Rules Vs Discretion
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Rules Vs Discretion

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This article summarizes two opposing views about how central banks should run policy: 1) central banks should stay close to predictable and well-proven rules; 2) policy makers should exercise ...

This article summarizes two opposing views about how central banks should run policy: 1) central banks should stay close to predictable and well-proven rules; 2) policy makers should exercise discretion and choose the most favored alternative in each situation. The history of policy rules and the pros and cons of each approach are discussed and focused in the current debate on the financial crisis.

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Rules Vs Discretion Document Transcript

  • 1. Did Government “indiscretion” cause the financial crisis? The resurrection of an old debate Carlos Madeira, Northwestern University, Dept of Economics March 20, 2009 For the Fed the recent financial crisis represents a change in public opinion. Greenspan’s two decade term was a period of steady growth and remarkable stability. Several economists perceived this period as the result of improved monetary policy by the Fed and Greenspan was elevated to the role of all-powerful Jedi Master. Depression periods by contrast often raise the question of “who to blame”. The Federal Reserve Bank is widely regarded as the ultimate guardian of economic and financial stability. The Fed is therefore not exempt from the public target. Perhaps no economist has been more critical of the Fed’s role in this crisis than Stanford faculty, John Taylor, who expressed his views in a scorching Wall Street Journal article and a recent book, “Getting off track: How government actions and interventions caused, prolonged and worsened the financial crisis”. According to Taylor there is reason to believe government intervention was one of the main factors behind the crisis, with excessively low interest rates dictated by Greenspan during 2001 to 2006 encouraging the housing boom and bankers’ high leverage ratios. Bernanke’s reaction to the crisis is then criticized. Taylor argues the Fed should have acted immediately to solve banks’ toxic assets problem. Instead the Fed decided to spread liquidity and easy money, creating a boom in oil-prices that further damaged the economy. Also, the US Treasury and the Fed created a dangerous game of choosing winners and losers which scared investors. Financial markets entered into turmoil when they realized policy makers had no consistent plan to solve the crisis. Some of Taylor’s arguments deserve perhaps more research before being completely accepted. Can econometric models really show all the credit boom and
  • 2. spikes in oil-prices were caused by low interest rates? In Europe the Bank of England and the ECB implemented much higher rates during the same period, yet their conservative policy did not avoid real-estate speculation in the UK, Spain and Ireland, or high debt ratios in British banks. Taylor’s basic argument, however, is that the Fed should not have departed from the policy prescriptions of traditional rules. In this conclusion Taylor implicitly resurrects an old debate for economists and policy makers alike: should government policy stick to predictable rules or is optimal policy to be decided by “discretion” on a case-by-case basis? Economics has long sought to limit the pernicious effects of bad government. Good rules have two main advantages: 1) they provide guidance to the markets, instead of leaving dumb-founded agents to do guess-work; 2) rules make it easier for policy makers to be seen as credibly committed to a good policy and avoid easy temptations (such as creating short-term inflation to increase employment). In the case of monetary policy, economic thought is particularly abundant in simple rules that central banks should follow. Milton Friedman (1960) was again a pioneer by suggesting a constant money-growth rule as a reasonable policy. This policy was intended to avert the steep fall in money supply that caused deflation and the Great Depression, while preventing authorities from creating excessive money and inflation. Other rules have been suggested since, including fixed exchange-rates and inflation targeting (Bernanke and Woodford, 2004). Inflation targeting simply means that governments provide a long-run target for an acceptable rate of inflation, leaving central banks the task of reaching that goal. If expected inflation seems to miss the target, then central bankers must explain why the target was missed (due, for instance, to unexpected conditions) and what their actions will be for restoring normal inflation. Chairman Bernanke as an academic often praised the virtues of inflation targeting. Inflation targeting is a framework that leaves lot of flexibility to the central bank, since it does not oblige bankers to set interest rates or money-growth at any particular level. Central bankers are allowed flexibility for attaining inflation stability. At the same time inflation targeting precludes out-right inflationary policies and forces central banks to be transparent and accountable to the public.
  • 3. However, perhaps the most debated monetary policy rule in the last decade was suggested by John Taylor himself in 1992, the Taylor rule. This rule is a brief equation based only on two simple assertions: 1) real interest rates must be increased when inflation surges (meaning central banks should be anti-inflationary); 2) real interest rates fall when economic growth decreases (i.e., central bankers care about unemployment). Taylor’s suggestion also requires surprisingly little information about the economy: central banks only need to know the current quarter’s inflation and growth rates to achieve good policy. This is a great contrast relative to other models suggested by economists, which assume that policy makers need to know everything about how the economy works and also how the economy is expected to change in the next few years. Taylor’s prescriptions are so deceptively simple they could be mistaken by standard common sense: you cool the shower water when it is too hot or warm it when you feel cold. Taylor’s research, however, shows that one or both of his prescriptions were not followed for the largest part of US history! In the 19th century policy makers did not care either about unemployment or inflation. The result was wild inflation and deflation periods, mixed with deep busts and booms. In the 60s and 70s Fed governors cared about unemployment but not inflation, resulting in the 70s’ “stagflation”. Only in the 80s and 90s did policy makers care both about inflation and unemployment. The Fed has been implicitly following a simple Taylor rule for the last 25 years. The result seems to have been great: 25 years of low inflation and stable growth! Overall, central banks appear to have learned Taylor’s lesson only in the last two decades. Over the last decade several academics show that the Taylor rule has a stabilizer effect in economic models and it is robust to several kinds of unexpected shocks. Paradoxically, models seem to show that the Taylor rule is far better than more complicated rules which use much more information. The reason is that complex rules work very well in some cases, but they can be terrible in other situations! A simple rule is guaranteed to work less well in some specific cases, but also avoids dangerous mistakes. The Taylor rule is therefore one of those rare cases of something which seems to work well both in the real world and in the abstract models of academia. Still, central banks are always wary of simple rules. Greenspan, for instance, argued that policy cannot follow rules, since we are not absolutely certain about how the real world works. Policy makers therefore must retain flexibility to choose the wisest
  • 4. course of action all the time. There can also be political criticism of rigid rules when these fail. Some critics also point out that a misguided rule can actually foment instability and damage the economy (see Christiano and Gust’s article in Taylor, 1999). The advocates of rules recognize the validity of all these weaknesses. Taylor himself only advocated his finding as a guide for monetary policy, never as a rigid law to be followed against better sense. All academics and policy makers are “discretionary” in this sense. Perhaps the difference resides in central banks that exercise “good” discretion relative to others that unwisely departed from useful policy guides. Taylor’s recent book certainly shows that both Greenspan and Bernanke seriously departed from the traditional policies that created economic stability in the previous two decades. Was this a wise policy? Some believe Bernanke was ingenious and creative in his attempt to avoid a Great Depression by issuing liquidity to non-bank institutions and even by buying private corporate debt. Perhaps, the historical jury is still out on the question of what caused the crisis and what could have prevented it. References: Bernanke, Ben and Michael Woodford (2004), “The inflation-targeting debate”, NBER Friedman, Milton (1960), “A program for monetary stability”, Fordham University Press Taylor, John (1999), “Monetary policy rules”, NBER Taylor, John (2009), “Getting off track: How government actions and interventions caused, prolonged and worsened the financial crisis”, Hoover Press Wall Street Journal (February 9, 2009), “How government created the financial crisis”, by John Taylor