Roosevelt Institute – J. W. Mason

At Roosevelt: Reimagining Full Employment

Mike Konczal, Lauren Melodia and I have a new report out from the Roosevelt Institute, on what true full employment might look like in the United States.

This is part of a larger project of imagining what an economic boom would look like. As Mike and I argued in our recent New York Times op-ed, there’s a real possibility that the coming years could see a historic boom, thanks to the exceptionally strong stimulus measures of the past year and, hopefully, the further expansions of public spending on the way. (Interestingly, the term “boom” is now making it into Biden’s speeches on the economy.) If the administration, Congress and the Fed don’t lose their nerve and stay on the path they’re currently on, we could soon be seeing economic growth and rising wages in a way that we haven’t since at least the late 1990s.

This is going to call for a new way of thinking about economic policy. Over the past decade or more, the macroeconomic policy debate has been dominated by a consensus that is more concerned with the supposed dangers of public debt than stagnation, and sees any uptick in growth or wages as worryingly inflationary. Meanwhile, the left knows how to criticize austerity and bailouts for business, and to make the case for specific forms of public spending, but has a harder time articulating the benefits of sustained growth and tight labor markets.

What we’re trying to do is move away from the old, defensive fights about public debt and austerity and make the positive case for a bigger more active public sector. There’s no reason the Right should have a monopoly on promises faster growth and improvements in peoples material living standards. Post-covid, we’re looking at a new “morning in America” moment, and progressives should be prepared to take credit.

One of the great appeals of the Green New Deal framing on climate change is that it turns decarbonization from a question of austerity and sacrifice into a promise to improve people’s material well being, not decades from now but right now, and in ways that go well beyond climate itself. I think this promise is not just politically useful but factually well-founded, and could just as well be made for other expansions of the public sector.

This is an argument that I and others have been making for years. Of course, any promise of faster growth and higher living standards has to confront the argument, enshrined in macroeconomics textbooks, that the economy is already operating close to potential, at least most of the time — that the Federal Reserve has taken care of the demand problem. In that case, the Keynesian promise that more spending can call forth more production would no longer apply.

We’ve tended to respond to this argument negatively — that there is no evidence that the US now was facing any kind of absolute supply constraint or labor shortage before the pandemic, let alone now. This is fine as far as it goes, and I think our side of the debate has won some major victories — Jay Powell and Janet Yellen both now seem to agree that as of 2019 the US was still well short of full employement. Still, I think it’s legitimate for people to ask, “If this isn’t full employment, then what would be?” We need a positive answer of our own, and not just a negative criticism of the textbook view.

This new paper is an attempt to do just that — to construct an estimate of full employment that doesn’t build in the assumption that recent labor market performance was close to it. One way to do this is to compare the US to other advanced countries, many of which have higher employment-population ratios than the US, even after adjusting for age differences. We chose to take a different approach, one that instead looks at differences in employment rates within the US population.

From the executive summary:

This issue brief argues that potential employment in the US is much higher than we have seen in recent years. In addition to those officially counted in the labor force, there is a large latent labor force, consisting of people who are not currently seeking work but who could reasonably be expected to do so given sustained strong labor demand. This implies much more labor market slack than conventional measures of unemployment suggest.

An important but less familiar sign of labor market slack is the difference in employment rates between groups with more- and less-privileged positions in the labor market. Because less-favored groups—Black workers, women, those with less formal education, those just entering the labor market—are generally last hired and first fired, the gaps between more- and less-favored groups vary systematically over the business cycle. When labor markets are weak and employers can pick and choose among potential employees, the gap between employment rates for more- and less-favored groups widens. When labor markets are tight, and workers have more bargaining power, the gap shrinks.

We use this systematic relationship between overall labor market conditions and employment rates across race, gender, education, and age to construct a new measure of potential employment. In effect, since more-favored workers will be hired before less-favored ones, the difference in outcomes between these groups is a measure of how close hiring has gotten to the true back of the line.

We construct our measure in stages. We start with the fact that changes in employment rates within a given age group cannot reflect the effect of population aging. Simply basing potential employment by age groups on employment rates that have been observed historically implies potential employment 1.7 points higher than the CBO estimates.

Next, we close the employment gaps by race and gender, on the assumption that women and Black Americans are no less able or willing to work than white men of a similar age. (When adjusting for gender, we make an allowance for lower employment rates among parents of young children). This raises potential employment by another 6.2 points.

Finally, reducing the employment gap between more- and less-educated workers in line with the lower gaps that have been observed historically adds another 1.8 points to the potential employment rate.

In total, these adjustments yield a potential employment-population ratio 10 points higher than the CBO estimates, equivalent to the addition of about 28 million more jobs over the next decade.

Adding these 28 million additional jobs over the next decade would require an average annual growth in employment of 2.1 percent. The employment growth that would fully mobilize the latent labor force, as estimated here, is in line with the rate of GDP growth required to repair the damage from the Great Recession of 2007–2009 and return GDP to its pre–2007 trend.

You can read the rest here.

A Baker’s Dozen of Reasons Not to Worry about Government Debt

(EDIT: It’s not sufficiently clear in the original post, but I wrote this as a sort of compendium of arguments one might use in response to claims that the federal debt is a binding constraint on new spending. I’m not saying these are the best or only reasons to reject the idea that federal government cannot borrow more. I’m saying that these are arguments that seem to have some traction in the mainstream policy world, such that you could use them in a newspaper op-ed or conversation with a congress member’s staff. Also, a premise here is that there are urgent needs we want the public sector to spend more on. Apart from the last couple, these are not arguments for more public dbet as an end in itself.)

Why might larger budget deficits be ok?

There are a number of reasons why economists, policymakers and advocates believe that increased public borrowing is not something to be afraid of. As I’ll discuss below, the fundamental factor linking most of these reasons is the idea that the US economy is generally operating below capacity.

When we think about the fiscal balance – the difference between government spending and government revenue – we always have to keep in mind that it has two sides: the real side and the financial side. Whenever the government increases spending, it has two kinds of effects. First, all else equal, it increases the amount of government debt in circulation. And second, it increases demand for goods and services, both directly when the government buys them and indirectly as government spending creates incomes for private businesses and households.

To put it another way, for government to successfully raise spending without raising taxes, two things have to be true. First, someone – banks, wealthy families, foreign countries – has to be willing to hold the additional debt that the government issues. And second, someone has to be prepared to sell whatever it is that the government is trying to buy. If we are asking what kinds of limits there might be to deficit spending, we have to think about both sides. A government’s spending may face financial constraints, if people are unwilling to hold more of its debt; or real constraints, if the economy cannot produce the additional goods and services it is trying to buy.

Some people who think higher deficits are not a problem – particularly those associated with Modern Monetary Theory – believe that the US federal government never faces financial constraints, so only the real constraints matter. Others believe that the federal government might in principle face financial constraints, but there are good reasons to think that they are not an issue today. For policy purposes, the difference between these positions may not be very important.

On the real constraint side, the essential question is how close the economy is to potential output, or full employment. (The two terms are used interchanegably.) In an economy operating at potential, government can only increase its spending f the private sector reduces its spending. This “crowding out” is the real cost of increased public spending. In an economy below potential, on the other hand, the goods and services purchased by increased public spending come from mobilizing unused productive capacity, so there is no crowding out. In. fact, if the fiscal multiplier is big enough (greater than one) then increased purchases of goods and services by the public sector will result in more goods and services being purchased by the private sector as well.

Below, I lay out a baker’s dozen of related arguments for why, from a macroeconomic perspective, we should welcome increased debt-financed public spending. Some people who believe in greater public borrowing would accept all of these arguments; some only some of them.

Real-economy arguments for more public borrowing

1. The economy generally operates below potential. Over the past 30 years, there have been three recessions, each followed by a long period of weak growth and high unemployment. By official measures, in 10 of the past 30 years GDP has been at least two points below potential; there have been only six months when it was more than two points above potential. And there has been no periods of high inflation. This suggests that in general, the economy is not running at full capacity; there is additional productive potential that could be mobilized by higher public spending, without crowding out private spending. In that sense, there is no real cost to higher public spending, and no need top offset it with higher taxes. Even better, higher public spending will help close the output gap and raise private spending as well.

2. There are long run forces pushing down demand. Larry Summers famously reintroduced into the economic conversation the idea of secular stagnation – that there is a long-run tendency for private spending to fall short of the economy’s productive potential. There are many reasons we might expect private spending to be lower, relative to national income, in the future than in the past. Among these: increased monopoly power; the shift toward information-based rather than resource-intensive production; increased shareholder power; a more unequal distribution of income; slower population growth; and the satiation of demand for market consumption, in favor of leisure and nonmarket activities. (The first three of these factors tend to reduce investment spending, the last three consumption spending.) If this idea is correct, the demand shortfalls of the past thirty years are not an anomaly, and we should expect them to grow larger in the future.

3. Potential output is mismeasured; we are still well below it. Even by the conventional measures of unemployment and potential output, the US economy has spent far more time in recent decades below target than above it. But if the target is mismeasured, the problem may be even worse. There are good reasons to think that both productivity and laborforce growth over the past decade have been depressed by weak demand. If this is the case, the US economy even at the height of a supposed boom, may in fact be operating well below potential today. The fact that even with measured unemployment below 4 percent wage growth has accelerated only modestly, and inflation has not accelerated at all, is important evidence for this view.

4. Recessions and jobless recoveries have occurred repeatedly in past, will occur again in the future. Whether or not the US economy is at potential today, the current expansion will not continue forever. Recessions have occurred in the past and will occur in the future. Many forecasts believe there is a high risk of recession is likely in the relatively near future; the fact that the Fed is moving toward cutting rates suggests that they share this view. When thinking about what fiscal balance is appropriate, we need to consider not just where the economy is today but where it is likely to be in coming years.

5. Monetary policy is not effective at maintaining full employment. In the past, weak demand and recessions weren’t considered an argument for more public spending because it was assumed that a central bank following the correct policy rule could quickly return the economy to full employment. But it is increasingly clear that central banks do not have the tools (and perhaps the willingness) to precent extended periods of weak demand. It is increasingly recognized that fiscal policy is also required to stabilize demand. In his July testimony before Congress, Fed chair Jerome Powell said explicitly that in the event of another deep recession, the Fed would need help from fiscal policy. One important reason for this is the problem of the zero lower bound – since the policy interest rate cannot be set below zero, there is a limit to how far the Fed can lower it in a recession.

6. It’s hard to ramp up public spending quickly in recession. Orthodox opinion has long been that fiscal policy is not as effective as monetary policy in a recession because it takes much longer to ramp up public spending than to cut interest rates. While the experience of the Great Recession undermined conventional wisdom on many points, it supported it on this one. The ARRA stimulus bill was supposed to direct spending to “shovel-ready” projects, but in fact the majority of the infrastructure spending funded by the bill came several years after it passed. There are many institutional obstacles to increasing public spending rapidly. This means that if we need higher public spending in a recession, the best thing is to have higher spending all the time. If that leads to an overheating economy in the boom, that is an easier problem for the Fed to solve then a deep recession.

7. The costs of getting demand wrong are not symmetrical. Traditionally policymakers have defined their goal as keeping output as close to potential as possible. But it is increasingly clear that the costs of demand falling short are greater than the costs of demand overshooting potential. One reason for this is the previous point – that conventional policy has an easier time reining in excessive demand than stimulating weak demand. (As the old saying has it, “you can’t push on a string.”) A second reason is that demand has effects that go beyond the level of output. In particular, strong demand and low unemployment redistribute income toward workers from owners, and toward lower-wage workers in particular. Periods of weak demand, conversely, reduce the share of income going to workers. If we think the upward redistribution of income over the past generation is a problem, we should prefer to let demand overshoot potential than fall short of it.

8. Weak demand may have permanent effects on potential output. Traditionally, economists saw the economy’s long-term growth as being completely independent of demand conditions. People spending more money might raise production and employment today, but the long-term growth of potential output depended on structural factors – demographics, technological change, and so on. More recently, however, there has been renewed interest in the idea that weak demand can reduce potential output, an effect known as hysteresis. high unemployment may lead more people to drop out of the laborforce, while low unemployment may lead more people to enter the laborforce (or immigrate from abroad.) Strong demand may also lead to faster productivity growth. If hysteresis is real, then demand shortfalls don’t reduce output and employment this year, but potentially many years in the future as well. This is another reason to be more worried about demand falling short than overshooting, hence another reason to prefer a more expansionary fiscal stance, which normally implies more public borrowing.

Financial arguments for more public borrowing

9. With low interest rates, debt does not snowball. Traditionally, concerns about the financing of government spending have focused on whether debt is “sustainable” – whether debt levels will stabilize as a fraction of GDP, or rise without limit. When interest rates are greater than GDP growth rates, this implies a hard limit to government borrowing – to keep the debt-GDP ratio on a stable path, a deficit in one year must be made up for by a larger surplus in a future year. Otherwise, the interest on the existing debt will imply more and more borrowing, with the debt-GDP ratio rising without limit. But when interest rates on government debt are below growth rates, as they have been for the past 25 years, the debt ratio will stabilize on its own – deficits do not have to be offset with surpluses. This makes much of the earlier concern with debt sustainability obsolete.

10. There is good reason to think interest rates will remain low. There are a number of reasons to think that interest rates on public debt are likely to remain low, even if debt ratios rise considerably higher. First, low interest rates reflect the conditions of chronic weak demand discussed above, for two reasons. First, low investment means less demand for borrowed funds. And second, weak demand means that the interest rate set by the central bank is likely to be low. A second reason to expect low interest rates to continue is that the past ten years have repeatedly falsified predictions of bond vigilantes driving up the rates on government debt. Prior to the financial crisis of 2007-2008, many observers expected a catastrophic flight by investors away from US government debt and the dollar, but in fact, the crisis saw a steep fall interest rates on government debt and a rise in the dollar, as investors all over the world rushed to the safety of Treasury debt. Similarly, in Europe, even in the worst crisis-hit countries like Greece, interest rates are at their lowest point in history. Similarly Japan, with one of the highest debt0-GDP ratios ever recorded (about triple that of the US) continues to borrow at very low rats. Third, the experience of the past ten years have made it clear that even if investors were to demand higher interest rates on government debt, modern central banks can easily overcome this. The most dramatic illustration of this came in the summer of 2012, when a public statement by European Central bank chief Mario Draghi “we will do whatever it takes, and believe me, it will be enough”) reversed the spike in interest rates in countries like Italy, Spain and Portugal practically overnight. Finally, the prices of bonds — with hardly any premium for 30 year bonds over 5 and 10 year maturities — show that private investors do not expect a rise in interest rates any time in the foreseeable future.

11. With hysteresis, higher public borrowing can pay for itself. Even if we are concerned about lowering the debt-GDP ratio, the existence of hysteresis (point 8 above) means that cutting public borrowing is necessarily the right way to get there. In a world where the long-term path of GDP depends on aggregate demand, austerity can be self-defeating even in its own narrow financial terms. If lower public spending reduces demand, then it can lead to lower GDP, potentially raising the debt to GDP ratio even if it succeeds in reducing debt. Greece offers a clear example of this – the fiscal surpluses between 2010 and 2015 succeeded in reducing government debt by 5 percent, but the deep austerity contributed to a fall in GDP of 25 percent. So the debt-GDP ratio actually rose. Similarly, if debt-financed public spending leads to faster growth, the debt-GDP ratio may end up lower than otherwise.

12. Federal debt is an important asset for financial markets. The points up to now have been arguments for why higher public debt is acceptable. But there is also an argument that increased public debt would be a positive good. Financial markets depend on Treasury debt as a safe, liquid asset. Federal government debt offers an absolutely safe asset that can always be sold quickly and at a predictable price – something that is extremely valuable for banks and other financial institutions. There is a strong argument that the growth of the mortgage-backed security market in the 2000s was fundamentally driven by a scarcity of government debt – many financial institutions wanted (or were compelled by regulation) to hold a substantial amount of ultrasafe, liquid debt, and there was not enough government debt in circulation to meet this demand. So financial markets came up with mortgage-backed securities as a supposed alternative – with disastrous results. Similarly, after the recession, one argument for why the recovery was so slow was a “safe asset shortage” – financial institutions were unwilling to make risky loans without holdings of ultrasafe assets to balance them. While these concerns have receded today, there is still good reason to expect a “flight to safety” toward Treasury debt in the event of a new crisis, and government debt remains important for settling many financial contracts and pricing other assets. So strange as it may sound, there is a serious argument – made by, among others, Nobel prize winner Jean Tirole in his book on financial liquidity — that increased government borrowing would make the financial system more stable and increase access to credit for other borrowers.

13. Federal debt is an important asset for the rest of the world. Federal debt is an important asset not just for the US financial system, but for the rest of the world. In today’s dollar-based international system, the great majority of international trade and investment is denominated in dollars, and most foreign-exchange transactions involve dollars. As a result, central banks (and private financial institutions) all over the world hold foreign-exchange reserves primarily in the form of dollars. These dollar reserves are mainly held in the form of Treasury debt. Close to half of federal debt is now held abroad, mainly as reserves by foreign governments. These holdings are essential for the stability of the international financial system – without adequate reserves, countries are vulnerable to sudden flows of “hot money” out of their countries. As Barry Eichengreen – perhaps the leading economic historian of the international financial system, — has noted, a deep market for government is an essential requirement for a currency to serve as the global reserve currency. If the US is going to be a responsible partner for the rest of the world — and continue reaping the benefits of being at the center of the global economy — it needs to provide an adequate supply of safe government debt for the rest of the world to hold as reserves.

(I wrote this document for internal use at the Roosevelt Institute. Figured I might as well put it up here as well. Obviously it would benefit from links to supporting material, which I may add at some point.)

Good News on the Economy, Bad News on Economic Policy

(Cross-posted from the Roosevelt Institute blog. I am hoping to start doing these kinds of posts on new economic data somewhat regularly.)

On Friday, the the Bureau of Labor Statistics released the unemployment figures for May. As expected, the reported unemployment rate was very low—3.6 percent, the same as last month. Combined with the steady growth in employment over the past few years, this level of unemployment—not seen since the 1960s—suggests an exceptionally strong labor market by historical standards. On one level this really is good news for the economy. But at the same time it is very bad news for economic policy: The fact that employment this low is possible, shows that we have fallen even farther short of full employment in earlier years than we thought.

Some skeptics, of course, will cast doubts on how meaningful the BLS numbers are. The headline unemployment rate, they will argue, understates true slack in the labor market; many of the jobs being created are low-wage and insecure; workers’ overall position is still weak and precarious by historical standards.

This is all true. But it is also true that the unemployment numbers are not an isolated outlier. Virtually every other measure also suggests a labor market that is relatively favorable to workers, at least by the standards of the past 20 years.

The broader unemployment measures published by the BLS, while higher than the headline rate, have come down more or less in lockstep with it. (The new release shows that the BLS’s broadest measure of unemployment, U-6, continued to decline in May, thanks to a steep fall in the number of people working part-time because they can’t find full-time work.) The labor force participation rate, after declining for a number of years, has now started to trend back upward, suggesting that people who might have given up on finding a job a few years ago are once again finding it worthwhile to look for one. The fraction of workers voluntarily quitting their jobs, at 2.3 percent, is now higher than it ever got during the previous business cycle. The quit rate is a good measure of labor market tightness—one of former Fed chair Janet Yellen’s preferred measures—because it shows you how people evaluate their own job prospects; people are much more likely to quit their current job if they expect to get a better one. Reported job openings, a longstanding measure of labor market conditions, are at their highest level on record, with employers reporting that nearly 5 percent of positions are unfilled. Wage growth, which was nowhere to be seen well into the official recovery, has finally begun to pick up, with wage growth noticeably faster since 2016 than in the first six years of the expansion. In the nonfinancial business sector—where the shares of labor and capital are most easily measured—the share of value added going to labor has finally begun to tick up, from a steady 57 percent from 2011 to 2014 up to 59 percent by 2017. Though still far short of the 65 percent of value added claimed by labor at the height of the late-1990s boom, the recent increase does suggest an environment in which bargaining power has at last begun to shift in favor of workers.

For progressives, it can be a challenge to talk about the strengthening labor market. Our first instinct is often to call attention to the ways in which workers’ position is still worse than it was a generation ago, and to all the ways that the labor market is still rigged in favor of employers. This instinct is not wrong, but it is only one side of the picture. At the same time, we need to call attention to the real gains to working people from a high-pressure economy—one where aggregate demand is running ahead of available labor.

A high-pressure economy is especially important for those at the back of the hiring queue. People sometimes say that full employment is fine, but that it doesn’t help people of color, younger people, or those without college degrees. This thinking, however, is backwards. It is educated white men with plenty of experience whose job prospects depend least on overall labor market conditions; their employment prospects are good whether overall unemployment rates are high or low. It is those at the back of the hiring queue—Black Americans, those who have received less education, people with criminal records, and others discriminated against by potential employers—who depend much more on a strong labor market. The Atlanta Fed’s useful wage tracker shows this clearly: Wage growth for lower-wage, non-white, and less-educated workers lagged behind that of college-educated white workers during the high-unemployment years following the recession. Since 2016, however, that pattern has reversed, with the biggest wage gains for nonwhite workers and those at the bottom of the wage distribution. This pattern has been documented in careful empirical work by Josh Bivens and Ben Zipperer of the Economic Policy Institute, who show that, historically, tight labor markets have disproportionately benefited Black workers and raised wages most at the bottom.

Does this mean we should be satisfied with the state of macroeconomic policy—if not in every detail, at least with its broad direction?

No, it means just the opposite. Labor markets do seem to be doing well today. But that only shows that macroeconomic performance over the past decade was even worse than we thought.

This is true in a precise sense. Macroeconomic policy always aims at keeping the economy near some target. Whether we define the target as potential output or full employment, the goal of policy is to keep the actual level of activity as close to it as possible. But we can’t see the target directly. We know how high gross domestic product (GDP) growth is or how low unemployment is, but we don’t know how high or how low they could be. Everyone agrees that the US fell short of full employment for much of the past decade, but we don’t know how far short. Every month that the US records an unemployment rate below 4 percent suggests that these low unemployment rates are indeed sustainable. Which means that they should be the benchmark for full employment. Which also means that the economy fell that much further short of full employment in the years after the 2008-2009 recession—and, indeed, in the years before it.

For example: In 2014, the headline unemployment rate averaged 6.2 percent. At that time, the benchmark for full employment (technically, the non-accelerating inflation rate of unemployment, or NAIRU) used by the federal government was 4.8 percent, suggesting a 1.4 point shortfall, equivalent to 2.2 million excess people out of work. But let’s suppose that today’s unemployment rate of 3.6 percent is sustainable—which it certainly seems to be, given that it is, in fact, being sustained. Then the unemployment rate in 2014 wasn’t 1.4 points too high but 2.6 points too high, which is nearly twice as big of a gap as policymakers thought at the time. Again, this implies that the failure of demand management after the Great Recession was even worse than we thought.

And not just after it. For most of the previous expansion, unemployment was above 5 percent, and the labor share was falling. At the time, this was considered full employment – indeed, the self-congratulation over the so-called Great Moderation and “amazing success” of economic policy reached a crescendo in this period. But if a perofrmance like today’s was possible then — and why shouldn’t it have been? — then what policymakers were actually presiding over was an extended stagnation. As Minnesota Fed chair Narayan Kocherlakota – one of the the few people at the economic-policy high table who seems to have learned something from the past decade – points out, the US “output gap has been negative for almost the entirety of the current millenium.”

These mistakes have consequences. For years now, we have been repeatedly told that the US is at or above full employment—claims that have been repeatedly proved wrong as the labor market continues to strengthen. Only three years ago, respectable opinion dismissed the idea that, with sufficient stimulus, the unemployment could fall below 4 percent as absurd. As a result, we spent years talking about how to rein in demand and bring down the deficit, when in retrospect it is clear that we should have been talking about big new public spending programs to boost demand.

This, then, is a lesson we can draw from today’s strong unemployment numbers. Strong economic growth does improve the bargaining position of workers relative to employers, just as it has in the past. The fact that the genuine gains for working people over the past couple years have only begun to roll back the losses of the past 20 doesn’t mean that strong demand is not an important goal for policy. It means that we need much more of it, sustained for much longer. More fundamentally, strong labor markets today are no grounds for complacency about the state of macroeconomic policy. Again, the fact that today’s labor market outcomes are better than people thought possible a few years ago shows that the earlier outcomes were even worse than we thought. The lesson we should take is not that today’s good numbers are somehow fake; they are real, or at least they reflect a real shift from the position of a few years ago. Rather, the lesson we should take is that we need to set our sights higher. If today’s strong labor markets are sustainable—and there’s no reason to think that they are not—then we should not accept a macroeconomic policy consensus that has been willing to settle for so much less for so long.

Could Trump Have a Point about Rate Hikes?

(Cross-posted from The Next New Deal at The Roosevelt Institute.)

At its December meeting, the Federal Reserve raised its benchmark interest rate a quarter point. The move, while widely expected, represented a clear rebuke to President Trump, who has repeatedly urged the Fed to keep rates low. He took to Twitter after the move to attack Fed head Jerome Powell as a golfer who has no touch (“he can’t putt”)—strong words in the president’s social circle.

Trump’s critics on the left may be tempted to cheer the Fed’s decision as a welcome triumph of the separation of powers. But opposing him on the grounds that the labor market is already great may end up weakening the case for a progressive agenda. We need to consider the possibility that, in this one case, the president is right.

By raising rates, the Fed is signaling that it thinks that the economy is now operating at potential, or full employment. Conventional economic theory says that when the economy is below potential, more spending will bring unemployed and underemployed people to work, and more fully utilize structures and equipment, but once potential is reached, additional spending will just lead to higher prices. So when output is below potential, anything that raises spending—whether it is tax cuts, increased federal spending, a more favorable trade balance, or lower interest rates—is macroeconomically useful. But once the economy is at potential, and there are no more unemployed people or underused buildings and machines, the same policies will lead only to more inflation.

By this standard, the case for the most recent rate increase was plausible, though not a slam dunk. By the official measures produced by the Bureau of Economic Analysis (BEA), 2018 was the first year since 2007 that GDP reached potential, and at 3.7 percent, the headline unemployment rate is quite low by historical standards. So textbook logic suggests that if demand growth does not slow, inflation is likely to rise.

The past decade, however, has given us reason to doubt the textbook models. As I argued in the Roosevelt report What Recovery?, it is far from clear that the BEA’s measure does a good job capturing the productive potential of the economy. Similarly, the headline unemployment rate may no longer be a good measure of the economically relevant category of people available for work; many people move directly between being out of the laborforce and being employed. The behavior of inflation has defied any mechanical linkage with GDP growth, wages, or unemployment. And even if one accepts that output is nearing potential, a higher interest rate may not be necessary to slow it. (This is related to the idea of r*, the “neutral” rate of interest, which neither raises nor lowers demand—something that many people, including Powell himself, have suggested we don’t actually know.) Given these uncertainties, many people—across the political spectrum—have argued that it’s foolish for the central bank to try to make policy based on guesses of where inflation is heading. Instead, they should wait to raise rates until it is clear that inflation is above target.

More broadly, the question of whether the economy is at full employment implies a judgement on whether this is the best we can do, economically. Are the millions of people who have dropped out of the laborforce over the past decade really unable or unwilling to engage in paid work? Is the decline of American manufacturing the inevitable result of a lack of competitiveness? Are the millions of people working at low-wage, dead-end jobs incapable of doing anything more rewarding? The decision to raise rates implicitly assumes that the answers are yes. People who think that the economy could work better for ordinary people should hesitate to agree.

We live in a country filled with energetic, talented, creative people, many of whom are forced to spend their days doing tedious busywork. Personally, I find it offensive to claim that a job at McDonald’s or in a nail salon or Amazon warehouse is the fullest use of anyone’s potential. When John Maynard Keynes said “we will build our New Jerusalem out of the labour which in our former vain folly we were keeping unused and unhappy in enforced idleness,” he didn’t only mean literal idleness, but wasted labor more broadly. In a society in which aggregate expenditure was constantly pushing against supply constraints, millions of people today who spend their working hours in menial, unproductive activities would instead be developing their capacities as engineers, artists, electricians, doctors, and scientists.

Progressives concerned about the distribution of income should also pause before cheering an interest rate hike. The textbook model assumes that wage changes are passed more or less one for one to prices (that’s why the Fed pays so much attention to unemployment). But we know that this is not true. Slow wage growth may simply mean a lower share of income going to workers, rather than lower inflation, and high wages may lead to an increase in labor share rather than to higher inflation. Indeed, as a matter of math, the labor share of income cannot rise unless wages rise faster than the sum of productivity growth and inflation. For most of the past decade—and much of the decade before—wages have risen more slowly than this. As a result, labor compensation has fallen to 58 percent of value added in the corporate sector (where it is most reliably measured), down from 60 percent a decade ago and 66 percent in 2000. The only way that this shift from labor to capital can be reversed is if we see an extended period of “excessive” wage growth. This recent hike suggests that the Fed will not tolerate that.

The alternative is to deliberately foster what is sometimes called a “high-pressure” economy. Allowing the unemployment rate to remain low enough for sustained rapid wage growth won’t just help restore the ground that workers have lost over the past decade. It could also boost laborforce participation, as discouraged workers return to the labor market. And it could boost productivity, as scarce workers and strong demand encourage businesses to undertake labor-saving investment. An increasing number of economists think that these kinds of effects, called hysteresis, mean that weak demand conditions can reduce the economy’s productive potential—and strong demand can increase it.

We are already seeing some signs of this. The fall in the laborforce participation over the past decade was, according to most studies, was much larger than can be explained by aging and other demographic factors. Now, as the labor market gets stronger, people who dropped out of the laborforce are reentering it. Some businesses in low-unemployment areas are now paying for English lessons so they can hire non-English speaking immigrants, who are normally among the last to be employed. After years of stagnation, wages are beginning to rise fast enough to produce a modest rise in the hare of output going to workers—the predictable result of a strong labor market. A recent study by the Federal Reserve Bank of Atlanta confirmed that a high-pressure economy, with unemployment well below normal levels, can boost earnings and strengthen attachment to the laborforce. The effects are long-lasting and strongest for those at the back of the hiring queue, such as Black Americans and those with less-formal education. Labor productivity has yet to pick up, but business investment is now quite strong, so it is likely that productivity may soon start rising as well. None of these gains will be realized if the Fed acts too quickly to rein in a boom.

Critics of the president who argue that the economy is already at full employment risk replaying the 2016 election, where the Democrats were perceived—fairly or not—as defenders of the status quo, while Trump spoke to and for those left behind by the recovery. And they risk throwing away one of the best arguments for a progressive program in 2021 and beyond. The next Democratic president will enter office with an ambitious agenda. Whether the top priority is Medicare for All, a Green New Deal, universal childcare, or free higher education, realizing this agenda will require a substantial increase in government spending. Making the case for this will be much easier if there is broad agreement that the economy still suffers from a demand shortfall that public spending can fill.

EDIT: The one thing I did not mention here and should have is that the principle of central bank indpedence is also not something that anyone on the left should be defending. Like the various countermajoritarian features of the US political system, it will be wielded more aggressively against any kind of progressive program. And as Mike Konczal and I have argued, both financial crises and extended periods of weak demand have forced central banks to broaden their mandate, making it much harder to mark off “monetary policy” proper from economic policy in general.

What to Do about the Trade Deficit: Nothing

Roosevelt Institute has a new roundup of policy advice for the next administration. There is a lot of useful stuff in there, which perhaps I’ll post more on later. My own contribution is on international trade. Here’s the summary:

It is natural to look to measures to improve the trade balance — through a weaker dollar, or through tariffs or other direct limits on imports — as a way to raise demand and boost output and employment. While the U.S. has done little to boost net exports in recent decades, there is increasing public discussion of such measures today…

We argue that while the orthodox view is wrong about trade being macroeconomically neutral, measures to improve the U.S. trade balance would nonetheless be a mistake. All else equal, a more favorable trade balance will raise demand and boost employment. But all else
is not equal, thanks to the special role of the U.S. in the world economy. The global economy today operates on what is effectively a dollar standard: The U.S. dollar serves as the international currency, the way gold did under under the gold standard. In part for this reason, the U.S. can finance trade deficits indefinitely while most other countries cannot. For many of our trade partners, any reduction of net exports would imply unsustainable trade deficits. So policies intended to improve the U.S. trade balance are likely to instead lead to lower growth elsewhere, imposing large costs on the rest of the world with little or no benefits here.

We do not deny that the trade deficit has negative effects on demand and employment in the U.S., but we argue this is only a reason to redouble efforts to boost domestic demand. The solution to the contractionary effects of the trade deficit is not a costly, and probably futile, effort to move toward a trade surplus, but rather measures to boost investment in both the public and private sector.

You can read the rest of my piece here.

There were a couple figures that didn’t make it into the final piece. Here is one, showing the stability of the international role of the dollar over the past 20 years.

The dotted line shows the share of central bank reserves held in dollars (source). The heavy line shows the share of foreign-exchange transactions that involve the dollar (source). About two-thirds of foreign exchange reserves are held in dollars, and close to 90 percent of foreign-exchange transactions involve the dollar and some other currency. These shares have not diminished at all over the past 20 years, despite continuous US trade deficits.

In my opinion, the international role of the dollar makes it exceedingly unlikely that the US could face a sudden outflow of foreign investment. (And given that US liabilities are overwhelmingly dollar-denominated, it is not clear what the costs of such an outflow would be.) It also makes it highly unlikely that the US can achieve balanced trade through conventional measures, unless we come up with some other mechanism to provide the rest of the world with dollar liquidity.