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OF THE
FEDERAL RESERVE
THE HISTORICAL PERFORMANCE
OF THE
FEDERAL RESERVE
T H E I M PORTA NCE OF RU LES
Michael D. Bordo
www.hoover.org
Copyright © 2019 by the Board of Trustees of the Leland Stanford Junior University
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CONTENTS
Foreword ix
John B. Taylor
xiii
Introduction/Overview
John B. Taylor
ix
x Foreword
performance. For example, the book shows that in both the 1920s and the
1950s the Federal Reserve responded relatively quickly by tightening
when the aggregate price level started to rise. In the 1960s the Fed de-
layed its tightening, waiting u ntil long a fter inflation began to rise. Thus,
the Fed was often too late, and inflation picked up leading to a boom bust
cycle.
Bordo goes back further into history to explore the case for monetary
rules. He looks at the operations of the Bank of England in the 1820s and
1830s, and contrasts the Currency School, which effectively endorsed a
monetary rule tying the money supply to the balance of payments, with
the Banking School, which allowed for much more discretion. In review-
ing the twentieth century he examines the work of Henry Simons, at the
University of Chicago, who made the case for rules that was further pur-
sued by Milton Friedman, who specified the constant money growth rule.
The Friedman rule was then improved upon by Bennett McCallum’s
monetary base-growth rule and by the Taylor rule, which explicitly showed
how interest rates should respond to economic developments, and which,
in Bordo’s assessment, was “widely accepted as the best-practice monetary
rule.”
The book examines deviations from policy rules and the harm that
such deviations may cause, including by showing that episodes in which
monetary policy is too easy are often followed by booms and inevitable
busts. Consider, for example, the chapter “Does Expansionary Monetary
Policy Cause Asset Price Booms? Some Historical and Empirical Evi-
dence,” written with John Landon-Lane. It collects data from eighteen
countries during the years from 1920 to 2011. Using these data, it esti-
mates the impact of loose monetary policy on housing, stock, and com-
modity prices. It shows that loose monetary policy—defined as having a
policy interest rate too low or money growth rate too high relative to a
given rule—has a significant, but temporary, inflationary impact on asset
prices. The research with many countries and many time periods shows
that asset price inflation follows excessive monetary accommodation.
More generally, the book continually brings history to bear on current
policy debates. The chapter “Deep Recessions, Fast Recoveries, and Fi-
nancial Crises: Evidence from the American Record” written jointly with
xii Foreword
Joseph Haubrich, directly relates to debates about the reasons for the re-
cent slow recovery from the 2007–2009 recession. The chapter shows that
recoveries from deep recessions in the United States are usually faster
than recoveries from shallow recessions. It thereby demonstrates that the
slow recovery from the deep recession of 2007–2009 and from the finan-
cial crisis was unusually weak compared to recoveries from past recessions
with financial crises in the United States.
This finding implies that something else was holding the recovery
back, and that something was probably poor economic policy. This view is
in direct contrast to the claim made by o thers that the slow recovery was
just what one would expect from a deep recession, with the implication
that policy was just fine and that a different policy would do little good.
As of the publication of this book, the controversy continues. It could be
that current developments affect the debate because economic growth ap-
pears to be accelerating to the fastest rate in the recovery, and the im-
provement has been associated with a change in policy. If this continues,
it will give further empirical support to Bordo’s hypothesis.
I have had the opportunity to learn much about monetary history and
policy from Michael Bordo, especially during the time he has spent at the
Hoover Institution over the years, much as I had a similar opportunity to
learn from Milton Friedman and Allan Meltzer when they were at the
Hoover Institution. I came away with a better appreciation that there is a
great deal that one can learn from history, especially when our theoretical
models do not always deliver. Michael Bordo makes that crystal clear in
this book. He is the person to reach out to on any policy issue relating to
monetary history, and there are many such policy issues addressed in this
book.
—John B. Taylor
February 2019
INTRODUCTION/OVERVIEW
xiii
xiv Introduction/Overview
Financial crises, as evident in the very recent past, can severely impact
the real economy. Banking crises since the 1970s have led to fiscal bail-
outs, which in turn increased fiscal deficits and national debt. As recently
witnessed in Greece, Ireland, Spain, and other countries, debt crises en-
sue that inevitably result in default (Bordo and Meissner 2016).
Fiscal bailouts can lead to monetization by the monetary authorities and
inflation. This can happen via “unpleasant monetarist arithmetic” (Sargent
and Wallace 1981) or via the “fiscal theory of the price level” (Leeper 2011).
Finally, price level and inflation variability can lead to and exacerbate
financial instability. Unexpected inflation or deflation can damage the bal-
ance sheets of firms and financial institutions, leading to restricted lend-
ing and insolvency (Schwartz 1995).
In sum, the failure to adhere to rules that produce monetary stability
will inevitably produce the dire consequences of real, nominal, and finan-
cial instability.
1844 Bank Charter Act, which governed the Bank of E ngland for a c entury.
The Banking principle was embodied in the Banking Department of the
Bank of England.
The Federal Reserve, founded in 1913, was based on both the gold
standard and the real bills doctrine, which derived from Banking School
theory. The basic premise of real bills was that as long as central banks
discounted only self-liquidating short-term real bills, then the economy
will always have the correct amount of money and credit. Adherence to the
real bills doctrine has been viewed as being responsible for monetary
and financial stability in the interwar period and even into the late 1970s
(Meltzer 2003, 2009).
In the twentieth century the question that followed the Currency Bank-
ing School debate was w hether monetary policy should be entrusted to
well-meaning authorities with limited knowledge or to a rule that could
not be designed to deal with unknown shocks. Henry Simons (1936) made
the case for rules. Milton Friedman, Simon’s student, posited the case in
1960 for his famous k% rule u nder which the central bank would set the rate
of monetary growth equal to the long-run growth rate of real income ad-
justed for the trend growth rate of velocity. Adhering to Friedman’s rule
would maintain stable prices.
Friedman argued, based on voluminous empirical and historical evidence
documenting how discretionary Fed policies exacerbated US business
cycles, that pursuit of his rule would have delivered economic performance
superior to that generated by the policies followed by the Fed.
Friedman’s (1960) rule, which was based on steady growth of broad
money, was improved upon by Bennett McCallum’s (1987) base-growth
rule with feedback from the real economy and by John Taylor (1993), who
developed an interest rate rule based on the policy instruments that central
banks were actually using. In his rule, the Fed would set its rate depend-
ing on the natural rate of interest and a weighted average of the deviations
of inflation from its target and real output from potential output. Taylor
(1999) showed how his rule could be converted into a money growth rule
that could be used in environments where central banks target monetary
aggregates. In the past two decades the Taylor rule has been widely ac-
cepted as the best-practice monetary rule.
xviii Introduction/Overview
Pursuit of rules like the Taylor rule or the McCallum rule by main-
taining price stability would mitigate real economic instability, avoid asset
price booms and financial crises, and prevent financial instability.
2. The Book
This book is a collection of my articles (some written with others) on the
importance of monetary stability and the case for monetary rules. The
chapters present theoretical, empirical, and historical perspectives to sup-
port the case.
We conclude with the case for a legislated monetary rule and provide em-
pirical evidence in favor of Milton Friedman’s constant money growth
rate rule.
pressure on the Fed; the Phillips curve trade-off; fear of repeating the
Great Depression; data mismeasurement; and an expectations trap. Many
of the alternative explanations are explained in detail in Bordo and
Orphanides (2013).
the Federal Reserve to the crisis of 2008. We revisit the debate on illiquid-
ity versus insolvency in the banking crises of the 1930s, providing evi-
dence that the banking crisis largely reflected illiquidity shocks. In the
2007–2008 crisis, the Federal Reserve, under its chair, Ben Bernanke, had
learned the lesson well from the banking panics of the 1930s of conduct-
ing expansionary monetary policy to meet demands for liquidity. How-
ever, unlike in the 1930s, the deeper problem of the recent crisis was not
illiquidity but insolvency and especially the fear of insolvencies of counter-
parties. A number of virtually insolvent US banks deemed to be too big or
too interconnected to fail w ere rescued by fiscal bailouts.
Chapter 13, “Could Stable Money Have Averted the Great Contrac-
tion?” (with Ehsan U. Choudhri and Anna J. Schwartz), directly tests
whether the implementation of Milton Friedman’s constant money growth
rate rule during the G reat Contraction of 1929–1933 would have largely
prevented the disastrous collapse of output that occurred. We simulate a
model that estimates separate relations for output and the price level and
assumes that output and price dynamics are not especially sensitive to pol-
icy changes. The simulations include a strong and weak form of Fried-
man’s constant money growth rule. The results support the hypothesis that
the Great Contraction would have been mitigated and shortened had the
Federal Reserve followed a constant money growth rule.
Chapter 14, “Was Expansionary Monetary Policy Feasible during the
Great Contraction? An Examination of the Gold Standard Constraint”
(with Ehsan U. Choudhri and Anna J. Schwartz), reconsiders a well-known
view that the gold standard was the leading cause of the worldwide
Great Depression of 1929–1933. According to this view, for most countries
continued adherence to gold prevented monetary authorities from offsetting
banking panics with expansionary monetary policies, thereby blocking
their recoveries. We contend that although this may have been the case for
small open economies with limited gold reserves, it is not the case for the
United States, the largest economy in the world, holding massive gold re-
serves. The United States was not constrained from using expansionary
policy to offset banking panics, deflation, and declining activity. Simula-
tions based on a model of a large open economy indicate that expansionary
open-market operations by the Federal Reserve at two critical junctures
xxiv Introduction/Overview
References
Ball, Laurence M. 2018. The Fed and Lehman B rothers: Setting the Record Straight on
a Financial Disaster. New York: Cambridge University Press.
Barro, Robert, and David Gordon. 1983. “Rules, Discretion and Reputation in a
Model of Monetary Policy.” Journal of Monetary Economics 12:101–21.
Bordo, Michael, and Joseph Haubrich. 2017. “Deep Recessions, Fast Recoveries, and
Financial Crises: Evidence from the American Record.” Economic Inquiry 55,
no. 1 ( January): 527–41.
Bordo, Michael, and Finn Kydland. 1995. “The Gold Standard as a Rule: An Essay
in Exploration.” Explorations in Economic History 32 (4): 423–64.
Introduction/Overview xxv
Bordo, Michael, and John Landon-Lane. 2012. “Does Expansionary Monetary Pol-
icy Cause Asset Price Booms; Some Historical and Empirical Evidence.” Journal
Economia Chilena, Central Bank of Chile, 16, no. 2 (August): 4–52.
Bordo, Michael, and Christopher Meissner. 2016. “Fiscal and Financial Crises.” In
Handbook of Macroeconomics, Volume 2A, edited by John B. Taylor and Harald
Uhlig, 355–412. Amsterdam: North Holland.
Bordo, Michael, and Athanasios Orphanides. 2013. The Great Inflation. Chicago:
University of Chicago Press.
Friedman, Milton. 1960. A Program for Monetary Stability. New York: Fordham Uni-
versity Press.
———. 1968. “The Role of Monetary Policy.” American Economic Review 58, no. 1
(March): 1–17.
Goodfriend, Marvin. 2012. “The Elusive Promise of Independent Central Banking.”
Institute for Monetary and Economic Studies, Bank of Japan.
Hetzel, Robert. 2012. The G reat Recession: Market Failure or Policy Failure? New York:
Cambridge University Press.
Kydland, Finn, and Edward Prescott. 1977. “Rules Rather than Discretion: The In-
consistency of Optimal Plans.” Journal of Political Economy 85 (3): 473–92.
Leeper, Eric. 2011. “Perceptions and Misperceptions of Fiscal Inflation.” Paper pre-
sented at the 10th Annual BIS Conference: Fiscal Policy and Its Implications
for Monetary and Financial Stability.
McCallum, Bennett. 1987. “The Case for Rules in the Conduct of Monetary Policy:
A Concrete Example.” Federal Reserve Bank of Richmond Economic Review 73
(September/October): 10–18.
Meltzer, Allan H. 2003. A History of the Federal Reserve. Vol. 1, 1913–1951. Chicago:
University of Chicago Press.
———. 2009. A History of the Federal Reserve. Vol. 2, Book 2. Chicago: University
of Chicago Press.
Sargent, Thomas, and Neil Wallace. 1981. “Some Unpleasant Monetarist Arithme-
tic.” Federal Reserve Bank of Minneapolis Quarterly Review 5 (Fall): 1–11.
Schwartz, Anna J. 1995. “Why Financial Stability Depends on Price Stability.” Eco-
nomic Affairs 15 (Autumn): 21–25.
———. 2008. “Banking School, Currency School, Free Banking School.” New Pal-
grave Dictionary of Economics. 2nd ed. London: Palgrave Macmillan.
Simons, Henry. 1936. “Rules versus Authorities in Monetary Policy.” Journal of Po
litical Economy 44 (1): 1–30.
Taylor, John B. 1993. “Discretion versus Policy Rules in Practice.” Carnegie Roches-
ter Conference Series on Public Policy 39 (1): 195–214.
———. 1999. “A Historical Analysis of Monetary Policy Rules.” In Monetary Policy
Rules, edited by John B. Taylor, 319–48. Chicago: University of Chicago Press
for the NBER.
xxvi Introduction/Overview
———. 2009. Getting Off Track. Stanford, CA: Hoover Institution Press.
Theil, Henri. 1967. Economics and Information Theory. Vol 7. Amsterdam: North
Holland.
Tinbergen, Jan. 1978. Economic Policy: Principles and Design. Amsterdam: North
Holland.
Viner, Jacob. 1937. Studies in the Theory of International Trade. Chicago: University of
Chicago Press.
Warburg, Peter. 1910. “The United Reserve Bank Plan.” In The Federal Reserve, Vol. 1,
edited by Paul Warburg. New York: Macmillan.
PART ONE
T heoretical
P erspectives
CHAPTER 1
Introduction
3
4 Theoretical Perspectives
Bank could maintain price stability with a mixed currency system (specie
and bank notes). They argued that the Bank should follow the Currency
principle, that is, the money supply should behave exactly as it would u
nder
a pure specie standard. Thus a gold inflow should lead to a one-to-one in-
crease in the total currency and the opposite for a gold outflow. This
principle led to the adoption of Palmer’s rule (1827), named after Horsely
Palmer, a governor of the Bank of England. Palmer posited that the Bank
should keep its security portfolio constant and keep its gold reserves at one-
third of its total liabilities. This would allow the Bank’s note issue to vary
directly with gold flows into and out of the Bank.
The Banking School criticized Palmer’s rule and the Currency princi
ple for omitting deposits at the Bank of E ngland and the country banks
for not accounting for movements in the velocity of circulation. They also
defined money as currency plus deposits, whereas the Currency School de-
fined it as simply currency (coins plus bank notes).
The Banking School argued that the money supply was endogenous and
was determined according to the real bills doctrine by the needs of trade.
If the Bank discounted only real commercial bills, reflecting the state of
the economy, t here never would be too much or too little money in circu-
lation. An increase in the note issue by the Bank would always return via
the operation of the price-specie flow mechanism and by the Law of Re-
flux (Schwartz 2008a).
Another critique of the Bank’s sole pursuit of the Currency principle
was the problem of internal drains, or commercial bank runs in the face of
financial distress. The demands for liquidity would reduce the Bank’s gold
reserves, and via the Currency principle would lead the Bank to tighten
monetary policy, thus aggravating the financial crisis. The Banking School
believed that discretionary policy was needed to deal with liquidity drains.
Serious banking panics in 1825, 1836, and 1839 led to the call for major
reform of the Bank of E ngland.
Reform came in the Bank Charter Act of 1844, which divided the Bank
into the Issue Department and the Banking Department. The Issue De-
partment would follow the Currency principle. Its balance sheet consisted
of a fixed fiduciary note issue of 14 million pounds, and then every addi-
tional pound would vary with gold flows into and out of the Bank’s
6 Theoretical Perspectives
was supposed to lower the Bank rate and encourage capital to leave and
stimulate the economy to increase the demand for imports (reduce the bal-
ance of trade) (Bordo 1984).2
The gold standard convertibility rule prevailed u ntil the collapse of the
classical gold standard at the outbreak of World War I in 1914. Following
the rule meant that countries would subsume domestic stability concerns
to maintaining the fixed gold parity. The rule followed was a contingency
rule under which the monetary authority would maintain the fixed gold
price except in the event of a major emergency, such as a war when con-
vertibility could be suspended and the central bank could expand its note
issue to raise seigniorage, and the fiscal authorities could run large deficits
to smooth taxes (Bordo and Kydland 1995).3
The gold standard rule was successful in the sense that it was associ-
ated with stable exchange rates and long-r un price stability, and its macro
performance was better than it had been in the interwar period (Bordo
1981). However, many contemporary economists w ere critical of the gold
standard because it was associated with short-run price level instability and
frequent recessions.
The price level exhibited long swings of low deflation (twenty years) fol-
lowed by long swings of low inflation (twenty years). Th ese swings in the
price level reflected the operation of the commodity theory of money (Barro
1979), whereby long-r un price stability (also known as mean reversion) in
the price level was brought about by changes in gold production and shifts
between monetary and nonmonetary uses of gold in response to changes
in the price level affecting the real price of gold. Thus in periods of defla-
tion, falling prices raised the real price of gold (assuming that monetary
authorities fixed the nominal price). This led to increased gold production
and occasional gold discoveries, in addition to a shift from nonmonetary
to monetary uses of gold, which led to an increase in the world monetary
gold stock and then rising prices. The opposite occurred in periods of
inflation.4
Contemporary economists posited that alternative variations of the gold
standard rule could produce price stability (Bordo 1984). W. S. Jevons
(1884) discussed stabilizing a price index. Alfred Marshall (1926) preferred
symmetalism—basing the monetary standard on a mixture of gold and
8 Theoretical Perspectives
silver whose value would remain constant with changes in the relative
supplies of the two metals. Irving Fisher (1920) developed the compensated
dollar, whereby the monetary authorities would change the official price of
gold to offset movements in a price index. His proposal was, in essence, a
price-level rule. Indeed, in the 1920s his scheme was incorporated in two
acts of Congress, which were never passed but which would have required
the Federal Reserve to follow a price-level rule (Bordo, Ditmar, and Gavin
2008).5
The classical gold standard broke down at the start of World War I.
Only the United States maintained the gold dollar peg (although the United
States imposed a gold embargo from April 1917 to April 1919). A fter the
war many major belligerents wanted to return to the prewar gold standard
at the original parities according to the gold standard contingent rule. Most
of these countries came out of World War I with very high rates of infla-
tion and unprecedented levels of outstanding national debt, making re-
sumption a daunting task. The United Kingdom returned to gold at the
original parity in 1925, but it did so at the expense of high unemployment
(Keynes 1925). France was unable to resume at the original parity because
of its high debt and unstable polity (Bordo and Hautcoeur 2007). Germany
and other former Central Powers ran hyperinflations. They all restored gold
at greatly devalued parities.
The interwar gold standard created at the Genoa Conference in 1922
was a gold exchange standard in which members held both gold and for-
eign exchange as reserves. The United Kingdom and the United States as
center countries backed their currencies with gold. The interwar gold ex-
change standard lasted only six years. It lacked the credibility of the prewar
standard, as most countries w ere unwilling to let the gold convertibility
rule dominate their needs for domestic stability. It also was plagued by
maladjustment in the face of disequilibrium parities and nominal rigidi-
ties (Meltzer 2003). It collapsed in 1931.
The last vestige of the gold standard rule was the Bretton Woods sys-
tem established at the international monetary conference in New Hamp-
shire in 1944. Under Bretton Woods, the United States as center country
would peg its dollar to gold at $35 per ounce while other countries would
peg their currencies in terms of dollars. Unlike the gold standard, the Bret-
Rules versus Discretion 9
ton Woods system was an adjustable peg system whereby members could
change their parities in the face of a fundamental disequilibrium brought
about, for example, by a supply shock that changed the real exchange rate.
Bretton Woods also had capital controls. Like the interwar gold exchange
standard, the Bretton Woods system, which had some of the flaws of the
Gold Exchange Standard, broke down between 1968 and 1971. A key
problem was that the basic rules of the system were not followed. The
United States as center country inflated its currency a fter 1965. Other
countries also broke the rules by not allowing the adjustment mechanism
to work in the sense that surplus countries like Germany did not allow their
money supplies to expand, and deficit countries like the United Kingdom
did not allow adjustment through deflation (Bordo 1993).
The opposite would happen when the economy faced inflationary pres-
sure. The resultant equilibrating change in income would restore both full
employment and budget balance. Nelson (2019) argues that Friedman
later changed his mind about this rule as he became more critical of the
Keynesian thinking that underlay it.8
In chapter 4 of A Program for Monetary Stability (1960) Friedman pro-
posed his famous CGMR. He argued that the Fed should set the growth
rate of the stock of money equal to the long-r un growth rate of real GDP
adjusted for the trend change in velocity. The trend growth of real GDP in
the c entury before 1960 was about 3 percent whereas the trend growth in
velocity was −1 percent. To achieve price stability (inflation equals zero),
money growth would need to be at 4 percent per year. Friedman argued
that the Fed should increase money growth at 4 percent, year in and year
out. He argued that the rule was s imple enough that p eople would under-
stand it and that adhering to it would eliminate the uncertainty that ac-
companied discretion.
Friedman was in favor of using M2 as his definition of money (cur-
rency plus demand deposits plus time deposits minus large certificates of
deposits) on the grounds that it was both a temporary abode of purchas-
ing power (his favored explanation for the use of money as both a medium
of exchange and an asset) and that it was the only monetary aggregate
where the data existed back to the nineteenth c entury (Friedman and
Schwartz 1970). But he believed that an alternative definition like M1 (cur-
rency plus demand deposits) could also work as long as the Fed stuck to
the rule indefinitely.
Friedman’s CGMR rule, or k% rule, was very controversial. It was crit-
icized for its definition of money, and for its simplicity. Some argued that
M2 was inappropriate b ecause the money multiplier was largely determined
by the real economy and that a monetary base rule would more appropri-
ately reflect a variable that the Fed actually controlled. Many argued that
it did not account for the endogeneity of the money supply (Tobin 1970).
Alternative variants of his rule were developed that accounted for feedback
from the real economy and short-r un changes in velocity (e.g., McCallum
1987). Modigliani (1964) showed that a simulation of the rule over the
postwar period did not stabilize the economy. In contrast, historical stud-
Rules versus Discretion 13
Friedman was highly critical of the Fed in the 1950s, 1960s, and 1970s
for not paying adequate attention to monetary aggregates in their policy
setting. In a number of papers he criticized the Fed for not tightening mon-
etary policy enough to prevent run-ups in inflation and during recessions
for waiting too long to follow expansionary policy (Bordo and Landon-
Lane 2013). In addition to criticizing the Fed for its destabilizing fine-
tuning policy, he also criticized it for using interest rates as both its policy
instrument and its target, arguing that had it used the money stock, it could
have done better. A fter Friedman predicted in the 1960s and 1970s that
there would be a large inflation, the economics profession and the Fed be-
gan to listen to him (Nelson 2019), and the Fed began to pay attention to
monetary aggregates in its policy setting. The height of Friedman’s influ-
ence was reached in 1975, when Congress passed a bill requiring the Fed-
eral Reserve to announce its monetary aggregate targets for the future and
to report to the Congress every year on how well it performed in hitting
its targets. Most of the time, the Fed missed its targets.
The Fed’s experience with monetary targeting, which was the closest
thing that it came to following Friedman’s CGMR, was quite dismal. The
Fed’s monetary policy strategy was to use a short-run money demand func-
tion with lagged adjustment (the Goldfeld [1973] model), and then based
on the coefficients of the model and forecasts of real output and inflation,
it would set the short-r un interest rate in order to hit its money growth
target. This strategy, which was used in the 1970s and 1980s by the Fed, the
Bank of Canada, and the Bank of E ngland, was abandoned because of the
“missing money problem”—that is, velocity kept shifting up in an unpre-
dictable manner, reflecting both financial innovation and changes in fi-
nancial regulation (Laidler 1985; Anderson, Bordo, and Duca 2017). By
the early 1980s the Fed and other central banks abandoned monetary ag-
gregate targeting and shifted to using short-term interest rates as its method
to operate monetary policy.
14 Theoretical Perspectives
lines, Taylor (1993) devised a simple version of an interest rate rule for the
United States, as shown in equation (1):
it = Π t + Θ (Π t − Π ) + γ yt + R (1)
where it is the target level of the short-term nominal interest rate (the fed-
eral funds rate), Πt is the four-quarter inflation rate, Π is the target level
of inflation, yt is the output gap (the per cent deviation of real GDP from
its potential level), and R is the equilibrium level of the real interest rate
(the natural rate of interest).
Taylor (1993) postulated that the output gap and inflation gaps entered
the central bank’s reaction function with equal weights of 0.5 and that the
equilibrium level of the real interest rate and the inflation target were each
equal to 2 percent. This led to equation (2), which is commonly known as
the Taylor rule.
it = 1.0 + 1.5Πt + 0.5yt (2)
A number of other interest rate instrument rules have been used in the past
two decades. Some rules (interest rate smoothing rules) have the interest
rate reacting to the lagged interest rate (Clarida, Galí, and Gertler 2000).
Other rules put a higher weight on real output than did Taylor, while some
rules focused on changes rather than levels of the interest rate and the pol-
icy objectives (Orphanides 2007).11
Taylor initially viewed his rule as a normative rule or as a guide to pol-
icy as well as an ex post description of the performance of monetary policy
makers. When output is below potential, the rule implies that the Fed
should reduce its policy rate sufficiently to reduce the real interest rate.
When inflation is above the target rate, the Fed should raise interest rates
sufficiently to raise the real interest. Based on the postulated coefficients,
the Taylor principle requires that the coefficient on the inflation term be
at least 1.5 to reduce inflation.
Taylor (1999b) used his rule to evaluate the performance of monetary
policy in the United States across historical policy regimes: the classical
Rules versus Discretion 17
gold standard, Bretton Woods, and the current regime of managed float-
ing. Each of the regimes conducted monetary policy differently, but they
could be evaluated using the same framework. Taylor found that the coef-
ficients derived from estimating his rule were much lower under the gold
standard than in the postwar period and that the coefficients u nder Bret-
ton Woods were lower than under the managed floating period. He also
found that the Taylor principle did not hold during the Great Inflation pe-
riod of the 1960s and 1970s. He attributed the rise in the coefficients over
time to a process of policy learning.
The Taylor rule can also be used to ascertain the extent to which cen-
tral banks are following rule-like behavior by comparing the actual policy
rate to the rate predicted by the Taylor rule. Taylor (2012) and Nikolsko-
Rzhevskyy et al. (2014) find that the federal funds rate was closest to the
Taylor rule during the G reat Moderation era from 1983 to 2003 when Paul
Volcker and Alan Greenspan were chairs of the Federal Reserve. Devia-
tions from rule-like behavior w
ere considerable during the G
reat Inflation
period in the 1970s—a regime characterized by Friedman (1982), Meltzer
(2012), and Taylor (2012) as discretionary. Beginning in 1965, the Fed
gradually fell behind the curve in reducing the rise in both the rate of in-
flation and inflationary expectations.
There is considerable debate about the causes of the Great Inflation
(Bordo and Orphanides 2013, see chapter 1). A key failing was the Fed’s
unwillingness to keep rates high enough and long enough to break the back
of inflationary expectations because of the fear of a political reaction to
the necessary recession and rise in unemployment. The appointment of Paul
Volcker as Fed chair, with a mandate to end inflation and his introduction
of a contractionary monetary policy based on monetary targeting, suc-
ceeded by 1983 to reduce inflation to low single-digit levels. Volcker and
his successor, Alan Greenspan, elevated the goal of low inflation and main-
taining credibility for low inflation to their highest priority.
The rules-based policy ended in 2003 when the Fed kept rates consid-
erably below the Taylor rule to prevent the economy from falling into a
Japan-style deflation (Reifschneider and Williams 2000). It is question-
able how serious this risk r eally was.12 As a consequence, monetary policy
18 Theoretical Perspectives
was overly expansionary, and some have argued (Taylor 2007, Taylor 2012;
Nikolsko-Rzhevskyy et al. 2014; Ahrend, Cournede, and Price 2008; Bordo
and Landon-Lane 2013) that this policy was a key contributor to the boom
in house prices that burst in 2006, leading to the subprime mortgage cri-
sis of 2007–2008. Taylor (2013), Meltzer (2012), Schwartz (2008b), Bordo
(2014), Goodfriend (2011), and o thers argue that some of the Fed’s lender
of last resort policies in 2008 involved both credit and fiscal policies, which
threatened the Fed’s independence. The policy of quantitative easing and
forward guidance in effect since 2009 has been viewed as largely discre-
tionary (Taylor 2012). The Fed instituted forward guidance to anchor the
public’s expectations. Yet it continually changed its announcements with
incoming data. In many ways this recalled the fine-t uning policies of the
1950s–1970s. The continued pursuit of discretionary policy has likely con-
tributed to an increase in policy uncertainty since the recent financial cri-
sis. This has contributed to the unusual slow recovery (Bordo and Haubrich
2017) via reduced bank lending (Bordo, Duca, and Koch 2017) and in-
vestment (Bloom 2009).
The Taylor rule can be used to evaluate economic performance under
rules and discretion regimes using a trade-off (indifference) curve between
the variance of inflation and the variance of real output (measured as a per-
centage deviation from trend), which can be estimated from DSGE mod-
els (Taylor 2013). Along each curve the Fed can achieve smaller inflation
variability at the expense of greater real variability. The position of the curve
depends on the structure of the economy and the size of exogenous shocks.
Taylor uses this apparatus to show that the Volcker regime change in 1979
that led to the G reat Moderation and the adoption of a rules-based policy
was associated with a shift inward of the trade-off curve.13 Similarly, the
movement away from rules-based policy in 2003 and subsequently has
led to a shift upward in the curve from its position during the Great
Moderation.
Not all economists have accepted the modern case for rules. Benjamin
Friedman (2012) argued that in the face of big shocks, like major finan-
cial crises, the central bank needs the flexibility to abandon the rule and
act as a lender of last resort. However, if one views modern instrument
rules as contingent rules like the classical gold standard, then the use of
Rules versus Discretion 19
lender of last resort actions during a financial crisis to expand money and
liquidity above what would be required in a normal business cycle should
not be inconsistent with the case for rule-like policies. On similar lines,
Bernanke (2003) made the case for constrained discretion, which meant
following rules as a rough guideline but maintaining flexibility to set pol-
icy in the face of incoming data. This raises the question of whether it is
rules or discretion that is being followed. This introduces uncertainty into
decision makers’ choice set and defeats the main purpose of following rules
made by Simons and Friedman.
Finally, the rules versus discretion distinction has great relevance for
international monetary relations. Economic performance (low and stable
inflation and high and stable real economic growth) performed best u nder
rules-based regimes: the classical gold standard, Bretton Woods and Great
Moderation regimes (Bordo 1993; Benati and Goodhart 2010; Rockoff
and White 2015). Moreover, international monetary cooperation worked
best under these rules-based regimes (Bordo and Schenk 2017). Devia-
tions from the Taylor rule were lower across countries during the Great
Moderation than they w ere in the period before and also lower than since
2003 (Nikolsko-R zhevskyy et al. 2014; Ahrend, Cournede, and Price
2008). Meltzer (2012) suggested that if countries were to follow a com-
mon inflation target or a Taylor rule, the global economy could be more
stable than under discretion. In many ways, countries following common
domestic monetary rules under flexible exchange rates would be similar to
the fixed exchange rate gold standard period when adherence to the gold
standard ensured good economic performance. U nder floating rates the real
exchange rate would adjust to real shocks, and nominal exchange rate
movements reflecting poor monetary policy would be greatly reduced
(Meltzer 1987).
Recently the US House of Representatives passed a bill that in some
sense echoes the 1975 bill requiring the Federal Reserve to report to Con-
gress on its progress with monetary targeting. This recent bill (HR 3189)
would require the Federal Reserve Open Market Committee to decide on
a policy rule and to then report periodically to Congress on its performance
in following the rule. Like the 1975 act, this new bill would encourage
the Fed to follow rules-based policy by clearly stating its policy strategy in
20 Theoretical Perspectives
advance and then justifying any significant departures from the rule. It
would encourage the Fed to reduce its dependence on discretionary policy
and move it back toward the good performance that it followed during the
Great Moderation.
Conclusion
The nineteenth-century Bullionist and Currency School versus Banking
School debates formulated the case for monetary rules instead of discre-
tion. The gold standard convertibility rule, the “rules of the game,” and
Bagehot’s strictures for a lender of last resort were part of the institutional
framework associated with good macroeconomic performance by the ad-
vanced countries and the establishment of the pre–1914 liberal order.
The m iddle of the twentieth century witnessed the breakdown of this
order and a long period of economic, financial, and political instability and
a movement toward discretionary monetary and fiscal policies. Henry
Simons (1936) and his successor at the Chicago School, Milton Friedman,
revived the case for monetary rules as an essential part of a restored liberal
order. Simons proposed a price-level rule while Friedman proposed his
constant growth rate of the money supply rule. Friedman was an effective
critic of the Federal Reserve’s ongoing discretionary regime and by the 1970s
was able to influence legislation that influenced the Fed to move toward
rules-based policy.
The rational expectations revolution in the 1970s led to a new perspec-
tive on rules versus discretion by Kydland and Prescott (1977). Now dis-
cretion was not viewed as misguided or mistaken actions by well-meaning
officials but as following time-inconsistent policies by not following through
on earlier-stated plans. Agents with rational expectations would understand
this, negating the effects of the discretionary policy. In this lexicon a rule
was a commitment mechanism to prevent policy makers from not follow-
ing through with their strategy. John Taylor (1993), using models that
incorporated rational expectations, developed an interest rate policy rule
that reacted to the central banks’ key policy goals of price and real output
stability in a way to provide optimal performance. The Taylor rule as well
Rules versus Discretion 21
Notes
1. Price indexes had not yet been invented and so by inflation p eople focused on
commodities like the price of wheat and the exchange rate for which t here was good
data.
2. The Bank of England generally followed the rules of the game, but the cen-
tral banks of most other countries did not. However, violation of the rules never led
them to break the basic gold standard convertibility rule (Bordo and MacDonald
2010).
3. The gold standard contingency rule could also be viewed as a rule or commit-
ment mechanism in the modern sense of Kydland and Prescott (1977).
4. In addition to long swings in the global price level, there was considerable price
variability between countries reflecting the operation of the price-specie flow mech-
anism of the classical gold standard (Bordo 1981).
5. Indeed, Sweden in the 1930s did institute a price-level rule (Berg and Jonung
1999).
6. In 1936 the Fed had de facto lost much of its independence to the Treasury
under Secretary Henry Morgenthau. It followed a low interest rate peg to facilitate
the Treasury’s fiscal expansion u
nder the New Deal and then during World War II.
The Fed regained its independence only to conduct monetary policy with the Fed-
eral Reserve Treasury Accord in February 1951 (Meltzer 2003).
7. As well as other colleagues, including David Meiselman and Philip Cagan.
8. Friedman, like Simons, considered and then rejected a price-level rule for the
same reasons that Simons did, that it would not account for changes in velocity due
22 Theoretical Perspectives
to the development of money substitutes, and b ecause of the long and variable lags
between changes in the money stock and changes in the price level. He argued that
the Fed should target something that it could control, such as the money stock.
9. McCallum (1990) also showed that had the Fed followed his constant growth
of the monetary base rule adjusted for feedback from the real economy, then the Great
Contraction could have been attenuated.
10. The dual mandate came out of the Employment Act of 1946, which elevated
full employment to a leading policy goal of monetary policy. Low inflation (price sta-
bility) was already incorporated in the Federal Reserve Act. In the past seventy
years, the dual mandate has been interpreted differently by e very successive Fed chair.
In the 1950s and early 1960s, William McChesney Martin Jr. attached highest pri-
ority to low inflation. He believed that maintaining price stability would provide the
framework to maintain full employment. L ater in the 1970s, Arthur Burns attached
greater weight to full employment than high inflation. In the 1980s and 1990s, Paul
Volcker and Alan Greenspan attached greater weight to low inflation and, like Martin,
believed that maintaining a regime of low inflation would be best for the real econ-
omy. Since the recent financial crisis, both Ben Bernanke and Janet Yellen have at-
tached greater weight to full employment and have argued that the dual mandate
requires equal attention to both goals.
11. See Taylor (1999b, 5–7) and Taylor and Wieland (2010).
12. Bordo, Landon-Lane, and Redish (2009) make a distinction between “good”
productivity-driven (supply side) deflation, as in 1879–1896 in the United States, and
“bad” aggregate demand-driven deflation, as in the Great Depression. It is not clear
that the low inflation of the early 2000s was a bad deflation.
13. A question that arose was the extent to which the improved economic per
formance during the Great Moderation reflected good policy or good luck. Stock and
Watson (2002) attributed it to good luck whereas Bernanke (2004), King (2012),
and Taylor (2013) attribute it to good policy.
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