MONETARY POLICY IN AN UNCERTAIN WORLD: THE CASE FOR RULES.

• Author: Dorn, James A.

Since monetary policy operates in an uncertain world, discretionary policymaking relying on macroeconomic models of the economy is a weak reed upon which to base policy. The complexity of economic systems and constant changes in the underlying data mean errors may occur in a discretionary regime that can lead to monetary and financial instability. (1) The 2008 financial crisis is a case in point: central bankers and their expert staffs failed to anticipate the crisis, and may have worsened it by keeping policy rates too low for too long (Taylor 2012).

Moving to a rules-based regime would not eliminate radical uncertainty, but it could decrease institutional uncertainty--or what Robert Higgs (1997) has called "regime uncertainty"--and thus reduce the frequency of policy errors. Higgs focused on the uncertainty caused by fiscal and regulatory policies that attenuated private property rights by decreasing expected returns on capital. A discretionary monetary regime increases uncertainty about the future purchasing power of money and thereby undermines an important property right.

Radical uncertainty is a given, but institutional uncertainty can be reduced by adopting credible rules. As Karl Brunner (1980: 61) has pointed out:

We suffer neither under total ignorance nor do we enjoy full knowledge. Our life moves in a grey zone of partial knowledge and partial ignorance. More particularly, the products emerging from our professional work reveal a wide range of diffuse uncertainty about the detailed response structure of the economy. ... A nonactivist [rules-based] regime emerges under the circumstances ... as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties ... on the market place. In a similar vein, Allan Meitzer (1983: 95), a long-time collaborator with Brunner, has noted:

The flexibility that permits government to change policy has a cost: Anticipations about the future conduct of policy are altered. The effect of uncertainty is an important, but often neglected, characteristic that affects the cost of following alternative rules in a world subject to unpredictable changes. Some congressional leaders think it's time to create a rules-based monetary regime. The Financial CHOICE Act of 2017 (H.R 10), which recently passed the House, would make the Fed responsible for specifying a monetary rule and justifying to Congress any Fed deviations from it. (2)

Whether the CHOICE Act passes or not, it is important to consider alternative monetary rules and to be prepared to make the case for rules over discretion when the opportunity for reform arises.

This article begins with a discussion of the case for rules over discretion in the conduct of monetary policy and draws upon the theory of monetary disequilibrium to support that case. In particular, a credible monetary rule can eliminate what Clark Warburton (1949) called "erratic money," which he viewed as the chief cause of business fluctuations. (3)

Various monetary rules will be examined, so will the difficulty of implementing them under the current environment in which unconventional Fed policy has plugged up the monetary transmission mechanism. Particular attention will be paid to rules designed to stabilize the path of nominal spending. The article ends with a call to establish a Centennial Monetary Commission to evaluate the Federal Reserve's performance over its 100-plus years and to consider the effectiveness of alternative rules to reduce regime uncertainty.

The Case for Rules over Discretion

It is sometimes argued that discretionary monetary policy is superior to a rules-based monetary regime because discretion includes the option to adopt a rule. That argument, however, begs the question. The real issue is whether a robust, credible monetary rule that constrains policymakers to a long-run objective, and is strategic in nature, is superior to a discretionary regime that focuses on period-by-period optimization using various tactics without committing to any rule.

Those who favor discretion over rules also argue that no rule is permanent and thus judgment is needed to choose among rules. But choosing among rules is different from having no rue to guide policymakers, which is what is generally understood by a discretionary monetary regime. Under the Taylor rule, for example, one has to define the goal variables--the inflation gap and GDP gap--and use discretion in assigning numerical values to the coefficients on the goal variables. Nevertheless, it is still a rules-based monetary regime with a definite strategy as opposed to a regime that gives monetary authorities wide discretion ("the rule of experts").

At the 2013 American Economic Association meeting, Lawrence H. Summers debated John Taylor on the issue of rules versus discretion. Summers used a medical analogy to make the case for discretion, arguing that he wants his doctor "to be responsive to the medical condition" rather than "to be consistently predictable." Taylor responded by arguing that "relying on an all-knowing expert" who practices medicine without "a set of guidelines" is risky--"checklists are invaluable for preventing mistakes" just as a rules-based monetary strategy is. This argument in favor of rules is not to say that doctors don't need to exercise good judgment in designing checklists. They do. But that kind of discretion needs to be distinguished from "a checklist-free medicine." (4) One could also argue that underlying Summers's preference for "a doctor who most of the time didn't tell me to take some stuff' is a fundamental rule: "Do no harm."

Taylor (2015: 10) recognizes that "some rules are better than others, and it makes perfect sense for researchers and policymakers to be looking for new and better rules." The focus should be on long-run strategy, not short-run tactics. The Fed did implicitly follow a Taylor rule during the Great Moderation, from the mid-1980s to 2007, and Taylor thinks that rule "does a good job at keeping nominal GDP on a steady growing trend."

Taylor (2015: 4) does not recommend following "a rule mechanically"--"judgment is required to implement the rule." He is thinking primarily of rules within the context of a government fiat money system. The question then becomes what is to bind policymakers to the rule. Although the Fed appears to have followed the Taylor rule in setting its policy rate during the Great Moderation, that adherence began to erode around 2003-05, when the fed funds rate was pushed significantly below the rate prescribed by the Taylor rule (ibid., p. 5).

The Fed has not returned to any rules-based monetary policy even though Fed chairman Ben Bernanke argued in 2015 that the central bank was following a rule of "constrained discretion." Yet, as Taylor observes, what Bernanke viewed as a rule--namely, setting goals (e.g., targeting inflation and employment)--differs substantially from adopting a rules-based monetary strategy. According to Taylor (2015: 12), "Simply having a specific numerical goal or objective function is not a rule for the instruments of policy; it is not a strategy; in my view, it ends up being all tactics."

In order to better understand the case for rules over discretion, it is essential to recognize the knowledge problem confronting policymakers, the value of having time-consistent rules to reduce uncertainty, and the need to reduce the risk that monetary policy may become politicized as public choice theory describes. (5)

The Knowledge Problem

In his classic essay "The Use of Knowledge in Society," F. A. Hayek (1945: 519-20) defined the "economic problem of society" as "a problem of the utilization of knowledge which is not given to anyone in its totality." That problem implies monetary policymakers are not omniscient: they cannot know tire structure of a complex economic system; their models will have serious flaws and forecast errors; there are long and variable lags in the effects of monetary policy, as noted by Milton Friedman (1968); and constant changes in economic data make it difficult to distinguish between permanent and transitory changes.

A discussion of the Hayekian knowledge problem, as it relates to monetary policy, is presented in O'Driscoll (2016). He argues that "unavoidable errors are an essential feature of discretionary policy" (p. 343), and that a rules-based monetary regime could help reduce uncertainty--an idea that both Hayek and Milton Friedman accepted. According to O'Driscoll (p. 350), "Hayek and Friedman agreed that we know too little to design an optimal monetary policy. ... A monetary rule facilitates the emergence of a monetary order."

Glenn Hubbard, former chairman of the Council of Economic Advisers under President George W. Bush, echoed those problems when he recently remarked, "Ignorance of economic conditions or doctrinaire attention to false models may blow Fed policy off course" (Hubbard 2017).

Nevertheless, Fed Vice Chairman Stanley Fischer, speaking at a Hoover Institution conference on May 5, 2017, argued that committees of experts rather than rigid rules are the best approach to sound monetary policymaking. (6) According to Fischer, experts must "be continuously on the lookout for structural changes in the economy and for disturbances to the economy that come from hitherto unexpected sources." However, the knowledge problem precludes such changes and disturbances from being known beforehand; hence, Fed action is often destabilizing.

A discretionary monetary regime suffers most from these flaws and can be improved upon by moving to a rules-based regime (Friedman 1968). Monetary rules that are operational, credible, and enforceable could help reduce uncertainty.

Rules that are market based, don't rely on experts, and can evolve as learning occurs would be in line with Hayek's warning against the "pretense of knowledge." In his Nobel Memorial...