Smith Faculty Opinion Article
The 30 Seconds Outlook
August 1, 2010
“The attempt to do more than we can will itself be a disturbance that
may increase rather than reduce instability.”
— Milton Friedman, Congressional testimony, 1958
Professor John Taylor, author of the “Taylor Rule,” has done us the favor of
summing up what must be done to rectify errors of Bernanke’s loose monetary
policy and Obama’s economic policy. Application of the Taylor Rule, if you
missed it, measures the extent to which the Fed funds rate deviates from what
was working so well during the Great Moderation that began in the early 1980s.
This deterioration reflects an interventionist monetary policy that is less
rules-based and less predictable. Thus, performance of the economy deteriorated
until the Great Recession came upon us.
Let us now turn to Taylor’s (Review, St Louis Fed 5-6/10) recommendations for
what now must be done in the areas of monetary policy and fiscal policy. He says
it best.
“ . . . [T]the crisis shows that the government interventions taken before,
during, and after the crisis did more harm than good. These interventions were a
deviation from what was working well. We got off track. The policy implications
are thus clear: Macro-economic policy should get back on track.
For fiscal policy, this means avoiding further debt-increasing and wasteful
discretionary stimulus packages, which do little to stimulate GDP. Ten years ago
there was a near consensus that such programs were ineffective. Fiscal policy
should focus on reducing the deficit and the growth of the debt-to-GDP ratio.
Reforming existing entitlement programs to hold their growth down and limiting
the creation of additional entitlement programs are essential.
For monetary policy, it means . . . returning to a policy with four basic
characteristics:
First, the short-term interest rate (the federal funds rate) is determined by
forces of supply and demand in the money market.
Second, the Fed adjusts the supply of money or bank reserves to bring about a
desired target for the short-term interest rate; there is thus a link between
the quantity of money or reserves and the interest rate.
Third, the Fed adjusts the interest rate depending on economic conditions:
The interest rate rises by a certain amount when inflation increases above its
target and the interest rate falls by a certain amount when the economy goes
into a recession.
Fourth, to maintain its independence and focus on its main objectives of
inflation control and macroeconomic stability, the Fed does not allocate credit
or engage in fiscal policy by adjusting the composition of its portfolio toward
or away from certain firms or sectors . . .. Of course, this means we should
exit from the MBS and other special programs as soon as possible. Obviously, we
can’t be draconian about this, but the sooner policymakers achieve this goal,
the better future policy will be.
Some suggest that monetary policy has to do more things, such as taking
actions to burst bubbles. . . . Our most successful past policy during the Great
Moderation did not include such attempts to pop bubbles and the economy
functioned very well.”
John A. Haslem
