Friedman and the Bernanke-Taylor debate on rules versus constrained discretion

Abstract

The debate about rules versus discretion in monetary policy is an old one. It goes back at least to the 1930s, when a group of University of Chicago economists, led by Henry Simons, proposed that the monetary authorities should be bound by a rule that aims to achieve price-level stability.1 Although for many years that debate was confined to the academic community, it spilled over to the public arena in 1958, when Milton Friedman proposed a money-supply growth rule to the Congressional Joint Economic Committee. Recently, the issue of rules versus discretion in monetary policy has been at the heart of a debate between the former Fed chairman, Ben Bernanke, who favors what he calls “cons-trained discretion” in the conduct of monetary policy, and John Taylor, who favors a “rules-based” monetary policy. In what follows, we address the following question: What would Milton Friedman have thought about the present debate on constrained discretion versus rules-based monetary policy? To shed light on this question, we begin by briefly reviewing the positions of Taylor and Bernanke, respectively, on rules versus discretion. Next, we consider the factors that led Friedman to favor a money-supply growth rule. During the late 1940s and early 1950s, Friedman favored using fiscal policy to effectuate changes in the money supply in order to stabilize output at the full-employment level. However, during the 1950s, his growing realization that the Federal Reserve System was culpable in both initiating the Great Depression with its policy tightening in 1928 and 1929 and deepening the Depression with its policies after 1929, led him to favor a rule that limited discretion. We show that a key factor underlying the rules of both Friedman and Taylor is their common view that monetary policy should aim to reduce uncertainty.