Kaushik Das: Rules vs discretion ? the Austrian perspective

A rule-based monetary policy of the Austrian type can be the best way to avoid boom-bust cycles.

The recent global financial markets turmoil might have taken a lot of market participants by surprise but not the proponents of the Austrian school of economic thought who have long prophesied this inevitable outcome. Austrians (in the sense of the Austrian school of economics established by Carl Menger and later popularised by Mises, Hayek and Rothbard, to name a few) believe that bubbles are created when interest rates are kept artificially low for a long time, thus sparking a temporary boom "" resulting in inflation and higher interest rates in the subsequent periods "" and finally culminating in a bust, leading to a liquidation of mal-investments.

This is exactly what happened in the current US "boom-bust" cycle too which finally led the Federal Reserve to aggressively cut both the benchmark Fed Funds rate and the discount rate by 50 bps in the latest FOMC meeting to avoid a full blown recession going forward.

This brings back a very long-standing and interesting debate pertaining to monetary policy, namely whether monetary policy should be guided by discretion or rules.

The first alternative where the central bank responds immediately to any kind of financial imbalances can be described as a "discretion-based monetary policy". This provides the central banks with enormous "flexibility" to act swiftly in times of financial market turmoil and a subsequent economic slowdown. However, history has repeatedly shown that the same discretion-based monetary policies which are often used to fight impending recessions have been themselves responsible for the creation of bubbles in the first place. Even in the current scenario, cutting rates to avoid a severe growth slowdown would give birth to another period of artificial boom/inflation going forward and thus prolonging the recession for a later period.

The second alternative is a "rule-based monetary policy" which is more transparent and provides central bankers with "credibility" to focus on certain rules which are beneficial for the economy in the long run without paying heed to short-term disruptions in the markets or the economy. The months of adjustment under a rule-based monetary policy might be painful, but it ensures that the economy gets back on a stronger footing without giving rise to any further bubbles in the subsequent years.

Given these two options under a central banking framework, needless to say, the Austrians will favour a rule-based monetary policy rather than a discretion-based one simply because the latter option is more distortionary in nature and gives rise to frequent boom and bust cycles. A rule-based framework on the other hand bestows the central banks with a lot of independence in conducting their monetary policy which is beneficial for the economy in the long run.

But what are the rules on the basis of which the central banks should conduct their monetary policy? This is where the proponents of Austrian economics differ with other schools of thought which support a rule-based framework. Central banks who believe in rule-based monetary policy often refer to inflation targeting as the single most important rule on the basis of which monetary policy should be conducted. According to this principle, if inflation is expected to go above the set target, say 2 per cent, in the coming months, then interest rates should be increased or vice-versa.

The Austrians do not agree with the principle of inflation targeting simply because they differ in their exposition of how inflation is caused in the first place. While the inflation targeters focus on aggregate inflation based on the premise of the neutrality of money, the Austrians tend to argue that money is non-neutral in nature and, therefore, focus their attention on the impact of change in relative prices (a step-by-step process), leading to an inter-temporal misallocation of resources in the structure of production and causing a boom and bust cycle.

So, what kind of rules would Austrians advocate under a rule-based monetary policy framework?

Rule 1: Allow interest rates to be determined by the loanable markets equilibrium, that is, the equilibrium interest rate determined by the savings and investment in an economy. If savings increase (decrease), then interest rates should fall (increase) and vice-versa. Monetary stimulus aimed at bringing interest rates artificially low in the absence of adequate savings should be avoided at any cost as this is the perfect recipe for inflation.

Rule 2: Credit and money supply growth should not exceed nominal GDP growth on a sustained basis as this can lead to overheating of the economy.

Rule 3: Excess money supply can flow into different asset classes (stocks, housing, commodities) without getting reflected in narrowly conceived indexes such as CPI and WPI. Therefore, central banks should build into their monetary policy decision the behaviour of a wide range of asset classes including traditional macroeconomic indicators such as the structures of production, debt levels, savings ratios, credit growth and so on, to understand whether financial imbalances are building up in the economy or not.

The present global credit market turmoil and the US "boom-bust cycle" has once again brought to the fore the importance of Austrian teachings that it is impossible to achieve a long-term robust sustainable growth on the back of easy money policy. Excess liquidity is bound to lead to inflation and cause a misallocation of resources in the structures of production resulting in a subsequent bust. A rule-based monetary policy of the Austrian sort, in this context, can be the best solution to achieve a sustainable growth without giving rise to global financial imbalances.

The author is an economist at Kotak Mahindra Bank Ltd. He can be reached at kaushik.das@kotak.com. The views expressed are personal.