Wednesday, December 1, 2010

Classic Economists and Mistakes

In the UK, the Bank of England has a mono mandate, so to speak: It is charged with keeping inflation low and stable - around 2%. In the US however, the Federal Reserve (the central bank system) has a dual mandate: To also achieve maximum employment via its monetary policy decisions.

It's fair to say some people disagree with this while others agree. John B Taylor is a prominent figure in monetary policy theory in economics, as you'll learn next term. He devised what is called the Taylor Rule: That the interest rate should be set taking into account both inflation and the output gap (the difference between actual and potential GDP).

However, despite this, Taylor is now a fierce critic of the Federal Reserve and commonly makes statements like: "The Fed's decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble." He states this based on a very simple equation called the Taylor Rule: It's not even estimated. It's a very theory-orientated construction and from his he asserts monetary policy was too loose in 2002-4 and this caused the housing bubble and subsequent crash.

Now Taylor, along with a Republican politician, is suggesting that this dual mandate should be removed and replaced with a single-mandate, just price stability.

Greg Mankiw isn't convinced about this, suggesting that even if the mandate was simply price stability some of the same policies (notably quantitative easing) would have still taken place.

Furthermore, Taylor is making a really fundamentally basic error of judgement that a lot of economics (and people more generally) often make: Comparing apples and oranges.

Taylor says: QE1 (quantitative easing last year) didn't work: The economy is still in a mess. Yet how on earth does he know this? He's comparing the pre-QE1 economy with the post-QE1 economy yet these are two fundamentally different things.

He wants to compare the post-QE1 (or today's) economy with another US economy run up to today without QE1, so a without-QE1 post-QE1 economy. But he can't and the next best thing is to compare where we are now with where we were back then.

But how does John B Taylor know that the without-QE1 economy today wouldn't be in a much worse situation? The answer is: He doesn't. He asserts it would be, based on no evidence.

Next term, we'll try and cover why this kind of analysis is very dangerous indeed because it often leads to policymakers changing policy - changing policy based on little or no evidence, but simple assertions, however strongly put.

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