I’ve been avoiding public policy in this blog, preferring to focus on ideas with actionable implications for business leaders. However, you’ve been asking, so here’s the answer. You should probably ignore this post and get back to business—unless you are Ben Bernanke or Barack Obama, in which case read on.
The nutshell: monetary policy can rev up the economy and bring us back to a normal unemployment rate (about five percent). Other policy options, such as fiscal stimulus, supply-side tax cuts and the many other ideas being tossed out, cannot do the heavy lifting needed by the economy today.
Let’s begin with the magnitude of the problem. Suppose we want to get the economy back to normal by the end of 2013. What kind of economic growth will pull unemployment down to five percent in just two years’ time? Here’s a picture of the growth rate we’d need:
That’s nine quarters of growth (including the current quarter, 2011q4) at a higher pace than we’ve seen for even one quarter of the recovery. It’s not a pace that’s unprecedented for an economy coming out of recession, but it would be unprecedented to get that growth rate for over two years. That should be our goal, plus or minus a quarter or two.
The many ideas for getting the economy going fall into four categories: small ideas, fiscal policy, supply-side policy and monetary policy.
“Small ideas” are those that could not possibly push the economy to full employment from its current weak state. Some of the ideas are good (regulatory reform) and some are bad (China bashing), but they would all have small impact at best, at least small relative to the gap we’re currently facing. The list includes most of the ideas that the President solicited his Jobs Council (made up of business leaders). His advisors, for instance, recommended reforming the visa process, improving FDA approval process, speed payments to small federal suppliers, job training, streamlining SBA financing access. Every good idea should be pursued, of course, but even adding them up will not close the gap between where we are now and where the economy should be.
Fiscal policy—Keynesian economic stimulus—is probably not the answer. Unlike many of my friends in the free market economics camp, I believe that Keynesian stimulus has a positive effect. However, I think the effect is small and temporary. Academics estimating the “mulitiplier” are coming up with estimates from 0.5 to 2.0. In real terms, a $2 billion stimulus package would have a net final impact of the economy somewhere between $1 billion and $4 billion. That wide range of estimates is a measure of our ignorance. My own judgment is that fiscal policy usually works, but with a small and temporary effect. In today’s environment, I’m not even sure about the small effect.
The effectiveness of fiscal policy is reduced by taxpayer belief that they will eventually have to pay higher taxes to cover the cost of the stimulus. If taxpayers have a one-to-one estimate of the future tax impact of current spending, then the stimulus would be fully offset by consumer savings to prepare for higher taxes. I thought this idea (called “Ricardian equivalence”) was non-sense when I first heard it. After all, who has any idea what his taxes will be in the future? However, when I talk to everyday people about the economy I continually hear concerns about the country’s deficit and accumulated debt. People really are worried. They may not have the magnitude of their future tax bills right, but they are reacting to the huge deficits by saving more. In fact, it’s possible that in a near-hysterical mood, people would overestimate the future tax burden, and a headline-grabbing stimulus package could actually lead to a negative short-term impact.
Supply-side policies were popularized in the Reagan administration. Cut marginal tax rates, the story went, and the economy would grow. A growing economy would increase tax revenues even at lower tax rates, so the cuts might pay for themselves. The logic of supply-side economics was never really doubted by mainstream economists, just the magnitudes and timing of the effect. There was never good evidence that our tax rates were above the “revenue-maximizing tax rate.” (Incidentally, economists have known that tax rates could be too high long before Professor Laffer drew his famous cocktail napkin curve.)
Some investment stimulus ideas fall into the supply-side category. For instance, tax preferences for business capital spending could make the private sector economy more productive. Infra-structure spending could also help business productivity, as good roads and ports help companies move goods to market.
The line between Keynesian and supply-side policies is sometimes blurry, as a tax preference for business capital equipment could be old-fashioned pump-priming, or it could be supply-side effort to increase productivity.
Can supply side policies help the economy? Yes, but not nearly enough to solve our current problem. The magnitude of the gap between where we are and where we should be is too great compared to the benefit we would get in the near term from cutting marginal tax rates. Though the benefits of cutting marginal tax rates are small in any given year, they do continue, year after year, and accumulate to some fairly sizable impacts over a decade or two. I have no problem at all recommending supply-side tax policy, but I do not expect the real gains from these policies to be felt in the near term. It’s near-term help that the economy really needs right now.
Monetary policy can get the economy growing at a faster pace. This is the key to full recovery for the economy. The Federal Reserve has to be far more aggressive than it has been.
The Keynesian model still permeates thinking at the Federal Reserve. In this view, monetary policy acts by lowering interest rates. Short-term interest rates are near zero, so there isn’t much that the Fed can do except maybe lower long-term interest rates. That’s hard because long rates tend to be determined in global credit markets, not just in America. Furthermore, long-term interest rates are so low that another drop might not have much impact on capital spending. They certainly won’t get the housing market going, given our large oversupply. So the Keynesian mindset argues against monetary policy being effective at this point.
That Keynesian mindset is wrong, however. Monetary policy is not just about interest rates. When the Fed increases the money supply, it does so by purchasing assets (typically Treasury bills or bonds, but conceptually any asset held by the public). The public previously had adjusted its affairs to get the proper balance among money, financial assets, and physical assets. The Fed steps in to offer a high enough price that some asset holders sell. Now the private sector has relatively more money than it had wanted, so it rebalances. It spends some money buying other assets. Most of the new purchases will be financial assets, but some will be physical assets. However, the economy as a whole cannot spend money. Individual people and companies can spend money, but all they do is pass the money on to someone else, and then that person has too much money. The spending only stops when balance is achieved, either through higher prices or greater production of assets. This rebalancing is how the economy is stimulated by monetary policy. Even if interest rates are virtually zero, monetary stimulus will increase spending.
Skeptics of monetary policy note first of all that the Fed substantially increased its purchases of assets after the Lehman Brothers bankruptcy, but we did not get proportionate money supply growth. That is true, as banks chose to hold higher levels of excess reserves. Going forward, however, it’s best to view the relationship between reserves and money as a clutch. It may sometimes slip, but revving the engine will transfer more power to the wheels, even if the clutch is slipping a bit. The relationship between the monetary base (essentially the Fed’s reserve assets) and the money supply is known as the money multiplier. In the chart you can see the big slip in late 2008. Since then, the multiplier has been stable enough that the money supply has managed to grow.
Other skeptics of monetary policy will say that although the money supply has grown, that has not stimulated the economy. The relationship between money and the economy is known as velocity. It has fallen, but again the linkage is stable enough that an increase in the money supply does translate into an increase in the overall economy. The greatest strength we’ve had in this recovery has been in the last quarter of 2009 and the first two quarters of 2010, about one year after the initial monetary stimulus. Monetary policy worked. Then the Fed started worrying about inflation. They let their reserves actually fall in mid-2010. The money supply growth rate dipped down toward nil, and a year later the economy was very sluggish.
So what about inflation? Persistent high inflation is always a monetary phenomenon, no doubt about that. However, that does not mean that all increases in the money supply are inflationary. The money-inflation connection is not some black box working at all times in equal magnitude. Money supply increases lead to inflation through increased spending which pushes the economy towards its limits of productive capacity. We are so far away from the limit of our productive capacity that significant increases in the money supply would not trigger inflation. Certainly there will come a time when inflation becomes a risk, but we are at least two years away from that time.
Inflation worriers have noted that the Federal Reserve has ballooned its own balance sheet, and that huge bulge could break out into increased spending and inflation at any time. However, I do worry that when the economy gains traction and starts looking good, banking activity may return to more normal levels. At that time, the huge level of Fed reserves could get translated into huge increases in the money supply. When we see that happening, it will be time for the Fed to tighten monetary policy. In the meantime, our nine percent unemployment rate is crying out for attention.
Should the Fed begin a major new program, Quantitative Easing III? The problem with “programs” is they set expectations of immediate impact. QE II is just now beginning to have an effect, long after most pundits have dismissed it as a failure. I recommend that the Fed just continue expanding the money supply at the high rate we’re seeing right now. If the rate of growth starts to slow, the Fed should buy more bonds as needed to keep money growth very strong.
Back in the 1980s, the Federal Reserve targeted monetary aggregates such as M1 and M2 (different definitions of the money supply). Financial reform made those measures less meaningful, so the Fed turned to interest rate targeting. That was a fine decision in its day, but interest rate targeting gives misleading information to policy-makers when rates are near zero. In today’s environment the Fed needs to focus on the money supply.
The economy can get back to normal within two years, but it won’t be easy. The Fed needs to be bold on the stimulus side, and it will need to be bold on the contractionary side some years in the future. After a couple of years of growth they may trigger a recession because it’s so hard to get the tightening phase just right as to timing and magnitude. That’s a small price to pay, however. Imagine that the Fed’s efforts do in fact bring the unemployment rate down from nine percent to six percent, then we have a brief recession where unemployment returns to eight percent for half a year. Such a path would be far better than our current nine percent malaise.
The key to near-term economic success is the Federal Reserve, but the administration and Congress can help. The Federal Reserve Board is currently has two vacancies out of seven members. Of the people now on the board, there are only two economists. There are as many lawyers on the board as economists! Certainly an attorney can learn a lot about the economy, but there’s a much deeper understanding that comes from a Ph.D. program in economics, not to mention the professional experience that people with decades as economists bring with them. The President needs to appoint two good economists to the board. They need not be inflation doves. I would be happy with political bookends: one conservative, one liberal. The Senate needs to rapidly confirm the appointees. The Senate’s refusal to vote on Peter Diamond’s nomination was terrible. The secret “hold” on the vote meant that one intransigent senator was able to deny a Nobel laureate a seat on the Federal Reserve Board.
We do not have to accept our current dismal underperformance. Our leadership, however, has to take the initiative to get monetary policy working for us.
What are the business implications of this viewpoint? I do not expect the Fed to carry out my recommendations. There is division among the Fed’s policy committee, so they will probably continue as they are now, easing a bit but not nearly enough.
Business planning should consider the possibility that the Federal Reserve governors and regional presidents wake up one morning, slap their foreheads, and say, “By golly, I think Conerly is right.” If that happens, then companies will be scrambling to find workers, supplies and equipment. Although that’s unlikely, it’s a possible scenario and a little advance planning can help any business be prepared for a brighter future.