With unemployment low by recent standards, steady job growth, and a federal funds rate near zero since the Great Recession, Federal Reserve governors are more open to raising the rates now that fears of Brexit’s global impact are allayed by the lack of an obvious economic downturn in the British Isles.
They are wrong.
The fairly modest jobs data released Friday again suggests this economy is not growing too rapidly and still runs the risk of slowing down further. Even Jason Furman, the chairman of the Council of Economic Advisers, said the economy must grow faster to generate more wage growth. It is premature to raise interest rates.
But we argue here that, while the Fed can suppress economic activity, expansionary fiscal policy is more effective than monetary policy in generating economic growth and full employment. The economy can continue to grow significantly faster, raise wages, and reduce unemployment substantially before GDP reaches its full potential, at which point inflation may become a threat. The potential rate of growth is higher than many economists believe and indeed than the Congressional Budget office estimates; this faster growth in demand could in itself stimulate capital investment and productivity growth.
We have reached an unmistakable inflection point. America has relied for far too long on monetary policy as the only federal lever that can influence economic growth. It is time for a shift.
As monetary policy is a powerful tool to restrain inflation, it became the sole lever of economic policy in the 1980s when fear of federal budget deficits was high and inflation was being fought aggressively. However, it is not an adequate tool to generate rapid economic growth. We believe the famous analogy of the futility of pushing on a string is appropriate in the current environment. Raising or lowering interest rates does little to affect investment in productivity- generating equipment and ideas without, in the current economic environment, commensurate demand supplied by Keynesian fiscal spending. Further, direct public investments (education, R&D, etc.) can increase productivity themselves over time. A rut of low productivity, in turn, can itself lead to further slow growth as unemployed workers lose their skills and the quality of public investment erodes. A rate hike by the Fed now risks undermining growth just when we need still more, especially if the president and Congress cannot agree on substantially more fiscal stimulus.
Over-reliance on monetary policy to expand the economy can also limit its effectiveness when it is needed in times of a downturn or outright recession. Janet Yellen, chair of the Federal Reserve Board of Governors, and other central bankers are aware of this risk; not many are inflation hawks urging the immediate increase of interest rates. But they are also aware that if sluggish growth leads to a recession in a time when the federal funds rate is low, monetary policy will have little room to operate. It has become a worry among central bankers with ideas of secular stagnation (a chronic depression of economic growth) on their collective minds. In other words, the problem isn’t the risk of recession, but rather that the 21st century U.S. economy cannot seem to get into gear.
Despite Yellen’s claims about signs of economic strength, historically modest levels of economic growth, slow wage growth for many working Americans, a low employment-to-population ratio, and slow productivity growth suggest that it is premature to “cool down” the economy by raising interest rates. Instead, we should look to targeted fiscal policy to bring the economy to full employment and increased growth/productivity. Most importantly, we believe the estimate of potential growth by the Fed and other federal agencies is too pessimistic.
Moving the Goalposts: On Potential GDP Projections
Given past estimates of potential output, the economy is well below what it would have been producing had there been no recession, according to past estimates of the Congressional Budget Office (CBO).
The Congressional Budget Office makes projections about potential growth two to three times a year based on a sort of production function for the macroeconomy. In practice, this tends simply to extrapolate the trend of labor productivity (output per hour of labor) in recent years. As a result, the CBO has consistently lowered potential output since the January 2007 projection, which is the trendline in red in the graph above.
As seen in the above graph, the August 2016 CBO revision (the blue line) is far weaker than the projection nearly ten years earlier. If we were on trend with the January 2007 projections, GDP would have been just above $18 trillion in 2015 (about $1.7 trillion more than it is now in 2009 dollars). Note, however, even with the significant downward revision, there is still a gap between potential and actual GDP (the green line). The gap between actual and potential output based on the August 2016 projections is far narrower due to the slow growth of labor productivity and the many pessimistic revisions CBO has made since 2007. Essentially, the CBO’s reductions in potential output over time can be attributed to slack demand.
Some economists suggest a target for potential GDP should fall at the midpoint between the 2007 estimate and the current estimate. We think this is reasonable. Given that monetary policy has been so easy and still unable to raise the rate of GDP growth towards this midpoint, we believe fiscal stimulus is now necessary to raise demand. No matter how many unique methods of stabilization central bankers can devise, from negative interest rates and quantitative easing to forward guidance, monetary policy without sensible fiscal policy is often underwhelming.
Opening up the Black Box: How Monetary Policy Works
Before discussing the benefits of strong fiscal policy, we need to review the basic mechanisms of current monetary policy and their effects on economic conditions. The way these mechanisms influence economic behavior can often seem like a black box. It is not as simple as reducing the rate of growth of the money supply, which is an oversimplification of how money is created that has long been discarded. Ben Bernanke, former chair of the Fed, wrote a paper with Mark Gertler back in 1992 that identified an updated view of how these mechanisms work. The upshot of their thinking is that lowering interest rates makes credit more readily available—encouraging investment and growth—while increasing them constrains credit, slowing investment and economic activity.
The Fed traditionally raises interest rates to prevent an economy from overheating. But the classic example of an inflationary spiral is when, with low unemployment, workers bargain harder for higher wages to buy goods and services; in response, firms raise their prices (causing inflation), cutting into the buying power of workers who in turn demand still higher wages.
There is no evidence for a wage price spiral in the past two years, as wages have grown at a slower pace after the Great Recession as compared to the boom of the late 1990s. Likewise, asset bubbles can form in overheated economies where the cost of borrowing is cheap. But there is also little evidence of a serious asset bubble of size.
To the contrary, the problem remains lack of demand. Inflation is low: in the last year (through the twelve months ended July 2016) the inflation rate has been below 1 percent. Indeed, there is a case to raise the Fed’s traditional inflation target to 3 percent.
The Need for Fiscal Policy
Fiscal stimulus had been significantly dampened in the United States and elsewhere once President Obama’s fiscal stimulus package of 2009 had been fully deployed.
Though it is not often called austerity, America adopted an austerity program when Congress and the president signed the sequester agreement in 2011, which was implemented beginning in 2013. More severe fiscal austerity programs in Europe have ravaged working people and economic growth. Europe’s economic justification of austerity was based on two papers (Alesina and Ardagna 2009; Reinhart and Rogoff 2010) that turned out to be questionable. This situation is all too real for Puerto Ricans. The territory defaulted on its bond payment on July 1 and creditors are imposing serious austerity in return for restructuring debt. The Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA, cuts to the Puerto Rican minimum wage (now $4.25 for workers 24 and younger), and its proposals to roll back overtime protections and calls to close schools more closely resemble a colonial edict than a bailout.
The imperative is to turn away from the legacy of austerity since 2011.
It is imperative now to avoid “the paradox of thrift.” This concept, popularized by John Maynard Keynes, which involves cutting social spending and making the labor market “competitive” (lowering wages and labor regulations, for example), can cause a vicious cycle of saving, disinvestment, and unemployment. The theoretical answer we subscribe to instead is a traditional one: Via a more activist fiscal policy, the paradox of thrift can be avoided; incomes can be bolstered through social programs, investments in infrastructure, jobs subsidies, training, and industrial policy.
In America some alternatives have been described. The Congressional Progressive Caucus’s (CPC) “People’s Budget” is an alternative to the Obama budget and Congressional proposals. Proponents claim that its combination of investment in infrastructure, jobs and occupational training, as well as rolling back the trend of economic inequality is the sort of fiscal action that could make this recovery more robust. The budget favors deficit spending now to reach full employment, increased consumer spending, and wage growth that would allow us to reduce deficits in the long-term more sustainably than austerity and “fiscal discipline” now. Some of these ideas are taking broader hold, with Secretary Clinton advocating for a larger infrastructure program within her first 100 days in office and Donald Trump acknowledging the need to invest in infrastructure. Indeed, Mr. Trump’s has proposed spending double that of Secretary Clinton’s $275 billion infrastructure plan.
Deficit spending and demand-enhancing fiscal policy could set the stage for reducing deficits in the long run.
Deficit spending and demand-enhancing fiscal policy could set the stage for reducing deficits in the long run. As an economy reaches full employment, growing output, and increasing investment, more tax revenues can be collected by the state—which can offset some costs of government spending. But budget proposals might also include corresponding tax increases down the road on the rich and corporations designed to increase revenues while redressing economic inequality (something that has also made this recovery less robust than past business cycles).
We seem to be at a moment in which fiscal stimulus is again becoming acceptable in the United States and elsewhere. In Britain, the new prime minister is in favor of reducing austerity constraints. In the United States, Secretary Clinton’s programs are carefully attached to tax increase proposals, or pay-fors. But she is also recommending doing away with the sequester and hasn’t suggested how to fund the increased spending. The upshot is that a net fiscal stimulus is likely. Indeed, the federal deficit in the United States will already increase as a percentage of GDP this year.
We see an opening for constructive policy that can get America back on track. Indeed, fears of secular stagnation and productivity weakness could be be significantly lessened by appropriate fiscal action under the next president.