This paper explains John Taylor’s view that if only central banks committed to monetary policy rules, international monetary disorder, and indeed large-scale capital flows, would be eradicated.

It’s an extension of his earlier argument that the US’ financial crisis and recession was caused, predominantly, by a departure from the Taylor Rule for monetary policy, and by fiscal uncertainty.

I didn’t find the earlier arguments convincing, and this one doesn’t persuade me either, for related reasons.

This new contribution repeats a problem with the original one, the contention that monetary policy was too loose in the early 2000s. This was dealt with convincingly by Bernanke in 2010. The Fed set rates pretty close to a ‘forward-looking’ Taylor rule in which one inserts not current, but forecast inflation. Very low rates back then was to head off forecast deflation.

The proposal amounts to assuming away one aspect of the problem. If authorities could just stop engaging in competitive, beggar-thy-neighbour monetary policy stimulus, then there would be no competitive, beggar-thy-neighbour monetary policy stimulus. In the real world, such problems exist because national objectives diverge, and there is frequently and incentive to depart from cross-country commitments. All international monetary and economic agreements reveal how this story goes.

In one version of the argument Taylor seems to think it realistic that central banks would never need to respond to exchange rate movements. He has in mind a model economy in which all central banks are simply following through systematic monetary policy, in turn derived from first principles using statements about central bank objectives. For Taylor, the financial crisis does not seem to have caused him to question the models that decades ago helped fashion the Taylor rule as a useful tool for monetary policy. For many others in the profession, the initial absence of finance from those macro models looks to have been a mistake, and we seem further than ever from a position where we could possibly agree to a formally and transparently stated monetary policy rule. For the same reason a commitment of this sorts would be nonsensical [and as a corollary not credible] for the Fed, it would be nonsensical for all world central banks.

For the foreseeable future, central banks are going to have relatively vague mandates, translated into broad statements of intent, and leaving them always pondering the causes of exchange rate movements and whether they warrant a response. And all with good reason related to the incompleteness of our models and knowledge.

Taylor globalises a thesis that he first applied to the US, which is that the financial crisis has a predominantly monetary cause, from which it is natural that he then concludes, in my view incorrectly, that it can have a predominantly monetary solution.

In the US, there are a long list of non-monetary causes suggested. A failure of risk management in systemically important banks and shadow banks; political interference in the government agencies tilting lending towards sub-prime; a failure to regulate; over-optimistic expectations about the correlatedness or otherwise of exposures by banks and non-banks; over-optimism about future long run growth; the possibility of runs on perfectly healthy institutions/markets/asset classes.

Correspondingly, there are a long list of non-monetary agents that may have contributed to the globalisation of the crisis. Most prominent are the ‘imbalances’ and capital flows ‘uphill’ into the UK/US/non-Teutonic-Eurozone caused by some combination of incorrect expectations about relative long run growth prospects, incorrect perceptions of relative risk, and a demand for safety [as, for example, articulated in Caballero-Farhi] away from the vagaries of property-rights disorder in China and the other emerging markets. These causes are ‘real’, ie they can be thought of in non-monetary economies, and are frequently described as such using a basic modelling philosophy that is common to the tradition in which the benefits of Taylor rules were worked out [though in that case of course the models were monetary sticky price models].

In his ‘Taylor rules for the whole world’ solution, Taylor does not grapple with the long literatures on sudden stops, or the newer literatures on how financial fluctuations, with rational and irrational causes, can amplify business cycles, and might have solutions in the form of taxes on capital flows of one sort or another.

The work of Taylor, Henderson and Mckibben on monetary policy rules is rightly praised for having transformed how we think about what central banks do. But it doesn’t provide a clue to how to avoid another convulsion in global finance, nor a template for a new international monetary system.