New paper: Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms

Our new paper on nominal GDP targeting is out now. Below is part of the press release we sent to the media; for the full press release, click here. To read the whole paper, click here. The Bank of England should abolish the Monetary Policy Committee, use Quantitative Easing instead of interest rates to conduct normal monetary policy, and switch from an inflation target to targeting the total amount of nominal spending in the economy, also known as nominal GDP, argues a new paper from the Adam Smith Institute released today.

The Bank should prefer a rules-based system like this to the discretionary system it currently uses but, the paper argues, it should ultimately look toward ending monetary intervention altogether. The UK’s monetary regime should eventually aim towards the ‘free banking’ systems that brought financial stability to 18th and 19th century Scotland and elsewhere.

The paper, Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms, is a comprehensive critique of the flaws in the way the Bank of England currently does monetary policy and offers a superior means of achieving their goals of macroeconomic stability.

Quantitative easing should be extended to the market generally rather than being an interaction with a few preferred dealers, so as to minimise distortions caused by buying from select financial institutions, it says. It should be made open-ended, with the purpose of stabilising the growth path of nominal GDP—the total amount of spending in the economy—letting the market determine how much of that nominal GDP is real output and how much is inflation.

Author of the report, Prof Anthony J Evans, concludes that, after a century of failure, it may even be time to strip central banks of their powers over monetary policy entirely entirely, and let private banks issue their own notes.

The paper takes inspiration from the free banking systems of the 19th century, especially those in Switzerland and Scotland, but also from the monetary economics of Nobel Prizewinners Milton Friedman and Friedrich Hayek, who both argued that central bank discretion tends to push the economy away from rather than towards stabilisation.

Friedman showed how the central bank’s unwillingness to accommodate massive spikes in money demand in the late 1920s and early 1930s led to the US Great Depression—and how industrial production rocketed at the fastest pace in history when Franklin Delano Roosevelt raised the money supply to meet market demand by going off gold in 1933. This has played out again in the recent financial crisis, where a free banking system would have seen less fanning of the pre-crisis flames and more water afterwards—tighter policy in the run up and easier policy during and following the crash.

NGDP targeting: Hayek's Rule

One thing I go on about on this blog is how nominal GDP targeting—a market monetarist policy proposal that has even won over a small group of New Keynesians—is also the kind of policy an Austrian should want in the medium term. Of course, in the long term we'd like to abolish the Bank of England altogether, but even then we'd get, with free banking, something like a stable level of nominal GDP, so it's a pretty good target to work towards. The economist Nicholas Cachanosky wrote a paper in the Journal of Stock & Forex Trading about a year ago, which I missed, called "Hayek’s Rule, NGDP Targeting, and the Productivity Norm: Theory and Application" which lays a lot of the Austrian arguments for targeting the level of nominal income in a very clear and cogent fashion. I include some key extracts below:

The term productivity norm is associated with the idea that the price level should be allowed to adjust inversely to changes in productivity. If total factor productivity increases, the price level (P) should be allowed to fall, and if total factor productivity falls, the price level should be allowed to increase. A general increase in productivity affecting the economy at large changes the relative supply of goods and services with respect to money supply. Therefore, the relative price of money (1/P) should be allowed to adjust accordingly. In other words, money supply should react to changes in money demand, not to changes in production efficiency.

The productivity norm was a common stance between monetary economists before the Keynesian revolution. Selgin [14, Ch 7,8] recalls that Edgeworth, Giffen, Haberler, Hawtrey, Koopmans, Laughlin, Lindahl, Marshall, Mises, Myrdal, Newcome, Pierson, Pigou, Robertson, Tausig, Roepke and Wicksell are a few of the economists from different geographical locations and schools of thought who, at some point, viewed the productivity norm positively.

One of the attractive features of productivity norm-inspired monetary policy rules is the tendency of the results to mimic the potential outcome of a free banking system, one defined as a market in money and banking with no central bank and no regulations. Among the conclusions of the free banking literature is that monetary equilibrium yields a stable nominal income.

Throughout Cachanosky distinguishes carefully between an NGDP target and a productivity norm, though I think these are overstated; and between 'emergent' stability in NGDP and 'designed' stability, which he (like Alex Salter) thinks are importantly different (I am not convinced).

Cachanosky believes that the 2008 crisis implies that NGDP growth beforehand was too fast, and led to capital being misallocated, but I still doubt the Austrian theory of the business cycle makes any sense when you have approximately efficient capital markets.

Despite our differences, I think that Cachanosky's papers are very valuable contributions to the debate, and hopefully they can go some of the way to convincing Austrian economists that the market monetarist approach is not Keynesian.

Nominal GDP targeting for dummies

Nominal Gross Domestic Product (GDP) targeting is a type of monetary policy that people like me think would give us a more stable economy than we currently have. It would replace the Bank of England’s current monetary policy, inflation targeting. Nominal GDP can be understood as sum of all spending in the economy. Total spending can increase either because of price rises (inflation) or because there’s more stuff to go around (economic growth). If this year inflation is 2% and we have 2% economic growth, nominal spending (nominal GDP) will have risen by 4%.

The current policy of inflation targeting means that the Bank of England tries to control the money supply so that prices rise, on average, by 2% every year. If prices rise by more or less than this, the Bank is judged to have failed in its job.

Nominal GDP targeting would mean that the Bank of England would stop trying to target price rises, and instead try to target the total amount of nominal spending that takes place in the economy. That means that if economic growth was lower than usual, the Bank would have to try to make inflation higher than usual. If economic growth was higher than usual, inflation would be lower than usual.

This system is appealing because it is often the total amount of spending in the economy that matters, rather than inflation per se. Wages are usually set in nominal terms, which means that they do not automatically adjust upwards and downwards according to inflation.

Because of this, a drop in the amount of spending going on can lead to a mismatch between all the wage demands in the economy and the amount of money available to pay them. In other words, there is not enough money in the economy to pay everyone. This has two possible outcomes: either wages can be cut to meet the new level of spending, or people will have to be fired.

Empirically, it seems as if firms prefer to fire some workers than to cut wages across the board. In fact, firms really hate cutting wages, for some reason, and unemployed people are often reluctant to take the same job that they once had for a lower wage. Economists refer to this phenomenon as “sticky wages”.

So the outcome of a fall in total spending is usually unemployment. This is an example of a nominal change having a real effect, and destroys wealth that need not be destroyed, because the previously-profitable relationship between the worker and the firm has now been undone.

When this happens across the economy it can affect economic growth. In fact, this seems to be a very important factor in recessions – when there is a steady level spending taking place, the market is pretty good at finding new ways of using unemployed workers fairly quickly. When there just isn’t enough spending going on, we have to wait for workers and firms to cut wages enough to hire them again, which can take a long time.

Under nominal GDP targeting, the Bank of England would commit to keep the spending level growing even if economic growth dipped. As I've said, that would mean more inflation in times of slow growth and less inflation in times of quick growth.

Because inflation is being used to offset the changes in economic growth, negative economic ‘shocks’ like oil crises will translate into higher prices, prompting the market to adjust to take account of new realities, but never creating the domino effect of mass unemployment that we sometimes currently experience. The real economy would still adjust to real shifts in supply and demand, but we’d avoid the chaos that unstable monetary environments can create.

The key is that almost all contracts in the modern economy are set in nominal terms. That means that money that is managed in the wrong way can create a lot of unnecessary destruction of wealth. Nominal GDP targeting would probably give us the most neutral monetary system possible with the government, with the monetary environment kept stable so the real economy can do its work in allocating resources.

Money matters. The 2008 crisis happened because expectations of inflation, and hence nominal spending levels, dropped sharply, causing the ‘musical chairs’ problem of too little money to fulfil all the existing contracts and wage demands, which led to widespread bankruptcies and job losses. Today, the UK and the US have begun to get their spending levels growing at a healthy rate again, and their real economies have begun to grow healthily again too.

The Eurozone is the saddest story. The European Central Bank has been obsessed with fighting inflation (possibly because Germany has not suffered much, and Germans have bad memories of hyperinflation during the 1920s), and as a result nominal spending has grown very slowly indeed. The consequences are easy to see: in the weaker European economies, like Greece, Spain and Italy, unemployment is at historically high levels. It seems likely to stay there for many years.

Many people, myself included, believe that a system where private banks could issue their own notes without a central bank at all would be the best system. This is known as ‘free banking’. One of the best arguments for free banking is that it would keep nominal spending levels steady, because banks would issue more notes during periods of slow growth and fewer notes during periods of high growth. This should sound familiar – nominal GDP targeting is probably the closest we can get to ‘stateless’ money while having a central bank.

Nominal GDP targeting would not prevent all recessions or guarantee growth. The real economy is what determines things like that. But badly-managed money can destroy growth, create recessions by itself, and turn small ‘real’ recessions into extremely bad depressions, as happened in the 1930s and 2000s. Nominal GDP targeting would give us stable, neutral money that avoids these things. We would have been better off with it in 2008, and we would be better off with it today.

Voxplainer on Scott Sumner & market monetarism

I have to admit that I usually dislike Vox. The twitter parody account Vaux News gets it kinda right in my opinion—they manage to turn anything into a centre-left talking point—and from the very beginning traded on their supposedly neutral image to write unbelievably loaded "explainer" articles in many areas. They have also written complete nonsense. But they have some really smart and talented authors, and one of those is Timothy B. Lee, who has just written an explainer of all things market monetarism, Prof. Scott Sumner, and nominal GDP targeting. Blog readers may remember that only a few weeks ago Scott gave a barnstorming Adam Smith Lecture (see it on youtube here). Readers may also know that I am rather obsessed with this particular issue myself.*

So I'm extremely happy to say that the article is great. Some excerpts:

Market monetarism builds on monetarism, a school of thought that emerged in the 20th century. Its most famous advocate was Nobel prize winner Milton Friedman. Market monetarists and classic monetarists agree that monetary policy is extremely powerful. Friedman famously argued that excessively tight monetary policy caused the Great Depression. Sumner makes the same argument about the Great Recession. Market monetarists have borrowed many monetarist ideas and see themselves as heirs to the monetarist tradition.

But Sumner placed a much greater emphasis than Friedman on the importance of market expectations — the "market" part of market monetarism. Friedman thought central banks should expand the money supply at a pre-determined rate and do little else. In contrast, Sumner and other market monetarists argue that the Fed should set a target for long-term growth of national output and commit to do whatever it takes to keep the economy on that trajectory. In Sumner's view, what a central bank says about its future actions is just as important as what it does.

And:

In 2011, the concept of nominal GDP targeting attracted a wave of influential endorsements:

Michael Woodford, a widely respected monetary economist who wrote a leading monetary economics textbook, endorsed NGDP targeting at a monetary policy conference in September.

The next month, Christina Romer wrote a New York Times op-ed calling for the Fed to "begin targeting the path of nominal gross domestic product." Romer is widely respected in the economics profession and chaired President Obama's Council of Economic Advisors during the first two years of his administration.

Also in October, Jan Hatzius, the chief economist of Goldman Sachs, endorsed NGDP targeting. He wrote that the effectiveness of the policy "depends critically on the credibility of the Fed's commitment" — a key part of Sumner's argument.

But read the whole thing, as they say.

*[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16]

Video: Adam Smith Lecture 2014 by Scott Sumner

Scott Sumner's Adam Smith Lecture, delivered last week, is now online. For my money it's the best outline of his view of the Great Recession and the correct role of monetary policy that I have yet seen. Scott's presentation can be downloaded here, and Scott wrote about his trip for TheMoneyIllusion here.

The eurozone is in dire need of nominal income targeting

It may well be that, in the US and UK, nominal GDP is growing in line with long-term market expectations.* It may well be that, though we will not bring aggregate demand back to its pre-recession trend, most of the big costs of this policy have been paid. And so it may be that my pet policy: nominal income/GDP targeting, is only a small improvement over the current framework here in the UK or in the US. But there is one place that direly needs my medicine. As a whole, the Eurozone is currently seeing very low inflation, but plenty of periphery countries are already suffering from deflation. And this is not the Good Deflation of productivity improvements (can be identified because it comes at the same time as real output growth) but the Bad Deflation of demand dislocation. The European Central Bank could deal with a lot of these problems simply by adopting a nominal GDP target.

When it comes to macroeconomics, the best analysis we really have is complicated econometric models on the one side, and highly stylised theoretical models on the other. Both are useful, and both can tell us something, but they rely on suspending quite a substantial amount of disbelief and making a lot of simplifying assumptions. You lose a lot of people on the way to a detailed theoretical argument, while the empirical evidence we have is really insufficient to conclusively answer the sort of questions I'm posing.

In general, I think that very complex models help us make sense of detailed specifics, but that "workhorse" basic theoretical models can essentially tell us what's going on here. Unemployment is a real variable, not one directly controlled by a central bank, and a bad thing for the central bank to target. But in the absence of major changes in exogenous productivity, labour regulation, cultural norms around labour, migration and so on, there is a pretty strong relationship between aggregate demand and unemployment. Demand dislocation is almost always the reason for short-run employment fluctuations.

Unemployment rose everywhere in 2008-9. But it nudged down only marginally post-crisis in the Eurozone, whereas in the UK and US it soon began to steadily fall toward its pre-crisis rate (the red line, though not on this graph, has tracked the green one very closely). In the meantime the Eurozone rate has risen up to 12%. This is not at all surprising, given the almost complete flattening off of aggregate demand in the Eurozone—this means a constantly-widening gap with the pre-recession trend (something like 20% below it now).

Although intuitively we'd expect expectations to steadily adjust to the new likely schedule, three factors mean this takes a while: firstly the ECB is very unclear about what it is going to do (and perhaps unsure itself), secondly some plans are set over long horizons, and thirdly the lacklustre central-bank response to the 2007-8 financial crisis is unprecedented in the post-war period.

1. We have a huge literature on the costs of policy uncertainty—the variance of expected outcomes has an effect on firms' willingness to hire, invest, produce, independent of the mean expected outcome.

2. Many firms invest over long horizons. It may have become clear at some point in 2011, when the ECB raised interest rates despite the ongoing stagnation and weak recovery, that the macro planners, in their wisdom, were aiming for a lower overall growth path and perhaps a lower overall growth rate in nominal variables. And so, after 2011 firm plans started to adjust to this new reality. But many plans will have been predicated on an entirely different 2009, 2010, 2011, 2012, 2013, 2014, and so on. And as mentioned before, the gulf between what was expected for the mid-2010s back in 2007 and what actually happened is actually widening.

3. Thirdly, and finally, the period 2008-2010 is unprecedented and will have slowed down firm adjustment substantially. As mentioned above, even if firms set plans with a fairly short-term horizon (a few years) they wouldn't have been able to adjust to the new normal in 2008, 2009 and 2010 unless they really expected the ECB's policy of not only not returning to trend level, but not even return to trend rate!

All of these three issues are convincingly resolved by nominal income targeting. It's very certain—indeed the best version would have some sort of very-hard-to-stop computer doing it. It promises to keep up to trend. And it is very stable over long horizons.

Recent evidence reinforces the view, implicit in our models, that (unconventional) monetary policy is highly effective at the zero lower bound, even through the real interest rate channel (!) All the ECB needs to do is announce a nominal income target.

*This reminds me: isn't it about time we had an NGDP futures market so we could make claims here with any kind of confidence?

Ignore the doomsayers: The recovery is real

Some commentators claim that the UK’s current economic recovery is illusory. They say that the recovery is based on an artificial boom fuelled by loose money and will eventually come crashing down to earth. I think it is very likely that this view is wrong, for at least two reasons. One, the UK does not have loose money that would fuel a credit boom. Two, the best tool we have for telling if the recovery is ‘real’ or not is the market. And the market is telling us that it sees things as looking good.

The idea that we have loose money is extremely common. It is based on the assumption that a Bank of England base rate of 0.5%, historically very low, must mean that money is loose. This is what Milton Friedman referred to as the ‘interest rate fallacy’. It is a fallacy because it fails to ask the key question: ‘compared to what?’

That ‘what’ is, or ought to be, the ‘neutral rate of interest’ – the interest rate where, in David Beckworth’s words, “monetary policy is neither too simulative nor too contractionary and is pushing the economy toward its full potential.” The tightness of money is determined by the central bank rate relative to the neutral rate. If the neutral rate of interest is lower than the base rate, then money is tight.

Is the neutral rate of interest in the UK currently above or below 0.5%? It's hard to say. Milton Friedman pointed out that usually low rates were a sign of tight, not easy money. This is because low rates almost always coincide with very low inflation, nominal GDP growth and money growth—which Friedman pointed out were much better ways of assessing the stance of policy.

It’s possible to infer from things like NGDP growth (well-below trend until recently) that money has been unusually tight. NGDP growth seems to be returning to the trend rate, if not the trend level, that it was before the crisis. People calling ‘easy money’ may disagree, but if they are simply pointing to low interest rates without trying to compare them to the neutral rate, they’re not proving anything at all.

But even if it’s not down to easy money, maybe the recovery really does sit upon a throne of lies that will inevitably collapse. How could we tell?

Since the world is very, very complex, it is unlikely that one individual expert or panel of experts will be able to possess all the information they would need to make reliable predictions about the future.

Where possible, we should prefer the ‘wisdom of crowds’. And we have something that can do so very effectively: the market. And the market seems pretty optimistic: the FTSE 100 is growing strongly; firms are taking on new staff; gilt yields are extremely low.

Second-guessing the market is particularly unusual for people on the right of the political spectrum. As Josh Barro put it recently, “A conservative is somebody who thinks every market is efficient — except the Treasury bond market.” (A point worth remembering next time you read about the UK's "looming debt crisis".)

Of course markets can get things wrong. There is a high degree of uncertainty involved in all predictions like this. But, given a choice between the aggregated judgement of millions of market participants, all bringing their local knowledge to bear, and the judgment of a few experts, I’ll go with the market.

In summary, there’s no reason to think that either we have excessively loose money or that the recovery is illusory. Note that mine is an entirely negative argument – I am not claiming that money is too tight, or just right, nor am I claiming that markets are correct. I'm saying that, given the information we have available to us, we should resist the urge to doomsay. In short: don't worry, be happy.

Seven things we'd like to see in Budget 2014 (but probably won't)

Here are seven things we'd like to see at this year's budget:

1. Personal allowance and employee National Insurance thresholds should be merged and set at the NMW level (approx. £13,000/year after the NMW is raised to £6.50/hour). The government should legislate to keep the tax & NI thresholds at at least at the NMW level. It is crucial that the National Insurance contributions threshold be raised as well as the income tax threshold.

2. The corporation tax cut planned for 2015 should be brought forward by a year (to 20% this year), with a commitment reduce it further by 2.5% per annum for the next three years to 12.5%. In the long-run it should be abolished altogether as it is a stealth tax on income (workers’ wages bear approximately 60% of the tax) and a distortionary tax on capital.

3. The Chancellor should go forward with plans to merge Income Tax and National Insurance. Employers’ National Insurance Contributions should be included on workers’ wage slips to highlight that this is a stealth tax on wages.

4. Help to Buy should be wound down ahead of schedule to reduce house prices in London and the South East. To create jobs and encourage construction the Chancellor should endorse radical planning reform that would allow more houses to be built.

5. Subsidies (“financial relief”) to energy intensive industries should be ended with the money saved paying for a broad reduction in green energy taxes to reduce consumers’ energy bills.

6. The ring-fence of NHS spending should be abolished. If savings can be made in the education, policing and welfare budgets, they can be made in the healthcare budget as well.

7. The Bank of England’s mandate should be revised, with the Bank instructed to target the level of nominal spending (nominal GDP) in the economy along a predetermined trend. This would reduce inflation in boom periods and prevent deep recessions by stabilising aggregate demand.

An alternative ‘Agenda for Hope’

Owen Jones has written a nine-point ‘Agenda for Hope’ that he argues would create a fairer society. Well, maybe. I’m not convinced by many of them. Then again, it would be quite surprising if I was.

But it got me thinking about what my nine-point agenda would be — not quite my 'perfect world' policies, but some fairly bold steps that I could just about imagine happening in the next couple of decades. Unlike Owen’s policies, few of these are likely to win much public support. On the other hand, most of the political elite would think these are just as wacky as Owen's too.

Nine policies to make people richer and freer (and hopefully happier):

1) The removal of political barriers to who can work and reside in the UK. Removing all barriers to trade would increase global GDP by between 0.3% and 4.1%. Completely removing barriers to migration, though, could increase global GDP by between 67% and 147.3%. Those GDP benefits would mostly accrue to the poorest people in the world. We can’t remove these barriers everywhere but we can show the rest of the world how it’s done. Any step towards this would be good – I suggest we start by dropping the net migration cap and allowing any accredited educational institution to award an unlimited number of student visas.

2) A strict rule for the Bank of England to target nominal GDP instead of inflation, replacing the discretion of the Monetary Policy Committee. Even more harmful than the primary bust in recessions is what Hayek called the ‘secondary deflation’ that comes about as people, fearing a drop in their future nominal earnings, hold on to more of their money. That reduces the total level of nominal spending in the economy which, since prices and wages are sticky in the short run, leads to unemployment and a fall in economic output. NGDP targeting prevents those ‘secondary deflations’ and would make economic busts much less common and harmful. In the long run, we should scrap the central bank altogether and replace it with competition in currencies (see point 9, below).

3) Significant planning reform that abolished the Town and Country Planning Act (which includes the legislation ‘protecting’ the Green Belt from most development) and decentralised planning decisions to individuals through tradable development rights (TDRs). This would give locals an incentive to allow new developments because they would be compensated by the developers directly, allowing for a reasonably efficient price system to emerge and making new development much, much easier. The extra economic activity from the new home building alone would probably add a couple of points to GDP growth.

4) Legalisation of most recreational drugs and the medicalisation of the most harmful ones. I think Transform’s outline is pretty good: let cannabis be sold like alcohol and tobacco to adults by licensed commercial retailers; MDMA, cocaine and amphetamines sold by pharmacies in limited quantities; and extremely dangerous drugs like heroin sold with prescriptions for use in supervised consumption areas. The sooner this happens, the sooner producers will be answerable to the law and deaths from ‘bad batches’ of drugs like ecstasy will be a thing of the past. Better yet, this would bring an end to drug wars like Mexico's, which has killed around 100,000 people in the past ten years.

5) Reform of the welfare system along the lines of a Negative Income Tax or Basic Income Guarantee. As it is, the welfare system disincentivises work and creates dependency without doing much for the working poor. A Negative Income Tax would only look at people’s incomes (not whether they were in work or not in work), reducing perverse incentives and topping up the wages of the poorest earners. This would strengthen the bargaining position of low-skilled workers and would remove much of the risks to workers associated with employment deregulation. Of course, the first thing we should do is raise the personal allowance and National Insurance threshold to the minimum wage rate to give poor workers a de facto 'Living Wage'.

6) A Singaporean-style healthcare system to replace the NHS. In Singapore, people have both a health savings account and optional catastrophic health insurance. They pay a portion of their earnings into the savings account (poor people receive money from the state for this), which pays for day-to-day trips to the doctor, prescriptions, and so on. The government co-pays for many expenses but the personal cost disincentivises frivolous visits to the doctor. For very expensive treatments, optional catastrophic health insurance kicks in. This is far from being a pure free market system but it is miles better (cheaper and with better health outcomes) than the NHS. (By the way, if you really like the NHS we could still call this an ‘NHS’ and still get the superior system.)

7) A school voucher system and significant reform of the state education and free schools sectors. This would include the abolition of catchement areas and proximity-based admission, simplification of the free schools application process, and expansion of the free schools programme to allow profit making firms to operate free schools. These reforms, outlined in more detail in two ASI reports, would increase the number of places available to children and increase competition among schools to drive up standards.

8) Intellectual property reform. As both Alex Tabarrok and Matt Ridley have pointed out, our IP (patent and copyright) law is too restrictive and seems to be stifling new innovation. Firms use patents as barriers to entry, suing new rivals whose products are too similar to their own. In industries where development costs are high but imitation costs are low, like pharmaceuticals, patents may be necessary to incentivise innovation, but in industries like software development where development can be cheaper than imitation, patents can be a terrible drag on progress. Tabarrok recommends that we try to tailor patent length in accordance with these differences; as a sceptic about our ability to know, well, anything, I’d prefer to leave it to private contracts and common law courts to discover.

9) Last but not least, the removal of the thicket of financial regulation and the promise of bailouts for insolvent banks. Known as ‘free banking’, this system of laissez-faire finance has an extremely strong record of stability – though bank panics still occurred in free banking systems, they were much less severe and rarely systemic. Only once the government started to intervene in the financial system to provide complete stability did things really begin to go wrong: deposit insurance, branch-banking restrictions, and other prudent-seeming regulations led to extremely bad unforeseen consequences. The financial crisis of 2008 probably owes more to asset requirements like the Basel accords, which heavily incentivised banks to hold ‘safe’ mortgage debt over ‘risky’ business debt, than anything else. Incidentally, the idea that having a large number of local banks is somehow better than having a few large banks is totally wrong: during the Great Depression, 9,000 of America's small, local banks failed; at the same time not one of Canada’s large banks failed. The small banks were more vulnerable because, unlike the big banks, they were undiversified.

Now, if only there was a think tank to try and make these dreams a reality.

What's the true free market monetary policy?

Let's imagine we are in a world where central banks are given key roles in the macroeconomy, and have been for decades or even centuries in almost every country. In this imaginary world, studies into the relative efficacy of free banking regimes have been undeservedly overlooked, and the orthodoxy among major economists, even ones otherwise sympathetic to free markets is that they are a bad idea. Major policymakers, let's imagine, are completely unaware of the free banking alternative, and most even use the term to mean something completely different. Proposals to enact free banking have not been mentioned in law making chambers for decades or centuries, if at all. It has not been in any party's policy platform for a similar period of time, in this imaginary world.

What's interesting about this imaginary world is that it is in fact our world. Economists like George Selgin, Larry White, Kevin Dowd (among many others) have done very convincing research about the benefits of free banking. And free banking may one day become a real prospect, perhaps in a new state or a charter city. But free banking has lost the battle for the time being, and abolishing the central bank and government intervention in money is as unlikely as abolishing the welfare state. Now one might say that if free banking is a desirable policy, it is worth continuing to wage the intellectual war for the benefit of future generations, who could benefit from the scholarship. Work done now could end up influencing and improving future monetary policy.

I do not discount the possibility this is true. At the same time, free banking is a meta-policy, not a policy—a way of choosing what monetary regime to enact, rather than a specific monetary regime. After all, it is at least possible that free banks could together target consumer prices, the GDP deflator, the money base, the money supply measured by M2, nominal income/NGDP. And for each of these different measures there are an infinite number of theoretical growth paths, and a large number of realistically plausible growth paths they could aim for. Now, free bankers say that the market will make a good decision, and I can buy that. But let's say we're constrained to choose a policy without the aid of the market mechanism: can we say there are better or worse central plans?

The answer is: of course we can! Old-school monetarism, targeting money supply aggregates, was a failure even according to Milton Friedman, whereas CPI targeting, for all its flaws, delivered 66 quarters of unbroken growth and a period so decent they named it the Great Moderation. The interwar gold standard brought us the stagnation of the 1920s (in the UK) and coming off us brought us our relatively pleasant experience of the Great Depression. Literally the order in which countries came off the gold standard is the order they got out of the Great Depression. And even though the classical gold standard worked pretty well, few of its benefits would obtain if we went back. Some central plans (the interwar gold standard, M2 targeting) don't work, some work a bit (the classical gold standard, CPI) and arguably some work pretty well (NGDP targeting is one in this category, according to Friedman, Hayek and I). If we are stuck with central planning, then why not have a good central plan?

And just because I'm allowing the term "central planning" to describe NGDP targeting, we needn't describe it as "government intervention in money". I don't think they are really the same thing. "Government intervention in money" brings to mind rapid inflation, wild swings in the macroeconomic environment; in short the exact circumstances that NGDP-targeting aims to avoid. Targeting aggregate demand keeps the overall macro environment stable—a truly neutral monetary policy—allowing firms and households to make long-term plans, and preventing recessions like the last one, caused as it almost certainly was by drastic monetary tightening. Indeed, as monetary policy determines the overall path of aggregate demand, we might easily call "sound money" policies aiming for zero inflation or a frozen base as dangerous government meddling—they allow the actually important measures like nominal income to fluctuate drastically.

Consider an analogy: school vouchers. Many libertarians may favour a system where parents can spend as little or as much as they want on schooling (considering distributional concerns separately), rather than having central planners decide on the voucher-set minimum. But we usually see a voucher system as an improvement on the status quo—parents may not be able to fully control how much is spent on their children's education but at least they can pick their school. Popular and successful schools grow to accommodate demand, while unpopular and unsuccessful schools can be wound down more quickly. Libertarians may see this as a way from the ideal situation, but none would therefore denounce the policy. The analogy isn't perfect, but I like to see NGDP targeting as similar to school vouchers, versus status quo schooling as the CPI target. Libertarians shouldn't make the perfect the enemy of the good.