Glenn and Donald Kohn on the Report of the Task Force on Financial Stability

   Glenn co-chairs the Task Force on Financial Stability with Donald Kohn, now a fellow at the Brookings Institution and formerly vice-chair of the Board of Governors of the Federal Reserve. The Task Force on Financial Stability was formed by the Initiative on Global Markets at the University of Chicago and the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution to make recommendations intended to increase the stability of the U.S. financial system.

On June 29, 2021, the Task Force issued a report, which can be found HERE. Glenn and Donald Kohn discuss the reports findings in an opinion column published on bloomberg. com.

The Federal Reserve building in Washington, D.C.

Our Financial Early Warning System Is Broken

The U.S. financial system emerged from the reforms that followed the 2008 global crisis stronger than it had been going in. But the onset of the pandemic in March 2020 demonstrated how much was left undone: Although banks weathered the storm well, financial disruptions elsewhere — in money market funds, in the Treasury market — necessitated extraordinary measures to prevent an even greater economic disaster.

A group that we co-chair, the Task Force on Financial Stability, has just released a report on how to make the system more resilient. Among other things, we see the need for a structural change: Overhaul the agencies tasked with identifying and addressing threats outside traditional banks.

The Dodd-Frank financial reform of 2010 created two new entities focused on systemic risk. The Financial Stability Oversight Council, which included the Treasury Secretary and the heads of all the major financial regulatory agencies, was supposed to foster collaboration in finding and fixing dangerous buildups, wherever they might arise. And the Office of Financial Research, formed within Treasury and equipped with subpoena power, was supposed to provide the FSOC with the data and analysis needed to do the job well.

This financial early warning system didn’t operate as intended. The FSOC’s efforts to impose special scrutiny on certain systemically important non-bank institutions, such as insurance companies, ran into legal and political headwinds. Its member agencies often proved reluctant to encroach on one another’s turf, and the FSOC lacked the power to compel action. The OFR never subpoenaed anything, for fear of making enemies. Ultimately, the Trump administration deemphasized and defunded the whole apparatus.

As a result, the U.S. was much less prepared for the shock of the pandemic than it could have been. A rush to cash triggered runs on certain money-market mutual funds, threatened the flow of credit to everyone from homebuyers to municipalities, and — in a troubling departure from the usual “flight to quality” — caused the prices of Treasury securities to fall sharply. The Treasury and the Federal Reserve had to go to extreme lengths and pledge trillions of dollars to restore stability.

Regulators’ objective should not be merely to put out fires once they see smoke, but to prevent the dangerous accumulation of combustible material. New threats will emerge in unexpected ways; solutions will prompt unanticipated responses. So regulation must be dynamic, requiring an ongoing assessment process, not just periodic changes. To meet that challenge, we urge a restructuring of the FSOC and the OFR.

  1. Congress should give each FSOC member agency an explicit financial stability mandate, and require each to establish a similarly focused office to inform its rule making. This would force agencies such as the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Consumer Financial Protection Bureau to consider systemic-risk issues that they can otherwise too often neglect.
  2. Only the Treasury Secretary should issue the FSOC’s annual report, avoiding the consensus-building process among member agencies that can weaken identification of risks and accountability for dealing with them. While each agency would write a separate appendix, the Secretary would bear ultimate responsibility. The report should include a look back at what risks were missed, why, and how they will be addressed. To ensure the subject gets adequate attention, a new under-secretary for financial stability should act as the secretary’s point person.
  3. The OFR should receive a clear new mandate to gather the data that policymakers need (and, today, often lack). To underscore its importance, it should be renamed the Comptroller for Data and Resilience — echoing the stature of the Comptroller of the Currency — and its head should have a voting seat at the FSOC, a level of authority that would help the government recruit talent and experience to the post.

As the pandemic begins to recede, concern over financial stability should not. We don’t know what major shock will next hit the economy and financial system. But a process to scan for risks and adapt to them should be front and center.

Glenn’s Take on the Proposal at the G7 Meeting to Impose a Minimum Tax on Corporate Profits

   The G7 (or Group of 7) is an organization of seven large economies: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. Only democratic countries are included, so China is not a member. At a recent meeting attended by U.S. Treasury Secretary Janet Yellen, the group agreed to adopt a uniform corporate tax rate of at least 15 percent.

Glenn discusses this decision in the following opinion column published in the Financial Times.

U.S. Treasury Secretary Janet Yellen and Paolo Gentiloni, European Commissioner for Economy, at a recent meeting of the G7.

Governments Should Tax Cash Flow, Not Global Corporate Income

From the Biden administration’s inception, US Treasury Secretary Janet Yellen has championed a global minimum tax for corporations. While the US walked back from a request for a 21 per cent rate (which was linked to an objective of raising the current US corporate tax of 21 per cent to between 25 and 28 per cent), it did lock in with G7 finance ministers a rate of at least 15 per cent. Secretary Yellen praised the move: “That global minimum tax would end the race to the bottom in corporate taxation, and ensure fairness for the middle class and working people in the US and around the world.”

It is tough to argue that corporate income shouldn’t pay its “fair share”. But the global minimum tax raises both political and economic questions.

Politics first. Approval in the US is likely to be tough. The minimum tax is estimated by the OECD to raise as much as $50bn-$80bn per year, much of it from successful American firms. Revenue to the US Treasury would be part of this amount, but small relative to the substantial expansion in spending proposed by the Biden administration. Will other governments engage their own political costs to achieve a deal that may be ephemeral if it fails to get US legislative approval? Even if the deal succeeds, might it hand a competitive victory to China? As a non-party to G7 or OECD proposals, could it not use both tax rates and subsidies to draw more investment to China?

But it is on economics that the global minimum tax draws more sensitive questions in two areas. The first is the design of the tax base. The second addresses the foundational question of the problem policymakers are trying to solve and whether the new minimum tax is the best way to do so.

A 15 per cent rate is not particularly useful without an agreement on what the tax base is. Particularly for the US, home to many very profitable technology companies, the concern should arise that countries will use special taxes and subsidies that effectively target certain industries. The US has had a version of a minimum tax of foreign earnings since the Tax Cuts and Jobs Act of 2017 enshrined GILTI (Global Intangible Low-Taxed Income) provision into law. The Biden administration wants to use the new global minimum tax to raise the GILTI rate and expand the tax base by eliminating a GILTI deduction for overseas plant and equipment investments.

For a 15 per cent minimum rate to make sense, countries would need a uniform tax base. Presumably, the goal of the new minimum tax is to limit the benefits to companies of shifting profits to low-tax jurisdictions, not to distort where those firms invest. The combination of a global minimum tax with the broad base advocated by the Biden administration could reduce cross-border investments and reduce the profitability of large multinational firms.

A still deeper economic issue is that of who bears the tax burden. I noted above that projected revenue increases are small compared to G7 government spending levels. It is not corporations who would pay more, but capital owners generally and workers, according to contemporary economic views of who bears the burden of the tax.

There is a better way to achieve what Yellen and her finance minister colleagues are trying to accomplish. To begin with, countries could allow full expensing of investment. That approach would move the tax system away from a corporate income tax toward a cash flow tax, long favoured by economists. In this revision, the minimum tax would not distort new investment decisions. It would also push the tax burden on to economic rents—profits in excess of the normal return to capital—better satisfying the apparent G7 goal of garnering more revenue from the most profitable large companies. And such a system would be simpler to administer, as multinationals would not need to set up different ways to track deductible investment costs over time in different countries.

In the debate leading up to the 2017 US tax law changes, Congress considered a version of this idea in a destination-based cash flow tax. Like a value added tax, this would tax corporate profits based on cash flows in a given country. The reform, which foundered on the political desirability of border adjustments, limits tax biases against investment and boosts tax fairness.

Returning to the numbers: countries with large levels of public spending relative to gross domestic product, as the Biden administration proposes, fund it mainly with value added taxes, not traditional corporate income taxes. A better global tax system is possible, but it starts with a verdict of “not GILTI.”

Glenn on Keynes, Hayek, and What It Will Take to Return to Full Employment

   Glenn wrote the following opinion column for the New York Times.

How to Keep the Economy Booming — And Meet the Demand for Workers

In recent economic news, optimists and pessimists could both find evidence to support their outlooks.

The May jobs report showed a gain of 559,000 jobs in May and a decline in the unemployment rate to 5.8 percent. It also showed a marked improvement from last month’s weaker showing across a number of sectors, and average hourly earnings continued to rise. Ahead of the monthly report, the unemployment insurance weekly claims report on Thursday showed the number of new unemployment insurance claims fell from 405,000 the week before to 385,000 — lower than levels typically indicative of a recession (400,000). This is the first time this has happened since the pandemic-induced closures began. Further wage growth should help draw more workers back to the labor force.

Yet at the same time, the recent jobs report showed a big miss relative to the expected gain of 650,000 jobs. Constraints in supply chains and business reopenings still complicate the return to work. And workers still aren’t out of the woods: Thursday’s report indicated the total number of already unemployed individuals claiming benefits hasn’t dropped since mid-March. If job creation is robust, that contrast between falling new claims and those still on the jobless rolls is odd.

What explains these confounding tensions? To unpack them, consider the legacies of the economists John Maynard Keynes and Friedrich Hayek.

In his day, Keynes argued for boosting aggregate demand during a recession to keep workers afloat — a prescription that has clearly shaped the ultra-stimulative fiscal and monetary policies from both the Trump and the Biden administrations. His influence also resonates in the recent jobs reports: The coming rebound in the consumption of services — restaurant meals, entertainment and travel — will lift demand above its prepandemic level, and reopening and abundant consumer cash, bolstered by policy, will increase the demand for workers.

While Keynes may have lit the path to recovery after last spring’s cataclysmic job loss, he offers little to guide us through the coming labor-supply crunch. If policy actively disincentivizes the unemployed from returning to the fold, as recent reports suggest, there will be no one in place to meet the coming surge in demand, imperiling our economic rehabilitation.

To preserve the still-shaky recovery, we must now turn to Hayek, the godfather of free-market thinking. He argued that policy should allow workers to adjust to changes in the economy. Looking ahead, policymakers must consider curbing elevated unemployment benefits and a focus on old, prepandemic jobs in order to let workers and the economy adjust to new activities and new jobs that are more promising in the postpandemic world. We don’t want unemployed workers to find the postpandemic economy has passed them by.

As demand revives, supply will need to keep pace. Those in some industries, like carmakers, can simply sell off excess inventories, something that is already happening. Tool and machinery makers can increase imports to keep up. But eventually, demand must be met by higher domestic production from workers. Once businesses are freed from pandemic restrictions, we can expect to see some improvements in supply.

But holding back a faster improvement in employment and output are the very challenges Hayek identifies, including slowing down the process of matching dislocated workers to new, postpandemic jobs. That is to say, demand growth with supply constraints won’t produce the sustainable jobs recovery we need.

Many workers are taking their time to find a new job or are choosing to work less, thanks to their generous pandemic unemployment insurance benefits. These benefits provided extra income for those who lost their jobs early in the crisis. As a result, the economy’s adjustment to a postpandemic paradigm will be slow. These benefits also slow future gains in the form of higher wages workers might earn from a new and better job. But as Hayek tells us, the longer it takes for these workers to rejoin the work force, the longer it will take for them to gain these benefits.

In the coming months, we will be able to assess the potency of dealing with these forces of supply and demand by comparing employment gains in the 25 states choosing to end federal pandemic benefit supplements with the 25 states retaining them. While employment is likely to rise quickly as the pandemic fades and extra unemployment insurance benefits fall away, unemployment rates are still likely to remain high relative to prepandemic levels for another year.

If we look ahead, wage gains should be robust for those employed, particularly for lower-skilled service-sector workers — especially if some employees delay returning to work. Those higher real wages are good news for recipients.

A less welcome wild card would be inflationary pressures, fueled by demand outstripping supply. Those pressures could be a brief blip in an adjusting economy. Or they could suggest a reduction in purchasing power from higher inflation for an extended period. Higher recent inflation readings in consumer prices are a cause for concern.

Whether this happens hinges on whether the federal government and the Federal Reserve dial back their extra Keynesian demand support in time to avoid increases in expected inflation. Inflation risks robbing them of purchasing power gains from their higher wages.

The latest jobs report, then, favors a more Hayekian solution — with a nudge: Policy should support returning to work and matching workers to jobs by supporting re-employment and training for new skills, not just boosting demand. That shift offers the best chance for a sustained lift in jobs as well as demand as the pandemic recedes. In the matter Keynes v. Hayek, then: Let Hayek now prevail.

The Debate over Macro Policy

   The current debate over monetary and fiscal policy has been particularly wide-ranging, touching on many of the issues we discuss in the policy chapters of the principles textbook.

Here are links to recent contributions to the debate.

Glenn and Tony discuss fiscal policy in a podcast HERE.

And monetary policy in a podcast HERE.

We discuss the Fed’s new monetary policy strategy HERE.

We discuss the current state of the labor market HERE.

The President’s Council of Economic Advisers discusses the need for additional fiscal policy measures in this POST on their blog.

An article on politico.com summarizes the debate HERE.

Harvard economist and former Treasury secretary Larry Summers has argued that fiscal and monetary policy have been too expansionary. A recent op-ed by Summers appears in the Washington Post HERE (subscription may be required).

Jason Furman, who was chair of the Council of Economic Advisers under President Obama gives his take on the division of opinion among academic economists in this Twitter THREAD.

Glenn Is Interviewed by the Financial Times

The Financial Times recently interviewed Glenn. Here is an edited version. The full interview can be found here.

Financial Times (Gillian Tett, editor-at-large for the United States): Gross domestic product data show that the economy is rebounding very fast from the pandemic; the Federal Reserve just said that it doesn’t intend to raise rates any time soon; and President Joe Biden has pledged a massive fiscal package. So what is your forecast for the American economy?

Glenn:  Re-opening as the virus recedes would always lead to a very significant pop in GDP growth. So the near-term is not really the big question. There will certainly be a transitory increase in inflation. But I think the Fed on balance is correct, that boost is likely to be transitory. My worry is when I hear the Fed talk, as its chair Jay Powell has done, about wanting to watch for labor market “re-healing” to finish. The problem in the labor market is [largely] structural. Just running the economy hot by the Fed doesn’t fix that.

On fiscal policy, this is not just a “boost”.… The American Rescue Plan was intended as stimulus. But the American Jobs Act, the American Families Plan, those are really a remaking of the size of government. It has to be paid for and arithmetically can’t be paid for by taxes on the rich. There’s just not enough there. So the honest conversation with the American people is a matter of public choice: if you want a big government that does what President Biden wants [it to do], you’ll have to pay for it. 

GT: How confident are you that inflation pressures are transitory?

GH: One can never be completely confident, but I think if the Fed had a clearer policy story I could be confident that commodity price increases are transitory. What worries me is the Fed thinking it can lean against structural changes in the labor market with monetary policy. One might worry a bit about inflation risks in the long-term—some of the structural headwinds against inflation to do with demography and growth in the emerging world, particularly in China, are going away. 

GT: Do you think that the Fed should be indicating that it’s willing to raise rates if inflation rises?

GH: I think the Fed is unlikely to do that. [But] one of the reasons you are seeing implied volatility in rates and credit markets so high relative to equities, is the fear in the bond market that, maybe, the Fed is saying one thing but if backed into the corner could do another. Remember that the Fed bought around half of Treasury issues last year, and owns 40 per cent of all of the outstanding 10-year plus maturity treasuries, so the Fed’s thoughts there, which aren’t really clear to the bond market, are very, very important. 

GT: Larry Summers has said this is way too much [stimulus], way too fast and will create inflation risks. You and Larry don’t often agree, but would you agree on this? 

GH: I would agree on the risk, but it’s [not] the problem that is worrying me the most. What worries me even more is [in trying to] create a government that large . . .  if you want a government that does those things, tax burdens will have to be higher.

If you look at the math on the tax burden, the [proposed] corporate tax increase or capital gains tax increase are not remotely large enough. The other structural thing that worries me is that I do see productivity reductions and investment reductions as a result of these large tax increases. 

GT: Biden said if you are earning less than $400,000 a year you will not see your taxes go up. 

GH: Well, it’s just not true, [neither] in the near-term [nor] the long-term. Take the corporate tax. Many economists have concluded that much of the burden of the corporate tax is borne by workers. In the 1970s and early 1980s, we thought it was capital that bore the burden of the corporate taxes. [But] that is not what economists believe today. So you simply cannot say that people who make less than $400,000 aren’t going to bear a part of the burden of the tax. 

Likewise with capital gains, the president says: “I’m only going after 0.3 per cent of taxpayers,” meaning [those] that make more than a million dollars a year and have capital gains. But those individuals don’t have 0.3 per cent of the capital gains—they likely have the bulk of them. So if there are any effects on risk-taking, on saving and investment, the [risks] are very large.

Those effects are borne by the economy, not by the top 0.3 per cent …. And in the longer term … if you look at the budget math here, there’s going to be a large revenue hole. Somebody has to pay for it. 

GT: Well, what about that “somebody” being companies? 

GH: Let’s put the tax changes into two buckets. On the rates, I don’t think we want to go as high as the president is proposing, certainly not back to the old rates. On the base, president Biden is proposing a tax increase by base broadening—it’s a very, very big change. I expect companies will acknowledge they need to pay some minimum level, but the math isn’t going to add up.

GT: What about taxes under the guise of climate change action, such as a fuel tax or value added tax?

GH: I think it’s a great idea. For years I have supported a carbon tax because I do believe that it is one of the best ways to deal with climate change. I’m very skeptical of subsidies in green things but if you put a price on carbon, businesspeople will rush around and innovate and do it efficiently and it does not have to be regressive .…

About [a value-added tax] VAT—there is no question that if we want the government President Biden is suggesting, you absolutely have to have a VAT.

European states that have much bigger [state sectors] than the American state as a share of GDP are not financed with taxes on capital. In fact, in many European countries capital taxes are lower than they are in the United States. They’re financed by consumption taxes [such as the VAT]. 

GT: Why do you think Biden’s package is undermining productivity? 

GH: Let me just take one step back. Some discussions of secular stagnation come from insufficient aggregate demand. Another school of thought thinks that structurally we have a problem with productivity growth, in terms of the supply side of the economy and the economy’s potential to grow. That is where I’m coming from. The tax plans are definitely anti-investment, as the lack of capital deepening explains low productivity growth and capital gains tax increases can affect risk-taking. There’s certainly nothing to enhance productivity [in Biden’s plans] and a lot to discourage productivity. 

It is not just the tax policy. I worry about a monetary policy that could lead to zombification of firms—an environment of very low interest rates that sustain low-productivity firms. To President Biden’s credit, pieces of what he’s proposing that are true infrastructure could, in fact, raise productivity, but that is a small part of what he’s actually calling infrastructure. 

GT: Are you concerned about a future debt crisis?

GH: Well, we are the reserve currency country, and we are borrowing in our currency, so I think a slow and steady malaise is more likely. To give a practical example, the Medicare trust fund could run out of money within a year or so, social security within five or so years. That will force discussions in Washington as to whether the public may wish to have a government this size. 

GT: So you don’t expect a debt crisis per se because of the reserve currency status?

GH: [Not] at the moment.

GT: Should Republicans be co-operating to create a bipartisan bill? 

GH: You could get bipartisan support for a new “GI bill” to prepare workers to adjust from the Covid world. For example, support in community colleges.

I’m not talking about free community college but supply side support—increasing their capacity to train people. Where you won’t get bipartisan support is [for] the notion that we need to move away from a work-supported social insurance system to a broader cradle-to-grave safety net.

The administration really fuzzed that up by calling it an infrastructure bill. Infrastructure doesn’t have to be just roads and bridges and airports—it could be broadband. But not healthcare. 

GT: Are childcare support and elderly support part of “infrastructure”?

GH: No—those are social spending. 

GT: One of the interesting ways you frame this debate is with the contrast between Keynes and Hayek, i.e. whether you’re trying to prop up the current system or encourage more rapid transformation. What do you mean?

GH: You could think of Covid [in terms of] a Keynesian response — we have a collapse in demand. The Keynesian response is not fanciful. But Hayek would say the new world after Covid isn’t going to look like the old world, so why support every single business? Both are right. We did a good job in policy on the Keynesian part. [But] we’ve done less well [thinking about Hayek]. 

GT: What do you think about Larry Summer’s concept of secular stagnation? 

GH: There’s a scene in Dickens’ A Christmas Carol, when Scrooge asks, [something like] “are these the shadows of things that are or might be?”. I feel the same way about Bob Gordon’s descriptions of the American economy — Larry and Bob are talking about the shadows of things that could be if we have bad enough public policy, going back to the anti-productivity story. But I don’t think they’re inevitable. 

Every businessperson with whom I speak is pretty optimistic about the technology frontier in productivity. If there’s a reason for pessimism, it’s more about the political system’s ability and willingness to let that productivity growth [run free].

GT: Do you think that the Republican party knows what it stands for with economics?

GH: … [An] approach Republicans could take is to go past the neoliberalism to liberalism (with a small L), to Adam Smith. He was anti-mercantilist—that’s what got him angry in The Wealth of Nations—and he was very interested in the ability of everybody in the economy to compete.

So a new Republican agenda might do more to help people compete—that sounds more like Lincoln, or like Roosevelt’s GI bill. In that lies a new agenda. But I don’t see the party really moving in that direction. 

GT: What about the second book of Smith’s, The Theory of Moral Sentiments?

GH: Smith referred to “mutual sympathy”, which today we would call empathy. Forward-leaning businesspeople and business leaders think that way. I don’t see [the environmental, social, and governance] ESG [approach to investing] as somehow an enemy of shareholders—this isn’t Milton Friedman versus socialism—it’s more a matter of what really is in the long-term interest of the firm.

Remember, Smith railed against the British East India Company, which he thought of as a cancer. He thought you had to be very careful in the social framing of corporations. Businesspeople today need to understand the corporate structure is a social gift. In fact, capitalism is a social gift. If the public doesn’t want it, it won’t happen. 

GT: I have a book coming out in a few weeks’ time that stresses this social and cultural aspect of business and finance and economics, and argues that business leaders need to move beyond tunnel vision to use lateral vision. Do you agree with this? 

GH: Yes. When I teach students political economy, I remind them that great thinkers like a Friedman or Hayek or Smith wrote [for] the times in which they lived. Friedman and Hayek were writing in response to a very slovenly and inefficient corporatist economic system and were horrified by fascism. If Ronald Reagan were with us today, I don’t think he would be the 1980s Ronald Reagan. If Friedman and Hayek were with us today, they might have a different view. Context shifts.

GT: Friedman was also operating when people assumed that they could outsource the difficult social decisions to government and when there wasn’t radical transparency and customers, clients and employees couldn’t see exactly what firms were doing. Does that matter?

GH: Yes. If Friedman were here he might correctly remind us that there are big social externalities no one company can fix. But there is no reason businesspeople can’t be leaders. When the Marshall Plan was passed, that was not because Congress in its great wisdom decided to do something. It was because the business community came together and said: “Good Lord, we are going to have communism in western Europe and what’s that going to do to our economic system?” They pushed Congress. I understand that [today business is] afraid. But it’s not an excuse not to act. At many companies, their own employees are going to put pressure [on them to act]. 

GT: You are starting to see a level of company collaboration which was unimaginable when we had Thatcherism and Reaganism. Will this last? 

GH: I do [think so] and Hayek would have celebrated this co-ordinated response because it bubbled up from the bottom. If you compare the production of vaccines, which was largely a private-sector activity, to the distribution of vaccines, which was more a public-sector activity, I think we know which one seemed to work better.

There are things that could help that—imagine if Biden put applied research centers all around the country that were linked with universities. That might help companies fix localities, as well as solving big problems like vaccines. 

GT: Are you concerned that we have an ESG bubble?

GH: I am, in several aspects. We are running the risk of industrial policy and rent seeking, with just subsidizing “green things.” I also worry about how CEOs can deal with this—you don’t want the CEO spending half of his or her day responding to social concerns.

GT: What about protectionism? Can the Republicans present an alternative voice on this? 

GH: I hope so, but I’m not sure. Like almost all economists … I believe in free trade. So why is something that is obvious in Econ 101 not so popular with the public?

I think for two reasons. One is whenever your Econ 101 professor talked about the gains from trade, he or she always [had] the idea that there would be losers, but compensation would somehow occur—and it hasn’t.

[Second] free trade is one of those examples, like the old classical gold standard, of a system that’s outside-in. You have to sign up for the rules of the game and then you just adjust. I think we need to go back to a period that says, look, we do need to understand domestic constituencies. That could mean much more support for training, it could be wage insurance, it could be lots of things rather than just saying free trade. 

GT: So it’s about trying to talk about free trade with both parts of Adam Smith. 

GH: Yes, exactly. Even Smith, who was the champion for openness, would not have countenanced whole areas just being left behind. Smith talked a lot about places—he said something like a man is a sort of luggage that’s hard to move, meaning you really have to look after places, not just jobs . . . its culture. 

GT: Hey, anthropology can mingle with economics! 

GH: Exactly—two social sciences, peas in a pod. 

GT: So what’s happening to the economics profession? With issues like [the debate around Larry Summers’ criticism of Biden’s policies] are we seeing a tribal warfare break out between economists? Is there a rethink of economics? Is Biden moving away from them?

GH: Well, let me start with some good news: the young stars in the [economics] profession today tend to be people who are talking about big problems with new tools and techniques, ranging from development to monetary policy to labor markets. I think that’s entirely healthy. 

I think the government needs people who have big macro views [too]. If I were in Janet Yellen’s shoes, I’d want to be talking to economists who could continue to give me that perspective, but also get micro perspectives from labor and financial markets. So there needn’t be a war. [But] I do worry from the way the Biden administration is talking about policies that economists just aren’t very involved at all. That’s not the first administration I’ve seen that happen—but it is a concern for the economics profession. 

Is the Natural Rate of Unemployment the Best Guide to Monetary Policy? The Fed’s New Monetary Policy Strategy

In response to the 2007-2009 financial crisis, in December 2008, the Federal Open Market Committee effectively cut its target for the federal funds to zero where it remained during the first six years of the recovery. In December 2015, Fed Chair Janet Yellen and the FOMC began the process of normalizing monetary policy by raising the target for the federal funds rate to 0.25 to 0.50 percent.

The FOMC raised the target several more times during the following years (Jerome Powell succeeded Janet Yellen as Fed Chair in February 2018) until it reached 2.25 to 2.50 percent in December 2018. In Chapter 27 of the textbook we discuss the fact that the experience of the Great Inlfation that had lasted from the late 1960s to the early 1980s had convinced many economists inside and outside of the Fed that if the unemployment rate declined below the natural rate of unemployment (also referred to as the nonaccelerating inflation rate of unemployment, or NAIRU), the inflation rate was likely to accelerate unless the FOMC increased its target for the federal funds rate. The actions the FOMC took starting in December 2015 were consistent with this view.

At the December 2015 meeting, the FOMC members gave their estimates of several key economic variables, including the natural rate of unemployment. At the time of the meeting, the unemployment rate was 5.0 percent. The average of the FOMC members’ estimates of the natural rate of unemployment was 4.9 percent. The inflation rate in December 2015 was 1.2 percent—well below the Fed’s target inflation rate of 2 percent. Although it might seem that with such a low inflation rate, the FOMC should not have been increasing the federal funds rate target, doing so was consistent with one of the lessons from the Great Inflation: Because monetary policy affects the economy with a lag, it’s important for the Fed to react before inflation begins to increase and a higher inflation rate becomes embedded in the economy. With many FOMC members believing that the NAIRU had been reached in December 2015, raising the federal funds rate from effectively zero seemed like an appropriate policy.

At least until the end of 2018, some members of the FOMC indicated publicly that they still believed that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. For example, in a speech delivered in December 2018, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, who was serving that year on the FOMC, made the following points:

“[P]eriods of time when the actual unemployment rate fell below what the U.S. Congressional Budget Office now estimates as the so-called natural rate of unemployment … I refer to … as “high-pressure” periods. … Dating back to 1960, every high-pressure period ended in a recession. And all but one recession was preceded by a high-pressure period….

One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows. You might argue that the simple answer is to not respond so aggressively to building signs of inflation, but that would entail risks that few responsible central bankers would accept. It is true that the Fed and most other advanced-economy central banks have the luxury of solid credibility for achieving and maintaining their price stability goals. But we shouldn’t forget that such credibility was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”

Bostic also noted in the speech that “it is very difficult to determine when the economy is actually overheating.” One indication of that difficulty is given by the following table, which shows how the average estimate by FOMC members of the natural rate of unemployment declined each year during the period in which they were raising the target for the federal funds rate. 

December 20154.9%
December 20164.8%
December 20174.7%
December 20184.4%
December 20194.1%
Federal Open Market Committee Forecasts of the Natural Rate of Unemployment, 2015-2019

As we discuss in Chapter 19, Section 19.1 of the textbook, because of problems in measuring the actual unemployment rate and in estimating the natural rate of unemployment, some economists inside and outside of the Fed have argued that the employment-population ratio for prime age workers is a better measure of the state of the labor market.  The following shows movements in the employment-population ratio for workers aged 25 to 54 between January 2000, when the ratio was near its post-World War II high, and February 2021. 

Employment-Population Ratio for Worker Aged 25 to 54, 2000-2021

The figure shows that in December 2015, when the Fed began to raise its target for the federal funds rate and when the average estimate of the FOMC members indicated that unemployment was at its natural rate, the employment-population rate was still 4.5 percentage points below its level of early 2000. The FOMC members do not report individual forecasts of the employment-population ratio. If they had focused on that measure rather than on the unemployment rate, they may have concluded that there was more slack in the labor market and, therefore, have been less concerned that inflation might be about to significantly increase.

In 2019, the Fed began to cut its target for the federal funds rate as the growth of real GDP slowed. In March 2020, following the start of the Covid-19 pandemic, the Fed cut the target back to 0 to 0.25 percent. During that time, some members of the FOMC and some economists outside of the Fed concluded that the Fed may have made a mistake by raising the target for the federal funds rate multiple times between 2015 and 2018. For example, Bostic in a speech in November 2020, noted that “the actual unemployment rate exceeded estimates of the NAIRU by an average of 0.8 percentage points each year” between 1979 and 2019. He concluded that “If estimates of the NAIRU are actually too conservative, as many would argue they have been …unemployment could have averaged one to two percentage points lower” between 1979 and 2019, which he argues would have been a particular benefit to black workers. In a speech in September 2020, Lael Brainard, a member of the Fed’s Board of Governors, noted that the Fed’s previous approach of making policy less expansionary “when the unemployment rate nears the [natural] rate in anticipation of high inflation that is unlikely to materialize risks an unwanted loss of opportunity for many Americans.”  

in August 2020, the Fed announced the results of a review of its monetary policy. In a speech that accompanied the statement Fed Chair Jerome Powell noted that in attempting to achieve its mandate of high employment, the Fed faces the difficulty that “the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.” Powell noted that the in the Fed’s new monetary policy statement, policy will depend on the FOMC’s: “’assessments of the shortfalls of employment from its maximum level’ rather than by ‘deviations from its maximum level’ as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.” 

At this point, the details of how the Fed’s new monetary policy strategy will be implemented are still uncertain. But it seems clear that the Fed has ended its approach dating back to the early 1980s of raising its target for the federal funds rate when the unemployment rate declined to or below the FOMC’s estimate of the natural rate of unemployment. Particularly after Congress and the Biden administration passed the $1.9 trillion American Rescue Plan in March 2021, some economists wondered whether the Fed’s new strategy might make it harder to counter an increase in inflation without pushing the U.S. economy into a recession. For instance, Olivier Blanchard of the Peterson Institute for International Economics argued that the combination of very expansionary fiscal and monetary policies might lead to a situation similar to the late 1960s:

“From 1961 to 1967, the Kennedy and Johnson administrations ran the economy above potential [GDP], leading to a steady decrease in the unemployment rate down to less than 4 percent. Inflation increased but not very much, from 1 percent to just below 3 percent, suggesting to many a permanent trade-off between inflation and unemployment. In 1967, however, inflation expectations started adjusting, and by 1969, inflation had increased to close to 6 percent and was then seen as a major issue. Fiscal and monetary policies tightened, leading to a recession from the end of 1969 to the end of 1970.”

Fed Chair Jerome Powell seems confident, however, that any increase in inflation will only be temporary. In testifying before Congress, he stated that: “We might see some upward pressure on prices [as a result of expansionary monetary and fiscal policy]. Our best view is that the effect on inflation will be neither particularly large nor persistent.” 

Time will tell which side in what one economic columnist called the Great Overheating Debate of 2021 will turn out to be correct.

Sources: Neil Irwin, “If the Economy Overheats, How Will We Know?” New York Times, March 24, 2012; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion Relief Plan,”  piie.com, February 18, 2021; Paul Kiernan and Kate Davidson, “Powell Says Stimulus Package Isn’t Likely to Fuel Unwelcome Inflation,” Wall Street Journal, March 23, 2021; Federal Open Market Committee, “Minutes,” various dates; Lael Brainard, “Bringing the Statement on Longer-Run Goals and Monetary Policy Strategy into Alignment with Longer-Run Changes in the Economy,” September 1, 2020; Raphael Bostic, “Views on the Economic and Policy Outlook,”  December 6, 2018; Raphael Bostic, “Racism and the Economy: Focus on Employment,” November 17, 2020; Jerome Powell, “New Economic Challenges and the Fed’s Monetary Policy Review,” August 27, 2020; and Federal Reserve Bank of St. Louis. 

NEW! – 04/16/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss monetary policy and the tools available to the Federal Reserve.

Authors Glenn Hubbard and Tony O’Brien follow up on last week’s fiscal policy podcast by discussing monetary policy in today’s world. The Fed’s role has changed significantly since it was first introduced. They keep an eye on inflation and employment but aren’t clear on which is their priority. The tools and models used by economists even a decade ago seem outdated in a world where these concepts of a previous generation may be outdated. But, are they? LIsten to Glenn & Tony discuss these issues in some depth as we navigate our way through a difficult financial time.

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Christopher Waller Confirmed by Senate as Federal Reserve Governor

Christopher Waller

On Thursday, December 3, Christopher Waller, executive vice president and research director at the Federal Reserve Bank of St. Louis, was confirmed by the Senate as a member of the Federal Reserve’s Board of Governors.  The Board of Governors has seven members and, under the Federal Reserve Act, is responsible for the monetary policy of the United States and for overseeing the operation of the Federal Reserve System.

Board members are appointed by the president and confirmed by the Senate to 14-year nonrenewable terms. The terms are staggered so that one expires every other January 31. Members frequently leave the Board before their terms expire to return to their previous occupations or to accept other positions in the government. The following table shows the current Board members, when their terms will expire, and which president appointed them.  Note that one seat on the Board is vacant. President Trump nominated Judy Shelton to fill this seat but it appears unlikely that she will be confirmed by the Senate before the change in administration takes place on January 20.

NameYear Term EndsAppointed to the Board by
Jerome Powell, ChairAs Chair: 2022
As Board member: 2028
As Chair: President Trump
As Board member: President Obama
Richard Clarida, Vice ChairAs Vice Chair and as Board member: 2022President Trump
Randal Quarles, Vice Chair for SupervisionAs Vice Chair for Supervision: 2021; As Board member: 2032President Trump
Michelle Bowman2034President Trump
Lael Brainard2026President Obama
Christopher Waller2030President Trump
Vacant

Information on the history and structure of the Board of Governors and on the backgrounds of current members can be found HERE on the Fed’s website.  An announcement of Waller’s confirmation can be found HERE on the website of the St. Louis Fed. A news story discussing Waller’s confirmation and the likely outcome of Shelton’s nomination, as well as some of the politics involved with current Fed nominations can be found HERE (those with a subscription to the Wall Street Journal may also want to read the article HERE).

Janet Yellen Nominated to Be Treasury Secretary

Janet Yellen

President-elect Joe Biden has nominated Janet Yellen to be treasury secretary. If confirmed by the Senate, Yellen would be the first woman to hold that post. She would also be the first person to have been both Federal Reserve Chair and treasury secretary. Yellen also served as President of the Federal Reserve Bank of San Francisco and as Chair of the Council of Economic Advisers during the Clinton administration. Prior to entering government service, Yellen was on the economics faculties of Harvard University and the University of California, Berkeley. At the time of her nomination she was a Distinguished Fellow in Residence at the Brookings Institution.

A news story on her nomination can be read HERE. Her biography on the Brookings Institution web site is HERE (includes a video conversation from a few years ago with former Fed Chair Ben Bernanke). A speech she gave in 2018 reflecting on the 2007-2009 financial crisis can be read HERE.

9/11/20 Podcast – Authors Glenn Hubbard & Tony O’Brien cover current events, Micro, and Macro! They discuss 9/11, the rising stock market, the challenges facing restaurants, as well as shifts in strategy for the Fed!

Authors Glenn Hubbard and Tony O’Brien continue their weekly discussion about the effects of the Pandemic on the US Economy. They discuss the disconnect between stock market performance and the overall economy. Also, they look at the decision of restaurants to stay open despite struggling to breakeven due to limitations on indoor seating. The Fed’s pivot on the dual-mandate is also discussed as they announce more of their monetary policy focus will be on unemployment rather than inflation.

Over the next several weeks, we will be gearing up this podcast to become an essential listen during your week. Whether your interest is teaching or policy, you will learn from this discussion.

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