Rules vs Discretion – a short historical perspective

John Taylor of Taylor Rule fame in this short speech (HT: his blog) shows how US policymaking has flip-flopped between rules and discretion over the years.  This in turn has effected the policy and economic outcomes.

It shifted to discretion based in 1960s leading to Great Inflation in 1970s, then in 1980s back to rules based and the stable years. Finally in 2000’s again shifted to discretion leading to prolonging the crisis.

In the end he asks, why this flip-flop? The answer could be dissatisfaction with existing economic outcomes. He is hopeful that this might lead to shift to more rules based policy now:

While the evidence in support of rules-based policies is convincing, an important question remains: What causes these shifts? The periods during which discretionary policy dominates or rules-based policy dominates overlap political regimes in  Washington: The first discretionary period overlaps the Kennedy, Johnson, Nixon, Ford and Carter administrations. The rules based period overlaps the Reagan, Bush 41, and Clinton administrations. The more recent period overlaps the Bush 43 and Obama administrations. So there is no obvious political explanation in the narrow partisan sense.

Perhaps the shift toward rules-based policy in the 1980s was the result of dissatisfaction with the economic performance of the 1970s. Perhaps the recent shift toward discretion was the result of complacency bred by the good economic times in the 1980s and 1990s. To put it more technically, perhaps Y Granger-causes X negatively. This is of course not inconsistent with X Granger-causing Y positively, which I have emphasized in this talk, and it suggests a way forward: Perhaps dissatisfaction with recent performance will cause a swing back toward rulesbased policy in the near future.

Interesting bit. Though, rules are welcome but implementing them and above all identifying an appropriate rule is always difficult. Taylor Rule for monetary policy is well conceptualised but there are many variants and criticisms for the same. How do we measure potential output/inflation etc.

Taylor ideas are similar to this Christy Romer paper. She says much the same.

I will argue that far from being the high point of economic policymaking in the postwar era, the 1960s represented the beginning of a long dark period for macroeconomic policy. Both monetary and fiscal policy actions were seriously misguided in the 1960s, and led to undesirable economic outcomes.

She adds at the end that US policymakers did learn from the mistakes over monetary policy and inflation but continued to err on fiscal policies. So as a result, the belief that deficits don’t matter much continues.

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