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532 the non-politics of monetary policy

What dragged India down, compared to China, were special interest politics of the

kind that have been described by public choice theorists, including Mancur Olson in

Rise and Decline of Nations (1982) (Diamond 2005). Large public works projects that

were sold by politicians and run by bureaucrats were a magnet for bribes and special

interest handouts. Then again, as Amartya Sen pointed out in Poverty and Famines

(1981), democracies are less prone to man-made humanitarian disasters such as large-

scale famines. The last Indian famine—the Bengal Famine—occurred in 1943, under

British rule, and it killed three million people. China’s Great Leap Forward Famine of

1958–61 cost 30 million lives. Let us not burn democracy just yet—the ideal, clearly, is

economic and political liberalization.

The point I wish to make for now is that public choice dominates political economy

when it comes to explaining the comparative performance of China and India. Eco-

nomic liberalization combined with some degree of political stability (people need

to know that they can keep the fruits of their entrepreneurial eﬀorts) outperforms

political liberalization combined with central planning. This is Hayekian thinking

rather than Keynesian, and this is roughly the public choice credo: free the markets,

limit the government, put in place a couple of simple and transparent rules, and let

the people do their thing. In contrast, political economy comes across as fussing over

market failures and deriving “optimal” institutions that will surgically correct the

problem.

Interestingly, the developing countries that are in the ﬁrm grip of the economic

experts at the IMF and the World Bank, especially the countries in Africa, have

done spectacularly badly in comparison to China and India. This is not surprising.

Even as the idea of top-down control has lost currency in the world, and ideas of

decentralization and bottom-up governance have become popular, the IMF and the

World Bank operate on the tried and untrue principle of “government by benevolent

experts,” or “father knows best”—and it shows.

3 Vibrance and Ossification in Macro

Political Economy

.............................................................................

Against this background, we can now assess the contribution of the sub-ﬁeld of macro

political economy. Before we examine the political vulnerability of monetary policy,

we must cover an apolitical model that dominated the literature. Just as the larger

political economy program addressed not just government failure but also market

failure, macro political economy took as its starting point a model of market failure,

in which a benevolent dictator produces a counter-productive inﬂation bias. The

time-consistency problem in monetary policy was ﬁrst described by Fynn Kydland

and Edward Prescott in 1977, and it works as follows. Because nominal wage contracts

do not get updated continuously, a monetary stimulus, by decreasing the real wage,

susanne lohmann 533

increases employment and output. A benevolent dictator who would like to increase

employment and output above the level that would obtain “naturally” in the labor

market (that is, in the absence of government intervention) thus has an incentive

to inﬂate. Unfortunately, wage-setters understand this incentive and write an inﬂa-

tion mark-up into their nominal wage contracts. The inﬂation mark-up is just high

enough to give the benevolent dictator, who is also inﬂation averse, a disincentive to

create surprise inﬂation. In equilibrium, inﬂation is equal to the inﬂation mark-up

in the nominal wage contracts, which implies that the real wage, employment, and

output are all realized at their natural levels. The benevolent dictator’s attempt to

stimulate employment and output is thus futile; all he achieves for his eﬀorts is an

inﬂation bias equal to the inﬂation mark-up.

One institutional solution would be for the benevolent dictator to tie his hands by

committing to a monetary or inﬂation target. A ﬁxed target, however, undercuts the

stabilization role of monetary policy: sticky prices imply that monetary policy can

oﬀset the eﬀects of real shocks to the economy.

Kenneth Rogoﬀ in 1985 oﬀered an institutional solution that traded oﬀ the goal

of controlling inﬂation against the goal of stabilizing the real economy. The benev-

olent dictator could tie his hands by delegating monetary policy to an independent

conservative central banker who places a higher weight on the inﬂation goal. The

wage-setters, upon observing that an independent conservative central banker is in

charge of monetary policy, would write a lower inﬂation mark-up into their wage

contracts.

Delegation to a conservative central banker comes at a cost, however, namely that

the conservative central banker, precisely because she places a lower weight on the

output stabilization goal, under-responds to real shocks. The deadweight cost of

delegation is low for small shocks and high for extreme shocks. A huge literature

followed up on Rogoﬀ to propose commitment devices that would improve the trade-

oﬀ between the inﬂation and stabilization goals of monetary policy, that is, allow for

some degree of commitment to low inﬂation (enough signiﬁcantly to lower people’s

inﬂation expectations) along with some degree of ﬂexibility especially when extreme

output shocks are realized (to stabilize the economy when it most hurts). Thus,

Susanne Lohmann in 1992 proposed that the optimal institution consists of a partially

independent conservative central banker who will accommodate political pressures

when extreme shocks hit the economy. Other solutions consist of an exchange rate

target with an escape clause; multiperiod monetary targets with optimal targeting

horizons; and optimal contracts for central bankers (Flood and Isard 1989; Garﬁnkel

and Oh 1993;Walsh1995).

Let me turn to models of the political vulnerability of monetary policy. Monetized

economies are politically vulnerable for two reasons. The ﬁrst consists of the incentive

to fund government spending with increases in the money supply; the second, of the

incentive to inﬂate to increase employment and output.

First, political pressures for government spending can translate into an excessive

use of the money printing press. Government spending can be ﬁnanced in three

ways: taxing, borrowing, or printing money. If voter resistance places limits on tax

534 the non-politics of monetary policy

increases, and ﬁnancial markets or balanced budget rules place a limit on borrowing,

then government spending will quickly translate into inﬂation, or even hyperinﬂation

(Buchanan and Wagner 1977).

Political pressures to spend take on two forms, opportunistic and partisan. An

opportunistic government might want to dole out special interest handouts just

before the election to increase its chances of staying in power. Alternatively, the

political party in power might be beholden to a partisan constituency that gains from

certain kinds of government expenditures, such as farmers’ associations or teachers’

unions.

The second source of political vulnerability consists of sticky prices, or contracts

denominated in nominal currency that are not inﬂation indexed and cannot be

quickly adjusted. By inﬂating, the government can devalue such contracts.

Once again, the vulnerability can take opportunistic or partisan form. The gov-

ernment might have an incentive to stimulate employment and output before the

election to improve its chances of re-election. Alternatively, one political party might

be beholden to a group that beneﬁts from easy money even as its opponent political

party represents sound money interests. For example, in nineteenth century America,

easy money beneﬁted farmers because it reduced the real value of their debt, and so it

will not surprise you to hear that banking and commercial interests stood for sound

money; the Democratic Party represented the former interests, the Republican Party,

the latter.

These two motives—opportunistic and partisan—were picked up by two models.

The ﬁrst one is due to William Nordhaus, who in 1975 coined the expression “political

business cycle.” He proposed that policy-makers increase the money supply before

elections to stimulate employment and output and thereby improve their re-election

prospects. The Nordhaus model was rationalized—that is, reformulated in a rational

equilibrium model—by Kenneth Rogoﬀ and Ann Sibert in 1988.Rogoﬀ and Sibert

triggered a huge follow-up literature that worked out their argument in further detail

and spelled out institutional solutions.

The impetus for the rationalization originated in the internal dynamics of the

scientiﬁc-literature life cycle, or the move from public choice to political economy.

What does “rationalizing Nordhaus” entail? It requires, ﬁrst of all, replacing adaptive

inﬂation expectations with rational expectations. Adaptive expectations are mechan-

ically updated: the wage-setters’ period t expectation of period t + 1 inﬂation is a

linear combination of the period t − 1 expectation for period t and the period t

realization. Thus, if period t + 1 is a pre-election period, the wage-setters will be

surprised by the pre-election monetary stimulus. Given their mechanical updating

rule, they will then expect a higher inﬂation rate for the post-election period t +2—

only to be surprised again. This is a mess, obviously. Rational expectations are based

on a correct understanding of the model: wage-setters expect inﬂation to be higher in

period t + 1 if it is a pre-election period and lower if it is not.

Next, the assumption of sticky wages implies that the policy-maker can stimulate

employment and output. Once again, rational expectations imply that wage-setters

cannot be systematically fooled, and so wage-setters will write an inﬂation mark-up

susanne lohmann 535

into their wage contracts. Meanwhile, the rationality assumption implies that voters

cannot be fooled in equilibrium—why should they vote for a policy-maker whose

futile and opportunistic attempt to stimulate employment and output yields an in-

ﬂation bias? The (theoretical) answer is that unobservable policy-maker competence

aﬀects the real economy. Thus, the policy-maker has an incentive to stimulate the real

economy to fool the voters into believing that she is more competent than she truly is.

In equilibrium, the voters see through this incentive and anticipate the pre-election

monetary stimulus and its eﬀects on employment and output. Even though monetary

stimulation is futile in equilibrium, the policy-maker is “forced” to go through with it

because the voters expect it; a policymaker who fails to meet the voters’ expectations

will decrease employment and output relative to what the voters expect and thus

come across as incompetent—and lose the election.

The opportunistic attempt to stimulate employment and output is necessarily

futile in equilibrium, as a consequence of the rationality assumption, and it gives rise

to a pre-election inﬂation bias over and above the standard inﬂation bias (the latter is

due to the standard time-consistency problem in monetary policy).

Rational inﬂation expectations and voter rationality thus imply that pre-election

monetary stimuli are futile and damaging, which in turn means that the policy-

maker has an incentive to tie her hands. Not only does the policy-maker want to

prevent herself from creating an opportunistic political business cycle; she needs the

voters to know that her hands are tied. The policy-maker could, for example, delegate

monetary policy to a central banker who shares her monetary policy goals but not her

re-election goal. This can be achieved, for example, by granting the central banker a

term in oﬃce that is longer than, or staggered relative to, the policy-maker’s term in

oﬃce (Lohmann 1998b).

The second political business cycle model is due to Douglas Hibbs who in 1977

oﬀered a partisan variant whereby two political parties represent two constituencies,

one of which prefers an easy monetary policy, or high inﬂation, the other a sound

monetary policy, or low inﬂation. As the parties succeed each other in power, mone-

tary policy will ﬂuctuate over time for reasons unrelated to economic fundamentals,

in tune with the partisan control of the government. Alberto Alesina in 1987 redid the

Hibbs model by replacing adaptive inﬂation expectations with rational expectations.

His contribution, too, triggered a huge follow-up literature.

In the partisan case, the willingness of the two parties to commit to a monetary

institution that will implement an intermediate monetary policy in place of the

partisan political business cycle depends on the time horizon of the two parties. If

their time horizon is very short, say, if the party in oﬃce cares only about the current

period, then the party in oﬃce would have no incentives to give up the power to

set monetary policy. If both parties have long time horizons, then they can reach

a consensus to lock in the intermediate policy. This can be achieved, for example,

by setting up an independent central bank with a council that reﬂects the all-party

consensus (Lohmann 1997;Waller1989, 1992).

Once behavioral and experimental economics hit the system, the rationalization

obsession of macro political economy seemed misplaced. Inﬂation expectations are

536 the non-politics of monetary policy

surely less than fully rational, and the assumption of voter rationality is arguably ﬂat-

out wrong.

Even so, macro political economy was hugely inﬂuential, and its rationalization

obsession played to its inﬂuence, but the exact way in which this happened is rather

more convoluted than meets the eye. A useful precedent can be found with the mon-

etarist revolution. In the 1960 and 1970s, monetarists proposed monetary targeting

rules arguing that monetary policy matters rather than ﬁscal policy (their Keynesian

opponents argued the opposite) and that stabilizing the money supply would serve

to stabilize employment and output (ditto) (Mayer 1998). In other words, monetary

targeting rules were celebrated for their economic properties and not their political

properties. The reason why policy-makers adopted monetary targeting regimes in

the 1970s, however, was because in the oil price shock era monetary targeting rules

turned out to be a useful political device to fend oﬀ political pressures to inﬂate. In

the political implementation of monetary targeting rules, their political properties

prevailed.

And so it went with macro political economy. The message that ﬁltered through

to policy-makers and central bankers was that money cannot systematically raise

employment and output. Moreover, political attempts to stimulate employment and

output are futile and damaging—all they do is create inﬂation. For this reason, policy-

makers themselves are better oﬀ delegating monetary policy to an independent cen-

tral bank. Macro political economy thus made a successful case for the depoliticization

of monetary policy.

The astonishing nature of this success becomes clear once you understand that

essentially the same arguments apply to ﬁscal policy (the time-consistency problem

and opportunistic and partisan political business cycles), and yet it is unthinkable for

democratically elected policy-makers to give up the power to tax. In monetary policy,

macro political economy made the unthinkable thinkable, and more: turned it into

conventional wisdom.

But if macro political economy successfully depoliticized monetary policy, the

question is how monetary institutions that emerged in an era of depoliticization will

cope when distributional conﬂict returns to monetary policy. Let us take a closer look.

4 Total Special Interest Gridlock

.............................................................................

One looming challenge consists of the rise of intergenerational distributional conﬂict

in the developed countries and between the developed and developing countries.

In the developed countries, the proportion of older people, including the retired

population, is ever increasing relative to the proportion of younger people, including

the working population. Older people are formally entitled—“entitled on paper,” that

is—to an ever greater share of GDP.

susanne lohmann 537

The redistribution from the young working population, which produces the GDP

pie, to the older retired population can be implemented through taxation. For

example, the government might ask workers to pay social security contributions,

which are then used to fund social security payments to retirees; or state govern-

ments might tax workers, and the tax revenue is then used to pay for state employee

pensions. But if there are too few workers producing the GDP pie and too many

retirees holding paper entitlements, the levels of taxation that are necessary to eﬀect

the redistribution will end up conﬁscatory and economically infeasible. (Workers

will not simply continue working if, say, 95 per cent of their earnings are taxed

away—they will work fewer hours, or participate in a worker riot, or emigrate to

another country.)

Something will have to give, and the question is what role monetary policy will

play in all of this. Monetary policy can, among other things, aﬀecttherealvalueof

entitlements that are denominated in nominal currency and not indexed to inﬂation.

The precise distributional eﬀects of monetary policy depend in detail on which kinds

of assets older people hold, which of those assets are indexed, and so on. Moreover,

there may well be distributional eﬀects within the group of older people, for example,

because the rich and the poor among them hold diﬀerent kinds of assets or are

protected from inﬂation to diﬀerent degrees. My purpose here is not to spell out the

redistributional eﬀects of monetary policy in detail. It is simply to say that because

monetary policy is such a powerful tool of redistribution, monetary policy is likely to

get dragged into the distributional conﬂict over the split of the GDP pie between the

working population and the retired population.

If one part of the problem concerns the distribution of the GDP pie between the

young and the old, the other part has to do with government spending on social

security, health care for older people, and state employee pensions. If biotechnology

increases lifespans to 120 years, then it will not help to increase the retirement age

by a couple of years at the front end when at the other end people will be spending

more time in retirement than they spent in the labor force. There will be pressures for

government spending to beneﬁt older people even as there are limits on the govern-

ment’s ability to tax and borrow, which translates into (you guessed it) pressures to

print money. Once again, it appears inevitable that monetary policy will get dragged

into this distributional conﬂict.

The deeper reason why an aging population is such a serious problem for advanced

democracies is because of the disconnect between the economic and the political

sides of the equation. On the economic side, there is no alternative to reneging

on the promises made to older people, at least to some degree. Reneging can take

various forms—increasing the retirement age, inﬂating away nominal entitlements,

outright default, and so on. Diﬀerent forms of reneging have diﬀerent political and

social costs, and the question is, what is the “least disastrous policy mix” taking into

account the welfare of young and old alike? On the political side, however, older

people will constitute a powerful voting bloc—there will be ever more of them; their

participation rates in elections are way above average; they have relatively homoge-

neous interests compared to the young working population; they are relatively well

538 the non-politics of monetary policy

informed, especially about the issues they care about (social security, health care);

and in the United States they are exceedingly well represented by the American

Association of Retired Persons (AARP), which is one of the most powerful lobbies in

Washington, DC.

And make no mistake—older people are attached to their entitlements, and they

will not let go of them without a (political) ﬁght. It is no good to say that older people

have no needs because their mortgages are paid oﬀ—aswespeak,theneedsarebeing

created. People disproportionately make use of the health care system when they are

old. Technological progress translates into expensive high-technology medicine—and

once it is available, there will be a demand for it. Health care for older people also

has a labor-intensive component, and labor-intensive services are subject to Baumol’s

disease. (The relative cost of delivering services in labor-intensive industries increases

over time as other industries experience technological progress, employ labor-saving

devices, and realize cost savings (Baumol and Bowen 1966)). And once older people

live longer, they will want to get a life, which includes cosmetic surgery and second

homes in warm places.

With such a powerfully united special interest group in place, it seems quite

unlikely that the political system will be capable of reneging in the least disastrous

way on promises made to older people. More likely, aging democracies will respond

to the impossible tension between the economic and political sides of the equa-

tion by postponing hard decisions and remaining mired in total special interest

gridlock.

What are the implications for money and central banking? On the one hand,

monetary policy must help society avoid the non-solution of special interest gridlock,

and it must contribute its share to the least disastrous policy mix; we can deplore

inﬂation, but the question is: how destructive are alternatives such as outright default?

On the other hand, monetary policy must remain aloof from counter-productive

political pressures. How to square the circle? We do not know, and this is precisely

why we need to develop a research base.

Intergenerational distributional conﬂict is ﬁrst of all a domestic problem, but it

does have international dimensions; ﬁrst, because older people can disportionately be

found in the developed countries, younger people, in the developing countries; sec-

ond, because chronic American trade deﬁcits imply that foreigners are accumulating

formal entitlements to slices of future American GDP pies. Here, monetary policy can

aﬀect the real terms of trade and the real value of the entitlements held by foreigners

by inﬂuencing real exchanges rates, capital movements, bond prices, and the like.

There is an obvious political incentive to bring relief to the domestic redistribution

problem by “taxing” foreigners. Here, too, monetary policy will inevitably get sucked

into the distributional conﬂict.

Let me move on to another international threat that arguably requires cross-

country collaboration and international institution-building. Many of the institu-

tions in place today, such as the European Central Bank and the IMF, emerged in an

era of (relative) peace and quiet. Are they equipped to deal with extreme unforeseen

contingencies on the scale of, say, the Great Depression?

susanne lohmann 539

5 The Poverty of International

Institutions

.............................................................................

To ﬁx ideas, imagine you could enter a time machine and return to the year 1900

to what was then the center of the world—western Europe. Looking back from the

vantage point of 1900, you will encounter a couple of proud nations that have just

experienced a century’s worth of immense technological progress and an increase in

material standards of living for which there exists no historical precedent. Now imag-

ine you could tell the policy-makers of that era what to watch out for in monetary

policy and central banking. What will you tell them?

Let us take a look what lies ahead. There is, ﬁrst of all, the Great War (later

renamed the First World War after it was followed by an even greater war). It was

funded, in part, by war bonds whose value was subsequently eroded by inﬂation. In

the aftermath of the First World War, the Weimar Republic responded to reparation

demands by printing money, which led to a hyperinﬂation that impoverished and

embittered the German middle class, which largely supported Hitler. The result was

the Second World War and the Holocaust. Meanwhile, Britain returned to the gold

standard at the pre-war parity—a stupid move that created economic hardship and

for no obvious gain. Ill-conceived monetary theory and policy contributed to the

Great Depression in the United States—which spread across the world and sank

the system of international trade. The resulting worldwide depression contributed

to the rise of Hitler.

Meanwhile, in eastern Europe, we ﬁnd the Russian Revolution and the Gulag.

Today, as we celebrate the supposed end of history, capitalism and liberal democracy

having won out, it is easy to forget that the big ideological debate of the ﬁrst half of the

twentieth century was about capitalism versus socialism versus fascism (Fukuyama

1992;Caldwell2003). People from all walks of life—not just the communists in the

Soviet Union—believed that capitalism is inherently unstable and requires central

planning to make it work; that the extreme inequities created by capitalism are

immoral and require for their correction massive government intervention; and that

capitalism contributed to the rise of fascism.

At the end of the Second World War, F. A. Hayek’s ideas, as expressed in The

Road to Serfdom (1994/1944), were seen as practically criminal, and they spelled

professional death among economists. Hayek proposed that central planning was

unworkable because central planners, as opposed to markets, cannot hope to pick up

all of the distributed information they need to make good decisions; that government

intervention, especially the surgical type, as opposed to the type that stands for the

rule of the law, tends to make things worse; and that National Socialism is a form of

socialism, and not a consequence of capitalism. It would take close to half a century

before the Berlin Wall fell, and Hayek’s ideas triumphed over John Maynard Keynes’s.

In the second half of the twentieth century, western Europe was, blissfully, at

peace. The process of European integration included repeated pushes for monetary

540 the non-politics of monetary policy

integration: after the gold standard broke down, there emerged the European Snake,

the European Monetary System, European Monetary Union, and the European

Central Bank. Economists, by and large, opposed ﬁxed exchange rate regimes and

monetary union. Voters in many countries, especially Germany, were negatively dis-

posed towards a common currency and central bank. But policy-makers like Helmut

Kohl pushed ahead against both expert and voter opinion. By any reasonable mea-

sure, Kohl’s actions were non-opportunistic and non-partisan. They were motivated

by the idea that the peoples of Europe, who over the centuries have gone to war

with each other to the tune of 100 million lost lives (give or take a couple of tens

of millions), will ﬁnd peace if they are tied together by a common set of institutions,

including a common currency and central bank.

Kohl may well be right, and the issue here is not just war. The issue is that any

extreme event that will require a coordinated response on the part of the European

countries will now meet upon an elaborate set of institutions that can deliver such

a response. This is not to say that the institutions of the European Community and

European Monetary Union are a pretty sight—they are cumbersome and costly, and

impossibly bureaucratic. It is simply to say that they will probably help avert large-

scale disaster in Europe.

Today, the center of the world is the United States. We can look back at a century’s

worth of immense technological progress and an increase in material standards of

living for which there is no precedent in history. But just as in 1900, if you look

carefully, you can see portents of trouble. Religious conﬂict looms large within the

United States and between the United States and Islam. Globalization is running

strong—and so are extreme inequalities within and between countries, and not to

forget identity politics and ethnic conﬂict. The Internet is creating unprecedented

amounts of public information, but all of this public information is not exactly cre-

ating “one world,” nor is it making people more tolerant. On the contrary, as people

emigrate into chatrooms and virtual worlds, they self-select into like-minded groups

that serve as echo chambers for their opinions. Religious and ideological conﬂict has

not come to an end, and there is no guarantee that history is ever upward lifting.

We cannot tell for sure what the twenty-ﬁrst century will bring us, obviously, but

we can say with a high degree of certainty that something extreme will happen. The

occurrence of further international ﬁnancial crises is almost a given, but there is so

much more that can happen, and much of it will require a coordinated monetary

policy response. What if the global spread of a contagious disease triggers a global

economic meltdown? What if global climate change leads to a sudden immersion un-

der water of whole countries, or parts of countries, which in turn leads to large-scale

population movements? What if a war breaks out driven by religious and ideological

conﬂict over the distributional eﬀects of globalization? And what will happen to

people’s ideas about capitalism and liberal democracy when the global economic and

political system comes across as grossly dysfunctional—and what will happen when

policy-makers act on the people’s ideas? Are our international institutions equipped

to respond adequately to extreme events, including ideological clashes over the way

the world works?

susanne lohmann 541

In the early 1990s the International Monetary Fund (IMF) promoted reforms to

liberalize capital and ﬁnancial markets in east Asia that probably aggravated, and

possibly caused, the 1997 crisis. Once the crisis was up and running, harsh policy

measures prescribed by the IMF probably contributed to the spread and severity

of the crisis. Ill-conceived macroeconomic theory met upon a poorly devised in-

ternational institution, and the result is a repeat performance, now at the interna-

tional level, of what we observed in the domestic sphere in the early nineteenth and

twentieth centuries.

What kinds of institutions are needed? Three characteristics are essential. First,

institutions must support an internal diversity of ideas and links to intellectual

communities so they can pick up on competing theories about the way the world

works. They must support elaborate internal collective decision-making processes

that are capable of synthesizing conﬂicting ideas and moving the synthesis to the ﬁnal

decision-makers. (For example, lower-level staﬀ might make a recommendation but

attach to it minority opinions that serve as red ﬂags.)

Second, institutions must have local listening posts allowing them to ﬁgure out

what is happening “on the ground” and to pick up on failures of conventional

wisdom. This information, too, must be synthesized and moved to decision-makers.

Third, institutions must develop external connections such that their decisions

reﬂect the preferences of the peoples whose economic fortunes lie in their hands,

and their decisions follow the people’s preferences when those preferences change.

In short, institutions must be politically responsive. And yet at the same time, the

precise way in which they are politically responsive must allow them to resist counter-

productive pressures (time-consistency problems, special interest gridlock, and

the like).

If it sounds like an impossible task to design such institutions, the answer is that

this is an impossible task for top-down institutional design. In well-functioning

democracies, such institutions can evolve, and have evolved, in interplay with the

pressures emanating from various political and economic actors and institutions. As

a result, domestic monetary institutions have the characteristics listed above, at least

in approximation.

The Federal Reserve System is a case in point. The geographically distributed

district banks, which are somewhat beholden to local interests, represent some degree

of intellectual and geographical diversity. The district bank presidents and their staﬀ

serve as local listening posts. There are elaborate internal processes in place by which

diverse ideas about the way the economy works move to the decision-making center

in Washington, DC, and by which distributed information is aggregated. Meanwhile,

there are equally elaborate political processes in place—powers of appointment and

budget approval, congressional hearings, and the like—by which the Federal Reserve

is forced to attend to its political principals, who in turn are electorally connected

to the people. Those political processes are sophisticated enough to include lags and

buﬀers and political costs, as a result of which the president and Congress cannot

simply reach into the Federal Reserve and order it to do their bidding, at least not

instantaneously and in full (Lohmann 2003b).