In my previous post about George Selgin’s comment on John Taylor’s critique of NGDP targeting, I observed that Selgin had correctly focused on Taylor’s ambiguous use of the concept of an “inflation shock” without identifying the nature of the shock (violating Scott Sumner’s dictum “never reason from a price change). As Selgin pointed out, if the inflation shock were caused by a shock to aggregate supply, NGDP targeting would do better than a price-level or inflation rule. If the source of the inflation shock were excessive aggregate demand, well, that just means that NGDP had not been targeted. But there was another part of Taylor’s post, not addressed by Selgin, deserving of attention. Taylor writes:
NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.
Taylor goes on to elaborate, invoking the authority of Milton Friedman, on the properties that a rule governing the conduct of a central bank ought to have.
For this reason, as Amity Shlaes argues in her recent Bloomberg piece, [coincidentally mentioning Taylor six times and quoting him twice!] NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.
The first point to make about this remark is that the money supply rule Friedman advocated, and Taylor endorses — despite its unworkability in theory (Goodhart’s Law) and its demonstrated unworkability in practice when adopted by the Fed under Paul Volcker in the early 1980s — did not – obviously did not! — satisfy Friedman’s own criterion of being stated in terms of “objectives that the monetary authorities . . . have the clear and direct power to achieve by their own actions.” The monetary aggregate that Friedman wanted to grow at a fixed rate was, for the most part, produced by private banks, not by the Fed, so there was obviously no way that the Fed could achieve its objectives for the growth of M1, M2, or Mwhatever by its own actions.
So what should one conclude from this? That Friedman was a hypocrite? I don’t think so. But he did have a propensity for getting carried away by his enthusiasms, and he took his enthusiasm for rules to an extreme, supposing that all problems of monetary policy could be solved by prescribing a rule for a fixed rate of growth in the money supply. Even in 1960, that was a remarkably simplistic, actually simple-minded, position to have taken, but in his obsession for simple rules, he thought he had found the Holy Grail of monetary policy. That John Taylor, half a century later, could approvingly cite Friedman’s rule for the rate of growth in the money supply as a benchmark by which to judge other monetary policy rules speaks volumes about Taylor’s grasp of what constitutes good monetary policy.
Actually to gain some obviously needed insight into monetary policy rules, Professor Taylor could do a lot worse than to start with Chapter 21 of Hayek’s Constitution of Liberty. Friedman could have profited from reading it as well, but Friedman, obviously disdaining Hayek’s abilities as an economist, probably did not take it seriously. Let’s have a look at some of what Hayek had to say on the subject of rules and monetary policy.
The case for “rules versus authorities in monetary policy” has been persuasively argued by the late Henry Simons [one of Friedman’s teachers at Chicago] in a well-known essay. The arguments advanced there in favor of strict rules are so strong that the issue is now largely one of how far it is practically possible to tie down monetary authority by appropriate rules. It may still be true that if there were full agreement as to what monetary policy ought to aim for, an independent monetary authority, fully protected against political pressure and free to achieve the ends it has been assigned, might be the best arrangement. . . . But the fact that the responsibility for monetary policy today inevitably rests in part with agencies whose main concern is with government finance probably strengthens the case against allowing much discretion and for making decisions on monetary policy as predictable as possible.
It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain. No automatic mechanism is known which will make the total supply of money adapt itself exactly as we would wish, and the most we can say in favor of any mechanism (or action determined by rigid rules) is that it is doubtful whether in practice any deliberate control would be better. The reason for this doubt is partly that the conditions in which monetary authorities have to make their decisions are usually not favorable to the prevailing of long views, partly that we are not too certain what they should do in particular circumstances and that, therefore, uncertainty about what they will do is necessarily greater when they do not act according to fixed rules. (p. 334)
And a bit later:
There is one basic dilemma, which all central banks face, which makes it inevitable that their policy must involve much discretion. A central bank can exercise only an indirect and therefore limited control over all the circulating media. Its power is based chiefly on the threat of not supplying cash when it is needed. Yet at the same time it is considered to be its duty never to refuse to supply this case at a price when needed. It is this problem, rather than the general effects of policy on prices or the value of money, that necessarily preoccupies the central banker in his day-to-day actions. It is a task which makes it necessary for the central bank constantly to forestall or counteract development in the realm of credit, for which no simple rules can provide sufficient guidance.
The same is nearly as true of the measure intended to affect prices and employment. They must be directed more at forestalling changes before they occur than at correcting them after they have occurred. If a central bank always waited until rule or mechanism forced it to take action, the resulting fluctuations would be much greater than they need be. . . .
[U]nder present conditions we have little choice but to limit monetary policy by prescribing its goals rather than its specific actions. The concrete issue today is whether it ought to kepp stable some level of employment or some level of prices. Reasonably interpreted and with due allowance made for the inevitability of minor fluctuations around a given level, these two aims are not necessarily in conflict, provided that the requirements for monetary stability are given first place and the rest of economic policy is adapted to them. A conflict arises, however, if “full employment” is made the chief objective and this is interpreted, as it sometimes is, as that maximum of employment which can be produced by monetary means in the short run. That way lies progressive inflation. (pp. 336-37)
Professor Taylor, forget Friedman, and study Hayek.
Uneasy Money 
A very simple rule for nominal GDP targeting
ΔM1(t) = C x k x (GDPn(t)* – GDPn(t-1))
Where
GDPn(t)* is the nominal GDP target for the current time period t.
GDPn(t-1) is measured GDP for the (t-1) time period.
k = 1/V
C is a coefficient that has to be much greater than 1 to prevent undershooting, but if you make C too high overshooting will result.
ΔM1(t) is the change the Fed needs to make in M1 for the current time period t.
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David:
This targeting discussion reminds me of how old Soviet officials used to try to develop rules about how much wheat they should produce. What they really needed was to get rid of the rule-makers and let markets work. If government officials would allow it, the invisible hand would produce the correct amount of money just as it produces the correct amount of wheat.
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I recall Scott Sumner actually advocating a rather simple rule in his interview with Russ Roberts on EconTalk. He spoke of creating an NGDP futures market and having the Fed buy and sell the futures until expectations reached the NGDP target.
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Richard, I don’t like any rule in which any monetary aggregate is an instrument.
Mike, The quantity of money is now determined by the invisible hand, not by the government. No one is targeting M1 or M2, and banks and depositors are deciding on their own how many deposits to create and to hold.
PrometheeFeu, I think Scott’s proposal is an excellent one. My post was intended not to advocate any specific rule, but to challenge Taylor’s conception of what a good rule would look like.
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David:
“The quantity of money is now determined by the invisible hand”
True for checking account dollars, credit card dollars, etc, but not for paper dollars and federal funds. Also, reserve requirements limit the freedom to issue checking account dollars. Luckily, the Fed doesn’t recognize credit card dollars as money, so they haven’t tried to regulate them yet.
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Make this part 147 (or thereabouts) in the series, “Hayek saying something surprisingly reasonable.” I’m continually amazed by how many policies he was willing to endorse that his present acolytes would denounce as steps down the “road to serfdom.”
Regarding Friedman: I found it interesting recently to watch the “inflation” episode of Free to Choose. In the present context, it doesn’t reflect especially well on him, though it does help me the lingering fear of inflation: http://www.youtube.com/watch?v=jE7zxo61Xc8.
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Discretion with a clear target is surely stabilising. That, at least is the Australian experience: despite the highly volatile mining sector being 9% of GDP.
The point is to provide a nominal anchor for expectations. Belief that the central bank is serious about its target and will act as necessary strengthens the anchor, blocks attempts to “game” it and does not fall foul of Goodhart’s law.
But I have already banged on about the need for explicit targets.
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Will,
Just because our problems right now aren’t inflationary, it doesn’t mean that they won’t be in the future. I bet Friedman in the 1970s would have dreamed about a situation where too tight a monetary policy was the problem, since moving from a monetary policy that is too tight to one that is looser is a lot less painful that moving from a monetary policy that is too loose that is too tight.
Put another way, going from being a drunkard to a temperate person is very hard; going from being abstinent to a temperate person requires at most a bit of courage and a little self-discipline/knowledge to avoid overdoing it.
Lorenzo from Oz,
“Discretion with a clear target is surely stabilising.”
I spent a few paragraphs in another post trying to say that one proposition!
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@W. Peden:
Of course, the exercise of trying to guess what Milton Friedman would have said is futile. That said, I don’t think you are right. Consider his analysis of the causes of the Great Depression: He believed the Great Depression was caused by too tight a monetary policy. I think he would probably worry that tight monetary policy today might cause another Great Depression.
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W. Peden-
There actually was a proverbial fire when that PBS series came out, so Friedman was not crying “fire, fire!” in Noah’s flood. Clearly inflation was at an impractically high level, and was cooked into the economy.*
Friedman disappoints in that video, though, by asserting that inflation causes unemployment, and by saying that it’s the *worst* thing that can happen to an economy. It was these sorts of overstatements that set us up for the current fiasco. He also repeatedly says that Japan’s central bank has guaranteed steady, sustainable growth, which doesn’t square well with subsequent experience — but he was an excellent historian, so I’ll forgive bad predictions.
*I am not old enough to remember that era, but my impression is that Americans exaggerate how bad it was. Brazil had much higher inflation for decades. The UK had inflation at 25 percent in 1980. The US inflation was just not that bad, comparatively, The fact that people sometimes refer to the “hyperinflation” of the 70s is ridiculous.
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PrometheeFeu,
Actually I think we basically agree: Milton Friedman would be primarily concerned about money being too tight right now; not Great Depression tight, but certainly tight enough to ensure prolonged stagnation. My point was that Friedman would think, correctly, that it would be easier to solve the current US crisis than it was to solve the inflationary crisis of the 1970s since the latter operation is so painful.
Will,
In what sense, in the long run, does (high and variable) inflation not cause unemployment?
Friedman’s statements about the BoJ were true in the 1970s and early 1980s. They were not true in the late 1980s and 1990s. I suspect that Friedman would have pointed to the BoJ’s newfound lack of regard for monetary stability as the cause of the problems in that period, since that was his diagnosis in the 1990s. It’s worth noting that the BoJ became the BoJ we all know and hate AFTER it abandoned its implicit money supply targets.
Americans certainly overstate how bad their inflation was. It wasn’t hyperinflationary by any definition. It was bad relative to what they had had since the inflation of the 1910s.
UK RPI inflation peaked at 24.2% in 1975 after the monetary expansion of the Barber Boom. However, annual RPI inflation was actually worse in 1917. The inflation of 1980, which was due to a combination of the end of the Healey boomlet and a large increase in indirect taxation under the Conservatives was not so bad.
Ultimately, it’s relative: compared to many countries’ experiences, the UK and US inflations in the 1970s were not so bad. Compared to these countries own experiences, the decade was truly a Great Inflation of unprecedented proportions and duration. The UK economy was still feeling the aftershocks in the 1990s.
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“…as Amity Shlaes argues…”
Does anybody in economics take Amity Shlaes seriously?
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Mike, I agree, but I thought you believe that the law of reflux applies to paper dollars and to Fed Funds, too.
Will, I agree that Hayek needs to be saved from the Hayekians. My teacher Axel Leijonhufvud wrote a wonderful book with a wonderful title, On Keynesian Economics and the Economics of Keynes. Maybe someone will write a similar book about Hayek. Here’s something I wrote about the misrepresentation of Hayek by his supposed supporters that Greg Ransom was kind enough to post on his blog.
Lorenzo, I agree, but I think it is worth explaining why Goodhart’s Law doesn’t apply to NGDP targeting or other nominal targets.
Will and W., Friedman’s opposition to inflation was partly political and partly a useful weapon against Keynesians and the Fed. Friedman did not have a strong economic argument for why inflation is bad. The economic costs seem to be second order relative to unemployment. There are political economic and public choice arguments that he could call upon, but if you believe that money is more or less neutral, it is hard to make a powerful argument that inflation is terrible.
Barry, Amity Shlaes is mainly a journalist, so there is no reason why professional economists would take her seriously. She is also an ideologue, so views about her would largely depend on one’s ideological orientation.
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David:
The Law of Reflux applies to paper dollars and fed funds in roughly the same way that the Law of Demand applies to the Post Office: It operates, but it’s been subverted by government monopoly.
There are multiple channels through which paper dollars (and fed funds) can reflux to the fed: the gold channel, the bond channel, the foreign currency channel, even the used furniture channel. (The fed sometimes sells used furniture, receiving paper dollars in exchange.) The gold channel is currently closed, but in 100 years, when people use only computer blips for money, the fed might use its gold to buy back its paper dollars. This possibility means the gold channel is not truly closed, as it would be if the fed dumped its gold in the ocean.
The bond channel is currently open, but that doesn’t stop the fed from going on a bond buying spree, and rolling the bonds over when they mature, effectively hampering the bond channel.
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“Barry, Amity Shlaes is mainly a journalist, so there is no reason why professional economists would take her seriously. She is also an ideologue, so views about her would largely depend on one’s ideological orientation.”
1) Your quote from John Taylor seems to have him using her as an authority.
2) See: http://en.wikipedia.org/wiki/Amity_Shlaes for her current status as teaching in schools of buiness, and her being used as an authority.
3) “She is also an ideologue, so views about her would largely depend on one’s ideological orientation” – or, for those interested in truth, on whether or not her ideas are true.
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