Wednesday, January 26, 2011

It's Good to be Consistent...

...but not when you're wrong.

John B. Taylor recently spoke at the American Economic Association luncheon. "I spoke about monetary and fiscal policy," he writes.

I presented evidence of an amazing six decade long correlation between rules-based policies and good economic performance. The correlation—along with basic economic reasoning—is strong evidence that rules-based monetary and fiscal policies are enormously beneficial to the economy.

That's about what you'd expect from the inventor of the Taylor Rule.

Watching Star Trek, the holodeck made me laugh sometimes. They would use it when they couldn't figure something out. They'd just run a simulation, and the results would tell them everything they needed to know. All well and good, for a TV tale. But in the real world, the quality of the results you get depends on the quality of your computer program and the data you start with. Garbage in, garbage out.

If you don't know all the relevant information to begin with, you cannot put that information into your holodeck program. You cannot put it into your economic-policy rules. Neither the rules of a simulator nor rules of economic policy can provide guidance when basic principles are unknown or overlooked. Garbage in, garbage out.

I let it go on Star Trek, because it advanced the plot and it wasn't real. But I won't let it go when somebody wants to do that to the economy.

The "Taylor Rule" encapsulates economic growth and inflation into a formula, so that when you do the calculation the Rule tells you what the interest rate should be. To me, that's like getting an answer from the holodeck.

The Rule takes the difference between actual and potential output, and the difference between actual and desired inflation, and the real interest rate, and the inflation rate. And from these numbers it calculates a "target interest rate" for the Federal Reserve to use. And this is said to give us the best of all possible worlds.

The Taylor Rule evaluates the primary concerns of policy -- growth and price stability -- in an objective and "scientific" way. The rule looks at things the economists who use it think are important. But it doesn't look at everything.

For example, the Rule does not look at the level of debt in the economy. So there is no way the rule could have predicted the the financial crisis of 2008.

After the fact, Krugman and others have used the rule to show that the target interest rate is now well below zero. That result tells Paul Krugman that there is a problem. But "after the fact" is not prediction.

The Taylor Rule has been telling us for years what the "right" interest rate is, for the Fed to set as policy. And (according to the graph Krugman shows) the Fed pretty much followed the Rule. But we had the crisis anyway, and we had the worst recession since whatever. The Rule didn't predict it. Garbage in, garbage out.

"The Rule didn't predict it," says I. Here's what Econbrowser has for 28 July 2008:

As Europe teeters on the edge of recession, and the United States remains mired in slow growth, expectations of what interest rates, and hence exchange rates, are shifting. Here's a familiar depiction of where policy rates in the US and the euro area have been, and where they are predicted to go.

As long the euro area rate is projected to be above, and rising relative to, the US interest rate, the euro should remain strong against the dollar. These expectations are popularly thought to be a function of output and inflation gaps. This suggests that output and inflation gaps usefully be thought of as fundamentals for exchange rates. In other words, Taylor rule fundamentals can be used as empirical determinants of exchange rates.
"Taylor rule fundamentals," indeed.

The graph predicts the U.S. number to remain stable at the 2% level for a year or more. Here's what happened:

About two minutes after the Econbrowser article was posted, the rate fell to zero.

It does make sense to me, up to a point, to be consistent and use rules for things. For the economy and things. More than most people, perhaps. But as Captain Barbossa said, "the code is more what you'd call "guidelines" than actual rules."

Not sure how to end this post, so I'm just gonna quote a couple things I said before.

From Christina at '50:

The Taylor rule produces a number that economists think should be the right number, based on their incomplete and flawed understanding of the economy. Confidence in the Taylor rule presupposes that the modern understanding of economic forces is accurate and complete.

And from I think they miss something...:

Or if the Federal Reserve overlooks the significance of the reliance on credit, it might drive reliance to too high a level on purpose, without understanding the trouble that would arise as a result of this change.

And if they combined this naivete with

1. the mistaken notion that "too much money" can cause inflation but "too much credit-use" cannot; and
2. incomplete, open-ended rules based on a flawed understanding of the economy,

there is every chance that even a carefully-engineered, Taylor-made interest rate would lead us straight to financial disaster.
Rules are made to be broken.

1 comment:

Ohm (Ώ) said...

GIGO indeed.
"If you don't know all the relevant information to begin with, you cannot put that information into your holodeck (Taylor) program."

Besides not taking in existing debt into consideration, lot of other thing too aren't (many of them because Economists simply cannot quantify or estimate them):
1. Propensity of people to take on more debt (all one can say is that it is a function of, among other things, how much debt they already have!)
2. How the new money/debt created will end up getting used. For instance, upon burst in 2001, interest rates were slashed. Now that went into a property boom, greatly magnified by the ARM type "innovations", massive securitization and derivitization. Instead, if it had engendered a Tech Boom II say with Robotics, Virtual Reality, Social Media et al, the macroeconomic results would've been totally different. But no Economist worth it's salt can tell exactly what the easy (or tight, for that matter) money will do. So (you rightly point out) they just ignore everything else they don't or can't have, or don't even know is a factor, and run the Taylor simulator, spewing...whatever.

Krugman I find particularly reckless in going about recommending "unconventional" ZIRPy monetary policies on the one hand, while building the groundwork for things like mass debt cancelations if it all goes horribly wrong. Like he's solving some GMAT word problem on paper, where he can scratch out his "solution" and start over!
Even in the better case results, following his advise, the Fed will have to run ZIRP FOREVER to support the fancy valuations of "assets" into which commonsfolk would end up buying into when CD rates go to 0.5% and Krugman "succeeds" in creating "expectation of inflation" (sic). He thinks he is playing some sort of board game for his intellectual entertainment, or what?

:-) Looks like your current post and mine are pretty complementary, eh!?