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 