Lesson 5 The FED and Monetary Policy Gone Bad

In 2015 we in the US regard the Fed as the only macro policy game in town.   In macro we teach about macro problems and macro policies. Because Congress is largely dysfunctional there is little hope that they could pass a bill which adequately addresses macro problems. What is often referred to as fiscal policy, or use of government spending and taxes to address the economy, is now mainly neutered. That mostly leaves The Fed as the only policy game in town. 

So there is much attention focused on Fed policy. In this summer of 2015 we are told that the Fed will soon change its policy. But there is much uncertainty about when and by how much the policy will change. So the financial markets are a little crazy. And the economy bobs up and down. Do we really have to experience all this madness?

I think not. The problem is that the Fed is trying to do something it is ill-suited for. It has taken about 60 years to figure this out but I think it is getting plainer all the time. It is like the 40 year old man who after a brief bout of unemployment gets a new job. Yet his mother isn’t satisfied. Honey – did you brush your teeth before you went to work? Were you nice to your new boss? Did you polish your brown shoes? This man has things under control and he doesn’t need his mother giving him bad advice. Mom – stop it! Fed – stop it!

This Fed is like this doting mother. The economy might have needed some Fed support in 2008. But if you look at your calendar, you will note that was seven years ago. The recession ended in 2009 and the US economy has been expanding ever since. I know of no theory of macroeconomics that says that expansionary policy must continue until everyone on the planet believes there is a 100% chance the economy might not regress.

Think about the theory of macro policy. First, John M. Keynes did not believe monetary policy should be used to stimulate the economy.  He likened it to pushing on a string. Second, he did believe the government could and should stimulate the economy – using what he likened to a priming operation. In a priming operation the government spends a little more and taxes a little less to get a little bit of spending going. Presumably this injection of spending will increase our incomes and our confidence and get things moving. Like the ball in a pin-ball machine, the ball doesn’t exit before it bangs against numerous cushions that indicate increases in your score. The injection of a little bit of stimulus gets us all spending before the injection ball exits the economy.

Keynes was writing in the 1940s and much has happened to this humble theory in the last 70+ years. Keynes’ followers (Keynesians) decided to quantify all this and before we knew it we had an elegantly expressed general theory in which the government and the FED could alter monetary and fiscal policies to keep the unemployment rate always at full employment with a corresponding GDP Gap equal to zero. Gone was the priming issue. Gone was the skeptical attitude about monetary policy. And of course gone were the days of conservative government budgeting and near-zero inflation. 

Consider where we live now – in a world where

            it is expected that the Fed if not the government will stimulate until we reach full employment;

            we have annual budget deficits and almost no surpluses and a national debt that is soaring;

            inflation has followed EVERY significant policy stimulation; and

            these inflation bouts were followed by policy reversals that led to recessions or very slow growth periods.

Anyone with an objective attitude about macro policy as practiced in the US since the end of World War II could not be very happy with these results. We clearly have a frying pan- fire-frying pan experience. What went wrong? It seems pretty straight forward. Macro is a legitimate social science. If macro indicators are showing a significant recession or slowdown, then policy variables can be altered so as to increase aggregate demand which in turn stimulates other spending until the macro indicators can be drawn with happy faces around them.

That sounds pretty easy. But the truth is much different. Hey mom, I have a temperature. Okay honey. Stick your head in the refrigerator and you should be fine in a few minutes. That sounds pretty stupid. But our Keynesian approach to macro problems and policy is the same. Follow me on this. I believe in macro. I believe that when real GDP declines this is a problem needing study and remediation. Okay so far? But what I do not believe is that EVERY TIME real GDP or other macro indicators fail to achieve better values, that we have a generalized macro problem requiring monetary and/or fiscal policy.

How is it possible that a macro slowdown is not caused by macro factors? Simple. We have a macro construct called aggregate demand. And Jim and Toni have five kids. Peter slugs Diane and she cries. Then the other three kids cry. Uncle Charlie comes in and sees five unhappy kids and concludes that Jim and Toni have been abusing their children. He sees virtually the whole family in disarray. The problem must have been caused by the parents, Jim and Toni. That’s what our brilliant macro economists do when they see aggregate demand falling. If AD is going down, then macro policy needs to bring it back up. Presto!

But in my family example above, the problem is that Peter is a mean boy and slugs people. There is no family problem. There is a Peter problem. The solution should be to fix Peter (please no Jenner jokes) . Fixing the whole family is misplaced. It lets Peter off easy. It is inefficient and won’t lead to a solution for a happier family.

And so it is with a fixation on aggregate demand and the national unemployment rate. There may be times when all of aggregate demand is declining. And in those times a general AD approach might seem reasonable. But in many or most cases, the problem showing up in AD is really a specific problem stemming from housing, or autos, or Japan, or other parts of AD or AS. Yes, sometimes AD is falling because of aggregate supply problems. In these cases, AD policy is wrong and inefficient at best. The right policies are those that address the real problems be they housing or autos or Japan or AS.

Today our Fed continues a zero interest rate policy* that intends to stimulate aggregate demand. The leaders explain with great pride that they will not relent in this generous policy so long as we have even the tiniest negative GDP Gap. Yet the economy jumps up and down and financial markets have fits because there are plenty of problems with the economy that do not get addressed because the Fed is so focused on AD – and AD hasn’t been the problem for years. Should the economy continue to slowly heal itself despite the FED, we can be sure that we will soon be wondering why inflation got so bad so fast – and wondering why the FED's abrupt policy reversal is throwing us into the next recession. 

* One more point. A zero interest rate policy might seem innocent enough. But note that in order for the Fed to keep interest rates near zero, it takes actions. To keep interest rates near zero in the last two years meant increasing the money supply. This is done by increasing something called the monetary base. It grew by 39% from Q1 2013 to Q1 2015. The result was that the narrow version of money, M1, grew by 20% during that time period,. The wider version, M2, grew by 13%. Money is exploding despite the fact that we have a growing economy. This is risky business.