The Federal Reserve's Utter Policy Failure

Karl Smith -- Assistant Professor of Public Economics at UNC-CH & Blogger at Modeled Behavior

PIMCO CEO Mohamed A. El-Erian gave a speech at the St Louis Fed in which he argued that the Federal Reserve and the ECB were trying to solve the world's problems alone, but they can't and need help from others.

What I take as his key points:

While central banks can -- and have -- stabilized things, there is little they can do on their own to engineer the fundamental realignments that must accommodate seven specific dynamics in advanced economies (something that we will come back to later in discussing the way forward):

  • Accommodating the "safe" debt de-leveraging of the private sector by enabling high sustained growth
  • Safely de-risking the financial sector
  • Clearing or replacing clogged credit pipes
  • Achieving a sustainable trajectory for public finances
  • Improving the functioning of the labor market
  • Compensating for inadequate past investments in human resources, productive capacity and infrastructure
  • Adjusting to the ongoing developmental breakout phase in several systemically important emerging countries (including Brazil, China, India, and Indonesia).

To be effective, central banks in advanced economies needed -- and need -- help from other policymaking entities to deal with the twin unfortunate realities of too much debt and too little growth. They must be assisted with the engagement of the healthy balance sheets around the world, and fortunately there are quite a few of them in both the public and private sectors. And this must be done in an internationally coordinated fashion in order to accommodate the new global realities.

El-Erian is attempting to tease apart what monetary policy can and cannot do, yet paradoxically he falls prey to the commonplace conflation of macroeconomic and microeconomic goals.

Put simply, the goal of macro policy is to balance maximum employment against stable prices. This, however, is easily confused with goals relating to growth, prosperity and health of public and private balance sheets.

Because, population and productivity have grown consistently in the capitalist world for the last 300 years or so, the only time that we have experienced strongly negative economic growth -- general declines in prosperity and widespread deterioration in balance sheets -- is during recessions and wars.

Central Banks don't have direct control of wars but they do control recessions. Thus its natural to think that the goal of central banking is to produce growth, prosperity and financial health.

However, on a basic level its not. If the economy is running at maximum employment and the prices are moving in a steady and predictable fashion then the central bank has done its job. What happens to growth is ultimately not the Fed's concern.

Consequently, when folks like myself point out the ongoing abject policy failure of the Federal Reserve and the absolute nightmare that is the ECB, our complaint is not about growth, it is about employment.

Let me be more concrete.

Presented by

Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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