The impending replacement of the chairman of the Federal Reserve has taken on elements of a political campaign, with members of Congress endorsing candidates and financial bloggers strafing rival monetary camps. One half expects to see ads go up in Iowa: “Janet Yellen: Inflation’s best friend,” or “Larry Summers: In your heart you know he’s skeptical of quantitative easing.”
This spectacle should not be allowed to distract from a reality indifferent to the views (or gender) of the next chairman: We are reaching the limits of monetary policy. And few know what lies beyond it.
For evidence, listen to the central bankers themselves. European Central Bank President Mario Draghi recently said, “Monetary policy cannot create real economic growth . . . The ECB has done as much as it can to stabilize markets and support the economy. Now governments and parliaments need to do all they can to raise growth potential.” Outgoing Fed Chairman Ben Bernanke has been gently suggesting there are limits to what the Fed can accomplish and warning against counterproductive fiscal policies and confidence-shaking political confrontations. Jeffrey Lacker, president of the Richmond Federal Reserve, argues that economic growth is limited “in large part, by structural factors that monetary policy is not capable of offsetting.”
America’s central bank has been engaged in a massive, partially successful experiment. In 2008, it arguably saved the country from a ruinous depression by pumping electronically printed money into the economy to get frozen credit thawed and flowing. Then an emergency measure was transformed into an economic policy tool. The Fed has attempted to promote economic growth and job creation by making regular, large-scale purchases of government and corporate bonds — now at $85 billion a month — in order to reduce the cost of long-term borrowing.
After five years of historically low interest rates and aggressive asset purchases, the results are mixed. The housing market and the stock market have clearly benefited (stock values have more than doubled since their bottom in 2009). Loose money makes riskier investments more attractive. And inflation fears have not (so far) been justified. But job creation and economic growth remain weak — significantly weaker than previous recoveries. We have a booming stock market grafted onto an anemic real economy. This has been a good deal for those who hold assets; not so good a deal for those who depend on wages.
Eventually, by nearly universal admission, this policy has diminishing returns and growing risks. Propping up stock and home values, however advisable during an economic crisis or downturn, does little to improve long-term economic fundamentals. And easy money involves the risks of speculative bubbles and future inflation. So the Fed has begun signaling that monetary stimulus will not last forever. A tapering in bond purchases could begin in the fall. The next Fed chairman will have the unenviable task of removing the training wheels from markets without causing a crash. To strain another analogy, he or she will test if easy money has been a caffeine high or a heroin high, with the consequences of withdrawal ranging from unpleasant to debilitating.
The larger risk of loose money is not in causing problems but in hiding them. High stock prices and positive (but slow) economic growth create a political atmosphere in which long-term structural problems can be ignored or avoided. I’m willing to admit that monetary and fiscal stimulus can help smooth out economic cycles. But these instruments do not cause economic development, which ultimately depends on factors such as the quality of education, the skills possessed by workers, technological innovation, modern infrastructure, reasonable regulation, predictable taxation and proper incentives for work and investment.
Other nations seem to be relentlessly focused on the need to innovate and compete. See the German approach to vocational education or the South Korean emphasis on educational outcomes.
But in the American political system, there is scant evidence of comparable seriousness. Our schools wallow in mediocrity — while some Republicans spin ideological conspiracy theories about common core standards. Our health system imposes a serious economic burden of waste – perhaps 30 percent to 50 percent of total spending — which Democratic reform hardly addressed. There is little prospect of fundamental tax reform, which some economists estimate might add 0.5 to 1 percentage point in GDP growth. Or for putting entitlement spending on a sustainable path, which might remove some uncertainty about future tax rates and economic conditions.
Our politics seems to be in worst sort of bubble — a bubble of complacency. And all bubbles eventually burst.