I gave a talk this afternoon at a panel on the Heritage of Monetary Economics and Macroeconomics at the meetings of the Southern Economic Association in Washington. The panel was brought together to commemorate a confluence of significant anniversaries this year: the 300th anniversary of David Hume’s birth, the 200th anniversary of the publication of the Bullion Report to the British Parliament, the 100th anniversary of the publication of Irving Fisher’s Purchasing Power of Money, the 75th anniversary of the publication of Keynes’s General Theory, and the 50th anniversary of the publication of John Muth’s paper on rational expectations. I spoke about the Bullion Report and the contributions of classical monetary theory. At some point, I may post the entire paper on SSRN, but I thought that the section of my paper on rules versus discretion in monetary policy might be of interest to readers of the blog, so here is an abridged version of that section of my paper.
The Bullion Report, whose 200th anniversary we are observing, is an appropriate point from which to start a discussion of the classical contribution to the perpetual debate over rules versus discretion in the conduct of monetary policy. The Bullion Report contained an extended discussion of several important theoretical issues, but its official purpose was to recommend an early resumption of convertibility (suspended since 1797) of Bank of England banknotes, to make them redeemable again at a fixed parity in terms of gold. In other words, the Bullion Report called for a rapid return to the gold standard, then regarded as a safe and workable rule for the conduct of monetary policy.
Despite the rejection by Parliament of the Report’s recommendation to quickly restore the gold standard, the general argument of the Bullion Report for the gold standard undoubtedly influenced the ultimate decision to restore the gold standard after the Napoleonic Wars. But full restoration of gold standard in 1821 did not produce the promised monetary stability, with ongoing disturbances punctuated by financial crises every 10 years or so, in 1825, 1836, 1847, 1857 and 1866. The result of the early disturbances was the adoption of new rules motivated by the idea that monetary disturbances were symptomatic of the failure of a mixed (gold and paper) currency to fluctuate exactly as a purely metallic currency would have.
These new rules seem to me to have been altogether misguided and pernicious, but their adoption reflected a fear that the simple rule embodying the gold standard, the requirement that banknotes be convertible into gold, would not ensure monetary stability unless supplemented by further rules limiting the creation of banknotes by the banks. The rules had to be tightened and spelled out in increasing detail to effectively limit the discretion of the bankers and prevent them from engaging in the destabilizing behavior that they would otherwise engage in.
Thus, over the course of the nineteenth century, there evolved a conception of the rules of the game governing the behavior of the monetary authorities under gold standard. However, the historical record is far from clear on the extent to which the rules of the game were actually observed. The record of equivocal adherence by the monetary authorities under the gold standard to the rules of the game can be interpreted to mean either that the rules of the game were unworkable or irrelevant — in which case following the rules would have been destabilizing — or that it was the failure to follow the rules of the game that caused the instabilities observed even in the heyday of the international gold standard (1880-1914).
The outbreak of World War I led quickly to the effective suspension of the international gold. The prestige of the gold standard was such that hardly anyone questioned the objective of restoring it after the war. However, there was an increasing understanding that the assumption that the gold standard was the simplest and most effective arrangement by which to achieve price-level stability was unlikely to be valid in the post-war environment. Ralph Hawtrey and Gustav Cassel were especially emphatic after the war about the deflationary dangers associated with restoring the international gold standard unless measures were taken to reduce the monetary demand for gold as countries went back on the gold standard. As a result, the 1920s literature on monetary policy contain frequent derogatory references by supporters of the orthodox gold standard to supporters of managed money, i.e., to advocates of using monetary policy to stabilize prices rather than accept whatever price level was generated by allowing the gold standard to operate according to the rules of the game.
Advocates of price-level stabilization, especially Hawtrey and Cassel, attributed the Great Depression to a failure to manage the gold standard in a way that prevented a sharp increase in the worldwide monetary demand for gold after France, followed by a number of other countries, rejoined the gold standard in 1928 and began redeeming foreign exchange holdings for gold. It was at just this point that the Federal Reserve, having followed a somewhat accommodative policy since 1925, shifted to a tighter policy in late 1928 out of concern with stock-market speculation supposedly fueling a bubble in stock prices. Supporters of the traditional gold standard blamed the crisis on the “inflationary” policies of the Federal Reserve which prevented the “natural” deflation that would otherwise have started in 1927.
Supporters of the traditional gold standard thought that they were upholding the classical tradition of a monetary policy governed by rules not discretion. But Hawtrey and Cassel were not advocates of unlimited policy discretion; they believed that the gold standard ought to be managed by the leading central banks with an understanding of how their policies jointly would determine the international price level and that they should therefore do what was necessary to avoid the deflation to which the world economy was dangerously susceptible because of the rapidly increasing monetary demand for gold.
The Keynesian Revolution after the Great Depression provided a rationale for not allowing policy rules (e.g., keeping the government’s budget balanced, or keeping an exchange rate or an internal price level constant) to preclude taking fiscal or monetary actions designed to increase employment. Achieving full employment by controlling aggregate spending by manipulating fiscal and monetary instruments became the explicit goal of economic policy for the first time. The gold standard having been effectively discredited, opponents of discretionary policies had to search for an alternative rule in terms of which they could take a principled stand against discretionary Keynesian policies. A natural rule to specify would have been to stabilize a price index, as Irving Fisher had proposed after World War I, with his plan for a compensated dollar based on adjusting the price of gold at which the dollar would be made convertible as necessary to keep the price level constant. But Fisher’s plan was too complicated for laymen to understand, and Milton Friedman, the dominant anti-Keynesian of the 1950s and 1960s, preferred to formulate a monetary rule in terms of the quantity of money, perhaps reflecting the Currency School bias for quantitative rules he inherited from his teacher at Chicago Lloyd Mints. A quantitative rule, Friedman argued, imposes a tighter, more direct, constraint on the actions of the central bank than a price-level rule.
The attempt by the Federal Reserve under Paul Volcker to implement a strict Monetarist control over the growth of the money aggregates proved unsuccessful even though the Fed succeeded in its ultimate goal of reducing inflation. Friedman himself, observing the rapid growth of the monetary aggregates, after inflation had been brought down, predicted that inflation would soon rise again to near double-digit rates. That error marked the end of Monetarism as a serious guide to conducting monetary policy.
However, traditional Keynesian prescriptions were, by then, no longer fashionable either, and we entered a two-decade period in which monetary policy aimed at a gradually declining inflation target, falling from 3.5% in the late 1980s to about 2% at present. The instrument used to achieve the inflation target was the traditional pre-Keynesian instrument of the bank rate. John Taylor suggested a rule for setting the bank rate based on the target inflation rate and the gap between actual and potential output that seemed consistent with the recent behavior of the Fed and other central banks. Everything seemed to be going well, and central banks basked in a glow of general approval and gratitude for achieving what was called the Great Moderation. But, perhaps because the Fed didn’t follow the Taylor rule for a few years after the dot-com bubble and the 9/11 attack, there was a housing bubble and then a recession and then a financial crisis, and we now find ourselves mired in the worst recession – actually a Little Depression — since the Great Depression.
The classical monetary theorists, with very few exceptions, believed in some sort of monetary rule, for the most part, either a simple gold standard governed only by the obligation to maintain convertibility or a gold standard hedged in by a variety of rules specifying the appropriate adjustments. Only a few classical economists had other ideas about a monetary regime, and of these they were also rule-based systems such as bimetallism or some form of a tabular standard. The idea of a purely discretionary regime unconstrained by any rule was generally beyond their comprehension.
The problem, for which we as yet have no solution, is that it is dangerous to formulate a rule governing monetary policy if one doesn’t have a fully adequate model of the economy and of the monetary system for which the rule is supposed to determine policy. Ever since the nineteenth century, monetary reformers have been proposing rules to govern policy whose effects they have grossly misunderstood. The Currency School erroneously believed that monetary and financial crises were caused by the failure of a mixed currency to fluctuate in exactly the same way as a purely metallic currency would have. The attempt to impose such a rule simply aggravated the crises to which any gold standard was naturally subject as a result of more or less random fluctuations in the value of gold. The Great Depression was caused by a misguided attempt to recreate the prewar gold standard without taking into account the effect that restoring the gold standard would have on the value of gold. A Monetarist rule to control the rate of growth of the money supply was nearly impossible to implement, because Monetarists stubbornly believed that the demand for money was extremely stable and almost unaffected by the rate of interest so that a steady rate of growth in the money supply was a necessary and sufficient condition for achieving the maximum degree of macroeconomic stability monetary policy was capable of.
After those failures, it was thought that a policy of inflation targeting would achieve macroeconomic stability. But there are two problems with inflation targeting. First, it calls for a perverse response to supply shocks, adding stimulus when a positive productivity shock speeds economic growth and reduces inflation, and reducing aggregate demand when a negative supply shock reduces economic growth and increases inflation. Thus, in one of the greatest monetary policy mistakes since the Great Depression, the FOMC stubbornly tightened policy for most of 2008, because negative supply shocks were driving up commodities prices, causing fears that inflation expectations would become unanchored. The result was an accelerating downturn in the summer of 2008, producing deflationary expectations that precipitated a financial panic and a crash in asset prices.
Second, even without a specific supply shock, if profit expectations worsen sufficiently, causing equilibrium real short-term interest rates to go negative, the only way to avoid a financial crisis is for the rate of inflation to increase sufficiently to allow the real short term interest rate to drop to the equilibrium level. If inflation doesn’t increase sufficiently to allow the real interest rate to drop to its equilibrium level, the expected rate of return on holding cash will exceed the expected return from holding capital causing a crash in asset prices, just what happened in October 2008.
Some of us are hoping that targeting nominal GDP may be an improvement over the rules that have been followed to date. But the historical record, at any rate, does not offer much comfort to anyone who believes that adopting a following a simple rule is the answer to our monetary ills.