Hayek’s Rule and the Productivity Norm

My replacement at Metro State, Nicolas Cachanosky, continues to write interesting, challenging papers in the Austrian tradition faster than those of us used to the slower pace of retirement can read them. His most recent is “Hayek’s Rule, NGDP Targeting, and the Productivity Norm: Theory and Application.” Cachanosky notes:

The 2008 crisis demonstrated that serious economic imbalances can take place even in the absence of inflationary problems. An important consensus regards monetary policy that kept interest rates too low for too long as a major driver of the financial crisis (Borio & Disyatat, 2011; Diamond & Rajan, 2009a; Hume & Sentance, 2009; Lal, 2010; Leijonhufvud, 2009; Meltzer, 2009; O’Driscoll, 2009; Schwartz, 2009; Taylor, 2009; White, 2008; Young, 2012). The absence of inflation introduces the question of whether price level stability is in fact a good guide to monetary policy.

I have argued elsewhere (Hayek and the 21st Century Boom-Bust and Recession-Recovery) this lesson should have been learned from the dot.com bust:

The first boom-bust of the period, 1995–2000, should have provided evidence that Hayek was premature in de-emphasizing the empirical importance of distortions in the structure of production caused by money and credit creation in a growing economy with relatively stable prices (Cochran, Yetter, and Glahe, 2004, pp. 13–14). A monetary shock which accommodated a produc­tivity shock generated a significant boom as exhibited by real GDP above potential GDP (see figure 1). The resulting malinvestment during this period and its effect on employment are illustrated in figures 2 and 3. The resulting “bust,” at least measured in terms of the cycle impact on GDP, was relatively mild.

The significance of this cycle for the role of monetary policy was perhaps missed because it occurred at the end of the relatively long period of growth and stability known as the “Great Moderation.” This period was a time of better—at least compared to monetary policy of the 1960s and 1970s—but not necessarily good policy (Garrison, 2009). During this period, central banks were heavily influenced by macroeconomic events of the 1970s which seemed to discredit the prevailing neo-classical synthesis/Keynesian consensus. A vast economic literature from the consequent policy effectiveness debate emphasized central bank policies that—at least in the long run—aimed at price stabilization as a dominant policy goal. The Fed, while not explicitly inflation targeting, followed a policy that mimicked a Taylor Rule policy. Garrison (2009) characterizes this as a “learning by doing policy” which based on events post-2003, would be better classified as “so far so good” or “whistling in the dark.”

Never the less, Austrian theory consistently argues that the best way to deal with a crisis would be to prevent the crisis in the first place. Prevention requires monetary institutions that limit—or better yet, prevent—monetary policy caused misdi­rections of production.  Most Austrians would favor monetary reform that would eliminate central banking as did Hayek in the 1970s when called for denationalization of money. But it is also important, like Hayek of the 1970s, to consider, especially given that it is highly unlikely that major central banks will be eliminated anytime soon, how ‘best’ to conduct monetary policy given the existence of such political institutions. Hayek, based on an empirical misjudgment that greatly underestimated the harm from malinvestments in a stable inflation environment, argued, absent significant institutional monetary reform, “Though monetary policy must prevent wide fluctuations in the quantity of money or the volume of the income stream …[t]he primary aim must again become stability of the value of money.” To paraphrase, in normal times there is a need to get back, a la Friedman, to a more or less automatic monetary framework. Where policy deviated and generated a boom-bust, then, to prevent “liquidity crises or panics” there is a need “to ensure convertibility of all kinds of near-money into real money” For this, “the monetary authorities must be given some discretion”

Cachanosky’s new paper fits nicely into this important niche in the literature. Right now the discussion is being dominated by the market monetarists and their call for nominal gdp targeting. Cachanosky places an emphasis on a productivity norm as a leading candidate for a policy ‘rule’ most likely to provide a policy norm more likely to prevent major boom-busts. Cachanosky concludes:

The productivity norm offers superior guidance for monetary policy compared to the principle of price stability. Still, the application of a rule informed by the insights of the productivity norm is not an easy matter. Notwithstanding the important challenges, the potential shortcomings of an application of such rules are present in other rules, such as price stability. Although the productivity norm is not part of the core of monetary policy today, there was a time when its consideration was important.

The revision of macroeconomic business cycle models and monetary policy in light of the 2008 crisis offers a convenient opportunity to revisit the insights of the productivity norm.

See Table 2: Reforms retaining central banking at the end of Fractional Reserves and Economic Instability for an assessment of various reforms from another Austrian perspective.

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