While the full complexity of an economic cycle can never be gauged, economists point to many contributory factors, each with its tinge of plausibility; but every recession, recovery, over-extension and relapse back into recession constitutes a unique series of actions and reactions. Turning from that complexity to the measure of an output gap (the difference between actual and potential aggregate supply) is a mighty shift. A monetary-policy rule (and a textbook topic) was thereby created: the Taylor Rule indicates by how much the interest rate should be changed given the state of the economy (as indicated by the output gap and an inflation index). The Taylor Rule – or, rather, rules, for as many rules exist as there are economists tweaking the measurement subtleties – purports to give direction to monetary policy: the interest rate must dip as output dips, and rise as inflation rises.

The manipulation of interest rates to steer economic growth has serious consequences: interest rates are integral to the price mechanism, which gives essential guidance to entrepreneurs. If left alone, interest rates would find their natural levels across diverse (credit) markets, thereby giving incentives to, and imposing constraints upon, business activities. In a decentralised market setting, interest rates emerge naturally as borrowers and lenders interact. However, in fixing a benchmark price for credit, central bankers face difficulties no different to those faced by central planners generally, when they attempt to co-ordinate decisions without guidance from market signals. Co-ordination failures are inevitable.

State intervention to fix prices inhibits enterprise and growth. Within liberal democracies price-fixing is rarely observed. The one exception is that of inter-temporal price fixing. Interest rates – derivatives of spot and forward prices – are inter-temporal prices.

It is necessary for entrepreneurs to anticipate consumers’ requirements. In this, they seek guidance as best they can. Where a commodity shows a ‘forward’ price premium, it is because it is expected to become in relatively short supply. This gives entrepreneurs the incentive to switch resources to the production of that commodity.If (say) investment to produce wheat offered a yield (that is, a forward premium) of ten percent and another to produce barley a yield of only five percent, resources would be diverted from barley (increasing its future scarcity) to wheat (reducing its future scarcity). This inter-temporal equivalent to John Stuart Mill’s ‘law of one price’ sets a tendency to equalise yields; that is, to set a ‘base’ interest rate.

This spontaneous outcome is disrupted whenever central bankers intervene, as the Taylor Rules suggest they ought. Cutting base interest rates to engineer economic recovery not only distorts the inter-temporal price mechanism, it undermines sound resource husbandry and economic welfare. In the deepest recession, market mechanisms remain relevant because resources have value, even though they may not be in current use.

Although fiscal and monetary interventions can lift an economy out of recession, there are unavoidable consequences and costs. By their very nature, crisis measures are unsustainable; but prices are inevitably shaped by the particular expenditure patterns encouraged by policy interventions. These incite a myriad of microeconomic adjustments which, in serving the unsustainable, must themselves prove unsustainable. So, even as a recession lifts, a chain of adjustments continues which adds to the legacy of inter-temporal price distortions.

In short, deficit spending to boost economic activity necessarily exacerbates the severity and duration of the next recession to follow. On top of which is the requirement to address the indebtedness that is created by that crisis spending – a ‘double-whammy’.

The Taylor Rule is but one detail of Keynesian panaceas which are especially pernicious because they appear to work at first; for example, in 2011 the US economy grows as the UK economy stutters. Moreover, because the adverse consequences and costs of a Keynesian stimulus are in the middle distance, they are likely to be discounted in the present and attributed to some specious cause in the future.

Keynesian reliance upon crude aggregations is not limited to inflation indices and the output gap of the Taylor Rule. Economic journalism is rife with erroneous commentary: to illustrate

‘Even if the output gap … were to be as little as 3 per cent … policy should seek to eliminate the gap … the UK also needs higher government savings, to offset low private savings and so help finance higher domestic investment without larger inflows of foreign capital’ (Martin Wolf, Financial Times, 10 February 2011)

To invoke such insight is at best misconceived and at worst a fraudulent application of ‘the pseudo-scientific economics of averages’ (Hayek, 1972, p. 20). It is the limit of absurdity to envisage that complex business entrepreneurship and socio-economic engagements are rendered in any degree comprehensible by such crude analysis.

1 thought on “Taylor Rules – far from ‘OK’!”

  1. Posted 21/02/2011 at 14:24 | Permalink

    I am keen on adjusting accounts for inflation, using a ‘general price index as an inverse proxy for the purchasing power of money. Once , feeling somewhat un-Austrian’ in adopting that approach, I asked Israel Kirzner his opinion, and he said he thought it was quite all right — which somewhat surprised me. Of course, I recognise that the index itself cannot be more than very approximate (hence the title of my latest book: ‘Margins of Error in Accounting’), though my own opinion is that the Retail Prices Index is less unsuitable than the Consumer Prices Index (to which the government has just switched the index-linking of my pension).

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