Hard Truths About Easy Money

The Fed’s reluctance to raise interest rates is eerily similar to its precrisis policies a decade ago.

By Edmund Phelps

Exactly a decade ago, several asset prices—most notably home prices—were at new heights and rising. The unemployment rate was down to 4.7% and falling—a level hardly ever seen since the 1960s. Although the Federal Reserve pushed the federal-funds rate from 2004 to 2006 into the upper reaches of the normal range—around 5.25%—it declined to push the rate to the abnormally high levels used to contain the Reagan boom of the late ’80s and puncture the internet bubble of 2000.

What were they thinking? Then-Fed Chairman Alan Greenspan took the steadiness of inflation as a sign that the prevailing unemployment rate was sustainable or that market forces would gradually drive it to whatever the sustainable level might be. His successor in 2006, Ben Bernanke, had newfound confidence in the Fed’s judgment. He and MIT economist Olivier Blanchard crowed at a 2005 conference in Boston that monetary policy had become a science: When money warrants tightening or loosening, experts will know it and act.

In reality, the economy was headed for a crash. It is always the same story—even if the personae may change: Some people had made bad investments, other players had gone too deep into debt, and the resulting fear put a halt to much investment activity. The Fed was wrong in believing that low and steady inflation is a reliable sign that the unemployment rate is on the right track. The theorists who believed that market participants dependably make the right bets under the circumstance were also wrong.

Today, once more, some asset prices are very high—commercial real estate, for example. The S&P 500, which hit 17 times operating earnings in 2007, is 20 times this year. The unemployment rate is down to 4.9%. Yet the Fed hasn’t raised the near-zero fed-funds rate to more normal levels, let alone to abnormally high levels. Once again the Fed appears to see the steadiness of the inflation rate as evidence that the economy is in no danger of a financial crisis.

Besides the risk of easy money, one can question the policy objective. Fed governors observe that, though unemployment is low, male labor-force participation is extremely weak. In response, they advocate maintaining easy money to induce young working-age people to enter, and discouraged workers to re-enter, the labor force. But there are problems.

First, the Fed seems not to have appreciated that the participation rate of men age 15 to 65 has been driven down largely by structural forces more than 40 years old, such as the “great productivity slowdown,” which took hold in the late ’60s, and globalization. Among this group labor participation shrank from 92.2% in 1965-69 to 82.6% in 2000-04. It dropped slightly to 81.5% in the crisis years, 2005-09, and slid further to 78.5% in both 2014 and 2015 as the baby boomers retired. Restoring participation rates to the levels of old would be daunting.

Second, the Fed conveys no sense of how far it would like to go with its ambition to boost participation. As it populates the labor force with more of the young and the discouraged workers who are on the whole less employable than the others, the overall unemployment rate, being an average, will increase. In other words, the Fed is in a dilemma: It cannot have both the unemployment rate and the participation rate it wants.

Concerns about Fed policy go deeper. There are reasonable doubts about whether the Fed, by easing or tightening money, has the power, generally speaking, to control the unemployment rate indefinitely—contrary to Keynesianism. When the Fed shifts to easier money, is it assured that employment will increase? There is, for one thing, the familiar theory, begun in 1968 by Milton Friedman and myself, that the effect will ultimately fall wholly on the wage and price levels, leaving employment in the end unchanged.

An even worse possibility arises from the peculiar structure of the U.S. economy. It is highly integrated with financial markets overseas, so financial yields cannot differ much. Yet it is too large and too distant to depend much on exports and imports, so its prices may differ quite a lot. As in any open economy, an interest-rate cut by the central bank causes the currency to drop in foreign exchange markets. But the peculiar structure of our open economy has radical consequences made clear in a theoretical model that economists Hian Teck Hoon, Gylfi Zoega and I conceived and built in 2004.

The finding from our model concerns how domestic firms respond to the shift to easy money.

The interest rate cut, in weakening the dollar, adds to their protection from entry by overseas competitors.

The domestic firms promptly respond by raising their prices—their markups over wages, roughly speaking. This rise of markups, in shrinking the demand for labor, reduces real wage rates and employment.

The implication for Fed policy is clear: Through this channel, the continuation of easy money may be causing or contributing to the stubborn gap between output or employment and their trend paths—thus a lull in the growth of output and employment.

Do we see evidence of dollar weakness that could be traced to easy money? We do. The U.S. dollar was strikingly weak against the Chinese yuan until mid-2015, when China devalued. The dollar was weak against the euro too until early 2015, when the European Central Bank acted.

There is also the high share of profits in business output in recent years, which can be attributed to the protection that dollar weakness has offered.

The Fed, it appears, would do well to cast off its Keynesianism, resist easy money and embrace a strong dollar.

Mr. Phelps, the 2006 Nobel laureate in economics and director of Columbia University’s Center on Capitalism and Society, is the author of “Mass Flourishing” (Princeton University Press, 2013).

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