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 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.

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,”, 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.

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe! Today’s episode is appropriate for Principles of Economics and/or Money & Banking!

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NEW! – 04/09/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the longer-term impact of several post-pandemic fiscal policy efforts and the new Biden administration infrastructure investment proposal.

Authors Glenn Hubbard and Tony O’Brien discuss the long-term impacts of recent fiscal policy decisions as well as the proposed infrastructure investment by the Biden administration. The most recent round of fiscal stimulus means that we’re spending almost 4.5 Trillion which is a high percentage of what we recently spent in an entire fiscal year. They deal with the question of if the infrastructure spending will increase future productivity or will just be spent on the social programs. Also, Glenn deals with the proposed corporate tax increase to 28% which has been designated to fund these programs but does have an impact on stock market values held by millions through 401K’s and IRA’s.

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe!

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NEW! – 02/19/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss early thoughts on the Biden Administration’s economic plan.

Authors Glenn Hubbard and Tony O’Brien discuss early thoughts on the Biden Administration’s economic plan. They consider criticisms of the most recent stimulus packages price tag of $1.9B that it may spur inflation in future quarters. They offer thoughts on how this may become the primary legislative initiative of Biden’s first term as it crowds out other potential policy initiatives. Questions are asked about what bounce we may see for the economy and comparisons are made to the Post World War II era. Please listen and share with students!

The following editorials are mentioned in the podcast:

Glenn Hubbard’s Washington Post Editorial with Alan Blinder

Olivier Blanchard’s comments on the Stimulus in a Peterson Institute for International Economics post

Larry Summer’s WaPo editorial about the risks of the stimulus:

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe!

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5/29/20 Podcast – Glenn Hubbard & Tony O’Brien Welcome Guest – Prof. Bill Goffe from Penn State University!

Glenn Hubbard and Tony O’Brien continue their podcast series hosting guest – Professor Bill Goff of Penn State University. In talking with Bill, we discuss the challenges of teaching online during the Pandemic this past spring. We talk some about unemployment as well as hearing how Bill how he developed his passion for photography in his travels around the world. The image on this post was a picture of the Milky Way taken by Bill in North Central Pennsylvania!

Links for podcast of May 29, 2020 with Bill Goffe of Penn State

1. Link to RFE:  Resources for Economists on the Internet that Bill edits:

2. Link to the website of the Journal of Economic Education where Bill is an associate editor:

3. Link to the CTALE TeachECONference – You can register – for free – by clicking HERE

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