Does giving broad discretion to allow reaction to complex challenges result in better outcomes for society? Or does discretion inevitably motivate popular short-term actions that cause harm in the long run?
This argument, initiated by University of Chicago Nobelist Milton Friedman, is largely about monetary policy. Should the Federal Reserve make money supply and interest rate decisions on an ad hoc basis or by following some predetermined rule?
This question remains at the center of the debate, but there are other areas in which the issue arises.
Right now, the nation’s eyes are focused on the Lower Mississippi, where the Army Corps of Engineers, trying to prevent catastrophic flooding in New Orleans, already decided to open one floodway by blowing out the Birds Point levee in Missouri. Then they opened the Bonnet Carre spillway in the east bank of the Mississippi to let water flow into Lake Pontchartrain, and opened the Morganza spillway above Baton Rouge to dump water into a floodway that leads to the Atchafalaya River.
That river is already high because unprecedented amounts are flowing into it via the Old River Control Structure 30 miles north of Morganza. Thousands of people living in the floodway or along the Atchafalaya itself are being forced to move out. Crops will be destroyed and homes flooded.
Read comments posted on the Internet and it is clear many citizens see these decisions as discretionary. To some, Barack Obama is directing the Corps to flood white people to spare blacks. Others see the Corps being paid by the petrochemical industry to spare their plants around Baton Rouge.
In reality, the Corps is just executing a detailed plan first written nearly 60 years ago, when Morganza and Old River Control were designed. It is revised from time to time, but specific actions and the river levels that would trigger them were decided with public input, albeit often contradictory, and are part of the public record.
Landowners in floodways like Birds Point and Morganza were paid for easements regarding the possibility of flooding in accordance with the plan. There is little discretion to vary from the plan now, though Congress and the Corps operated with great discretion prior to the 1950s.
SOCIAL SECURITY COLA ISN’T DISCRETIONARY
Cost-of-living adjustments to Social Security benefits are another rules-vs.-discretion issue. When there were no COLAs for 2010 and 2011, some retirees were up in arms. Many believe this to be a discretionary decision by the Obama administration.
In reality, the lack of COLAs is required by a law passed by bipartisan majorities in Congress in 1972 and signed by Richard Nixon. Prior to this, benefits were increased only when Congress saw fit. From the first payment of benefits in 1940, there was no increase until 1950. After that, increases came at two- to six-year intervals at the discretion of various congresses and presidents. So Social Security existed for 35 years before the transition from discretion to a rule when the first automatic COLA took place in 1975. It was not until 2009, however, that the CPI in the third quarter fell below year-earlier levels and thus, by law, obviated any COLA for the next year.
From its inception, the Federal Reserve has had discretion to change the money supply and thus change interest rates. This first was up to the boards of directors of individual district banks. Since 1935, it has been up to the Federal Open Market Committee.
Conservative economists of the monetarist and rational expectations schools generally argue this discretion has been detrimental, either with too-tight control causing the Depression or too-loose policies causing the inflation of the 1970s.
Friedman argued that the money supply should be increased at the same rate as the long-term growth of real output. As the economy grew, the money supply should grow, but without any acceleration or braking to meet short-term problems. Nowadays, people who advocate rules champion approaches like that of John Taylor, a Stanford University professor and undersecretary of the Treasury in the George W. Bush administration.
The “Taylor Rule” specifies that the money supply be managed to set short-term interest rates in accordance with actual inflation and GDP growth and how these compare to desired levels. (Google “Taylor Rule.” and you will find numerous explanations.)
Rules are popular as long as they don’t seem to bite anyone. Seniors liked their annual COLA until the Consumer Price index fell in 2009. Suddenly, the rule was unjust. One complained to me that he needed a bigger monthly check because the dollar had lost value compared to the euro, even if the CPI was below earlier levels. A few people with property in the recently inundated Missouri and Louisiana floodways complain, although more carping comes from people ignorant of easements the Corps purchased decades ago.
In terms of monetary policy, despite decades of support by conservative economists for monetary policy rules, we have never formally established any. At times, Fed decisions have seemed to mimic Taylor’s prescription, but 2001 to 2007 was an exception, as was the panicked improvising from 2008 to now.
The 1913 Federal Reserve Act called for “an elastic currency.” Fed officials seem loath to surrender their discretion over the process.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.