The Dangers of an Interventionist Fed

By JOHN B. TAYLOR, WSJ

America has now had nearly a century of decision-making experience under the Federal Reserve Act, first passed in 1913. Thanks to careful empirical research by Milton Friedman, Anna Schwartz and Allan Meltzer, we have plenty of evidence that rules-based monetary policies work and unpredictable discretionary policies don't. Now is the time to act on that evidence.

The Fed's mistake of slowing money growth at the onset of the Great Depression is well-known. And from the mid-1960s through the '70s, the Fed intervened with discretionary go-stop changes in money growth that led to frequent recessions, high unemployment, low economic growth, and high inflation.

In contrast, through much of the 1980s and '90s and into the past decade the Fed ran a more predictable, rules-based policy with a clear price-stability goal. This eventually led to lower unemployment, lower interest rates, longer expansions, and stronger economic growth.

Unfortunately the Fed has returned to its discretionary, unpredictable ways, and the results are not good. Starting in 2003-05, it held interest rates too low for too long and thereby encouraged excessive risk-taking and the housing boom. It then overshot the needed increase in interest rates, which worsened the bust. Now, with inflation and the economy picking up, the Fed is again veering into "too low for too long" territory. Policy indicators suggest the need for higher interest rates, while the Fed signals a zero rate through 2014.

It is difficult to overstate the extraordinary nature of the recent interventions, even if you ignore actions during the 2008 panic, including the Bear Stearns and AIG bailouts, and consider only the subsequent two rounds of "quantitative easing" (QE1 and QE2)—the large-scale purchases of mortgage-backed securities and longer-term Treasurys.

The Fed's discretion is now virtually unlimited. To pay for mortgages and other large-scale securities purchases, all it has to do is credit banks with electronic deposits—called reserve balances or bank money. The result is the explosion of bank money (as shown in the nearby chart), which now dwarfs the Fed's emergency response to the 9/11 attacks.

Before the 2008 panic, reserve balances were about $10 billion. By the end of 2011 they were about $1,600 billion. If the Fed had stopped with the emergency responses of the 2008 panic, instead of embarking on QE1 and QE2, reserve balances would now be normal.

This large expansion of bank money creates risks. If it is not undone, then the bank money will eventually pour out into the economy, causing inflation. If it is undone too quickly, banks may find it hard to adjust and pull back on loans.

The very existence of quantitative easing as a policy tool creates unpredictability, as traders speculate whether and when the Fed will intervene again. That the Fed can, if it chooses, intervene without limit in any credit market—not only mortgage-backed securities but also securities backed by automobile loans or student loans—creates more uncertainty and raises questions about why an independent agency of government should have such power.

The combination of the prolonged zero interest rate and the bloated supply of bank money is potentially lethal. The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself—i.e., the Fed determines the interest rate by declaring what it will pay on bank deposits at the Fed without regard for the supply and demand for money. By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended consequences throughout the economy.

For all these reasons, the Federal Reserve should move to a less interventionist and more rules-based policy of the kind that has worked in the past. With due deliberation, it should make plans to raise the interest rate and develop a credible strategy to reduce its outsized portfolio of Treasurys and mortgage-backed securities.

History shows that reform of the Federal Reserve Act is also needed to incentivize rules-based policy and prevent a return to excessive discretion. The Sound Dollar Act of 2012, a subject of hearings at the Joint Economic Committee this week, has a number of useful provisions. It removes the confusing dual mandate of "maximum employment" and "stable prices," which was put into the Federal Reserve Act during the interventionist wave of the 1970s. Instead it gives the Federal Reserve a single goal of "long-run price stability."

The term "long-run" clarifies that the goal does not require the Fed to overreact to the short-run ups and downs in inflation. The single goal wouldn't stop the Fed from providing liquidity when money markets freeze up, or serving as lender of last resort to banks during a panic, or reducing the interest rate in a recession.

Some worry that a focus on the goal of price stability would lead to more unemployment. History shows the opposite.

One reason the Fed kept its interest rate too low for too long in 2003-05 was concern that raising the interest rate would increase unemployment in the short run. However, an unintended effect was the great recession and very high unemployment. A single mandate would help the Fed avoid such mistakes. Since 2008, the Fed has explicitly cited the dual mandate to justify its extraordinary interventions, including quantitative easing. Removing the dual mandate will remove that excuse.

A single goal of long-run price stability should be supplemented with a requirement that the Fed establish and report its strategy for setting the interest rate or the money supply to achieve that goal. If the Fed deviates from its strategy, it should provide a written explanation and testify in Congress. To further limit discretion, restraints on the composition of the Federal Reserve's portfolio are also appropriate, as called for in the Sound Dollar Act.

Giving all Federal Reserve district bank presidents—not only the New York Fed president—voting rights at every Federal Open Market Committee meeting, as does the Sound Dollar Act, would ensure that the entire Federal Reserve system is involved in designing and implementing the strategy. It would offset any tendency for decisions to favor certain sectors or groups in the economy.

Such reforms would lead to a more predictable policy centered on maintaining the purchasing power of the dollar. They would provide an appropriate degree of oversight by the political authorities without interfering in the Fed's day-to-day operations.

Mr. Taylor is a professor of economics at Stanford and a senior fellow at the Hoover Institution. This op-ed is adapted from his testimony this week before the Joint Economic Committee, which drew on his book "First Principles: Five Keys to Restoring America's Prosperity." (W.W. Norton, 2012).

Want Growth? Try Stable Tax Policy

By JOHN B. TAYLOR, WSJ

The two-month payroll tax cut being debated in Washington reduces to the absurd the recent revival of short-term Keynesian stimulus programs. That such a temporary cut would stimulate the recovery and get employment growing defies common sense.

There is no hard evidence that the temporary payroll tax cut of this year stimulated the economy, and another one for the first two months of next year will obviously do even less. In fact, economic growth declined after this year's temporary tax cut was implemented, so proponents need to appeal to dubious "things-would-have-been-worse" arguments.

Like the one-time rebate of 2001, the temporary tax cut of 2008, the cash-for-clunkers and stimulus payments of 2009, or similar policies tried back in the 1970s, these temporary policies consistently fail to stimulate sustainable recoveries. And as this history shows, extending the temporary reduction from two months to six months or even to 12 months would be at best a marginal improvement.

Even economists who claim that these policies stimulate—such as those at forecasting firm Macroeconomic Advisers—admit that they cost jobs as they are turned off, leaving the recovery no better off. Republican presidential candidates Michele Bachmann and Mitt Romney are right to call the payroll tax scheme, respectively, a "temporary gimmick" and "just a Band-Aid."

But the policies are worse than doing nothing at all. Rather than stimulate the economy, they hold the economy back by creating policy unpredictability and by distracting Washington from crucial long-term reforms that are key to restoring economic growth and creating jobs.

Indeed, this type of temporary tax change is making the entire tax system unpredictable. According to the Joint Committee on Taxation, the payroll tax cut is only one of 84 tax provisions expiring this year, about the same as in 2009 and in 2010. This is 10 times greater than the number of provisions that expired in 1999. As shown in a paper presented this October by economists Scott Baker and Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago Booth School of Business, this increase in policy uncertainty is one of the factors slowing economic growth.

Many of these temporary changes, such as the "three year depreciation for race horses two years old or younger," serve special interests, illustrating their unfairness and economic inefficiency as well as unpredictability. The "temporary and targeted" mantra in support of stimulus packages has wrought an on-again, off-again discretionary fiscal policy in which Congress puts virtually the whole tax system up for grabs each year.

Some claim that such policy unpredictability is not a problem, arguing that an obvious lack of demand rather than policy uncertainty is holding the economy back. But demand is low in part because firms are reluctant to hire workers or invest long term not knowing what tax rates and other provisions will be. Demand for investment will increase if policy unpredictability is reduced. And consumption demand will increase if workers' incomes increase on a more permanent basis, which requires a sustainable recovery with much lower unemployment, not the current short-termism of stimulus packages.

Others say that these temporary stimulus policies actually work by pointing to the Reagan tax cuts. But the 1980s tax cuts were not temporary—they lowered tax rates permanently, and that is why they were so effective.

Extending the payroll tax cut from two months to six or 12 months does not reduce policy uncertainty by much. People who now say that we need another temporary tax cut to avoid a devastating tax hike will certainly say the same thing at the end of those six or 12 months, creating the same partisan debates and unpredictability and also raising serious doubts about the future of Social Security, which is of course funded from the payroll tax.

A more promising and lasting approach would be to take on payroll tax reform as part of Social Security reform. Though not feasible in the last two weeks of the year, taking a small step in that direction would be a big positive step for the economy.

Currently there is significant debate over whether Social Security can be reformed without a future increase in the payroll tax. Many of the reform proposals put forth last year by the Congressional Budget Office (CBO) in its report on "Social Security Policy Options" call for such an increase. So it is not surprising that many firms and workers expect a permanent increase in the payroll tax down the road, regardless of temporary measures. A credible bipartisan agreement not to include a payroll tax increase as part of future Social Security reform would effectively be a permanent tax cut.

There are many reforms that do not require a tax increase. One, put forth by the CBO in its report, would simply keep real benefits adjusted for inflation from rising in the future as they are now expected to do. In this "golden rule" reform, each generation transfers to the next generation the same real benefit that it received from previous generations.

There are other reforms worth considering, including shifting future benefits toward those with lower lifetime earnings. But the point is to take some action now that creates more policy predictability and thereby brings about a robust sustainable recovery.

Mr. Taylor, a professor of economics at Stanford and a senior fellow at Stanford's Hoover Institution, is the author of "First Principles: Five Keys to Restoring America's Prosperity" out next month by W.W. Norton.

The End of the Growth Consensus

By JOHN B. TAYLOR, WSJ

This month marks the two-year anniversary of the official start of the recovery from the 2007-09 recession. But it's a recovery in name only: Real gross domestic product growth has averaged only 2.8% per year compared with 7.1% after the most recent deep recession in 1981-82. The growth slowdown this year—to about 1.5% in the second quarter—is not only disappointing, it's a reminder that the recovery has been stalled from the start. As shown in the nearby chart, the percentage of the working-age population that is actually working has declined since the start of the recovery in sharp contrast to 1983-84. With unemployment still over 9%, there is an urgent need to change course.

Some blame the weak recovery on special factors such as high personal saving rates as households repair their balance sheets. But people are consuming a larger fraction of their income now than they were in the 1983-84 recovery: The personal savings rate is 5.6% now compared with 9.4% then. Others blame certain sectors such as weak housing. But the weak housing sector is much less of a negative factor today than declining net exports were in the 1983-84 recovery, and the problem isn't confined to any particular sector. The broad categories of investment and consumption are both contributing less to growth. Real GDP growth is 60%-70% less than in the early-'80s recovery, as is growth in consumption and investment.

In my view, the best way to understand the problems confronting the American economy is to go back to the basic principles upon which the country was founded—economic freedom and political freedom. With lessons learned from the century's tougher decades, including the Great Depression of the '30s and the Great Inflation of the '70s, America entered a period of unprecedented economic stability and growth in the '80s and '90s. Not only was job growth amazingly strong—44 million jobs were created during those expansions—it was a more stable and sustained growth period than ever before in American history.

Economic policy in the '80s and '90s was decidedly noninterventionist, especially in comparison with the damaging wage and price controls of the '70s. Attention was paid to the principles of economic and political liberty: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform led to lower marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. And with strong economic growth and spending restraint, the federal budget moved into balance.

As the 21st century began, many hoped that applying these same limited-government and market-based policy principles to Social Security, education and health care would create greater opportunities and better lives for all Americans.

But policy veered in a different direction. Public officials from both parties apparently found the limited government approach to be a disadvantage, some simply because they wanted to do more—whether to tame the business cycle, increase homeownership, or provide the elderly with better drug coverage.

And so policy swung back in a more interventionist direction, with the federal government assuming greater powers. The result was not the intended improvement, but rather an epidemic of unintended consequences—a financial crisis, a great recession, ballooning debt and today's nonexistent recovery.

The change in policy direction did not occur overnight. We saw increased federal intervention in the housing market beginning in the late 1990s. We saw the removal of Federal Reserve reporting and accountability requirements for money growth from the Federal Reserve Act in 2000. We saw the return of discretionary countercyclical fiscal policy in the form of tax rebate checks in 2001. We saw monetary policy moving in a more activist direction with extraordinarily low interest rates for the economic conditions in 2003-05. And, of course, interventionism reached a new peak with the massive government bailouts of Detroit and Wall Street in 2008.

Since 2009, Washington has doubled down on its interventionist policy. The Fed has engaged in a super-loose monetary policy—including two rounds of quantitative easing, QE1 in 2009 and QE2 in 2010-11. These large-scale purchases of mortgages and Treasury debt did not bring recovery but instead created uncertainty about their impact on inflation, the dollar and the economy. On the fiscal side, we've also seen extraordinary interventions—from the large poorly-designed 2009 stimulus package to a slew of targeted programs including "cash for clunkers" and tax credits for first-time home buyers. Again, these interventions did not lead to recovery but instead created uncertainty about the impact of high deficits and an exploding national debt.

Big government has proved to be a clumsy manager, and it did not stop with monetary and fiscal policy. Since President Obama took office, we've added on complex regulatory interventions in health care (the Patient Protection and Affordable Care Act) and finance (the Dodd-Frank Wall Street Reform and Consumer Protection Act). The unintended consequences of these laws are already raising health-care costs and deterring new investment and risk-taking.

If these government interventions are the economic problem, then the solution is to unwind them. Some lament that with the high debt and bloated Fed balance sheet, we have run out of monetary and fiscal ammunition, but this may be a blessing in disguise. The way forward is not more spending, greater debt and continued zero-interest rates, but spending control and a return to free-market principles.

Unfortunately, as the recent debate over the debt limit indicates, narrow political partisanship can get in the way of a solution. The historical evidence on what works and what doesn't is not partisan. The harmful interventionist policies of the 1970s were supported by Democrats and Republicans alike. So were the less interventionist polices in the 1980s and '90s. So was the recent interventionist revival, and so can be the restoration of less interventionist policy going forward.

Mr. Taylor, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of "Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis" (Hoover Press, 2009).