Is Our Economy Too Broken for the Fed to Fix It?

Noah Millman -- blogger for The American Conservative

A variety of much more knowledgeable commentators than I have been making the case for some time that the primary cause of our lingering economic difficulties is that the Fed has been too tight with money. Scott Sumner is probably the best exponent of this view, and of the view that a change in the Fed's policy framework is necessary to address this problem effectively for both the short and long term (if the Fed targeted NGDP rather than following some version of the Taylor rule, he argues, the policy responses during both the Great Recession and the Great Inflation of the 1970s would have been more correct), and he's won support from both the left and the right for his views - which makes sense because, from the left's perspective, he's making an argument for higher inflation and for placing a higher priority on reducing unemployment versus protecting the interests of asset-holders, while from the right's perspective he's articulating a policy alternative that could actually address our economic problems without increasing spending or the scope of involvement of the Federal Government in the economy (as a Keynesian fiscal policy would be likely to do).

But the implicit assumption behind a call to shift to NGDP targeting is that we know what the long-term growth potential of the economy is. But what if we don't?

If we don't -- if there's been a drop in the long-term growth potential of the American economy -- then an inflationary response will at best mask that fact. Assuming we can successfully target a 5% NDGP growth rate, there is a big difference between a situation where the inflation component of that rate is stable, whether it's stable at between 1.5% and 2.5%, and a situation where the inflation component of that rate is 3.5% and rising, and the real growth rate is 1.5% and falling, because while nominal growth is the right measure of economic activity, real growth is the right measure of wealth-generation.

Why, though, would such a drop have occurred? Did everybody's left arm fall off with the financial crisis? No, of course not. But there are a variety of possible explanations for why the long-term growth potential of the economy has deteriorated over time. The skill level of our workforce is stagnating, possibly because of poor productivity in the education sector, possibly because of demographic change, likely because of both. The tax system has grown markedly less-efficient since the last round of tax reform. The drivers of the financialization of the economy are hard to discern, but the effects aren't. The inefficiencies of our enormous health-care sector are well-known; that's 16% of the economy, and growing. The atrocious inefficiencies of infrastructure investment in America are less-well-known, but quite serious - we get less bang per buck than basically any other developed country, and as a consequence we have almost stopped investing in our physical infrastructure. Rent-seeking in the patent system, anybody? An over-extended military sector?

It's not actually hard to come up with a list - a list that withstands some scrutiny based on international and historical comparisons. None of the trends on this list appeared overnight, of course. The argument, then, is that these factors eroded the long-term growth potential for the economy, but that the market didn't respond to these facts because abnormally fast credit growth masked them, making it look like the growth potential of the economy was as strong as it had been. Which then raises the question: why was credit growth abnormally fast during the bubble period?

It seems to me that the monetary explanation of the aftermath of the crisis needs to be extended backward to account for the bubble that preceded the crisis. Was monetary policy too loose in the 2003-2007 period? If so, and this fueled the bubble, then unemployment was (effectively) too low and nominal growth too high during this period as well. Which, in turn, seems to me to bolster the position of those who argue for an underlying structural explanation of our problems. If the anemic growth of the Bush years was actually higher than it "should have been" with proper monetary policy, then that fact requires an other-than-monetary explanation.

Alternatively, one can argue that the bubble either wasn't caused by too loose money, or that financial crises don't "really" cause recessions, and would be relatively innocuous given the proper stimulative monetary response. But in that case, what did the bubble, and the financial crisis it caused, mean? What information were participants in the economy supposed to glean from the massive price signal of a global financial crisis?

The right answer to that question is precisely that expectations for the long-term growth potential of the economy should be adjusted downward - not because everybody's left arm has suddenly fallen off but because we've just realized that the weights we thought we were lifting with our left arms weren't measured in kilograms, but in pounds. We need to adjust our expectations of how much we can lift in the future accordingly. We aren't as strong - as wealthy, as productive - as we thought we were.

And the right policy response is a policy response. I feel sometimes like both left and right have wandered into a cul-de-sac where they argue not about what the policy response should be but about whether there should be a policy response at all. The Keynesian left argues that all we're dealing with is a shortfall in demand - a shortfall relative to a benchmark that assumes the pre-crisis trend was perfectly sustainable, of course - and that therefore all we need to do is increase demand, whether by loosening money or cutting taxes or increasing spending (it doesn't matter too much spending on what). A great deal of the negative political consequences of the first year or so of the Obama Administration's economic policymaking relate to the fact that this kind of "we have to do something and it doesn't matter much what so long as we do enough of it" attitude is lousy politics, but more because the economic results weren't all that was hoped either. The Norquistian right, meanwhile, argues that all we have to do is, on some level, nothing - that is to say, do less of whatever it is the government is doing. Tax less. Regulate less. Spend less. Don't worry too much about how the tax burden is structured, or the policy purpose of regulations, or what spending might be more valuable and what less, because by definition whatever the government does is destructive, so if it does less that's a net positive. Outside of the precincts of true believers, this is lousy politics, too, but it's also exceptionally lousy policy, and for much the same reason as the equivalent left-wing approach is: it isn't putting a priority on crafting good policy.

If expectations for long-term real growth (real wealth generation) have dropped, and this has become something of a self-fulfilling prophecy, then the policy response needs to change that expectation. That requires having policies that actually appear to be designed to improve the long-term real growth potential of the economy.

Higher expectations for long-term real growth will improve the short-term economic situation, and will also make it easier for the monetary authorities to continue to offer stimulus without triggering inflation. If the market were more certain that long-term expectations for the American economy matched the pre-crisis trend, then the Fed would have an easier time maneuvering us back to that trend, whether through NGDP targeting or anything other policy framework. There shouldn't really be an argument between the monetarists and the structural problems crowd about this, because if the structural problems folks are right, then fixing those problems is a prerequisite to closing the output gap. And if they are wrong, but their ideas are still worth doing, then not only are they still worth doing, they will make the monetary authority's job easier.