Taylor's (and Friedman's) Error

In a book review by Clive Crook in todays Financial Times, we read about the new work Getting Off Track by John Taylor, creator of the "Taylor Rule" for monetary policy. According to Taylor, if the Federal Reserve had followed his famous Rule instead of their own discretion over the last decade, we wouldn't be in the mess we're in today.

Taylor's Rule gives a mathematical formula for the calculation of monetary policy. As Crook describes it:

"The rule says central banks should set the short-term interest rate equal to one-and-a-half times the inflation rate; plus half of the gap between actual and trend gross domestic product; plus one. For example, if the inflation rate is 5 per cent and the output gap 3 per cent, the Taylor rule says make the interest rate 10 per cent: one-and-a-half times 5, plus a half of 3, plus 1."

His idea is similar to the formula of Milton Friedman, which at one point economists called the "k-percent rule." Friedman would have had the Fed increase the money supply annually by a fixed percentage. He is essentially Taylor's precursor.

Both economists advocated a fixed, formulaic determination of the expansion of money supply because they were wary of a discretionary monetary policy open to the whims of central bankers and the politicians who appoint them.

Where both these illustrious gentlemen err is in their naive belief that any political appointee(s) would be capable of limiting themselves to a non-discretionary monetary policy once they have the power not to.

In a July 2006 e-mail exchange with the Wall Street Journal's Tunku Varadarajan, Friedman wrote: "There are certainly occasions in which discretionary changes in policy guided by a wise and talented manager of monetary policy would do better than the fixed rate, but they would be rare." WSJ Archives.

Rare indeed. Didn't he realize that "rare" is in the eyes of the rate-setter?

Friedman's incongruous naivety is at odds with his skeptic personality. In his own book Capitalism and Freedom, he says:

"As matters now stand, while this rule [the k-percent rule] would drastically curtail the discretionary power of the monetary authorities, it would still leave an undesirable amount of discretion in the hands of Federal Reserve and Treasury authorities with respect to how to achieve the specified rate of growth in the money stock, debt management, banking supervision, and the like."

So why does he even bother with the k-percent rule in the first place?

Both Friedman and Taylor seem to be aware of the fallibility of agency intervention into the supply of money; and yet, inexplicably, both seem in the end to take for granted that the agency in question will be willing to renounce discretion when push comes to shove.

This is equivalent to sitting two-year-old Dick and Jane in a room with a big box of chocolates, telling them they can have only one each, then leaving the room. It just won't work.


[Thanks to www.lib.udel.edu, the Univ. of Delaware Library, and The New Fun with Dick and Jane, Chicago: Scott, Foresman and Co., 1956.]

And it's not Dick or Jane's fault. Dick and Jane are only two years old. Monetary policymakers are just humans. Humans are control freaks. They are tinkerers. It is a rare economist who, once appointed to the position of Federal Reserve Board Member, can look deep down inside existing economic science and declare the truth of what he finds, i.e. that no one knows how to control monetary policy, with or without a formula.

For one illustration of the mindset of our FRB Members, read this speech by Governor Mishkin. It's an eye-opener, revealing just what the more rational economists like Taylor and Friedman are up against. These Governors see themselves as monetary artists, not scientists.

For a second example of Federal Reserve mindset, take a look at this astonishingly self-serving article by Alan Greenspan in the Wall Street Journal last month. We perceive between the lines that there's a nasty feud going on between Taylor and Greenspan, and rightfully so. Taylor is Jane's older brother (he's six) and Greenspan is little Dicky.

Now children: I guess we'll just have to take that box of chocolates away, now won't we? (Gold standard and sound commercial banking, anyone?)

It's Time to Reconfigure the Fed's Modus Operandi

Our central banking network, called the Federal Reserve System, has several functions one of which is coordinating overnight exchanges between banks around the country and insuring a smooth flow of banking transactions in general. The Fed regulators are also responsible for the oversight of some bank operations (although some have accused them of laxity in this regard).

The job should stop here, but unfortunately there's more. A third thing the Fed does--or at least is supposed to do--is maintain just the right amount of purchasing media in circulation to support the economy's needs, nothing more and nothing less.

The centralized maintenance of the money supply is a superhuman task. Some economists believe that it could be much better performed by a private banking system. (For more on this idea, see Breaking the Banks: Central Banking Problems and Free Banking Solutions, published at the American Institute for Economic Research.)

But there's even more to their job. According to the Federal Reserve Board's Congressional mandate, they are also required "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (Source.)

That's like handing over to your local supermarket manager the responsibility for maintaining the stability of your job, your salary, the purchasing power of your money, your available credit, and the supply and demand of everything you buy.

Economists are not in agreement regarding the feasibility of centralized control of the money supply, never mind of accomplishing this Congressional mandate, i.e. whether the status of the economic science is competent to allow any person(s) to undertake such responsibilities. The Fed has had to utilize existing "scientific" tools that are of necessity inadequate to achieve these goals, even by their own admission.

Federal Reserve Chairman Ben Bernanke said, in November of last year, "because our knowledge of the structure of the economy is incomplete and future economic disturbances are often unforeseeable, economic forecasting is a highly uncertain enterprise. The only economic forecast in which I have complete confidence is that the economy will not evolve along the precise path implied by our projections." I applaud his openness, revealing courage and humility, two qualities that some former Chairmen have not possessed.

I am not alone in my evaluation of the Fed's incapacity to fulfill its duty. To quote just one other skeptic, here is what economist Milton Friedman has said about this subject:

"Any system which gives so much power and so much discretion to a few men that mistakes--excusable or not--can have such far-reaching effects is a bad system.... Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality.... [M]oney is much too serious a matter to be left to the Central Bankers." (From Capitalism and Freedom.)

When you read Wall Street news tickers like this one from the bond markets, you get a sense of how much the economy's short- and medium-term well-being is dependent upon the Fed. Before making any decisions, stock market players and industry leaders all look to the Fed to see what their next move will be.

Why are the Fed movements so important? Because the use by our central bankers of exceptional powers to affect the supply of purchasing media, and the credit that goes with it, creates an uncertain playing field in which players can no longer make long-term plans. Instead, they must become Fed-watchers.

In other words, our vital economic equilibrium no longer depends upon predictable market parameters but rather upon what the central bankers do--even what the individual members say. One wrong word or action can literally make or break an economy, or at least that's what the Fed-watchers believe.

Friedrich Von Hayek, another great economist, once said in The Road to Serfdom, "If the individuals are to be able to use their knowledge effectively in making plans, they must be able to predict actions of the state which may affect their plans."

Our money managers might do better to replace themselves by a computer, as Friedman himself once remarked only half in jest. Scientists like John B. Taylor have searched for a computer-like formula that might aid the Fed in managing the stock of money. It's possible that a solid rule like his Taylor Rule would furnish much better results than allowing central bankers the discretion to move economic parameters as they see fit.

Even if such a rule would not be perfect (perfection doesn't exist), surely predictability is better than hunch, no matter how educated.

As for what the central bankers think about this idea, here's an excerpt of a speech by Fed Governor Mishkin:

"Monetary policy will [...] never become as boring as dentistry. Monetary policy will always have elements of art as well as science. (That is good news because it will keep life interesting for monetary economists like me.)" (Source.)

Maybe it's time to get rid of the artists and try the Taylor Rule. Even if it doesn't produce perfection, surely the market's renewed capacity to plan ahead would cure much that ills us today.

And if that doesn't work, we should go back to the gold standard or something like it, coupled with a private banking network where reputations count and sound commercial banking controls the money supply. (For more on this, see the chapter on commercial banking in Cause and Control of the Business Cycle by E.C. Harwood, published also by the American Institute for Economic Research.)