The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, you have been having us read a book called First Principles, by John Taylor, who has, of course, advised presidents all the way back to Ford, Carter, and Reagan. He was part of the Treasury Department during the Bush administration. He knows Greenspan. He was a friend of Milton Freedman. It goes on and on. This is a man who actually has applied economics to politics.
David: I think that is one of the things that we continue to look at as we try to understand the issues in play today – this interface between economics and politics, between finance and economics, to not look at these as individual fields, but to see the overlap. While John Taylor is a professor of economics at Stanford today, and has been for a long time, it is not just economics that is in play, because economic policy ends up driving so many other things that are near and dear to our hearts.
Kevin: David, I think, probably, to be able to advise that many presidents, or to be around that circle, you have to come at it with a non-partisan approach, and he seems to do that. He tries to apply his principles. He has laid out five principles and they apply to what we have been talking about. He wants to see predictability in the market. He wants to see market forces take action. He wants to see the rule of law and smaller government, but if you are going to do that you have to meld, and learn to adapt to whatever administration is in office at the time.
David: It is remarkable that when you look at things that may seem non-interesting, in terms of a topic over the dinner table, just very academic or obtuse questions, these are the questions that end up determining the course of our country, the course of our economic policies, the way we do business or do not do business, whether or not we go into a growth cycle, or remain in an economic malaise for an extended period of time. As trivial as they may seem for the person who is just going about their life, trying to live it and make ends meet, these are the issues which will determine what our lives look like circa 2014, 2015, 2016.
Kevin: And it is certainly not trivial when you are talking about this being an election year. We are going to see policies implemented over the next 1-3 years that will be affected right now by how people vote.
David: We have been discussing discretionary policy measures versus rules. We have been discussing the credit markets, and of course, a part of the credit markets is interest rates, and today I am sure we will venture into the Taylor rule where interest rates, inflation, and projected interested rates – where they should be, as set by the Federal Reserve Board. All of these things we would like to explore with Dr. Taylor.
Kevin: David, you have talked about the Taylor rule before, and as simple as it sounds, it really is a guideline for central bankers as to where interest rates should be.
David: Joining us today is John Taylor, author of First Principles, and Professor of Economics at Stanford University. We want to look at a couple of things today – first of all, the policy issues which are in play that will determine the course for us, as a country, over the next 2-5 years. There is a lot at stake. John, perhaps you could define that precarious place where we are, and perhaps the way you see policy as a positive. Do we have a positive outcome potential? Is there an inevitable demise, as some would suggest? And what really is at stake here?
John Taylor: We certainly have the possibility for a positive outcome if we make the right decisions and take the right policies, but recently, we haven’t been. We have moved to a situation where fiscal policy has led to increasing debts, with high deficits. We have a situation where regulation has increased quite a bit. The policy has become quite unpredictable, with stimulus packages and actions by the central bank in terms of large purchases of securities.
I think that we have evidence that a better approach is out there, and that is the approach that was followed, for the most part, in most of the 1980s and 1990s, until we got into this mess, so we can get back to that. It’s a new world, it’s a different world, but the principles have not changed.
David: Let me key in on one word that you mention, because unpredictable is something the market really doesn’t know what to do with, and this goes back to monetary policies which, to some degree, have been rule-based at periods of time in U.S. history, and then at other periods of time, have become very discretionary, and the market just doesn’t know what to do with being unable to anticipate the future.
If they can anticipate it, if they can plan, now we are talking about business executives, CFOs, CEOs, COOs, who are willing to say, “I understand the regulatory environment I am in, I understand the tax environment that I am in, and here is how we are going to invest.” Do you see the current discretionary policy measures versus the rules-based of yesteryear, as being a real problem?
John: It’s a serious problem, and it is unpredictability that is the symptom of the problem. We have large segments of our tax code that are up for grabs, up for renewal each year. Over 100 provisions are up for change, for example, compared to maybe half a dozen, or 10, ten years ago. So it is much less predictable.
Monetary policy was following a more rules-based policy, as you said, in the 1980s and 1990s, until this crisis began to flare up in, I think, early 2005 or 2006 when we began to see it. That is why I think there is a great deal of hope that we know what works. We know that these kind of rules-based predictable policies based on the rule of law work, and we can apply these principles, I call them, to our current environment in a way which will increase economic growth and reduce unemployment, and get America to a more prosperous situation.
David: Keying in on that one word, unemployment, you certainly have fiscal measures and stimulus which have been put into the system. On the monetary side, you have the dual mandate: Price stability, and limiting the unemployment number. It seems that QE-I, QE-II, Operation Twist – it is not getting the Fed what it wants in terms of the kind of improvement that they would want in the unemployment number. Are we likely to see continued discretionary monetary policy? Are we likely to see continued stimulus? Since we haven’t gotten to that number, what might that look like? And perhaps you could reflect on your view of the single versus dual mandate.
John: I think right now monetary policy has gotten very interventionist compared to the 1980s to 1990s. Until recently, that is, as you mentioned, the quantitative easings have increased the size of the Federal Reserve’s balance sheet to levels that have never been seen before. It is completely unprecedented, and people don’t know how that is going to get resolved. The ideal for me would be if the Fed lays out a plan to gradually reduce that overhang in a predictable way, so people know what is going on, but that they begin to do it sooner, rather than later. That would, I think, be beneficial to the economy.
In terms of the dual mandate, it is in the law that the Federal Reserve must achieve both maximum employment and price stability. I think it has been detrimental. It was put into law in 1977. It made things worse for a while. Paul Volcker came in as Chairman of the Fed starting in 1979 and interpreted that dual mandate in a way which let him focus on price stability.
More recently, the dual mandate has come back in favor as the rationale for the quantitative easing and other interventions, so in my view, it would be better to remove that dual mandate, at least to put the law back where it was before 1977, or at least say that the Fed should focus on price stability. I think that would lead to a more predictable, more effective policy, and actually would reduce unemployment in a way which may seem surprising to people.
David: Looking at the principles in First Principles – predictable policy framework, the rule of law, strong incentives, reliance on the markets, and the clearly limited role for government, regarding the last point, a limited role for government, as a share of GDP, we have seen government grow from 7% to nearly 40%. In the last five decades, we have seen a combination of both public sector debt and private sector debt grow from 1 trillion to 50 trillion, and at this point, the private sector is not expanding its debt.
The government is stepping in and filling that gap, to the tune of about 8% of GDP. We don’t have a clearly limited role for government. It would seem that the trend of the day is, in fact, that it is expanding its reach. How would you suggest we address that, because it is private sector solutions and it is the market that seems, in the past, to have created very innovative solutions and growth? How do we step back from this government prop, if you will?
John: I think that people have to recognize the importance of limiting the scope of government. The government has an important role, but it has gotten too big. Just very recently, the federal sector has gone from 19½ percent of GDP to 23-24% of GDP. That is a gigantic increase just since 2007, so it is very important to get this back to reasonable levels.
I think that there are other areas where the scope of government has increased. Various financial regulations were put in place after the crisis. I think that some of them have nothing to do with the crisis. We are regulating payday loans and things like that, and there are many others that have nothing to do with the crisis. I think the new health care act also has lots of regulations, and of course, that is moving away from the market system. We have so many ways in which we have deviated from the five principles that I have tried to articulate in my book, but we know how to get back to them.
To answer your question again: Number one, that people understand why they are important. Number two, that they elect leaders who they think will bring these principles into play. Number three, that they help the leaders, in the sense of looking at what they are doing to make them accountable. That is what we have seen has worked in the past, and it will work again in the future.
David: In the issue of there being provisions up for grabs, or things that are changing in the tax code, I assume one of the things you are referencing is the expiration of the tax cuts from the Bush era. Is this is a foregone conclusion? What do you think are the implications? Our primary concern here is that as we look at the 2013 Obama budget, there is this increase in revenues via an increase in taxes, and yet, we are still penciling in a 1.33 trillion dollar deficit. I am wondering if there is that much of an increase in revenues, exactly where is that money going, and are we really moving anywhere closer toward a balanced budget or anything that looks like fiscal responsibility?
John: No, because spending is increasing in that budget so rapidly. It is not an exaggeration to say that spending is a major source of the problem now, and I think it is very important to get that spending growth under control. It’s not really even cutting spending, it’s just preventing it from rising so rapidly, which is what is happening now and is projected to rise in the future.
In my view, we should not be raising taxes, or making the economy slow down on the basis of higher tax rates, but what we should be doing is looking for tax reform, making the tax system more efficient to encourage economic growth, and also, at that same time, removing the unnecessary programs that have expanded so rapidly very recently.
David: If you had the ear of the next president, whoever, it may be, as you have had the ear of past presidents, if there was singular bit of advice, what would you start the conversation with?
John: The principles that I outlined in my book would be a preamble, there is no question about it, because it makes so much sense. The policy has been unpredictable, the rule of law has been deviated from. We need to fix those two things. We have to have more emphasis on a market system and incentives, and limiting the role of government. But then the thing is, how do you apply those? Those are abstract if you like, more academic. They are extraordinarily important, but how do you apply those principles?
I would start with the budget. We have a gigantic budget gap. We have a deficit that is getting larger, and the debt is exploding, so taking that into account, I have a plan to do that which is not draconian, it’s not austerity, it’s just common sense. As for monetary policy, you mentioned the dual mandate, unwinding the programs that we have currently put in place, getting back to a more normal kind of monetary policy and regulatory policy, the same kind of thing, trying to pull back some of the extra regulations that have been put in place recently.
I think in all these cases, it is pretty straightforward what you need to do. A person has to be committed to it, and has to have people around him, or her, that will do these things. That is what I would urge – the principles, and the people who will deliver on the principles.
David: One of the things that you note in your book is that it was not without pain that Reagan and Volcker, in tandem, implemented a number of these principles, and although there was an increase in unemployment following Volcker’s actions, he had the support of the Reagan White House. I guess that’s what you mean by taking a principled approach, and sticking with it. There can, in the short run, be a cost to that.
John: Yes, sometimes you just have to get started, and the courage that Volcker had, and the support from Reagan, were essential, and the end result was much lower unemployment. They basically had to get started reducing that inflation rate, get back to a monetary policy that was much less interventionist than in the 1970s, and the fact that the president of the United States supported the Chair of the Fed, and his actions, was so important.
The past presidents would urge the Fed to back off, to lower interest rates, to stimulate the economy, and it was always counter-productive. This time, Reagan supported Volcker, and that is what it takes sometimes. It is not just having the principles, it is having the courage, and the wherewithal, and the knowledge about how to apply them in practice.
David: I think one of the fascinating things that I appreciate about your dialogue in the book is that you really point out that ideas matter, and you look at these different schools of thought that have influenced the President’s Council of Economic Advisors. You tie it back to a theoretical framework, a system of belief, wherein certain schools hold to a very Keynesian approach.
Having studied at those schools, having done your Ph.D work at those schools, it is almost like a cookie-cutter approach. You are going to be of the belief that intervention is the key. Or, on the other hand, you would probably cast the Chicago school as different than that. But ideas matter. If you could focus on one idea in that conversation with the next president that we will elect in November, what would be the one idea? You have focused on economic freedom as one of the core ideas in this book. Would that be the gist of the conversation?
John: Absolutely. That wraps it all together in a way that I think most people can understand. It takes us back to the founding principles of our country, which are based on freedom, and economic freedom. When you think about it, that term sounds a little vague, but it is really what has made America great. We have had so much better progress and success here than other countries – the rule of law, for example, and the focus on markets. Other countries have followed us, and when they have, they have done better.
We are drifting away from it now. Our policy is much less predictable – we talked about that. The rule of law is getting violated in ways that are clear when certain favored people get benefits compared to others, so economic freedom would be the key. I really emphasize, though, that there is terminology like “steady as you go,” “long-term thinking,” “being predictable,” that goes along with a good framework for providing economic freedom to people, and I would urge that, too.
One is always so tempted when in office, or in a position of responsibility, to try to do things which may look good in the short-run, but they end up being very harmful. So “steady as you go” and “predictable” are the buzz words or concepts that I think should be part of the discussion.
David: On occasion, our listeners will listen to a CNBC pundit or an academic mention the Taylor Rule, and, lo and behold, this is your rule. You have devised a way of figuring out where interest rates should be. Maybe you could explain that a little bit, and suggest where interest rates should be. We had Operation Twist under the Kennedy administration in the 1960s, and we have Operation Twist today, which is essentially a manipulation of interest rates, a changing of where the yield curve is, whereas, it should be at a different level. Where should rates be, following the John Taylor Rule?
John: The rule is a guideline for central bankers to use to determine where they should set their interest rate. It is very straightforward. The guide says when inflation picks up then the interest should rise by a certain amount. When the economy goes into a recession the interest rate should fall by a certain amount. The terminology “by a certain amount” is very important because the rule says how much the interest rate should change, and that is why I think it has become interesting, and useful, quite frankly, to many central bankers around the world when they are making their decisions. Monetary policy is a very tough job, and if they have a guideline like this it helps.
With respect to your question about where rates should be now, I think they should be moving into positive territory. The Federal Funds rate is between 0 and 0.25, so effectively, zero. I think it would be wiser if the Fed started to move up toward 1% at this point. That is what the Taylor Rule would suggest. That would allow the money markets to function a little better, and I think it would also get us in a situation back to the kind of normal policy that we have had in the past.
Whether you call it the Taylor Rule or something else, the message of history is clear. When central bankers have been close to this kind of a policy principle, things have worked well. When they have deviated, things have not been so good.
David: It is interesting, because there are areas where you respect what Volcker had done in the past in terms of monetary policy, and looking at how he, using his model for calculating inflation, would have calculated today’s current rate of inflation, the old model would be close to 10%, which might affect your Taylor Rule in an interesting way, because obviously, the current inflation rate that is being used is far less than that.
The MIT Billion Prices project would suggest somewhere between 6 and 6½. Using the old Volcker methodology, it would be 10%. I’m pretty sure that we had real inflation, that it wasn’t a figment of our imagination in the 1970s, but today, we are told it is 2-3%. What if Volcker was right, and inflation today is coming upon double digits? Then what would your Taylor Rule suggest interest rates should be?
John: If the inflation rate is 10%, you have to have an interest rate over 10% to control the inflation rate. That is sometimes called the Taylor Principle, by the way, that when inflation rises, you have to raise the Federal Funds rate by more than the amount by which inflation rises, so heaven forbid, we don’t get into a situation of that kind, or that we are not already there, as you suggested.
But if that were the case, you would have to raise rates quite a bit, and in fact, that is what Volcker did. When inflation got that high, he raised rates considerably, and a lot of people didn’t like it, but that is what it took to, ultimately, get inflation down, and ultimately, interest rates down, and ultimately, unemployment down.
David: The academic discussion today is sort of chained versus unchained CPI and the argument is actually that we are overstating inflation, that it needs to come down a number of basis points. Maybe that is just for the academics to sort out, but I look at the Kennedy administration’s Operation Twist, and in their buying of long-term Treasury bonds and selling of short-term Treasury bills, it is the same thing that we are doing today, and we really don’t have a clear reference point in the interest rate market. What are your thoughts on, is it fair to say, a manipulation of interest rates? We certainly can’t afford more than the 2% that we are paying on the national debt, so there is a clear motive to keep it low.
John: Manipulation is the correct word that has inserted itself into the money market, and almost has replaced the money market with itself. It has pumped in so many reserves and the interest rate is now manipulated simply by deciding now much interest will be paid on bank reserves. It is not a market rate in the sense that supply and demand is determining the rate.
I taught my students for many, many years that Operation Twist in the 1960s didn’t work. That was the conventional wisdom, by the way. That is what most faculty, most professors, who taught the subject, taught their students, that Operation Twist didn’t work. So it’s quite remarkable that we have moved back to Operation Twist. It is like we just ignored all the things that had been done. What that shows to me is that there is this urge to intervene, there is this urge to do something, even if there is experience that says it doesn’t work. We have to get away from that. I read a lot of books about history, and history is so important for understanding these things, so that we won’t make these mistakes again.
David: The market rate is an interesting question. Is the market rate two percentage points higher? We have been able to manage that rate lower, and again, I appreciate your principle of the Taylor Rule, but the danger is that if inflation is, in fact, being understated, then we have a real issue with interest rates. Is it possible to see a Volcker come in and “do the right thing?”
John: No, I would say that the situation is quite different than when Volcker came in, and I would say I am not really quarreling with the measures of inflation at this point. There is debate about the core and about bias, and headline and all that, to be sure, but I think that the inflation rate is low now, and probably because there is so much unused capacity. It may be picking up, but I wouldn’t expect someone to come in and bring interests up to double digits like Volcker did. There is no need for anything like that. There is a need to start getting back to normal, which would be to just start to move the rate up a little bit. And if it is done, there will be no reason to take it up to those high levels. It is not necessary if we get started on this now, and fix the problems that have been created recently.
David: Again, you are tying into rules, principles, predictability, behaving in a way that the market can say, “We know that we are here, and therefore action should be x, y, and z,” versus just waiting. Literally, we are waiting to see what happens at the end of June when Twist expires. When Quantitative Easing I and Quantitative Easing II expired we had a 15-20% swoon in the equities market, and then a 30-40% recovery with the reinstatement of a new monetary policy. It is beginning to have a very negative effect in the markets in the sense that the markets are not moving on the basis of good, proactive, organic growth. Instead, it is an anticipatory work to see what the Fed is going to say or do next. That is really not the basis of a strong recovery is it?
John: That’s a serious problem, because no one really knows the impact of what the Fed is doing. A lot of people now, as you are referring to, are looking at the impacts on the stock market. We don’t really know, but what’s worse is that to the extent that people think the Fed’s actions are having these effects on the market, as distinct from fundamentals like profits and expected earnings, then we are in a situation where manipulation is the correct word, and of course, the Fed cannot manipulate so much that it determines the future of the stock market. At best it can make these shorter-term movements, and I think those are even questionable. So there you have it – unpredictability, difficulty predicting, noise in the markets, uncertainty that holds people back – and that is the problem we have right now.
David: To bring into focus what our point of dialogue should be, we are coming into full swing, in terms of the election cycle. What should the question be? What should the topic be? How do you direct the conversation, productively, to bring these issues to bear? Real decisions are going to made, the votes will be counted, and we will have policy-makers next year implementing someone’s ideas. How do we try to shape the debate, or influence the debate, today?
John: The most important thing is to have a good substantive debate about these policy issues. This is a great opportunity this election year because there are really some quite different proposals out there. Just take the budget, for example. President Obama has submitted a budget. It is out there. It has been voted down by the Congress but it is out there. We also have a budget that the House of Representatives has put forth that is sometimes called the Ryan budget. It has passed the House. These are two conflicting visions. The more people can understand the difference between those substantively, and decide on which approach to take, the better off we will be.
I think that the extent to which spending comes down more rapidly, the extent to which we deal with the explosion of our debt, and those are dealt with, objectively speaking, better in the Ryan plan than in the Administration’s plan, then we can have a good debate about it. But I think it is so important that people look at a graph, or look at the numbers, or think about what people are saying, or read a book. I know it is tough, and election years focus on personalities and other issues, but this one is so important right now, and I hope people do it. That is the responsible thing for the citizenry to be doing.
David: If we step away from the sound bites and political clichés we can certainly recommend First Principles, your book. The subtitle is Five Keys to Restoring America’s Prosperity. If you were trying to draw a distinction between the schools of thought and the basis that the Obama budget versus the Ryan plan had in mind. What is the background? How do you develop some clear thinking for someone who is not astute, or read, in these areas? What else would go onto that library shelf or onto that book list?
John: Number one, I would say, is what is happening to federal spending. In the last few years, from 2007 to now, federal spending has really increased tremendously, and it is expected to increase even more if we don’t take some action. I think when people see those numbers and say, “What are we doing? Why did we raise spending so much after 2007, and do we have to keep it as those levels?” That is one of the biggest differences, I think, that people can latch onto and see.
Another one is a program like Medicare. Everyone realizes we need to control the growth of Medicare since it is exploding at this point, but in the Ryan budget it is done by using the market more, and giving people some opportunity to make choices. In the Obama budget it is more of a central authority, an Independent Payments and Advisory Board, it is called, that makes the decisions. So there is quite a difference there on principles. One is more market-oriented, decentralized. One is more federal government-oriented, and less decentralized. I think people can see that, and based on their experience, try to make a decision which is going to be best for them, and best for the country.
David: There are a number of references in your book to Thomas Jefferson, to Adam Smith’s The Wealth of Nations, to Friedrich von Hayek’s The Road To Serfdom, and a number of his other books. There is, I think, the need for people to do some work – real, hard work, intellectual heavy lifting, to better understand these issues and carry the dialogue. We will look forward to perhaps an update, and maybe the next time the update is being garnered, you will be back in the oval office talking to the president and advising again. We appreciate your time today, and your addition to our dialogue.
John: Thank you very much for having me. I appreciate it, too.
Kevin: David, would that be an ideal, if we could have more predictable policy, and a return to the rule of law, and strong incentives to rely on the markets, and really, a limited role for government? Those are five principles that he is pointing out. They seem very simple, very common sense, yet we are wandering from it right now.
David: I’d like to go back to one title that I mentioned in the conversation today – Friedrich von Hayek’s The Road to Serfdom. It has been nearly twenty years since I was T.A. for an American History class and we had the flexibility of bringing in outside reading. That was a book that I wanted to introduce to everyone in the class. The Road to Serfdom defined Hayek’s view of what socialism looks like and how it grows, through time, and ultimately, is unsustainable in terms of its trajectory. That, I think, is one of those first-reads. It needs to be on every shelf. It needs to be well-worn, not because you bought it used, but because you have read it many times.
Kevin: In many ways, some of the people and the principles that we outline with our listeners come from some of those source materials. It is almost assumed that a person has read some of the classics that lay the foundation.
David: And this is a clear distinction between what works in terms of market dynamics versus the idea of centrally controlled dominance in the market place. Yes, that would be at the top of our list, if these issues are important to you, and if you want to define the discussion points as we come into this election cycle, with friends, family members, and colleagues.