Monetary and Fiscal Rules 
By Antonio Martino

In the entry ‘Fascism’ in Enciclopedia Italiana, signed by Benito Mussolini, one reads: ‘If the 19th century has been the century of the individual (for liberalism means individualism), it may be conjectured that this is the century of the State … that this is the century of authority, a Fascist century.’ 

The century that is coming to its end has indeed been the century of the State, a century of ruthless dictators, the century of Hitler and Stalin, as well as the century of big, arbitrary government, and of unprecedented intrusion of politics into our daily lives – a ‘Fascist’ century.

The end of the 20th century, however, has been marked by epic changes both in the prevailing views about the role of government and in the historical arrangements of the world. Established powers have been wiped out, the ‘evil empire’ has collapsed, dictators have nearly disappeared from Earth, and the intellectual climate seems to have changed drastically.

One of the threats to individual liberty and prosperity has come in the course of the last fifty years from the use of money and the public budget as instruments of discretionary policy. This marked a departure from previous views, and resulted in monetary instability and growing mountains of public indebtedness. The subject of my paper is to appraise our theoretical victories of the past half century and look at the challenges that confront us today and for the future.

1936

In 1936 The Journal of Political Economy published a paper by Henry C. Simons, in which the Chicago economist compared two different conceptions of monetary policy: that of entrusting it to the discretion of authorities on one hand, and on the other that of adopting a predetermined, rigid and known set of rules. Simons’ preference was for this second view:

In that same ominous 1936, John Maynard Keynes published his most influential book. His perspective was diametrically opposed to that of Simons: only the accurate manipulations of monetary aggregates and especially of the public budget by the authorities in charge of economic policy could prevent the instability, cyclical fluctuations, and crises typical of a capitalist system. It was up to economic policy – the enlightened action of government officials – to remedy the deficiencies of a market economy, prevent stagnation, recession and mass unemployment.

For the better part of the last 50 years, the Keynesian view has been prevalent, and Simons’s opinion has been little more than an intellectual curiosity known only to monetary scholars. Today, in the light of the historical experience and the intellectual achievements of the last half century, Simons’s wisdom is vindicated: a growing number of economists support the need to take monetary policy decisions away from the discretion of monetary authorities. Similar considerations apply to fiscal policy: fewer and fewer economists today believe that full employment, price stability, and economic growth can be achieved by the expert manipulation of budget deficits. But let us go back to Keynes.

Keynes

In a Keynesian world, price stability is not necessarily desirable. Most Keynesians were convinced that inflation was the unavoidable price of economic growth, that there was a stable trade-off between inflation and unemployment, that it was possible to reduce interest rates through monetary expansion, and that the time horizon for monetary policy decisions had to be dictated by the needs of short term stabilisation policies. All of these views have succumbed to the empirical evidence and the theoretical analyses of the last thirty years.

There is no evidence that economic growth inevitably involves price inflation. On the contrary, there are good reasons to believe that monetary instability hinders long term projects and makes economic growth more difficult, as evidenced by the experience of a number of Latin American countries.

The idea of a stable trade-off between inflation and unemployment is thoroughly discredited: an unexpected acceleration of inflation may temporarily reduce unemployment below its ‘natural rate,’ but this effect is short-lived. Only an accelerating inflation could keep unemployment below its ‘natural rate,’ but even that unappetising possibility is dubious (Bordo and Schwartz 1983).

Manipulation of monetary aggregates can influence interest rates only temporarily: as soon as inflationary expectations catch up with reality, the Keynesian ‘liquidity effect’ is replaced by the ‘Fisher effect,’ which will more than offset the initial impact of the unexpected change in monetary policy (Thornton 1988). Nominal interest rates tend to be higher, not lower, when monetary policy is loose.

As for stabilisation policies, it is now largely (though certainly not unanimously) agreed that our insufficient knowledge, unreliable short run macroeconomic forecasts, and variable time lags in the impact of monetary policy decisions, make it likely that policies aimed at stabilising the short run may end up being pro-cyclical rather than anti-cyclical. Attempts at ‘fine-tuning’ the economy often result in additional, avoidable instability (Meltzer 1991).

Our victory at the theoretical level can hardly be disputed. Even though nostalgia for the fine tuning, Keynesian view of monetary policy still survives, it is undeniable that the number of its supporters is considerably smaller and less vocal than it was even a few years ago.

The need for rules

‘Money matters’ is no longer a controversial slogan, as it undoubtedly was 50 years ago, and monetary stability has been restored to its status as an important policy goal (Dorn 1987). From the point of view of its importance, price stability has reacquired the position it held in pre-Keynesian times, when it was believed that stable purchasing power of money was a necessary precondition for a free and prosperous economy.

For these reasons, the old pre-Keynesian wisdom that monetary stability is a necessary (though by no means sufficient) condition for economic progress has again acquired widespread popularity. Price stability may not be a cure-all, but while there is no long-lasting benefit to be gained from the instability of the price level, this may in itself be the cause of serious economic problems.

In other words, the post-Keynesian ‘counter-revolution’ has resulted in the abandonment of money as an instrument of discretionary policy, limiting its role to its three traditional functions as unit of account, medium of exchange, and store of value or ‘temporary abode of purchasing power,’ to use Milton Friedman’s felicitous expression.

What kind of rule?

Even assuming that we have scored a definite victory at the theoretical level against supporters of discretionary monetary policy, and (a much bigger assumption) that there is a consensus on the need for monetary rules, we are still left with the problem of the particular type of monetary constitution to be adopted. This seems to me to be the real challenge for the present and for the future.

The argument in favor of a monetary constitution leaves us with the problem of choosing the specific set of rules to be adopted. Now, it is indeed more important to agree on the need for rigid rules than to agree on the particular rule to adopt (Buchanan 1983). However, as long as supporters of monetary constitutions widely disagree on what kind of rules must replace the present discretionary conduct of monetary policy, they are unlikely to make theirs a convincing case. I shall, therefore, look at some of the monetary constitutions that have been tried or proposed and attempt to single out their advantages and drawbacks, in the effort of finding out the most suitable arrangement.

Gold

The oldest form of monetary constitution is the gold standard, which can still count on many advocates. Supporters of gold believe that a gold backed currency would severely limit the discretion of monetary authorities and the power of government to debauch the currency for political purposes. On the other hand, critics of the gold standard maintain that historically its performance was not as good as its supporters claim.

The trouble with gold, as emphasised by Friedman’s classical work (1953, 1961), is that there is an enormous difference between a 100 percent gold standard, a ‘real’ gold standard in which gold is used as money, and a ‘pseudo’ gold standard, in which money is linked to gold through governmental fixing of its price. If a 100 percent gold standard is destined to evolve into a fractional reserve system, then it is fair to conclude that the monetary arrangement that would result from adopting the gold anchor would be exposed to the kind of monetary instability which has been typical of fractional reserve systems, with bank panics and the like (Cagan 1986).

However, the historical evidence on the performance of gold is mixed and far from conclusive. For example, Italian history from 1845 to 1915 seems to support the case for gold. If the yardstick by which one measures the success of a monetary standard is price level stability, the gold standard period, on the basis of circumstantial evidence, was superior to any other time in Italy’s history (Spinelli and Fratianni 1991). One can question whether this outcome is entirely attributable to the gold anchor or not, but it is a fact that those were the most stable in the past 150 years of Italian history.

The obvious answer to the apparent contradiction in the evaluation of the performance of gold is that it is better to have some kind of monetary constitution limiting the discretionary powers of monetary authorities, no matter how imperfect, than to have no constitution at all. The gold standard was far from perfect, and it is doubtful whether it could provide us with an answer to today’s problems, but it has proven to be better than a purely discretionary regime.

Currency competition

Following a famous proposal by F.A. Hayek (1976), a more radical kind of monetary reform has received considerable attention: the privatisation of money. Different monetary instruments would be offered by competitive suppliers, and, if the rates at which they exchanged for one another were flexible and continuously determined by the market, a virtuous circle would be established. A ‘Gresham’s Law’ in reverse would lead to the elimination of the less stable currencies in favor of the more stable ones. It is beyond the scope of this paper to go into the details of the various proposals; I shall limit myself to looking at competing currencies as a viable monetary constitution.

Choice in currency is an important component of freedom in general and a desirable feature of a truly free society. However, there are various reasons, aside from political feasibility, which make private competitive currencies unsuited as a monetary constitution, at least for the time being.

The first, and possibly most important, function of money is to be a unit of account, allowing prices to be expressed in a single measuring unit. The simplification money introduces in economic calculations is enormous. Money prices transmit information and allow markets to perform their function of information retrieval systems (Hayek 1945). As such, money resembles language: it conveys information. As in the case of language – most people are proficient in only one language – we tend to think in terms of one unit of account (Cagan 1986). It would be costly to think in terms of two or more currencies all the time, especially if – as required by the logic of competition – their exchange rate would vary continuously. In all likelihood, therefore, competition between currencies would be severely limited.

Secondly, according to the logic of competing currencies, competition favors the most stable one. Yet, stability does not seem to be the only criterion for success in currency competition; other factors play a role. One is the size of the domestic market. Like language, whose usefulness increases with the number of people speaking it, the importance of a given currency increases with the number of people using it. The Swiss franc may be more stable than the US dollar, but the fact that the number of people using the Swiss franc is smaller makes people prefer to use the dollar. In short, currency competition is likely to be imperfect and unlikely to act as a filter mechanism in favor of the most stable currency.

Finally, as in the case of language, in the choice and use of money there is a considerable amount of inertia (Bordo and Schwartz 1983). People don’t ask themselves which is the most effective language for communicating with others, they just pick up the language spoken in the area where they grow up. And, once they have learned it, they continue to use it without even asking themselves the question if it is the most convincing language available. This is because in most cases the cost of learning a superior language (whatever that means) outweighs the benefits. At least in the short run (as measured in decades, if not centuries), therefore, people stick to the language they already know.

The same is true of money: the dollar may be a superior monetary instrument to the Italian lira, but when I am in the US I always translate prices from dollars into lire to understand their real meaning. Currency competition is more a notion for theoretical economists than a realistic proposal for monetary reform, at least for small or unsophisticated transactors.

A monetary growth rule

The third kind of monetary constitution is the well-known one of a constant monetary growth rule (Friedman 1969). The logic of this proposal is well-known and it need not be repeated here. In one form or another it is accepted by nearly all monetarists.

I have argued that a monetary growth rule would be the ideal arrangement for Europe should the EEC adopt a common currency (Martino 1990), and I am still convinced that Friedman’s monetary rule would offer a superior monetary arrangement in most circumstances. However, we must acknowledge the fact that (at least in a legislated form) it has never been really tried and that, in Friedman’s own words, even in the US ‘the Fed has been unable or unwilling to achieve such a target, even when it sets it itself, and … it has been able to plead inability and thereby avoid accountability’ (1984). If even the monetary authorities of the country where the case for Friedman’s rule is known best have been unable or unwilling to enforce it, what likelihood is there that it might be given a chance in countries where its significance is less understood and appreciated?

The unpleasant conclusion is that, for one reason or another, none of the major types of monetary constitutions that have so far been proposed appears immune from criticism. The gold standard would have the advantage of simplicity and credibility, but in its fractional version it would be exposed to crisis; monetary authorities might decide to go off gold whenever they deemed it necessary. A monetary constitution based on competing currencies has the enormous advantage of not being dependent on the goodwill of authorities for its existence: it is self-enforcing. However, it is doubtful that it would work. The monetary growth rule would be ideal if authorities would allow it to work, but the evidence so far suggests that, even if formally adopted, it would not be carried out.

It would seem that monetary economists have no workable rule to prescribe. We agree on the need for a monetary constitution, but we have not devised one that is likely to be accepted, and to deliver monetary stability.

Fiscal policy

Budget deficits were regarded as the ultimate propellant of economic growth when, under the influence of the ‘Keynesian revolution,’ most economists believed that high employment and stability could be achieved through appropriate manipulations of the budget. In recent times, however, we have witnessed a reversal in the profession’s conventional wisdom. Deficits are now being blamed for a lot of different economic problems: inflation, unemployment, slow growth, the stock market crash, high interest rates, balance of payments difficulties, instability of exchange rates and a variety of other troubles.

While some of these criticisms are dubious or definitely unfounded, it is increasingly recognised that, whereas deficit-financed increases in public spending change the structure of total spending, their long run impact on the level of aggregate demand may very well be negligible in most cases.

Budget deficits make government growth easier. The possibility of running a deficit allows politicians to hide the cost of government from those who bear it. Under different circumstances, the preoccupation with the size of the deficit may slow down the growth of spending. This has recently been the case in the USA (Friedman 1988). I maintain, however, that in the long run the ‘Friedman effect’ is less important in slowing down spending growth than financial illusion is in accelerating it. Finally, while constitutional constraints may ultimately prove ineffective, they are probably all we can hope for to (temp-
orarily?) halt or slow down the increase in public sector spending.

An explanation

Professor Gordon Tullock (1983) has maintained that we do not have a general theory of government growth that explains the rapid increase in taxation and spending in many different countries in the post-World War 2 era. There is no doubt that we do not have any satisfactory explanation for such a wide range of events. But in another sense we do have a theory of government growth that explains fairly closely the prevailing tendencies in Western democracies during the last 25 to 30 years. It is not new, but it is worth mentioning.

The starting point of such an explanation is the existence of three asymmetries in the perception of costs and benefits of public spending. Firstly, the democratic political process tends to favor decisions that result in benefits for a small group where the cost is spread over a large number of taxpayers. For example, a decision to confer a benefit of, let us say, $250,000,000 to 1,000 beneficiaries (say, a subsidy to the domestic exporters of a given good) gives each one of them a $250,000 incentive to make sure the proposal is approved. On the other hand, if the cost of the bill is spread evenly over the entire US population, it would cost each and every American citizen only $1. ‘In these circumstances the outcome is not in doubt: the spoliators will win hands down’ (Pareto 1896).

This asymmetry is confirmed by the realisation that spending on public goods has not been the main factor behind the growth of total spending. Since public goods benefit the whole of society, they often lack a constituency lobbying for them. There is further evidence of the existence of this asymmetry in the near-impossibility of reducing government spending, since the costs of the reduction would fall on a small number of former beneficiaries and the benefits would go to society as a whole. Finally, it is obvious that the success of the first group of beneficiaries will provide an incentive for the formation of other groups, so that the asymmetry results in a process of government growth that continues over time.

The second asymmetry occurs because the political process tends to favor decisions based on visible benefits and invisible costs. The visibility of benefits guarantees the support for the proposal by the potential beneficiaries, while the invisibility of costs neutralises the opposition of the taxpayer-voters who will bear them. In the previous example, while each one of the producers of the good has an incentive of $250,000 to be exactly informed about the effects of the subsidy for him, the value of the information for the individual taxpayer is only $1. In all likelihood, therefore, while the beneficiaries will know exactly how much they stand to gain from the proposal, those who bear its cost will (rationally) be ignorant of its impact on them.

Finally, the political process favors decisions that result in an immediate (even if small) gain whose cost (even if large) is paid in the distant future. This last asymmetry is particularly acute in Italy because, given the high instability of the executive (the average ‘life expectancy at birth’ of Italian governments is less than a year), the time horizon of political decision-makers tends to be very short. Governments generally favor spending decisions that confer an immediate gain to some group in society, even if the future cost of the decision is substantial, because in all likelihood it will be borne by another government.

If this analysis is correct, we would expect government growth to be faster when public spending is financed by a device that: a) spreads costs over large numbers of taxpayers; b) hides these costs from those who bear them; c) gives politicians the impression of producing immediate benefits at the expense of high (if not disastrous) consequences in the future. Such a device exists, and it is called a deficit. The validity of this analysis does not depend on the existence of an uninterrupted growth of the deficit. What happens is that, when the deficit reaches a certain amount, the need to reduce it – stressed with great vigor by fiscal conservatives of all political parties – results in higher taxation. It is quite possible, therefore, that those asymmetries will produce increases in the deficit followed by increases in explicit taxation, and a reduction in the deficit, and so on.

Europe’s Monetary and Fiscal Constitution

If the preceding considerations are correct, discretionary manipulations of monetary aggregates and of the budget deficit are undesirable. Not only are they unlikely to promote stability and growth, they might also result in greater instability and in the uncontrolled and irrational growth of government spending.

The most significant recognition of the liberal position in favor of monetary and fiscal rules in our times comes from the European Union’s plan for Economic and Monetary Union (EMU).

According to the Maastricht Treaty, discretionary monetary policy in the Union will be replaced by a firm commitment to price stability on the part of an independent European central bank. Debt monetisation, by far the single most important cause of price inflation in this and previous centuries, will become impossible. The Treaty explicitly forbids the European central bank to come to a defaulter’s rescue, i.e. to monetise any country’s borrowing.

Not only will member countries be unable to finance government spending through inflation, they will also be bound by a ‘stability pact’ to keep their deficit at less than 3% of GDP. Except under unusual recessionary circumstances, violators would face automatic or semi-automatic and massive fines. Should the process succeed, discretionary fiscal policy on the part of national governments would disappear. Finally, the adoption of a single European currency would mean the end of arbitrary manipulations of the exchange rate. In its intentions at least, the Maastricht world is a world of strict and impartial rules, a living monument to liberal wisdom.

This being said, it is surprising that some advocates of a liberal order question not the workability of the plan, but the desirability of its goals – as if restraining arbitrary government in the fields of money and public budgets was incompatible with our ideals. Criticism of the EMU has stressed that the plan would prevent national authorities from adjusting to external shocks through changes in the exchange rate. Other liberal scholars have argued that constraints on the size of the budget deficit would deprive European countries of much needed automatic fiscal stabilisers. Still others have mourned the end of national stabilisation policies, which would condemn their countries to otherwise avoidable instability.

Nor have these eccentricities been the privilege of ‘Britain’s minds-of-oak Eurosceptics, who think EMU, however conceived, is a foreign plot to enslave them’ (The Economist, 14 December 1996:13). The same arguments have been used by American economists, which is surprising. None of them, as far as I know, has ever advocated that each State in the US should have its own currency, be free to run large budget deficits, be allowed to monetise its debt, and manipulate the exchange rate in its dealings with the other 49 States!

The Maastricht plan of monetary unification, like its predecessors, deserves to be criticised, but it seems to me ironic that we should criticise it because it puts an end to discretionary political manipulation of money, deficits, and exchange rates. It seems to me that this is its most admirable part, a veritable tribute to Henry C. Simons, Milton Friedman, James Buchanan, and other great scholars who have fought against arbitrary government.

Conclusion

The previous considerations on EMU are not based on confidence in the success of that plan. On the contrary, I am even more convinced now that should we continue with the present strategy, based on gradual convergence according to the Maastricht parameters, a common currency for Europe is unlikely to be achieved. Furthermore, the ‘convergence paradigm’ might result in the division of Europe, in the separation of the group of ‘virtuous’ countries that have succeeded in meeting Maastricht’s arbitrary criteria from all other European countries, presumably unfit to be admitted to the exclusive club of the virtuous (see Martino 1990).

Considering that the EMU plan, for reasons that would be too long to repeat here, is likely to fail, we are left with a mixed picture. Although the theoretical work and the historical experience of the last 50 years have succeeded in showing that short-run monetary and fiscal policy has undesirable consequences, and that rules are preferable, we have not produced a monetary and fiscal constitution that could be accepted and yield the desired results.

References

Bordo. Michael D. and Anna J. Schwartz, 1983 ‘The Importance of Stable Money: Theory and Evidence.’ Cato Journal 3(4): 63-82.

Buchanan, James M. 1983, ‘I limiti alla fiscalita,’ in La Costituzione Fiscale e Monetaria: Vincoli alla Finanza Inflazionistica, CREA, Rome.

Cagan, Philip 1986, ‘Competitive Monies: Some Unanswered Questions,’ Cato Journal 5(3): 943-7.

Dorn, James A. 1987, ‘The Search for Stable Money: A Historical Perspective,’ in James A. Dorn and Anna J. Schwartz, The Search for Stable Money, Essays on Monetary Reform, University of Chicago Press, Chicago.

Friedman, Milton 1953, ‘The Effects of a Full-Employment Policy on Economic Stability: A Formal Analysis’, in his Essays in Positive Economics, University of Chicago Press, Chicago.

Friedman, Milton 1961, ‘Real and Pseudo Gold Standards,’ Journal of Law and Economics 4, October: 66-79.

Friedman, Milton 1969, ‘The Optimum Quantity of Money,’ in his The Optimum Quantity of Money and Other Essays, Aldine Publishing Company, Chicago.

Friedman, Milton 1984, Market or Plan?, CRCE, Occasional Paper 1, London.

Friedman, Milton 1988, ‘Why the Twin Deficits Are a Blessing,’ Wall Street Journal Europe, 15 December.

Hayek, Friedrich A. 1945, ‘The Use of Knowledge in Society,’ American Economic Review 35, September.

Hayek, Friedrich A. 1976, Denationalisation of Money, Hobart Paper Special, 70, Institute of Economic Affairs, London.

Martino, Antonio 1990, ‘A Monetary Constitution for Europe?’, Cato Journal 10(2):519-533.

Meltzer, Alan H. 1991, ‘Is Monetarism Dead?’, National Review, 4 November: 30-32.

Pareto, Vilfredo 1896, Cours d’Economie Politique, reprinted in Vilfredo Pareto, Sociological Writings, trans. D. Mirfin and ed. S. E. Finer, London, 1966.

Simons, Henry C. 1936, ‘Rules Versus Authorities in Monetary Policy,’ in F.A. Lutz and L.W. Mints (eds) 1951, Readings in Monetary Theory, The American Economic Association, Richard D. Irwin, Homewood, Illinois.

Spinelli, F. and M. Fratianni 1991, Storia monetaria d’Italia, Mondadori, Milan.

Thornton, D.L. 1988, ‘The Effects of Monetary Policy on Short-Term Interest Rates,’ The Federal Reserve Bank of St Louis Review, May-June: 53ff.

Tullock, Gordon 1983, ‘Esiste una teoria generale della crescita dello statalismo?’, in La Costituzione Fiscale e Monetaria:
Vincoli  alla Finanza Inflazionistica, CREA, Rome: 35 ff.

Antonio Martino is Professor of Economics at LUISS University in Rome, a Member of the Italian Parliament and former Italian Minister of Foreign Affairs. A longer version of this paper was published in An Austrian in France: Festschrift in honour of Jacques Garello, 1997: La Rosa Editrice, Turin; reprinted by permission. Professor Martino will deliver the 1998 John Bonython Lecture in Melbourne on 21 October.

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