Rules, Discretion, or No Central Bank

Recent discussions in the econ blog world on whether the Fed keeping interest rates too low for too long from 2003-2005 was a significant factor in the most recent boom-bust episode, triggered by John B. Taylor’s March 31, “Policy Failure and the Great Recession,” reinforces how important and useful Austrian insights are for properly interpreting causes of the current crisis and guiding discussions of appropriate reforms in monetary institutions.

In his post, Taylor used his interpretation of Robert Hetzel’s in his new book, The Great Recession: Market Failure or Policy Failure? as platform to attempt to bolster his positions that 1. Rules are preferred to discretion and 2. Excessive discretion allowed the monetary authorities led to two significant policy errors during the Greenspan/Bernanke watch; interest rates were too low for too long in 2003-05 leading to a boom and a necessary consequent bust and 3. The bust was compounded and/or triggered by interest rates being too high in 2007-08. While point 3 does not appear to be controversial among defenders of Central Bankers, many commentators, especially supporters of nominal GNP targeting and market monetarism, reacted defensively relative point 2. The general impression one gets from these criticisms of Taylor is essentially if a Central bank policy did not lead to significant price inflation or increases in inflationary expectations, loose monetary policy generates no problems for the economy. Problems for the economy due to policy errors are Friedman plucks which pull the economy below its potential. Taylor, who has the elements essentially correct, rates were too low for too long, but working from a highly aggregated model, has no really adequate response to his critics except to argue that while Hetzel in his book defends Fed policy in 2003-05, gives away the “too easy policy” when later in the book he (Hetzel) argues, “In 2003-2004, the Greenspan FOMC did make a decision that would later have enormous implications. At this time, The FOMC backed off its long-run objective of returning to price stability and instead adopted an ill-defined objective of positive inflation.” To Taylor, given this interpretation of policy circa 2003-2005, “there is a clear connection between the ‘go’ and the ‘stop’ in a ‘go-stop’ monetary policy, which those who warn of too much discretion warn about.

Taylor, unlike his critics, who see the only errors by the Fed as the “Great Moderation ended as being on the too tight side, recognizes, as do the Austrians, that the “Fed’s action in 2003-2005 should be considered as possible part of the problem.” Too bad he is unfamiliar with or unwilling to use Austrian analysis to support his position relative to 2003-2005.

Austrian monetary theory and business cycle theory with its emphasis on Cantillon effects, mis-directions of production, and misallocations of investment spending which distort the structure of production, provides a much clearer understanding of why expansionary monetary policy, even during periods of no or low inflation and even as a tool to speed recovery from a recession, sow the seeds for a new bust.

As I have argued elsewhere (“Hayek and the 21st Century Boom-Bust and Recession-Recovery,” Quarterly Journal of Austrian Economics 14, no. 3, Fall 2011: 261-285):

The macroeconomic developments in the U.S. economy from 1995 to present cannot be understood without a reference to a capital-structure based macroeconomic framework. The first boom-bust of the period, 1995–2000, should have provided evidence that Hayek was premature in de-emphasizing the empirical importance of distortions in the structure of production caused by money and credit creation in a growing economy with relatively stable prices. A monetary shock which accommodated a productivity shock generated a significant boom as exhibited by real GDP above potential GDP. The resulting “bust,” at least measured in terms of the cycle impact on GDP, was relatively mild.
The significance of this cycle for the role of monetary policy was perhaps missed because it occurred at the end of the relatively long period of growth and stability known as the “Great Moderation.” This period was a time of better—at least compared to monetary policy of the 1960s and 1970s—but not necessarily good policy (Garrison, 2009). During this period, central banks were heavily influenced by macroeconomic events of the 1970s which seemed to discredit the prevailing neo-classical synthesis/Keynesian consensus. A vast economic literature from the consequent policy effectiveness debate emphasized central bank policies that—at least in the long run—aimed at price stabilization as a dominant policy goal. The Fed, while not explicitly inflation targeting, followed a policy that mimicked a Taylor Rule policy. Garrison (2009) characterizes this as a “learning by doing policy” which, based on events post-2003, would be better classified as “so far so good” or “whistling in the dark.”
The mildness of the first recession of the 21st century was followed by a relatively slow, jobless recovery, which could be viewed as trading depth for duration. This led many economists and pundits to encourage the Fed to re-inflate—create another boom or bubble—to ignite growth and employment. Thus the Fed turned to monetary excess. Interest rates were kept too low for too long, which led to “a boom and an inevitable bust [emphasis mine]” (Taylor, 2008). This housing bubble-led boom-bust is an excellent example of Hayek’s ([1939b] 1975) misdirection of production that results from monetary stimulus of an economy currently operating below potential. This attempt to use monetary policy to reduce unemployment in the short run, as predicted, became a cause of “more unemployment than the amount it was originally designed to prevent” (Hayek, 1979, p. 11). Following this extended period of historically low federal funds rate circa 2002–2004, investment and GDP recovered relatively rapidly as employment also eventually increased. The economy appeared healthy and at least temporarily returned to its potential GDP growth path. The health was only apparent.

While discussions of policy, such as those triggered by Taylor’s response (for examples see “Reading John Taylor’s Mind” at http://uneasymoney.com/2012/04/02/reading-john-taylors-mind/, Marcus Nunes at Historinhas http://thefaintofheart.wordpress.com/2012/04/02/was-monetary-policy-easy-in-2003-2004-not-according-to-robert-hetzel/, or Scott Sumner at http://www.themoneyillusion.com/?p=13765 ) focus on how a central bank in fiat money system can do ‘better policy’, an Austrian capital-based (better) understanding of the causes of the current crisis shifts the focus to monetary reform; are there monetary institutions that could generate consistently better economic outcomes? As such, more attention should be paid to research such as that by Selgin, Lastrapes, and White which asks “Has the Fed Been a Failure?” (Cato Institute Working Paper No. 2 (December)). Their conclusion is yes:

“Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.”

This does not even take into account, following the Crisis and Leviathon, how the Fed has greatly increased its powers and discretion in ways that move it toward using policy instruments to pick winners and losers, a monetary central planner as pointed out by Hummel (2011) and dubbed MOndustrial Policy by Taylor.

Whether rules or discretion leads to better central banking is moot if the correct answer is the better arrangement is no central bank!