I was just about to treat myself to a little R&R last Friday when — wouldn't you know it? — I received an email message from the Brookings Institution's Hutchins Center. The message alerted me to a new Brookings Paper by former Minneapolis Fed President Narayana Kocherlakota. The paper's thesis, according to Hutchins Center Director David Wessel's summary, is that the Fed "was — and still is — trapped by adherence to rules."
Having recently presided over a joint Mercatus-Cato conference on "Monetary Rules for a Post-Crisis World" in which every participant, whether favoring rules or not, took for granted that the Fed is a discretionary monetary authority if there ever was one, I naturally wondered how Professor Kocherlakota could claim otherwise. I also wondered whether the sponsors and supporters of the Fed Oversight Reform and Modernization (FORM) Act realize that they've been tilting at windmills, since the measure they've proposed would only require the FOMC to do what Kocherlakota says it's been doing all along.
So, instead of making haste to my favorite watering hole, I spent my late Friday afternoon reading, "Rules versus Discretion: A Reconsideration." And a remarkable read it is, for it consists of nothing less than an attempt to champion the Fed's command of unlimited discretionary powers by referring to its past misuse of what everyone has long assumed to be those very powers!
To pull off this seemingly impossible feat, Kocherlakota must show that, despite what others may think, the FOMC's past mistakes, including those committed during and since the recent crisis, have been due, not to the mistaken actions of a discretionary FOMC, but to that body's ironclad commitment to monetary rules, and to the Taylor Rule especially.
Those who have paid any attention to John Taylor's own writings on the crisis and recovery will not be surprised to discover that his own response to Kocherlakota's article is less than enthusiastic, to put it gently. As Taylor himself exposes many of the more egregious shortcomings of Kocherlakota's paper, I'll concentrate on others that Taylor doesn't address.
A Fanciful Consensus
These start with Kocherlakota's opening sentence, declaring that "Over the past forty years, a broad consensus has developed among academic macroeconomists that policymakers' choices should closely track predetermined rules." That sentence is followed by others referring to "the consensus that favors the use of rules over discretion in the making of monetary policy" and to the "conventional wisdom" favoring the same.
That such a broad consensus favoring rules exists is news to me; I suspect, moreover, that it will come as a surprise to many other monetary economists. For while it's true that John Taylor himself claimed, in a passage cited by Kocherlakota, that a "substantial consensus" exists regarding the fact "that policy rules have major advantages over discretion," Taylor wrote this in 1992, when both the Great Moderation and Taylor's own research, not to mention the work of earlier monetarists, appeared to supply a strong prima-facie case for rules over discretion. To say that this strong case had as its counterpart a "broad consensus" favoring strict monetary rules in practice seems to me to be stretching things even with regard to that period. In any case it can hardly be supposed that the consensus that may have been gathering then has remained intact since!
Instead, as everyone knows, the crisis, whether for good reasons or bad ones, led to a great revival of "Keynesian" thinking, with its preference for discretionary tinkering. To suggest, as Kocherlakota does, that monetarist ideas — and a preference for monetary rules over discretion is essentially monetarist — have remained as firmly in the saddle throughout the last decade as they may have been in 1992, is to indulge in anachronism.
How does Kocherlakota manage to overlook all of this? He does so, in part, by confusing the analytical devices employed by most contemporary macroeconomists, including new-Keynesians, with the policy preferences of those same macroeconomists. Thus he observes that "Most academic papers in monetary economics treat policymakers as mere error terms on a pre-specified feedback rule" and that "Most modern central bank staffs model their policymaker bosses in exactly the same way." These claims are valid enough in themselves. But they point, not to the policy preferences of the economists in question, but merely to the fact that in formal economic models every aspect of economic reality that's represented at all is represented by one or more equations.
In the Kydland-Prescott model, for example, a discretionary monetary policy is represented by a desired future rate of inflation, where that rate depends in turn on current levels of various "state" variables; the rate is, to employ the phrase Kocherlakota himself employs in describing rule-based policy, "a fixed function of some publicly observable information." Discretion consists, not of the absence of a policy function, but in the fact that an optimal policy is chosen in each period. (The rule for which Kydland and Prescott argue consists, in contrast, of having policymakers pick a low inflation rate and commit to stick to it come what may.) This example alone should suffice to make it perfectly clear, if it isn't so already, that representing monetary policy with a formula, and hence with what might be regarded as a monetary rule of sorts, is hardly the same thing as favoring either the particular rule the formula represents, or monetary rules generally.
Inputs aren't Injunctions
Suppose that we nevertheless allow that most monetary economists and policy makers favor rules. Doing so certainly makes Kocherlakota's claim that the Fed has been rule-bound all along appear more plausible. But it hardly suffices to establish that claim's truth. How, then, does Kocherlakota do that? He does it, or attempts to do it, by misrepresenting the part that the Taylor Rule plays in the Fed's deliberations, and by artful equivocation.
The misrepresentation consists of Kocherlakota's confounding a mere input into the Fed's post-1993 policymaking with a rule that the Fed was bound to obey. Starting not long after 1993, when Taylor published his now famous paper showing that, over the course of the preceding decade or so, the Fed behaved as if it had been following a simple feedback rule, the Fed began to actually employ versions of what had by then come to be known as the Taylor Rule to inform its policy decisions. In particular, board staff began supplying the FOMC with baseline inflation and unemployment rate forecasts based on the assumption that the Fed adhered to a Taylor Rule.
It is to these forecasts or "projections" that Kocherlakota refers in claiming both that the Fed was "unwilling to deviate greatly from the recommendations of the Taylor Rule" and that its poor handling of the crisis and recovery were instances of the failure of that rule. As Taylor explains (for I can't do any better), Kocherlakota's proof consists of nothing save
an informal and judgmental comparison of the Fed staff's model simulations and a survey of future interest rate predictions of FOMC members at two points in time (2009 and 2010). He observes that the Fed staff's model simulations for future years were based on a Taylor rule, and FOMC participants were asked, "Does your view of the appropriate path for monetary policy [or interest rates in 2009] differ materially from that [or the interest rate in 2009] assumed by the staff." However, a majority (20 out of 35) of the answers were "yes," which hardly sounds like the Fed was following the Taylor rule. Moreover, these are future estimates of decisions not actual decisions, and the actual decisions turned out much different from forecast.
As for equivocation, Kocherlakota begins his paper by referring to Kydland and Prescott's finding that (in Kocherlakota's words) "to require monetary policymakers to follow a pre-determined rule" would enhance welfare (my emphasis). He thus understands a "monetary rule" to be, not merely a convenient rule-of-thumb, but a formula that must be followed, which is only proper, since that is the understanding that has been shared by all proponents of rules both before and since Kydland and Prescott's famous contribution. But when it comes to establishing that the FOMC has been committed to the Taylor Rule all along, he speaks, not of the FOMC's having had no choice but to adhere to that rule, but of its "unwillingness to deviate from" it, of its understanding that the rule is "a useful" or "key" "guide to policy," and of its "reliance" upon it.
The plain truth is that the FOMC's members have long been entirely free to make any decisions they like, including decisions that deviate substantially from the Taylor Rule owing to their consideration of "non-rulable information" — Kocherlakota's term for the sort of information that formal rules can't take into account. To the extent that they so deviated (and John Taylor himself insists that they deviated a great deal), they faced no sanctions of any kind — not even such desultory sanctions as the FORM Act would impose, were it to become law. What's more, Kocherlakota himself understands that they were free to deviate as much as they liked, for he goes on to answer in the affirmative the question, "Could the FOMC Have Done Anything Differently?" What Kocherlakota apparently fails to appreciate is that an FOMC that could have done things differently is ipso facto one that was not genuinely "rule-bound."
Theory and Practice
In light of all this, what merit is there to Kocherlakota's formal demonstration, near the end of his paper, of the superiority of discretion over rules? Not much. For once one recognizes that, if the FOMC allowed itself to be guided by the Taylor Rule, it did so voluntarily, then one must conclude that its conduct was that of an essentially discretionary policy regime. It follows that, if Kocherlakota's formal model of discretionary policy were reliable, it would predict that a discretionary Fed confronted by the same "environment" faced by the actual Fed would do just what the actual Fed did, including (perhaps) following a faulty monetary rule, instead of doing something wiser.
Suppose, on the other hand, that Kocherlakota's model of discretion did predict that a legally discretionary FOMC might slavishly follow a severely flawed rule. What policy lesson could one draw from such a model, other than the lesson that unlimited monetary discretion is a bad thing, and that the only way out is to impose upon the FOMC a different and better monetary rule than the one the FOMC would voluntarily adopt were it left to its own devices?
To state the point differently, there are not two but three conceivable FOMCs to be considered in properly assessing the merits of discretion. There is, first of all, the actual FOMC which, according to Kocherlakota, followed a (bad) rule, though it did so of its own volition. Then there's Kocherlakota's ultra-discretionary FOMC, which uses discretion, not the way the FOMC actually used it, but to do just the right thing, or at least something a lot better than what the actual FOMC did. Finally, there is a genuinely rule-bound FOMC, where the rule may differ from one that the FOMC might voluntarily follow if it could. The third possibility is one that Kocherlakota altogether ignores. That matters, because even if Kocherlakota's ultra-discretionary Fed is the best of the three, that fact would matter only if he told us how to make an already legally discretionary FOMC do what his ultra discretionary FOMC does. Since he does nothing of the sort, his ultra-discretionary FOMC is a mere chimera.
If, on the other hand, we can identify a rule that does better than the FOMC's favorite rule, supposing that it really has one, then we could really improve things by forcing the FOMC to follow that rule. Imaginary discretion beats both a bad monetary rule and actual discretion that depends on such a rule; but a better rule beats imaginary discretion, because a better rule is not merely something one can imagine, but a real policy alternative.
Kydland, Prescott, and Those Dead Guys
Finally, a word or two concerning Kocherlakota's scholarship. Of the many general arguments favoring monetary rules over monetary discretion, he refers only to that of Kydland and Prescott, in which the authorities are modeled as being both equipped with all the pertinent information needed to wield discretion responsibly, and free from any inclination to abuse their powers. What's remarkable about Kydland and Prescott is not that by making these assumptions they were more faithful to reality than past advocates of monetary rules, who based their arguments on appeals to limited information (and monetary authorities' limited forecasting powers especially) and the potential for willful abuse of discretionary authority. It is that Kydland and Prescott were able to make a powerful case for rules even despite setting such considerations aside.
A compelling case for discretion must, on the other hand, answer not only Kydland and Prescott's argument, but the less subtle but no less important arguments of Henry Simons and Milton Friedman, among others. Despite his conclusion that "there are good reasons to believe that societies will achieve better outcomes if central banks are given complete discretion to pursue well-specified goals," Kocherlakota never really does this. Instead, his demonstrations make only very limited allowances for those central-banker infirmities that caused early exponents of rules to plead for them in the first place. In particular, he allows that central bankers may suffer from an "inflation bias." But he does not allow for the many other political as well as cognitive biases to which central bankers may be subject. More importantly, he does not allow for the very real possibilities that central bankers might respond to "non-rulable" information inappropriately, or that such information might be inaccurate or otherwise misleading.*
More egregious still is Kocherlakota's failure to refer to any work by John Taylor save his 1993 paper. Since Kocherlakota comes within an ace of blaming Taylor for the fact that the U.S. economy has gone to seed, you'd think that he would at least acknowledge Taylor's own rather different opinion on the matter. Instead he leaves his readers with the impression that Taylor himself believes that his rule remains the centerpiece of a "broad consensus" in which the Fed itself takes part. As Taylor points in his own reply to Kocherlakota to some evidence to the contrary, I'll simply observe that, if he believed that the Fed stuck to his rule in the years surrounding the subprime debacle, he wouldn't have called his book on the Fed's role in that debacle Getting Off Track.
In short, Kocherlakota's attempt to treat the Fed's failures as proof of the desirability of monetary discretion is as unsuccessful as it is bold. He might, after all, have spared himself the effort, had he only kept in mind an advantage of discretion that even its most determined opponents aren't likely to deny, to wit: that it's the bigger part of valor.
*Even so, Kocherlakota's formal demonstration still favors a rule over discretion in the event that "the bias of the central bank exceeds the standard deviation of the central bank's non-rulable information."