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.

The American public education system is by many accounts a train wreck. We consistently fail to motivate and educate the poorest third of our children. Poignantly, we even seem to be failing poor children who score highly on aptitude tests when they are very young.

Without developing skills in math and science it is highly unlikely that these children will be able to reach their potential as contributors to the American economy and consequently they are likely to earn very low wages and be poor as adults.

This is a deep problem.

However, it is not a problem that suggests the United States will face high unemployment or unstable prices. A macro-economically healthy economy will create low wage jobs for our low skilled workers. Overall GDP will be lower. More or our citizens will live in poverty. The pace of human knowledge expansion will slow. However, the macro-economy will be steady and the Fed will have done its job.

What tells us that the Fed is failing is that there are not enough low wage jobs to employ all of our low skilled workers. Moreover, this is happening at exactly the same time that price growth is slower than its long run trend.

The challenge of Central Banking is the goals high balance job creation and low inflation. When job creation is slow and inflation is lower than our long run goals the Central Bank is failing.

This is not the fault of fiscal policy. This is not the fault of microeconomic problems like poor education or a crumbling infrastructure. This is not the fault of a private sector that is unwilling to do its part.

This is the fault of a Federal Reserve hamstrung by a gutless unwillingness to do its job. Though I would rate the performance of the ECB as vastly worse, at least it has the excuse that it is only official task is holding inflation steady. This, like the Eurozone itself, was a dreadful policy decision, but it is the world we live in.

The Federal Reserve on the other hand has a dual mandate which it is consistently and flagrantly ignoring. Offering sympathetic sounding bromides about the need for policy makers to work together may make Federal Reserve officials feel better about themselves but it disguises the deeper truth that the failure of the US economy to reach full employment is their failure.

The erosion of skills, the decline in capital formation and the destruction of lives that stem from high unemployment is the doing of one policy institution.

The Federal Reserve knows exactly what it needs to do to remedy this situation: commit to zero interest rates until nominal spending in the US economy is within 2% of its 1990- 2007 trend line.

That the Federal Reserve refuses to do this is a choice that it alone must answer for.