Poor Ben Bernanke! He has gone further than any other central banker in recent times to try to stimulate the economy through monetary policy. He has cut interest rates to the bone. He has adopted innovative new methods of monetary easing such as quantitative easing. Again and again he has repeated that while inflation is contained, his main concern is the high level of unemployment in the United States. And yet he is chastised by progressive economists for not doing enough.
What could they possibly want? Raise inflation, they say, and all will be well. Of course, this would be a radical departure for the Fed, which has worked hard to convince the public that it will keep inflation around 2 per cent. The inflation credibility it has acquired over the years has allowed it to be aggressive – it is hard to imagine the Fed could have expanded its balance sheet to the extent it has if the public thought it could not be trusted on inflation. So why do these economists want the Fed to sacrifice its hard-won gains?
The answer lies in their view of the root cause for continued high unemployment – excessively high real interest rates. Their logic is simple. Pre-crisis, demand in the US was buoyed by the spenders, who borrowed heavily against their rising house prices. Post crisis, these households are heavily indebted and cannot borrow and spend any more. An important source of aggregate demand has evaporated. As the spenders stopped buying, real interest rates (which equal nominal interest rates less inflation) should have fallen to encourage thrifty households to spend. But real interest rates did not fall enough because nominal interest rates cannot go below zero. By increasing inflation, the Fed will make real interest rates seriously negative and coerce thrifty households into spending instead of saving. With rising demand, firms will hire and all will be well.
The logic seems persuasive but it has some serious weaknesses. First, while low rates may increase spending if credit were easy, it is not at all clear that lower rates today will encourage traditional savers to go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough to retire on. Given the terrible returns since 2007, the prospect of continuing low interest rates may make her put even more money aside to give her enough to retire on. Moreover, it could also push her (or her pension fund) to reach for yield by taking more risk with her money, buying long maturity risky bonds. Given these bonds are already aggressively priced, such a move may set her up for a fall when interest rates eventually rise. We may well be in the process of adding a pension crisis to the unemployment problem.
Second, household over-indebtedness in the US, as well as the fall in demand, is localised, as my colleague Amir Sufi and his co-author, Atif Mian, have shown. Hairdressers in Las Vegas lost their jobs, in part, because households there have too much debt stemming from the housing boom and in part because many local construction workers and real estate brokers were laid off. But even if we can coerce traditional debt-free savers to spend, it is unlikely enough of them are in Sin City. Instead, many of them may be in New York City, which did not experience as much of a boom and a bust. So even if cutting real interest rates further encourages spending on haircuts, it will do so in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a tool, even if they work.
Third, we have very little idea of how the public forms its expectations about the central bank’s future actions. If the Fed announces that it will tolerate 4 per cent inflation, could the public think the Fed is bluffing? Or will it think that if an implicit inflation target can be broken once, it can be broken again? Will expectations reform at a much higher rate? How will the added inflation risk premium affect long term interest rates? What kind of recession will we have to endure to bring inflation back to comfortable levels? We really don’t know very much about what could happen. Given the dubious benefits of still lower real interest rates, we should not give up central bank credibility in a hurry.
Finally, it is not even clear that the zero lower bound is primarily responsible for the high unemployment. Traditional Keynesian frictions like the difficulty of reducing wages and benefits in some industries, as well as non-traditional frictions such as the difficulty of moving when one cannot sell (or buy) a house, may all share the blame.
We cannot ignore high unemployment. Clearly, easing the ability of indebted households to refinance at the low current interest rates could help lower their debt burden, as would writing off some of the debt of those that are deeply underwater. More could be done here. The good news is that household debt is coming down through a combination of repayments and write-offs. But it is also important to recognise that the path to a sustainable recovery does not lie in restoring irresponsible unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance. With a savings rate of barely 4 per cent of GDP, the US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country so that they can get sustainable jobs with steady incomes. That takes time, but it may be the best option left.
The writer is a professor at Chicago’s Booth School of Business
Response by Michael Konczal
In 1926, John Maynard Keynes attacked socialist ideas for being “little better than a dusty survival of a plan to meet the problems of fifty years ago, based on a misunderstanding of what someone [Karl Marx] said a hundred years ago.” Right now the monetary policy debate in the US is centered on answering the problems of 30 years ago – when inflation and unemployment were both at high levels – based on a misunderstanding of what someone said 50 years ago: Milton Friedman.
The problem at the core of the US economy is that interest rates have been too high since the recession started. However, the Fed is not in a straightjacket. It has the tools to get the economy going again and must put them to use. The absence of pressure on the Fed, which has received only one dissenting vote demanding more stimulus but several to tighten earlier, to do more to reduce unemployment speaks to an intellectual paralysis as challenging as the orthodoxy of the gold standard and balanced budgets in the Great Depression.
The Fed uses monetary policy to balance unemployment and inflation. It has typically done this with an inflation “target”. But the target metaphor is inaccurate; it functions far more like a “ceiling.” People aim for targets but can go over them. Yet what we’ve seen over the last five years is that rather than a balance between its two goals, the Federal Reserve supports the economy up until the point where it is near the inflation target, and thereafter backs down from monetary stimulus. The market understands this and output remains equivalently depressed.
The Fed is fighting the last war: against 1970s stagflation. It is of course essential that the Fed maintains its hard-won credibility against runaway inflation. But the best way to do so isn’t to keep the economy in a perpetual state of high unemployment. It is to be explicit in what it wants to see accomplished and what it is willing to tolerate in order to get it. As Charles Evans, President of the Chicago Federal Reserve, recently pointed out, the Fed could “make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities.” An “Evans Rule” would mean the Fed would agree to keep interest rates at zero and tolerate 3 per cent average inflation until unemployment went down to 7 per cent, setting market expectations in such a way that would allow aggregate demand to surge.
If conventional monetary policy was available – if interest rates were at 1 per cent instead of zero per cent – Mr Rajan’s argument suggests he wouldn’t lower interest rates further. Even though inflation has been lower than the target for several years, and unemployment is significantly higher than it should be, his editorial suggests he believes interest rates are already too low. Lower rates will not help the unemployed, since unemployment is localised. As he puts it, people are out of work in Las Vegas, but lower interest rates will increase demand in New York. So we won’t see increased employment, just savers “coerced” into buying risky bonds.
Contrary to Mr Rajan’s argument, the crisis is a national one. The median state’s unemployment rate is 1.65 times higher than it was before the recession began. New York has an unemployment rate of 8.5 per cent, up from its pre-recession rate of 4.7 per cent. Meanwhile, as Edward Luce wrote in the Financial Times yesterday, “risk capital is far harder to come by”. If lower rates would, as Mr Rajan says, increase demand for riskier assets, that’s exactly what the economy needs.
This would help with our current dilemma, but the Fed must also change its future approach to monetary policy. It has failed to balance inflation and growth, especially in periods of low inflation. Our low inflation target doesn’t work precisely at the moment when we most need it. Changing the target to inflation and growth added together, or what economists call NGDP (nominal gross domestic product), would better balance these goals. Alternatively, moving to a higher inflation target, say 4 per cent a year, would give the Fed much more room to fight recessions. Four per cent was the average annual rate during much of the past 30 years. The costs of a higher target would be minimal. Given that the cost of the current recession is in the trillions of dollars, this demands serious reconsideration.
It seems like a radical statement to some to note that the Fed has the ability to bring us closer to full employment with little risk and is simply choosing not to do it. They believe the Fed is full of disinterested technocrats doing the best they can. No doubt those at the Fed believe they are trying hard, but if the situation was reversed, with unemployment at ultra-low rates and inflation well above what anybody could possibly want, they would be working overtime to try and fix the problem. Chairman Bernanke, when he was a scholar of Japan, understood that a central bank could end up in a situation of “self-induced paralysis,” like where our current Federal Reserve is. And Milton Friedman himself, who people arguing against looser monetary policy would like to invoke, also understood that the Bank of Japan had “no limit” on closing output gaps if “it wishes to do so.”
Commentators would like to argue that monetary policy rewards some people over others, forgetting that mass unemployment is the most regressive policy imaginable. But beyond that, monetary policy is not a morality play, and it’s not about rewarding the good people and punishing the bad ones. It’s about stabilising growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen. Now, more than ever, a commitment to both goals is necessary for the good of our economy.
The writer is a fellow with the Roosevelt Institute