CIAO DATE: 10/2011
Volume: 31, Issue: 3
Fall 2011
Legislating a Rule for Monetary Policy (PDF)
John B. Taylor
In these remarks I discuss a proposal to legislate a rule for monetary policy. The proposal modernizes laws first passed in the late 1970s, but largely discarded in 2000. A number of years ago I proposed a simple rule as a guideline for monetary policy. 1 I made no suggestion then that the rule should be written into law, or even that it be used to monitor policy, or hold central banks accountable. The objective was to help central bankers make their interest rate decisions in a less discretionary and more rule-like manner, and thereby achieve the goal of price stability and economic stability. The rule incorporated what we learned from research on optimal design of monetary rules in the years before. In the years since then we have learned much more. We learned that such simple rules are robust to widely different views about how monetary policy works (see Taylor and Williams 2011). We learned that such rules are frequently used by financial market analysts in their assessment of policy and by policymakers in their own deliberations (see Asso, Kahn, and Leeson 2007).
A Dangerous Brew for Monetary Policy (PDF)
Charles I. Plosser
It is a pleasure to join you at Cato’s 28th Annual Monetary Conference. In preparing today’s remarks, I noted that this year’s topic of how monetary policy should deal with asset prices was also discussed here in 2008. The speakers at that time expressed a wide variety of views and opinions. The fact that this important question continues to resurface here and at other prominent meetings in recent years suggests that a consensus has yet to emerge. Today I will offer one policymaker’s views on a few of the key issues. And I do mean one policymaker’s views, as my remarks do not necessarily represent those of the Federal Reserve Board or my colleagues on the Federal Open Market Committee. It is probably only a modest stretch to say that the prevailing view among many, if not most, monetary policymakers has been that a central bank should not make asset prices a direct focus of monetary policy (see Kohn 2009, Posen 2009, Bernanke and Gertler 2001, and Bean et al. 2010). Yet, the housing boom, its subsequent collapse, and the financial crisis that followed are viewed as central elements that gave rise to the Great Recession.
Limits of Monetary Policy in Theory and Practice (PDF)
Vincent R. Reinhart, Carmen M. Reinhart
The Federal Reserve’s conduct of monetary policy casts a spell over market participants, commentators, and academics. The pages of financial newspapers parse subtle differences among the comments of Fed officials and delve deeply into potentially multiple meanings of official statements. Academic discussions argue that the path of the policy rate may (as in Taylor 2009) or may not (as in Bernanke 2010, and Greenspan 2010) have fueled a home-price bubble in the United States. The view that modest alterations to monetary policy have vast consequences for national economies would seem to be inconsistent with theory and evidence. Most modern economic models (represented authoritatively by Woodford 2005) offer limited scope for policy surprises. The basic logic is that spending depends on decisions capitalized over the longer term, and small perturbations in the level of the short-term interest rate do not matter much to those values. More fundamentally, the prominence accorded to authorities controlling nominal magnitudes seems to undervalue the resilience of market economies, which are supposed to be efficient in grinding out appropriate relative prices so as to employ resources efficiently. In other words, if central bankers are crucial to moderating the operations of capitalist economies, then capitalist economies may have serious drawbacks.
The Revived Bretton Woods System, Liquidity Creation, and Asset Price Bubbles (PDF)
Harris Dellas, George S. Tavlas
In this article, we argue that the present constellation of exchange rate arrangements among the major currencies has led to the creation of excessive global liquidity, which has contributed to asset price bubbles. Although the exchange rates of many of the major currencies—including the U.S. dollar, the euro, the yen, and the pound sterling—float against each other, the currencies of many Asian emerging market economies and oil-exporting economies are pegged to the dollar. Dooley, Folkerts-Landau, and Garber (2004a) labeled this system “Bretton Woods II” (BWII). 1 The original Bretton Woods regime (BWI) lasted for about a quarter of a century. Dooley, Folkerts-Landau, and Garber (DFG) argue that the present regime, despite its large global imbalances, will also be sustainable. We have a different view. In what follows, we argue that the original Bretton Woods system comprised two fundamentally different variants. The first variant lasted from the inception of the system in 1947 until around 1969
A Gold Standard with Free Banking Would Have Restrained the Boom and Bust (PDF)
Lawrence H. White
President George W. Bush famously remarked in July 2008 that
during the housing boom "Wall Street got drunk . . . and now it has
a hangover." It was the Federal Reserve that spiked the punchbowl.
The Fed sowed the seeds for the bust of 2007-08 by overexpanding
credit, keeping interest rates too low for too long. The Fed made
these mistakes despite our having been assured that it had learned
from past errors and that the art of central banking had been all but
perfected. A commodity standard with free banking, and no central
bank to distort the financial system, would have avoided such a
boom-and-bust credit cycle.
To very briefly recap the cycle, the Fed in 2001-06 kept interest rates too low by injecting too much credit (White 2008,
Taylor 2009). A disproportionate share of that credit flowed into
housing, channeled there by federal subsidies and mandates for
widening home ownership by relaxing mortgage creditworthiness
standards. The dollar volume of real estate lending grew by
10-15 percent per year for several years-an unsustainable path.
Rising real estate prices bred the illusion that creative mortgages
to noncreditworthy borrowers were safer than previously
thought. When prices leveled off, the truth was revealed. The reestablishment of sustainable housing prices has revealed scads of
nonviable mortgages.
U.S. Decapitalization, Easy Money, and Asset Price Cycles (PDF)
Kevin Dowd, Martin Hutchinson
In Matthew 25: 14–30, Jesus recounts the Parable of the Talents, the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence. He then returns and holds them to account. The first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn’t be bothered even to put the money in the bank where it could earn interest. Instead, he simply buried the money and gave his master a zero return. He is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth. In the modern American version of the parable, the eternal truth of the original remains: Good stewardship is as important as it always was and there is still one master—the American public (albeit in name only)—who entrusts capital to the stewardship of his supposed servants. Instead of three, however, there are now only two: the Federal Reserve and the federal government. They are not especially wicked, but they certainly are incompetent. They run amok and manage to squander so much of their master’s capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment
Financial Crises: Prevention, Correction, and Monetary Policy (PDF)
Manuel Sánchez
The financial crisis that surfaced in 2007 has stressed the need to
identify the ultimate sources of the incentives that were behind the
preceding credit and housing bubbles. To lower the likelihood of
future financial collapses, prudent economic policies as well as an
adequate regulatory and supervisory framework for financial institutions are required. Monetary policy, in turn, should be directed
toward price stability, which is a central bank's best contribution not
only to long-term economic growth, but also to financial stability.
Three Narratives about the Financial Crisis (PDF)
Peter J. Wallison
The most important lesson we can learn from the financial crisis is what caused it. Even though the Dodd-Frank Act (DFA) has been signed into law, this is still an important question. If we do not attribute the crisis to the right cause, we could well stumble into another crisis in the future; and if the DFA was directed at the wrong cause, we should consider its repeal. There are several competing narratives. One of them will eventually be accepted, and will determine how the great financial crisis of 2008 is interpreted, and thus how it affects public policy in the future. A Brookings Institution study issued in late 2009 lays out three competing narratives, including the one favored by the authors, Douglas J. Elliott and Martin Neil Baily (Elliott and Baily 2009). The Elliott-Baily theory is interesting and explains much of what happened. Their view is that the “great moderation”—the quiet period of almost continuous growth and low inflation between 1982 and 2007—caused investors, managers, and regulators to believe that we had come to understand how the economy worked and how to tame the business cycle. This mistaken view in turn caused a decline in the normal aversion to risk, creating a housing bubble and the financial crisis. This is a compelling narrative and accounts for much of the risk-taking that was observed in the period leading up to the crisis, but in the end it is no more than an interesting theor
Supply: A Tale of Two Bubbles (PDF)
Mark A. Calabria
To the extent that monetary policy influences asset prices, it does so via the demand for assets, by changing the borrowing costs to purchase assets, or via supply, where movements in interest rates can make investment in assets look more or less attractive. Fiscal policy interventions can also contribute to bubbles by changing the cost of acquiring specific assets. Most discussions of asset bubbles, particularly those involving the role of monetary policy, focus on demandside factors. This article examines the role of supply-side factors in the recent booms in the U.S. housing market and dot-com stocks. The importance of supply constraints in each market is discussed. Policy implications are then presented.
Incentive-Robust Financial Reform (PDF)
Charles W. Calomiris
Will Rogers, commenting on the Depression, famously quipped: “If stupidity got us into this mess, why can’t it get us out?” Rogers’s rhetorical question has an obvious answer: persistent stupidity fails to recognize prior errors and, therefore, does not correct them. For three decades, many financial economists have been arguing that there are deep flaws in the financial policies of the U.S. government that account for the systemic fragility of our financial system, especially the government’s subsidization of risk in housing finance and its ineffective approach to prudential banking regulation. To avoid continuing to make the same mistakes, it would be helpful to reflect on the history of crises and government policy over the past three decades. The U.S. banking crises of the 1980s—which included the nationwide S&L crisis of 1979–91, the 1986–91 commercial real estate banking crisis (Boyd and Gertler 1993), the LDC debt crisis primarily afflicting money-center banks from 1979 to 1991, the farm credit crisis of the mid-1980s (Calomiris, Hubbard, and Stock 1986; Carey 1990), and the post-1982 Texas and Oklahoma banking crisis (Horvitz 1992)—were disruptive and pervasive
Preventing Bubbles: Regulation versus Monetary Policy (PDF)
David Malpass
Over the years, there has been a lot to consider in the Federal Reserve’s choices of monetary policy and their relationship to bubbles. My conclusion is that mistaken U.S. monetary policy, usually related to the Fed’s indifference to the value of the dollar, has repeatedly caused harmful asset bubbles in the United States and abroad. Policy is again at risk with the Fed’s imposition of near-zero interest rates and its decision to conduct large-scale asset purchases (termed “quantitative easing”). Regulatory policy has often been ineffective at identifying or addressing asset bubbles, especially those caused by Fed policy. The solution is a parallel track to improve monetary policy so that it provides a more stable dollar and fewer asset bubbles; and to strengthen regulatory policy so that it provides a more reliable base for growth-creating free markets. In an October 1999 speech at the Cato Institute’s Annual Monetary Conference, I criticized U.S. monetary policy for strengthening the dollar, driving gold and commodity prices down, and creating unsustainable deflationary pressures in developing countries. While the United States felt satisfied with the tech boom and low unemployment, the inflow of hot money driven by the strong and strengthening dollar was creating an artificial global capital allocation that ended in a bust and recession. I think the Fed should have sought a strong and stable dollar in the late 1990s, not a strengthening dollar, and encouraged stronger regulatory scrutiny in those financial markets where it perceived irrational exuberance.
Honest Money (PDF)
Jerry L. Jordan
This article addresses some of the recent proposals for the conduct of monetary policies in the post-bubble environment. Advocacy of higher inflation targets is analyzed, and the challenge of maintaining monetary discipline in the face of massive fiscal deficits and mounting government debts is presented. Proposals for reforms of monetary arrangements must be based on consensus regarding the objectives of such reforms. The article concludes with some suggestions for near- and intermediate-term changes to present arrangements, as well as ideas for longer-term reforms.
Milton Friedman's 1971 Feasibility Paper (PDF)
Leo Melamed
The story is fairly well known. In 1971, as chairman of the Chicago Mercantile Exchange, I had an idea: a futures market in foreign currency. It may sound so obvious today, but at the time the idea was revolutionary. I was acutely aware that futures markets until then were primarily the province of agriculture and—as many claimed— might not be applicable to instruments of finance. Not being an economist, the idea was in need of validation. There was only one person in the world that could satisfy this requisite for me. We went to Milton Friedman. We met for breakfast at the Waldorf Astoria in New York. By then he was already a living legend and I was quite nervous. I asked the great man not to laugh and to tell me whether the idea was “off the wall.” Upon hearing him emphatically respond that the idea was “wonderful,” I had the temerity to ask that he put his answer in writing. He agreed to write a feasibility paper on “The Need for Futures Markets in Currencies,” for the modest stipend of $7,500. It turned out to be a helluva trade. In celebrating Milton Friedman’s centennial in 2012, it is instructive to marvel at his legendary prescience by again reading his 1971 paper. Keying off on President Nixon’s closing of the gold window on August 15, something that he had urged the president to do, Friedman asserted that the system of fixed exchange rates “is now dead.” It was!
The Need for Futures Markets in Currencies (PDF)
Milton Friedman
Under the Bretton Woods system, the central banks of the world undertook to keep the exchange rates of their currencies in terms of the dollar within 1 percent of the par value as determined by the official values of gold registered with the International Monetary Fund. In practice, the central banks generally kept the margins even narrower: 1 ⁄2 of 1 percent or 3 ⁄4 of 1 percent. So long as they had confidence that these limits would be maintained indefinitely, persons engaged in foreign trade were subject to negligible risk from fluctuations in exchange rates. Even so, large traders with sharp pencils found it desirable to hedge any future transactions by buying foreign currencies forward to meet commitments coming due or selling foreign currencies forward to match scheduled receipts. These forward transactions were handled by the large commercial banks, often with the active participation of foreign central banks in the forward market. Episodically, confidence that the par value could be maintained waned. Whenever this occurred, there were major movements of funds both in the spot and futures markets.
Friedman and Samuelson on the Business Cycle (PDF)
J. Daniel Hammond
Chicago School economists have come in for criticism since the financial crisis and so-called Great Recession began in 2007. Commentators have blamed recent problems on a laissez-faire faith in the efficacy of markets and simple rules for business-cycle policy— ideas associated with economics as taught and practiced at the University of Chicago. Events over the past four years, we are told, demonstrate the need for a restoration of Keynesian thinking about business cycles and activist government policies to keep markets from failing. However, there is another aspect of Chicago School economics that is commonly overlooked. This is the conviction that economists’ understanding of the business cycle is meager in light of the knowledge necessary for activist countercyclical policy to be effective. From this comes the Chicago School concern that economists and policymakers not attempt to do something beyond their capability. Overreaching can make the problems worse. In the public mind, Milton Friedman and Paul Samuelson represent more than any other individuals two competing schools of thought that dominated macroeconomic and business cycle debates over much of the past century.
Peddling Protectionism: Smoot-Hawley and the Great Depression by Douglas A. Irwin (PDF)
Daniel Griswold
Let me preface this review with a confession: As an advocate of free trade, I love to link the 1930 Smoot-Hawley tariff bill with the Great Depression at every opportunity. More than 80 years after its passage, the bill still evokes negative feelings about protectionism. After reading Douglas Irwin’s Peddling Protectionism: SmootHawley and the Great Depression, I can see I need to curb my enthusiasm. Irwin does not defend the bill, far from it. He concludes that it failed to achieve its objectives and that it did, in an incremental way, make the Great Depression worse. But in the careful language of the professional economist and historian that he is, Irwin documents in rich and often colorful detail that the most infamous trade bill in American history had less impact than either its advocates or its opponents understood at the time or understand today. Even so, the story of Smoot-Hawley offers valuable lessons for today as our politicians seek to craft U.S. trade policy in the 21st century. Irwin is superbly qualified to write the definitive history of what was officially the Trade Act of 1930. A professor of economics at Dartmouth College, he has authored Against the Tide: An Intellectual History of Free Trade (1996), and Free Trade under Fire (3rd ed., 2009)
Robust Political Economy: Classical Liberalism and the Future of Public Policy by Mark Pennington (PDF)
Richard L. Gordon
Pennington undertakes a needed effort to provide a systematic, analytic critique of recent efforts to discredit what he terms “classical liberal economics.” His is effectively the standard but hard-to-sell proposition that prescient impartial counselors—Plato’s philosopher kings—have failed to emerge from the development of modern knowledge. In particular, Pennington makes good use of Hayek’s radical contrast between the competitive testing of concepts in a spontaneous market order and the construction of solutions by government monopolies. As Pennington’s conclusions nicely summarize, skepticism of limited government is high and fostered by those who are seeking rents from intervention. Thus, ideas that committed libertarians see as obviously absurd need systematic debunking for a broader audience. Pennington, therefore, pretends that he is treating serious arguments and confronts them respectfully.
America Identified: Biometric Technology and Society by Lisa S. Nelson (PDF)
Jim Harper
Lisa Nelson's America Identified: Biometric Technology and
Society is a slow and careful examination of a formidably broad landscape-at least until she springs to her conclusions. Among them:
"Individual liberty must be reconceptualized to account for the use
of data by individuals for communication, transactions, and networking." It's a scholar's way of saying, "Move over, sovereign individual.
Experts are going to handle this."
Nothing about biometrics commands this outcome. Given her
ideological choices, Nelson could reach the same result with reference to any modern technology-and many consumer products and
services. Indeed, for its titular emphasis on biometrics, the book is
very light on the technologies that permit machines to identify
humans with improving accuracy.
Nobody could capture all the issues arising from the interplay
between biometrics and "society." The book progresses earnestly
from chapter to broad-themed chapter, examining security, privacy,
anonymity, trust, and paternalism in loose relation to biometrics.
Evidence from public opinion research occasionally punctuates the
vast expense between an important emerging technology and the
philosophical questions Nelson seems to prefer.