Last Saturday, John Taylor posted a very favorable comment on Robert Hetzel’s new book, The Great Recession: Market Failure or Policy Failure? Developing ideas that he published in an important article published in the Federal Reserve Bank of Richmond Economic Quarterly, Hetzel argues that it was mainly tight monetary policy in 2008, not the bursting of the housing bubble and its repercussions that caused the financial crisis in the weeks after Lehman Brothers collapsed in September 2008. Hetzel thus makes an argument that has obvious attractions for Taylor, attributing the Great Recession to the mistaken policy choices of the Federal Open Market Committee, rather than to any deep systemic flaw in modern free-market capitalism. Nevertheless, Taylor’s apparent endorsement of Hetzel’s main argument comes as something of a surprise, inasmuch as Taylor has sharply criticized Fed policies aiming to provide monetary stimulus since the crisis. However, if the Great Recession (Little Depression) was itself caused by overly tight monetary policy in 2008, it is not so easy to argue that a compensatory easing of monetary policy would not be appropriate.
While acknowledging the powerful case that Hetzel makes against Fed policy in 2008 as the chief cause of the Great Recession, Taylor tries very hard to reconcile this view with his previous focus on Fed policy in 2003-05 as the main cause of all the bad stuff that happened subsequently.
One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.
In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008.
A bit later, Taylor continues:
[T]here is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.
Moreover in a blog post last November, when targeting nominal GDP made a big splash, receiving endorsements from such notables as Christina Romer and Paul Krugman, Taylor criticized NGDP targeting on his blog and through his flack Amity Shlaes.
A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. 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.
For this reason, as Amity Shlaes argues in her recent Bloomberg piece, 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.
Taylor does not indicate whether, after reading Hetzel’s book, he is now willing to reassess either his view that monetary policy should be tightened or his negative view of NGDP. However, following Taylor post on Saturday, David Beckworth wrote an optimistic post suggesting that Taylor was coming round to Market Monetarism and NGDP targeting. Scott Sumner followed up Beckworth’s post with an optimistic one of his own, more or less welcoming Taylor to ranks of Market Monetarists. However, Marcus Nunes in his comment on Taylor’s post about Hetzel may have the more realistic view of what Taylor is thinking, observing that Taylor may have mischaracterized Hetzel’s view about the 2003-04 period, thereby allowing himself to continue to identify Fed easing in 2003 as the source of everything bad that happened subsequently. And Bill Woolsey also seems to think that Marcus’s take on Taylor is the right one.
But, no doubt Professor Taylor will soon provide us with further enlightenment on his mental state. We hang on his next pronouncement.
Uneasy Money 
David – Nice “coroner´s job”. Well “dissected”. I don´t believe for a minute that Taylor will easily give up his Taylor Rule, especially now that he´s campaigning for a single taraget – price stability, or IT. It´s “criminal” and the major source of our predicament.
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Here is a plot comparing the output gap (Real GDP versus Real potential GDP) and the fed funds rate:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=GDPC1_GDPPOT,FEDFUNDS&transformation=lin_lin,lin&scale=Left,Left&range=Custom,Custom&cosd=1954-07-01,1954-07-01&coed=2012-02-01,2012-02-01&line_color=%230000ff,%23ff0000&link_values=,&mark_type=NONE,NONE&mw=4,4&line_style=Solid,Solid&lw=1,1&vintage_date=2012-04-02_2012-04-02,2012-04-02&revision_date=2012-04-02_2012-04-02,2012-04-02&mma=0,0&nd=_,&ost=,&oet=,&fml=100*%28b-a%29%2Fb,a&fq=Quarterly,Monthly&fam=avg,avg&fgst=lin,lin
Notice that while the federal reserve held interest rates at a “scary high” of 5 1/4%, the output gap was in fact relatively calm. In fact output was slightly higher than potential at the end of 2008. Here is what spooked the federal reserve into cutting interest rates:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=TCMDO&transformation=pc1&scale=Left&range=Custom&cosd=2000-01-01&coed=2011-10-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-04-02&revision_date=2012-04-02&mma=0&nd=&ost=&oet=&fml=a&fq=Quarterly%2C%20End%20of%20Period&fam=avg&fgst=lin
The Minsky moment in one graph. Couple this with:
http://research.stlouisfed.org/fred2/graph/?chart_type=line&s%5B1%5D%5Bid%5D=SPCS20RSA&s%5B1%5D%5Brange%5D=10yrs
Price declines on housing began in earnest one year prior to the federal reserve cutting interest rates. What was happening was that the price of the underlying asset purchased with debt was falling while the fixed cost debt service remained the same (classic debt deflation). And so if we come up with a “real interest rate” for just housing, it might look something like this:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=USSTHPI_MORTG&transformation=pc1_lin&scale=Left&range=Custom&cosd=1971-04-01&coed=2012-02-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-04-02_2012-04-02&revision_date=2012-04-02_2012-04-02&mma=0&nd=_&ost=&oet=&fml=b-a&fq=Quarterly&fam=avg&fgst=lin
Notice that “real” mortgage rates bottomed at about -6% in 2006 and climbed steadily peaking at about +12% in late 2008.
This put the federal reserve in a policy bind because of this:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=OILPRICE&transformation=lin&scale=Left&range=Custom&cosd=2000-01-01&coed=2010-01-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-04-02&revision_date=2012-04-02&mma=0&nd=&ost=&oet=&fml=a&fq=Monthly&fam=avg&fgst=lin
Oil prices spiking at the same time that housing prices are falling. This is what bad economics is all about. In 1983, the federal government decided that housing prices should not be included in the consumer price index. Considering that fully 1/4 of the total U. S. outstanding debt is mortgage, this was a very bad policy change because it puts the federal reserve in a position of trying to allow increases in the price of one good while discouraging price increases in another. This is an impossible task for a free market impartial fed / and a politically difficult task for a heavy handed regulating fed.
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Great blogging.
John Taylor is a nice guy. He is also a hardcore GOP partisan and solon.
He has tied himself into knots in recent years, trying to be against NGDP and QE in the USA, the very tools he advocated for Japan. There are obvious parallels between NGDP and the Taylor Rule—indeed, the Taylor Rule is just lower on the same evolutionary branch as the better and more advanced NGDP targeting, MM plan.
And now he likes Hetzel. Hetzel makes Taylor look like a pretzel.
Seriously, if highly intelligent economists such as Sumner, Glasner, Nunes and Woolsey are dissecting Taylor’s commentaries for rhyme or reason, then Taylor is obviously not consistent or the worst communicator ever born (well, he is an economist).
I sense Taylor is positioning himself for a Romney Presidency (in which case Taylor will support robust NGDP targeting) or even for an Obama win. Then Taylor can come out for NGDP figuring the GOP will probably win in 2016 anyway.
Taylor is now gravitating towards the right monetary policy framework.
I welcome John Taylor to Market Monetarism!
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Now wait a minute, Sumner has some splaining to do on 2004-2006.
The numbers don’t lie.
Under his 4.5% level, we’d have had the Fed taking more and more drastic action to NUKE Congressional activity on housing.
NUKE as in cannot happen. Period. The End.
In may ways, the clarity of NGDPLT is almost too much for most people to stare into directly.
If the Fed CAN DO whatever needs to be done well it certainly would have ruined the Housing Market shitty credit buyers and the derivatives built on it.
Woolsey says this:
“As an advocate of a target for a growth path of nominal GDP, I tend to agree with Nunes at first pass. Nominal GDP was below trend in 2002 and 2003. Long ago, Beckworth complained that it was growing faster than trend, but how else could nominal GDP get back to trend? The difference is between a growth rate target and a growth path target. The experience of the last few years has settled any debate on that issue–there is a near consensus among Market Monetarists in favor of a “level” target.”
“I am more and more convinced that there is no substitute for a clearly articulated policy rule. In particular, a specified growth path for nominal GDP. Even if nominal GDP happens to come close to an appropriate path, creating appropriate expectations is key.”
And as much as everyone wants to yap at Taylor for not going in whole hog – even though he comes down hard for RULE based and could probably agree on level targeting – I haven’t seen Scott go through such a come-to-jesus on 2004-2006.
Taylor is at least saying out loud his rule would have stopped the crisis.
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@Marcus, you are so right about a price stability target.
If anyone’s interested, I wrote a small critique of Mr. Taylor’s theses in that article:
http://socialmacro.blogspot.com/2012/04/john-taylor-and-great-recession.html
Feel free to criticize.
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Marcus, Thanks. Looks as if you’re ready to write the book on Taylor.
Frank, Thanks for sharing those very interesting graphs.
Benjamin, You are quite the prognosticator. Let’s see how good your crystal ball is.
Morgan, Welcome back. It’s been a while. NGDP from 2003 to 2006 was growing at an annual rate a bit faster than 5%, but from 2000 to 2003 it was growing at rate a bit slower, so it’s not clear to me that Fed performance was that bad.
Julian, Thanks for the link to your blog. You make some very good points. I agree that the downturn was not caused by the 5.25% interest rate which is on the high side but not unusually so. But with the economy collapsing the rate should have come down faster. Instead it stayed at 2% for over 6 months, and almost a month after the Lehman collapse.
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I would follow Milton Friedman view that targeting wouldn’t be the way to go.
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David,
I was wondering if you would advocate capital controls to keep monetary stimulus in the domestic economy? Sumner didn’t, asserting that you can always just have more monetary stimulus. But that makes as much sense to me as saying that if a bucket has a hole in it, you can just fill it up even faster.
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@David Glasner,
I also felt that the rates should have come down quicker, but didn’t really want to focus on that aspect, since I was looking more at his “cause” of the “Great Recession/Little Depression”.
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David we start with 4.5%, not 5%.
1. opportunistic disinflation was the expectation and the Fed goal.
2. we want less bubble than we got on historical 5% path
Under 4.5% we are more quickly ending the easing 2001-2003 and more quickly turing up dial thereafter.
BUT you really aren’t understanding my point.
Lets say I’m the 4.5% level target and Q3 2004 Barney Frank mentions a policy that might bump into me.
So I raise rates bit, to warn him off.
And THEN Barney Frank comes charging in and pushes at past me determined to get Fannie and Freddie giving out loans to the lower middle class credit risks – AT THAT POINT:
I so go batshit crazy and jack rates hard enough that Barney is visited late in the night by small businessmen in his district it looks like this:
This is WHY it matters.
In fact let me say this more clearly, Fed policy with NGDLT has to be LOW ENOUGH that this is what happens.
So if you don’t even think 4.5% does it, you just argued for 4%.
Morgan’s rule #3: Good monetary policy ruins the life of Barney Frank.
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Tas, Sorry, but Milton Friedman’s specific advice on what to target is no longer accepted by anyone. No one believes that it is possible to achieve a steady 3% rate of growth in M1 or any other monetary aggregate other than currency or the monetary base, or that it would be desirable to do so if it were possible. Even Friedman eventually conceded (about 10 years after everyone had figured it out) that his policy recommendation would not and could not be implemented.
Unlearningecon, I am totally against capital controls because they are incompatible with the basic tenets of liberalism. Only unfree societies like Cuba, North Korea, Iran, and Venezuela keep citizens from taking their wealth out of the country.
Julian, I thought so, but wanted to make sure that I was understanding you.
Morgan, I don’t accept that bubbles are the result of NGDP growth above 5%. There is nothing sacred about 5%. Bill Woolsey wants 3% and I am not so sure that he is wrong. In my book on Free Banking, I advocated stabilizing an index of wages which would translate into an average rate of NGDP growth even less than 3%. Now I am not sure as I sit here writing this what the best policy would be, but how Barney Frank would feel about it probably would not sway me one way or the other. Besides he’s not running for re-election, so after next January, he’s outta here.
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To me the puzzle seems pretty clear:
1. Assume right now the govt. is causing problems with convoluted fiscal policy.
2. Find out what the past growth rate has been. Target rate must be below this to force fiscal into austerity.
3. Argue for a target rates as close to 3% as I can get.
And as long as the NGDLT is low enough we cannot have real serious boom / bust bubbles.
The reason I don’t think we’ll get 3% is because it will scare Fed economists.
But no matter as long as it is low enough to almost certainly feel and taste like a cap on RGDP and inflationary fiscal policy I’ll be happy.
And I think it is impossible for liberals to be happy under any of this. Under 6 or 7%? Sure. Not down at 4.5%.
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I just heard Taylor interviewed on John Bachelor’s radio program, along with Larry Kudlow, who is a regular guest. Taylor would seem to have little memory of ever agreeing with Hertzel’s argument that too-tight money was the cause of the crisis. He repeatedly asserted the opposite, called for a raise in the interest rate to 1 percent, and agreed with Larry Kudlow on a number of points that can only be described as alarmist and fearmongering, e.g., that the Fed is “doing the same thing now” as in 2003-2005. He also, amazingly, agreed with Bachelor that the ECB is following “the Bernanke model” and being overly accommodating.
He’s no better than Kudlow.
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David, at least from a purely technocratic perspective do you think it would help make monetary stimulus more effective?
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Morgan, You may be right about a long-term goal, but I would not favor moving 4.5% ngdp growth until we get a lot closer to full employment than we are now.
Will, My brother-in-law actually heard Bachelor mention my name to Taylor on his show a few months ago after I wrote my post “A Walk Down Memory Lane with John Taylor.” Taylor didn’t take the bait and bash me. Don’t know if I feel good about that or bad. I actually remember Larry Kudlow criticizing the Fed for not cutting interest rates more aggressively when the stock market dove in 2006 when it was becoming clear that the housing bubble was starting to burst. He also was assuring everybody in 2008 that there was not going to be any recession.
Unlearningecon, It might, but I also think that monetary stimulus can be effective without it.
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David, if Bachelor is aware that there exist economists like you who don’t view the world as Kudlow and Taylor do, one would think he could do his listeners the service of talking to one some time! Alas.
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