Quantitative Easing: Rules Vs. Discretion

The use of monetary policy such as quantitative easing, the purchase of securities by the Federal Open Market Committee, is standard theory in Macroeconomics.  The policy can be implemented using discretion of Fed officials or through the use of rules like the Taylor rule and this is the source of controversy among economists.  Former Fed Chairman, Alan Greenspan, outlined many issues of the debate “Rules vs. discretionary monetary policy,” a speech delivered in 1997. 

Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y.

Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials?The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking.

Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior.

The current policy of monetary easing is discretionary and has a political problem not identified by Greenspan.  It is widely unpopular with leaders in exporting countries who view it as an attempt to devalue the dollar relative to their currency reducing their exports to the United States and increasing the attractiveness of our imports in their countries.  Will these countries use discretionary policy to reduce the value of their currencies and ignite a trade war through monetary debasement?