Not long ago, there lived an American economist who thought that it would be best to close down the Federal Reserve, the US central bank. A rather drastic view. What makes it particularly interesting is that it wasn’t voiced by some extremist, sidelined, unrecognised scholar. On the contrary.
This view was held by Milton Friedman, one of the most influential economists that ever lived, a Nobel Prize winner economic counsellor to President Reagan. Paradoxically, he is commonly referred to as the father of monetarism. But what in fact was his problem with central banks?
According to socialist economic theory, the economy should be controlled through smart plans rather than market mechanisms. This allows market inefficiencies, disruptions and injustice to be avoided, resulting in a higher level of general well-being. The experts of the planning board convene to draw up a central plan about the prices and quantities of the goods to be produced. In the 20th century, an experiment called socialism was run in many countries for decades, in the course of which it was clearly demonstrated that the otherwise fine theory just won’t work in practice.
Nevertheless, the model may also be terribly familiar from our own times. Namely, the price of money is interest. And nowadays it is common practice to determine this price centrally, even in developed economies. The planning board of the monetary system is called Monetary Council. And this has brought us to perhaps the greatest contradiction of capitalism: the price of its core product, its most important asset is determined by a handful of decision makers, according to the socialist model. We believe to be living in a market economy, but, of all things, the price of money, which affects the price of any other goods and services available, is determined through central planning. And since the fall of socialist regimes, we know this for sure to be a precursor of trouble.
This was Friedman’s problem with central banks and active monetary policies. He knew that a few decision makers can’t be smarter than the whole of the market, and they are bound to make mistakes sooner or later. And some of the mistakes are likely to be big. The root causes of the credit crisis (savings crisis) also include such a mistake. And we can be certain that it hasn’t been the last one to occur.
At the same time, they can’t be blamed for this as such. As the saying goes, governing monetary policy is like driving a car by looking backwards. An unexpected curve may lead to disaster. What’s more, the monetary system is so constructed that each move of the steering wheel will only be felt with a great lag. It’s no accident that monetary policy typically works on a horizon of 1 or 2 years. This doesn’t help decision making either.
The Fed celebrated its 100th anniversary in December. It’s an old institute, very old; perhaps it is indeed time it was closed. The question is what should replace it. We’ll discuss that later on.
Original date of Hungarian publication: 22 july 2014