Now that we’ve determined that the economy is destined for a decade or more of depressed growth with no hope, it’s perhaps a small comfort that one important policymaker actually views this as a huge problem which he could play a role in solving. Charles Evans of the Chicago Federal Reserve released a paper yesterday spelling out why high unemployment is a huge failure of Fed policymakers.
In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.
The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.
That this is a refreshing change of pace is truly an indictment of Fed biases. 5% inflation would inspire comparisons to Zimbabwe in this country. 9% unemployment elicits a yawn. That’s ridiculous, and Evans is right to point that out.
He also makes the greatest rebuttal I’ve seen to the Rogoff-Reinhart idea that financial crises automatically lead to a long period of recovery. Basically, he says this is a chicken-or-the-egg fallacy:
In their book This Time is Different, Carmen Reinhart and Ken Rogoff documented the substantially more detrimental effects that financial crises typically impose on economic recoveries. Recoveries following severe financial crises take many years longer than usual, and the risk of a second recession before the ultimate economic recovery returns to the previous business cycle peak is substantially higher. In a related study of the current U.S. experience, Reinhart and Rogoff show that the current anemic recovery is following the typical post-financial crisis path quite closely, given the size of the financial contraction. It would be nice to point to some features of the recovery that suggest greater progress relative to the Reinhart-Rogoff benchmark. But those are hard to come by.
It bears keeping in mind that the Reinhart-Rogoff predictions of a slow recovery are based on historical averages of macroeconomic performances across many different countries at many different times. They highlight a challenge we face today, but from the standpoint of the underlying economic analysis, there is nothing pre-ordained about these outcomes. They are not theoretical predictions—rather, they are reduced form correlations. The economy can perform better than it did in these past episodes if policy responds better than it did in those situations. In my opinion, maintaining the Fed’s focus on both of our dual-mandate responsibilities is a necessary and critical element of an appropriate response to the financial crisis that can produce better economic outcomes.
In other words, just because other policymakers abdicated their responsibilities after financial crises doesn’t mean that current policymakers have to fall into the same trap.
Evans’ paper is a serious response to the fatalists who think there is nothing that can be done. He wrestles with policy options at the zero lower bound, and the political implications of unorthodox policies. He believes that impressing upon elites the extreme nature of the crisis is the way to free up political will to meet these challenges.
This could be having an impact; Evans may be a leading indicator. The Fed could come up with a range of options at their two-day September meeting.
“Federal Reserve officials are considering three unconventional steps to revive the economic recovery and seem increasingly inclined to take at least one as they prepare to meet this month,” the Wall Street Journal reports. Fed Chairman Ben Bernanke, who is scheduled to speak later today in Minneapolis, is likely to reiterate that the central bank is studying all its options before officials meet Sept. 20 and 21. One step getting considerable attention would shift the Fed’s portfolio of government bonds so that it holds more long-term securities and fewer short-term securities. According to the Journal, “The move . . . is meant to further push down long-term interest rates and thus encourage economic activity.” A second, more controversial step under consideration would reduce or eliminate a 0.25 percent interest rate the Federal Reserve is currently paying banks that keep cash on reserve with the central bank. Some argue the Fed should not be in the business of rewarding banks for holding cash instead of making loans. “A third step Fed officials are debating would involve using their words to make their economic objectives and plans for interest rates more clear,” the Journal states. Some officials want the Fed to say what unemployment rate or inflation rate would trigger it to boost rates.
Removing the reserve payment seems like a no-brainer, as does using the communications channel (especially if it says something about accepting higher inflation). I don’t think much of the “Operation Twist” option, I think it hurts long-term savers and won’t do much on interest rates that would spur investment. But we have to try, and the failure of imagination isn’t foreordained. That was Evans’ point.