The long and short of the economy
Whoever wins the presidential election will have political responsibility for an economy beset by four distinct problems. At the moment neither party has a compelling answer to them.
The first challenge is, of course, the weakness of the recovery. Unemployment remains high. Worse, it has been high for a long time. The longer people are out of a job, the less productive they become — and the less likely to stay in the labor force at all. Long-term unemployment thus has even longer-term consequences.
Second, the federal government is running a very high deficit and the future looks bleak, largely because of the escalating costs of entitlement programs. Many state and local governments also have pension debts they have no money set aside to repay.
Third, take-home pay has been stagnant for most people even during years when the economy has expanded. This stagnation has reduced Americans’ confidence in the country’s future.
Fourth, it is possible that the long-term growth rate that the country is capable of reaching has declined. The jury is out on this question. The Great Depression saw similar views become conventional wisdom, only to be discredited in the high-growth postwar decades. It would be risky, though, for a leader to assume that trend growth will be as high in the future as it has been in the past.
Liberals have offered answers to these challenges. To kick-start the economy they would provide short-term fiscal stimulus and help underwater homeowners refinance their mortgages. To address the long-term deficit they would raise taxes and cut health-care spending. They would achieve the latter by, for example, having federal health-care programs stop paying for procedures that a board of experts considers wasteful. They expect these sorts of measures to drive down inflation in health-care markets generally, thus allowing firms to give workers raises instead of spending the money to pay for ever-more-expensive health-insurance policies. To improve the long-run growth rate they would, for example, spend money on improving the country’s infrastructure and allow more legal immigration.
These policies seem either unlikely to achieve their objectives, likely to worsen other problems, or both. Will the federal government really spend extra infrastructure dollars efficiently, or will it throw money at high-speed-rail systems that population density renders unsustainable? The research on the economic effects of liberalized immigration yields murky results; there is at least a strong possibility that adding more low-skilled workers to the labor force will make life worse for people at its bottom end. The federal government has been trying to use its power as a large purchaser in the health-care market to drive costs down for decades, without notable success. Raising tax rates on capital and high incomes, as liberals prefer, is among the most economically damaging ways to raise revenue.
Fiscal stimulus seems exceedingly unlikely to work. It is true that some models predict that increased deficit spending will raise economic output in a depressed economy. These models do not, however, take account of how monetary policy interacts with fiscal policy. The flaw in the models can perhaps best be seen through the use of a stylized example. Assume that the Federal Reserve has a 2 percent inflation target and hits it perfectly: When inflation threatens to go to 1.8 percent it loosens money, and when inflation could hit 2.2 percent it tightens.
Under those circumstances any fiscal policy, even one that was more perfectly designed than any that Congress would ever pass, would be perfectly offset. If the government were to try to stimulate this hypothetical economy with a steady 2 percent inflation rate, the Fed would simply tighten money to keep inflation stable — and you’d be exactly where you were, but with more federal debt. In the real world, of course, the Fed does not shoot for a perfectly stable inflation rate and does not perfectly hit its target. It does, however, seem to want and be able to keep inflation expectations in a narrow band a bit below 2 percent. That doesn’t leave a lot of room for fiscal stimulus to have an effect.
The point isn’t that Ben Bernanke would deliberately set out to undermine a fiscal stimulus. He might well want Congress to enact one because it would make his own life easier: The more Congress stimulates the economy, the less he would need to engage in the types of monetary easing that have brought him so much criticism. So long as he maintains his inflation target, fiscal stimulus cannot do much to boost the economy. If the Fed adopted a nominal-income target instead, as some economists counsel, the fiscal-policy story would be the same: More fiscal stimulus would mean a tighter (or less loose) monetary policy, and the economy would end up in roughly the same place.
The dominance of monetary over fiscal policy is one reason conservatives are right to insist that we can tackle the budget deficit now without weakening the economy. If Congress cut its deficit spending so much that inflation expectations dropped below what the Fed deemed acceptable, the Fed would respond by loosening money. To the extent the market expects this response, the Fed would not even have to take much action, since inflation expectations would have a floor under them. The net result should be the same amount of economic activity, but with more of it taking place in the private sector. Many conservatives believe there would even be more economic activity. On this argument reduced spending, now and in the future, will reduce future tax burdens and thereby improve present incentives to work, save, and invest.
The bulk of any reduction in federal spending should come in the form of future cuts to entitlement programs. The growth of Social Security benefits should be restrained. Benefits for tomorrow’s high earners should be the same as benefits for today’s high earners, plus an adjustment for inflation. Right now, they are scheduled to be much higher. That’s unaffordable, and the alternative to reducing future benefit levels is perverse: to raise taxes on these people just to give them these higher benefits. Medicare is a bigger and longer-term challenge. The correct response to it is the one Representative Paul Ryan and Governor Romney have outlined: Have the federal government allot a certain amount of money to help senior citizens pay for the health insurance of their choice, with the amount depending on their age and risk factors. Let competition moderate the growth of costs.
Current and future spending cuts should provide long-term dividends, because the association between smaller government and increased economic growth appears to be strong. When it comes to spending, then, the appropriate policy is the same over both the short and the long run: cut it.
Conservatives take a similar approach to taxes and regulation, treating the appropriate policy response to our short-term and long-term challenges as identical. An economic slump is the best time, in this view, to deregulate and cut taxes, especially taxes on investment. Thus Governor Romney and congressional Republicans are offering no policies that are specifically directed at counteracting the business cycle. The strength of this frame of mind is that it directs the attention of a government often oriented to short-term thinking to long-term imperatives.
The drawback to this line of thinking is that it offers no plausible answers to a recession or slow recovery. It is one thing to say that cutting income-tax rates would improve the long-term health of the economy. Income-tax rates are, however, low in historical terms. The top rate is 35 percent: It has been lower than that for only five of the last 80 years. It is hard to believe that this tax rate has had much to do with our recent economic troubles. Dropping it to 28 percent, as Governor Romney proposes, would increase the after-tax return on a dollar earned by a modest 11 percent of taxpayers. Reagan’s 1981 tax cut was six times more powerful because taxes were so high back then.
Tax cuts, spending cuts, deregulation, free trade, tort reform: The economic policies that conservatives usually tout can boost the trend growth rate but cannot do much when we are growing below trend. The situation is reversed with monetary policy. It can’t improve the economy’s long-term potential growth rate. Bad monetary policy can, however, cause growth to fall below (or rise temporarily above) that rate, and righting it can therefore have positive near-term effects.
During the Great Moderation that preceded the crash, American monetary policy was reasonably good, though not perfect, at holding the growth of nominal spending steady. It thus enabled debt contracts, most of which are written in nominal terms, to be made against a backdrop of stable expectations. In 2008 and 2009, however, nominal spending plummeted at the fastest rate since the Great Depression. Debts suddenly became harder to service than expected, and asset values premised on the maintenance of monetary stability tumbled.
The failure of the Federal Reserve to keep nominal spending stable played a larger role in the economic crash than even the housing bubble and bust. Residential-construction employment had been dropping for two years before the economic meltdown, and unemployment had risen only slightly. Tight money in mid-2008 made the housing bust, and everything else, much worse within months.
Monetary stability is a prerequisite for long-term growth. There are two ways to achieve it, however, and they have different short-term consequences. If the Fed made a credible commitment to bring nominal spending back toward its pre-crash trend line, we would expect a more robust recovery. Or the Fed could let market expectations adjust to a new post-crash trend line, which would be a more drawn-out and painful affair.
The Left and Right have been complicit in the Fed’s defaulting to Option Two, with much of the Left arguing that the Fed cannot raise nominal spending and much of the Right insisting that it should not. Liberal skeptics are mistaken: There has never been a case of a central bank in a fiat-money system trying for monetary expansion and failing. The conservative skeptics are wrong, too, with respect to current monetary conditions. They fear a revival of inflation. On any reasonable measure, though, inflation and inflation expectations are well below the average rate of the last few decades. A credible nominal-spending rule would constrain future inflation, and by reducing the demand for money balances would also make it possible to shrink the monetary base. The crawling recovery the Fed is opting for, on the other hand, will mean the continuation of our abnormally enlarged base.
Monetary policy has been one of the Right’s blind spots; wages another. The experience of the “Bush boom” suggests that even a robust economic recovery may not lift wages. During that period rising health-insurance premiums swallowed every increase in the cost of compensation. Conservatives sometimes respond to complaints about wage stagnation by pointing to this increase in benefits as though it made things better. It is little comfort to most people to be told that their paychecks are flat but at least their health-care costs are up.
If people want to direct all of the added income from economic growth to health care, they should have that choice. But it is hard to believe most people would do that in a more transparent system: one, that is, that does not hide costs from those who ultimately pay them, as ours does. The stagnation of wages has probably also played a role in reducing Americans’ willingness to support free-market reforms such as free trade. In the context of stagnation, foreign competition begins to look more and more like a threat.
Various conservatives have advanced policies that solve the wage-stagnation problem, even if they rarely talk about it in those terms. The key is to replace the current tax break for health insurance, which gets bigger the more expensive the policy is, with a tax credit that helps people buy insurance but does not reward them for picking the deluxe option. That credit, unlike the current tax break, should also be available to people who do not have access to coverage from their employers and therefore have to buy it themselves. It is a reform that Governor Romney should endorse.
So each of our sets of challenges should call forth distinct answers: We need stable money to get out of the slump, entitlement reform to bring federal debt to manageable levels, better health-insurance incentives to revive wage growth, and structural changes to increase long-term economic growth. These policies are mutually reinforcing. We are unlikely to get entitlement reform without first addressing our short-term economic weakness. People probably won’t get behind structural changes to increase productivity unless they have a reasonable prospect of earning higher take-home pay for their trouble. If we do not meet our challenges with conservative ideas, we are likely to end up with liberal ones that are wrong — and expensive.