Janet Yellen, President Obama's choice to lead the Federal Reserve, went up to Capitol Hill yesterday to face the Senate Banking Committee for her confirmation hearing.
Predictably Republicans were critical of Ms. Yellen while Democrats were supportive. The Fed's so-called quantitative easing policy took center stage. Republican senators took their time criticizing the policy and raising the specter of inflation. Their contention was that the expansive monetary policy was not working.
On that point I agree with them. But not for the reasons they gave.
According to the Keynesian model, whenever the economy is in a period of decline, it is primarily because their is an inadequate level of investment. Keynes theorized that if there was insufficient private investment in the economy then the government needed to step in to make up the difference. This could be accomplished in a variety of ways.
First, the government could take the direct approach and up the level of aggregate spending. This is the path that President Roosevelt eventually took to try to bring the country out of the Great Depression. Some of the increase in spending is the result of welfare programs that assist folks in need. Overall investment can also be increased by reducing taxes - therefore freeing up more money for investment. Finally, total investment can be increased by reducing the interest rates the Fed charges banks to borrow money. Reducing those rates should, in theory, lead to lower interest rates on loans and credit cards.
Of these methods, the most direct way of impacting the economy is through direct government investment. That entails public works projects such as road, bridge and school construction. It can also be accomplished through programs in which the government hires unemployed folks to carry out various projects. President Roosevelt's New Deal created an alphabet soup of direct hire programs that brought the unemployment rate down. The New Deal programs put money in the pockets of those who needed it most. They spent the money on essential goods and services which insured that the money kept circulating through the economy.
While cutting taxes also puts more money in people's hands, it puts more money in the hands of those who have more money. Just think about it, if you cut taxes, the folks who benefit are the folks who have the most money to begin with. Some of that money is spent on essential goods and services but a good chunk of that money is squirreled away where it doesn't increase overall demand for goods and services and, therefore, workers. The best example of this would be the mountain of cash most corporations are sitting on as we speak. Instead of using that money to hire new workers, companies are hoarding it or doling out more bonuses to executives and managers.
The least effective method of spurring economic growth is through monetary policy. While raising interest rates is a great way to choke off the economy by making it more expensive for businesses to borrow money to invest in new plants, equipment and workers, lowering rates have a very marginal effect on economic growth. Again, just look at the amount of cash that companies have sitting in their bank accounts right now. If banks aren't willing to lend out money, it doesn't matter how low interest rates are - no one will be borrowing. As it stands right now, the interest rate the Fed charges banks to borrow is effectively zero - yet the economy still stumbles along with unreasonably high unemployment.
We have sat through years of record low interest rates and expansive monetary policy and yet we still have unemployment well over 7% and low- to moderate economic growth. It's the policy, stupid.
Trying to restart the economy by tinkering with interest rates is, as Mr. Keynes once said, akin to trying to push a string. Republicans would have you believe that the biggest worry we have right now is the possibility of inflation. I've got news for you. The only folks worried about inflation are bankers and those who lend money. The real problem is unemployment and sluggish demand. Those problems are not going to be solved by expanding the money supply. Those problems will only be solved by polices that promote full employment.
Until we have unemployment down to manageable levels, inflation isn't something we should fear. Quite the contrary. Except for inflation caused by external shocks to the economy, inflationary pressures are a sign that aggregate demand is increasing due to increased employment.
If working folks had political power in proportion to their numbers, we wouldn't be having this silly debate over inflation versus employment. But such is that artificial world known as Washington, D.C.