Monetary policy is not a tightrope

[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]

Here is a summary of the Federal Reserve’s Principles for the Conduct of Monetary Policy, which aims at “walking the tightrope” between inflation and unemployment:

…the central bank should provide monetary policy stimulus when economic activity is below the level associated with full resource utilization and inflation is below its stated goal. Conversely, the central bank should implement restrictive monetary policy when the economy is overheated and inflation is above its stated goal.

In contrast, here is the real bills doctrine:

Money should be issued in exchange for short-term real bills of adequate value.

The real bills doctrine was developed by practicing bankers over centuries of experience, and was written into the Fed’s original charter. The real bills doctrine survived for centuries because banks that obeyed it survived. They tended to stay solvent, and they provided an elastic currency that grew and shrank with the needs of business. At the same time, the real bills doctrine helped banks to avoid inflation, recession, liquidity crises, and bank panics.

In this essay, I hope to make the point that as long as the Fed obeys the real bills doctrine, it cannot go wrong in issuing as much money as the public will absorb. In other words, monetary policy is not like walking a normal tightrope. It is perfectly safe to lean in the direction of “too much money”, but dangerous and pointless to lean in the direction of “too little money”.

A few points to notice:

1. As long as new money is issued in exchange for adequate backing, the Fed’s assets will move in step with its issue of money, and there will be no inflation. This explains (among other things) why the Fed was able to issue enormous amounts of money after 2008, without causing inflation.

2. If unemployment is a threat, then the Fed should not hesitate to issue new money (adequately backed). Unemployment is often caused by a tight money condition and accompanying liquidity crises. Issuing new money in this situation will relieve the liquidity crisis, thus reducing unemployment. Meanwhile, adequate backing assures that the new money will not cause inflation.

3. If inflation is a threat, then a restrictive monetary policy will only succeed in creating a tight money condition, without addressing the real problem, which is too little backing per unit of money. The right solution to inflation would be to correct whatever problem is causing the Fed’s assets to fall relative to its issue of money, and then, so long as backing is adequate, issue as much money as the public will receive. The only drawback is that the public might be faced with unwanted cash piling up in vaults and mattresses, but the storage cost of too much cash would be insignificant in comparison to the recessionary effects of too little cash. Besides, unwanted cash can only pile up so much before it simply refluxes to its issuer.

The recessionary effects of tight money, as well as the stimulative effects of issuing new money, have been noted by nearly all observers of monetary history.

The remedy was forthcoming in a scheme prepared at a meeting which had been held a week earlier (April, 1793) at Pitt’s private house. It provided for the creation of additional liquid assets in the shape of Exchequer bills, to be lent to temporarily embarrassed firms. By this means the channels of trade were successfully thawed, and, as it proved, without loss to the Treasury. Clearly, therefore, the panic was due to a temporary need for greater liquidity, which the Bank could not this time meet by contracting advances to the government, since these were needed to prosecute the war. (Ashton and Sayers, p. 10, 1953).

The real bills view is that the Fed should not only provide liquidity in times of crisis, but should provide abundant liquidity at all times, in order to assure that crises never get started in the first place. So the real bills doctrine tells us not to worry that the Fed’s balance sheet has been exploding over the last few months. An exploding balance sheet may be exactly what the economy needs. But the “tightrope” mindset makes the Fed wary of issuing too much money, for fear of causing inflation. This fear is unjustified. On real-bills principles, the Fed need only take the simple precaution of only issuing cash in exchange for assets of adequate value, and inflation will cease to be a threat. We have nothing to fear from too much money, and everything to fear from too little. Rather than unwinding the Fed’s balance sheet, the Fed should unwind its “tightrope” approach to monetary policy.