America’s slow average rate of economic growth is double trouble, as Federal Reserve Vice Chairman Stanley Fischer recently pointed out. First, it highlights the recovery’s lack of vigor; second, it suggests that a continuation of this slow growth could start to feel permanent, calcifying the economy’s pulse and leading to slower long-term output and employment growth. Particularly ahead of the Fed’s annual gathering of policymakers and economists in Jackson Hole later this week, the question arises as to what more the Fed can do to advance the recovery and job creation.
The short answer is “not much.” A longer and more complicated answer acknowledges that growth is a problem and policy does matter—but needed policy changes require action from the president and the Congress, because what is needed is mainly fiscal.
Recent answers in some quarters emphasize that the economy’s short-term woes trace back to the financial crisis and that longer-term challenges reflect “secular stagnation”—that is, that deeper problems in the economy will slow the rate of growth considerably in the coming years. These “answers” carry a Victorian feel of both punishment (where there was pleasure in the boom, economic pain cannot be far behind) and inevitability (we will need to adjust expectations). But these answers are too fatalistic, and they do not offer a guide to monetary policy now.
Monetary policy has, of course, played a role in the recovery. Bold decisions by the Fed to enhance liquidity as the financial crisis weakened economic activity were crucial to the bounce back. And fiscal actions to recapitalize banks helped patch over broken plumbing in the financial system. The Fed’s initial purchases of mortgage-backed securities helped restore more normal spreads between mortgage interest rates and Treasury yield, assisting the housing rebound. And initial Fed purchases of longer-dated Treasury securities modestly reduced long-term interest rates.
But now? Continued Fed purchases of longer-term Treasury securities likely have a quite small effect on yields and economic activity. While interest-sensitive spending for businesses (investment) and households (durable goods and housing) are important for GDP, many small and mid-sized businesses and most households (other than the wealthy) are unable to borrow at rates close to current default-risk-free interest rates. And ultra-low rates for an extended period of time send signals for financial and real investment that are divorced from economic fundamentals, leading to credit misallocation and asset bubbles. A legitimate concern arises that Fed policy is no longer anchored by a clear rule, creating uncertainty among financial market participants and business leaders about the future course of interest rates and the Fed’s exit from its present “do-what-it-takes” policy.
The Fed counters that it remains focused on entry first – entry into expanding employment, that is, restoring vigor to the labor market and job creation. This goal is a laudable one in line with the Fed’s dual mandate, but it raises two familiar worries. One concerns the Fed’s limited ability to fine-tune its policies; the second is about fiscal policy’s inaction in the face of structural problems. The first worry was expressed in Milton Friedman’s famous “fool in the shower” analogy: Turning dials too quickly without considering lags risks a shower of either cold or scalding water. (Though in the case of the Fed, it’s just as tricky to get out of its bond-buying “shower” as it was getting in.)
The larger concern is the structural one—that is, that the Fed’s tools are not so effective at remedying broad slack in the labor market. To see this, note that the Fed is focused principally on a bathtub of the labor market (to stretch Friedman’s shower analogy). As the bathtub fills with water, job creation can be thought of as the rate at which the water flows in, while unemployment is the space left in the tub before it overflows. The goal is to fill the tub to the top but avoid overflowing—in other words, causing inflation. At the present pace of job creation (while not a blockbuster, the six-month growth rate of nonfarm payrolls is largest since the spring of 2006), only a year would pass before the unemployment rate would arrive at the point where the Fed traditionally starts to worry about inflation. (Technically that means the rate would drop to the bottom of the Fed’s 5.2-5.5 percent for NAIRU—or “non-accelerating inflation rate of unemployment”—the level of unemployment below which inflation rises, while wage pressures are building.) Unless the Fed can increase labor force participation, the tub risks overflowing fairly soon under present policy.
What, then, can policy do to assist the recovery and employment? Simply put, business and household expectations of long-term growth need a jolt. And such a jolt must come from fiscal policy. By that I do not mean the “stimulus” policies pursued by the Obama administration to shift aggregate demand over time, but a dramatic shift in people’s expectations about the future. Such a shift must acknowledge structural problems in the economy—something the president has never really done.
Altering long-term expectations requires three categories of policy action: (1) removing policy barriers to growth, (2) offering a sustained boost to aggregate demand, and (3) supporting work.
Three of the key structural barriers to growth are business taxation, trade policy and immigration policy. No policy action offers a greater long-term support for growth than fundamental tax reform, with gains of 0.5 percent -to-1 percentage point per year in GDP growth over a decade, according to research by economists Alan Auerbach and Kevin Hassett. Much of this gain would come from improvements in business taxation—reducing marginal tax rates to enhance competitiveness and innovation. In addition, switching to consumption taxes would enhance investment at home and encourage U.S. multinationals to bring their overseas cash hoards home, while encouraging foreign multinationals to invest and create jobs in America. Reducing business taxes will also boost wages, as labor bears much of the burden of high business taxes.
The current kerfuffle over “inversions”—the controversial practice by which companies escape high U.S. taxes by relocating headquarters abroad—is a distraction from this bigger discussion. Trade policy needs to continue to emphasize opening of markets – a win for U.S. businesses and consumers – as in the Trans-Pacific Partnership. Immigration reform should start with the obvious goal of making the United States the most attractive place to work for the highly skilled.
A sustained boost to aggregate demand requires a long-term infrastructure strategy. The Obama administration’s early flirtation with “shovel-ready” projects was a distraction that failed to change business leaders’ longer-term expectations of demand. That limited investment and hiring. Sustained infrastructure spending offers that support, and legitimate concerns about waste can be addressed by both oversight and the use of public-private partnerships.
Finally, returning to the Fed’s concern, fiscal policy needs to shift to support the expansion of work. As with inversions and the stimulus, the Obama administration’s focus on the minimum wage is a distraction. The idea of a higher minimum wage is both poorly targeted and, if anything, will likely reduce the number of jobs. The Earned Income Tax Credit (EITC), an important tool with bipartisan approval, now centers more on family support than work support. Reforming the EITC to boost all eligible workers’ incomes (including single workers) or using wage subsidies to guarantee no poverty for working Americans is a big step toward reducing structural barriers against labor-force participation and work. Done in the context of tax reform, these changes are affordable and promote both growth and employment.
The bottom line is this: We are asking too much of the Fed and not enough of our elected officials. There is no reason the actions suggested here should not acquire bipartisan support. The president should submit plans to Congress for removing barriers to growth, enhancing demand and supporting work. If he does not, perhaps a new Congress can place them on his desk for signature.
R. Glenn Hubbard is dean of Columbia Business School. He was chairman of the Council of Economic Advisers under President George W. Bush and advisor to Republican nominee Mitt Romney's 2012 presidential campaign.