Professor John Taylor on the US Economy, Past and Present

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, as well as the George P. Shultz Senior Fellow in Economics at the Hoover Institution. Professor Taylor has become one of the field’s leading experts on monetary policy. Most notably, his 1992-1993 research that formulated a strategy to coordinate the interest rate with the inflation and output gaps revolutionized the way in which modern central banks set interest rates. This past fall, his consideration for Federal Reserve Chairman brought his accomplishments and expertise into the spotlight. He sat down with Stanford Politics to give his input on the current economic climate and what the future might hold for our world’s financial systems.  


Thomas Pfeiffer: There’s this idea of a 0-dollar minimum wage, which is discussed in your introductory economics class. Do you believe this idea has any merit or is it oversimplified?

John Taylor: Sometimes when I refer to the 0-minimum wage idea, that goes quite a ways back to a New York Times editorial in 1987 (“The Right Minimum Wage – $0”). It essentially stated that the optimum minimum wage is zero and it recommended other ways to deal with the problem of poverty. But I would say since then, the idea of having a minimum wage has changed quite a bit, so now we’re talking about not zero, but a significantly larger minimum wage compared to that. Here I think you have to consider the costs and benefits. My main concern about a minimum wage is the cost – it does have a risk of less unemployment than there otherwise would be. However, if you have a job and don’t lose it, you’ll have a higher wage, so that’s the benefit to those whose income is low. I’ve become most concerned about the people who are hurt the most by it, and they’re generally low-skilled individuals who are unfortunately priced out of the market or those who are disadvantaged without access to a quality education, so a minimum wage basically reduces the chance of improving some of their lives.

The other thing is that it’s not very targeted. You can have people who are young, maybe teenagers, that are living at home in well-off families that receive the minimum wage, which isn’t helping poor individuals. If we put too much emphasis on the minimum wage approach, it can have costs, and you therefore we want to implement a policy that could be more valuable (such as investment in K-12 education).

TP: Do you think it’s appropriate for the state of California to schedule a minimum wage nearly double that of the federal mandate?

JT: The real concern is that it can reduce employment for the people that you want to help. The costs can become quite high in that case because a firm will not hire someone with minimum skills at $15/hour, so they won’t hire people rather than pay what they are mandated to. There’s debate amongst economists about what the right level is, but there’s no debate that at some level wages get too high. It’s also important to consider that when students think about this issue, they need to pay attention to who is making the argument. Sometimes it’s not the people who will be helped who are making the arguments. In any kind of public policy debate, it’s important to see who is making the argument and what their rationale is.

TP: If you look back at the previous 10 financial quarters, the change in real GDP growth has fluctuated anywhere from 0.5% to 3%. Where does this overall trend in real GDP growth stand in relation to potential GDP growth? Do you believe the US economy is growing at the best rate possible?

JT: I think if you average out those ups and downs and go back a little bit longer, you will see the average is about 2% real GDP growth per quarter. There’s no question in my mind we would be better off with a higher growth rate than recently, and I don’t think it’s inevitable we have a 2% average or less. I think we could have a 3% growth rate for quite a few years. Part of that is a need for higher productivity growth and more participation in the labor force. Right now the low productivity growth can be related to the fact that capital growth and investment in equipment, machines, and tools is quite low.

TP: Considering the current US federal funds rates, they stand at 1.25% after remaining well below 1% after the 2008 recession. Do you believe the current 1.25% rate is optimal given current economic conditions?

JT: Right now, the Federal Reserve is on their way to raise it by their own accounts. You have a lot of history to look at when the interest rate is very low, it can’t go much lower, so if there’s a problem in the economy, it’s difficult to lower it rapidly. I think by both calculations it probably should be higher, which is the direction where the Fed is going.

TP: If you look at the past 25 years when the Federal Reserve has determined interest rates, they’ve consulted a rule that you formulated, The Taylor Rule (the central bank’s policy combining inflation and output gaps to calculate the Federal Funds rate).How did your results come to such a fundamental conclusion regarding modern day monetary policy?

JT: Some of my early work as an undergraduate was focused on how to implement a sound monetary policy. In that context, we were looking for ways to formulate monetary policy for the Fed or any other central bank. In those days (1970s), monetary policy was terrible. Inflation was growing, unemployment was growing – it was a mess. There was a lot of motivation to try and find a better monetary policy so that was the motivation behind it.

By the late 80s and early 90s, I determined that we really need a strategy. By that time, the Fed’s policy had basically begun to change for the better, so I devised this rule to setting the instrument of monetary policy, which is the Federal Funds rate. It was a long process, I presented it in a paper, never thought it would be of that much interest to people, but it turned out to be very intriguing to organizations across the world. I would say it’s been positive in the sense in that you can look over all these years and see that when central banks were close to the rule, things were better. When policy (interest rate) was away from it, the economy didn’t work well.

TP: Quantitative Easing was another monetary policy instrument used by the Fed in the previous recession to help lower interest rates and stimulate the economy by increasing the money supply. In the letter to Ben Bernanke (then chairman), you and fellow colleagues raised concerns about a higher inflation rate from such policies. While inflation did rise slightly following QE, how would you explain the fact that we didn’t see a drastic increase in inflation? Especially hyperinflation?

JT: You’re correct, I’ve been critical of QE, but not in 2008. 2008 was the panic, and so the Federal Reserve provided loans to financial institutions to prevent runs on them. It was in 2009 and 2010 when they purchased large amounts of mortgages and mortgage-backed and government securities that I tended to question the practice. One risk I feared was that this would slow the economy down and there wouldn’t be a good recovery. Also, it was possible that it would cause inflation. I thought both were possible, but neither were necessarily an exact forecast. It turns out, one did happen, the slow economy. The other risk didn’t turn out to be the case.

Your question though is why not the second risk? The first, I believe occurred because the policy just wasn’t effective; it had negative effects on other aspects of the economy. And the reason the second risk didn’t occur is because the economy itself was very slow. If you have a slow economy, and unemployment is remaining high and job growth is not the greatest, you’re not going to get the inflation people forecast. On top of that, where money growth didn’t increase like expected, inflation didn’t either.

TP: You’ve mentioned how policies like Quantitative Easing (QE) can reduce the independence of the Federal Reserve. What exactly does this independence entail and how can it lead to negative or positive economic circumstances?

JT: The idea of central bank independence is important because the central bank has such a great degree of power to affect the economy. It’s possible for the central bank to increase the money growth by a lot, allowing the economy to boom, thus causing unemployment to go down. But ultimately it has inflationary effects, and the Fed must eventually take steps to reduce that. That’s the story of central banks in other countries as well, called boom-bust cycles. And usually those booms and busts occur for political reasons. The idea behind independence is that it removes the central bank’s power from shorter term political influences, so it’s independent of the current government in power, and I think that’s very important. So that’s the reason why there’s a danger from widening the scope of the central bank so much that people start to question its independence.

TP: How has your time here at Stanford and prior professorships and jobs shaped your overall worldview of economic?

JT: My career has been in academia, but also in government and business. The academic part is very important because that’s where the research, teaching, and majority of ideas have come from. But I would say my interest in economics has been much more in the policy application and how we can improve people’s lives. For me, the chances to apply those [ideas]whether in government or business is essential because it does no good to have a book on a shelf or simply give a lecture that’s not applicable or practicable to the real world. The third thing, the business and market aspect, has also been important to me because a lot of the way the economy works and what you learn about the economy comes from what’s going on in markets. So those three together and the integration has been essential, to the extent where I believe people need opportunities in each and should take advantage of them.

Thomas Pfeiffer is a freshman staff writer for Stanford Politics.