Should the Fed be a computer program?

John Mauldin in his latest weekly commentary, quotes a 2007 interview of Milton Friedman and his idea that the Fed policy should be determined by a computer program.

When asked “Do you still think it would be a good idea to have a computer run monetary policy?” he answered:

“Yes. Of course it depends very much on how the computer is programmed. I am not saying that any computer program would do. In speaking of that, I have had in mind the idea that a computer would produce, for example, a constant rate of growth in the quantity of money as defined, let us say, by M2, something like 3% to 5% per year. There are certainly occasions in which discretionary changes in policy guided by a wise and talented manager of monetary policy would do better than the fixed rate, but they would be rare.

“In any event, the computer program would certainly prevent any major disasters either way, any major inflation or any major depressions. One of the great defects of our kind of monetary system is that its performance depends so much on the quality of the people who are put in charge. We have seen that in the history of our own Federal Reserve System. Surely a computer would have produced far better results during the 1930s and during both world wars.

“That raises a question about the desirability of our present monetary system. It is one in which a group of unelected people have enormous power, power which can lead to a great depression or which can lead to a great inflation. Is it wise to have that power in those hands?

“An alternative would be to eliminate the Federal Reserve System; to reduce the monetary activities of the federal government to the provision of high-powered money, that is, currency and bank reserves, and to constitutionalize, as it were, what is to be done with high-powered money. My preference is simply to hold it constant and let financial developments produce the growth in the quantity of money in the form of bank deposits, a process that has been going on for many decades. But that is, of course, politically impossible.”

Of course the problem of how the issuance of money should be managed is directly related to the fact that we assume a system where there is a single currency issued and accepted.

In my view, the Fed was established simply because private financial institutions have a better track record than governments at ensuring widespread acceptability of the money they issue by preserving its purchasing power and providing convenient means of payments. The single currency on the other hand facilitates tax collection, and channeling large capital amounts towards measurably profitable ventures.

The problems in such systems are several:

• bankers must be paid for their diligence service in the form of interest on loans, which requires endless monetary debt expansion to pay for the interest on the previously issued debt.
• there is a limit to debt expansion since debt is a claim on wealth and wealth is a physical concept, not a mathematical concept like debt.
• as a result the system is systematically prone to booms and busts. Regulations will do little except comfort the masses that “this time is different” until the next bubble “we couldn’t foresee” blows up.
• money issued privately by banks is in fact ultimately backed by the government, which means they have to be bailed out when peak debt is reached.

How do we design a complementary system where:

• money issuance is interest free, because it does not require the diligence of bankers,
• systemic risk from local default to deliver is not protected by banker’s over-leveraged capital or by the taxpayers, but by the system itself, but not by loss of purchasing power of the monetary unit.
• money is issued in proportion to known deliverable wealth, not desired profitability.

My ideas in a coming post.