Uneasy Money

John Taylor responded to my post criticizing his op-ed piece in yesterday’s Wall Street Journal.  Here are some comments on Professor Taylor’s response.

Professor Taylor responds to my charge of exaggerating the difference between U.S. policies “in the years after World War II . . . promoting economic growth through reliance on the market and the incentives it provides” and current supposedly interventionist fiscal and monetary policies and increasingly burdensome regulation by admitting that post-war “American economic policy was not perfect.”  Nevertheless, in the aftermath of World War II, when America helped Japan and Europe recover, “the American model was a far cry from what was being set up in large areas of the world which were not free either economically or politically.” 

Well, yes, but it is somewhat chauvinistic on Professor Taylor’s part to assume that the only intellectual and policy resources on which Europe and Japan could draw were to be found in America.  Economic and political liberalism were imported and adopted, perhaps even improved, by America from Europe, not vice versa.  It is an old story, but perhaps worth repeating for Professor Taylor’s benefit, that in 1948, with the German economy in a state of semi-collapse owing to runaway inflation, price controls, and rationing imposed by the occupying powers, Ludwig Erhard, the German economics minister in the British and American occupation zones, unilaterally lifted price controls and ended rationing while imposing a tight monetary policy, despite the objections of the Allied authorities.   Thus began what would become known as the “German economic miracle” of which Erhard was the acknowledged architect.

Professor Taylor was also a bit shaky in describing what happened in the 1980s and 1990s, calling American economic ideas “contagious, not just in Britain under Margaret Thatcher but in the developing world.”  But Mrs. Thatcher came to power in May 1979, over a year and a half before Ronald Reagan.  So, once again, the flow of ideas went from east to west.

Turning to my charge of inconsistency in opposing quantitative easing by the Fed in 2009 and 2010, when he had supported a similar policy for Japan in 2002, Professor Taylor maintains that since there was actual deflation in Japan (measured by both the CPI and the GDP price deflator) while inflation in the U.S., with only brief exceptions, remained positive after the 2008 financial crisis.  But Professor Taylor himself acknowledged in one of the papers cited in his response to my post that even positive inflation is potentially dangerous when it approaches zero (especially at the zero-interest lower bound) . 

In addition, “increasing the monetary base in Japan” was supposed to “get the growth rate of the money supply . . . back up . . . not to drive up temporarily the price of mortgage securities or stock prices, which is frequently used to justify quantitative easing by the Fed today.”  Ahem, the purpose of getting the growth of the money supply back up in Japan was to stop deflation, thereby increasing output and employment.  Increasing the money supply is just a means to accomplish that objective.  The purpose of quantitative easing in the US is to increase the rate of nominal GDP (NGDP) growth, and thereby increase output and employment.  That some people believe doing so would also have the beneficial side-effect of raising the prices of mortgage securities or stocks is just a red herring.

Professor Taylor also refers to the debate over rules versus discretion in the conduct of monetary policy. 

If a central bank follows a money growth rule of the type Milton Friedman argued for – and which is quite appropriate when the interest rate hit zero in Japan – then the central bank should increase the monetary base to prevent money growth from falling or to increase money growth if it has already fallen.  In other words such an easing policy can be justified as being consistent with a policy rule, in this case for the growth of the money supply.  The rule calls for keeping money growth from declining.  But the large-scale asset purchases by the Fed today are highly discretionary, largely unpredictable, short-term interventions, which are not rule-like at all.  It is the deviation from more predictable rule-like policy by the Fed (which began in 2003-2005 and continues today) that most concerns me.

A Friedman-type rule for growth of the money supply has long since been abandoned even by Friedman, the so-called Taylor rule being an attempt to provide an alternative with which to replace the Friedman rule.  But the Fed, since its unsuccessful attempt to adhere to a Friedman-type rule in 1981-82, has never articulated a specific rule, so it is not clear what rule Professor Taylor believes the Fed has been deviating from since 2003-05.  One could as easily infer from the data that the Fed was following a rule targeting a 5-6% growth path for NGDP as any other rule.  If so, one could argue that quantitative easing designed to restore NGDP growth to its 5-6% long-run trend is as good a rule as any.  Indeed, with inflation expectations (as measured by the TIPS spread) now running well under 2%, and with a substantial output gap, most versions of the Taylor rule would imply that monetary policy should be eased.  If the target interest rate is already at the lower bound, then the alternative is to increase the monetary base.  That’s called quantitative easing. 

Finally, Professor Taylor refers to my “long rebuttal” to his criticism of “recent interventionist fiscal and monetary policies in the United States.”  Inasmuch as nearly half of my post consisted of direct quotations from Professor Taylor, I am afraid that he has an equal share in the blame for the length of my rebuttal.

HT:  Scott Sumner, Lars Christensen, Nick Rowe