Michael Biggs and Thomas Mayer Make the Case Against the Taylor Rule

Michael Biggs and Thomas Mayer have a new article at VoxEU arguing that inflation targeting has led to excessive credit growth. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit.

Our credit impulse approach has proved useful for the analysis and forecasting of economic activity in both the US and the Eurozone over the past three years. Domestic demand growth in the US rebounded in line with the credit impulse in 2010 (Figure 1), even though credit growth was still negative (Figure 2). The same was true in the Eurozone and many other countries around the world. With the concept of the credit impulse we could also debunk the myth of creditless recoveries (or so-called ‘Phoenix Miracles’) (Biggs et al. 2010a).

That is, the change in private sector borrowing (the credit impulse) gives us a clearer picture of where GDP growth is likely to go:

If fluctuations in the credit impulse around zero are correlated with fluctuations in GDP growth around trend, then it follows that the output gap must be correlated with new borrowing as a % of GDP (Biggs and Mayer 2012). …

The implications of this view is that if we know what new borrowing as a % of GDP is, we have a reasonable estimate of the output gap. If new borrowing is high as a % of GDP then the economy is operating above potential. For given periods of time, credit growth can be used as proxy to new borrowing in % of GDP and hence provides a readily available, excellent indicator for a possible overheating of an economy, which is much easier to measure than the unobservable output gap.

Biggs and Mayer maintain that by keeping a wary eye on credit growth, central bankers might have avoided fueling dangerous asset bubbles:


In the US, over the past 20 years an output gap of 0% has been consistent with nominal credit growth of 7.0%. Potential nominal GDP growth averaged 4.8% in the US over the observed period and less than 4.0% in the Eurozone. In other words, when the output gap was 0%, credit was rising faster than nominal GDP and the debt ratio was rising. Exactly the same was true in the Eurozone.

An output gap of 0% would have suggested that the economy was performing at its potential and on a growth path that is generally perceived as being sustainable. Unless there were worrisome signals from actual inflation, the Taylor Rule would have suggested that policy interest rates were appropriate at existing levels. However, the right hand scale of the Figure suggests that growth at potential went along with credit growth that was faster than nominal GDP growth. In other words, growth in line with potential was associated with an ever increasing debt-to-GDP ratio. What might have appeared to have been a sustainable growth path from an output gap perspective was a growth path that gave rise to unsustainable debt dynamics. In short, the application of the Taylor Rule by the US Federal Reserve would have paved the way towards excessive debt accumulation, financial instability, and the subsequent financial crisis. [Emphasis added]

Would the U.S. growth trajectory have been dramatically different has the Federal Reserve sought to restrain asset price inflation? Would it have been lower — or just smoother?

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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