- Aaron Careaga
- Bellingham, WA
- United States
The Marginal Utility of Central Banking
Economists often discuss the marginal utility of goods and services. For instance, your second donut is less satisfying than the first and by the fifth donut the value of one additional donut is slim. With each passing donut the marginal value of another donut is small. The question we now pose is does monetary policy and by extension all central banking have a marginal utility curve, and if so what is the optimal amount?
On one extreme you get the popular mantra “Abolish the Fed”. Free market advocates often side here explaining that central bankers have a terrible track record throughout history and most often make the problem worse. The Nobel Prize winner Milton Freidman was an advocate for this style of monetary policy well before it was in fashion. He went on record saying we should do away with the Federal Reserve and instead tie interest rates to inflation. One of the primary strengths of this strategy is that excesses are quickly cleared from the system often through deflation and liquidation. Famed investor Jim Rogers explains simply that recessions are like small forest fires that clean out the system of excess. If the fire is prevented the kindling accumulates until a larger crisis occurs.
The major downside of a Fed-free model is that the economy and asset prices become extremely volatile. In fact, the process that often clears out excesses is an increase in either inflation, deflation, or both. These periodic shocks make corporate planning very difficult, which in turn would create a higher reluctance to hiring, leading to higher unemployment. Moreover, a more volatile economy would likely lead to corporations holding more cash (like we have now), which leads to underinvestment and sub-optimal efficiencies... (continued after jump)