Monday, August 17, 2009

Why John Taylor is wrong to blame the Fed, redux

John Taylor is a renowned monetary economist who has decided that the Federal Reserve is at fault for the housing boom, and thus most of the current crisis. As I've blogged before, his arguments are curiously difficient: they all seem to boil down to "well, the Fed didn't follow the Taylor rule, and the Taylor rule can't possibly be wrong." One can imagine economists putting a little too much faith in rules named after themselves...

First, it's important to understand what economics does not tell us. Monetary theory does not provide any mechanism through which the Fed's decisions about the money supply can produce massive distortions in the relative prices of assets, cause banks to make loans to customers who clearly can't pay them back, or lead investors to systematically misprice risk. Monetary theory does tell us that if the Fed keeps rates unnaturally low, we'll suffer from inflation—but as Brad DeLong points out, this is not at all what happened in the current crisis.

Let's take a look at the only publicly available and even slightly rigorous argument that Taylor has provided for his position: this speech from September 2007. In it, he performs a "counterfactual simulation," comparing the rise in the housing starts simulated under the actual Fed rate to an alternate path computed under what Taylor believes the rate should have been. This is what he obtains:

Indeed, this is already far from rigorous: he's using the historical correlation with the federal funds rate to predict housing starts even when there are innumerable other variables and directions of causality in play. As we can see, however, his simulations don't capture the dynamics of the housing bubble at all—and it's revealing that he doesn't even show us a curve of housing prices, which are the most difficult part to rationalize in an economic model.

To better fit the data, he adds a new dimension to the model:
However, such sharp falls frequently occur at the end of booms because of rapid changes in housing inflation expectations. In fact, there is a close interactive relation between housing price inflation and housing construction (technically, two-way Granger causality). Placing housing inflation directly into the housing starts equation, and adding a simple equation to explain housing inflation, helps explain more of the decline as shown in Figure 3, but psychological factors (a Shiller swoosh) still seem to have been at work as the boom ended.
The result is a slightly more impressive picture:

Hidden in the discussion, however, is an important clue about what's really going on. He adjusts the model for the "two-way Granger causality" (which is really correlation with a lag, not actual causality) between housing starts and housing price inflation. More housing starts lead to greater price inflation, which in turn leads to more housing starts, and so on; it's easy to see why this make the paths in his simulation more dramatic! This is really, however, an embedded assumption that's enough to generate bubbles completely independent of the Fed's policy. It's a classic feedback loop where price increases beget additional price increases—perhaps the essential characteristic of a speculation-driven bubble. Maybe in this case he thinks that the Fed was the initial trigger (I'd disagree), but if Taylor really believes in the methodology he's using for these simulations, he has to admit that all kinds of other events could have triggered the same sequence. In this model, all you need is some initial runup in prices and construction, and then the speculative feedback loop—the real driver of the bubble—takes over. The Fed is no more to "blame" for the bubble than the proverbial butterfly flapping its wings is to blame for the subsequent tornado.

And if speculative feedback—enhanced by regulatory failure and widespread mispricing of risk—is the real culprit, we're brought to a very different set of conclusions. Pinning responsibility on the Fed, Taylor makes it seem as if our real problem is simple and technical: just set rates according to his formula and everything will be fine. Reality, however, isn't so simple, and we'll need more than slight tweaks to monetary policy to make ourselves safe in the future.


Artturi said...

Why do you think we don't have a mechanism that could explain relative distortion of prices?

Don't you think that the prices of goods with inelastic supplies should rise more than the prices of goods with elastic supplies?

Matt Rognlie said...

When the Fed increases the money supply in the economy? I don't think so... Supply curves are only meaningful when the prices are in real terms; a general rise in the price level (like that induced by a rise in the money supply) doesn't affect the willingness to supply goods, and elasticities don't even come into play.

It's true that there are some subtle macroeconomic effects associated with monetary policy that can cause changes in relative prices, but these aren't nearly big enough to account for the massive changes in housing prices we saw over the last decade. Thus we get Casey Mulligan struggling valiantly to explain the housing boom and bust in terms of supply and demand "fundamentals," which results in some fairly strange conclusions. (You have to posit that investors thought there was going to be some massive future increase in rents in Las Vegas and Phoenix, even when the costs of land are almost zero, that they included in their present value calculations... and then suddenly they all changed their mind).

Artturi said...

First to make it clear: I'm not arguing that the Fed caused the housing boom. I'm only interested in your claim that increases in the money supply don't cause changes in the relative prices of goods and services.

The way extra money causes inflation is that the demand for goods and services increases. Why do you think that this extra demand wouldn't be met with increased supply and only by higher prices?

Why don't you think that the prices would rise more in goods whose supply reacts more slowly than goods whose supply reacts almost instantly?

Do you think that an increase in the money supply is instantly visible trough the whole economy, or do you think that actors in the economy observe prices and react to these observations (in this case by increasing supply if the cost of production has not increased as much)?

Uncle Billy Cunctator said...

He does, however, have a modestly competent barber.

Glad I wandered into your blog. You have a really good critical mind. Please keep the bad guys away from it.