Monday, July 30, 2012

Rules, discretion, and management of the economy

I've seen odd claims about "rules vs. discretion" a couple places now, so I thought I might comment on this. First, on a facebook, a relatively well known economist that everyone here would know recently equated "discretionary policy" and Keynesian policy in reference to Kydland and Prescott (1977). Then just yesterday Don Boudreaux acted as if Nicholas Wapshott, in suggesting that Milton Friedman would have advocated greater steps to "manage the economy" (Wapshott's words), was saying that Friedman would have supported discretionary policy. Don's response was that Friedman was an enemy of discretion and preferred policy rules.

Don, I think, is trying to pull the wool over his readers eyes here. The consensus for a long time now has been that policy rules are superior to policy discretion. All the major Keynesian voices Don usually complains about, and those who he would associate with Nicholas Wapshott, support policy rules - not discretion. Paul Krugman has specifically cited a Taylor rule to govern monetary policy, and has worked out a Mankiw rule answer in the past as well. Brad DeLong has come out in favor of an NGDP level target, although he's made points in the past grounded in the Taylor rule. And then of course there's Mankiw who is presumably pro-Mankiw rule and John Taylor who is presumably pro Taylor rule.

In short, Keynesian policy is rules-based policy. People might just cite the need for stimulus right now, because the shortfall is so egregious. But when you ask Keynesians what is required, a rule of one form or another is invoked.

Now there are important discussions going on about what rule is best, and level rules of any sort (NGDP level, price level, etc.) have important properties that rate-based rules don't have, particularly when we get knocked off trend so severely. It's important to have these discussions. But nobody is advocating discretionary policy.

To be honest, I doubt anyone ever did support discretionary policy. It's true, before Barro-Gordon and Kydland and Prescott the rules people followed were probably more ad hoc. It was probably more of the form "estimate the output gap with this proceedure and then fill the output gap". And since economic science and engineering get better over time, there are very real ways in which our rules are better than those old ad hoc rules. But I doubt anyone ever really advocated discretionary policy in the way that it's sometimes presented. The thing is, nobody had a reason to talk about "rules vs. discretion" until the rational expectations revolution made "rules vs. discretion" a thing. And then to make their case, they labeled the old guys "discretionary" and the new guys "rule based".

And that case was an important case to make, and the rhetoric used was effective for making it.

But I doubt there was ever a such a really stark divide on the question. People were always more or less rule based they had just never thought about the issue in those terms before.


  1. Keynes himself seems to have supported rules over discretion.

  2. If I am asked if a central bank/monetary authority should have clear targets, I agree (provided it is an appropriate one). If I am asked if it should be constrained in the means to achieve that target, I am less comfortable.

  3. I agree that most economists favor rule-based policy in relation to monetary policy, but believe there are (at least) two other important points to consider in the debate:
    1) In relation to fiscal policy, there appears to be much less agreement on rules-based vs. discretionary policy.
    2) While many economists promote rules-based monetary policy, there appears to be good reason to question whether those ideals will be maintained during a "crisis"? An example with a 5% NGDP target is what happens if RGDP is -1% and inflation is 7%? Will the Fed really move to reduce NGDP or succumb to pressure to maintain easy monetary policy until RGDP turns around?

    Rules-based policy sounds preferable in theory, for many obvious reasons, but is much harder to accomplish in practice.

  4. Curious how the rational expectations people championed rules. One of the major benefits of rules is to control irrationality. :)

    1. the rational expectation theory is a fiction created out of whole cloth for the sole purpose of creating a foundation for arguing for limited government.

      Today's WSJ had a great piece on people being more successful if they lie and deceive themselves.

      To suggest that "rules" can work----silly

  5. The problem with rules is that it's hard to imagine how a rule could be optimal in all states of the world. You can see this with inflation targeting. Everything is great for a couple of decades while there are no shocks. As soon as there are shocks, inflation targeting goes straight out the window.

    1. But if you don't have any rules then actors have to decide under a great deal of uncertainty all the time.

      The great recession has shown the problem with rules that are presented as universal. But, that doesn't mean there can't be rules for normal times. I think rules for unusual times could be thought out in many circumstances too.

    2. People are generally good with rules that have unspoken exceptions. But there have certainly been times and places where people deferred to authority instead of relying on rules. It does seem that, as societies grow larger and more complex, people rely more and more upon rules.

      One problem with computerization is that programmers do not code much for human exceptions. :(

    3. Current: I agree with you, but I think that it's tricky for central banks. Rules derive credibility from their optimality. If rules are not optimal under shocks, then they suffer from time inconsistency. But overcoming time inconsistency is supposed to be the whole point of formulating optimal rules, so...

    4. It doesn't do any harm to speak about the exceptions from time-to-time.

    5. Vimothy, I agree with you about that.

      There's this point made in different ways by Hayek and Nietzche. Nietzche talks about the death of god. What he means is that once there is an alternative to believing in god that turns believing in god into something else. When no explanation exists for much of what happens on earth except supernatural forces then it's just a matter of picking the supernatural forces you're going to believe in. But, once science provides a choice believing in god anyway becomes something entirely different to what it was.

      Hayek makes a similar point about the gold standard, it worked well when everyone believed it was necessary. After everyone had learned that it wasn't necessary it couldn't work as well ever again. In the 19th century people didn't believe governments could be trusted with fiat money, that they would resort to inflation. Of course, in the 20th century they have on many occasions so those critics were proven at least partially right, but there have also been long periods of fairly predictable low inflation. The markets have found the job of dealing with fluctuating exchange rates much easier than it was thought they would. So, commodity currency has been shown to be something optional for economic success not something necessary.

      I think we're at a similar juncture now. The Taylor rule and targeting of consumer goods inflation central banking worked well as long as it could be plausibly said that nothing radical would happen. Now, we're no longer in that world. I'm not saying that the advocates were stupid enough to think they'd be no recessions, they certainly weren't. But, they believed that it would be politically possible to continue inflation-targeting during a recession, but it didn't turn out that way. From now on even if there is a long period of stability there will be an expectation that it won't last forever.

      In the short-run this is likely to make short-term policy have a stronger effect than it would otherwise. It's hard to tell what it means in the long-run.

      In the long-run it may be possible for other rules to work more robustly. As an Austrian I'm worried that people are targeting and thinking about the wrong things. Anyway, I think that as long as we are targeting the wrong things rules will fail. Economics will have been shown to have progressed when those occasional failures become rarer. But, it will take decades to gather even a little evidence of that sort.

    6. Current: "From now on even if there is a long period of stability there will be an expectation that it won't last forever."

      Why did this long period of stability end? Arguably because we changed the rules, through massive deregulation of finance.

    7. "Arguably because we changed the rules, through massive deregulation of finance."

      "Arguably" - exactly.

      Most of the deregulation was there at the start. I think low interest rates have been crucial this time.

      What Americans forget is that places like Britain and Ireland were in the grips of property booms at the same time as the US, but they had no sub-prime or securitization to speak of. In Ireland house prices started to crash before they did in the US but there was no securitization here. All the problems stem from normal mortgages and loans.

    8. Current,

      That's a nice analogy.

      I think it's important to remember that the whole K&P '83 rules vs discretion thing, Taylor rules, and work by Woodford, McCallum & Nelson, Svensson and others in a DGE context, came out of a specific context. People were worried about the high inflation of the 70s and early 80s and these guys seemed to offer useful ways to approach the problem consistent with the dominant economic theories of the time.

      Like you say, that era seems to have ended now. The rational for favouring rules over discretion still makes sense, but that leaves open the challenge of actually formulating rules that still work in the states of the world that we worry about today (e.g., low growth, financially fragile, etc, etc).

    9. Hopefully that makes rough sense--toothache may be impairing my ability to think or form sentences properly...

  6. It seems to me that a whole lot of very sloppy thinking, if one can call it thinking, is going on here.

    1. You fail to distinguish between various kinds of rules and you fail to distinguish between guidelines and rules. Rules can prohibit: You cannot drive more than 50 mph. Rules can confer discretion: You can drive at any speed, as long as you do not drive in an unsafe or unsound manner. Rules can have external conditions: you may drive at any speed, if the sun it out and it is not raining and the temperature is > 50F. Rules can be targets: You may drive at any speed, provided you arrive on or before 8/1 at 12 noon. I could no one, but obviously macro economics is unable to give a foundation for any of these kinds of rules, so what is the point.

    Rules can appear as guidelines or, checklists (see Munger), which would be a much better description. If the price of corn futures moves above its 100 day moving average by more than X%, then consideration should be given to raising interest rates. This is no rule. It is a test, but not nearly as good as a simple real world test, like testing for chlorine in a swimming pool.

    2. Progressive thinkers do not favor rules, for they know, being lead by the three best economic minds of the last 50 years (Soros, Munger, and Kahneman ) that the economic world is irrational and that any "rule" will not work, for it will be lead to unanticipated actions.

    As proof, the honest progressive will tell you, we talk about rules solely to play a mind game with silly people who give credit to Friedman, etc. We know that the US Const. has a non-delegation doctrine which reactionary forces attempt, repeatedly, to get the Courts to interfere with sensible governance. To avoid legal battles, we will talk in the lingo of rules, but we don't mean it. All sensible liberals and progressives know that gov't has to have a vast reserve of arbitrary power, for we do not know the future.

    3. When Friedman and others offer rules, what they are really trying to do is play Moses and start a cult, appealing to the same psychological forces that turned parts of the Old Testament into a recipe book and diet guide. They know if someone bites on their rule, then by reason of inertia that can elevate themselves (the Taylor rule being an obvious example). NGDP targeting is just someone trying to mimic Taylor as a Jonestown style cult leader from the left.

    In sum, again, my friends, "It is what it is." There are no rules in a World as competitive as this one. If we are to succeed economically, we need an entirely new paradigm of thinking. Economists and our Country would profit if people were instead working on Boyd's OODA loops, but then no one hear are read Col John Boyd.


    A loser is someone is someone —individual or group —who cannot build snowmobiles when facing uncertainty and unpredictable change;


    A winner is someone —individual or group —who can build snowmobiles, and employ them in an appropriate fashion, when facing uncertainty and unpredictable change.

    Circa 1987

    1. If you don't have any rules, how do you know that the individual or group who built the snowmobile won?

  7. "I agree with you, but I think that it's tricky for central banks. Rules derive credibility from their optimality."

    No rule is infallible. Every country makes new laws (rules) all the time. There is nothing special about central banks in that regard. Life is change.

    1. But we don't really want central banks to behave like that, if it can be avoided. We think that there are benefits to committing to rules, and that there are credibility gains if the optimality of those rules don't vary with time.

  8. Current: "Hayek makes a similar point about the gold standard, it worked well when everyone believed it was necessary. After everyone had learned that it wasn't necessary it couldn't work as well ever again."

    Gold standard? England used tally sticks for six centuries, until they burned most of them (and both houses of Parliament in the process) in 1834. It is not like the gold (or silver) standard was monolithic. Even when they were adopted, most countries went off them during wartime. Napoleon was a notable exception. Countries went off them during the Great Depression. Sure, some people made fun of the Japanese for going off it in 1931, but nobody in the know thought that it was a necessity, even if they thought it was desirable.

    1. The claims about tally sticks made by chartalists and neo-chartalists are dubious. Tally sticks were debt contracts. Governments used them to borrow and to deal with tax gathering. They were not money. It was exactly because they were not money that the government had to sell them for money in order to obtain money to spend. Tally sticks were replaced by treasury bonds and bills.

      You're quite right that governments often suspended the gold standard during wars and sometimes in other times. But that doesn't mean that they thought they could get away with suspension forever. They believed (correctly or otherwise it's hard to say now) that they needed it in the long term.

      "Every country makes new laws (rules) all the time. There is nothing special about central banks in that regard. Life is change."

      In countries where many laws, or many important laws have changed quickly there has often been chaos. Also, when laws are struck down they are usually replaced with other laws immediately. In Central Banking though we have a situation where the established law (inflation targeting) has been struck down without being replaced. So, we now have Central Bankers judging what to do arbitrarily. That would be like judges deciding each case individually without referring to other cases or judges.

  9. Krugman can be remarkably slippery in his NYT stuff.

    For example, he’s made plenty of statements suggesting that monetary policy is useless at the zero bound, so we need fiscal stimulus, blah blah blah.

    On the other hand, you can also find him making lots of statements suggesting that the Fed isn’t doing enough, and needs to engage in more stimulus.

    Perhaps if you parse the statements closely enough there is some way of reconciling them, but they at least appear to be inconsistent.

    Given the inconsistencies (what Bob would call “Krugman Kontradictions”) a question like “Does Krugman favor rules or discretion in monetary policy?” is surprisingly difficult to answer.

  10. "Now there are important discussions going on about what rule is best, and level rules of any sort (NGDP level, price level, etc.) have important properties that rate-based rules don't have, particularly when we get knocked off trend so severely. It's important to have these discussions. But nobody is advocating discretionary policy."

    When you can, ex post, argue about which rules should guide your conduct in a given situation -- such as being "knocked off trend so severely" -- then your actions are discretionary.

    1. Well then nothing but the laws of physics are "rules" (and maybe not even those). This doesn't seem like a very helpful point, unless your intent is just to brand people as discretionary.

      I think everyone agrees that we have a big problem now of policymakers not following the rule as a historical matter. That is definitely the problem.

      But the fact that any given rule could go off course in and of itself doesn't negate the fact that it's a rule. The world is imperfect. That's the way life is.


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