Rethinking the international monetary system.

• Author: Taylor, John B.

In previous articles in the annual monetary issue of the Cato Journal, I drew on historical facts and economic theory to explain the benefits of rules-based monetary policy and why legislation could help the United States reap those benefits (Taylor 2011, 2013a). In this article, I discuss the international aspects of monetary policy, a subject often glossed over in modern debates about rules-based policy, at least compared with discussions about the classic rules-based gold standard. (1)

The Situation

As I see it, the international monetary system has drifted away in recent years from the kind of steady rules-based system long advocated by academic reformers and experienced practitioners across the economic spectrum all the way from Milton Friedman (1953) to Paul Volcker (2014). When you look around the world, you see huge swings of capital flows especially into and out of emerging markets; you see increased volatility of exchange rates reminiscent of currency wars and competitive devaluations; and worst of all you see poor economic performance, including a global financial crisis, a great recession, a very slow recovery, and now disappointing economic growth in many emerging markets and developing countries. (2)

On the economic policy front, you see the spread and amplification (3) of unusual monetary policy actions and interventions across countries; you see governments increasingly imposing capital controls, intervening in exchange markets, and fine-tuning macro-prudential regulations to affect international exchange transactions. You even see top officials at the international financial institutions endorsing such controls and interventions, suggesting that they should be built into a new global system, a far cry from the days when these institutions were arguing for the removal of such controls. (4)

These developments have led some to conclude that a steady rules-based international monetary system is literally impossible, at least one built on the three-pillar foundation of flexible exchange rates, open capital markets, and an independent rules-based monetary policy in each country. This foundation was implicit in Milton Friedman's (1953) case for flexible exchange rates, which held that "the logical domestic counterpart of flexible exchange rates is a strict fiduciary currency changed in quantity in accordance with rules designed to promote domestic stability." And it was explicit in research work starting in the 1980s, which found that if each country followed its own rules-based monetary policy consistent with its own domestic stability, the result would be a nearly optimal international rules-based system. (5)

After documenting recent "surges and retrenchments in capital flows" for central bankers at a recent Jackson Hole conference, Helene Rey (2014) argued that there is an "irreconcilable duo: independent monetary policies are possible if and only if the capital account is managed, directly or indirectly via macro-prudential policies" and "if they are not sufficient, capital controls must also be considered." In other words, independent monetary policies and open capital markets are irreconcilable.

And after reviewing evidence that monetary policy in several central banks is significantly contaminated by policy spillovers from decisions at other central banks, (6) Sebastian Edwards (2015b) called "into question the idea that under flexible exchange rates there is monetary policy independence." He thereby pointed out another apparently irreconcilable duo: independent monetary policies designed to achieve domestic economic stability and flexible exchange rates.

The Problem

In my view, there is no inherent incompatibility between internationally independent monetary policies and either open capital markets or flexible exchange rates. The recent empirical correlations that suggest otherwise are likely spurious, stemming from a substantial deviation from rules-based monetary policy in many countries, which is neither necessary nor advisable.

That there has been such a deviation is beyond dispute. Empirical research by Ahrend (2010) on interest rate policy in the OECD countries and by Taylor (2007), Kahn (2010), and Selgin, Beckworth, and Bahadir (2015) on interest rate policy in the United States shows that a deviation from rules-based policy started around 2003-05--well before the financial crisis--creating a boom and an inevitable bust. Hofmann and Bogdanova (2012) find an ongoing "Global Great Deviation," which is caused in part by the spread and amplification of policy deviations around the world. Deviations from rules are also seen in the large-scale asset purchase programs known as quantitative easing (QE) and in frequently changing discretionary forward guidance operations. In response to quantitative easing in the United States, policymakers in Japan engaged in quantitative easing and then policymakers in Europe expanded their own quantitative easing in response to both. Exchange rate effects were on their minds and openly discussed. Note that these departures from rules-based policy refer to events before and after the panic of 2008, not to the actions taken by central banks during the panic.

There is evidence that the increased volatilities of capital flows and exchange rates are associated with these deviations from rules-based policy. Taylor (2015) finds an...