John Taylor's Counter-narrative
By Arnold Kling
You may not have heard much about the Great Deviation. I define it as the recent period during which macroeconomic policy became more interventionist, less rules-based, and less predictable. It is a period during which policy deviated from the practice of at least the previous two decades, and from the recommendations of most macroeconomic theory and models. My general theme is that the Great Deviation killed the Great Moderation, gave birth to the Great Recession, and left a troublesome legacy for the future.
He offers a list of 12 discretionary interventions. However, only two of them preceded the full-blown crisis in 2008, and one of those two was the creation of the Term Auction Facility by the Fed, which no one, including Taylor, wants to count as a big deal.
Basically, for the U.S., his whole argument rests on deviation from the Taylor Rule in 2003-2005. There are two defenses of the loose monetary policy of that period. One, which Taylor addresses, is that the Fed was (incorrectly) forecasting low inflation. Another, which Taylor does not mention, is that the payroll survey of employment, which is considered more reliable, was portraying the labor market as weaker than the household survey, which supplies the unemployment rate used in the Taylor Rule.
But Scott Sumner’s dog does not bark here. That is, Taylor omits to suggest that monetary policy deviated in a contractionary direction in 2008. Does Taylor believe that monetary policy was contractionary at this time? If so, then it is a striking omission. If not, then there is an interesting debate to be had between Taylor and Sumner. (One problem for Taylor is that his rule uses the Fed Funds rate as the indicator of monetary policy, and the Funds rate was quite low during the period when Sumner views monetary policy as contractionary.)
Taylor applies his narrative to the European crisis. There, he says that the rules that were broken were those of the European Stability Pact, which was supposed to limit deficit spending by individual countries. What I heard economists say when I was in Europe was that Germany and France were the original countries to obtain waivers to allow them to run larger deficits, and this caused the pact to break down. Regardless, I think it helps support Taylor’s view.
I don’t think Taylor’s counter-narrative will prove successful. I think that the “Keynesian moment” narrative will prevail among insiders. For outsiders, I prefer my narrative.
For me, the top three causal factors for the 2008 crisis are: flawed international capital standards for banks, flawed U.S. housing policy, and the suits vs. geeks divide. I think that what is going on in Europe amounts to a simple sovereign debt crisis in a few countries, which is being treated as something much more complex in order to justify and throw a smokescreen over a bank bailout. So, yes, it would have been better to have enforced the Stability Pact, but if you dig into things deeply enough you will find that flawed capital standards played a role in this crisis as well, because those standards told banks that they could treat sovereign debt as risk free.