There is Merely a Distinction of Reason Between Rules and Discretion in Central Banks’ Monetary Policy

by Vishal Wilde

Abstract: I briefly review some key articles within the monetary policy literature regarding the debate surrounding rule-based versus discretionary monetary policy and relate them back to a paper I wrote for The Cobden Centre (where I present a reconceptualised theory of money as being an instrument of expectations-management) as well as to articles in the Free Banking literature. I conclude that there is but a distinction of reason between rules and discretion in the monetary policy debate.

I approach the question of whether delegation of monetary policy to an independent central bank improves the conduct of monetary policy with (arguably) biased preconceptions regarding the overall efficacy or even legitimacy of central banks’ and governments’ maintaining a monetary monopoly over their jurisdiction. In this sense, I will relate the literature reviewed back to a paper I published with The Cobden Centre that reconceptualises money as an “instrument of expectations-management” (Wilde (2015)) and which explores its implications for value theory, policy and so on. I specifically suggest that there is only a distinction of reason between monetary rules and discretion and that, ultimately, central banks’ policies (presuming that they and their overarching governments maintain a legally and politically imposed monetary monopoly) results in systemic instability leading to financial crises, boom-and-bust cycles etc. and that if, as the Bank of England has stated, its “mission is to promote the good of the people of the United Kingdom by maintaining monetary and financial stability” then, although, rules-based central banking monetary policy may offer some advantages over discretionary policy, we ultimately essentially require a system where agents have a true choice of monies in which to trade and pay taxes in – whether they be public, private or public-private monies (my understanding of ‘Free Banking’).

Alesina and Summers (1993) suggest that delegating monetary policy to an independent central bank that is more inflation-averse “permits sustaining a lower rate of inflation” but they also found that when they plot Central Bank Independence (CBI) against real macroeconomic performance variables such as “economic growth”, “unemployment” and “real interest rates” that there are limited benefits or costs despite CBI reducing the “level and variability of inflation” (although, notably, only 16 countries are included in the sample). For example, with respect to the level or variability of “economic growth” in particular, Switzerland (with an “extremely independent central bank”) shows slower and less variable growth than the average country in the sample, while Germany and the Netherlands have relatively independent central banks and also relatively good economic performance. In the case of those “countries with relatively dependent central banks”, “Spain and New Zealand have relatively variable economic growth” whereas “France… has enjoyed steady growth.” Indeed, they do acknowledge that a multitude of other institutional factors (which are difficult to control and account for) could be obscuring the relationship (if it exists).

Nevertheless, the authors problematically presume that an independent central banker being more inflation-averse than the “majority of voters” is a “socially desirable goal”. Of course, to the extent that it is desirable to sustain low inflation, delegation to an independent central bank is good but this is merely altering the mode of the imposition of expectations-management preferences upon agents. Whereas discretionary policy purportedly aligned with politically expedient preferences, monetary rules merely make the alternative imposition of inflation-averse preferences upon society. I am not denying that unchecked inflation can be problematic but it must be conceded that agents are heterogeneous with diverse preferences; some may prioritise (expected) nominal interest rate (time-path) stability, or (expected) exchange rate (time-path) stability. By imposing either discretion or rules upon society, heterogeneous agents with diverse preferences are further constrained in their choices during optimisation whereas in a regime with multiple monies with various, competing (or even cooperative) monetary rules and/or discretion, agents would be able to optimise accordingly (presuming rationality). In this sense, there is only a distinction of reason between discretion and rules. Furthermore, Havranek and Rusnak’s (2013) meta-analysis of the empirical literature across countries would seem to suggest that the lag between monetary policy actions and their effects on prices lengthens considerably when financial systems are more developed and, indeed, it would be reasonable to presume that financial systems have largely become more complex and/or developed across countries since the time of Alesina and Summer’s (1993) paper. This also agrees with Belongia and Ireland’s (2015) finding that “identified monetary policy shocks appear to have large and persistent effects on output and prices, with a lag that has lengthened considerably since the early 1980s.”

Another problem with (inflation-targeting) monetary rules is their inability to prevent financial crises, asset price bubbles and so on (their mandate being only to deal with the aftermath) and many agents may prefer if this were dealt with or at least restricted rather than the imposed focus on inflation-targeting. Bean (2004) explains that this is infeasible due to a number of “serious practical difficulties in implementation”; after all, to reliably identify a bubble is difficult, to deal with it swiftly is complicated due to lags in the monetary transmission mechanism and even raising interest rates could actually reinforce the negative consequences. However, Bean (2004) uses a rather standard Keynesian model and it is interesting to note that Keynes (1936) himself once wrote that it is arguable “that a more advantageous state of expectation might result from a banking policy which always nipped in the bud an incipient boom” since he believed that it is “chiefly” the “Dependence of the marginal efficiency of [a given stock of] capital on changes in expectation [that] renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle” (especially since the schedule of the marginal efficiency of capital determines liquidity preference). Furthermore, with respect to banking crises in particular, Selgin’s (1994) findings are that government regulation through central banks, deposit insurance and so on are actually likely to be the cause of banking crises; he found that eras with relatively “free banking” in countries such as Scotland had comparatively far fewer crises. Nevertheless, it must be conceded to Bean (2004) that even if the argument for “preemptive action” is persuasive, we still do not know “how best to do so in practice” and that, in the meantime, although monetary policy is constrained in the event of a crisis in terms of response, “average inflation is lower” and this is due partly to significantly stabilising inflation-expectations through credible pre-commitment via rules.

Rogoff (1985) suggests that “it can be entirely rational for society to structure its central bank in such a way that the monetary authorities have an objective function very different from the social welfare function” since “society can be made better off by having the central bank place “too large” a weight on inflation rate stabilization.” Again, however, this imposes a monetary monopoly and a particular set of expectations-management preferences amongst heterogeneous agents who are likely to have diverse preferences; nevertheless, Rogoff (1985) concedes that his model does not allow for reputational factors in a multiperiod setting. Barro and Gordon (1983), however, find that when reputation is factored into the dynamic interactions of monetary authorities and private agents, that “given the repeated interaction between the policymaker and private agents, it is possible that reputational forces can substitute for formal rules.” Indeed, they suggest that the resulting equilibrium is a weighted average of the the ideal rule and discretion where a higher discount rate (amongst other contributing factors) would lead the monetary authority to tend towards outcomes closer to discretion despite a “punishment” through which they lose credibility for subsequent periods. Again, this lends support to my theoretical contention that, in reality, there really is only a distinction of reason between rules and discretion in monetary policy when we have a monetary monopoly reinforced by central banks, legal tender legislation and taxation laws (i.e citizens only being allowed to pay taxes in central bank-issued money which artificially privileges that money over other potentially usable monies for trade, credit and so on).

There is one significant concession I will make, however, in terms of the advantage of delegating monetary policy to an independent central bank. That is; its potential to stabilise or at least mitigate fluctuations via political expediencies. Although Alesina and Roubini (1992) work with a small sample of 18 OECD economies, their analysis is insightful in that it lends support to the idea that “inflation tends to increase immediately after elections” and that there are “temporary partisan differences in output and unemployment and of long-run partisan differences in the inflation rate” but that there is “virtually no evidence of permanent partisan differences in output growth and unemployment.” These phenomena are concerning in that it seems to imply that monetary policy can be manipulated according to partisan preferences (with respect to unemployment and inflation preferences amongst “right” and “left” political coalitions, most simplistically) for short-term gains (output and employment) at the expense of long-run differences in the inflation rate if it is not delegated to an independent agency. Indeed, this lends normative support to Alesina and Summers’ (1993) aforementioned paper’s policy implications.

To relate these contentions back to the case of the United States and the Free Banking literature more broadly, Selgin (1994) has indeed suggested that eras with relatively free banking experienced far fewer financial and banking crises and this lends support to the idea that an imposed monetary policy upon agents leads to systemic imbalances. Nevertheless, I find myself disagreeing with Selgin’s (2010) contention that “nominal GDP futures targeting, in which speculators in the open market play a crucial role in implementing and enforcing the monetary authority’s rule (see Sumner 1989 and 1995)” would be preferable since even though “the main virtue is that it significantly reduces the discretionary element”, I have just argued that that there is but ultimately a distinction of reason between rules and discretion when agents have a monetary monopoly imposed upon them which, thereby, restricts their choice of instruments of expectations-management. Although having speculators in the open market play a role in implementing and enforcing the monetary authority’s rule may arguably be better than the current arrangement since market forces would help shape the rule, the fundamental problem of the monetary authority’s rule being enforced and imposed upon agents still stands and, without a genuine choice of multiple monies being offered to agents, such an arrangement would still lead to systemic financial imbalances because the imposed monetary monopoly denies other agents the chance to determine their own mode of expectations-management even if other market actors are involved in the determination of the monetary authority’s rule. In this sense, I have far more sympathy for the plan to “get government out of the paper currency business” in conjunction with private actors issuing their own monies and allowing the public in turn to make “greater use of electronic forms of payment, which have many advantages besides”. However, to immediately remove government from this business would be shock various actors’ expectations and it would be wiser on the view that money is an instrument of expectations-management to allow the choice to be had between public, public-private partnership and wholly private monies and, with time, the long-run equilibrium may well be one where agents choose to switch wholly private or public-private monies more so than completely public monies. However, if the choice were given in such a way, the government and Federal Reserve would still reap the advantages associated with being the incumbent or ‘first-mover’ in a dynamic game of asymmetric information. So, as long as agents have a choice and continue to choose and adjust their portfolios between a variety of monies, the long-run equilibrium may well involve a mix of such monies coexisting within economies.

In addition to this, the Federal Reserve has a dual mandate of both price-stability and full employment but the issue here is that its instrument – the monetary base – is problematic not only for the Federal Reserve but for the affected agents more broadly in meeting these goals since the Federal Reserve can only partially stabilise and meet the expectations-management preferences to various, largely unsatisfactory degrees and the agents themselves are unable to optimise their own preferences through a choice of multiple monies that would otherwise be available in an arrangement wherein the Federal Reserve, in conjunction with the government, does not impose and perpetuate a monetary monopoly upon the population (across jurisdictions, this is perpetuated to various degrees by tools such as taxation laws and mechanisms – i.e only being allowed to feasibly pay taxes in particular monies – legal tender legislation in others and also trading and financial market laws elsewhere). This limitation of the policy instrument is further compounded by the fact that one can even question the degree of ‘independence’ that the Federal Reserve has; for example, Caporale and Grier (1998) “show the existence of significant executive, legislative, and bureaucratic influence on the real rate of interest from 1961 to 1966.” Furthermore, the interpretation of the Great Depression as occurring most significantly due to a sudden contraction of the money supply after the stock market crash of 1929 (Friedman and Schwartz, 1971) accords with my contention that recessions and serious depressions can be interpreted as being as a result of shocks to expectations with respect to pre-established expectations-management preferences. At the same time, I would contend that the theory of money as an instrument of expectations-management also agrees with Anderson, Shughart II and Tollison’s (1988) alternative interpretation of the Great Contraction as being due to rationally self-interested policymakers (rather than an irrational or “inept” Fed as Friedman and Schwartz (1971) seem to suggest) which sees the resulting monetary policy as indicative of the Fed and Government’s’ intentions in that “the failure rates of non-member banks in the early 1930s were significantly higher in states with representation on the House Banking and Currency Committee.” Although some may argue that such a view is sinister, it is entirely valid but also consistent with my conjecture that money is an instrument of expectations-management and that the monetary policy pursued reflects the expectations-management preferences (on this view) of the Federal Reserve and Congress through privileging and enriching particular interest groups at the expense of relatively less well-resourced ones by imposing policies intended to distort expectations-management to obtain (what they may have expected to be) a favourable outcome. Such questions of true ‘independence’ are particularly relevant when we consider contemporary developments in (unconventional) monetary policy.

Ultimately, delegation of monetary policy to an independent central bank is only useful insofar as imposing inflation-targeting (or another accompanying or differing monetary rules) upon society is desirable and to the extent that it mitigates political risks. Nevertheless, both rules and discretion premise that agents would be better off by having expectations-management preferences imposed upon them and thereby institutionally distorted rather than being able to choose how they manage their diverse and (time-)varying expectations-management preferences through an authentic, genuine choice of multiple monies. In this sense, there is but a distinction of reason between rules and discretion and the extent to which this improves monetary policy insofar as it has the aim to promote the good and welfare of peoples is dubious.


Alesina, A., and Roubini, N. (1992). “Political Cycles in OECD Economies.” Review of Economic Studies, 59(4), pp.663-688.

Alesina, A., and Summers, L. H. (1993). “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.” Journal of Money, Credit and Banking, 25(2), pp.151-162.

Anderson, G. M., Shughart II, W. F., and Tollison, R. D. (1988). “A Public Choice Theory of the Great Contraction.” Public Choice, 59(1), pp.3-23.

Barro, R. J., and Gordon, D. B. (1983). “Rules, Discretion and Reputation in a Model of Monetary Policy.” NBER Working Paper Series, Working Paper No. 1079. Cambridge, MA: National Bureau of Economic Research.

Bean, C. R. (2004). “Asset Prices, Financial Instability, and Monetary Policy.” American Economic Review, 94(2), pp.14-18.

Belongia, M. T., and Ireland, P. N. “Money and Output: Friedman and Schwartz Revisited.” NBER Working Paper Series, Working Paper No. 21796. Cambridge, MA: National Bureau of Economic Research.

Capolane, T., and Grier, K. B. (1998). “A Political Model of Monetary Policy with Application to the Real Fed Funds Rate.” Journal of Law and Economics, 41(2), pp.409-428.

Friedman, M., and Schwartz, A. J. (1971). A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press.

Havranek, T., and Rusnak, M. (2013). “Transmission Lags of Monetary Policy: A Meta-Analysis.” International Journal of Central Banking, 9, pp.39.75.

Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Palgrave Macmillan.

Rogoff, K. (1985). “The Optimal Degree of Commitment to an Immediate Monetary Target.” Quarterly Journal of Economics, 100(4), pp.1169-1189.

Selgin, G. (1994). “Are banking crises free-market phenomena?” Critical Review: A Journal of Politics and Society, 8(4), pp.591-608.

Selgin, G. (2010). “The Futility of Central Banking”, Cato Journal, 30(3), pp.465-473.

Sumner, S. (1989). “Using Futures Instruments Prices to Target National Income.” Bulletin of Economic Research, 41(2), pp.157-63.

Sumner, S. (1995). “The Impact of Futures Price Targeting on the Precision and Credibility of Monetary Policy.” Journal of Money, Credit and Central Banking, 27(1), pp.89-106.

Wilde, V. (2015). “A Unifying Theory: Money, Goods and Services Are Instruments of Expectations-Management.” The Cobden Centre. Available at: Date of Access: 04/05/2016.


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