Why John Taylor might be a good choice for Fed chair

I’ve done a few posts expressing opposition to Kevin Warsh being nominated to chair the Fed.  Now there are rumors that John Taylor’s stock is rising:

Stanford University economist John Taylor, a candidate for Federal Reserve chairman, made a favorable impression on President Donald Trump after an hour-long interview at the White House last week, several people familiar with the matter said.

Former Fed board governor Kevin Warsh has meanwhile seen his star fade within the White House, three of the people said. They would not say why but Warsh’s academic credentials are not as strong as other candidates, and his tenure on the Fed board has been criticized by a diverse group of economists ranging from . . . [obscure nobodies] . . . to Nobel laureate Paul Krugman.

I had several problems with Warsh.  He doesn’t have expertise on monetary economics, he didn’t do well during his stint at the Fed, and I worried that he might be more “political” than Bernanke and Yellen.

I have much less concern about Taylor.  I believe that Taylor (and most other conservatives) missed the boat during the Great Recession, and was excessively worried that QE would lead to high inflation.  But he is also extremely smart and well-qualified, and a person who is likely to keep the Fed out of politics.  While the Taylor Rule is not the specific policy I favor, he’s a strong advocate for a rules-based approach.

Here’s why I think Taylor might be a good choice, despite my reservations about the Taylor Rule:

1.  Fed chairs are generally not dictators, but work with a very well entrenched Fed establishment.  Thus I would not expect Taylor to come right in and install the Taylor Rule.

2.  Point one might seem like a weak argument in his favor, but I’m also thinking about the fact that the current Fed is not sufficiently rules-based.  If Taylor and the Fed met halfway, it might well be a policy I could support wholeheartedly. In other words, I see Taylor as someone who might nudge the Fed toward a more rules-based approach.

3.  The Fed has a 2% inflation target, and I’d expect Taylor to take that target quite seriously.  Thus I’m not all that concerned about whether policy is “hawkish” or “dovish”, I want a more stable monetary regime.  It’s not the end of the world if core inflation average 1.8% instead of 2% over the next 10 years (although I’d prefer they hit their targets), but it would be really bad if the core inflation rate became highly unstable, and also procyclical.

4.  If (as I expect) Taylor were not able to immediately install his preferred policy rule, I believe he’d look to make progress in other areas.  One obvious choice would be to adopt some of the accountability measures that I have advocated.  These would make policy more disciplined and rules-based, without going all the way to a rigid mechanical formula.  Policymakers would have to provide a clearer sense of what macroeconomic outcomes they are trying to achieve, and how they see their instrument setting enabling those outcomes.

5.  Another possibility is Bernanke’s modified price level targeting proposal, which would make policy more accountable and rules-based at the zero bound.  That sort of policy would have reassured conservatives who worried about the risk of high inflation back in 2010, while actually providing additional stimulus.  Under level targeting there is basically no long-term inflation risk. Also recall that Taylor said good things about NGDP targeting during the 1980s, so that’s another possible direction for reforms.

To summarize, rather than think about a new Fed chair in isolation, we should think about the outcome of the new chair interacting with the existing structure of the Fed.  In the post title I said Taylor “might” be a good choice.  In this sort of area one can never be certain, but my instincts tell me that he’d nudge the Fed a few degrees toward a rules-based policy approach, which is exactly what the Fed needs.

PS.  Don’t take this post as an endorsement of Taylor as my first choice, rather I’m responding to the perception that I would oppose Taylor.  Not true.

The crybabies who blamed economists for not predicting the financial crisis

Back in 2008, it seems like everyone from the Queen of England on down was blaming economists for not predicting the financial crisis.  I seem to recall that Bob Lucas pointed out that economic theory explains why economists cannot predict financial crises, so our failure to do so was a feather in the cap of modern economic theory.  I also seem to recall that lots of people rolled their eyes at his seemingly too clever excuse.

In the past I’ve argued that Lucas was exactly right, but in this post I’ll assume he was wrong.  I’ll assume the EMH is wrong.  Even in that case I’m going to argue the complaints were silly, just a bunch of crybabies.

So how do I respond to those people who are moaning that we didn’t warn them that a crisis was coming?  One answer is that some economists, such as Nouriel Roubini, did issue warnings.  But then the crybabies might respond, “But most economists didn’t warn us.  How were we to know that he was the one to listen to? The economics profession as a whole should have issued a warning, so that it was unambiguously clear to the public that a financial crisis was coming.”

To summarize, a few economists did warn the public, so the crybabies’ lament only makes sense if you assume that these people wanted the profession as a whole to offer a clear credible warning to the public.  Something that would be believed.

Were you the sort of person who believed in Santa Claus, and thought he would bring you a fairytale castle floating on a cloud, with unicorns prancing about in front?  If not, why would you make such a patently unrealistic demand of the economics profession?

You wanted us to warn you that a big financial crisis was coming so that you could sell all your stocks before they went down?  I ask this because a prediction of a severe financial crisis is implicitly also a prediction of a massive asset price collapse.  So the people complaining that economists didn’t predict the financial crisis are (whether they know this or not) effectively complaining that economists didn’t warn them that their 401k plan was about to lose a few hundred thousand dollars.

Let’s suppose we have a time machine and economists from October 2008 can go back 6 months in time, to April 2008.  They are told to warn the public that a massive financial crisis is coming in the fall.  They warn the public that Lehman won’t be bailed out, and its failure will trigger a rush for liquidity and a Great Recession.  What exactly would that warning have done, other than move those events up 6 months in time?  Then the crybabies would have asked why we didn’t warn them in October 2007 (assuming they didn’t lynch the economists for causing the crash.)

And as for those stocks you were going to sell if economists had warned you of the crash—just who did you plan to sell them to?  And at what price?

A better argument is that the economics profession didn’t warn the public that public policy was creating excessive lending, as Fannie and Freddie and FDIC and TBTF were creating moral hazard.  In fact, I did warn people I met about this problem (but I completely failed to forecast the financial crisis.)  Some other economists also warned about moral hazard, but not all.  But no one wants to listen to a bunch of killjoy economists on public policy questions.  It would be like blaming economists for tariffs, or rent controls.

When I explain to non-economist commenters what economic theory tells us about some public policy, they almost universally blow off my advice, unless it coincides with their pre-existing view on that particular public policy.  No one cares what economists think, so don’t blame us for areas where we have no control.  (Monetary policy is a different case; there the economics profession actually deserves far more blame than it’s gotten from the public.)

PS.  I see that Trump threw a temper tantrum when his aides told him that Iran had been adhering to the nuclear agreement.  We now have an administration with no ability to negotiate because no one trusts them to keep their word.  The focus of his top aides is not dealing with foreign crises but rather managing unnecessary crises created by an out of control and mentally ill president.  North Korea knows we’ll renege on any agreement we sign with them, and so a nuclear deterrent is their only option.  Meanwhile they show their population images of Trump threatening to destroy their country.

Meanwhile Trump has abandoned the utilitarian approach of the Obama administration and the slaughter of innocent civilians has been skyrocketing:

Airwars reports that under Obama’s leadership, the fight against ISIS led to approximately 2,300 to 3,400 civilian deaths. Through the first seven months of the Trump administration, they estimate that coalition air strikes have killed between 2,800 and 4,500 civilians.

Trump seems like excellent black comedy to me, but unfortunately there are lots of dead women and children for whom he is no joke.

PPS:  New Flash:  Americans horrified to discover Hollywood producer behaving like a President of the United States.  Hillary and Fox News particularly disgusted by this behavior.

PPPS:  Another gem:

Speaking over the phone, Mr Reich said he asked his friend whether other Republican senators were preparing to follow Senator Bob Corker and “call it quits with Trump”.

His source told him: “Others are thinking about doing what Bob did. Sounding the alarm. They think Trump’s nuts. Unfit. Dangerous.” . . .

“Tillerson would leave tomorrow if he wasn’t so worried Trump would go nuclear, literally,” he added.

“Who knows what’s in his head? But I can tell you this. He’s not listening to anyone. Not a soul.

“He’s got the nuclear codes and, well, it scares the hell out of me. It’s starting to scare all of them. That’s really why Bob spoke up.”

Trump ran for President as a crazy man, and we are shocked to discover he is governing as a crazy man?

No matter how cynical I get, I can’t keep up

Commenter Ben Cole likes to point out that the Wall Street Journal was dovish when Reagan was President, but then became hawkish under Democratic Presidents.  It looks like they are back to their old tricks:

But Mr. Trump is counting on tax reform and deregulation to boost growth to 3% a year from 2%. If that growth happens, the Yellen-Powell Fed may believe it has to raise rates rapidly, endangering faster growth. Guess whose policies will be blamed? Not the Fed’s.

This is why the old “hawk vs. dove” monetary debate isn’t all that relevant at the current moment. Outsiders like Messrs. Warsh and Taylor, or Columbia’s Glenn Hubbard, believe that tax reform and deregulation can increase the economy’s capacity to grow above 3%. They therefore might raise interest rates more slowly than the Yellen-Powell faction would.

Translation:  Now that we have a Republican President we need easy money to hide the fact that Trump’s “pro-growth” policies are likely to fail.

They are right about one thing, with a 2% inflation target the question of hawks and doves becomes far less important; it’s really about competence vs. incompetence.

PS.  I wonder what John Taylor thinks of the WSJ claim that he’d be more dovish than Yellen.

Warsh on fiscal and monetary policy

Because Kevin Warsh is apparently the frontrunner for Fed chair, his record has been attracting a lot of attention.  Here’s Ike Brannon of the Weekly Standard:

In 2010, in his waning days on the board, Warsh remained preoccupied with the specter of inflation despite the complete lack of evidence suggesting its incipient appearance. In an FOMC meeting late that year he argued that the Fed should consider pulling back on its quantitative easing despite the fragile nature of the economy, reasoning that if it were to do so it would prompt Congress and the White House to act with another round of expansionary fiscal policy.

Suggesting that the Fed play political chicken with Congress is, in a word, insane. The Federal Reserve has a legislative mandate to pursue both full employment and price stability in monetary policy. What Warsh suggested would have effectively set that aside and inserted the Fed into the middle of a highly charged political battle that could have harmed the economy. People who allege that Warsh’s appointment would make the Fed more political can point to this as Exhibit A.

I agree that this sort of policy would be insane, although I’m not sure that this is precisely what Warsh was proposing.  I found this passage in the transcript of the November 2010 meeting, which suggests a slightly different interpretation (albeit equally “insane”):

First, my views on policy. As I said when we met by videoconference, my views are increasingly out of step with the views of most people around this table. The path that you’re leading us to, Mr. Chairman, is not my preferred path forward. I think we are removing much of the burden from those that could actually help reach these objectives, particular the growth and employment objectives, and we are putting that onus strangely on ourselves rather than letting it rest where it should lie. We are too accepting of dangerous policies from others that have been long in the making, and we should put the burden on them.

I can think, Mr. Chairman, of a tough weekend that the Europeans had, particularly your counterpart at the ECB, in the spring or summer, when we all knew that the European Central Bank, rightly or wrongly, was going to take action. But Jean-Claude Trichet did not take action until very late that Sunday night, until the fiscal authorities did their part. He thought that if on Friday night he were to say all of the things he’d be willing to do, he’d be taking the burden off the fiscal authorities. He chose to wait. I think we would be far better off waiting. If we proceed on this path, as I suspect we will, I would still encourage you to put the burden where it rightly belongs, which is on other policymakers here in Washington, and to do so in a way that is respectful of different lines of responsibility.

A few comments:

1.  Warsh’s comments in the transcripts are consistently disappointing, on almost every level.  Unlike other people I often disagree with (Krugman, Summers etc.) he doesn’t have a first rate mind.  His reasoning process is poor and he lacks good communication skills.  He has very poor judgment when interpreting data.  I really don’t know what he’s trying to say here, but the reference to Trichet is interesting.  Trichet was trying to encourage fiscal authorities to adopt more contractionary fiscal policies, not expansionary policies.  Trichet did not want to “bail out” expansionary policies with ultra-low interest rates, and Warsh seems to be endorsing Trichet’s approach.  And given Warsh’s reputation as a conservative, and the massive deficits being run by Obama back in 2010, I find it odd that Warsh would be advocating fiscal stimulus, as Brannon suggests.  But again, the passage is so garbled that I could easily be wrong.

2.  Warsh doesn’t seem to take the Congressional mandate seriously.  He seems to believe the Fed should be free to ignore this mandate, as a way of pressuring Congress to do what a few unelected private sector bankers want it to do.  To say that’s deeply disturbing is an understatement.  The Fed’s only argument for policy independence is that they are selfless non-political technicians trying to achieve goals set by Congress.

It is, of course, good news that equity prices have moved up, but I’m less convinced of their durability if this achievement is mostly because of what we’re doing here in the FOMC rather than because of what’s going on in the real economy.

This is disturbing on so many levels.  Start with the fact that no one could care less whether Warsh thinks the rise is equity prices was “durable”.  His opinion is worthless.  The fact that he thinks his opinion is worth mentioning is itself quite revealing.  And of course it’s not a question of monetary policy vs. the real economy; policy impacts stocks precisely because it impacts the real economy.  And of course he was totally wrong; the rise was durable.  Indeed stocks could crash tomorrow, and still be far above 2010 levels.

Warsh was also totally wrong about the NAIRU:

I share the staff’s view that the NAIRU has moved up.

In researching this post I came across this very revealing passage:

CHAIRMAN BERNANKE. President Evans, did you have a question?

MR. EVANS. Well, I just wanted to ask a question and offer a reaction to something that has come up at the last several meetings. I second the proposal of characterizing what optimal policy is in some way that we could better appreciate. President Bullard was absolutely correct when he pointed out that, after a big shock, optimal policy could well lead to fairly substantial gaps, or however you want to describe this outcome. But it’s also the case that bad policy would lead to gaps like that, too, and we need to understand why the current situation should be characterized as optimal and not simply bad. [Laughter] I mean, there is just a presumption here.

MR. BULLARD. Can I just clarify?

CHAIRMAN BERNANKE. President Bullard. November 2–3, 2010 141 of 238

MR. BULLARD. I just said that merely saying that unemployment is high and inflation is very low doesn’t tell you anything one way or the other about the quality of the policy, so that’s consistent with what you’re saying. It could be that we are following completely horrible policy, but we can argue that.

MR. LACKER. My point was that we don’t want to lead people to believe that, if unemployment is ever high, it’s because we have failed and are doing bad policy. You’d agree with that, wouldn’t you? MR. EVANS. I second the proposal for clarity on all of these objectives. [Emphasis added]

This is an amazing exchange–just amazing.  It perfectly demonstrates why we need the sort of accountability I’ve called for in recent posts.  Evans is right, OF COURSE you’d want to be able to discriminate between bad outcomes due to bad policy, and bad outcomes due to bad luck.  The Fed needs to establish a criterion by which policy actions can be judged, at least retrospectively.  If the Federal Reserve cannot establish a set of agreed upon metrics by which to evaluate whether previous policy stances were too expansionary or too contractionary, then the Fed ought to be abolished, with monetary policy turned over to the Treasury.

I found the experience of reading this transcript to be very depressing, giving me even greater respect for Ben Bernanke.  There were many people resisting monetary stimulus for reasons that are very hard to understand.  Bernanke is very polite, but it must have been an incredibly frustrating experience for him, knowing that the economy needed more stimulus and finding so much resistance.  In retrospect, it’s clear that many of his comments at the press conferences were attempts to explain the views of the committee as a whole, not necessarily his personal views.  Here I’m especially thinking in terms of his warnings about costs and risks associated with QE.

Basically you had one group of people seriously trying to hit the Fed’s targets, and another group that looked for any excuse they could find to do nothing.

HT:  Stephen Kirchner, Adam Ozimek, Craig Torres

Off topic:  As a child I had a very severe case of hay fever (fortunately I outgrew it).  So I was pleased to see Japan’s number two political party plans to address this underrated problem:

Yuriko Koike’s ‘zero policy’ pledges:

Zero nuclear power

Zero corporate cover ups

Zero corporate political donation

Zero children waiting for places in day care

Zero passive smoking

Zero packed commuter trains

Zero putting down of unwanted pets

Zero food waste

Zero violation of labour laws

Zero hay fever

Zero disabled and aged people unable to receive means of transport

Zero overhead power cables

Define “cause”

Tyler Cowen links to a couple of studies looking at the contribution of sectoral shocks to the business cycle.  Here’s one example, from a paper by Enghin Atalay:

Next, I examine whether the choice of elasticities has implications for individual historical episodes. Figure 4 presents historical decompositions for two choices of εM. In both panels, εD = εQ = 1. In panel A, I set εM = 1; and, in panel B, εM = 0.1. With relatively high elasticities of substitution across inputs, each and every recession between 1960 and the present day is explained almost exclusively by the common shocks. The sole partial exception is the relatively mild 2001 recession. In 2001 and 2002, Non-Electrical Machinery, Instruments, F.I.R.E. (Finance, Insurance, and Real Estate), and Electric/Gas Utilities—together accounting for GDP growth rates that were 2.0 percentage points below trend.

Table 3, along with panel B of Figure 4, presents historical decompositions, now allowing for complementarities across intermediate inputs. Here, industry-specific shocks are a primary driver, accounting for a larger fraction of most, but certainly not all of, recent recessions and booms. According to the model-inferred productivity shocks, the 1974–1975 and, especially, the early 1980s recessions were driven to a large extent by common shocks.27 At the same time, the late 1990s expansion and the 2008–2009 recession are each more closely linked with industry-specific events. Instruments (essentially computer and electronic products) and F.I.R.E. had an outsize role in the 1996–2000 expansion, while wholesale/retail, construction, motor vehicles, and F.I.R.E. appear to have had a large role in the most recent recession.

Let’s think about this using an analogy.  Suppose you study the causes of cycles in house collapses.  Assume a community where 90% of houses have solid foundations, and 10% have rotten wood foundations.  Also assume that during floods the rate of house collapses rises from 7 per week to 450 per week.  A cross sectional study shows that 425 of the 450 collapsed houses during a flood had rotten foundations, while 25 had solid foundations.  This despite the fact that only 10% of overall homes had rotten foundations.

How much of the “cycle” in house collapses is “caused” by floods, and how much is caused by rotten foundations?  Show work.

The important question is: “How big would the business cycle be in a counterfactual where the Fed successfully stabilized NGDP growth?” I say “fairly small”.

Another question that is actually much less important, but seems more important to most people is: “How much of the instability in NGDP is due to monetary policy mistakes triggered by sectoral shocks, such as a decline in the natural rate of interest that the Fed overlooked, which was itself caused by a housing slump?”

When you read impressive looking empirical studies in top journals, do not assume that the authors are asking the right question.