Macro Solutions, Practical And Otherwise

President Obama outlined a new plan to create jobs last night in his speech before a joint session of Congress, although the old debate about what’s keeping the economy from recovering in a meaningful way rolls on. But if the perspective appears fuzzy on cause and consequence, Paul Kasriel, chief economist at Northern Trust, insists that your perspective isn’t properly focused. As a solution, he dispatches a crisp review of what went wrong and what, in theory, could go right, assuming a certain institution headed by one Ben Bernanke acts decisively.

Kasriel begins by noting what isn’t a problem. For example, some pundits charge that the recovery is being held back by the weight of uncertainty on businesses, which are said to be responding by refraining from investment and spending. But the numbers suggest otherwise, as Kasriel points out in this chart, which shows a strong rise in real business expenditures recently.

“If there has been so much uncertainty,” he asks, “why have businesses been so willing to purchase capital equipment and software?”
Kasriel goes on to use the numbers to show:
• The case for arguing that U.S. businesses are no longer competitive because of “high taxes and regulation” looks weak in light of the sharp rise in the country’s real exports of goods and services.
• Federal government spending hasn’t exploded on the scale that some politicians suggest. As evidence, Kasriel offers a graph that shows the 12-month percentage change in cumulative total federal outlays is relatively low vs. the past decade while real federal government consumption/gross investment is near a 20-year trough.
• The charge that record federal deficits of late are “crowding out” private spending by raising bond yields doesn’t stand up to scrutiny either.
• The argument that the weak economy is due to structural unemployment looks weak too. Instead, it’s mostly cyclical, which implies that we need cyclical solutions.
What’s the solution? Kasriel explains why the Fed is the only true choice left, and economist Milton Friedman, the former darling of the GOP, would agree. “Some dare call it quantitative easing treason,” but that’s misinformed, he asserts:

Because the essence of quantitative easing is for the Federal Reserve to create the credit that depository institutions would otherwise be creating under normal circumstances, rather than specifying ahead of time the amount of securities it would purchase, the Federal Reserve should purchase an amount of securities such that combined Federal Reserve and depository institution credit grow at some specified target rate, perhaps consistent with some desired rate of growth in nominal domestic demand.

By targeting a growth rate in combined Federal Reserve and depository institution credit, the Federal Reserve would have the added benefit of guidance
with regard to its “exit” strategy.

As depository institutions become able to create more credit, the Federal Reserve would begin to scale back its purchases or engage in sales of securities so as to not exceed its target growth rate of combined Federal Reserve and depository institution credit.

The bottom line: “In the face of weak and/or contracting growth in depository institution credit and the absence of quantitative easing, what otherwise might be the case could be declines in goods/services and/or asset prices, similar to what occurred in the early 1930s.” Is this doomed to bring uncontrollable inflation that wrecks the economy? No, Kasriel explains:

If the Federal Reserve conducts its quantitative monetary policy so as to achieve a rate of growth in combined Federal Reserve and depository institution credit consistent with some moderate rate of growth in nominal domestic demand, say 5%, then there will not be excessive sustained increases in the prices of goods and services nor will there be asset-price bubbles.

Kasriel’s view might be easily dismissed if he were a long voice in the wilderness. In fact, it’s easy to find like-minded dismal scientists espousing similar views. True, this group is in the minority, but the collective influence of voices like Scott Sumner, Marcus Nunes, David Beckworth, and others seems to be rising… maybe.
Talk is still cheap, of course, and skepticism remains high as to what the Fed could do, or will do. But the stakes are clear, even to some within the Federal Reserve system. As Charles Evans, president of the Chicago Fed, explained earlier this week:

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

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.