I just finished John Taylor’s new book, First Principles. It’s a very good and fast read. It’s a little over 200 pages, and not a derivative in it. I don’t think there is even an explicit formula in it. Taylor writes very well, especially for an academic economist. Maybe that is from all his years advising policy makers.
Taylor’s trying to supply principles to guide policy makers as they try to put our economy on track again. He has five of them:
- Predictable policy framework
- Rule of law
- Strong incentives
- Reliance on markets
- Clearly limited role for government
Taylor provides lots of evidence that our current problems are a result of not following these principles. I believe him. However, I’m not sure his arguments are strong enough to convince someone not predisposed to believe him. He was clearly trying to write something for non-technical people, and that probably weakened his case. It won’t change any hard-Keynesian minds.
It’s not surprising that when it comes to monetary policy, Taylor recommends a policy rule. He created the Taylor Rule after all. I’ve never been sympathetic to policy rules. Constraints usually don’t improve outcomes. Still, Taylor makes a good argument that the short-term demands of modern politics provide irresistible incentives for action at the expense of long-term prosperity.
Once you decide to use a rule, you have to decide which rule. Again, it is not surprising that Taylor recommends a Taylor Rule. That presents a couple of problems.
There are lots of Taylor Rules. They’ve become a class of rules. Probably every monetary economist at a top-ten department has his or her own version.
The various Taylor Rules can come up with rather different policy prescriptions. So, the selection of the proper Taylor Rule is a real issue. However, probably none of them would have the devastating impacts of some of the worst mistakes the Fed has made in its almost 100 year history.
I have a bigger problem with Taylor Rules though, and it the zero bound on interest rates. Sometimes some Taylor rules recommend negative nominal interest rates, and we just haven’t figure out how to do that. I think Taylor’s response would be that if you followed a Taylor Rule in the first place, you would never have reached the problem of a zero lower bound. That’s probably true.
There is a rule that competes with the Taylor Rules, a Nominal GDP Target Rule. Scott Sumner has been a key proponent of NGDP targeting. Sumner argues that the Fed has the power to create any nominal GDP it wants.
Here’s an example: Suppose the Fed creates a target of five percent nominal GDP growth. If nominal GDP is shrinking at, say, two percent, then all the Fed has to do is generate seven percent inflation. If it can create the seven percent inflation, it will create the five percent NGDP growth.
I have a problem with this too. I don’t believe that the Fed can always create inflation. The Fed controls the monetary base, but turning the base into money, which is what is required to generate inflation, requires the cooperation of banks and borrowers. The past few years provide strong evidence that banks and borrowers can’t be counted on to cooperate. That is, banks may not lend and borrowers may not borrow, at exactly the time we need them to if monetary policy is to be effective.
I think Sumner would have two responses. First, he would argue that if the Fed had followed this policy in the first place, we would never have reached the problem of banks and borrowers not cooperating in creating money. That’s probably true.
A second response would be that the Fed just hasn’t tried hard enough. Like the Keynesian response that true fiscal stimulus was never tried, this argument can always be made, and I think they are both wrong. At over 35 percent of gross product, total government spending (including federal, state, and local) exceeds that at the peak of WWII, and no one would argue that we are seeing a vigorous recovery. Similarly, QEs 1 and 2 were unprecedented efforts to increase the money supply. They failed, because banks weren’t lending and borrowers weren’t borrowing.
These are second order problems, though. If either Taylor or Sumner were in charge of our monetary policy over the past decade, we’d probably be a lot better off than we are today. If policy makers had followed Taylor’s principles, we’d probably be a lot better off than we are today.
It’s a shame that Taylor’s principles are controversial. It is a shame that millions of Americans are unemployed, in part because we’ve moved so far away from those principles. Taylor has written an excellent guide for policy going forward. I highly recommend First Principles.