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.