Economists State Why Policy Rules Legislation Is Needed

Recent policy rules legislation introduced in the House and Senate has attracted  much attention—including in op-eds, blog posts, tweets, editorials, speeches, research papers, conferences and Congressional testimony over the past few years. A particular version of this legislation passed the full House of Representatives on November 19, 2015.  It is entitled “Requirements for Policy Rules of the Federal Open Market Committee” and was passed as Section 2 of the Fed Oversight Reform and Modernization Act.  There is debate about what the next steps will be.

In the meantime there is a useful statement in support of this legislation signed on to by a group of economists. The group includes Nobel Prize winners with seminal contributions to the field of macroeconomics, former senior economic policy officials—including several who have served as members of the Federal Open Market Committee, distinguished monetary historians and economists. The signatories—listed at the end of the statement—are Lars Peter Hansen, Robert Lucas, Edward Prescott, George Shultz, Robert Heller, Jerry Jordan, Athanasios Orphanides, William Poole, Michael Bordo, Michael Boskin, Charles Calomiris, Varadarajan Chari, John Cochrane, John Cogan, Steven Davis, Marvin Goodfriend, Gregory Hess, Peter Ireland, Mickey Levy, Bennett McCallum, Allan Meltzer, Gerald O’Driscoll, Lee Ohanian, and John Taylor.

The statement gives specific reasons why the legislation is needed.

Posted in Monetary Policy

The Economic Hokum of Secular Stagnation Redux

Two years ago I published a piece in the Wall Street Journal titled The Economic Hokum of ‘Secular Stagnation.’ I wrote it after Larry Summers presented the secular stagnation view at a joint Brookings-Hoover conference. I argued that the bout of slow growth was not secular, but rather due to recent—and entirely reversible—swings away from good economic policy.   Since then economic policy has not reversed course, economic growth has not picked up, and the economic hokum has engulfed the public intellectual world. If the past two years are any guide, the longer a policy reversal is delayed, the more that secular stagnation will appear to be real.  taylorfig2

In the meantime, evidence keeps accumulating that the slow economic growth is anything but secular.  Economic growth equals the sum of employment growth and labor productivity growth. With the unemployment rate at 5 percent, boosting employment growth requires an undoing of the recent sharp drop in the labor force participation rate (shown in the chart). Such an undoing is possible with right policy incentives. Comparing the 2007 BLS forecast, which took demographics into account, with the actual labor force participation rate, indicates that the sharp drop is not due to secular demographics and should be responsive to incentives from policy reforms which encourage firms to expand and hire. A three percentage point rise in the labor force participation rate from 62.6 percent to 65.6 percent—as the BLS predicted —would mean a 5 percent increase in the labor force. Over 5 years it would mean a 1 percentage point rise in the growth rate. Over ten years it would mean another .5 percent per year rise which would double the .5 percent per year now forecast by the BLS.

Recent labor productivity growth also reveals nothing secular.  The chart below shows the cyclical-like swings in labor productivity growth in the nonfarm business sector. In my view the swings are related to policy. taylorfig1According to the BLS, annual labor productivity growth fell from 3.0 percent during the years 1996-2005 to 0.7 percent during the years 2011-2014, or by 2.3 percentage points.  Over those same two periods, multifactor productivity growth fell from 1.6 percent to .6 percent per year, and growth in capital services per hour fell from 3.7 percent to -.5 percent per year.  Restoring these two contributors to growth to their pre-crisis levels would give a huge boost to productivity growth.

It’s time to change policy and get all this started.

Posted in Slow Recovery

Trying Out a New Video on the Power of Markets

49a96-li3I always enjoy teaching the introductory economics class—we call it Econ 1 at Stanford— and I’m teaching the course again this winter. Part of the fun is trying out new teaching ideas. During the first couple of weeks I emphasize the power of the price system in competitive markets, and later we consider various market failures and, of course, government failures.

In the “free market” lectures I wear this Adam Smith tie, give a summary of Smith’s invisible hand idea, and show Milton Friedman’s famous two-minute pencil lecture on YouTube. While such stories and videos are wonderful, they do not convey the idea of how exactly competitive markets and the price system lead to a Pareto efficient allocation of resources and production. So I also dive into a technical explanation trying to keep as close as I can in a first course with no math to the spirit of the first fundamental theorem of welfare economics which we teach graduate students.

This year I tried out a short new video for this purpose. I produced it with the help of four graduate teaching assistants (who appear with me in the video) and the online course production staff at Stanford. I tried it out this past week in the free market lectures. It’s called Illustration of the Famous Invisible Hand Theoremand it’s a little corny, but judging from the response of the students in the lecture hall, it conveys a pretty good idea of the economic reasoning behind the market efficiency theorem. Before showing the video the students learned about deriving the supply curve and demand curve for price-taking profit-maximizing firms and utility-maximizing consumers.

The video effectively illustrates or “proves” efficiency by showing that in market equilibrium the efficiency conditions hold. After a short pause (at 8.50), the video then shows the consumer and firm response to a supply shock. I also use the video in an online version of the course, but it is easier to judge its effectiveness in a live lecture because I am in the same room as the students.

Posted in Teaching Economics

An Economic Policy–Performance Cycle

For several years I have writing about an cycle in which economic policy swings toward and away from certain key principles of economic freedom. The poor performance of the U.S. economy during the past decade —the Great Recession, the Not-So-Great Recovery, the stagnation of real income growth—can be traced to a Great Deviation from these principles, or, as John Cochrane writes, to an Era of Great Forgetting of what policy works well.  In the prior two decades—the period of the Great Moderation in the 1980s and 1990s—policy moved toward a greater adherence to these economic principles, and in the period before that, in the late 1960s and 1970s, policy swung away. During the past 5 decades policy appears to have swung back and forth with a frequency somewhat longer than typical business cycle, but shorter than the word secular conveys.

For remarks at a session at the recent AEA meetings on “The U.S. Economy: Where To From Here?” I looked at smoothed trends in labor productivity growth. I produced the graph below showing labor productivity growth for the nonfarm private business sector with high-frequency fluctuations smoothed out using a five-year moving average and a Hodrick-Prescott trend. Note how productivity has swung down and up and down again, roughly in tandem with the changes in policy, giving some evidence of an economic policy–performance cycle, which contrasts greatly with secular stagnation stories and gives hope for another upturn if there is a change in policies.


Regarding the recent low productivity growth, the Solow growth accounting formula points to both a decline in growth of total factor productivity and capital services per hour worked as explanations. According to the Bureau of Labor Statistics, annual labor productivity growth fell from 3.0% during the years 1996-2005 to 0.7% during the years 2011-2014, or by 2.3 percentage points.  Over those same two periods, multifactor productivity growth fell from 1.6% to .6% per year, and growth in capital services per hour fell from 3.7% to an amazingly low -.5% per year. Thus a capital share of 1/3 implies a reduction in the contribution of capital from 1.2% to -.2%.

Restoring these two contributors to growth to their pre-crisis levels would give a 2.4% per year boost to productivity growth going forward far above the forecasts of economists who have written off a major change in policy such as pro-growth tax and regulatory reform.

Even assuming the “low hanging fruit have already been picked” story of technological progress and thus a continuation of low multifactor productivity growth, we could get a 1.4% increase in labor productivity growth to around 2% through more private investment which would raise the capital stock and services of both physical and intellectual capital. Tax and regulatory reforms—part of a move toward First Principles—would be expected to do just that

The recent swing down in labor productivity growth, along with the unusually low contribution from capital services, suggests that it could turn up again if boosted by reform-induced incentives. If so, policy reforms would not only raise the long-run growth rate of the economy, they would also likely bring an extra boost to growth in the short run.

Posted in Fiscal Policy and Reforms, Regulatory Policy

Listen to the Economic Experts

Each year I look forward to reading the Annual Report of the President’s Council of Economic Advisers which endeavors to explain the economy and policy from the perspective of the current Administration; my interest may have been piqued from working on Reports in the ’70s and ’90s.

There are similar reports from other governments, of course, including the Annual Economic Report of the German Council of Economic Experts (GCEE), which this year is particularly good with chapter one and some other chapters available in English. Unlike in the US, the Council in an independent economic-policy advisory body–now consisting of Christoph Schmidt, Peter Bofinger, Lars Feld, Isabel Schnabel and Volker Wieland–which submitted the Report to Angela Merkel last month.  This year’s Report has excellent  policy analysis on topics ranging from regulatory policy to bailout policy to monetary policy.

This year they examined the controversy over secular stagnation and the equilibrium real interest rate.  They concluded that evidence “contradicts the hypothesis that there is a ‘secular stagnation’ across the euro area, which would be accompanied by negative long-term equilibrium interest rates. Instead, there are indications that structural reforms, which strengthen markets and competitiveness…” are the way to exit from the crisis and restore growth.

I particularly liked two very interesting and informative charts relating to the US in the macro chapter of the Report.  In one they examine an idea discussed by Janet Yellen in a widely-cited speech from March of this year. Janet Yellen shows that if you insert estimates of the equilibrium interest rate computed by Thomas Laubach and John Williams (LW) into a Taylor rule, you get a lower policy interest rate in the US than if you assume a 2 percent real rate as in the original version of the rule. However, as the Report of the Council of Economic Experts shows, that’s not true if you also insert, along with the LW equilibrium interest rate, the LW output gap as logic and consistency would suggest. The chart below from the Report (with boxes in English by me) shows this.Chart YTLWAnother chart in the macro chapter of the Report provides estimates of the equilibrium real interest rate from the famous Smets-Wouters model estimated using rolling 20-year windows of real time data.  It shows that the equilibrium real interest rate in the US is now a bit more than 2 percent (not zero percent as some, including Laubach and Williams, have argued) and has changed by a relatively small amount over the years—from around 3 percent in the early 1990s. Chart Rstar SW GOverall the Report warns that there is high degree of uncertainty in estimating and using time-varying estimates of the equilibrium real interest rate in monetary policy analysis, whether using rules or discretion.


Posted in Monetary Policy

Ideas and Action: A Rules-Based Deal for the IMF

Several months ago in Congressional testimony, in a Wall Street Journal article, in meetings with public officials, and in a post on Economics One, I suggested the idea that “There is room for a deal” on an important IMF reform that had been internationally pending for years, explaining that: “Treasury wants Congress to raise the U.S. contribution to the IMF, but Congress is reluctant to do so with no framework limiting IMF lending. If Treasury agreed to restore the framework, then Congress could provide the support. This deal would be a first step in putting America in the lead again on international monetary reform.”

I am pleased to say that such a deal has been struck: The Treasury and the Administration agreed to remove their objection to restoring the IMF’s framework for limiting large lending, and Congress included support for the reform in the budget bill, which will likely become law in the next few days.  Rob Kahn and Ted Truman explain the details.

The IMF’s exceptional access framework limiting loans was a set of rules first put into place in 2002 and 2003, and was followed by a halt to financial crises emanating from emerging market countries which had been raging before then.  Unfortunately these rules were broken in 2010 when the IMF made a large loan to Greece which eventually led to a bailout of many private creditors.  Until this week, the U.S. Treasury had objected to restoring the rules arguing the case that discretion was needed rather than rules. With the IMF management, staff and other countries in favor of restoration, the shift in the U.S position is all that is needed to usher in the needed changes.

The move back toward rules-based policy and the overall reform at the IMF call for celebration, especially when coupled with the first move toward normalization at the Fed yesterday.  Of course there is a long way to go—especially in establishing long-term commitment—but first steps are essential.

Posted in International Economics

Learning from Experiences in International Economic Policy

Last week we had a wonderful symposium in celebration of George Shultz’s 95th birthday. Many of George’s friends and colleagues spoke on the theme “Learning from Experience” in economic policy, security policy, social cohesion, and politics. For my part, I spoke of lessons learned from international economic policy in the 1940s when the International Monetary Fund was created, in the 1980s when the international Plaza Accord was forged, and in the 2000s when I served on the G7 and the G20 and when several international economic initiatives following 9/11 were originated.

U.S. leadership played a role in all three periods, and an especially positive role in the strategy developed in the ‘40s. As Jacob Viner said in 1945, “The United States is in effect, and, as concerns leadership, very nearly singlehanded, trying to reverse the whole trend of policy and practice of the world at large in the field of international economic relations…..It is largely an American blueprint for the post war economic world…. It seems to me a magnificent blueprint.”

One serious economic problem in the 1940s was the continuing threat of competitive devaluations and currency wars which had been a factor leading up to World War II. A second stemmed from extensive “exchange controls.”  Both caused all sorts of distortions and injustices.

To deal with these problems, U.S. policymakers in Treasury and State—working closely with their U.K. counterparts—developed a global strategy in which each country would commit to two basic monetary rules; these rules would become the foundation of a new rules-based international monetary system.  First, countries swore off competitive devaluations by agreeing that any exchange rate change over 10% from certain values, or pegs, would have to be approved by a newly-created IMF. Second, they agreed to remove their exchange controls during a transition period. With commitment to these two rules, the IMF would provide financial assistance with the help of a large contribution from the United States.

In important respects the strategy succeeded. The currency wars ended, exchange controls were removed (though that took more than a decade), and eventually the adjustable peg system gave way to a better flexible exchange rate system.

But today the problems facing the international monetary system have returned with volatile exchange rates and large capital flows in and out of emerging markets. Some are calling for capital controls, and even the IMF is sympathetic, while others are questioning the flexible exchange rate system itself.

In my view the problem traces to deviations from rules-based monetary policies at both the national and international level. These deviations not only helped bring on and worsen the global financial crisis, they have been a factor in the sub-par recovery and the recent global volatility of exchange rates and capital flows.  Recent bouts of quantitative easing (QE) have been associated with large fluctuations in exchange rates akin to currency wars: QE in the United States was followed by QE in Japan which was followed by QE in the Eurozone, with exchange rates moving sharply in each case.

Interest rate decisions at central banks around the world also resemble currency wars.  Whether you ask or watch central bankers, you can tell that they are following each other. Extra low U.S. interest rates were followed by extra low interest rates in many other countries, in an effort to fight off currency appreciations.

So we need a new strategy to deal with these problems.  We now have evidence that the key foundation of a rules-based international monetary system is simply a rules-based monetary policy in each country.  Research shows that the move toward rules-based monetary policy in the 1980s was the reason why economic performance improved in the 1980s and 1990s.  More recent research shows that the spread and amplification of deviations from rules-based monetary policy are drivers of current international instabilities.

Learning from the 1940s we should forge an agreement where each country commits to certain rules.  It would be a flexible exchange rate system in which each country—each central bank—describes and commits to a monetary policy rule or strategy for setting the policy instruments. The strategy could include a specific inflation target, some notion of the long run interest rate, and a list of key variables to react to in certain ways. It would be the job of each central bank to formulate and describe its strategy.  The strategies could be changed if the world changed or if there was an emergency. A procedure for describing the change and the reasons for it would be in the agreement.

For the new agreement to work well, it should include a commitment to remove capital controls analogous to the commitment to remove exchange controls in the 1940s. This would be a substantial reform; currently, there are 64 countries, including China, classified as “wall” or “gate” countries with varying degrees of capital controls, so a transition period would likely be needed as safety and soundness regulations on financial institutions are implemented.

There’s also an important lesson here from the policy of Plaza Accord of the 1980s. The intent of the Plaza Accord, which included the U.S., the U.K, Japan, Germany and France, was to ease down the value of the dollar, and the dollar did come down.  However, under the Accord the Bank of Japan was forced to shift its monetary policy in a way that adversely affected its economy—too tight at first and too easy later—causing a severe boom and bust.  In contrast U.S. monetary policy—according to Fed Chair Paul Volcker—was not affected: the Fed simply clarified in a constructive way what it was doing, and the U.S. economy performed well, starting off the Great Moderation.  The clear lesson is that the process that I am proposing would not impose specific strategies on central banks, except to say that the strategies be reported. Such a process would pose no threat to the national or international independence of central banks.

The time may be ripe for such a reform.  Paul Volcker, the former Fed chair, Jaime Caruana, the head of the Bank for International Settlements, and others have been calling for reform.  But it will be difficult because there is still disagreement about the diagnosis and the remedy, though that was true in the 1940s too. Moreover, some countries are still in the midst of unconventional monetary policies, and even if they normalize there is a question of follow-through and commitment.

Here we can learn from more recent policy strategies such as the so-called G7 Agenda for Growth of 2003. Under this agreement, which was in the form of a G7 communique, each country committed to pro-growth supply-side policies.  However, unlike several other post 9/11 economic initiatives, such as combatting terrorist financing or putting collective action clauses in sovereign debt, the Agenda for Growth agreement eventually lost steam as people supporting the agreement rotated out of leadership positions in their governments.

Last year another very similar Growth Agenda was agreed to in a communique by the G20 countries. It had a goal of increasing economic growth by ½ percent per year for 5 years. Thus far, however, the 2014 Growth Agenda is suffering the same fate as the 2003 Growth Agenda. Countries have not followed up with their pro-growth commitments.

So something is missing in the 2000s compared with the 1940s or 1980s.  In my view insufficient U.S. leadership and commitment compared to those years is a major part of the problem. In the 1940s the U.S. Congress participated with the Administration passing into law the Bretton Woods Agreement Act establishing the IMF and the World Bank. One possibility would be for the Congress to become a partner in the agreement proposed here by passing legislation requiring that the Fed report and commit to a monetary policy strategy as in the proposed agreement.  In fact, such a requirement is already written into legislation—the Fed Oversight Reform and Modernization Act—and has passed the U.S. House of Representatives.

I recognize that the approach suggested here may not be the be-all and end-all, but it is supported by lessons learned from economic policy and extensive research over the years. And it has the practical advantage that each country could choose its own independent strategy, avoid interfering with the principles of free and open markets, and contribute to the common good of global stability and growth.

Posted in International Economics