Tuesday, July 31, 2012

Horwitz on Monetary Rules

Steve distinguishes between constitutional and policy rules here.

I agree with what he has to say. If we could have a constitutionally bound Fed that would obviously be considerably more predictable than a policy rule.

Steve suggests I don't understand the distinction, which I don't think is quite right. The discussion just wasn't about that distinction initially. And Kydland and Prescott (which I raised in my post) don't get into that distinction (UPDATE: I don't think they do at least... I'd probably have to go back and check to be sure). Don suggested that Wapshott advocates discretion and that "management of the economy" is the same as "discretion". That seems wrong to me no matter how you cut it. We are talking about rules, not discretion. If we want to get into the discussion of constitutional vs. policy rules, then I'd agree with Steve that most of what you see macroeconomists talk about today is policy rules, not constitutional rules. But that's a somewhat different issue than the rules vs. discretion point.

Steve also says this: "It is this last point that makes people sympathetic to Friedman unwilling to call that a “rule” in the same sense – it ultimately doesn’t constrain the central bank because it still has the discretion to change the rule.

Put differently, a policy-guiding rule is adopted by the central bank;  a policy-constraining rule is imposed on the central bank.  Their purposes are very different."

This is true, but whipping it out as a criticism of me is a little silly. Constitutional or legal impositions on the central bank (which we do have to some extent, by the way, in the Federal Reserve Act) are "discretionary" in this sense. After all Congress or the various actors involved in the various mechanisms for constitutional amendment have "discretion" over the constitutional rules!

Does that mean at its heart a constitutional rule is discretionary?

No, of course not. And neither is a policy rule.

There is a lot that's appealing to me about a constitutional rule, but part of what makes me hesitate is that we're still learning a lot about the economy and I'd worry that a bad constitutional rule might get locked in in a way that a bad policy rule might not. I'm not saying discretion should dictate monetary policy. We all agree that that's wrong. But consider this wild hypothetical: after thirty years of a monetary policy rule we have a once-in-a-lifetime shock and a fundamental rethinking of the ideal policy rule (say, we're considering whether NGDP level targeting is actually better than a Taylor rule). It seems to me that having the Fed switch to this new policy rule for many decades to come is not a bad thing. That sort of improvement might be stymied by a constitutional rule.

Or it might not be, I don't know.

But that's why I hestitate to go all-in for a constitutional rule. Not because I advocate discretion but because I genuinely think the trade-off between the costs of a bad rule on the one hand and the costs of the somehwat weaker assurance of a policy rule on the other is in fact a real trade-off.

If you want to read more about constitutional rules, I recommend Steves JEBO article here, or just do a search for "monetary constitution" at the Cato Journal - they've produced a lot of interesting stuff on the issue.

UPDATE: So the thirty year reference to the Taylor rule is a little odd I know because of the date Taylor published! This adds an implicit/explicit wrinkle to the constitutional/policy wrinkle of the rule/discretion debate. That's too many wrinkles for me, so I'll just let that whole discussion slide for now.

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