In perhaps no other sector of the economy is F.A. Hayek’s Use of Knowledge in Society an apt description of the challenges facing economic actors than in the money, banking and financial sector. Very briefly, here are three reasons why the execution of monetary policy ought to be viewed with a lot more humility than it typically is.
(1) What is money? It is not even clear what the money supply is in the US (or any) economy. Is it M1? Is it M2? Is it something in between? How do we even know what should fall into each aggregate? Even if we decide what goes into each, is it reasonable to believe that we can measure those things with any degree of accuracy? And if so, can we capture how these change from day to day?
(2) The supply of money: the Fed, at best, has the ability to change the amount of base money in an economy. How much those changes translate into changes into the amount of purchasing media in the economy is subject to factors beyond the Fed’s control, and beyond their ability to measure. Two such factors are how banks are going to respond to changes in base money and how consumers’ demands for currency change over time. Not only are these hard to predict, but they are extremely hard to measure.
(3) The demand for money: remember that the Fed does not operate in a vacuum. Even if it had a perfect ability to measure the amount of money and even if it had perfect control over the supply of money – the price level in the economy is a function of supply AND demand. Now you can make arguments that the Fed can influence the demand for money (perhaps by instilling confidence) it ultimately has little control over the many factors which affect Md. For example, the Fed cannot predict the pace of financial innovation, it cannot impact real interest rates, etc.
Any one of those factors ought to make readers skeptical about the ability of the Fed to conduct monetary policy. However, when taken together, asking the Fed to run effective monetary policy is like driving a truck at night with beer goggles on. You might be able to stay on the pavement, but you are likely to wipe out a few little old ladies driving Ford Fiestas along the way …
In future posts, we will explore each of these factors in more detail, along with the other things that the Fed is asked to do.