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Sunday, July 27, 2014

No. 000060 An open letter about the Taylor Rule, Keynes and Minsky

Sunday, July 27, 2014
Dr. Miles Kimball
Dr. Brad Delong
Dr. Noah Smith
Dr. Roger Farmer
Dr. David Andolfatto
The Taylor Rule, Keynes and Minsky
Gentlemen:
A letter to suggest that thought or investigation be given to questions about the Taylor Rule.

Interest rates should be as low as possible

In his General Theory Keynes argued for Government to work for the greatest possible reduction of interest rates at all times to encourage private investment as far as possible.
His arguments were so forceful I have always expected Professor Kimball to write a post or article relying on Keynes to support his argument for negative interest rates.

Republicans advocating for statutory Taylor Rule

Recently, the Republican Party has advocated statutory adoption of the Taylor Rule for the Federal Reserve.
This seems to me to beg this question:
Does the Taylor Rule lead to the greatest possible reduction of interest rates?

2008 Minsky Moment

Since we had a profound Minsky moment in 2008 (and a Federal Reserve which did not see such coming)[1] we certainly have what the GOP/Taylor/Cochrane group would call causation by the Taylor Rule as one event followed the other.[2]
That is to say that, following a prolonged period of application of the Taylor Rule interest rates were too high and debtors could no longer service their debts, resulting in a Minsky moment.
Has the Taylor Rule Been Investigated?
So my question is, does the Taylor Rule price interest rates too high? 
In closing I think it important to recall the lesson of Professor Taleb for all of this. Professor Taylor has cherry picked his data in support of his rule. His time frames are not long enough for us to say with confidence that he has included all the relevant data.
A work that supports this point of view is an OECD publication in 1999, EMU Facts, Challenges and Policies.
On page 54 the authors use the Taylor Rule to argue that interest rates set by the EMU were too high.
I think it important to use this dated work for the authors could not cherry pick their point of view on the Taylor Rule as they did not know the future and what we have learned from experience and observation in the last 15 years.

Of course, we now know, based on first hand experience, that both the EMU and Taylor Rule rates were too high from 1990 on and throughout the decade, resulting in a deep recession from which the United States never fully recovered before the Lesser Depression of 2008.
In that OECD study the Taylor Rule rates crossed over the EMU short term rates in mid-1999, showing or tending to show that the Taylor Rule sets interest rates too high.
However, that does not mean that the time frames are not long enough for others to show that his rule set interest rates too high.
Sincerely,
John L. Davidson

[2] Brad Delong, The Return of Hyman Minsky (May 18, 2009) (labeling events of 2008 as Minsky Moment).

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