Growing the economy, part two: Fix the bad fiscal policy

Above is the full video of the press conference held by Fed Chairman Ben Bernanke held last week -- Thursday, September 13, 2012 -- as he announced yet another in a long line of "unprecedented levels of policy accommodation in recent years" (0:01:46).

In our previous post, entitled "Growing the economy, part one: Get off of a 'War Footing' with monetary policy," we argued that the Fed's unprecedented levels of accommodation over the past four years were inappropriate and in fact harmful. We also promised to discuss why the Fed continues to take this approach, and because the Fed really went "all-in" on that approach last week, it becomes even more important to understand what is behind their actions.

As Mr. Bernanke explains in his opening remarks at the press conference in the video above, the Fed has in its job description something called the "dual mandate," which is to use monetary policy to ensure both price stability and maximum employment.  With government measurements of unemployment still stubbornly above 8%, the Fed is compelled by this second part of their dual mandate to take additional steps to try to reduce unemployment.

In this regard, Mr. Bernanke and the Fed can hardly be criticized: their job description includes taking steps to ensure full employment, and unemployment remains at 8.1%, well above "maximum employment."  Never mind the fact that their control over the tools of monetary policy gives them precious little in the form of tools that can actually create employment -- it is in their mandate, so they have to do something with the tools they have, as inappropriate as that may seem.

To fix that mandate, lawmakers should get rid of it, by amending the Federal Reserve Act (in fact, the dual mandate was only added by Congress to the Federal Reserve Act as recently as 1977).  We have previously published our view that the dual mandate should be abolished (see this previous post, for example).

In his opening remarks, Mr. Bernanke makes reference to the fact that what is really needed in this situation are not monetary tools but rather fiscal tools, and we agree.  All the monetary accommodation in the world will not induce businesses to hire and expand if misguided fiscal policy (set by policymakers in Congress, not the Fed) imposes enormous burdens to hiring and expanding, by increasing the costs of employee health insurance, increasing the regulatory burdens and penalties aimed at businesses, increasing government activity in areas that were previously addressed by private businesses, increasing the taxes on business activity or making the threat of increased taxes seem more likely, and increasing government's spending to the point that future taxes seem even more likely.

Therefore, in order to unleash economic growth (and improve the employment picture at the same time), we need to fix the broken fiscal policy coming out of Washington lawmakers.  As distinguished economist  Dr. Walter Williams points out in his most recent syndicated column, fiscal policy (the power to tax and spend) is the responsibility of the Congress, not the responsibility of the Fed, and also not the responsibility of the President.

In the video below, Brian Wesbury (another economist with whom we agree), explains why he believes the Fed's action yesterday can be called "QE3," why it is misguided, and why it is the fiscal policy that must be fixed if the economy is going to grow:

He also provides some additional thoughts on the reasoning behind the Fed's incredible new tactic of telling the public that interest rates would remain essentially at zero until at least the middle of 2015 (this is what the Fed now calls "forward guidance"), while initiating additional balance sheet activities (often called "quantitative easing" as explained in this previous post) that it will continue until levels of unemployment fall.

At about the 2:30 mark in the above video, Mr. Wesbury points out that -- in addition to trying to fulfill their dual mandate -- the Fed officials may also be trying to correct the difference between the current rate of nominal GDP growth and the rate of nominal GDP growth that had prevailed before mid-2007.  However, as Mr. Wesbury insightfully observes, that is a terrible mistake!  That would be, in Mr. Wesbury's words, "trying to get GDP back to where it was in a bubble time!"  

This brings us to our final point for today's post.  The bubble to which Mr. Wesbury refers was primarily a bubble in housing prices and housing activity, and it was a bubble that was almost entirely created by . . . misguided monetary policy after the previous recession and bear market!  

All of this shows the folly of trying to use monetary policy to "steer the economy," as the 1977 dual mandate  requires by law, and as yesterday's Fed announcements clearly indicate the Fed is trying to do once again.  We have written about the dangers of such "Fed steering" many times in the past

As Mr. Wesbury argues beginning at about 1:30 in the above video, the biggest deterrent to economic growth right now is "bad fiscal policy: too much spending, too many regulations, fears about future regulations [. . .], and fears about future tax hikes -- all of that is holding back the economy, and its not a lack of money that is the problem."

We couldn't agree more.
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Growing the economy, part one: Get off of a "War Footing" with monetary policy

As investors return from a three-day Labor Day weekend in the US, much of the talk in the financial media centers around the activity of the central banks, particularly the European Central Bank and the US Federal Reserve. 

Many interpret Fed Chairman Ben Bernanke's comments at Jackson Hole last week as indicating that the Fed is preparing to "do something" at the upcoming Fed meeting on September 13, possibly including the formal declaration of the intent to keep US short-term interest rates at zero through 2015 (rather than through 2014, as the Fed has already pledged to do).

Why does the Fed feel the need to "do something," and why do many investors and pundits continue to argue that the Fed needs to "do something"?  The answer is pretty obvious to anyone who has been paying attention to economic matters at all, which is that unemployment remains stubbornly high and economic growth remains stubbornly low, and many assume that central bank action is part of the solution to these woes.

In this first installment of a short series of posts about how to fix the economy, however, we will make a different argument.  We would argue that when it comes to monetary policy, the best way to allow the economy to experience more robust growth with more jobs is to pursue a stable monetary policy and (equally important) a normal monetary policy.

Unstable monetary policy creates unpredictability and uncertainty that creates obstacles for businesses.  If your business requires purchasing components or ingredients and you don't know whether the prices for those components or ingredients will be going up rapidly over the next few weeks or months, it makes it difficult to plan.  When prices fluctuate wildly, businesses end up spending money trying to hedge against future price fluctuations, and time and talent that could be spent more productively doing something else is instead spent trying to analyze and predict price fluctuations and to plan strategies to lessen the impact of the price volatility.

Unstable monetary policy also creates obstacles to the critical function of supplying businesses with the capital that they need to grow and expand.  If central banks allow massive inflation, for example, lenders may be worried about loaning capital that will be repaid to them later with less-valuable dollars.  To guard against this danger, they may have to charge higher and higher interest rates, or they may become much more reluctant to lend.  Either way, capital can become less available to innovative businesses -- not because those businesses are not promising but because monetary policy is unstable.

Just as important as having a stable monetary policy, however, is having a normal monetary policy. This fact is something that commentators often overlook (especially those who continue to clamor for the Fed to "do something" next week).  The US Federal Reserve has kept short-term interest rates effectively at zero since December of 2008!

A zero interest rate is not a normal interest rate: it is an emergency interest rate, akin to going on a "war footing."  The dramatic cuts to the fed-funds rate that were enacted in 2008 were seen as emergency measures necessitated by a potential liquidity crisis.  Whether the actions taken in 2008 were appropriate or necessary can be debated, but four years later we are no longer in the middle of a financial panic and a potential liquidity crisis.  Why are we still on a "war footing" with regard to interest rates? 

US GDP has been growing at an average of 2.2% annual since the recovery officially began in mid-2009, and at 2.3% in the past year (as economist Brian Wesbury explains here).  While these are not stellar growth rates for GDP, they do not call for a 0% interest rate.  Many economists believe that interest rates are inappropriately low and monetary policy overly loose when they lag below real GDP by even a fraction of a percent.

Keeping interest rates this low may well be contributing to the slow economic growth, and it is certainly inviting dangerous inflation.  The Fed has enormously beefed up bank balance sheets by its emergency actions since 2008 (for an explanation with diagrams of what this means, see this previous post), which certainly alleviates any possibility of a liquidity crisis.  But, as central planners typically do, they are "fighting the last war."  It is no longer 2008!  All that excess money on bank balance sheets has not found its way out into circulation for a variety of reasons, but it certainly could do so and it could do so very rapidly.  If it did, that would have the potential to be enormously inflationary.

Finally, there is an aspect of "self-fulfilling prophecy" in this continued "war footing" mentality.  The US economy acts like it is still in an emergency mode because the Fed continues to enact an emergency monetary policy (and has said that it will need to do so through at least 2014).  

To allow the economy to return to healthy growth, it is time to stop fighting the last war and get rid of these unnecessary -- and harmful -- emergency monetary gimmicks.  A crucial aspect of a healthy growing economy is a stable and a normal monetary policy.

All of this begs the question: "Why is the Fed taking this approach?"  We'll tackle that in our next installment in this series.

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