September 16, 2007
Rules vs. Authority in Central Bank (and Other) Policies
Rules vs. Authority in Central Bank (and Other) Policies-Becker
There is tremendous speculation about how much, if at all, the Fed will reduce the federal funds rate at its meeting next week on Sept. 18th. This is the interest rate that banks use to lend their reserves held with the Fed to other banks. This rate in turn affects the interest rates banks charge borrowers, and ultimately that affects other interest rates in the economy. The Fed changes the federal funds interest rate through open market operations that involves buying or selling bonds. Some investors are looking for a full ½ point reduction from a federal funds rate of 5 1/4 per cent to 4 3/4 per cent, while others expect a reduction of only ¼ of one per cent. If the Fed took no action, there would be many disappointed investors, and probably a large sell off in worldwide stock markets.
The uncertainty among investors about what the Fed (and other central banks) will do, and the expectations that form around this uncertainty, have created an environment where central banks almost have to take some actions to avoid major negative reactions in financial markets. Instead of central banks determining expectations in financial and other markets, expectations are now determining central bank policies. As decision time approaches, the Fed comes under enormous political pressure to take the actions expected by influential investors and businesses. Although political and other forces help determine what the Fed will do, there is still great uncertainty over the precise actions it takes, as with the current speculations over the magnitude of the change next week in the federal funds rate. This political process surely is not what was intended when "independent" central banks were created.
To regain control over expectations and its own policies, the Fed should establish a rule easily calculated from publicly available information about how the federal funds rate is determined. With such a rule, investors and businesses would be able to forecast perfectly what the Fed will do next week because market participants would know all the information that determine the Fed's behavior. There could be no disappointments, and all market adjustments to any changes in the federal funds rate would be fully and continually incorporated in asset prices and other market measures before, not after, the Fed makes its decisions. Then Fed policies would be determining expectations about interest rates and other variables rather than the other way around.
To show how rules would work, suppose the rule was to target the inflation rate at 2 per cent per year. If say the actual inflation rate were 3 per cent over a several month period prior to a Fed meeting, the Fed would "lean against the wind", and raise the federal funds rate from its long run level by a specified amount known in advance to investors. This would counteract the higher than desired inflation rate. Conversely, if the actual inflation rate had been 1 per cent, the Fed would lower this interest rate by a specified amount that would be known by market participants. This action would help strengthen an economy that was weaker than the Fed desired. Investors would know what the Fed would do weeks and even months before the Fed did it, and they would adjust their behavior more smoothly to their accurate expectations about central bank behavior.
The same considerations would apply to more complicated "Taylor rules" that relate actions by the Fed not only to deviations of actual inflation rates from a targeted rate, but also to deviations of actual GDP growth from a potential growth rate. Since information could be made available to the public about how the Fed would use trends in labor force growth, investments, and productivity to calculate potential GDP growth, the Fed's responses implied by such a rule would also be known in advance. In this way, investors and other market participants could anchor their expectations to what the Fed will actually do in different macroeconomic situations.
According to a recent unpublished paper by John Taylor of Stanford University, the Fed would have raised the federal funds rate between 2002 and 2006 by considerably more than it did had such a Taylor rule been followed. By doing that, the Fed's actions would have prevented some of the mortgage and other lending at very low interest rates that took place during the past few years. Taylor's analysis suggests that following such a rule would have reduced, and perhaps even largely eliminated, the excesses in the housing boom since 2003.
Although the Fed is the most influential central bank, similar advantages of rules over discretion in setting interest rates apply to the European, British, Chinese, Japanese, Indian, and other major central banks. The less important central banks already have little discretion over their interest rates since global forces outside their control basically determine these. Of course, in the global economy what any major central bank does, especially what the Fed does, greatly affects the choices available to other central banks.
The use of rules rather than discretion to guide interest rate policy would shield central banks from domestic political pressures, and would anchor market expectations in accurate knowledge about what central banks will do in various local and global economic circumstances. These types of advantages of rules over discretion apply not only to central bank behavior, but also to policies by other government agencies. For example, should anti-trust authorities treat each merger, buyout, or meeting among competitors as unique events that require separate analysis to determine if they are anti-competitive, or should these regulators have clear and easily understand rules about what determines anti-trust violations? Clear rules are preferable here too since that would enable companies to predict the responses by anti-trust regulators when considering mergers and other actions. It would also help insulate these regulators from political pressures. In particular, the American and European attacks on Microsoft, and the European opposition to the merger of GE and Honeywell, probably would not have happened if competitive policies were guided by clear and sensible rules about what constitutes anti-competitive actions rather than by complaints of and pressures from politicians and from competitors to Microsoft and GE.
Rules versus Discretion--Posner's Comment
I am not competent to offer an opinion on macroeconomic policy. But I can, with some confidence, say this about Becker's proposal that the Federal Reserve Board adopt a rule approach to adjusting the money supply to limit inflations and recessions: there is no way in the existing legal regime to make such a rule enforceable. The Board is a creature of Congress. If it resists strong political pressures, Congress can retaliate. Unlike the Supreme Court, the Board has no constitutional standing. And even the Supreme Court, which Congress could not abolish without a constitutional amendment, is not immune from political pressures, because Congress can limit the Court's jurisdiction and controls the Court's budget. Moreover, political pressures influence who is appointed to the Court--and to the Fed as well. And Congress can pass laws that would impede or even nullify Fed policy, as by raising or lowering taxes or running deficits or surpluses in the federal budget.
Therefore, it might well be a mistake for the Fed to surrender discretion in favor of a rule approach. Discretion enables the Fed to bend in the face of political pressure; rigid adherence to rules might cause the Fed to break in the face of particularly intense such pressure. I understand that some central banks do follow a rule approach, but they may operate in a political context different from ours--I do not know.
The larger question is whether any public official can be totally nonpolitical in a democratic (perhaps in any) system. I suspect not.
On the broader issue of rules versus discretion, I doubt that generalization is possible. Rules have great virtues, but they are limited because they are necessarily based on information possessed by the rulemaker when the rule was made. No rulemaker is omniscient. After the rule is promulgated, unforeseen circumstances are likely to arise to which the rule will be maladapted. The inflexibility of rules has to be traded off against the benefits in simplicity, clarity, and ease of compliance and application that rules confer. The tradeoff will not always favor rules.
There are three alternatives to rules. One is standards. A fixed speed limit is a rule; negligence is a standard. A standard is less definite than a rule, which is a minus, but it is more flexible, which is a plus. It would be impossible to anticipate every possible cause of an accident (driving above 60 m.p.h. at night, in snow, in heavy traffic, on a divided highway, or in an SUV, etc.) and make a rule that would declare each cause to be either culpable or excusable. The negligence standard enables a court to determine liability as cases arise, on the basis of a weighing of the costs and benefits of measures that would have avoided the particular accident.
One way to state the difference between rules and standards is that standards enable information obtained after promulgation to be incorporated into the law without need for formal rulemaking. When for example Congress passes a vague statute, thus leaving it to the judges enforcing the statute to fill in the details, in effect the judges are enlisted in the legislative process. An example is the per se rules of antitrust laws, which are judge-made rules supplementing the general directives in the antitrust statutes.
Another alternative to rules is discretion, which differs from a standard in not being enforceable in court. For example, prosecutors in our system have discretion whether or not to prosecute a particular person for a particular crime. Unless a prosecutor bases an exercise of his discretion on an invidious ground, such as race or religion, a court will not review that exercise. Discretion in the criminal law is a way of introducing needed flexibility without creating loopholes through which criminals could escape the law. Criminal laws tend as a result to be overinclusive. People are constantly cutting corners of various sorts, often not realizing that by doing so they actually are violating a criminal statute. Prosecutors are, quite wisely, not given sufficient resources to prosecute every crime, but instead are given discretion to allocate their limited resources as they see fit. They can overlook the minor crimes without worrying that the criminal law contains loopholes that may enable a major criminal to elude justice.
Similarly, no driver actually obeys all the driving laws, but police rarely bother to ticket anyone who exceeds the posted speed limit by less than 5 or 10 m.p.h. Suppose the posted speed limit is 60 m.p.h., but the de facto speed limit is 70. If the posted speed limit were raised to the "realistic" speed limit of 70, many drivers would drive faster because the police would not have enough resources to catch all the speeders, so the realistic speed limit would rise. Moreover, police would lack flexibility to ticket the occasional driver who was driving above the posted but below the de facto speed limit but who the police believed should be ticketed anyway because he was driving erratically--weaving, tailgating, etc. Of course they could ticket him for these activities, but it would be harder to determine and prove them, compared to detecting speed with a radar gun.
The third alternative is presumptions or guidelines, which have the structure of rules--that is, are simple and definite--but which allow discretion in enforcement. An example is the federal sentencing guidelines, which enable a defendant, a judge, and probation officers to determine a definite range for a sentence for a particular crime committed by a person having particular characteristics (such as criminal history), but allow the judge to sentence outside the range if he can give a good reason for doing so based on sentencing factors set forth by Congress. This approach makes sense when there is a need for guidance but strict rules would be too inflexible.
The merger guidelines used by the Justice Department and the Federal Trade Commission are a further illustration of the presumption/guideline approach. They enable firms contemplating mergers to have a pretty good idea in advance of whether the merger will provoke a challenge from one of the enforcement agencies. The firms can go to the agency assigned to their proposed merger before the merger is consummated and get a definitive determination of whether it will be challenged. This procedure enables the lawyers and economists at the agency to decide whether the proposal is consistent with the spirit as well as the letter of the guideline.