Paul Krugman Pontificating on Policy Rules

From John Taylor.

"In a recent blog post Paul Krugman talks a lot about policy rules and the Taylor rule in particular.

He complains that “Republicans are pushing to mandate that the Fed follow the so-called Taylor rule.”  But the policy rule legislation that has come out of Congress recently would simply require the Fed to describe a rule or strategy of its own choosing, not follow any specific rule.  The legislation refers to a policy rule that I invented, but simply as a “reference rule,” not a “mandated rule.”   Fed officials have been referring to that rule for many years as a benchmark, or as an example, or simply as a framework to argue for change, such as a lowering of the equilibrium real interest rate in that rule. Such references reflect standard practice for the Fed.

Krugman talks about the history of the Taylor rule.  He does not dispute that monetary policy was well described by that rule during the good economic performance period of the Great Moderation. And he does not dispute that policy departed from that rule during the pre-crisis period leading up to the end of the Great Moderation. Rather he claims that the departure was slight and, according to some models, not enough to cause a deterioration of economic performance.  But the departure was not slight; it was as large as the deviations during the 1970s when economic performance also deteriorated. And there are plenty of empirical studies that connect that departure to a deterioration in performance,  including the work on monetary policy and the housing boom and bust I presented in Jackson Hole in the summer of 2007 and the work by Jarocinski and Smets and Ahrend.

Historical research showing that a more rules-based policy works better than pure discretion is vast, much of it reviewed in a recent issue of the Journal of Economic Dynamics and Control. “I think it is important, based on my own experience, to have a rules-based monetary policy,” writes former Secretary of Treasury, George Shultz in the volume.  And monetary historian Allan Meltzer concludes that “The main lesson of this trip through history is that following a rule or a quasi- rule…produced two of the best periods in Federal Reserve history.”  Michael Bordo states that “The Fed has moved away from rules policy in its lender of last resort function,” and “this policy shift contributed to moral hazard and created new threats to financial stability.”

Krugman talks about the zero interest rate bound and the Taylor rule. He claims that the zero bound on interest rates was considered too minor to incorporate in work on policy rules. But the bound was explicitly taken into account in my research work that led to the Taylor rule.

Krugman opines that people are “inventing ever-more bizarre stories to avoid admitting having been wrong about something,” the Taylor rule in particular. Yet my 2007 paper was completed before the start of the Great Recession, and empirical macroeconomists, such as David Papell and his colleagues, are carefully reviewing the same old policy rule story not inventing new bizarre stories."