Copyright © 2018 by the Cato Institute All rights reserved ISBN: 978-1-948647-14-4 eBook ISBN: 978-1-948647-15-1 Library of Congress Cataloging-in-Publication Data available Printed in the United States of America Cover design: Jon Meyers and Mai Makled Cato Institute 1000 Massachusetts Avenue, N.W Washington, D.C 20001 www.cato.org CONTENTS EDITOR’S PREFACE PART LESSONS FROM THE CRISIS Chapter Rethinking Central Banking Gerald P O’Driscoll Jr Chapter Sorting Out Monetary and Fiscal Policies Mickey D Levy Chapter Learning the Right Lessons from the Financial Crisis Kevin Dowd and Martin Hutchinson Chapter The New Monetary Framework Jerry L Jordan Chapter Liquidity Risk after the Crisis Allan M Malz PART EXIT STRATEGY AND NORMALIZATION Chapter Exit Strategies from Monetary Expansion and Financial Repression Gunther Schnabl Chapter Needed: A Federal Reserve Exit from Preferential Credit Allocation Lawrence H White Chapter The Optimum Quantity of Money and the Zero Lower Bound J Huston McCulloch Chapter Normalizing Monetary Policy Martin Feldstein Chapter 10 Priorities on the Path to Normalization Kevin Warsh Chapter 11 Interest on Excess Reserves: The Hobie Cat Effect George Selgin PART MONETARY RULES Chapter 12 Monetary Policy in an Uncertain World: The Case for Rules James A Dorn Chapter 13 Reforming the Rules That Govern the Fed Charles W Calomiris Chapter 14 Improving Monetary Policy by Adopting a Simple Rule Athanasios Orphanides Chapter 15 Nudging the Fed Toward a Rules-Based Policy Regime Scott Sumner PART INTERNATIONAL MONETARY REFORM Chapter 16 Toward a Rules-Based International Monetary System John B Taylor Chapter 17 Some Thoughts on International Monetary Policy Coordination Charles I Plosser Chapter 18 The Case for a New International Monetary System Judy Shelton INDEX EDITOR’S PREFACE T en years after the 2008 financial crisis we are again facing the possibility of economic turmoil as the Fed and other central banks exit their unconventional monetary policies by raising interest rates and shrinking their balance sheets Although central banks will move gradually, unforeseen circumstances could trigger a flight to safety and a collapse of asset prices that had previously been stimulated by near-zero interest rates and large-scale asset purchases, popularly known as “quantitative easing.” This book brings together leading scholars and former policymakers to draw lessons from the decade of unconventional monetary policies relied upon to stimulate the global economy in the aftermath of the financial crisis The articles included in this book combine historical perspectives and forward-looking views of the Fed’s exit strategy and monetary normalization, along with the arguments for a rules-based monetary policy both at the domestic and international levels Kevin Warsh, a former member of the Board of Governors of the Federal Reserve System, reminds us in his article that, although the economy has improved since the crisis, the tasks facing the Fed are still large “So we should resist allowing the policy debate to be small or push aside ideas that depart from the prevailing consensus The Fed’s job is not easier today, and its conclusions are not obvious.” The contributors to this volume meet Warsh’s challenge by questioning the status quo and offering fresh ideas for improving monetary policy The financial crisis highlighted the uncertainty that confronts policymakers Having failed to prevent the 2008 financial crisis and the Great Recession, the Federal Reserve and other major central banks all subsequently adopted similar policies characterized by near-zero interest rates, quantitative easing and forward guidance Those unconventional monetary policies were designed to increase risk taking, prop up asset prices, increase spending and restore full employment While asset prices have risen and unemployment is at historic lows, the Fed’s balance sheet ballooned from about $800 billion before the crisis to more than $4 trillion today, and the long period of near-zero interest rates has created a series of asset bubbles, which risk being burst as interest rates rise again Moreover, the Fed has engaged in preferential credit allocation through its large-scale asset purchase program, in which it has acquired billions of dollars’ worth of mortgage-backed securities and shifted out of short-term Treasuries to longer-term government debt In order to expand its balance sheet, the Fed has radically changed its operating procedure Instead of engaging in open market operations nudging the policy rate toward a single target rate by buying and selling short-term Treasuries, the Fed now establishes a target range for the funds rate—with the rate of interest on excess reserves (IOER), introduced in October 2008, as its upper limit and the Fed’s overnight reverse repurchase (ON RRP) agreement rate as its lower limit Because the IOER exceeds comparable market rates, some banks now find it worthwhile to accumulate excess reserves instead of trading them for other assets The economy is, in other words, kept in a purpose-made “liquidity trap,” so that the traditional monetary “transmission mechanism” linking increases in the monetary base to changes in bank lending, overall spending, and inflation, no longer functions as it once did Under the new operating arrangements, the Fed changes its policy stance by changing its IOER and ON RRP rates, thereby influencing not the supply of but the demand for the Fed’s deposit balances Meanwhile, the Fed’s regulatory powers have increased dramatically as well The Federal Reserve System, which was intended to be decentralized so that policymakers would take account of divergent ideas, has become even more centralized with each new crisis As a result, monetary policy has also become more politicized Finally, the lack of any systematic policy rule to guide long-run decisions has increased regime uncertainty The so-called knowledge problem—and the limits of monetary policy—need to be widely recognized Policymakers err by paying too much attention to short-run remedies and too little attention to the long-run consequences of current decisions If human judgments were perfect, then purely discretionary monetary policy would be ideal However, as Karl Brunner (1980: 61) wisely noted, the reality is that: We suffer neither under total ignorance nor we enjoy full knowledge Our life moves in a grey zone of partial knowledge and partial ignorance [Consequently], a nonactivist [rules-based] regime emerges as the safest strategy It does not assure us that economic fluctuations will be avoided But it will assure us that monetary policymaking does not impose additional uncertainties on the market place Before serious consideration can be given to implementing any rules-based monetary regime, the Fed needs to normalize monetary policy by ending interest on excess reserves and shrinking its balance sheet to restore a precrisis federal funds market Once changes in base money can be effectively transmitted to changes in the money supply and nominal income, the Fed can then implement a rules-based regime to reduce uncertainty and spur investment and growth The ideas put forth in this volume for monetary reform are meant to inform policymakers and the public about the importance of maintaining a credible monetary policy regime both for financial stability and economic prosperity Ensuring long-run price stability, letting market forces set interest rates and allocate credit, and keeping nominal income on a steady growth path will create new opportunities and widen the scope of markets to promote economic performance I thank the contributors to this volume for their work which will help us better understand the complexities of monetary policy and the remedies that can help us prevent future crises Special thanks go to The George Edward Durell Foundation which has long supported the Cato Institute’s work on monetary policy All the articles in this volume were first presented at the annual monetary conferences and appeared in various issues of the Cato Journal, with the exception of George Selgin’s article, which first appeared in Alt-M Finally, I would like to thank my colleagues at the Center for Monetary and Financial Alternatives for ongoing conversations that have deepened my knowledge of monetary history and policy, and to our donors who have generously supported our efforts to give monetary and financial institutions the attention they deserve —J A Dorn Reference Brunner, K (1980) “The Control of Monetary Aggregates.” In Controlling Monetary Aggregates III, 1–65 Boston: Federal Reserve Bank of Boston ABOUT THE CATO INSTITUTE AND ITS CENTER FOR MONETARY AND FINANCIAL ALTERNATIVES Founded in 1977, the Cato Institute is a public policy research foundation dedicated to broadening the parameters of policy debate to allow consideration of more options that are consistent with the principles of limited government, individual liberty, and peace The Institute is named for Cato’s Letters, libertarian pamphlets that were widely read in the American colonies in the early 18th century and played a major role in laying the philosophical foundation for the American Revolution The Cato Institute undertakes an extensive publications program on the complete spectrum of policy issues Books, monographs, and shorter studies are commissioned to examine the federal budget, Social Security, regulation, military spending, international trade, and myriad other issues Major policy conferences are held throughout the year The Cato Institute’s Center for Monetary and Financial Alternatives was founded in 2014 to assess the shortcomings of existing monetary and financial regulatory arrangements, and to discover and promote more stable and efficient alternatives In order to maintain its independence, the Cato Institute accepts no government funding Contributions are received from foundations, corporations, and individuals, and other revenue is generated from the sale of publications The Institute is a nonprofit, tax-exempt, educational foundation under Section 501(c)3 of the Internal Revenue Code CATO INSTITUTE 1000 Massachusetts Avenue, N.W Washington, D.C 20001 www.cato.org ... and offering fresh ideas for improving monetary policy The financial crisis highlighted the uncertainty that confronts policymakers Having failed to prevent the 2008 financial crisis and the Great... of fully winding down the Fed’s MBS holdings and reining in the scope of monetary policy Monetary Influences on Fiscal Policy The Fed’s balance sheet, low policy rate, and forward guidance aimed... “transmission mechanism” linking increases in the monetary base to changes in bank lending, overall spending, and inflation, no longer functions as it once did Under the new operating arrangements,