More on a Two-Track Plan to Restore Growth

The Wall Street Journal’s choice of a headline for my op-ed last Friday “A Two-Track Plan to Restore Growth,” was a great way to pair the proposed fiscal reform with the proposed monetary reform. The Congress and the President would lay out the fiscal track to reduce the exploding debt and then nail down the track with the golden spike of entitlement reform. In parallel the Fed would lay out the monetary track to reduce its exploding balance sheet and then nail down the track with the golden spike of reporting and accountability reform. In each case reform is needed: for fiscal policy entitlement reform is needed to provide incentives to control spending growth and improve the quality of services; for monetary policy, reform is needed to provide incentives to follow more rules-based policies.

Hearings at the House Financial Services Committee last Wednesday covered many of these same issues in detail with new members of Congress asking good questions. Witnesses were Don Kohn (former vice chair of the Fed) and I who focused on monetary policy, as well as Bill Poole and Hal Scott who focused on fiscal policy and regulatory policy, respectively. There was also a good second panel with witnesses from the private business sector.

Somewhat surprisingly, Don Kohn agreed that reporting and accountability about monetary policy decisions could be improved, as I had argued in my testimony and in the op-ed, though he was not sure whether legislation was needed. In my view Congress should restore the Fed’s reporting requirements which it removed in the year 2000 in a little-known section of the American Homeownership and Economic Opportunity Act of 2000. Don emphasized that the congressional committees could ask better questions and thereby hold the Fed more accountable even without restoring the former type of requirement.

Two other related policy matters from last week:

Bob Heller (like Kohn and Poole, a former member of the FOMC) spoke out forcefully against recent Fed policies. According to Bloomberg News: “While most critics of the Federal Reserve are investors and market pundits, one noteworthy individual was a former member of the U.S. central bank. Robert Heller, Federal Reserve Governor from 1986-1989, described the Fed’s second round of quantitative easing, QE2, as ‘dangerous’ and ‘misguided’ in a Bloomberg interview.”

Ron Paul reintroduced a bill to repeal the law (31 USC 714(b)) which now prevents GAO from auditing certain monetary policy activities at the Fed. The Bill would delete the following language “Audits of the [Federal Reserve] Board and Federal Reserve banks may not include— (1) transactions for or with a foreign central bank, government of a foreign country, or nonprivate international financing organization; (2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, and open market operations; (3) transactions made under the direction of the Federal Open Market Committee; or (4) a part of a discussion or communication among or between members of the Board and officers and employees of the Federal Reserve System related to clauses (1)–(3) of this subsection." Other legislation related to the Fed is likely on the way.

A Law Might Speed Up the Taylor Cycle

The phrase in the headline above concludes Amity Shlaes's "amazingly thorough" article (quoting AEA President Orley Ashenfelter here) on the long cyclical swings between rules and discretion which I documented in a speech at the annual AEA-AFA luncheon in Denver on January 7. Given that the previous period of discretion (in the 1960s and 1970s) lasted nearly two decades, a continuation of the normal cycle means that it might take another dozen years to get back to more stable rules-based monetary and fiscal policies, which is the length of time Amity Shlaes suggests. She also suggests that a law could move the balance back toward rules much sooner. I think that’s why we are beginning to see renewed interest in legislation to modify the Federal Reserve’s mandate and add reporting requirements and accountability for its monetary strategy.

Higher Investment Best Way to Reduce Unemployment, Recent Experience Shows

Some economists argue that the efforts now underway to reduce government spending as a share of GDP will have adverse effects on unemployment. This is not what the data show. Consider this chart which shows the pattern of government purchases as a share of GDP and the unemployment rate over the past two decades. (The data are quarterly seasonally adjusted from 1990Q1 to 2010Q3.) There is no indication that lower government purchases increase unemployment; in fact we see the opposite, and a time-series regression analysis to detect timing shows that the correlation is not due to any reverse causation from high unemployment to more government purchases.In sharp contrast, the data on spending shares show that the most effective way to reduce unemployment is to raise investment as a share of GDP. The second chart shows the relation between unemployment and fixed investment over the past two decades. Higher shares of investment are associated with lower unemployment. The time series in the third chart show the relationship from another perspective. Either way you look at it, the relationship between unemployment and the investment share is remarkably close. It holds for both non-residential and residential investment, and is a subject of my current research. Of the four shares of GDP (the other two of course being consumption and net exports), the investment share shows by far the largest negative association with unemployment.
Encouraging the creation and expansion of businesses should be the focus on government efforts to reduce unemployment. The recent compromise agreement to prevent the increase in tax rates on small businesses and the move to lighten up on the anti-business sentiment coming out of Washington are two steps in the right direction.

Historical Evidence on the Benefits of Rules-Based Economic Policies

Each year since 1948 the American Economic Association and the American Finance Association hold a joint luncheon with an invited speaker. Over the years the luncheon has grown to a very large affair usually held in the big hotel ballrooms. This year’s luncheon was held today in Denver, and I was the speaker. Like the first two speakers—Winthrop Aldrich, president of Chase National Bank, and Paul Douglas, U.S. Senator from Illinois and known to economists from the Cobb-Douglas production function—I spoke about monetary and fiscal policy. I presented evidence of an amazing six decade long correlation between rules-based policies and good economic performance. The correlation—along with basic economic reasoning—is strong evidence that rules-based monetary and fiscal policies are enormously beneficial to the economy. The historical swings away from rules toward discretion have been damaging whether during the Great Inflation of the 1970s or the recent Great Recession. Here is a copy of the speech and here is the video of the speech with introduction by AEA President elect Orley Ashenfelter (AEA ID is needed for video).

New Revealing Study of FOMC References to the Fed's Mandate

Dan Thornton of the Federal Reserve Bank of St. Louis just completed a very revealing paper called What Does the Change in the FOMC’s Statement of Objectives Mean? in which he traces FOMC references to the Fed’s mandate over many years. He documents a historically significant recent shift in the language with important legislative and policy implications. Until very recently the FOMC policy statement did not explicitly mention the “maximum employment” part of the dual mandate in the Federal Reserve Act. FOMC members preferred to refer to the goal of price stability and its role in creating strong economic and employment growth.

But on September 21, 2010 the FOMC changed the policy statement by starting to refer explicitly to “maximum employment.” It did so again following the November and the December FOMC meetings. The change coincides with efforts to promote QE2 and thereby provides factual evidence that the dual mandate was a factor in gaining support for this unconventional large-scale asset purchase program, an issue which has been debated recently as I wrote about here.

Dan Thornton also goes back further in time, documenting changes in the FOMC Directive. He finds no references to “maximum employment” from 1979, when Paul Volcker took over as Fed chair, until the language was inserted in the December 2008 Directive, just as the Fed was embarking on its first large scale asset purchases program, now called QE1.