Money, Markets, and Government

The Next 30 Years

James A. Dorn

• Publisher: Cato Institute
• Year: 2013
• ISBN:
  9781939709349
• Topic: Business
• Subtopic: Government & Business
• Index: Business

The 2008-2009 financial crisis and Great Recession have vastly increased the power and scope of the Federal Reserve, and radically changed the financial landscape. This ebook, an edited volume of papers presented at the Cato Institute's 30th Annual Monetary Conference, examines those changes and considers how the links between money, markets, and government may evolve in the future. By studying the past, one can learn how to avoid future crises and improve monetary institutions, provided political barriers to real reform can be circumvented. Some of the general topics covered in this ebook include how the choice of monetary regimes affects economic freedom and prosperity, the policy steps needed to avoid future financial crises, the limits of monetary policy, the lessons from the Eurozone debt crisis, and China's path toward capital freedom.

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INTRODUCTION
MONEY, MARKETS, AND GOVERNMENT: THE NEXT 30 YEARS

James A. Dorn*

All those who wish to stop the drift toward increasing government control should concentrate their effort on monetary policy.

—F. A. Hayek

The articles in this volume were first presented at the Cato Institute’s 30th Annual Monetary Conference, which was held in Washington on November 15, 2012. They appeared in the Fall 2013 issue of the Cato Journal and are being reprinted here as an e-book to provide broader access. The 2008–09 financial crisis and Great Recession have vastly increased the power and scope of the Federal Reserve. Ultra-low interest rates, quantitative easing, credit allocation, debt monetization, and new regulations have radically changed the monetary and financial landscape.

This book examines those changes and considers how the links between money, markets, and government may evolve in the future. One path is to maintain a regime of discretionary government fiat money. An alternative path is to limit the size and scope of government, adopt a rules-based monetary regime, and let free capital markets allocate credit. The choice of monetary institutions will help determine whether economic and social harmony emerges spontaneously or government power continues to grow.

By studying the past, one can learn how to avoid future crises. The financial crises in the United States and Europe, and the problems that face China as it internationalizes the renminbi, deserve close attention. Lessons can be learned that improve monetary institutions, provided political barriers to real reform can be circumvented.

Some of the general topics covered in this volume include: (1) how the choice of monetary regimes affects economic freedom and prosperity; (2) the policy steps needed to avoid future financial crises; (3) the limits of monetary policy, and the case for simple rules and an “antifragile” system of money and banking; (4) the lessons from the eurozone debt crisis; and (5) China’s path toward capital freedom.

Avoiding the Next Crisis

To avoid the next crisis, one must understand and draw lessons from the recent crisis. John B. Taylor, professor of economics at Stanford University, examines monetary policy during the past 30 years. He finds that during the 1980s and 90s, Fed policy was largely in line with the so-called Taylor Rule, but beginning in the early 2000s, the Fed turned to a strongly discretionary policy and held interest rates too low for too long, thus fueling the housing bubble. He argues that adhering to a rules-based monetary regime would reduce institutional uncertainty, lead to a more predictable path of monetary policy, and generate better economic performance.

Charles I. Plosser, president and CEO of the Federal Reserve Bank of Philadelphia, contends that the Fed needs to take “a systematic approach to policymaking, centered on using robust simple rules as guides to both its policy decisions and the way in which it communicates those decisions.” Good intentions and short-run thinking are not sufficient for good policy and long-run price stability. The Fed’s ultra-low interest rate policy discourages conservative investments and increases risk taking. The Fed’s massive expansion of its balance sheet, the switch toward longer-run assets, the preference given to mortgage-backed securities, and the monetization of government debt complicate monetary policy and pose long-run risks. If the Fed is to successfully exit its current “extraordinary accommodation,” it will need “to be systematic and transparent about its policy decisions.”

Kevin M. Warsh, a former member of the Federal Reserve Board of Governors, points to the limits of monetary policy and holds that the Fed would be “wise to acknowledge those limits” if it is to maintain credibility. David Malpass, president of Encima Global, also discusses the limits of monetary policy and argues that what is needed for full employment is a robust supply-side economic policy, not monetary fine-tuning and credit allocation.

Robert L. Hetzel, a senior economist at the Federal Reserve Bank of Richmond, is critical of the Fed’s focus on forecasting and the absence of a policy rule. He recommends that models be developed “to evaluate the efficacy or mistakes of past monetary policy.”

Jeffrey A. Miron, director of undergraduate studies at Harvard University and a senior fellow at the Cato Institute, raises the question “should policy attempt to avoid financial crises?” In his view, the proper role of policy should be to improve economic performance and increase prosperity. Laws and regulations designed to avoid financial crises may instead create impediments to economic growth. He notes, for example, the adverse effects of Dodd-Frank and the “stimulus” programs that have expanded the state at the expense of the market. He concludes that “anti-crisis policies might be worse than the disease.”

The Fragility of the Fed and Too Big To Fail

The politicization of money and banking has led to an overreaching money policy and a serious moral hazard problem, whereby financial institutions considered “too big to fail” act irresponsibly and take excessive risks.

Allan H. Meltzer, University Professor of Political Economy at Carnegie-Mellon University, asks, “What’s wrong with the Fed? What would restore independence?” He is highly critical of the Fed’s short-term perspective and, hence, the neglect of the medium- and longer-run consequences of expanding the Fed’s “unrestricted power to do what it chooses.” By engaging in credit allocation, acquiring mortgage-backed securities, and greatly increasing the monetary base, the Fed risks accelerating inflation and another, even deeper, crisis. He proposes that the Fed adopt a credible monetary rule; take account of money, credit, and asset prices in its macro models; and clearly state its lender-of-last-resort policy. Most important, the Fed should be held accountable and its powers limited.

Thomas F. Cargill, professor of economics at the University of Nevada, Reno, and Gerald P. O’Driscoll Jr., a Cato senior fellow, argue that Fed independence is a myth. Although the Fed has de jure independence, it has never achieved de facto independence. Consequently, one should expect the politicization of monetary policy and its drift into fiscal policy.

Steven Gjerstad, a Presidential Fellow at the Economics Science Institute at Chapman University, and Vernon L. Smith, professor of economics and law at Chapman University and a Nobel laureate, argue that both the Great Recession of 2007–09 and the Great Depression of 1929–33 were preceded by unsustainable increases in housing credit and construction. When the housing bubble deflated, homeowners’ equity fell sharply. Leverage (borrowing) is fun on the way up but painful on the way down. It takes time for households and financial institutions to restore their balance sheets and to deleverage. Consequently, even with ultra-low interest rates, the demand for credit has been weak. The authors provide extensive empirical evidence to support the view that the Great Recession was a balance sheet crisis and examine various responses to such crises. Dealing sharply with insolvent banks and not allowing any bank to be “too big to fail” would mitigate future crises.

Lawrence H. White, professor of economics at George Mason University, calls for “antifragile banking and monetary systems,” meaning ones that are adaptive and error-correcting. He contends that letting insolvent banks fail would make the financial system stronger, not weaker. More market discipline is necessary. Consequently, he argues that deposit insurance and other safety nets should be eliminated and a “free-banking” system should replace “centralized monetary policy.”

Thomas M. Hoenig, vice chairman of the Federal Deposit Insurance Corporation, argues that the too-big-to-fail problem is still serious and moral hazard is a threat to financial stability. Dodd-Frank has not increased market discipline or narrowed the safety net to reduce risk taking. The largest financial institutions continue to have an incentive to overleverage. He recommends limiting the safety net to deposit-taking commercial banks, adopting simple rules for capital adequacy, and avoiding the highly complex Basel risk-weighted approach.

The Future of the Euro

Harris Dellas, professor economics at the University of Bern, and George S. Tavlas, a member of the Monetary Policy Council of the Bank of Greece, examine “the gold standard, the euro, and the origins of the Greek sovereign debt crisis.” Unlike the classical gold standard, the eurozone lacks a market-based feedback mechanism and has failed to enforce fiscal discipline. The expectation of a bailout gave investors an incentive to hold Greek sovereign debt and allowed Greece to live beyond its means. The lesson is that there must be a credible adjustment mechanism and sound fiscal arrangements to achieve long-run stability in the eurozone.

Pedro Schwartz, professor of economics at San Pablo CEU University in Madrid, has supported competing (parallel) currencies and opposed harmonization of regulations. A monetary union requires flexible wages and prices to operate efficiently. Political constraints have hampered that flexibility. He believes that the European Central Bank (ECB) has “strayed too far from the automaticity of an anchored monetary system.” He is pessimistic that either Europe or the United States will achieve “a neutral and solid currency” given the “insatiable demands” of the welfare state.

Wolfgang Münchau, associate editor of the Financial Times, criticizes the Maastricht Treaty for failing to provide guidance in time of crisis. Moreover, under current law, there are no provisions for exiting the eurozone. He argues for structural reform to increase flexibility, as well as the need to move toward greater integration via reform of fiscal, banking, and political institutions.

Jürgen Stark, a former member of the ECB executive board, considers the policies that led to the euro crisis and what needs to be done to ensure the survival and success of the European Economic and Monetary Union. The fiscal rules provided by the Maastricht Treaty and made operational in the Stability and Growth Pact were not enforced when they should have been. Rules need to be followed, especially in time of crisis. The euro crisis “is not just a sovereign debt crisis,” argues Stark. It is a crisis of confidence, an institutional crisis, and a structural crisis—all of which need to be resolved if the EMU dream is to be realized.

China’s March toward a Global Currency

The rise of China as a global economy has been breathtaking. In 1976, China was a closed economy. Today it is the world’s second largest economy with a vibrant trade sector. Yet, the renminbi, also known as the yuan, is not fully convertible. Progress is being made to internationalize the RMB, but the institutional changes needed face political barriers.

Eswar Prasad, the Tolani Senior Professor of Trade Policy at Cornell University, and Lei Ye, a graduate student in the department of economics at Cornell, examine the prospects for making the RMB a global reserve currency. They emphasize that for China to fully internationalize its currency there needs to be free capital markets, a more flexible exchange rate, and financial market deepening. China is making progress in those areas but much remains to be done to eliminate financial repression.

Yukon Huang, a senior associate at the Carnegie Endowment for International Peace, and Clare Lynch, a junior fellow, recognize that internationalizing the renminbi and relaxing capital controls have costs as well as benefits. They are concerned about the proper sequencing of reforms to reduce short-run costs and increase long-run benefits. In their view, priority should be given to further liberalization of domestic capital markets, reform of state-owned banks, and greater flexibility of interest rates, as well as fiscal reform.

Zhiwu Chen, professor of finance at the Yale School of Management, provides a detailed account of the political constraints that hamper the operation of China’s stock market. He goes to the root of the problem, noting that without political and legal reform—including privatization—China will be unable to realize capital freedom. In particular, there needs to be “a formal debate or reform to define and limit the scope of government.” He concludes that unless there is a genuine rule of law and widespread private ownership, economic and individual freedom will suffer.

The Next 30 Years

Cato’s first monetary conference in 1983, “The Search for Stable Money,” sought to extend the debate over alternatives to discretionary government fiat money by including alternatives consistent with limited government, the rule of law, and free markets. Since that time, more than 400 articles by leading scholars and policymakers have appeared in the Cato Journal, and several books have been published.

Cato has gained an international reputation for its scholarly work on alternative monetary regimes and for recognizing early on the dangers of “too big to fail” and the moral hazard problem inherent in government-sp...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Chapter 1: INTRODUCTION: Money, Markets, and Government: The Next 30 Years
• PART I: AVOIDING THE NEXT CRISIS
• Chapter 2: Monetary Policy during the Past 30 Years with Lessons for the Next 30 Years
• Chapter 3: Fed Policy: Good Intentions, Risky Consequences
• Chapter 4: The Conduct of Monetary Policy
• Chapter 5: The Fed Needs to Change Course
• Chapter 6: Avoiding the Next Crisis: Can Central Banks Learn?
• Chapter 7: Should Policy Attempt to Avoid Financial Crises?
• PART II: THE FRAGILITY OF THE FED AND TOO BIG TO FAIL
• Chapter 8: What’s Wrong with the Fed? What Would Restore Independence?
• Chapter 9: Federal Reserve Independence: Reality or Myth?
• Chapter 10: Balance Sheet Crises: Causes, Consequences, and Responses
• Chapter 11: Antifragile Banking and Monetary Systems
• Chapter 12: The Case for Simple Rules and Limiting the Safety Net
• PART III: THE FUTURE OF THE EURO
• Chapter 13: The Gold Standard, the Euro, and the Origins of the Greek Sovereign Debt Crisis
• Chapter 14: Why the Euro Failed and How It Will Survive
• Chapter 15: The Euro at a Crossroads
• Chapter 16: Lessons from the European Crisis
• PART IV: CHINA’S MARCH TOWARD A GLOBAL CURRENCY
• Chapter 17: The Renminbi’s Prospects as a Global Reserve Currency
• Chapter 18: Does Internationalizing the RMB Make Sense for China?
• Chapter 19: Capital Freedom in China as Viewed from the Evolution of the Stock Market