Michael Bordo is one of the most pre-eminent economic historians of our time, cited on his Wikipedia page as “the third most influential economic historian worldwide according to the RePec rankin/IDEAS ratings.” Could it be due in part to the fact that he got off to a good start a start as a student of Milton Friedman?
He joined me this week as Stanford University’s Hoover Institution is holding not one but two major monetary policy conferences. Besides it’s annual deep dive into the monetary policy path of the Federal Reserve and global central banks, it chose this year to add a separate event, “A Celebration in honor of John Taylor.” Yes, the very same economist who in the early 1990’s invented the Taylor Rule, which established a simple, powerful way to guide policy at the same time toward price stability and growth.
Currently the Fed is working on revising its Policy Framework, last changed in 2020, just as the Pandemic was hitting monetary policy hard and thought of by many to have led to mistakes that let inflation get out of control. Looking back, a closer following of the Taylor rule could have been especially helpful.
And Bordo is a perfect economist to discuss it. He is a distinguished visiting fellow at Hoover, an economics professor at Rutgers University, and much more. He is the author of many books about economic history, and in particular the role of the Taylor Rule - some co-written with Taylor himself.
So dive in and hear what he has to say. Why he stresses that “Taylor has always said this, you know, if you really just follow my rule, okay, you will do a lot better than you do without doing so.”
John Taylor, the economist…the scene 00:01:16:16
So the period from about the mid-sixties, maybe ‘65 or even earlier until the end of the 1970s was called the Great Inflation. And many people think that the great inflation was caused by excessive monetary expansion by the Federal Reserve in the US, and similar type of policies followed in other countries. There's a big debate about what the causes, whether it was what's called demand, you know, excess aggregate demand or was it the supply shocks. And we all know that the great inflation ended finally when Paul Volcker came in after a disastrous 1970s came in and instituted a very tight monetary policy, which is often called the Volcker shock, which was so tight that it broke the back of inflationary expectations that had been building up throughout the 1970s, caused a very serious recession, but ended the inflation and brought it down to more normal levels to like 3% or 4% by the mid 1980’s.
Pre-Taylor the Fed used rates but money supply was the key 00:03:21:13
In the sense that the Fed did use interest rates, but it did not understand the role of inflationary expectations and did not understand the distinction between what was called nominal interest rates, which is the rate that stated and real interest rates which adjust for inflation. And so as a consequence, we had inflation and the Fed kept tightening, but it didn't tighten enough because it needed real interest rates to rise, to reduce, the excess demand in the economy.
Volcker used rates to crush inflation not weak money growth 00:04:24:10
What they did, what Volcker did, was he where he knew he had to raise rates a lot. He knew that he had to raise rates to make real rates rise, to deflate the economy. But what he did was he called his policy monetarist by focusing on non-borrowed reserves, which is a form of monetary aggregate. And he used that as a sense of cover to raise interest rates. And he raised interest rates! Interest rates got to about 18%. Yeah. By about 1980. So that was the peak.
Taylor’s rule emerges from the dual mandate 00:06:08:00
And so what Taylor did, in a sense, I mean, it took a few years to get there, but he basically said, look, the Federal Reserve doesn't use monetary aggregates. It doesn't like monetary. What does it do? It likes to use interest rates. So let's think of a way in which we can set up a rule which would be a closer fit to what the Fed actually does. And so the rule is to have interest rates, the policy instrument, react to the dual mandate, to react to inflation being above its target, or to put it even more simply, to have to react to inflation, deviating from price stability and to react to the real economy rising or falling below its potential. In other words, the Fed's dual mandate was, you focus on inflation and real output.
An Instrument rule 00:07:10:16
The Fed always thought that way. Okay. And so, what Taylor did was he with a lot of others, it wasn't just him, but a lot of people were working on coming up with what was called an instrument. Which means you use the instrument that the Fed uses. Okay. And you make it a reaction called the reaction function to the variable(s) that the Fed is thinking about stabilizing.
The ’Rule’ to gain acceptance had to swim against the prevailing current of the quantity theory of money 00:08:16:00
Well, I mean, you know, in the 1960s and seventies. Okay, Milton Friedman and a lot of other monetarist economists, Karl Brunner, Alan Meltzer. They thought that the Fed was making a big mistake by using interest rates as its instrument because it did not understand the distinction between real the interest rates and nominal rates. And so what they argued, amongst a lot of arguments, was that if you control the money supply, which the Fed can do, (because it can operate on the monetary base) then it can achieve price stability. And they were following a theory that was a very ancient theory called the quantity theory of money, you know, which says that money, that price that that the price level is largely determined by the quantity of money.
Money supply Vs the interest rate rule 00:09:53:04
Friedman said you should have money growth growing at 4% a year, 5% a year. And if you do that on an off year in and year out, you will maintain stable prices. So <Taylor asked> why don't we come up with a rule which would be like a rule that Milton Friedman pushed in the 1960s called the money Growth Rule <and apply it to interest rates>.
Taylor rule takes off like a rocket-well accepted 00:10:35:04
So here's John Taylor and his rule. How was it first received? What was that? It was kind of like gold. it boomed. Everyone started talking about it. What happened next? Well, it took off like a rocket. Okay. Because in a sense, what Taylor did with his rule was he said, look, this is a very simple rule of thumb <easy to understand>.
Citations chart the path of the ‘rocket’ 00:14:24:22
Taylor, wrote his first big paper on the Taylor Rule in 1993. Okay. And immediately, there was tremendous interest in it. In the talk I'm going to give on Thursday, I'll show you that the citation rate, citation pattern of his paper was enormous. Citations are what academics want to see to assess the influence of your work. Do people cite you in their work? Mm hmm. And so what we what we found was that his citation pattern took off like a rocket after that. Everyone was starting to accept it and academics loved it. And the Fed loved it. And central bankers all around the world loved it. And they wrote working papers of it.
The nuts and bolts of it 00:11:04:04
If you're a central bank, all you’ve got to do is look at whether inflation is higher than what your target is and whether output is above or below what the potential. And then you have to attach weights to these two variables. Okay. Which could be termed by a lottery for a lot of reasons, whether you attach more weight to unemployment or more to inflation than to real output. And Taylor's simple rule said, why don't we just assume the weights are 50/50? Okay, so this is the classic dual mandate. The Fed's interested in both price stability and the stable real economy. And it attaches equal weights to them. Okay. And so, then what he did on that simple assumption is he just constructed a very simple mathematical rule that showed that the interest rate that would that would come from this this function, this reaction function would be a rate which would we could then compare to what the Fed actually produced.
The Rule as a benchmark 00:13:35:09
Okay. And so if you follow this simple benchmark, you can achieve your goal or goals. And he also said it's real simple. You can explain this to people. Okay. We have a rule. We're following this rule. Why didn't we follow the rule? Well, something happened. We had a supply shock. We had a war. Okay. So it's used as a benchmark which ordinary people can use to evaluate the Fed's policy and the Fed itself can use as a way of seeing whether it's doing the right thing.
The Taylor Rule and The Great Financial Crisis (GFC) 00:16:49:00
But John Taylor warned about this… But what Taylor said was, look, this housing boom is going to get a lot worse, okay? Because you are keeping interest rates too low. You are you are throwing fuel on the fire. Okay. So it's the fuel on the fire analogy. And he said you're making a big mistake. He gave this talk at Jackson Hole in August 2007. Okay. That's exactly when things started really getting bad. Okay. And they didn't listen to him.
Bad Taylor Rule following by the reserve currency country spreads bad policy globally- 00:21:22:10
Taylor said the US kept interest rates too low for long, too long <after the GFC>. And we were in a world of floating exchange rates. Okay. This meant that in a sense, the dollar got cheaper and other countries exchange rates went up. When other countries exchange rates go up, it means that there's a fall in aggregate demand. So other countries followed what the US did. So the US made a policy mistake and every other country followed it. And he called that the great deviation. And he said this started with the great global financial crisis and it carried forward in the slow recovery period from 2009 to 2016, because the Fed and other countries followed quantitative easing policies which kept <rates below> the Taylor Rule, creating deviations from his Taylor Rule. And so his policy prescription, which he's given in many, many papers in the past 15 years, is every country should just have a Taylor rule follow their Taylor rules, okay.
Covid balks at the Taylor Rule 00:17:40:21
<then>… there was a pandemic. But the way he saw it and the way Mickey Levy and I saw it, was this is a case of excess aggregate demand, and it's going to lead to inflation. We looked at money growth. We looked at demand. He looked at the Taylor Rule. He <Mickey> said, look at the Taylor rule – the interest rate is way too low. The Fed is going to make a big mistake. I was right. He was right. Okay. And so, you know, the Taylor Rule is, in a sense, a very good benchmark to evaluate policy. If policymakers follow it, Taylor has always said this, you know, if you really just follow my rule, okay, you will do a lot better than you do without doing so.
Rules RULE! 00:20:14:03
And they're very there are some very sophisticated variants of Taylor Rule. Okay. We just describe the simplest one. So how do you work rules based policy in with actual day to day policy? That's the big question. Okay. That's a question which central banks haven't figured out. Some central banks are better at it than others. Okay. The Fed isn't one of the better ones. Bank of Canada has done better. The Swedish Riksbank, the Norges Bank. There are a lot of small countries which have followed much more of what Taylor would call rules based policy. So as far as he's concerned, this is what central bank should do.
Michael D. Bordo is the Ilene and Morton Harris Distinguished Visiting Fellow at the Hoover Institution. Bordo is a Board of Governors Professor of Economics and director of the Center for Monetary and Financial History at Rutgers University, New Brunswick, New Jersey. He has held academic positions at the University of South Carolina and Carleton University in Ottawa, Canada. Bordo has been a visiting professor at the University of California at Los Angeles, Carnegie Mellon University, Princeton University, Harvard University, and Cambridge University, where he was the Pitt Professor of American History and Institutions. He is currently a distinguished visiting fellow at the Hoover Institution, Stanford University. He has been a visiting scholar at the International Monetary Fund; the Federal Reserve Banks of St. Louis, Cleveland, and Dallas; the Federal Reserve Board of Governors; the Bank of Canada; the Bank of England; and the Bank for International Settlement. He is a research associate of the National Bureau of Economic Research, Cambridge, Massachusetts, and a member of the Shadow Open Market Committee. He is also a member of the Federal Reserve Centennial Advisory Committee. He has a BA degree from McGill University, an MSc in economics from the London School of Economics, and PhD from the University of Chicago in 1972.
He has published many articles in leading journals including the Journal of Political Economy, the American Economic Review, the Journal of Monetary Economics, and the Journal of Economic History. He has authored and coedited fourteen books on monetary economics and monetary history. These include (with Owen Humpage and Anna J Schwartz), Strained Relations: US Foreign Exchange Operations and Monetary Policy in the Twentieth Century (University of Chicago Press, 2014); (with Athanasios Orphanides), The Great Inflation (University of Chicago Press for the NBER, 2013); (with Will Roberds), A Return to Jekyll Island (Cambridge University Press, 2013); (with Ronald MacDonald) Credibility and the International Monetary Regime (Cambridge University Press, 2012); (with Alan Taylor and Jeffrey Williamson), Globalization in Historical Perspective (University of Chicago Press for the NBER,2003). He is also editor of a series of books for Cambridge University Press: Studies in Macroeconomic History.
He is currently doing research on a Hoover Institution book project The Historical Performance of the Federal Reserve: The Importance of Rules, a project on “Bank Lending and Policy Uncertainty”; a project on “Financial Globalization and Financial Crises”; and a project on “Central Bank Credibility and Reputation: A Historical Perspective.”
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