What Is Optimal Monetary Policy, Anyway?

Ever since the important contributions of new classical economists Finn E. Kydland and Edward C. Prescott during the 1970s and 80s, modern macroeconomics seeks optimal rules for monetary policy. Indeed, Milton Friedman had previously emphasized the importance of a binding rule for monetary policy. He recommended a constant but moderate expansion of the money stock over time as well as the abolition of fractional reserve banking in order to improve the central bank’s control over the money stock. Neither of these two measures has ever been implemented over an extended period of time.

Creating Rules for Monetary Policy

Many modern macroeconomists have come to reject the idea of a constant growth rule in favor of a more complex rule that incorporates feedback effects from other macroeconomic aggregates. According to their rationale, political discretion in the form of unexpected accelerations of the money growth rate may lead to short-term benefits. Yet, the latter would come at long-term costs of either permanently too high price inflation or a consecutive readjustment to lower money growth rates that goes hand in hand with real economic losses in output and employment. This is what economists would refer to as the sacrifice ratio. Optimal monetary policy thus requires abstention from reaping some of the potential short-term benefits for the sake of long-term financial and economic stability.

The most famous monetary policy rules that have been deemed optimal are named after John B. Taylor. According to such Taylor rules the central rate of interest should be set in response to changes of actual price inflation, the natural rate of interest, as well as the output gap. There is one obvious practical problem, namely, that the output gap and the natural rate of interest are non-observable theoretical concepts that have to be estimated or replaced by more or less arbitrary empirical proxies. It is then not altogether clear how such rules can really protect us from arbitrary policy discretion.

But What Should be the Goal of these Rules?

Be that as it may. Another pertinent question arises. What makes these rules optimal in the first place? They are optimal with respect to what exactly?

This question hints at a fundamental problem in the social sciences. Ever since the influential works of Max Weber, most social scientists seek to remain value-free in their analyses. This ideal was endorsed by Weber’s friend Ludwig von Mises. And most modern economists when asked would subscribe to it as well. But as Murray Rothbard pointed out, they usually sneak in value judgments, especially when questions of public policy are concerned. Certainly, when the optimality of any policy is discussed, one cannot do without value judgments.

Murray Rothbard agreed in principle that economics “like other sciences, is the value-free handmaiden of values and ethics,” but when we discuss whether one policy is better and desirable, or another worse and hence undesirable, we necessarily need to combine value judgments and economic analysis. In general, whenever we attempt to draw a broader picture of social reality, economics alone is insufficient. Sociological, psychological, as well as ethical considerations have to be incorporated.

When “Optimal” Is Arbitrary

For one thing, taking the idea of subjective value seriously, one can only conclude that whether or not any given monetary policy is considered optimal must to some extent remain arbitrary. However, there arguably is a way to reduce the arbitrariness in our quest for the optimal monetary policy. As noted above it all depends on the criterion for optimality, and there probably is a criterion that is somewhat less arbitrary than the maximization of a fictitious utility function of some postulated representative household, or alternatively and more pragmatically a price inflation target of slightly below 2%.

If values truly are subjective, a criterion that leaves equal room for differing valuations to express themselves seems adequate. This of course would be Rothbard’s criterion of demonstrated preference. For this criterion to be applicable, one would have to eliminate all existing legal privileges that central banks as the very institutions that implement monetary policy enjoy. In particular, legal tender legislation has to be abolished. Hence, genuine competition in the provision of media of exchange is necessary.

Now obviously, this criterion does not tell us what the optimal monetary policy would be a priori. Under these circumstances, however, one could conclude that whatever medium of exchange happens to emerge as the generally accepted one on the market, and by definition becomes money, is from the perspective of the money users the optimal one among the available alternatives. Likewise, the changes that the stock of this chosen medium of exchange is subjected to by its producers, can be interpreted as “optimal monetary policy.”

Privileges Created by Public Policy

The same conclusion is not tenable under the current financial system. It is true that that central- and commercial-bank-produced fiat money is actually used by the overwhelming majority of people. Yet, from this fact we cannot deduce that it truly is considered optimal among the available alternatives, precisely because it is to a considerable extent forced upon the money users by political power.

If we were to abolish the legal privileges of fiat money producers, and their product would then remain over an extended period of time the generally accepted medium of exchange, we could indeed conclude that the respective central bank monetary policy underlying its production is optimal in the limited sense described above. Yet, it is not entirely unlikely that monetary policy under such an institutional change would bear very little resemblance to the actual monetary policy we observe today.

In fact, abolishing legal tender laws would mean to deprive central banks of their constituting characteristic, namely their monopoly in the production of the base supply of legal tender. Hence, we come to the somewhat paradoxical conclusion that we have to abolish central banks in order to identify optimal monetary policy. In other words, in order to find out what an optimal monetary policy would look like, we have to get rid of it.