Confidence and Credibility

John Taylor is an economist at the right-wing Hoover Institution. His specialty is monetary policy. He is best known for proposing the Taylor Rule, a simple rigid formula for how the central bank should change its nominal interest rate based on departures from targeted inflation rates and differences from potential GDP.

The purpose of the Taylor rule is to systematically reduce uncertainty and increase the credibility of future central bank actions to foster price stability and full employment. In the video above, Taylor extends his uncertainty-credibility analysis beyond the central bank to all areas of government policy, to include fiscal policy, health care policy, regulatory policy, etc.

The extended generalization hinges on whether uncertainty-credibility are at the root of our current financial crisis. Taylor thinks that business would be hiring if the government was "credible" (instituted austerity programs) and business had "certainty" (business can be certain that they can do whatever they want without regulatory interference).

The Keynesian response to the "business confidence" argument (stated here and critiqued here) is that actual demand is more important to investment. What's the point of investing if there is no demand? In the current financial crisis where investment has been chocked off with the evaporation of liquidity, we're in a situation where consumption (C) and employment (L) are at low levels consistent with the downturn in GDP. We might hope that exports (a positive balance of payments, BOP) might help, but that's unlikely because the world system is also in recession.

Eliminate "Investment" and "BOP" from the graph above and you are left with government expenditure (deficit spending) as the only way to increase consumption and employment. You can lower the interest rate as much as you want and it won't stimulate investment because (1) current capacity is not being fully utilized and (2) the interest rate cannot go below zero.

John Taylor's arguments about uncertainty-credibility make sense in a business-as-usual environment when inflation and GDP are near their targeted values. To make these arguments during the Great Recession, when inflation and GDP are well below targeted values doesn't even make sense using Taylor's own formula (see below).

THEORY: The Taylor Rule is roughly i = i* + a(P - P*) + b(GDP-GDP*) where i is the interest rate, P is the price level, GDP is gross domestic product, and the starred values are desired, equilibrium or attractor levels. If P* and GDP* are a lot greater than P and GDP, respectively, the interest rate becomes negative, the dreaded zero-bound when the Taylor Rule no longer applies.

Analyzing the Taylor Rule would, by itself, be an interesting topic for a future post. For me, the key issues here are how to specify the dynamic attractors for inflation and GDP and how well changes in nominal interest rates would lead to price stability and full employment. The fact is that central banks do not use the Taylor rule so its application is purely counterfactual.