Archive for January 2010

 
 

What should the Grand Bargain look like?

It’s 2010.  That means WWII ended 65 years ago.  And that means a fiscal train wreck is approaching fast.  And that means it’s time for one of those committees of “wise men” to reach some sort of grand bargain, which provides political cover for both sides.

WASHINGTON (AP) — President Barack Obama Saturday endorsed a bipartisan plan to name a special task force charged with coming up with a plan to curb the spiraling budget deficit, though the idea has lots of opposition from both his allies and rivals on Capitol Hill.

The bipartisan 18-member panel backed by Obama would study the issue for much of the year and, if 14 members agree, report a deficit reduction blueprint after the November elections that would be voted on before the new Congress convenes next year. The 14 would have to include at least half of the panel’s Republicans — a big obstacle.

“These deficits did not happen overnight, and they won’t be solved overnight,” Obama said in a statement. “The only way to solve our long-term fiscal challenge is to solve it together — Democrats and Republicans.”

The deficit spiked to an extraordinary $1.4 trillion last year and could top that figure this year as the struggling economy puts a big dent in tax revenues. Even worse from the perspective of economists and deficit hawks, the medium-term deficit picture is for deficits hitting around $1 trillion a year for the foreseeable future.

Before I begin, I’d like to clarify a few points.  I am not going to discuss my preferred solution, which is the Singapore small government model.  Rather, I will consider a solution that might actually be politically feasible given the realities of American politics, although even I’d admit it would be a stretch.  And finally, I will use numbers that I think are plausible, but the actual numbers would be somewhat different, as I am not a walking computer.

The basic problem is that the current trajectory of spending and taxes is not sustainable.  For most of my life federal spending has been around 21% of GDP and federal taxes have been around 19%.  The 2% of GDP budget deficit has been sustainable, indeed the debt/GDP ratio in 2008 wasn’t much different than the year I was born (1955.)  But we no longer are on a sustainable path.

For simplicity, assume spending is likely to move to a 26% of GDP plateau; that means we then need another 5% of GDP from taxes.  Experts on the European model such as Peter Lindert say that they are able to support large governments only by having relatively efficient tax systems, which rely more heavily on regressive taxes like the VAT, the payroll tax, and the gas tax.  The progressivity of their system comes from bigger government benefits programs for the unemployed, health care, child care, etc.  This is pretty much common knowledge among the smarter public finance economists on both the left and the right.

As of today, President Obama is not in a strong negotiating position.  I think he understands that the government needs more money if the Democrats’ goals are to be achieved, but also knows that Congressional Democrats would not be enthused about implementing a 12% VAT and higher gas taxes on a party line vote.  And I can’t blame them.  The Republicans have three choices.

1.  Put “moderates” on the commission who will cave into the Democrats’ demand for a VAT, in return for token Republican objectives.

2.  Stonewall, letting Obama stew in his own juices until they can re-take power.

3.  Do the sort of grand compromise I will describe below.

I think Republicans would be foolish to choose the first option, but that hasn’t always stopped them in the past.  The most likely scenario is the second, but that isn’t necessarily in their interest either.  When they retake power they are going to be faced with the same difficult decisions, and the Democrats would (quite rightly) be reluctant to bail out a Republican Party that had just refused to cooperate with them.  So what sort of grand bargain would be fair to both sides?  The answer starts from the insight that the public policy world is full of “free lunches,” or changes in public policy that produce massive net gains for society.  I will try to describe one such policy package:

1.  Raise about 7% of GDP through a VAT (and gas or carbon tax if you wish; those details aren’t important here.)  Now you have an extra 2% of GDP to work with.

2.  Abolish the income tax.  I seem to recall that the income tax raises about 8% or 9% of GDP.  So to get the extra 5% percent of GDP you would need another tax to raise about 6% or 7& of GDP in other taxes.

3.  The other tax would also have to be very progressive, or else the Dems will never go along.

4.  Increase the payroll tax on upper-middle class and wealthy American enough to raise at least 6% of GDP.  Currently the tax has a flat rate of about 15.3%, and then drops to about 2.5% somewhere over $100,000 a year.  Under my plan those making over $100,000 would face a marginal payroll tax more in the 25% to 40% range, although I have no idea what the exact numbers would be.  There would probably be a graduated system, with perhaps a 20% rate for those making between $60,000 and $100,000.   The EITC might have to be increased a bit to offset the VAT, and ditto for low income Social Security recipients.   The experts would tweak the rates so that the overall progressivity of the tax system (including the VAT) is roughly unchanged.  I think that would be necessary to getting any deal.

5.  Then we need to follow Steve Forbes’ advice and abolish the income tax entirely.  If we try to simply reform it (as in 1986) the bracket creep and loopholes will gradually return over time.  If we abolished it entirely that would represent a pretty definitive repudiation of the whole idea.  The Senate would likely filibuster any future attempt to reinstate it.

6.  That would be enough, as even liberal economists understand that a progressive consumption (or payroll) tax is better than an income tax (which double-taxes saving.)  But it would still look unfair to the average person as the rich coupon clippers wouldn’t seem to be paying much tax at all (although they actually would be paying taxes indirectly).  So you change the system so that taxation of capital is done at the source.  Banks would withhold taxes on interest, bond issuers on bonds, corporations would withhold taxes on dividends before they are paid out.  This means taxes on capital could not be progressive, but that’s not much of a problem as the poor receive very little capital income.  Any distributional effects could be offset by tweaking the payroll and EITC rates.  We could also allow corporations to expense new investment, which I believe would greatly reduce the problem of “double taxation of saving.”  I’ll leave the complex issue of taxing capital to the experts.

What are the advantages of this deal?

1.  Republicans get rid of the hated income tax.

2.  Democrats get political cover to expand the federal government as a share of GDP through higher taxes.

3.  Neither side wins or losses through changes in progressivity.

4.  Most importantly, you get massive net efficiency gains over the more likely alternative.

And what is the more likely alternative?  A mushy compromise.  Government only grows by 3% of GDP, not 5%.  The other 2% is cut through means-testing entitlements and other changes.  The income tax stays in place, massively distorting health care, housing, and all sort of other sectors.  In addition, using up valuable labor to deal with the complexity of the system.  Also remember that means-testing is really just another implicit marginal tax rate, so no Republican that worries about high MTRs should go for a plan that slightly reduces the growth in explicit taxes, if the means-testing raises IMTRs.  And means-testing means even more complexity, more forms to fill out.

By now you must think I am a John Lennon-type dreamer.  Yes, but I’m not the only one . . .

Seriously, it is a long shot, but maybe a bit less far-fetched that it seems.  There is currently near-total gridlock in government.  Any deal at all would be extremely difficult to achieve.  But at some point there simply must be some sort of deal.  And don’t talk about inflation as a solution, a bit more inflation would help a lot right now, but it doesn’t address the long run steady-state issues.  You can choose to be as cynical as you want, but we aren’t going to have 50% steady-state inflation in this country.  It will be higher taxes and/or lower spending.  Given that my proposal has such large net efficiency gains as compared to the more likely alternative, it’s not impossible that such a compromise might emerge from a committee of statesmen (and women.)  Whether it can get through Congress is another thing.  But sometimes you need to be so bold that the special interest groups just get overwhelmed, or form a circular firing squad.  The cut in the top rate from 70% to 28% under Reagan did hurt some special interest groups, but it also got substantial support from both liberals and conservatives in Congress.

In the end what makes me slightly optimistic about this solution is the incredible difficulties of achieving any other solution, combined with the fact that some sort of deal will almost certainly need to occur within the next 10 years.  The alternative muddled compromise that I described earlier could also be constructed in such a way as to appear to leave the balance of power relatively unchanged.  But in practice, any gains to the Republicans would be ephemeral, as their preferred reforms would be washed away over time, while the VAT would hang around forever.  That might seem to imply that the alternative approach is better for the Democrats.  But I don’t see it that way, as public finance isn’t a zero sum game.  In a two party system the two parties will always take turn governing, that is a given.  The real question is: What sort of policy outcomes do we get?  And that is far from being a zero-sum game.

PS.  I would allow states to piggy-back onto this system if they wished, so that they could also raise taxes more efficiently.  This would allow states to abolish their income and sales taxes, and replace them with VATs and progressive payroll taxes.  Also, if you are comparing the 26% of GDP to European numbers, don’t.  You need to add in state and local spending.  If the US federal government moved up to 26% of GDP, then total government spending would move up to the bottom end of the Western European level, and above Australia/Canada/Japan, unless I am mistaken.  Given the anti-tax character of Americans, I don’t think the Democrats could realistically expect anything higher.

PPS.  Totally off topic, but if you like bizarre political humor you might find this funny.  It’s from an actual German movie I saw a few years back (I believe called Downfall), but the subtitles have been changed.  (BTW, I hope it goes without saying that the humor obviously isn’t really directed against either party.)

What we should be debating

We should be debating:

1.  Whether to cut the fed funds target from 0.25% to 0%

2.  Whether to put an interest penalty on excess reserves

3.  Whether to do additional QE

4.  Whether to set an inflation or NGDP target

5.  Whether to target growth rates or levels

6.  And of course the key overarching question:  Would the economy benefit from an increase in AD, or nominal spending?

Instead, the blogosphere is full of debate over whether Bernanke should be reappointed at the Fed.  Obviously President Obama gets to choose the Fed Chairman; if he thinks the economy would benefit from additional monetary stimulus, then I presume he would not have picked Bernanke.  Thus I don’t much care either way whether Bernanke is reappointed.  If he is not reappointed then I presume Obama would replace him with someone holding similar views.

I think we need to step back and think about how the Fed operates.  You cannot expect leadership from a large bureaucracy.  Unless there is dissatisfaction with Fed policy among economists, pundits, journalists, businessmen and politicians, you cannot expect the Fed to suddenly change its policies.  As far as I can see, very few people are calling for additional monetary stimulus.  So why should we expect the Fed to provide such stimulus, with or without Bernanke?

It seems like lots of the discussion of whether Bernanke should be reappointed revolves around issues other than monetary policy.  And I think that fact tells us a lot about how we got in this mess; many people still don’t seem to think the big drop in NGDP was a monetary policy failure.

Instead we have debates about whether to allow big banks to exist.  Again, doesn’t this miss the point?  If our banking system absorbs trillions in losses you can be sure the government will step in, regardless of whether we have big banks or small banks.  And if our banking system isn’t in crisis, then FDIC is perfectly capable of handling an isolated bankruptcy, even at a large bank.  In any case, I can’t imagine a future where the US doesn’t have any large banks, but Europe, China, Japan and Canada have lots of large banks.  Can you?  Wouldn’t it make more sense to try to prevent the banking system from suffering trillions in losses after a bubble bursts, perhaps by requiring sizable downpayments?

But then I read that the FHA is about to set much tougher standards for FHA mortgages—they plan to require borrowers with a 590 credit score to put down at least 3.5% downpayments.  As Tyler Cowen recently argued, you knew Congress wasn’t serious about global warming when they refused to make Americans pay more for gasoline.  And I would add that you can be sure that the populists who want to “re-regulate the banking system” aren’t serious when all they can do is talk about 3.5% downpayments for bad credit risks.  It is so much more fun to bash big banks.

PS.  In this article David Henderson suggests a better way of imposing discipline on banks; get rid of FDIC.

PPS.  On a more positive note, Barney Frank now proposes that we eliminate Fannie and Freddie:

A top House Democrat on Friday said his committee was preparing to recommend “abolishing” mortgage-finance giants Fannie Mae and Freddie Mac and rebuilding the U.S. housing-finance system from scratch.

And later on there was even better news:

One such report came from analysts at Standard & Poor’s this past week. “It’s hard for us to imagine” how enough capital could be attracted to replace Fannie and Freddie with stand-alone private companies that would be able to offer low-cost funding for 30-year fixed-rate mortgages, the analysts wrote.

Now I’m getting really excited.  Not “enough capital” for lots of low-cost 30 year mortgages?  Please God let’s hope these “analysts” are correct.

Is China a bubble?

No, at least according to The Economist:

By most measures average prices have fallen relative to incomes in the past decade (see chart 1).

The most cited evidence of a bubble””and hence of impending collapse””is the ratio of average home prices to average annual household incomes. This is almost ten in China; in most developed economies it is only four or five. However, Tao Wang, an economist at UBS, argues that this rich-world yardstick is misleading. Chinese homebuyers do not have average incomes but come largely from the richest 20-30% of the urban population. Using this group’s average income, the ratio falls to rich-world levels. In Japan the price-income ratio hit 18 in 1990, obliging some buyers to take out 100-year mortgages.

Furthermore, Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash. The average mortgage covers only about half of a property’s value. Owner-occupiers must make a minimum deposit of 20%, investors one of 40%. Chinese households’ total debt stands at only 35% of their disposable income, compared with 130% in Japan in 1990.

China’s property boom is being financed mainly by saving, not bank lending. According to Yan Wang, an economist at BCA Research, a Canadian firm, only about one-fifth of the cost of new construction (commercial and residential) is financed by bank lending. Loans to homebuyers and property developers account for only 17% of Chinese banks’ total, against 56% for American banks. A bubble pumped up by saving is much less dangerous than one fuelled by credit.

OK, but what about investment, isn’t that a bubble?

China’s second apparent point of similarity to Japan is overinvestment. Total fixed investment jumped to an estimated 47% of GDP last year””ten points more than in Japan at its peak. Chinese investment is certainly high: in most developed countries it accounts for around 20% of GDP. But you cannot infer waste from a high investment ratio alone. It is hard to argue that China has added too much to its capital stock when, per person, it has only about 5% of what America or Japan has. China does have excess capacity in some industries, such as steel and cement. But across the economy as a whole, concerns about overinvestment tend to be exaggerated.

.   .   .

Even in industries which clearly do have excess capacity, China’s critics overstate their case. A recent report by the European Union Chamber of Commerce in China estimates that in early 2009 the steel industry was operating at only 72% of capacity. That was at the depth of the global downturn. Demand has picked up strongly since then. The report claims that the industry’s overcapacity is illustrated by “a startling figure”: in 2008, China’s output of steel per person was higher than America’s. So what? At China’s stage of industrialisation it should use a lot of steel. A more relevant yardstick is the America of the early 20th century. According to Ms Wang of UBS, China’s steel capacity of almost 0.5 tonnes per person is slightly lower than America’s output in 1920 (0.6 tonnes) and far below Japan’s peak of 1.1 tonnes in 1973.

.   .   .

Given the scale of the spending, some money is sure to have been wasted, but by and large, investment in roads, railways and the electricity grid will help China sustain its growth in the years ahead. Some analysts disagree. Pivot, for instance, argues that China’s infrastructure has already reached an advanced level. It has six of the world’s ten longest bridges and it boasts the world’s fastest train; there is little room for further productive investment. That is nonsense. A country in which two-fifths of villages lack a paved road to the nearest market town still has plenty of scope for building roads. The same goes for railways. Again, a comparison of China today with the America of a century ago is pertinent. China has roughly the same land area as America, but 13 times more people than the United States did then. Yet on current plans it will have only 110,000km of railway by 2012, compared with more than 400,000km in America in 1916. Unlike Japan, which built “bridges to nowhere” to prop up its economy, China needs better infrastructure.

OK, but aren’t the banks in trouble?

The biggest cause for worry about China is the third point of similarity to Japan: the recent tidal wave of bank lending. Total credit jumped by more than 30% last year.

.   .   .

However, too many commentators talk as if Chinese banks have been on a lending binge for years. Instead, the spurt in 2009, which was engineered by the government to revive the economy, followed several years in which credit grew more slowly than GDP (see chart 3). Michael Buchanan, of Goldman Sachs, estimates that since 2004 China’s excess credit (the gap between the growth rates of credit and nominal GDP) has risen by less than in most developed economies.

Even so, recent lending has been excessive; combined with overcapacity in some industries, it is likely to cause an increase in banks’ non-performing loans. Ms Wang calculates that if 20% of all new lending last year and another 10% of this year’s lending turned bad, this would create new bad loans equivalent to 5.5% of GDP by 2012, on top of 2% now. That is far from trivial, but well below the 40% of GDP that bad loans amounted to in the late 1990s.

But what about the Chinese stock market bubble?

Japan’s stockmarket and land-price bubbles in the early 1960s offer a better (and more cheerful) analogy to China than the 1980s bubble era does. Japan’s economy was poorer then, although relative to America its GDP per person was more than double China’s today, and its trend rate of growth was around 9%. According to HSBC, after the bubble burst in 1962-65, Japan’s annual growth rate dipped to just under 6%, but then quickly rebounded to 10% for much of the next decade.

South Korea and Taiwan, which experienced big stockmarket bubbles in the 1980s, are also worth examining. In the five years to 1990, Taipei’s stockmarket surged by 1,600% (in dollar terms) and Seoul’s by 700%, easily beating Tokyo’s 450% gain in the same period. After share prices slumped, annual growth in both South Korea and Taiwan slowed to around 6%, but soon regained its previous pace of 7-8%.

The higher a country’s potential growth rate, the easier it is for the economy to recover after a bubble bursts, so long as its fiscal and external finances are in reasonable shape. Rapid growth in nominal GDP means that asset prices do not need to fall so far to regain fair value, bad loans are easier to work off and excess capacity can be more quickly absorbed by rising demand.  (Italics added.)

Imagine that, rapid NGDP growth makes it easier to work off credit excesses.  I wonder what happens if NGDP falls during a credit crisis.  (You knew I wasn’t going to write an entire post without mentioning NGDP. )

China has lots of problems: poverty, pollution, inefficient SOEs, lack of rural property rights, political repression, and  worst of all (in my view) a dangerously unbalanced male/female gender ratio.  Bubbles are the least of their problems (although asset prices in China will continue to be highly volatile, and at times this will make it seem as if the bubble worriers were correct.)

BTW, Nick Rowe has another excellent post on bubbles.  He draws a useful distinction between the perspectives of social scientists and market participants.  I entirely agree with his post, which meshes with my earlier argument that anti-EMH theories are useless.  Anti-EMH theories are generally created by social scientists, who are wasting their time if they think they can outsmart the market.  If someone like George Soros develops a useful anti-EMH theory, I assume he would be smart enough to keep it to himself.  Once the theory is in the public domain its market value falls to zero.

John Taylor on the Big Think (part three)

In an earlier post I discussed John Taylor’s answers to two questions I asked about monetary policy in late 2008.  One of his answers included this comment:

In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at. And that rate came down so rapidly because of the large expansion in the reserves. So, it’s hard to see how measured in terms of interest rates policy could be much easier in the October, November, December period.

It isn’t just John Taylor that holds this view, as far as I can tell most economists look at the fed funds rate as the indicator of the stance of monetary policy.  But Taylor overlooked something else the Fed did in late 2008, which made the fed funds rate almost meaningless.  On October 3rd 2008 the Fed adopted a policy of paying interest on reserves.  The program was a bit complicated, but eventually settled on a policy of paying interest at a rate equivalent to the fed funds target.  In December it became slightly more complicated when the fed funds rate target became a range (0% to 0.25%) rather than a single number.  In addition, the interest payments on reserves were set at 0.25% percent.  However, I think Taylor was discussing the situation September, October, and November, when the market equilibrium fed funds rate was often far below the official target, and also far below the rate of interest the Fed was paying on reserve balances.

[Update 1/24/10:  The commenter Jon questioned my facts, and another commenter named dlr indicated that October 3rd was the day Congress authorized the policy, it was announced by the Fed on the 6th, and implemented on the 9th.  In addition, the rate paid on reserve balances was set below the fed funds target prior to November 5th.  But even so, during October the actual fed funds rate in the free market was generally below the interest rate that the Fed paid on reserves.]

The gap between the interest rate on reserves and the market fed funds rate was viewed as being very puzzling, as it seemed to suggest that banks were giving up easy arbitrage opportunities.  A number of studies looked at the issue, and some explanations were offered, although none were completely satisfactory.  I recall one explanation had to do with the fact that some institutions (such as Fannie Mae and Freddie Mac) were significant lenders of reserves, but were not eligible to receive interest on their reserve holdings.

Now let’s think about what this all means for monetary policy.  Economists are used to thinking about the fed funds rate as the banking system’s opportunity cost of short term loanable funds.  And usually it is.  But what happens when the market fed funds rate is 1%, but banks are earning 2% percent on their reserve holdings?  In that case there seem to be two different opportunity costs of fed funds.  Which one is correct?  Which one determines how banks view the opportunity cost of short term loanable funds?  To solve this problem I went back to my economics 101 text, and found this definition of ‘opportunity cost.’

The opportunity cost of choosing X is the highest valued alternative foregone.

OK, so in this case what is the banks highest valued alternative to lending out reserves?  Is it holding them as excess reserves?  Or lending them out to other banks through the fed funds market?  Obviously the former.  Economists need to recognize that once the Fed starts paying interest on reserves, the relevant opportunity cost of funds is the interest rate on reserves any time that this rate is above the equilibrium rate in the fed funds markets.

Many economists engaged in sloppy reasoning last year, arguing that the Fed had already cut rates to zero, and that hence nothing more could be done via conventional monetary policy.  But that is not correct, they only cut rates to 0.25%.  There must have been some reason why the Fed didn’t go all the way down to zero.  Perhaps as James Hamilton argued they feared the inflationary consequences of not paying interest on reserves.  But make no mistake about it, the Fed deliberately decided to not ease policy any further after mid-December.  (And the ECB, faced with a similar macro environment held rates even higher than the Fed.)  But because most economists focused on the market rate for fed funds, they completely missed the contractionary nature of this program.  A further cut in the fed funds target to 0% would have boosted AD at least slightly, but the Fed obviously thought that the economy didn’t need any more demand, that NGDP growth expectations were satisfactory.  I think that was nuts, but even if you don’t agree with me it is important to recognize what the Fed actually did.  Even today very few economists understand the contractionary nature of this policy.

BTW,  If you don’t think a quarter point sounds very important, keep in mind that the famous decision by the Fed to raise reserve requirements in 1937 merely increased short term rates from 0.10% to 0.35%.  And that policy shift is now widely viewed as a major blunder.  Indeed the nature of the error was quite similar, as both the October 2008 policy and the 1937 policy had the effect of increasing the demand for reserves, and reducing the money multiplier.

Woolsey comments on John Taylor

I’ve already discussed John Taylor’s appearance on the Big Think.  Today I’d like to do two more posts delving more deeply into Taylor’s responses and discuss some of the problems that I see in his approach to monetary economics.  I asked Taylor whether money was too tight in late 2008.  Here is what Bill Woolsey had to say about Taylor’s response to my question:

what is most striking about Taylor’s response is that “monetary stimulus” is simply identified as lowering the Fed’s target for the federal funds rate.

More troubling, however, is the notion that the targeted level of the federal funds rate was fine, but it was rather uncertainty generated by the financial policy — the bailouts — that caused the problem.

.   .   .

This view is wrongheaded. “The” natural interest rate is the interest rate that coordinates saving and investment–given the expectations that households and firms actually have. It is the level of the interest rate that makes total real expenditures equal the productive capacity of the economy–again, given the expectations that households and firms actually have.

If uncertainty about government action raises saving or reduces investment, the natural interest rate is lower. The role of any market price, including the market interest rate, is to coordinate given actual market conditions, not hypothetical ideal conditions.

The phrase, “hypothetical ideal conditions” got me thinking about the Fed’s fateful decision not to ease policy on September 16, 2008, and how the Taylor Rule may have contributed to this mistake.  Recall that the Taylor Rule is backward-looking; policy reflects lagged data on inflation and output gaps.  As of September 2008 the lagged inflation data was fairly high.  There was a small output gap, but the recession was not yet very severe.  So if the Fed was using a backward-looking Taylor Rule, then there may have been no need to ease policy.  These are the “ideal conditions” Woolsey alluded to.

Now let’s think about how policymakers could respond to a financial crisis.  From a backward-looking Taylor Rule perspective, the financial crisis is not something you’d want to keep in mind when setting policy; after all, its effects had not yet shown up in the price and output data.  At the same time, it was clearly a problem that could have a deflationary effect in the future, as it was associated with an increased demand for liquidity and a lower Wicksellian natural rate of interest.  So what can a Taylor Rule economist suggest?  From their perspective, the only solution is to deal directly with the banking problem.  It doesn’t show up in their interest rate equation, so it becomes a sort of “non-monetary factor’ which is reducing aggregate demand.  That is, a problem that cannot be addressed through ordinary monetary stimulus.  Thus the financial crisis seems like it is the “root cause” of our problems, precisely because the Fed doesn’t have a good way of using monetary policy to respond to the crisis.

From the perspective of a forward-looking NGDP targeter, a financial crisis is just one more factor that can lead to velocity shocks, and hence is something that should be offset with a change in the monetary base (or fed funds target) sufficient to keep expected NGDP growth on target (say around 5%.)  That’s not to say that the government might not want to do something about the banking crisis, after all it could have undesirable real effects even in a nominal economy expected to grow at 5%.  But those real effects would be much smaller than you might imagine, partly because much of the output collapse that has been attributed to banking problems is actually due falling NGDP, and partly because if NGDP was expected to grow at 5% then the banking problems would have only been a small fraction of what we actually observed.

Taylor’s mistake is nothing new, many prominent economists such as Irving Fisher, Herbert Simon and Milton Friedman once toyed with the idea of “100% money,” which is a banking system where bank deposits are 100% backed by reserves.  Under this system a banking crisis would not reduce the money multiplier.  Why were these free market-types led to such draconian regulatory proposals?  If you believe monetary policy should target the money supply, then you’d view a banking crisis as something that could shock the multiplier, and hence aggregate demand.  And if you didn’t want to give the Fed a lot of authority to try to fine tune the economy, then you’d do whatever seemed necessary in order to prevent banking crises from disturbing the monetary multiplier, so that the Fed could implement a simple, nondiscretionary policy rule for the monetary base.  You’d even be willing to pass a law banning fractional reserve banking.

Today most people think that 100% banking is a bad idea and that the Fed should offset shocks to the money multiplier by adjusting the monetary base.  I predict that we will eventually see the backward-looking Taylor Rule in the same light.  Instead of blindly following this sort of rule during a financial crisis, we should follow Svensson’s advice and set the money supply or the fed funds target at a level that is expected to hit the central bank’s policy objective.

BTW,  Fisher didn’t favor a money supply rule.  I presume he proposed the 100% banking idea because he feared the impact of excess reserve hoarding in a world where the monetary base was still constrained by the size of central bank gold stocks.