The U.S. economy is currently growing sluggishly and has too much unemployment. No one thinks this is a good thing. Indeed, at the IMF research conference last month, many economists expressed particular concern about the high youth unemployment rate in the U.S. and elsewhere and the negative implications of this for society.
They are right to be concerned.
The question is what should be done.
One answer is given by two economists of different political stripes. They are Paul Krugman and Ken Rogoff. Krugman is clearly a liberal; he even uses that word in the title of his widely read New York Times blog – “The Conscience of a Liberal.” Rogoff’s politics are somewhat less clear; I heard him say at a seminar arranged as part of the program of the World Bank/IMF annual meetings in October that he was not political, just a scholar. However, he was an adviser to the John McCain presidential campaign in 2008.
Even though they have had
disagreements, they both advocate that central banks in the current situation
target a higher inflation rate than the current two percent. (For example, see here and here.)
The principal argument of some
economists advocating a higher inflation target is that it is a way to achieve
a negative real rate of interest (the nominal interest rate is lower than the inflation rate), given that the Fed cannot lower nominal interest rates below zero. They believe that a negative real interest rate is
necessary to achieve full employment. Another reason, though this seems to be
less explicitly argued, is that inflation encourages current consumption (and
discourages savings). Consumers have an incentive to buy now before prices
increase. The resulting increase in consumption stimulates the economy.
There are a few problems with
these arguments. First, in the current period, the Federal Reserve does not
seem capable of increasing inflation. It has increased its balance sheet and,
hence, the monetary base to an unprecedented degree. This has not, though,
translated into rapid growth of the money supply and the current inflation
rate, as measured by the CPI, is less than 2 percent. (I have commented on this
here, here, and here.) There is, though, concern about possible
bubbles in stocks and bonds and in housing prices.
Second, assuming that the Fed
could eventually produce four percent or higher inflation, the economists making
the case for this seem to assume that there would not be a political reaction
reflecting heightened concern among the public about the future value of their
savings and their ability to generate earnings that keep up with inflation.1 In this regard, it is interesting to note that in July 1971, the CPI had risen
by 4.4 percent year over year. The next month, President Richard Nixon
announced wage and price controls (as well as severing the last remaining link
of the dollar to gold).
The public would be right to be
concerned about inflation. Monetary policy is a blunt instrument, and it is
doubtful that the Fed would be able to achieve a narrow target on the inflation
rate for a substantial period of time. Higher inflation also can feed upon
itself, as the aftermath of the Nixon’s Administration’s experiment with wage
and price controls demonstrates. If this happens, ultimately the Fed would have
to slam on the brakes and generate a recession, as Paul Volcker did when he was
Fed chairman. Targeting inflation is not the same as targeting a short-term
interest rate, such as the fed funds rate (the rate at which banks lend to each
other on an unsecured basis). Inflation is only observable with a lag, and it
takes some analysis and judgment to discern whether a higher or lower than expected monthly
number is due to a temporary aberration or is indicative of something more
permanent.
Finally, using fiscal policy is
preferable and more likely to be effective than monetary policy to stimulate
the economy in a prolonged period of sluggish growth (or worse). When the Fed
increases the monetary base, it does not directly add to demand. If the money
is lent out by the banks, the borrowers will spend or invest it. But what if the banks sit on a huge amount of
excess reserves, as they are doing now? Then nothing much happens to the real
economy except for whatever stimulatory effect there is from the increase in
the prices of the assets the Fed has bought (Treasury notes and bonds and
mortgage backed securities).
On the other hand, if the
government spends money, this directly adds to demand. In this regard, there is
a strong argument that the federal government should be investing in improving
infrastructure, both because infrastructure, such as highways, bridges, public
transportation systems, and water and sewer systems, need to be improved and
because such projects will put people to work. Krugman and Rogoff agree on
this, as does Martin Feldstein, who disagrees with the other
two on monetary policy. Also, if the federal government finances this by
increased borrowing rather than taxes, it can borrow very cheaply since
interest rates are too low. The cost in inflation-adjusted terms may even be
negative, if inflation turns out to be higher than the nominal rate at which
Treasury borrowed.2
The rejoinder to this argument
is that it is not currently politically possible to increase government
expenditures in any significant way. That is true, which is why the Fed feels
it has no choice but to follow an aggressive monetary policy. Janet Yellen
apparently believes that regulatory tools can be used to contain any bubbles
that may develop because of this before they cause too many problems. I hope
she is right, but I understand why the Fed needs to run this risk when fiscal
policy has been contractionary. It is a troubling fact that the current
economic distress and uncertainty have given rise to a populism of the right
that believes that shrinking government in the current situation will solve
economic problems rather than prolong them. It is also troubling that there is
a dearth of skilled and knowledgeable politicians who can lead the public to
understand the right solutions. Instead, we have a faction of the Republican
Party riding the Tea Party wave for opportunistic reasons, though it is
doubtful that they will reap the political benefits they hope.
While I think the Fed has no
good options other than following its current course, announcing an inflation
target of 4 percent would be a mistake. The risks of doing that are, I believe,
higher than Krugman and Rogoff appreciate. In any case, it is doubtful that it
is politically possible. While the Fed is an independent agency and insulated
from the political winds of the moment, it cannot totally ignore political
reality.
1. When I worked at Treasury, I was heavily involved in the discussions about and the development of Treasury inflation-indexed bonds (Treasury Inflation-Protected Securities or “TIPS”). One of the arguments made for Treasury issuing inflation-indexed bonds is that this would facilitate the private sector’s creation of other inflation-indexed products, such as inflation-indexed annuities or mortgages. There has not been much interest in other inflation-indexed products, except for mutual funds that invest in TIPS and, sometimes, physical commodities. Note, though, that, if there were greater use of inflation-indexed products, these instruments could have served to mitigate to a degree people’s fear of inflation, but at the same time they would also have acted to limit inflation’s ability to stimulate the economy.
2. Treasury
does not match particular security issuances with particular expenditures.
Therefore, as a practical matter, it is not possible to determine the borrowing
costs for any particular expenditure without making some assumptions.
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