Mateusz Machaj, PhD in economics, is a founder of the Polish Ludwig von Mises Institute

[This is a transcript from the September 22, 2014 episode of the Tom Woods Show, featuring Mateusz Machaj, former Summer Fellow at the Mises Institute, and founder of the Mises Institute of Poland.]

Thomas Woods: The Taylor rule has been cited for so long by so many people who describe themselves as free-market economists that it has become more or less the conventional wisdom that the Taylor rule is a good guide for the central bank in formulating monetary policy. Let’s start off by explaining who Taylor is and what the Taylor rule says, in a way that’s understandable to the layman.

Mateusz Machaj: Well, John Taylor started working on monetary policy in the early ’90s. He published a paper describing what the Federal Reserve System was doing in terms of monetary policy in the ’80s, and he apparently discovered that the Federal Reserve was following some version of the monetary policy rule, a sort of fixed rule. It was not probably fixed like the famous Friedman rule. It was short lived, but still it was a general rule for monetary policy. And it was a purely descriptive paper. And then after a few years, suddenly, from this purely descriptive paper in the literature we have a flourishing of the concept of the Taylor rule, based on this paper as if it were some normative proposition of how to conduct a correct monetary policy, whereas it was just a description of what was done in the ’80s. And that’s how we got into the whole Taylor rule thing.

Also, in the early 21st century, various versions of the Taylor rule were proposed for monetary policy. Unfortunately, they failed, but Taylor himself, in 2009, after the Great Recession started, published a paper arguing that the Federal Reserve System was not following his rule, and that was the reason for the real estate boom, and that was the main factor for the recession. And therefore, from his description of various, let’s say, mildly pro-market people with a sort of Friedmanite sentiment for having government rules that are supposed to constrain the government, we have the sentiment somehow about following the Taylor rule that is constraining government in some way by proposing a form of monetary constitution or something like that in order to stabilize the economy. But of course, the main problem is that this rule itself is vague, it’s unclear, and it actually opens the door for destructive monetary policy because it’s still a monetary policy performed by the government, by a government agency.

TW: Right, so that, of course, is going to be the ultimate problem with it. But one of the points you’re making in the paper is that even if we accept the idea that the Taylor rule is a good policy, even if we accept the idea that we should have some rule that overrides what would spontaneously occur on the market, nevertheless there are practical problems even with implementing the Taylor rule, one of them being the problem of figuring out which data ought to be used. Depending on which numbers you use, you wind up getting a different Taylor rule. Before we get into that, what exactly is the Taylor rule saying the central bank should do? He is saying, if you would listen to my Taylor rule, interest rates would have been higher, and you wouldn’t have had this housing bubble. So what does the rule tell the central bank it should do with interest rates?

MM: The Taylor rule itself is just an equation, and the equation can have many different forms. To make it as simple as possible to our listeners, the equation says that you are supposed to arrive at a certain level of interest rates set by the central bank based on two other main variables: price inflation and the so-called output gap. Apart from that, we have some additional coefficients that we put in the equation, and we arrive at the final number. The higher the inflation rate, of course, the higher the recommended interest rate by the central bank, and the bigger the output gap — that is, the further away we are from, let’s say, potential production, potential output — then the interest rates are supposed to be lower in order to boost spending and boost the economy and reach the potential level. Now, there are two main problems with this approach, one group with mainstream objections to the rule itself, and the other group employ Austrian objections — well, the mainstream objection would be that you have various problems with measurements, as you mentioned. That is, how you measure price inflation, and how you measure the so-called output gap. And there are lots of articles written in the mainstream literature actually arguing that there are serious problems with measuring the so-called potential output, the potential production. Some mainstream economists argue that we should get rid of it and forget it about it, because various ways of measuring this whole potential output are actually so vague that we should downplay it completely and forget about it.

TW: Well, actually, let me jump in on this issue of the output gap, because this is the term that I would think most normal people are not familiar with. The output gap is something that you’ll hear especially among Keynesian economists when there is a recession. They say that there’s an urgent need for stimulus programs because every day that we don’t engage in stimulus, we are losing potential output. Our factories are idle, our workers are idle. We have this potential to produce all of these goods because, look, we have the raw materials, we have the factories, we have the people, but none of these things are coming together, and stimulus can bring them together. In other words, every day that they don’t come together we lose potential output, because we could potentially be producing at this level up here, but because of the recession conditions and the unemployment of resources, we’re producing only down here. So there’s an output gap between where we would be producing if everything were gainfully employed as opposed to what we’re producing now when some things are not gainfully employed. That’s what’s meant by the output gap. Am I right about that?

MM: Yep, yep. Well, on the very, very general level, the term itself, potential output, makes some sense, of course, because every economist would tell you that when we are in the recession, our production possibilities are not fully utilized. They are not fully used because we have high unemployment. We have various scarce and idle factors of production that we could employ to increase our production. So on the very, very general level this is very correct, but the question is, how do we solve this problem? So how do we make sure that all of those various factors are employed in fact? Various stimulus programs, government programs that are being used often result in some form of employment of those factors, but this employment is at the expense of malinvestment created by that government spending or that government stimulus —

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