July 14, 2021
Robert Hockett, Cornell Law School
Introduction – Modulation, Allocation, and the ‘Twin-Bladed’ Fed
Just Money has arranged yet another timely and well-framed symposium. I could not be more delighted to take part. I’d like here to highlight the bearing on this season’s symposium topic – ‘Central Bank Independence’ – of an overlooked fact about central banking. I claim that a central banking imperative often effectively taken to justify independence – what I call the necessary modulation of endogenous credit aggregates – cannot be done without doing something else effectively taken to rule-out independence – what I call the productive allocation of endogenous credit flows. We used to know and to do this, I’ll argue, and can do it again at no cost to the accountability that independence is mistakenly assumed to offend. All we need to do is to learn the right lesson of 1929, which we have failed to learn up to now. I’ll define my terms, naturally, as we proceed.
- Central Bank ‘Independence’ – A Dependent Variable
Let’s start with the word ‘independence,’ in order to clarify what’s at stake. Central bank independence is often extolled or decried in an untethered, free-floating manner. This can occasion unnecessary confusion. Calls by some of my friends to ‘end independence’ and ‘democratize the Fed’ several years back, for example, apparently meant that the Fed should be more answerable to Congress. Yet it seemed not to have occurred to my friends, while they were on this roll, that the White House and Congress were in the hands of a crisis-fomenting and -perpetuating political party that had garnered, and routinely still garners, many millions fewer votes in national elections than does their rival party. If you want to democratize the Fed, I recall suggesting, you might want to start by democratizing the United States – or at least the White House and Congress.
The broader point should be clear. Central bank independence cannot really be understood in political isolation any more than central banks can themselves operate in political isolation. The word ‘independent’ is typically followed by a preposition. It is a relative, ‘unsaturated’ predicate, implicitly indexed by some assumed ‘independent variable’ from which or of which various values of the dependent variable – ‘independence’ of one sort or another – are variably dependent or independent. And there are many independent variables in relation to which we might unreflectively be taking the ‘independence’ in question dependently to vary. Do we mean ‘independent of’ the executive of a national government? ‘Independent of’ the legislature? ‘Independent’ of ‘the democratic process’ or ‘the political process’ more generally? ‘Independent’ of what, exactly?
Even once we decide which independent variable(s) we have in mind, of course, we require yet further specification of the dependent variable itself before we know what we are talking about. Do we mean ‘complete’ independence (in some sense) from what the bank is meant to be independent of, under all circumstances, always and everywhere? Do we mean independence only in respect of certain decisions or subject matters, and/or within certain time intervals – for example, only as to interest rate targets, workforce participation rates, wealth gaps, environmental impacts … or within political campaign cycles, ‘staggered’ across campaign cycles, outside of financial or other crises, or … again, what? Without more refinement, it’s not clear we are talking about anything at all.
As critical as further specification along all these broad lines is to productive discussion of central bank independence, it is a somewhat narrower range of context-relativity within this larger range that will be my focus here. For my subject is central bank independence as it figures into a specific set of institutional understandings that current discussions of the subject seem simply to assume as background conditions – conditions that require more careful attention to the modulation and allocation functions that I have just mentioned than is typically forthcoming.
My task is accordingly to foreground and sympathetically critique this set of understandings, which I shall ultimately accept in part while also rejecting in part. For (a) it is an institution-bound ‘thought-complex’ in which most, if not all, present-day discussions of central bank independence are implicitly embedded, and (b) this complex implicitly assumes certain falsehoods about the credit modulation and allocation functions. Because this complex is thus partly but not wholly sound, and can be made wholly sound only through careful identification, critical examination, and purposeful reconstruction, I shall have to do the latter to make the claim with which I introduced this symposium contribution convincing.
In the end, we shall see that one principal assumption upon which most if not all contemporary discussions of central bank independence tacitly rely – namely, that central banks must and do engage only in what I long ago dubbed neutral ‘modulation,’ and not in inherently contestable ‘allocation,’ of endogenous Wicksellian credit-money (more on which below) – is false. So – and relatedly – is the assumption that central bank allocation cannot be done neutrally or, therefore, incontestably and independently. At least this is so in connection with the only forms of neutrality, legitimate contestability, and independence we should care about where public finance in a would-be democratic republic is concerned.
The implications of this conclusion are ‘radical,’ in the original Latin sense of the term: they are foundational and far-reaching where sound public allocation of the public’s own investment capital – its central-bank-issued credit-money – is our ultimate interest. For they suggest we must reconstitute and recombine the roles of individual and collective action in the realm of finance and, therefore, production.
- Independence in Context: Endogenous Public Capital and the Twin ‘Scissors’ of Public Finance
Let us now turn, then, to a sympathetic, ‘ground-up’ schematization of the institution-bound thought-complex to which I’ve alluded. This is the institutional-cum-intellectual context from which most if not all contemporary discussions of central bank independence seem effectively, if not always cognizantly, to spring.
Where public finance in a decentralized market-exchange economy with endogenous credit-money is concerned, there are broadly two public functions that have to be collectively discharged. This is so notwithstanding – indeed, even because of – market-exchange’s primarily decentralized, ‘privately ordered’ character. People seem never explicitly to say – or perhaps even to recognize – this. But they implicitly commit to it every time they speak of ‘monetary’ and ‘fiscal’ policy, or of ‘central banks’ and ‘finance ministries,’ as legitimate yet putatively distinct functions and institutions, respectively.
The first such function is what I just called the money-modulatory task, while the second is what I just called the money-allocative task. These tasks are seldom identified, let alone named. They go, in effect, barely noticed, because only tacitly assumed. Partly for this very reason, what goes yet more crucially unnoticed is (a) that these two functions both are necessitated by credit-money’s endogeneity itself, and (b) that this same endogeneity renders the functions both theoretically and operationally inseparable. They succeed or fail together.
The modulatory and allocative functions accordingly constitute, we might say, two blades of one scissors of public finance. I’ll explain why in a moment. But first a bit more on money endogeneity and the blades individually, along with their links to central bank independence. For only when we are fully clear on the blades’ purposes can we grasp their mutual functional dependence.
- Endogenous Credit-Money: Privately Allocated, Publicly Generated Capital
I and many others have written extensively on credit-money’s endogenous character elsewhere, so there is no need to be tedious here. The essentials, however, must be grasped firmly to ‘get’ my argument. So here they are in two paragraphs…
Contemporary polities publicly license private sector banks and other financial institutions to generate and allocate national money supplies without falling foul of anti-counterfeiting laws. This they do by (a) authorizing these institutions to extend spendable credit in fiduciary account form, while (b) publicly ‘recognizing’ payments made out of such accounts as discharging commercial obligations via legal tender laws and associated public administration of national payments systems. This amounts to public outsourcing of the public’s own money-issuance authority to private sector lending institutions. Hence Wicksell’s (1898, 1906) dubbing this money-form ‘bank money,’ which we can generalize to additional financial institutions through use of the broader term ‘credit-money.’
There are three characteristics of endogenous Wicksellian credit-money worth emphasizing for present purposes. First, it represents by far the greater portion of contemporary economies’ ‘money supplies.’ Second, the only limitation on this form of money’s generation by private sector institutions, apart from public guidance (more on which below), is the prospective profitability of lending – a prospective profitability that includes, crucially, loans for speculative gambling purposes as well as legitimately productive purposes. And third, owing to the dispositive role played by public authority in enabling this form of credit to function as money at all, Wicksellian credit-money is effectively public capital.
Publicly licensed, yet profit-motivated, endogenous credit-money extension just is publicly issued, yet privately allocated, finance capital. In this very hybridity lies the inseparability of credit modulation and allocation as public functions.
- First Blade of the Scissors: Modulation, Technocracy, ‘Independence’
Now, what I call public finance’s modulatory task is necessitated by the aforementioned endogeneity itself. It is the task of retaining variable money quantity fluctuations, rooted in the indefinite extensibility and contractibility of bank-issued credit-money, within a tolerable band. In finance parlance, this is a collaring function. Variable credit-money availability, made possible by money endogeneity, opens the door to aggregate over- or under-extension of credit relative to goods, services, and (euphemism alert) financial ‘asset’ quantities purchasable with credit-money. This in turn renders credit-fueled inflation, hyperinflation, deflation, and debt-deflation ever-present dangers.
Because credit-money endogeneity also renders inflations and deflations potentially self-worsening without limit – amplifying them into what I long ago christened recursive collective action problems (‘ReCaps’), more on which below – centralized management of endogenous credit-money supplies is imperative if decentralized market finance, and with it decentralized market exchange generally, is to be sustained over time. Money supply management is, in other words, one minimal degree of centralized jurisdiction that must be retained if otherwise decentralized market exchange is to be possible over the long term at all.
That bears repeating. Continued private ordering of production requires, at a minimum, a significant degree of publicly-ordered finance. And, as we’ll soon see, this means public allocation (of a sort) nearly as much as it means public modulation.
Now the populations of many contemporary polities seem to be at least partly or semi-consciously aware of the modulatory need. For they all exercise some degree of modulatory collective agency where endogenous credit-money supplies are concerned. (My argument below is that they will now have to exercise more.) They do so through public instrumentalities tellingly labeled ‘central banks’ or ‘monetary authorities,’ the italicized components of these phrases suggesting collective agency and corresponding concentration of control. Polities then task these instrumentalities with collaring price fluctuations by modulating supplies and circulation-velocities of endogenous credit-money relative to that which money exchanges for or commands.
Now comes a crucial move in the thought-complex I’m reconstructing. The modulatory task as I have just characterized it is inherently counter-majoritarian, in what lawyers will recognize as the Bickelian sense, as a theoretical matter. And it is inherently technical as a practical matter. And this is the justification, fully appreciated or not, of modern central banks’ simultaneously ‘independent’ and ‘technocratic’ characters.
The modulatory task is counter-majoritarian because it has to be counter-cyclical within any environment of decentralized market-exchange. It has to be counter-cyclical in turn because it is rooted in inflation’s and deflation’s character as endogeneity-rooted recursive collective action problems, in the sense just noted, in any such environment. To explain…
- Endogeneity’s Achilles Heel: Recursive Collective Action Problems
A collective action problem is, of course, simply a choice situation in which multiple individually rational decisions aggregate into collectively irrational outcomes. It is accordingly ‘tragic’ in the classical Greek (‘damned if you do, damned if you don’t’) sense of the word. A recursive such problem is just such a tragedy as self-worsening through iterated decisions, each decision at time t informed by and as it were ‘replying’ to the outcomes of decisions at time t-1. It is in other words an ongoing collective action predicament with ‘feedback’ effects.
Markets in which endogenous publicly generated but privately allocated credit-money figures as a medium of exchange are rife with predicaments of this sort – a fact that continues to go surprisingly unremarked. In an inflation or hyperinflation (a.k.a. ‘bubble’), for example, individuals rationally buy now in anticipation of prices’ rising later. In so doing, they collectively drive prices yet higher, leading to more purchasing, more price rises, and so on. In a deflation or debt-deflation (or ‘bust’), the same happens in reverse.
In all such cases, individual agents collectively drive cycles simply by making individually rational decisions. Only a collective agent, acting in the name of all, can prevent such decisions’ aggregating into collectively irrational outcomes. This the agent does by short-circuiting the recursion cycle – crucially, by countering the crowd, by ‘acting contrarian.’ Specifically, the agent does so by rendering participation in the relevant ‘crowd’ no longer individually rational – for example, by raising borrowing costs, by taxing away asset price ‘capital gains,’ by taxing speculative ‘short swing’ transactions, or the like.
It is easy to see why some degree of insulation from crowd preferences – some form and degree of ‘independence’ – will be necessary if this contrarian task of counter-cyclical collective agency is to be discharged effectively. Counter-majoritarian action is only possible when short-term majoritarian preferences can be temporarily disregarded, hence when democratic accountability is ‘lagged’ rather than immediate.
There is the ‘independence’ piece of the modulatory task. The ‘technocratic’ bit enters through what is required to discharge the role not so much at all, as competently and effectively. Central banks have to modulate endogenous money supplies relative to anticipated resources, goods, services, and asset supplies that money purchases. This involves massive data collection, aggregation, estimation, and prediction. So does the task of deploying the tools used to vary credit-money availability relative to those projections. These are technical tasks in which technical expertise, although not sufficient to discharge of the task, is in any event necessary.
- Second Blade of the Scissors: Allocation, Democracy, ‘Accountability’
There is the modulatory task in brief outline. Now for the allocative task. Here we speak less in ‘quantitative’ than in what might be called ‘qualitative’ terms where endogenous credit-money is concerned. We are foregrounding not ‘how much’ money is flowing so much as ‘where’ it is flowing. The first question to ask about allocation is whether and why it is really an objective of public finance at all? Is collective agency as obviously necessary here as it is in the case of modulation?
It takes some, but not much, reflection to see that the answer has to be yes. Polities do things and act on decisions about what shall be done. That is indeed all that collective agency and collective action themselves are – decisions made and executed jointly by or on behalf of multiple deciders acting ‘as one.’ What anyone does, polities and other collective agents included, in turn always involves some use of resources. And, again in any monetary-exchange economy such as our own, this in turn requires the commanding of resources through money expenditures. That is just allocation. It is money-allocation for purposes of resource-use in pursuit of particular public objectives.
Polities also typically take interest, for purposes of maintaining some degree of social and juridical cohesion if not actual justice, in distributions of advantage and disadvantage among their constituent members. This too just is an interest in resource allocation, with ‘resources’ now understood broadly as materials used not in this case by publics in pursuit of public objectives, but by private sector citizens and associations in pursuit of privately conceived plans and projects.
Now because resource allocation produces comparative ‘winners and losers’ in connection with literally every decision, polities actuated by democratic values will tend to view the allocative character of particular matters of collective decision as best subject to democratic accountability. The legendary war cry of the American Revolution – ‘no taxation without representation’ – is but one dramatic example of the idea at work here. We accordingly tend to vest the more overtly money-allocative authority of our polity in institutions that we endeavor to keep less technocratic and insulated, more democratic and accountable.
We resort, in other words, to legislatures subject to regular elections, and to finance ministries subject, in turn, to continuous legislative oversight.
Here, again with varying cognizance of the fact, is the basis for contemporary jurisdictions’ maintaining finance ministries separate from their central banks and other monetary authorities. Here also, accordingly, is the basis for running aspirationally separate ‘fiscal’ and ‘monetary’ policies via these institutions, with each institution issuing its own monetary or quasi-monetary financial instruments in furtherance of its mission (Federal Reserve Notes or ‘dollar bills’ in the one case, for example, and Treasury Notes, Bills, or Bonds in the other).
The idea, implicit or otherwise, is that the one institution will only modulate supplies of, and accordingly be authorized to issue, explicitly monetary instruments and their fiduciary (e.g., bank account) equivalent. The other institution will primarily help allocate and accordingly be able to monetize only such of its own financial instruments as the legislature authorizes for particular purposes, and which the ‘independent’ central bank or public are willing to purchase to convert into spendable money. Et voila, central bank independence and finance ministry accountability in modern public finance.
- Scissors Need Two Blades: No Modulation without Allocation
Now, even granting the intuitive tractability and provisional usefulness for some purposes of (a) the modulation/allocation distinction as just elaborated, and (b) its modern institutional embodiment, recent events confront us with a set of questions that we can now either continue to duck, as we have done for five decades, or instead finally address. The questions are: (1) is the modulation/allocation distinction as crisp as I’ve just made it sound? (2) has it always been observed, tacitly or otherwise? And (3) if it isn’t or hasn’t, is the thought-complex that latently and therefore uncritically relies upon the distinction salvageable?
I think the answer to the first two queries is no while that to the third query is yes – with revision. That is, the distinction partly dissolves under scrutiny and has often been at least tacitly rejected, at least in part, in consequence. But it also is partly salvageable, if we attend carefully to its actual contours and respond institutionally by partly reconstructing our principal organs of public finance – our central banks and finance ministries. My reasons for saying these things are rooted in the very phenomenon that leads us to recognize the urgency of the modulatory task itself – again, money endogeneity.
Credit-money’s endogeneity, which necessitates modulation as a necessary collective function in the first place, also renders modulation impossible absent a certain definable range of forthright collective allocation – a range I’ll define shortly in principled fashion. And this means that more thoroughgoing fiscal and monetary coordination or consolidation – independence’s partial contrary – which always intensifies during crises but then recedes once the crises appear to be past, must become a ‘new normal.’ At least that is so if ever-deeper and more frequent crises are not themselves to remain a new normal. Here’s what I mean…
Credit-fueled bubbles develop as over-issuances of speculative credit-money to traders who spot and then trade upon fads in the making. The objects of these fads can be virtually anything – ‘junk’ this, ‘subprime’ that, ‘crypto’ whatever… Once a ‘boom’ in such objects begins attracting (euphemism alert) ‘momentum traders,’ a decentralized monetary-exchange economy with endogenous credit-money and ‘deep’ secondary financial and tertiary derivatives markets – what I elsewhere call ‘meta-markets’ – generates the most formidable of all known recursive collective action predicaments: the credit-fueled asset price bubble. For indefinitely extensible credit can be borrowed cheaply to purchase ‘assets’ whose prices are rising at rates higher than ‘borrowing rates.’
Under boom conditions it becomes individually rational for ‘investors’ (euphemism alert) to borrow in order to buy in order then either (a) to sell on the secondary markets or (b) to ‘hedge’ (euphemism alert) on the tertiary markets. But everyone’s acting thus rationally aggregates into irrational outcomes, as prices are driven to points at which even the most profligate lenders balk. Ensuing reversals then culminate in busts as intemperate as their antecedent booms, leaving debt overhang in the wake since borrowing costs are fixed while asset prices are variable.
Reactive ‘downside’ Fisherian (1932, 1933) debt-deflations, which are themselves recursive collective action problems of the same sort, are, of course, the bane of sustained macroeconomic stability, and hence of continuous productive and full-employment activity. They must accordingly be defused collectively too. But this is just the modulation challenge that I sketched above, begun in an allocation challenge, as are all endogenity-rooted modulation challenges.
What then to do? Must all endogenous credit-money allocation be ‘independently’ and ‘technocratically’ managed just as must modulation? Must fiscal and monetary policy be collapsed into one another – fully ‘consolidated’? And what then of all of that ‘picking of winners and losers,’ and of the intolerable ‘democratic deficit’ that doing this ‘technocratically’ and ‘independently’ of politics would seem to entail?
- Production and Speculation: More Distinguishable than Modulation and Allocation
Well, relax. The quandary is not as acute as it looks at first blush. The key is to retrieve a distinction that both (a) is more or less objectively and technically drawable, and (b) used to be routinely technically drawn. We mistakenly abandoned this distinction in 1935 owing to a false lesson drawn from the first years that followed the 1929 crash, but can retrieve it in ‘new and improved’ form both theoretically and operationally – with few if any changes to our law.
Really? Yes. I am alluding to the distinction between productive investment and merely speculative betting, and the implications of drawing that distinction for how we govern primary investment markets on the one hand, and secondary and tertiary betting markets on the other hand. Our past understanding of this distinction found expression in the old ‘Real Bills Doctrine’ (RBD) favored by Fed founders Paul Warburg and Carter Glass (yes that Carter Glass), among others. The problem with the RBD was that it was only half-right, not that it was wholly wrong. Hence our effectively dispensing with it entirely after 1935 was but half-right as well.
To see what I mean, start with the distinction itself. While productive investment and speculation of course overlap at the margin, paradigmatic cases of the former are cases in which producers and suppliers of material goods and services, or of material inputs to productive processes, are doing the borrowing or otherwise tapping the capital markets. We can call the markets in which all of this happens the ‘primary’ markets.
Paradigmatic cases of merely speculative betting are cases in which the claims generated by real or putative primary market investment are themselves bought, sold, or bet upon or against, with the speculators borrowing in order to purchase those claims with a view either to selling them at higher prices or to capitalizing on such secondary market price changes through tertiary derivative instruments. The markets in which these purchases and sales occur are accordingly what I call the ‘secondary,’ ‘tertiary,’ and iteratively through time what I call ‘n-ary’ markets or ‘meta-markets.’
Primary markets in decentralized-exchange economies with endogenous credit-money do not typically generate serious recursive collective action predicaments of the kind that I highlighted above. For they are ultimately ‘grounded’ in, ‘anchored’ by, or ‘tethered’ to, something that nature or physics themselves more or less exogenously modulate – viz., potentially profitable material production. Where credit-money is endogenous and profitability is not immediately tethered to material production but can also include winning bets, on the other hand, meta-markets have to be artificially modulated if there is to be any exogenous constraint upon endogenous credit dissemination.
And this means that modulation will require allocation – steering money from speculative meta-markets to productive primary markets. Meanwhile, the exogenous modulation in question will still have to be done collectively – both in the manner, and for the reasons, elaborated above.
But if the latter is allocative, at least as between productive primary markets and speculative meta-markets, is it politically viable to do it technocratically and ‘independently’? Are we faced with an operational paradox or ‘tragedy,’ with modulation requiring independent collective agency while also requiring allocation, and the latter in turn requiring independence-excluding accountable collective agency?
Conclusion – Privately Ordered Production and (Partly) Publicly Ordered Finance
The answer is no. There need be no real operational paradox or tragedy. For the production/speculation distinction is itself technically tractable and universally appreciable as critical to macroeconomic stability – a proper concern of everyone – while at the same time there is sufficient variety under each heading to allow for a great deal of private ordering where allocation under them is concerned. Hence we can extend a great degree of independence to certain broad forms of central bank allocation and concomitant fiscal-cum-monetary consolidation without (a) resorting to comprehensive ‘state planning’ or (b) objectionably insulating the ‘pickers of winners and losers’ from desirable democratic accountability.
We can see this in early Fed history and current conditions alike – conditions for which I’ve proposed an updated pre-1935 (that is, pre- Banking Act of 1935) style ‘spread Fed’ model that retrieves what was sound in the old model while eschewing what was unsound. The short-playing version of the mentioned history is that we were right to allocate endogenous money but wrong to overlook and not modulate exogenous money before 1935, then to do the latter and not the former after 1935. (You cannot be only halfway Wicksellian – you must attend both to exogenous and to endogenous money, and to the cumulative process through which they interact, especially in a globally ‘open’ economy.) The short-playing version of the mentioned proposal is that it does precisely that – retaining the post-1935 Federal Open Market Committee (FOMC) as nationwide modulator, while restoring the pre-1935 Federal Reserve District Banks as regionally distributed (‘spread’) productive allocators.
Return to Central Bank Independence roundtable prompt.