The Fed, Quantum Physics, and Leeches

I have never read so much about the Fed as last week. It is as if I was an astrophysicist and everyone wanted to debate the probability of an atom decaying. Until recently the average guy in the street didn’t know anything about the Fed and now school children have opinions about tapering and professional basketball players are recommending their best friends to be the next Fed chairman.

I should be happy. Most of my life few people cared about the Fed and about macroeconomics and I had fewer visits than the famed Maytag Repairman. So now everyone wants to talk about the Fed. The problem is that the Fed has gone beyond its capabilities and most of the debates and discussions are so wrong-headed that it makes me want to spout. So here we are.

Wrongheaded is a pretty nasty thing to say about Ben Bernanke and his gang of misfits. But it is true. Let’s suppose you decided to go for a jog in the neighborhood. You were about to put on your favorite running shoes when your son suggested that you try wearing your winter boots to run in August. Your daughter then countered it would be much better to wear your flip flops. A discussion then followed about whether to wear flip flops or winter hiking boots for your run around the neighborhood in August. No I am not drinking JD at 10 am in the morning. This example makes a simple point – it is possible to have a debate whose answer will not be helpful. It has been posed in such a way as to deliver only a bad solution…and possibly a blister or two.

Much of the discussion these days about the Fed and about monetary policy revolves around a so-called choice of the Fed – should the Fed focus on inflation or should it emphasize unemployment. Bernanke has stated clearly that the Fed will continue to pour money into the economy at a very fast pace until the unemployment rate reaches 6.5%. That’s pretty clear language. Implicit in this goal is that so long as inflation does not come unglued and inflation expectations seem well anchored, it is okay to focus on the unemployment goal. I have already written a lot about inflation and inflation expectations so I won’t get into that part of this false debate.

What I want to address is the idea that the Fed can or should determine the nation’s money supply and interest rates based on something as specific as the unemployment rate. You might think that Bernanke has a magical megaphone that lets him speak to human resource directors or workers or labor unions or someone who might have some control over the unemployment rate.

Bernanke has none of that. He pretty much has one shovel that he uses to spew money into banks. Sometimes he requires short-term government bonds in exchange – sometimes he trades money for mortgage securities. But he really only has this one trowel. It is sort of like saying that if Florida was at war with Michigan, it should send troops into Georgia and before too long they would find their way to Detroit for the fighting. If you have ever been to Georgia or Tennessee you know that a lot of things could happen to divert these warriors – not to mention lard-soaked fried chicken and hot buttery hominy grits – as they trudged northward. It might make more sense to drop these fighters in Ohio and hope they could make their way to Michigan from there.

It is the same thing with monetary policy. Bernanke’s shovel cannot create one single 

job. In fact, notice that the Fed’s goal is not spelled out as JOBS OR EMPLOYMENT. He did NOT promise to stop the monetary flood gates when 300,000 jobs were created per month. He had to make it even more impossible! He wants to get the unemployment rate down to 6.5%.

For those of you who forgot to memorize the definition of the unemployment rate, you will now have to do 20 push-ups. It is a simple division of the number of people counted as unemployed divided by the number of people in the labor force.  These numbers come from the now-famous Gangnam-style dancing. No not really – these two critical pieces of information come from something called the Bureau of Labor Statistics Household Survey. There is one and only one “official" unemployment rate for the country. It is calculated and reported each month.

Sure the unemployment rate in California is different from the one in Kentucky, but Bernanke doesn’t care about those differences. He wants the national number to get itself below 6.5%. So if you are in a state with a high unemployment rate when the national rate improves – then Bernanke apparently does not care about you.

But that is small potatoes. Notice what happened last Friday when the unemployment rate was announced. It fell from 7.6% to 7.4% -- edging closer to the magical 6.5%. 

You would have thought that Bernanke would have been driven through the national capital in the pope mobile with teenage girls shrieking and trying to shred his clothes. The reaction to the news of the unemployment rate falling was muted because the improvement was not the main result of a lot of new good jobs – but instead was the result of a few more low-paid part-time jobs coupled with another hunk of people deciding they could not find jobs so they left the labor force. The more people leave the labor force (for you math jocks – the more the denominator of the unemployment equation declines) the better is the measured official unemployment rate.

So here’s the point. Bernanke has his eye on the wrong ball. He might as well be sending soldiers into Cuba to win a war in Luxembourg. 

But here is a bigger point. There is no single macroeconomic indicator that will unambiguously communicate that the US patient is well again. There will always be strengths and weaknesses in the national economy. A simple rule that focuses on any single variable is bound to fail when the nation’s welfare is jointly determined by employment, unemployment, wages, consumer spending, the share earned by the middle class, the housing market, and much more. And of course, with one shovel, the Fed just doesn’t have the equipment to get the job done.

Unemployment can be improved. A nation has a lot of tax rates and government regulations that fall under what is often called fiscal policy. I am not going to oversimplify the myriad short- and long-term factors that are causing unemployment to rise in the USA. What I am going to say is that unemployment is like many issues that can be objectively analyzed. What is causing people to drop out of the labor force? Why aren’t firms hiring more workers? Why are wages not keeping up with inflation?

Rather than have a real debate about how to reduce the unemployment rate with effective and intuitive tools, we would rather cling to old-fashioned, inappropriate yet popular approaches. It is as if modern doctors kept advocating blood sucking leeches despite advances in medical technology and pharmacology. Current monetary policy is like a leech, it is not only harming the patient but is preventing effective remedies from being discussed.