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.

What do Central Banks do?

I'm lecturer for second term (econ101b), which is macroeconomics. Currently Martin Jensen is lecturing you on microeconomics, and so when I post I'll be pointing you towards macroeconomic events and news and how that links in to what we'll look at next term.

One thing we'll ask next term is: What do Central Banks do? They are always in the news, particularly around Monetary Policy Committee (MPC) meeting times in the UK. The Bank of England is the Central Bank for the UK. In the US, a system called the Federal Reserve System operates in place of a single Central Bank, and there are Federal Reserves of a number of regions in the US - Minneapolis, New York, Philadelphia, San Francisco, etc. But they all hang together under the Federal Reserve, naturally headquartered in Washington. Their equivalent of the MPC called the FOMC, or the Federal Open Market Committee.*

But what do these Central Banks actually do? Generally they are given responsibility for monetary policy in most economies: The MPC sets interest rates to achieve an inflation target, the idea being that if inflation is kept low and stable, the macroeconomy will stay roughly in order. In the US, the objective of the Federal Reserve is a little wider than just inflation and includes the wider macroeconomy.

There have been many criticisms over the years about whether targetting is the right thing: What's the right target? Why just inflation? Why not asset prices? What is the effect of different targets? An alternative school of thought, pushed more than most by an economist called Scott Sumner, is that Central Banks should target nominal GDP (that's GDP in the actual prices we pay before any correction is carried out for inflation).

It turns out that in its most recent meeting the FOMC hinted it may well begin such a targetting exercise. Next term we'll consider much more what this actually means, other that at the basic level it means that the Federal Reserve would target a particular level of nominal GDP (NGDP) and hence choose interest rates and other monetary tools in order to achieve this aim, just like currently the Bank of England chooses interest rates to achieve 2% inflation.

*: Despite the prevalence of Wikipedia links in this post, the advice is: Don't rely on Wikipedia. Anyone can edit it and hence put false information in there. Rely instead, if you need to for referencing, on something like the New Palgrave Dictionary of Economics. If you refer to Wikipedia in any assignments you hand in, you'll likely incur the wrath of your tutor!