[Title amended to copy Noah Smith’s catchier tweet of this post]
I am just back from a conference on uncertainty hosted by the Federal Reserve Bank of Dallas. John Taylor spoke over lunch about what he thought the causes of the crisis were, and what would improve policy now, articulating a view he has made many times now. (For example, here). His basic diagnosis is: the principal cause of the crisis was interest rates being too low during the early 2000s, as indicated by deviating below what the Taylor Rule would have recommended. He acknowledged that fiscal uncertainty was weighing against the economy, but argued that that was because of the Obama stimulus package of early 2009, which was a departure from ‘predictable’ and sound fiscal policy. He also explained that he thought QE was creating economic uncertainty, and that the world would be better without it. So, in his view, we would be better off with tighter monetary policy, and greatly tighter fiscal policy. And the other smoking guns causing the crisis (lax regulation, global imbalances, irrational exuberance, politically motivated lending to subprime borrowers, etc) were a sideshow.
Taylor’s normative monetary policy analysis was conducted in sticky price models. In those models, fiscal policy has very similar effects to monetary policy. At the zero bound, fiscal policy can be indispensable. Ok, there are many (like Cochrane, for example) who are greatly sceptical of these models, and that government spending is the solution to weak demand. But Taylor can’t be in that camp, surely, because he has arrived at views about the efficacy of monetary policy based on a belief in sticky prices and wages. If you want to deny the benefits of conventional fiscal stabilisation, then you have a hard job explaining to yourself why Taylor Rules are a good thing. Without the stimulus package, which many argue was too feeble, the recession would surely have been greatly deeper and perhaps even more protracted. What would be more ‘predictable’ about that?
One interpretation of what he said might be: ok, I buy that in these idealised model worlds fiscal stabilisation policy works, especially at the zero bound. But in the US, right now, attempting to pursue such a policy was bound to lead to open warfare with the Tea Party Republicans. So it would have been better to forgo the benefits of the stimulus and avoid the danger of a fight over the debt ceiling. This is at least a coherent argument. Although it’s highly contentious. And I don’t think it was what Taylor was saying.
As for deviations from the Taylor Rule causing the financial crisis? This argument seems to me to be stretching things beyond belief. For a start, monetary policy just isn’t that powerful in the models in which Taylor was led to conclude that following a Taylor rule was a good idea. Beyond the very short run, they display what’s called the ‘classical dichotomy’ in the economics profession. You might dispute the classical dichotomy. (Plenty suffering in the periphery of the euro zone at the moment would). But if you do, you have to throw away what you thought you had learned about the Taylor Rule. Second, what is so special about the Taylor Rule anyway? Even in the model worlds, you can do much better. Who knows what the right rule for monetary policy is in the real world? Bernanke argued (eg here) against Taylor explaining that rather than following Taylor Rules, (which prescribe that interest rates should respond to today’s inflation rate…) a central bank would be better advised following rule that responded to forecasts of future inflation (etc). Looked at that way, rates weren’t too low in the early 2000s. The Fed was facing the real prospect of deflation, and had watched Japan struggle for 10 years already at the zero lower bound, and was determined to avoid it. Taylor offers no arguments that weigh heavily enough against Bernanke’s response.
Taylor’s remarks sounded like a classic Republican critique of monetary and fiscal policy. Many Republicans objected to QE, fearful that it would stoke up inflation. And they objected to the stimulus package because it went against their preference for small government. But this Republican critique flies in the face of Taylor’s own path-breaking work took on the causes of the business cycle, what monetary policy can do about it, and, by very close analogy, what fiscal policy can do too. Personally I hope that this Taylor Critique of current US policy continues to be ignored by the Fed and the US Treasury. To do otherwise would, in my view, ignore the real wisdom that Taylor’s own pivotal work conferred on macroeconomics.