The Knowledge Problem in the Financial Sector
May 11, 2010 Money

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.

"4" Comments
  1. Well-put, professor.

    When I was 24 working on Wall Street, I was lucky to have mentors who told me that nobody knew what the price of something would be tomorrow, despite the fact that there were thousands of people outside eager to tell you they did.

    This is not to say that useful financial advice is unavailable — just that, as Dirty Harry said, “A man’s gotta know his limitations.”

    Hayek and Milton Friedman, among others, understood this and expressed it clearly. Shots across the bow of Progressivism.

    We had in our house when I was a teenager a book by Max Eastman entitled Reflections on the Failure of Socialism, and I recall references to Hayek, making the same point.

    While learning the arcane language of the Federal Reserve can be tedious, one should not assume that Ben Bernanke, or anyone in that crowd holds the secret formula for turning lead into gold.

    Otherwise, we’d be on a gold standard and all of our lead paint problems would have been solved long ago.

  2. Hayek’s piece was written in 1945. I find it surprising that so little attentiion has been paid to these ideas since.

    The prevailing progressive view then was that as science and mathematics advanced technologically it would only be a matter of time before central planners perfected their craft.

    In following years the central planners would suffer withering setbacks. Every year the Soviet Union would blame a failed harvest. Cuba would never get past its one chicken per month. North Korea can barely feed it’s army, and then only with aid it extorts Venezuela is short of coffee.

    In contrast, there a million examples why economic freedom, being good in itself even if it were not always perfect in causing the manager of the shop to choose perfectly about the tin he uses, makes a far better choice that any central planner might, even if the manager and planner had lunch together every day.

    Milton Friedman wanted the Fed run by a computer, with it’s role to be to stabilize the value of the dollar, where the rules for the computer being clearly defined enough that a caveman could understand it. Friedman understood the epistemological limitations of wise men.

    To answer one of your implicit questions, the Fed might select a commodity or a basket of commodities on which to anchor our currency, and here is not a place to argue which or the mechanism, but in this regard the Fed might have a chance of success. I would settle for a gold dollar, or any commodity used for wedding anniversaries, except paper and any metal proscribed by the EPA. Just don’t have an unemployment dollar, or a balance- of-trade dollar.

    The progressive planners want to tackle bigger subjects. The biggest is the climate, which for them is the ultimate prize, since it subsumes the soil, the watershed, and everything in the earth’s crust , including the plant and animal kingdoms.

    Looking forward to Perfesser Wintercow’s insights!

  3. The paragraph about Venezuela and North Korea is incoherent because I inadvertently deleted the ends of two sentences. Apologies for that.

    But Venezuela and North Korea are not only confusing. They delete people

  4. So the Fed can’t change the supply or demand for money in any meaningful way….so why do so many libertarians claim the Fed to be so evil if it can’t change anything!!?

    I was under the impression that by increasing the supply of money, the Fed penalized those with savings through depreciation?

    I think statistically you can also see that the Fed’s monetary policy can be very influtential…maybe not always in a good way, (or hardly ever….or ever at all), but at least it has some impact.

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