Fed Doves Need to Think Big
After weeks of delay thanks to the federal government shutdown, the U.S. Bureau of Labor Statistics released the lackluster September jobs report this morning. Economists at the Federal Reserve Bank of Chicago think that we won't return to full employment until sometime in 2018 if jobs growth remains at the pace set since the start of 2011 -- and that's after making generous assumptions about aging, birthrates and immigration. One possible solution: financial reform.
Some people think that growth could be improved if the Federal Reserve just pushed harder on its magic lever that controls the economy. Others, such as Fed Governor Jeremy Stein, worry that central banks trying to revive weak economies face a much more complex set of tradeoffsthan suggested by standard models, which only look at consumer prices and joblessness. Monetary stimulus may juice growth in the short term but at the risk of a future crisis as bad as what we recently experienced.
Charles Evans, the president of the Chicago Fed, weighed in on this dispute last week. After hemming and hawing about whether monetary policy actually affects risk-taking, he made a useful suggestion about how to thread the needle:
When weighing the costs and benefits of alternative policy actions under these circumstances, I would have to question whether the financial system has become too complex — perhaps complex enough to generate negative marginal social value. Rather than degrading our macroeconomic performance through suboptimal monetary policies, I also would have to consider whether we should contemplate big changes to the financial system — a lot more rules, substantially higher capital requirements for all institutions and maybe even fewer financial products.
Monetary policy mostly works by affecting the incentives of financial firms. If we really have to choose between permanent economic weakness and temporary periods of rapid growth punctuated by devastating crises, then a lot of work needs to be done fixing the financial system, as Evans intimated. Fundamentally, there needs to be ahard separationbetween assets that are guaranteed by the government and those that are exposed to risk of loss. That would make it easier for the central bank to literallygive people money, which would boost the economy without disastrous side effects. (The vicissitudes of human nature mean that some form of the business cycle will always be with us, however.)
Evans thinks that the reforms implemented since 2010 have already solved this problem, going so far as to say that "these regulatory efforts can effectively minimize the risks of another crisis." That sanguine view may turn out to be right, but it sounds uncomfortably familiar to Nobel laureate Robert Lucas's 2003 assertionthat the "problem of depression prevention has been solved."
I would find Evans's plans to suppress interest rates far less troubling if I shared his confidence that the instability in the financial system had been removed. But all the big firms remain insufficiently capitalized to withstand losses in a severe recession, much less the liquidity drain that would attend a flight by short-term creditors in a panic.
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