Uneasy Money

In his op-ed in the weekend Wall Street Journal, John Taylor restates his confused opposition to what Ben Bernanke calls the policy of constrained discretion followed by the Federal Reserve during his tenure at the Fed, as vice-chairman under Alan Greenspan from 2003 to 2005 and as Chairman from 2005 to 2013. Taylor has been arguing for the Fed to adopt what he calls the “rules-based monetary policy” supposedly practiced by the Fed while Paul Volcker was chairman (at least from 1981 onwards) and for most of Alan Greenspan’s tenure until 2003 when, according to Taylor, the Fed abandoned the “rules-based monetary rule” that it had followed since 1981. In a recent post, I explained why Taylor’s description of Fed policy under Volcker was historically inaccurate and why his critique of recent Fed policy is both historically inaccurate and conceptually incoherent.

Taylor denies that his steady refrain calling for a “rules-based policy” (i.e., the implementation of some version of his beloved Taylor Rule) is intended “to chain the Fed to an algebraic formula;” he just thinks that the Fed needs “an explicit strategy for setting the instruments” of monetary policy. Now I agree that one ought not to set a policy goal without a strategy for achieving the goal, but Taylor is saying that he wants to go far beyond a strategy for achieving a policy goal; he wants a strategy for setting instruments of monetary policy, which seems like an obvious confusion between strategy and tactics, ends and means.

Instruments are the means by which a policy is implemented. Setting a policy goal can be considered a strategic decision; setting a policy instrument a tactical decision. But Taylor is saying that the Fed should have a strategy for setting the instruments with which it implements its strategic policy.  (OED, “instrument – 1. A thing used in or for performing an action: a means. . . . 5. A tool, an implement, esp. one used for delicate or scientific work.”) This is very confused.

Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?

It is worth noting that the practice of defining a rule in terms of a policy instrument rather than in terms of a policy goal did not originate with John Taylor; it goes back to Milton Friedman who somehow convinced a generation of monetary economists that the optimal policy for the Fed would be to target the rate of growth of the money supply at a k-percent annual rate. I have devoted other posts to explaining the absurdity of Friedman’s rule, but the point that I want to emphasize now is that Friedman, for complicated reasons which I think (but am not sure) that I understand, convinced himself that (classical) liberal principles require that governments and government agencies exercise their powers only in accordance with explicit and general rules that preclude or minimize the exercise of discretion by the relevant authorities.

Friedman’s confusions about his k-percent rule were deep and comprehensive, as a quick perusal of Friedman’s chapter 3 in Capitalism and Freedom, “The Control of Money,” amply demonstrates. In practice, the historical gold standard was a mixture of gold coins and privately issued banknotes and deposits as well as government banknotes that did not function particularly well, requiring frequent and significant government intervention. Unlike, a pure gold currency in which, given the high cost of extracting gold from the ground, the quantity of gold money would change only gradually, a mixed system of gold coin and banknotes and deposits was subject to large and destabilizing fluctuations in quantity. So, in Friedman’s estimation, the liberal solution was to design a monetary system such that the quantity of money would expand at a slow and steady rate, providing the best of all possible worlds: the stability of a pure gold standard and the minimal resource cost of a paper currency. In making this argument, as I have shown in an earlier post, Friedman displayed a basic misunderstanding of what constituted the gold standard as it was historically practiced, especially during its heyday from about 1880 to the outbreak of World War I, believing that the crucial characteristic of the gold standard was the limitation that it imposed on the quantity of money, when in fact the key characteristic of the gold standard is that it forces the value of money – regardless of its material content — to be equal to the value of a specified quantity of gold. (This misunderstanding – the focus on control of the quantity of money as the key task of monetary policy — led to Friedman’s policy instrumentalism – i.e., setting a policy rule in terms of the quantity of money.)

Because Friedman wanted to convince his friends in the Mont Pelerin Society (his egregious paper “Real and Pseudo Gold Standards” was originally presented at a meeting of the Mont Pelerin Society), who largely favored the gold standard, that (classical) liberal principles did not necessarily entail restoration of the gold standard, he emphasized a distinction between what he called the objectives of monetary policy and the instruments of monetary policy. In fact, in the classical discussion of the issue by Friedman’s teacher at Chicago, Henry Simons, in an essay called “Rules versus Authorities in Monetary Policy,” Simons also tried to formulate a rule that would be entirely automatic, operating insofar as possible in a mechanical fashion, even considering the option of stabilizing the quantity of money. But Simons correctly understood that any operational definition of money is necessarily arbitrary, meaning that there will always be a bright line between what is money under the definition and what is not money, even though the practical difference between what is on one side of the line and what is on the other will be slight. Thus, the existence of near-moneys would make control of any monetary aggregate a futile exercise. Simons therefore defined a monetary rule in terms of an objective of monetary policy: stabilizing the price level. Friedman did not want to settle for such a rule, because he understood that stabilizing the price level has its own ambiguities, there being many ways to measure the price level as well as theoretical problems in constructing index numbers (the composition and weights assigned to components of the index being subject to constant change) that make any price index inexact. Given Friedman’s objective — demonstrating that there is a preferable alternative to the gold standard evaluated in terms of (classical) liberal principles – a price-level rule lacked the automatism that Friedman felt was necessary to trump the gold standard as a monetary rule.

Friedman therefore made his case for a monetary rule in terms of the quantity of money, ignoring Simons powerful arguments against trying to control the quantity of money, stating the rule in general terms and treating the selection of an operational definition of money as a mere detail. Here is how Friedman put it:

If a rule is to be legislated, what rule should it be? The rule that has most frequently been suggested by people of a generally liberal persuasion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of a rule [my emphasis]. It is the wrong kind of a rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway.

As an aside, I note that Friedman provided no explanation of why such a rule would disperse responsibilities. Who besides the monetary authority did Friedman think would have responsibility for controlling the price level under such a rule? Whether such a rule would give the monetary authorities “too much leeway” is of course an entirely different question.

There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities. (p. 53)

Friedman continues:

In the present state of our knowledge, it seems to me desirable to state the rule in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System shall see to it [Friedman’s being really specific there, isn’t he?] that the total stock of money so defined rises month by month, and indeed, so far as possible day by day, at an annual rate of X per cent, where X is some number between 3 and 5. (p. 54)

Friedman, of course, deliberately ignored, or, more likely, simply did not understand, that the quantity of deposits created by the banking system, under whatever definition, is no more under the control of the Fed than the price level. So the whole premise of Friedman’s money supply rule – that it was formulated in terms of an instrument under the immediate control of the monetary authority — was based on the fallacy that quantity of money is an instrument that the monetary authority is able to control at will.

I therefore note, as a further aside, that in his latest Wall Street Journal op-ed, Taylor responded to Bernanke’s observation that the Taylor rule becomes inoperative when the rule implies an interest-rate target below zero. Taylor disagrees:

The zero bound is not a new problem. Policy rule design research took that into account decades ago. The default was to move to a stable money growth regime not to massive asset purchases.

Taylor may regard the stable money growth regime as an acceptable default rule when the Taylor rule is sidelined at the zero lower bound. But if so, he is caught in a trap of his own making, because, whether he admits it or not, the quantity of money, unlike the Fed Funds rate, is not an instrument under the direct control of the Fed. If Taylor rejects an inflation target as a monetary rule, because it grants too much discretion to the monetary authority, then he must also reject a stable money growth rule, because it allows at least as much discretion as does an inflation target. Indeed, if the past 35 years have shown us anything it is that the Fed has much more control over the price level and the rate of inflation than it has over the quantity of money, however defined.

This post is already too long, but I think that it’s important to say something about discretion, which was such a bugaboo for Friedman, and remains one for Taylor. But the concept of discretion is not as simple as it is often made out to be, especially by Friedman and Taylor, and if you are careful to pay attention to what the word means in ordinary usage, you will see that discretion does not necessarily, or usually, refer to an unchecked authority to act as one pleases. Rather it suggests that a certain authority to make a decision is being granted to a person or an official, but the decision is to be made in light of certain criteria or principles that, while not fully explicit, still inform and constrain the decision.

The best analysis of what is meant by discretion that I know of is by Ronald Dworkin in his classic essay “Is Law a System of Rules?” Dworkin discusses the meaning of discretion in the context of a judge deciding a “hard case,” a case in which conflicting rules of law seem to be applicable, or a case in which none of the relevant rules seems to fit the facts of the case. Such a judge is said to exercise discretion, because his decision is not straightforwardly determined by the existing set of legal rules. Legal positivists, against whom Dworkin was arguing, would say that the judge is able, and called upon, to exercise his discretion in deciding the case, meaning, that by deciding the case, the judge is simply imposing his will. It is something like the positivist view that underlies Friedman’s intolerance for discretion.

Countering the positivist view, Dworkin considers the example of a sergeant ordered by his lieutenant to take his five most experienced soldiers on patrol, and reflects on how to interpret an observer’s statement about the orders: “the orders left the sergeant a great deal of discretion.” It is clear that, in carrying out his orders, the sergeant is called upon to exercise his judgment, because he is not given a metric for measuring the experience of his soldiers. But that does not mean that when he chooses five soldiers to go on patrol, he is engaging in an exercise of will. The decision can be carried out with good judgment or with bad judgment, but it is an exercise of judgment, not will, just as a judge, in deciding a hard case, is exercising his judgment, on a more sophisticated level to be sure than the sergeant choosing soldiers, not just indulging his preferences.

If the Fed is committed to an inflation target, then, by choosing a setting for its instrumental target, the Fed Funds rate, the Fed is exercising judgment in light of its policy goals. That exercise of judgment in pursuit of a policy goal is very different from the arbitrary behavior of the Fed in the 1970s when its decisions were taken with no clear price-level or inflation target and with no clear responsibility for hitting the target.

Ben Bernanke has described the monetary regime in which the Fed’s decisions are governed by an explicit inflation target and a subordinate commitment to full employment as one of “constrained discretion.” When using this term, Taylor always encloses it in quotations markets, apparently to suggest that the term is an oxymoron. But that is yet another mistake; “constrained discretion” is no oxymoron. Indeed, it is a pleonasm, the exercise of discretion usually being understood to mean not an unconstrained exercise of will, but an exercise of judgment in the light of relevant goals, policies, and principles.

PS I apologize for not having responded to comments recently. I will try to catch up later this week.