Essays on the Political Economy of Monetary Institutions and Policy

Alexander William Salter

Advisor: Lawrence H White, PhD, Department of Economics

Committee Members: Richard E. Wagner, Peter T. Leeson

Enterprise Hall, #418
October 17, 2013, 02:00 PM to 11:00 AM


The microfoundations revolution in macroeconomic theory has almost entirely displaced the hydraulic Keynesianism of old. Nonetheless, monetary policy in mainstream models is still primarily concerned with the appropriate estimation of changes in output and employment following the manipulation of short-term interest rates. There is little consideration of whether policymakers--or the individual agents whose behavior they are attempting to influence--possess the knowledge or incentives necessary to act in the way prescribed by the models.  My dissertation addresses these concerns on three separate margins.

In “Robust Political Economy and the Lender of Last Resort,” I apply the standard of robust political economy to the three chief versions lender of last resort doctrine (hereafter LLR) has historically taken: Bagehot’s rules, open market operations only (Richmond Fed doctrine), and any actions necessary to stop financial contagion (New York Fed doctrine).  I compare each to the mechanisms to prevent financial panics that developed in free banking systems.  Robust political economy questions how institutions function to solve social dilemmas even in unfavorable knowledge and incentive environments; if social cooperation breaks down in the presence of deviations from the ideal of perfect information and sufficient altruism, then the system is not robust.   I conduct an ordinal ranking of LLR, based on the robustness criteria outlined above.  I conclude that market-based LLR responses, because they are based on profit-seeking residual claimants acting on the basis of their local knowledge, are more robust than responses that place LLR responsibility in a public authority.

In “Is There a Self-Enforcing Monetary Constitution?” I extend robustness considerations to the search for desirable monetary rules.  A self-enforcing monetary constitution is one whose rules do not require sovereign enforcement and therefore do not rely on the wisdom and virtue of the sovereign.  Agents in the market uphold the rules, even when they have realistically imperfect knowledge and selfish incentives.  I discuss two radical alternatives to current monetary institutions—a version of NGDP targeting that relies on market implementation, and free banking—that represent self-enforcing monetary constitutions.  To evaluate such proposals we go beyond monetary theory narrowly conceived and consider insights from constitutional political economy.

In “A Theory of the Dynamics of Entangled Political Economy with Application to the Federal Reserve,” I present a framework that explains the dynamics of entangled political economy, illustrating how, over time, a public authority (the Fed) interacting with private organizations (banks and other financial businesses) results in the public authority “exporting” its logic of orderings to the private institutions.   This blurs the distinction between private and public organizations, resulting in unintended and undesirable consequences.  Distorting the boundary between public and private organizations results in incentives that encourage the worst aspects of both, such as rights to profits remaining in the hands of private claimants, but the burden of losses being passed on to the taxpaying public.   This framework, while yielding conclusions similar to the regulatory capture story of traditional public choice economics, highlights aspects of the interaction between public authorities and public organizations that only an emphasis on the process of entanglement can reveal.