At the very least, I think government should get out of the rate-setting game.
Interest rate-setting is a crucial function of the private market. It is by this mechanism that we arrive at the price of debt and investment. Too low a price and you encourage more debt and speculation. Too high a price and you kill the market itself. Is this crucial mechanism market mechanism best served by leaving it up to the will of unelected technocrats? People who insist on 'independence' and non-accountability of action? How does the general public even know why they arrive at the decisions they do? Why do they keep on lowering rates when there is too much debt and speculation in the market already? Why would they suddenly jack up the rates just when the real businessmen are starting to undertake long-term investment? When they have to make a decision where the interest of a few large capitalists are in conflict with the interests of a larger but more diffuse set of businessmen, whose interest prevails in the end?
In short, do central bankers really have a positive value to the efficient rate-setting of the market? My gut says not really. More often than not, we've seen government intervention in this area only creates speculative bubbles and unnecessary recessions, which would have otherwise been avoided, if government had only let the market decide the price level of interest rates. This control of the monetary rates subjects the entire economy's price level and inflation and deflation on the whims of a few technocrats with little or no accountability to the people. The only use I see for ceding private sector control to the government is to use this as an international trade war weapon.
Central bankers have always said that they do not have any control over bubbles. When humans want to believe in something, they can make it so. If they believe that something will go up in value, then it will go up in value, low rates or not. If central banks cannot cause bubbles, as they have always said, from Greenspan on to Bernanke, then they cannot also do anything to burst them. If rate setting and quantitative easing do not affect the market , then what is the purpose of giving central banks the lever that can influence human beliefs? Haven't we seen that QE2's objective is precisely to influence the beliefs of the market? QE2's plan after all was to cause the price of financial assets to appreciate, because this makes people feel they are wealthier, and therefore more open towards purchasing more. QE2's intended mechanism is that rising monetary base increases inflation expectations, such that people begin to purchase things now rather than later. But instead of causing more purchasing velocity in the real economy, QE2 instead jacked up speculation.
From the time of Greenspan, we've seen how central bank rate-setting can unduly affect how the market speculates. The process has always been – lower interest rates – bond investors hunt for higher yield (more risk) and this leads to a bigger bubble than without the lower rates, as speculation is now turbocharged by greater leverage. When the bubble deflates, the losses are larger, and the downturn is steeper, as investors take stock of their losses and deleverage. As we saw during QE2, we saw that central bank rate-setting can actually disrupt the market,even at the zero level bound. At the end of the day, the central bank looks nothing more than a glorified asset price jockey.
And then, if we are to believe the all-encompassing usefulness of monetary policy to pick up the pieces each time a bubble bursts, we should believe that monetary easing should always do the trick. Will we reach to QE9? QE10? After all, if we truly belive there’s no problem that can’t be solved by lowering nominal interest rates, throwing more money into the economy (and thereby lowering real rates into negative territory) then it doesn't make sense to believe that we will ever reach a point where this doesn't work or make sense any more. Either it really works, or it never really worked. More likely, it only seemed to work, while delaying the inevitable, by 'kicking the can down the road' and extending the bubble until the next central banker ends up with a bigger mess.
The central bank should just set and maintain a fixed rate for its discount window. If the securities and commodities investment markets are becoming frothy and possibly bubbly, that should have nothing to do with the reality of the real economy businessman's world, and should be separated in the central banker's decision-making process of whether to burst that possible bubble. The discount rate could be kept steady while just going after the offending speculators, and imposing more taxes and regulatory overview on that particular offending sector only. Everybody else shouldn't be made to suffer just because a bunch of hooligans are trying to game their particular market to make a little more money.
I could be persuaded by the suggestion to just abolish the Central Bank. If we do away with the central bank altogether, its function of money issuance can be integrated with Treasury, thereby doing away with a possibly unnecessary layer of bureaucracy and possible loss of transparency and accountability. Some MMTers have already written on this.
If it stays, its most useful function would be just to ensure that private players keep playing by the rules (play fair) and follow macroprudential controls, so they don't develop dangerous bubbles all by themselves. We should start focusing more on what macroprudential controls should be in place once instead, so that private sector-led bubbles do not get out of hand either.
The central bank needs to be a stronger regulator. If we want borrowers and small investors to be protected from the vagaries of the market, it has to step up. If a certain level of rates can influence the creation of bubbles (and I believe this to be so), and the effect is transmitted in the market via financial entities that are beyond central bank purview, such as money market funds, hedge funds, pension and insurance funds, shouldn't it then be regulating everybody else's speculation/investment activities?
I'm not yet clear on its keeping the lender of last resort function. This function is important in preventing some bank failures from developing into full-blown systemic crises, but if it encourages moral hazard, this function becomes self-defeating. If a central bank can ensure individual players always follow macroprudential rules, a lender of last resort will be barely necessary. In those few times when there's a failure of regulation, we should penalize both the regulated, and to some extent, the regulator.
Proving the regulator could see the failure coming will always be the tricky part though. But the posibility of being penalized should concentrate the minds of the regulator. And if the regulator is being paid a salary commensurate to what he's doing, i.e., a salary similar to those he's supposed to be regulating, we should have no problem retaining highly-competent regulators who are constantly on top of what the private sector financiers are doing. But this is a discussion for a separate time.