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Saturday, July 14, 2012

One of the Most Important Lessons of Modern Macroeconomics

I completely agree with John Cochrane when he writes in his review of my book First Principles that the “preference for rules is one of the most important lessons of modern macroeconomics” and that it is still the major point of disagreement among those writing about economic policy today. As John nicely puts it, the disagreement is about “rules vs. discretion, commitment vs. shooting from the hip, and more deeply about whether our economy and our society should be governed by rules, laws and institutions vs. trusting in the wisdom of men and women, given great power to run affairs as they see fit.”

The disagreement can be seen all over the place. Compare First Principles with Paul Krugman’s End This Depression Now or with Joe Stiglitz’s The Price of Inequality. (All three books published by W.W. Norton, by the way). Many have said that this difference is the main takeaway from the Harvard and Stanford debates between me and Larry Summers.

But even among those of us who agree about the lesson, there are differences in how you go about applying it as John Cochrane points out in reviewing the chapter “Who Gets Us In And Out Of These Messes.” For example, John expresses some skepticism about my proposal to achieve more rule-like behavior in monetary policy through legislation, mainly because the proposal is too “middle-of-the-road,” simply requiring that the Fed report its rule or strategy and narrow its mandate.

I am very open to discussing alternatives, but it is important for the discussion to set the record straight on one point. John Cochrane characterizes my so-called Taylor rule paper published in 1993 as follows: “The Taylor rule was originally an empirical description of Fed actions in the 1980s, a description of how the Fed acted to implement its dual mandate. It only slowly became a normative description of what the Fed should do.” Actually from the start the Taylor rule was meant to be normative. It was the outcome of a search over many years for good policy rules using monetary theory and empirical models with rational expectations and rigidities. And it has only one normative target—a 2 percent inflation rate—along with a process of minimizing fluctuations around that target and around whatever is the given natural rate of output or unemployment.

In any case, the big question is how to apply this "most important lesson." George Shultz offers some ideas in his interview today in the Wall Street Journal where he emphasizes the importance of rules-based policy with a football game analogy (without predictable rules, no one will play).