In the 1960s, Milton Friedman was the chief spokesman for the monetarists. They differed from Keynesians in two respects. First, they argued that monetary policy (setting the growth rate of the money supply) was at least as important for macroeconomic outcomes as fiscal policy (setting the level of government spending and tax rates). Second, they argued in favor of rules rather than discretion.
Until the 1970s, Keynesian macroeconomics focused almost exclusively on fiscal policy. To the extent that they considered monetary policy at all, they emphasized the role of the monetary authority (the Federal Reserve) in setting interest rates. To the extent that they worried about policies to control inflation, Keynesians viewed government guidelines issued to workers and firms to restrain wage and price increases as the most promising approach.
Yet, in spite of the strongest government intervention in wage and price setting behavior since World War II, the 1970s saw a surge in inflation. Because this surge was accompanied by unemployment rates that were high rather than low, Keynesians were forced to give ground. The experience of the 1970s validated the monetarists' concern with inflation and with the role that monetary growth plays in macroeconomic performance.
Rules vs. Discretion
The experience of the 1970s validated the monetarists' concern with inflation and with the role that monetary growth plays in macroeconomic performance.The 1970s experience also forced Keynesians to give ground on the issue of rules vs. discretion. Friedman had argued that fiscal and monetary policy should be guided by rules. For fiscal policy, the rule should be a budget that is balanced on average, with deficits only varying with natural movements in tax revenues and expenditures caused by the economy's cyclical fluctuations. For monetary policy, the rule should be a steady growth rate in the money supply of, say, 5 percent per year.
In the 1960s, Keynesians mocked Friedman's fixed rules. As I recall, it was Paul Samuelson who used the metaphor of a stopped clock to suggest that rules were likely to be inferior to the use of discretion. I also recall James Tobin writing that Friedman viewed the monetary authority as if it were an “amateur shower-tuner,” unable to keep from alternately scalding and freezing itself. Like Samuelson, Tobin found it implausible that the Fed could do no better than to follow a simple rule.
The late 1970s saw the “rational expectations revolution” sweep through academic macroeconomics. According to these theories, what affects the economy are deviations of fiscal and monetary policy from the paths that workers and firms have been led to expect.
The rational expectations hypothesis virtually ensures that macroeconomic performance will be better under rules than under discretion. If policy follows predictable rules, then individuals in the private sector will not make mistakes that come from guessing incorrectly about the path of policy. If such mistaken guesses are the main cause of recessions, then the use of rules could eliminate recessions.
From the early 1980s until the most recent financial crisis, the consensus among academic macroeconomists overwhelmingly favored rules rather than discretion. The “great moderation” that took place during this time was widely attributed to a rule-based approach to monetary policy.
The Taylor Rule
The rational expectations hypothesis virtually ensures that macroeconomic performance will be better under rules than under discretion.The rule that monetary policy was understood to be following is known as the Taylor Rule, so named for John Taylor, an economist currently at Stanford University. Economists were wary of Milton Friedman's proposal for steady money supply growth, in part because of doubts about the stability of people's use of money given ongoing technological change. The Taylor Rule instead calls for the Fed to make interest-rate adjustments aimed at stabilizing the inflation rate. The Taylor Rule incorporates both the inflation rate and the unemployment rate as indicators of where the interest rate should be set in order to follow the rule.
The “great moderation” consensus also held that discretionary fiscal policy is not necessary. Instead, the Fed's use of the Taylor Rule should be sufficient to prevent a major recession.
This consensus in favor of rules fell by the wayside in 2008. The older monetarist and Keynesian factions have resurfaced. Using blogs, stubborn monetarists and stubborn Keynesians have debated vociferously.
The monetarist view is that monetary rules would work, if they were tried. John Taylor himself insists that the housing bubble was exacerbated by the Greenspan Fed's deviation from the Taylor Rule from 2003 to 2006. The subsequent crash could have been avoided, he argues, had the Fed raised interest rates sooner.
Another monetarist, Scott Sumner, argues that the worst monetary policy deviations came not before the crisis but afterward. In his view, the issue is less the Fed's earlier looseness and more the Fed's excessive tightness in 2008 and ever since.
Sumner favors having the Fed target the forecast for nominal gross domestic product (NGDP). Focusing on an NGDP target differs from the Taylor rule in two respects. First, it is explicitly forward-looking, rather than relying on recent economic data. Second, Sumner views NGDP as a more reliable indicator to target than any measured rate of inflation. The accuracy of government inflation indices is questionable, but as a measure of total spending NGDP does not depend on the ability of government officials to sort out price changes from quality changes from changes in the pattern of consumer preferences.
I find it somewhat disconcerting that two prominent stubborn monetarists differ in their analysis and proposals for implementing rule-based policy. (As an aside, there are Keynesian economists who claim that their preferred version of the Taylor Rule would have called for much more monetary expansion than what Taylor himself thought appropriate in 2009-2010.) If the appropriate monetary policy rule is in dispute, then selecting a rule becomes a matter of choice, which makes the rules vs. discretion argument a bit less clear-cut.
The Keynesians believe that without the fiscal stimulus and the Fed's quantitative easing, the recession would have been worse.The view of the stubborn Keynesians, including most of the economists consulted by Lawrence Summers in his now-infamous memo to President Obama,1 is that both monetary policy and fiscal policy needed to be used in dramatic, discretionary ways when the financial crisis hit. In this view, the large fiscal stimulus and additional monetary expansion both played a constructive role in the economy in 2009-2011. The Keynesians believe that without the fiscal stimulus and the Fed's quantitative easing, the recession would have been worse. They believe that had even greater stimulus efforts been undertaken, the outcome would have been better.
Is there any chance that the dispute between stubborn Keynesians and stubborn monetarists will be settled empirically? I find it difficult to be optimistic on that score. We have accumulated more than six decades of macroeconomic experience since the end of World War II, yet neither stubborn Keynesians nor stubborn monetarists have encountered any data that would make them change their minds. Instead, since 2008, the Keynesians have effectively “taken back” all of the concessions that they made in the 1970s and 1980s.
The net result is that stubborn Keynesians and stubborn monetarists have put their debate right back to where it was in 1970.
Many other economists see the current macroeconomic situation as having unusual characteristics. Some emphasize that financial crises tend to produce long, deep recessions, as Ken Rogoff and Carmen Reinhart have documented in . Others emphasize structural factors, including those I described in “What if Middle-Class Jobs Disappear?” Neither stubborn Keynesians nor stubborn monetarists see a need to take into account financial markets or structural unemployment. Instead, they take the view that any desired macroeconomic outcome can be achieved with the right fiscal and monetary policy approach.
Just as in 1970, the Keynesians emphasize fiscal policy and favor discretionary policies. And just as in 1970, the monetarists emphasize monetary policy and favor rules. Each side is certain that it is correct, although in my opinion both sides are probably wrong. The last essay in this series will include my own views.
Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for , part of the Library of Economics and Liberty.