John Taylor is a respected professor of economics at Stanford University. This week he has becoming a leading figure in the political debate over the stimulus package. When I was at Stanford, Taylor’s economics had come to the fore. He was in the White House’s Council of Economic Advisors during the recession of the early 1990s and his Taylor rule for monetary policy was widely adopted by central banks around the world. And I got to tell you, he did not seem like the extremist that the Government painted him in Parliament this week. And that is for good reason, he isn’t one.
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There is a core debate in macroeconomics regarding whether rules are better than discretion. A rule is a set of policies that are committed to and then left to their own devices. Designed right, when economic activity looks like tumbling they automatically inject liquidity into the system and bring budgets from surplus to deficit. They do the reverse when the economy is growing. It is the macroeconomic equivalent of an autopilot.
Discretion is where you drive yourself. You gather information about the economy and you tailor a response. This is good if each cycle has unique circumstances but it is bad in the sense that the government reaction might be unpredictable and governed by non-economic factors.
To many economists, myself included, there is a real appeal to rules done right. For starters, you don’t have to worry about the lag between gathering information (“waiting for the data to come in”) and your ability to decide upon a response. It happens automatically. In addition, private agents know what the government is doing or not doing and can plan accordingly. Commitment of this kind is a key tool in the macroeconomic policy game just as it is in any policy setting.
The problem with rules is that they might be out of alignment or might simply not work. This is the issue right now where monetary policy rules are not working and we appear to be in a liquidity trap.
As an analogy, consider the difference between cooling your house based on a thermostat versus managing temperature yourself. Thermostats adjust and save you from the work of monitoring temperature and reaction to it. The problem is that they sometimes over-shoot and in extreme weather you might want to take over.
John Taylor has been the leading proponent and researcher on the desirability of rules. This has its origins with Milton Friedman. It is a view borne of the Great Depression and government mismanagement there and it is entirely consistent with both Keynesian and neoclassical streams of economic thought. Put simply, it is mainstream economics.
Taylor, like most of us, justifies his beliefs on his reading of the evidence. And let’s be clear about this, and as I was asked by a journalist just yesterday, the evidence on the helpfulness of discretionary fiscal policy is not at all clear. As I wrote yesterday, we don’t know whether handouts really stimulate and when they do. And not surprisingly, one might be reluctant to hand over the wheels of discretion in that information vacuum. This is not an extremist view. This is entirely reasonable given our evidence on discretionary fiscal policy. And up until recently, it was the view held by many macroeconomists including those in the RBA and Treasury.
At the recent AEA meetings, John Taylor reviewed the evidence. Based on the two temporary tax rebates in the US in 2001 and 2008 he argued that there is no evidence these stimulated consumption. He also argued that monetary policy could still work to stimulate the economy. Now while the recent experience might change those views, he is correct in stating that the evidence is not at all clear. It is certainly not a view that warrants the attack by the Government on John Taylor’s economic credentials.
But let’s turn now to the use of John Taylor by the Coalition. Malcolm Turnbull, correctly states, that Taylor would like to see permanent tax cuts used as a stimulus in the US. OK, well then at the very least, propose them! The Coalition has only proposed bringing the legislated permanent tax cuts forward. That does not change permanent income and provides no additional stimulus beyond what would come from discretionary hand-outs. It is discretionary and not ruled based and I cannot imagine that John Taylor would see it as vindication of his position. So if the Coalition is serious then propose permanent policy changes that allow for better automatic stabilisation. Don’t dress up that position in policies that are, but for targeting, the same as the Government’s.
Put simply, we are actually already following the Taylor policy. The government has been doing it for the last year ever since tax cuts were legislated. And remember what big cuts they were (on a par with any stimulus package) so much so that we worried then whether they were a good idea. Turns out, we are all glad they are coming now. Moreover, we still have a structural surplus in our budget even with the government’s proposed stimulus. As far as I am concerned the Government’s patron saint of economics is John Taylor more than anyone else.
My own view is that the current Government stimulus package is an insurance policy. It is not clear it will work but given lags and the size of the economic event we are facing it is a policy I think we should take out. Worse comes to worse, low to middle income households have some more savings, our schools have shiny libraries and our roofs are insulated.
[This post appear in Crikey on the 6th February, 2009.]