John B. Taylor (Stanford University) and Representative Ryan provided some interesting commentary dated November 30 at the Investors.com a site powered by Investor’s Business Daily on QEII (quantitative easing 2) and the role of the Fed, “Refocus the Fed on Price stability Instead of Bailing Out Fiscal Policy”. The commentary is most likely based on Taylor’s longer paper, “Swings in the Rules-Discretion Balance,” prepared for 40th anniversary of Phelps micro foundations volume, November 20, 2010, Columbia University.
Taylor and Ryan argue that the Fed, post 2000, began veering from a successful rules based approach to monetary policy that was responsible for the long period, 1981-2002, known as the “Great Moderation” where improved monetary policy contributed to improved economic performance and a more stable economy.
Austrians should find much to agree with in their underlying analysis of current Fed policy.
“Quantitative easing [both I and II] is part of a recent Fed trend toward discretionary … monetary actions.”
“The Fed’s decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble.”
“while the Fed did help to arrest the ensuing panic in the fall of 2008, its subsequent interventions have done more long-run harm than good [some Austrians agree with the former, most support the latter].”
“QE1 failed to strengthen the economy, which has remained in a high-unemployment, low-growth slump, and there is no convincing evidence that QE2 will help either. On the contrary, QE2 will create more economic uncertainty, stemming mainly from reasonable doubts over whether the FED will know exactly when and how to contract its balance sheet after such an unprecedented expansion.”
Taylor and Ryan go on to argue for eliminating the “dual mandate” of the Fed, eliminating the high employment goal and focusing on a goal of long-term price stability within a framework of economic stability, including clear reporting and accountability requirements. Within this framework the Fed would still retain some flexibility during a crisis to provide liquidity and serve as lender of last resort. Per Taylor and Ryan, such a change in focus would “lay the monetary foundation for strong and sustained economic growth and job creation.” Such a recommendation is perhaps not too far from Hayek’s position in the 1970s where he argued (Unemployment and Monetary Policy, Cato, 1979, p. 17 and 18),
“Though monetary policy must prevent wide fluctuations in the quantity of money or the volume of the income stream, the effect of employment must not be a dominating consideration. The primary aim must again become the stability of the value of money [emphasis original]. But (p. 18), “to avoid severe liquidity crises or panics, the monetary authority must be given some discretion.”
While such reforms may be a short run improvement over policy which from mid 1990s forward generated not 1 but 2 significant boom-busts periods, it most likely is not optimal. In a very interesting working paper, “Has the Fed Been a Failure?” (Cato see: http://www.cato.org/pub_display.php?pub_id=12550), Selgin, Lastrapes, and White point reform in another direction. Contra Taylor, the Great Moderation was perhaps not as great as Taylor implies. The improvement was temporary and ‘appears to be due to factors other than improved monetary policy.” Their conclusion, ‘the real hope for a better monetary system lies in regime change.” Austrians should have a strong comparative advantage in discussion of what the foundations of this regime change should look like. Reform should go much further with a goal of sound money, not a goal of stable prices. A good starting point would be Salerno’s recently released volume, Money, Sound and Unsound.