which, therefore, has a pervasive and roundabout influence on all prices in the economy. Such an influence, of course, is why monetary policy is non-neutral and can boost employment and production (in the short run, if you’re a New Keynesian). This was Keynes’ fundamental argument in his 1936 General Theory, namely, that “involuntary unemployment” can be alleviated by increasing the supply of money and stabilising the price level. Central banks – dominated by New Keynesian economists – intervene monetarily into the economy with this theory as their justification. In so doing, central banks, through their monetary policy operations, wield strong power over the real price of labour, of cars, of cornflakes, as well as the price of every other good or service available in the economy. Therefore, monetary policy, to a great degree, centrally plans the economy.
Thus, the knowledge problem that F. A Hayek so brilliantly elucidated in much of his work should take a central place in any critique of monetary policy. Indeed, it was Hayek’s recognition that the economy is an inherently complex phenomena which led him to convincingly argue that intervening into the economy was extremely difficult, nigh impossible. The problem that Hayek posed to his socialist colleagues – building on the work of Ludwig von Mises – was that a central planner would need to attain all the relevant information to choose the correct price or make the correct command, but much of this indispensable information is impossible to codify, communicate, store or process. Even if we assumed such subjective, tacit and voluminous knowledge could be communicated to, and processed by, a central planner, the constant temporal advancement of the economy means that the central planner will always be one step behind the market because the market is constantly creating knowledge. Systems engineer and author John Gall elucidates the point explored here in a few of his ‘systems laws’, which he capitalises for effect:
INFORMATION DECAYS
or, as Professor Whitehead has so aptly put it:
KNOWLEDGE DOES NOT KEEP ANY BETTER THAN FISH
THE MOST URGENTLY NEEDED INFORMATION DECAYS FASTEST
THE INFORMATION YOU HAVE IS NOT THE INFORMATION YOU WANT.
THE INFORMATION YOU WANT IS NOT THE INFORMATION YOU NEED.
THE INFORMATION YOU NEED IS NOT THE INFORMATION YOU CAN OBTAIN (Gall, 2002, Part 20)
Current Fed Chair Jerome Powell echoed Gall’s fundamental point in 2019: “Good decisions require good data, but the data in hand are seldom as good as we would like.” (Federal Reserve, 2019).
Our critique, however, can be deepened. Not only is the knowledge problem insurmountable originally, but central banks must also conduct monetary policy into a market which, at the very same time, watches – and waits for – the central bank to announce their monetary policy stance in order to determine which economic decisions to pursue. This will speed up the rate at which central banks “inevitably run up against the impossibility of socialist economic calculation” (Huerta de Soto, 2006, P. xlvii) Once the central bank announces their policy stance, the market reacts, and the economic picture might quickly change into a state wholly incompatible with the central banks original policy stance. We thus find central banks caught in a paradox. The same problem is laid out by John Gall:
Now, when a Primatologist observes Primate behavior, there is one piece of behavior that the Primatologist does not want to observe and that is the Primate observing the Observer as the Observer tries to observe the Primate. That sort of thing Gets In The Way. (Gall, 2002, Part 36)
This phenomenon, where markets wait for monetary policy operations to be announced or undertaken before they make their economic plans, means Central Banks face an even greater knowledge problem, and are liable to thus make even greater mistakes. In today’s economy, monetary policy is an extremely powerful tool that has a powerful command over economic conditions, and its arbitrariness and case-by-case heterogeneity makes it by definition unpredictable (indeed its unpredictability is its only lifeline, as Friedman correctly argued in his 1968 paper titled The Role of Monetary Policy). As this is the case, individuals and businesses therefore find the future even more uncertain than it already would be without this added uncertainty created by central banks. Thus arises the business known as ‘Fed Watch’, where economists are paid to merely predict what the Fed will do. This added degree of uncertainty, which has become larger and larger as monetary policy has become more and more potent and important, forced Ben Bernanke in 2012 to adopt the policy of ‘forward guidance’ in an attempt to reduce this uncertainty. This becomes very problematic for, as Friedman explained, the very potency of monetary policy comes from its unpredictability, it comes from “unanticipated inflation” (Friedman, 1968, p. 11). Central Banks thus shoot the market in the foot by increasing uncertainty, and then shoot themselves in the foot by attempting to decrease it.
The implication of this fact that central banks cannot attain the necessary knowledge is that central banks can never know what the correct interest rate or money supply level should be, thus they always choose/target wrong, which causes unintended and unexpected consequences. The consequences – including economic inequality, asset bubbles, financial crises and housing unaffordability – then lead to more government intervention into the economy which is aimed at solving the unintended consequences caused by the government itself in the first place. We thus arrive at a classic feedback loop; “As (they) did not know they were causing iatrogenics,” Nassim Nicholas Taleb writes, “they cure iatrogenics with iatrogenics. Then things explode” (emphasis mine) (Taleb, 2014, Ch. 23).
References:
Allison, J. A. (2012). The Fed’s Fatal Conceit. Cato Journal, 32(2), 265–278. https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2012/7/v32n2-4.pdf
De Soto, J. H. (2006). Money, Bank Credit, and Economic Cycles. Ludwig von Mises Institute.
Gall, J. (2002). The systems Bible: The Beginner’s Guide to Systems Large and Small : Being the Third Edition of Systemantics. General Systemantics Press.
Federal Reserve. (2019) Speech by Chair Powell on data-dependent monetary policy in an evolving economy. Board of Governors of the Federal Reserve System.
Friedman, Milton. “The Role of Monetary Policy.” American Economic Review, Mar. 1968.
Taleb, N. N. (2014). Antifragile: Things That Gain from Disorder. Random House Trade Paperbacks.
James Anderson is a recent Economics graduate from the University of Exeter and is currently writing a book with the working title: Monetary Folly: Intelligence is no Guarantee of Wisdom. He is looking to begin his career either in economic research or in finance after the completion of his book.
