What’s Past is Prologue. Study the Past


Each year the Wall Street Journal asks friends for their favorite books of the year. Two years ago I chose Thomas Sowell’s history of income distribution in Wealth, Poverty, and Politics and Brian Kilmeade’s history on Thomas Jefferson and the Tripoli PiratesLast year I chose The Man Who Knew, Sebastian Mallaby’s biography of Alan Greenspan, and War by Other Means by Bob Blackwill and Jennifer Harris.

This year I chose two amazingly relevant  books on U.S. economic history: John Cogan’s The High Cost of Good Intentions: A History of U.S. Federal Entitlement Programs and Doug Irwin’s Clashing over Commerce: A History of US Trade Policy. My reasons in brief are found in the passage below from the printed December 16 WSJ edition. In these days of big economic policy changes, history is essential, and if I had room for a third book, it certainly would be another economic history, namely Tom Hazlett’s The Political Spectrum: The Tumultuous Liberation of Wireless Technology, from Herbert Hoover to the Smartphone.


Posted in Budget & Debt, International Economics, Teaching Economics

A Policy Rule Presented at a Conference 25 Years Ago Today

Ed Nelson sent me a nice note today saying that the past two days (November 20-21) mark “the twenty-fifth anniversary of the Carnegie-Rochester Conference at which you laid out your rule.” I had forgotten about the specific dates, but his note reminds me how much has changed in those 25 years.

Back then, research on monetary policy rules was indicating that rules needed to be very complex with many variables and many lags. There were serious doubts about the usefulness of the research, and some expressed doubts that the results would ever be applied in practice. I had been conducting research at Stanford in the 1980s with a number of graduate students including Volker Wieland and John Williams. So Allan Meltzer (who organized the Conference Series with Karl Brunner) called me and requested that I present a paper on the subject at the November 1992 conference.

The question was: Could we design a simple practical policy rule that was consistent with our research? The answer turned out to be yes, with the interest rate—the federal funds rate—rather than the money supply or the monetary base as the instrument.  The Fed still wasn’t talking publicly about its settings for the federal funds rate, so there was criticism of that design. However, several discussions with Alan Greenspan, who was then Chair of the Fed, gave me a degree of confidence that this approach was workable. In fact, Greenspan later joked that the Fed deserved an “assist” in the developing the Taylor rule.

Ben McCallum was the discussant of my paper at the conference, and he recently wrote a retrospective on the impact of the conference and the rule.  Ben describes how the request to me from Allan Meltzer originated in a meeting of the Carnegie-Rochester Advisory Board on which Ben served.  Ben’s recollection of what Allan was supposed to ask me to do was quite different from what I recall Allan actually asked me to do.  We will perhaps never know how that interesting “miscommunication” arose, but it clearly made a difference.

Posted in Monetary Policy, Teaching Economics

New Results on International Monetary Policy Presented at the Swiss National Bank

This week I gave the Swiss National Bank’s  Annual Karl Brunner Lecture in Zurich, and I thank Thomas Jordan who introduced me and the hundreds of central bankers, bankers, and academics who filled the big auditorium. Karl was a brilliant, innovative economist who thought seriously about both policy ideas and institutions. For the lecture, I focused on ideas and institutions for international monetary policy.

Since Karl died in 1989, we can only wonder what he would think about monetary policy in the past dozen years. But we can get some hints from his former student, collaborator, friend, and great economist Allan Meltzer, who died earlier this year.

About one year ago at the annual monetary conference in Jackson Hole, Meltzer argued that the Fed’s “quantitative easing” was in effect a monetary policy of “competitive devaluation,” and he added that “other countries have now followed and been even less circumspect about the fact that they were engaging in competitive devaluation. Competitive devaluation was tried in the 1930s, and unsuccessfully, and the result was that around that time major countries agreed they would not engage in competitive devaluation ever again.”

In the lecture, I examined this idea empirically, and I found striking results. A monograph with the details will soon be published by the MIT Press, but a very short taste of the results can be given here.

I began by introducing a simple modelling framework which captures key features of recent economic policy. I focused on the balance sheet operations of the Federal Reserve, the European Central Bank, and the Bank of Japan. I concentrated on the liability side and, in particular, on reserve balances which are used to finance asset purchases, as a measure of the balance sheet operations. For the three central banks this gives RU which measures the Fed’s reserve balances in millions of dollars, RJ which measures the BOJ’s current account balances in 100s of million yen, and RE  which measures the ECB’s current account plus deposit facility in millions of euros. I also considered the central bank in a relatively small open economy—the Swiss National Bank.

To examine the impact of the balance sheet operations of the central banks in the three large areas I estimated the following equations.

XJU = α0 + α1RJ + α2RU + α3RE

XJE = β0 + β1RJ + β2RU + β3RE

XUE = γ0 + γ1RJ + γ2RU + γ3RE

where XJU is the yen per dollar exchange rate; XJE is the yen per euro exchange rate; and XUE is the dollar per euro  exchange rate.

All the estimated coefficients are significant, and they showed that:

  • An increase in reserve balances RJ at the Bank of Japan causes XJU and XJE to rise, or, in other words, causes the yen to depreciate against the dollar and the euro.
  • An increase in reserve balances RU at the Fed causes XJU to fall and XUE to rise, or, in other words, causes the dollar to depreciate against the yen and the euro.
  • An increase in reserve balances RE at the ECB causes XJE and XUE to fall, or, in other words, causes the euro to depreciate against the yen and the dollar.

The charts below show the patterns of reserve balances and the corresponding exchange rate movements: first there is the increase in reserve balances at the Fed with a depreciation of the dollar; second there is an increase in reserve balances at the BOJ with a depreciation of the yen; and third there is increase in reserve balances at the ECB and a depreciation of the euro.

In other words, there are significant exchange rate effects of balance sheet operations for the large advanced countries.  In the lecture I then went on to show that there are similar effects for the Swiss National Bank, as in other central banks in small open economies that have little choice but to react to prevent these unwanted moves in their own exchange rates.

These exchange rate effects are likely to be a factor behind balance sheet actions taken by central banks and the reason for the policy contagion in recent years as countries endeavor to counteract other countries’ actions to influence exchange rates. In this sense, there is a “competitive devaluation” aspect to these actions as argued by Allan Meltzer—whether they are intentional or not.

The resulting movements in exchange rates can be a source of instability in the global economy as they affect the flow of goods and capital and interfere with their efficient allocation. They also are a source of political instability as concerns about currency manipulation are heard from many sides. They are another reason to normalize and reform the international monetary system. In my view a rules-based international system is the way to go, as I discussed in the lecture at the Swiss National Bank referring to earlier work here.


Posted in International Economics, Monetary Policy

Still Learning From Milton Friedman: Version 3.0

We can still learn much from Milton Friedman, as we celebrate his 105th birthday today.  Here I consider what we can learn from his participation in the monetary policy debates in the 1960s and 1970s. I draw from a 2002 paper that I presented to lead off his 90th birthday celebration in Chicago in 2002  and from two 2012 pieces: a paper I presented at the centennial of his birth in 2012 and an article written on his 100th birthday in 2012.The lessons are very relevant to the debates raging during the last 15 years and continuing today.

Back in the early 1960s, the Keynesian school first came to Washington led by Paul Samuelson who advised John F. Kennedy during the 1960 election campaign and recruited Walter Heller and James Tobin to serve on the Council of Economic Advisers. The Keynesian approach received its official Washington introduction when Heller, Tobin, and their colleagues wrote the Kennedy Administration’s first Economic Report of the President, published in 1962. The Report made the case for discretion rather than rules. For monetary policy it said that a “discretionary policy is essential, sometimes to reinforce, sometimes to mitigate or overcome, the monetary consequences of short-run fluctuations of economic activity.”

In that same year Milton Friedman published Capitalism and Freedom (1962) giving the competing view. He argued that “the available evidence . . . casts grave doubt on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy—at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better . . .”

So there were two different views, and the fundamental difference was over discretion versus rules-based policies. From the mid-1960s through the 1970s the Samuelson view was winning with practitioners putting discretionary monetary policies into practice, mainly the go-stop policies that led to both higher inflation and higher unemployment. Friedman remained a persistent and resolute champion of the alternative view. Fortunately, Friedman’s arguments eventually won the day and American economic policy moved away from an emphasis on discretion in the 1980s and 1990s. Paul Volcker, who as chair of the Fed implemented the more rules-based policy, had to confront the disparity of views as he did so as I described here.

But this same policy debate is back today. Economists on one side push for more discretionary monetary policy such as the quantitative easing actions and resist the notion of rules-based monetary policy. Other economists argue for a return to more predictable and rule-like monetary policy. They argue that the bouts of quantitative easing were not very effective, and that deviations from rules-based policy helped worsen the great recession.

Of course there are many nuances today, some related to the difficulty of distinguishing between rules and discretion when the zero lower bound is thought to be a constraint. Interestingly, you frequently hear people on both sides channeling Milton Friedman to make their case.

The debate is not merely academic. Rather it is a debate of enormous practical consequence with the well-being of millions of people on the line. The House of Representatives has passed a bill calling for the Fed to describe its policy rule and recent Fed reports have talked about normalization raising questions about a return to rules-based policy.  The same issues arise in discussions of unconventional monetary policy in Europe and Japan.

Can the disagreements be resolved? Milton Friedman was optimistic that debates could be resolved, and I am sure that this is one reason why he kept researching and debating the issue so vigorously.

Today people on both sides can learn from him. First, while a vigorous debater he was respectful, avoiding personal attacks. Second, he had a strong believe that empirical evidence would bring people together. Yes, people would come to the issue with widely different prior beliefs, but their posterior beliefs—after evidence was collected and analyzed—would be much closer. In this way the disagreement would eventually be resolved.

Although posterior beliefs in the monetary area now seem just as far apart as prior beliefs were 50 years ago, I sense that empirical work on the policy decisions of recent years, like the empirical paper by Alex Nikolsko-Rzhevskyy, David Papell, Ruxandra Prodan, can bring about more convergence of views.  As I said at the time of his 100th birthday, clearly we can learn a lot from Milton Friedman in deciding how to proceed.

Posted in Monetary Policy

Debate Over the Very Principles of Economics

Today is the launch of the online version of my Economics 1 course (and namesake of this Blog and my Twitter handle) on the Principles of Economics for summer 2017. This year is also the tenth anniversary of the start of the Global Financial Crisis and the Great Recession which began in 2007.

During these ten years there has been great deal of hand-wringing among economists and others about the subject of Economics. This is an important debate, and the different positions deserve to be covered in the basic economics course.

As early as 2009, a cover of The Economist magazine showed a book titled “Modern Economic Theory” melting into a puddle to illustrate what the writers viewed as the problem with economics. It was the most talked about issue of the year.

Some economists have been calling for a complete redo of economics—or for a return to a version of the subject popular decades ago. They say that economics failed to prevent the Great Recession and the Global Financial Crisis or even led to them. Many of these economists argued for a change government policy, saying that John Maynard Keynes was right and Milton Friedman was wrong.

Paul Samuelson spoke this way in an interview in the New Perspectives Quarterly in 2009 saying, “today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself… This prevailing ideology of the last few decades has now been reversed…I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas”.

Paul Krugman, in a piece in the New York Times Magazine in 2009, also faulted modern economics for bringing on the crisis. He said it focused too much on beauty over practicality and did not recognize the need for more government intervention to prevent and cure the crisis. His fix was to add more psychology to economics or to build better models of credit.

And over the years the debate has continued. Last year Thomas Sargent, in commenting on a Handbook by macroeconomists said the “collection belies uninformed critics who assert that modern macroeconomics was wrong footed by the 2007-2009 financial crisis….both  before and after that crisis, working  macroeconomists had rolled up their sleeves to study how financial frictions, incentive problems, incomplete markets, interactions among monetary, fiscal, regulatory, and bailout policies, and a host of other issues affect prices and quantities and good economic policies.”

But also last year Paul Romer, now chief economist at the World Bank, wrote a widely discussed piece called “The Trouble with Macroeconomics.” Then Ricardo Reis of the London School of Economics wrote a paper more supportive of economics with the title “Is something really wrong with macroeconomics?” My colleague John Cochrane commented positively on the views of Reis, and Noah Smith explained in a Bloomberg View column why “So Many Critics of Economics Miss What it Gets Right

So the debate moves on. My view, throughout this period, has been that the Great Recession and the Global Financial Crisis do not provide evidence of a failure of economics. Rather theses events vindicate the theory. The research I have done, here for example for the Fed’s Jackson Hole Conference in 2007, points instead to a deviation of economic policy from the type of policy recommended by economic principles–a deviation from the type of policy that was responsible for the remarkably good economic performance in the two decades before the crisis. Economists call this earlier period the Long Boom or the Great Moderation because of the remarkably long expansions and short shallow recessions. In other words, the crisis did not occur because economic theory went wrong. It occurred because policy went wrong.

Posted in Financial Crisis, Teaching Economics

Economics 1 Online. No Charge.

This summer I will be offering my Stanford course Principles of Economics online for free.  You can find out more and register for the course, Economics 1, on Stanford’s open on-line platform Lagunita.  The course starts at 8 am PT Monday July 17, when I will post the first week’s videos and reading material, and it goes through 11:59 pm PT September 18. It is possible to register and join the course at any time throughout this period.

The course is based on my on-campus course at Stanford. Each day after giving a 50-minute lecture, I recorded the same lecture divided into smaller segments for online viewing. We added graphs, photos, and other illustrations–just as in the on-campus course; we captioned and indexed the videos–an attraction not in the on-campus course; and we added study material, reviews, quizzes, and a discussion forum.

The first week of the course covers “The Basic Core of Economics” focusing on such ideas as opportunity cost and the supply and demand model with practical applications. Just learning this Basic Core is a significant and worthwhile accomplishment. The course then goes on to consider many topics in microeconomics and macroeconomics including key economic policy issues. I draw on experience in government and the private sector. The course stresses the key idea that economics is about making purposeful choices with limited resources and about people interacting with other people as they make these choices. Most of those interactions occur in markets, and the course is mainly about markets, including labor markets and capital markets.

People who participate in the open online course and take the short quizzes following each video will be awarded a Statement of Accomplishment, or a Statement of Accomplishment with Distinction. The latest version 8.0 of my textbook with Akila Weerapana, Principles of Economics, and its shorter versions, Principles of Microeconomics and Principles of Macroeconomics, can be purchased and downloaded to go along with the course thanks to FlatWorld.

I am pleased to say that there has already been a buzz about the course on Twitter during the past 24 hours. Here is a sampling:

  • Russell Roberts‏ @EconTalker: Great class. Great teacher. No charge. Get your basics right here.
  • Ike Brannon‏ @coachbuckethead: The most entertaining economist I know.
  • Brian Wesbury‏ @wesbury:  If you want to learn Economics from one of the best, click on this link!  What great news!
  • Chris Pippin‏ @ChrisPippin: Wow. Can’t recommend highly enough. This is the class and the professor that made me choose Econ as a major.
  • Juan Carlos Martinez‏ @juank700410: Educación gratuita y de calidad

Thank you!


Posted in Teaching Economics

A Whole New Section on Policy Rules in Fed’s Report

The Federal Reserve Board’s semi-annual Monetary Policy Report issued by Chair Janet Yellen last Friday contains a whole new section called “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The section contains new information and is well worth reading. Below is an excerpt which first lists three “key principles of good monetary policy” that the Fed says are incorporated into policy rules; it then lists five policy rules, including the Taylor rule and four variations on that rule that the Fed uses, with helpful references in notes which are also excerpted below.

The three principles sound quite reasonable: on the third–called the “Taylor Principle” by Mike Woodford and others–the Fed is quite specific in that it gives the numerical range for the response of the policy rate–the federal finds rate–to the inflation rate. The policy instrument is not mentioned specifically for the other two principles

More information, including some algebra, is given in Figure A which is reproduced below. It is good that one of the five policy rules–which the Fed calls the “Taylor (1993) rule, adjusted”–is based on the important 2000 research paper by David Reifschneider and John Williams on the zero lower bound which I have written about here. Note that the Fed describes these rules using the unemployment rate rather than real GDP, relying on an empirical connection between the real GDP/potential GDP gap and the unemployment rate (Okun’s law). Note that what the Fed calls the “balanced-approach rule” is the Taylor rule with a different coefficient on the cyclical variable

The Fed’s Report then goes on to compare the FOMC’s settings for the federal funds rate with the rules as summarized in the next chart. It shows that the interest rate was too low for too long in the 2003-2005 period according to the Taylor rule (not sure if the Fed was looking at the other rules back then), and that according to three of the rules the current fed funds rate should be moving up. (The Fed makes these calculations using its estimate of time variation in the neutral rate of interest ).In reporting on well-known policy rules, the Fed is doing part of what is called for in the legislation which recently passed the House as Title X, Section 1001 of H.R. 10. However, aside from being positive about the three principles, it does not say much about its own policy strategy in the document as also called for in the legislation.

In addition, the report focuses extensively on differences, rather than similarities, in the policy rules, and on the differences in inputs to the policy rules. The differences in measures of inflation, the neutral interest rate, and other variables are part of monetary policy making and always will be. In reality they are a reason to use policy rules as a means of translating these differences in measurement into differences about policy in a systematic way. Such differences do not imply that policy rules or strategies are impractical, as the Report seems to suggest, at least based on some financial reporting.

Chair Yellen will testify at the Financial Services Committees of the House on Wednesday and at the Banking Committee of the Senate on Thursday of this week on the Report and other matters. The testimony and the questions and answers about the Report at the hearings will be well worth following.





Posted in Monetary Policy