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Friday, June 3, 2011

Why Macroeconomic Policy Doesn't Work

This morning we got an anemic employment report, as expected, with a slight pickup in the unemployment rate. This comes after, in effect, throwing the kitchen sink (in terms of fiscal and monetary policy) at the economy.

On the fiscal policy front, the Bush tax cuts have been extended and a payroll tax cut has been enacted along with a massive stimulus program. On the monetary policy front, short-term rates have been driven to zero and two massive programs of monetizing the debt, known as QE1 and QE2, have been carried out. The end result of these policies have been a record deficit of $1.4 trillion, a national debt equal to the GDP production of a year, a bloated Federal Reserve balance sheet, a sinking dollar, and a protracted fight over increasing the debt limit.

And still, the economy limps along. How can this be? Why isn't macroeconomic policy working?

The answer, IMHO, goes deep into misinterpreting British economist Keynes, the inevitable arrogance that power brings, and a basic misunderstanding of economics.

Let's start with the basic misunderstanding of economics. Controlling prices distorts resource allocation. This is Econ 101. Instructors put up the well-known minimum wage graph and show the unemployment that results. Instructors put up the graph of rent control and explain that, over time, rent control destroys cities.

Then they go teach their macroeconomic class and somehow fail to grasp the long run consequences of the Federal Reserve controlling arguably the most important price in the economy - the price of short-term money.

Take a quick look at the past decade during which, in 2003, the federal funds target rate under former Fed Chairman Greenspan was driven to 1%, during a strong housing market. This poured gasoline on a fire. The housing market took off on a moonshot. The labor force poured into the home building market, the mortgage creation industry, and, yes, the financial services industry of securitizing exotic mortgages. In other words, controlling prices and jerking them around have real consequences.

The Fed then turned around a year later and systematically, as shown on the graph ( CLICK TO ENLARGE), pushed short-term rates sharply higher. This caused the housing market, which was speeding ahead at 110 miles an hour, to slam head-first into a wall. In real terms. all of sudden the home builders, real estate agents, etc., were superfluous.

These are people, many of whom would have finished college with a degree in another area, satisfying a legitimate economic need - not one artificially created by a Fed controlling the price of short-term money. And today people need to be retrained in a world that has become considerably more complicated. Putting people back to work takes a long time in today's technologically driven world.

The story for fiscal policy is just as depressing. John Maynard Keynes, in The General Theory of Employment Interest and Money (arguably the most influential book of the 20th century), outlined a specific strategy for countering a severe economic downturn. It justified deficit spending during such periods. Unfortunately, politicians have used the justification to spend irresponsibly during all phases of the business cycle. This brought us into the present situation already with a massive debt and a large deficit. In other words, there were holes in the roof before it started to rain.

Even the man in the street knows that fiscal policy programs have to be paid for. Politicians have ignored this basic principle and now are willing to bring the U.S. to the brink of default, surely causing Alexander Hamilton to spin in his grave.

The programs lead to spending, but they don't retrain people for the types of jobs that are now available.

Where does the arrogance come in? It clearly is a power trip for those who have taken it upon themselves to set the price of short-term money. Former Chairman Greenspan was at the point of changing the rate practically every time he forecasted a change in the overall economy. It is reminiscent of former Soviet Union economic planners.

And many have argued that the Fed Chairman is the second most powerful person in the world. In fact, this is probably true - unfortunately, this power is hurting millions of American families.


  1. Considering these guys are answerable to no one once their power trip is over, this is depressing.

  2. It is depressing. I often wonder how much progress the economy would have made if government policy makers stop screwing things up. Make the rules and get out of the way and let the market set prices on interest rates, currencies etc.

  3. I'm no economist, but I truly think that one of our biggest problems is not training people for the types of jobs available. They're fighting so hard to keep the car industry in detroit, but what good will it do America to raise another generation of assembly line workers? Aren't we supposed to be moving up the value chain? So yea, save the car industry, but save (i.e. build, grow, and train) the engineers and designers and accountants, not the factory janitors.