Tuesday, March 03, 2015

Is the Best Path to Prosperity Too Boring to Talk About? Tom Palley Doesn't Think So

-- Posted by Neil H. Buchanan

During the Great Recession and its punishing aftermath, the most obvious place to begin any policy discussion was with government spending and taxing, aka fiscal policy.  Fiscal policy can seem boring (especially the tax part), but it is actually quite easy to describe its flesh-and-blood importance.  Whether to provide extended benefits to unemployed workers, to give tax credits to home buyers, to pay for infrastructure spending, to provide funds to states to prevent teacher layoffs, to cut taxes on businesses and the rich in the hope that their prosperity will trickle down on everyone else, and so on, are the debates that drive U.S. politics (and, I suspect, politics everywhere).  In one way or another, we are always asking how the government should use its powers to spend (or not) and tax (or not), such that people's lives are improved.

In the background of all such discussions is the financial system.  When the Federal Reserve reached the point where it had reduced short-term interest rates effectively to zero, it was left with two policy levers: (1) "quantitative easing," which was essentially a way to indirectly decrease the interest rates that the Fed does not control directly, and (2) making sure that the financial system would be stable enough to support the recovery and to make sure that the post-recovery boom (still just around the corner!) would not lead to another crash.

But the Fed, and monetary policy, really are boring.  Most people cannot become especially agitated about the Fed, because it is all too abstract.  ("Why do I care what the Federal Open Market Committee said about the long-term path of the fed funds rate?")  Most people, that is, but not all.

On the right, although most of the current Republican Party is as bored with monetary policy as is the rest of the world, there is rising anti-Fed fervor, due to what must now be called the Rand Paul Wing of the party.  That wing has always existed, but with Paul now emerging as the golden boy of movement conservatives (winning the otherwise-meaningless presidential preference poll at last week's Conservative Political Action Committee conference), the anti-Fedsters are in their glory.

The problem is that the right-wing critique of the Fed is nonsense.  Ever since the U.S. went off the gold standard in the 20th Century, there has been a group of people who are sure that the Fed is up to no good.  Fed conspiracy theorists exist on the left as well (and were trying to influence the Occupy movement a few years ago), but it is on the far right where anti-Fed fervor thrives.  There is no serious anti-Fed politician on the left, much less one as influential as Paul is on the right.

And Paul's recent attempt to intimidate the Fed by "auditing" it is insanity.  For an excellent description of how well audited the Fed already is -- and, more importantly, for a fun take-down of Paul's special brand of crazy -- readers should check out Matt O'Brien's recent "Clueless in Kentucky: Rand Paul’s ideas about the Fed make absolutely no sense," in the Washington Post.  (I have also posted some thoughts along these lines here on Dorf on Law, e.g., here and here.)

None of this, of course, means that the Fed is a perfect institution.  Indeed, it is designed to be a creature of Wall Street, insulated from popular meddling by a process that puts conservative insiders in positions of power.  If anything, the Fed (and even more, the European Central Bank) has been subject to capture by people who are solely interested in fighting inflation, even when inflationary threats are imaginary, and who are uninterested in having the central bank try to reduce unemployment or enhance long-term growth.

That Ben Bernanke (a Republican) and Janet Yellen (a Democrat) have engaged in policies that anger some people on Wall Street does not make them lefties.  They are open-minded pragmatists, and they have been able to see that the Fed has the latitude and the responsibility to do what it can to minimize the damage of the 2008 crisis.  They still, however, are (or were, in Bernanke's case) part of a system in which a premature move to restore monetary austerity is the default position.

Tom Palley, an economist who is a policy advisor at the AFL-CIO, provides a useful analysis of how that default position harms the economy, and how it can be changed.  (He has provided his analysis both as an op-ed and as an academic policy paper.)  Palley reminds his readers that the Fed is legally required to try to achieve full employment, and he advocates a "test the waters" method of setting monetary policy that would do just that.  Essentially, this means that the Fed would take an expansionary approach, even as the economy continues to improve, until it finds the point at which we have reached full employment, and respond to any inflationary pressures only once they have become apparent (rather than the preemptive approach favored by Wall Street and its backers).

Palley, though clearly a man of the left (see, e.g., here), is hardly describing anything radical.  There is no equivalence here between the frothing anti-Fed right and the left critique of the Fed's policy mix that Palley describes.  He is simply saying that the Fed has the ability (and the legal mandate) to change the way it sets policy, such that it could set the stage for real prosperity, by supporting increased hiring as a way to push up wages, and thus to support the return of a vibrant middle class.

As the title of this post indicates, however, talking about this path to prosperity runs the risk of simply being too boring to talk about.  One man became President by repeating ad nauseam, "Read my lips: No new taxes," and then he lost his presidency by agreeing to increase taxes.  It is doubtful that anyone will win the Presidency on the platform, "Read my lips: The Fed is too conservative in setting monetary policy."

Still, Palley's economic analysis is right.  And he might even be right about the politics.  If someone on the left-ish side of the Democratic Party wants to back an idea that would genuinely help to support long-term growth in incomes and prosperity, she or he must understand that the Fed alone holds the ability to enhance or undermine everything else that we might do to help the middle class.  Carefully reading Palley's work would be a good place for that politician to start.


tjchiang said...

Monetary policy used to be something that presidential candidates had quite a lot of say about. See, e.g., William Jennings Bryan. And I agree that the Fed's insulated structure has a tendency to make it biased in the direction of banker interests, since its members are drawn from that pool. But that is not really different from saying that the judiciary's insulated structure tends to make it biased in the direction of lawyer interests, since its members are drawn from that pool. In both cases, it is not clear that the benefits of greater political responsiveness are worth the costs of greater political interference.

David Ricardo said...

The problem that most economists and most policy makers have with monetary policy can be illustrated with the following passage from this post.

“Palley reminds his readers that the Fed is legally required to try to achieve full employment, and he advocates a "test the waters" method of setting monetary policy that would do just that.”

The problem, monetary policy alone cannot achieve full employment. Low interest rates and readily available credit are a necessary but not sufficient condition for economic expansion. The other necessary but not sufficient condition is an increase in Aggregate Demand which must come from fiscal policy. Neither fiscal policy nor monetary policy alone can bring an economy out of recession and move it towards full employment. That this concept should be so difficult to understand and accept is one of the true mysteries of current economic policy analysis.

Need proof? Compare the European experience with the U. S. experience in recovering from the Great Recession. Monetary policy is not symmetric. An increase in interest rates and reduction in the availability of credit will stop an expansion and create a recession all by itself. A decrease in interest rates and increase in the availability of credit will not in and of itself stop a recession and create an expansion.

Palley hints at this in his discussion of the role of infrastructure and the role that the Fed could play in supporting bonds to finance infrastructure. But no progress can be made until economists and policy makers alike stop thinking that cutting interest rates from 1% to .75% and flooding the system with bank reserves for which there is no demand will alone solve economic problems of high unemployment and start thinking Aggregate Demand to complement the monetary policy.

Shag from Brookline said...

Thomas Edsall's column in the NYTimes today focuses on Larry Summers' current positions concerning low demand for employment and the need for various government actions that will make conservatives even testier.

Bob Hockett said...

Hear hear, Neil and all three commentators thus far. Two quick supplementary points:

(1) That loose monetary policy alone will not suffice to jumpstart growth has happily been widely noted for a good while now - hence the 'pushing on a string' simile that gained popularity circa 2010. Also gratifyingly widely observed has been the role that QE-pursuit notwithstanding low aggregate demand plays in fueling mini-bubbles in various sectors - notably commodities, whose inflation disproportionately harms the non-wealthy. What has been less widely noted, though I've been trying to bang the drum for a while (including here on DOL in October 2011), is that the Fed could render QE less harmful and possibly even more helpful by actively working to SHORT assets whose prices QE artificially pushed up. That would be a radical move in a sense, but nevertheless a straightforward extension from QE3 and FRBNY's Maiden Lane programs.

(2) It is possible that there is some underestimation here of the threat to the Fed posed by a few on the left. While the latter was admittedly most pronounced at Zuccotti Park back in 2011, there's been a fair bit of raking the Fed over the coals of late by Senator Warren and some other progressives. Their critiques are quite sound and to be applauded, but I fear we might soon have to take pains to make clear to the uninitiated that they are of a different order than those from the yayhoos.

Thanks again!


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