Scott Sumner vs. John Taylor: An Imaginary Dialog
The purpose of this exercise is to test my understanding of Sumner’s view of monetary theory and policy. I will do this by putting words in the mouths of Sumner and Taylor. It will be a long post, so it goes below the fold.
As background, Sumner and Taylor would each claim to be the intellectual heir to Milton Friedman. Yet Sumner comes down in favor of strongly expansionary monetary policy today, while Taylor does not.Let us start by asking each to explain why he is the true heir of Milton Friedman.
Taylor: I am Milton Friedman’s true heir because I believe in the importance of rules rather than discretion in monetary policy. Discretionary policy is policy that is not predictable. The important thing about money is that it provides the nominal anchor for the economy. Workers and firms make long-term arrangements based on assumptions about how the general level of prices will behave. When their assumptions are correct, macroeconomic outcomes will be good. When their assumptions are incorrect, outcomes will be bad. They are more likely to be correct if the Fed follows predictable rules than if it undertakes discretion.
Sumner: I am Milton Friedman’s true heir because I believe that one of the biggest tragedies in economic policy is the failure to diagnose bad macroeconomic performance as a monetary phenomenon. Part of the reason that the Great Depression was as bad as at was is that policies were undertaken that exacerbated problems. The National Industrial Recovery Act, which cartelized big business and labor, was a prime example. It took several decades for the diagnosis of the Great Depression as a monetary contraction to be articulated and accepted in the profession. Because the monetary contraction was not understood at the time, not only was short term policy bad, but we lost precious economic freedom. I do not want the same thing to happen today, and yet I see it happening.
Next, let us ask each to explain why we have had such high unemployment in the past two years.
Taylor: We have high unemployment because from 2003 through 2006 the Fed deviated from the Taylor rule by being overly expansionary. They kept the nominal interest rate too low for too long. This created a housing bubble and was followed by a crash. We are paying the price today for the excesses of the earlier period.
Sumner. The nominal interest rate is not the correct indicator of monetary policy. The correct indicator is growth in nominal GDP. Growth in nominal GDP was reasonably steady from 2003 through 2006, relative to its previous trend. Therefore, it is wrong to characterize monetary policy in that period as being overly expansionary. If you look at nominal GDP growth, the most striking data point is the spectacular decline that started in the fall of 2008 and that has never been offset. This shortfall in nominal GDP growth is the Great Recession, pure and simple.
Next, we note that Taylor does not favor expansionary moves today, such as quantitative easing. Sumner does favor such moves. We ask each to criticize the stance of the other.
Taylor. Sumner is wrong because he fails to have monetary policy adhere to a rule.
Sumner. Taylor is wrong because he uses his rule to justify the monetary contraction that took place in 2008. If the rule that you are following leads to a horrendous decline in nominal GDP growth, then you are following the wrong rule.
Taylor. If you change the rule when you think that nominal GDP is too low, then you are not following a rule. You are using discretion.
Sumner. My rule isto target nominal GDP.
Next, we note that Milton Friedman did not argue for monetary policy that targets nominal GDP. He favored steady monetary growth. This would create a stable, nominal anchor. Friedman was known for fearing that, due to “long and variable lags” in monetary policy, the attempt to hit a target for GDP would result in overshooting. In James Tobin’s phrase, Friedman feared a Fed that, like an amateur shower tuner, alternately scalded and froze the economy in reaction to past data.
Taylor. That’s right. What my rule does is that it makes sure that the Fed does not over-react in one direction or another.
Sumner. The modern twist in macro is to focus on expectations. We think of the private sector as forming expectations for nominal variables. In addition, the Fed can use indicators of market expectations for prices and output growth. Because the private sector’s expectations matter, the lags in monetary policy are not necessarily long. And because we can read market expectations for prices and output, we can avoid overshooting, because we are not reacting to past performance but instead we are reacting to expectations about the future.
Next, we ask whether the sharp drop in nominal GDP growth in 2008-2009 was due to monetary contraction or a velocity shock.
Taylor. It was a velocity shock. You don’t try to offset velocity shocks, because that is what leads to over-reaction.
Sumner I don’t think that distinction matters. It was a nominal shock, and that is all we care about. If the Fed is targeting expected nominal GDP growth, then it will naturally act to offset velocity shocks.
Next, we ask how they would address the argument that the “zero bound” made monetary expansion ineffective in the Great Recession.
Taylor. The zero bound did not matter, because we did not need more monetary expansion. The Taylor rule, as I formulate it, did not call for negative nominal interest rates.
Sumner. The zero bound is a red herring. There is nothing about interest rates that impedes the Fed from hitting a target for nominal GDP. To argue otherwise is to suggest that we have reached the point in a fiat money economy where the government can no longer debase its currency. That is clearly false. It is absurd.
This concludes our imaginary dialog. At this point, Sumner would appear to be the winner, in my imagination. Next, we need to have him take on those of us who would argue that monetary debasement would not, under present circumstances, do much to relieve unemployment.