Why Fiscal Stimulus Fails

Richard Epstein*

Richard Epstein

Richard Epstein

Over the past several weeks, we’ve once again seen how the Federal Reserve’s stimulus policy has done nothing to help the economy. Fourth quarter growth for 2015 was a disappointing 0.7 percent, and there are no obvious signs of improvement in sight for 2016. Nonetheless, as the U.S. economy continues to smolder, the Fed acts as though pulling levers on interest rates will get us out of this seemingly endless trough.

In December, the Fed thought that the economy was turning around and accordingly raised the federal funds rate from one-quarter to one-half percent, with the prospect of further increases down the road. In January, the Fed let the interest rate remain constant, and there is now an active debate over whether the weak growth numbers will induce the Fed to postpone raising that key rate as widely expected. As usual, the Fed conceives that its mission is to run a delicate balancing act between overall economic activity on the one hand and the job market on the other. Thus the justification offered for the December increase—the first in about seven years—was the “considerable improvement” in the job market, which is in reality far weaker than it appears, given the low labor market participation rate, the rise in part-time employment, and the general stagnation in wages.

Nor is the U.S. exceptional in how it deals with these problems. Labor market problems in Europe are chronic, and the prolonged economic slowdown is of increasing worldwide concern. In late January, nervous central bankers in other major countries adopted stimulus policies more aggressive than the Fed’s. The Bank of Japan, joined by number of European banks, set key short-term interest rates at below zero, in effect charging banks to hold their deposits in order to encourage private lending. Japan’s central bank accomplished this by imposing a 0.1 percent penalty on excess reserves. No longer is there general expectation of a 2 percent inflation rate. Instead the recent central bank decisions presage a new deflationary cycle, which is no recipe for growth.

Clearly something is amiss if the basic stimulus approach of the last seven years has failed to stem the tide of global economic stagnation. In making this claim, I do not think that budgetary austerity will solve most problems either, but think that these poor results, far from being an unexplainable accident, are evidence of systematic blunders and cry out for a top-to-bottom reassessment in the U.S. and elsewhere. Forget the subtle cross-national differences in institutional arrangements. What the world faces today is a basic common mode failure.

The conventional wisdom dubiously holds that a stimulus program is the best way to secure economic growth when the economy falters. The usual story is that low interest rates induce individuals and firms to borrow money, which in turn leads to higher levels of risk-taking, which in turn leads to faster rates of growth—faster, that is, than the anemic growth rates we’ve seen since the financial meltdown of 2008. In a recent speech, Economic Central Bank President Mario Draghi emphasized that although Germany’s low interest rates might encourage excessive risk-taking, he found no indication that these rates have led to financial instability. The boo-birds, Draghi notes, have been proved wrong time and again. The risks of the stimulus program, he concludes, are smaller than the risks of doing nothing.

Draghi’s last sentence is true after a fashion. The key point here is that what needs to be done is not to fiddle with interest rates, but to make major structural reforms in important economic areas, most notably in labor markets. To start with the basic story, there is at best a tenuous connection between the alteration of interest rates and improved productivity in any market in goods and services. Of course, it can be said that the low interest rates will induce people to borrow. But low interest rates reduce incentives for people to lend their money to those potential borrowers. In addition, the low interest rates tend to lead to lower earnings on savings, which means that many people in the economy, especially retirees who depend on the income generated by their basic portfolio, might reduce their consumption today to conserve wealth for consumption tomorrow. These choices between consumption-now and consumption-tomorrow will be made on an individual basis, so it is hard to see any systematic trend toward higher buying today once low interest rates are in place. It goes without saying that retirees and others living on fixed incomes do not have much wealth in reserve to make capital investments. So it looks as though contraction in the supply of available funds should offset the increase in demand.

Indeed if it were otherwise, then why not keep interest rates artificially low in good times as well as bad? To this objection, the Fed answers that the government should only stimulate demand by low interest rates when the private sector is unproductive. Once the private sector roars back, government can take a back seat by letting interest rates slowly rise. That was just the strategy that the Fed embarked on in December before the low growth reports of the fourth-quarter took the air out of the growth balloon.

But why think that the gradualist strategy could ever work? One difficulty with that approach is that short-term improvements have remained below the two-percent increment in gross domestic product for close to a decade. No policy that has failed for so long can become successful overnight. Worse still, this policy faces an irreducible timing risk. Monetary policy cannot rest on some abstract expectation that things will get better soon. It has to make precise judgments as to when. But economies are like large ships that turn slowly in the water, so it is hard to know whether any particular move in one direction counts as a real shift or a temporary aberration. That is exactly the problem that faced the Fed in January when it held off a further rate increase.

There should be no surprise here. The Fed only looks at gross measures of capital market and labor market activity, about which it is easy to make crude guesses that miss the mark. Modifications in short-term interest rates are a form of fine-tuning that neither the Fed nor other central banks can execute with any assurance. It is laudable for the Fed to give advance notice of its intentions. But the benefits of that approach are diminished with each change in course. The constant need to predict what the central banks around the globe will do adds another layer of uncertainty that weighs down the private market. It is one thing for private parties to enter into hedging transactions as part of their overall business strategy. Given that these are voluntary transactions, there is every reason to think that the gains to the two (or more) transactors will exceed the costs of putting them together: otherwise the market would close down. But government efforts to fine-tune interest rates face no such market constraint, so these efforts only feed system-wide uncertainty, which more stable interest rates could effectively combat.

The current policies fail for a second reason. The preoccupation over interest rate fluctuations diverts attention from the urgent reforms needed in regulatory policy. The task here is not to launch a misguided crusade that gets the government out of the business of protecting property rights and voluntary exchanges. These forms of regulation improve market performance at very low cost. Thus the standard forms of verification for many contracts—writings and registration, for example—do not place any constraint on the substantive terms of any contract, whether for the sale of land or the hiring of labor. These simple forms just eliminate a potentially huge back-end uncertainty that bad documentation could produce.

But the whole spate of modern regulation in labor, real estate, and capital markets goes far beyond that modest effort. Far outside the purview of the Fed, a never-ending stream of new regulations and taxes imposes high transactional barriers that kill off voluntary exchange and cooperation. There are many subtleties in each of these markets, but for these purposes, one common element unites them all. The new generation of regulations and taxes are all burden and no benefit. Their consequence is two-fold. They suck out the joint benefits of the transactions that go forward. And they block a whole range of potential sales and exchanges when these associated costs exceed the gains in question. Just that happened when legislative increases to the minimum wage led Wal-Mart to close down 154 retail outlets in the United States at a loss of 10,000 jobs, mostly concentrated at the lower end. Remember that in some markets Wal-Mart has announced wages increases voluntarily. Why use coercion, which fails to differentiate between different local markets?

The same mischief occurs when President Obama signs yet another of his misguided executive orders, this time to require firms to break down wage reports by race, gender, and ethnicity. President Obama claims this burden on employers is designed to combat persistent forms of discrimination, but the method fails to correct for relevant variables such as employment type or hours worked. Statutes like this are bad not only for the harm that they cause, but also for the future enactments that they signal. That message is read not only by large firms, which can cut back on employment, but also by potential entrepreneurs of new or unformed ventures who throw in the towel in light of heavy tax and regulatory burdens that promise to get only heavier.

These direct attacks on particular markets have huge negative effects. It is pie-in-the-sky thinking to suppose that anything that the Fed can do to discharge its jobs mandate can have the slightest effect given all the mischiefs that come at the microeconomic level. But so long as the Fed runs on about job creation, it is an open invitation for federal and state governments to mess up labor markets on the benign assumption that interest rate fluctuations will solve the problem. They cannot. There are major structural flaws that pervade every area of the economy. The Fed’s role should be limited to maintaining monetary stability, broadly defined. The Fed and the ECB should not send the message that their policies can magically improve the economy. Instead, Janet Yellen and Mario Draghi should say something like this:

Sorry folks, you think that we are magicians, but we are only trained in monetary economics. And we are here to tell you that we have shot our wad with a set of stimulus programs that were broken from the outset. Only now the situation is worse. The law of diminishing returns to additional efforts has set in so any measures we take will make our economies worse. The burden is squarely on the political branches to do their part. Deregulation and lower taxation reduces administrative costs and economic burdens. It will allow private firms to increase output. Either your elected officials make structural reforms today, or we shall have another fruitless set of stimulus programs tomorrow.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Our Fickle Fed

Richard Epstein*

Richard Epstein

Richard Epstein

Two related topics have defined our news cycle of late. The first is the deep populist discontent in the face of prolonged tepid economic growth rates and anemic labor markets. The second is that the Federal Reserve is once again uncertain about whether to raise the interest rate above the near-zero level where its lingered since December 2008. As recently as September 24, 2015, Fed Chairwoman Janet Yellen warned the financial markets that the low rates would not be kept forever, and that firms should adjust by gradually increasing wages. But less than one month later, her plan seems to have been derailed by the disappointing performance in wages, job creation, and consumer spending. The new thinking is that the Fed wants to wait until prices and wages firm up before it begins raising rates. It may wait until 2016 or later. Some experts, like former Fed advisor Andrew Levin, recommend interest rate increases be postponed until the labor markets are nursed back to health.

That analysis is necessarily complicated at the outset because it is difficult to estimate the level of slack in the labor markets. Right now the current unemployment rate stands at about 5.1 percent, which could be read as relatively full employment. That in turn means that wage levels should start to rise as employers compete for new workers. But the low rate of employment growth in the past several years points to serious economic underemployment, well caught in the consistently low levels of labor market participation. The 5.1 percent official unemployment rate does not include those people who have quit looking for work because their job prospects are grim. Nor does it include the many workers with only part-time employment who would be only too happy to take full time jobs if they were available.

From this baseline of conventional wisdom, Levin urges that we delay any increase in interest rates until the slack is absorbed so that employers will be willing to assume the costs of higher interest rates. But just when will this take place? Yellen takes the conventional line and assumes that the recent round of bad news is best attributable to temporary factors including weak energy prices and low import prices. But this is wishful thinking. The low energy prices are in part a function of improved fracking technologies that are only going improve with time. And they could still go lower if at long last the U.S. allows the export of crude oil, and OPEC members maintain their current high production levels. Yellen also believes that the flood of imports attributable to the relative weakness of the Euro is another factor that explains our weak economy. But this, too, is not likely to change any time soon.

Even if both of my predictions are proven wrong, temporary economic impediments are never in short supply. A cold spell, or hurricane, or political disruption could count as a short-term factor. None of these temporary factors precluded the far higher rates of growth that the United States enjoyed during much of the post-World War II period. But now, these factors always seem to count.

It’s likely that the slack in labor markets has become the new normal, which means that interest rates will never be allowed to rise. We have now tried to boost the economy and labor markets with a zero-interest rate strategy for close to seven years, with nothing to show for it. The belief that low interest rates will make the economy stronger is the triumph of hope over experience. In my view, our sorry state of affairs is no surprise. There is no theoretical reason to believe that any interest rate manipulation could repair fractured labor markets.

Let’s start with the simple observation that if low interest rates work in hard times, why don’t they work in good times? The answer is that artificially low interest rates are bad at all times. The stated rationale is that these interest rates are needed to stimulate borrowing and investment. Of course, low rates induce people to borrow. But from whom? It can only be from the people who will be less willing to lend at low interest rates. The affected classes include the large number of retired individuals whose ability to maintain their standard of living is reduced by the low rates of interest that they are likely to receive. They may now have to cut their consumption in the short run in order to make ends meet, just as their lower savings translate into reduced pools of investment capital. The entire strategy is just an ill-disguised subsidy to borrowers from lenders, which at best is a zero-sum transaction with little or no net economic effect.

Indeed a fuller evaluation is more pessimistic. Individuals and firms must borrow and invest over the long term. They cannot introduce major capital improvements in a day, a month, or even a year. Every time the Fed flips in one direction and then another, the added uncertainty negatively impacts borrowers, lenders, savers, and consumers alike. That added uncertainty reduces participation on both sides of any market, consistent with the low long-term levels of growth.

The unbroken record of disappointment should give rise to a fresh start. The first place to look is the Fed’s own mission statement, which lists as its first duty “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” The difficulty here is that the Fed cannot be all things to all people. There is no question that only the Fed can make adjustments in interest rates that will stabilize the money supply and eliminate one measure of uncertainty in lending, labor, and sales markets—thus increasing the ease of voluntary business transactions.

Nonetheless, the successful execution of this part of its mandate is inconsistent with the Fed’s efforts to create maximumemployment. There is no way that the Fed can pick a single interest number that discharges both functions if stable money requires a market rate of interest and maximum employment requires a low rate of interest. There is no reason why the Fed should even try to serve two inconsistent objectives. It is striking that virtually none of the discussions of the Fed’s role on the labor market asks this simple question: What other factors influence efficiency in labor markets?

Why that reticence? The simplest explanation is that the Fed thinks that the interest rate is the close to an all-powerful determinant of labor market health. But this view reflects a total lack of awareness of the massive impact that multiple forms of labor market regulation can have on job creation and wages. Instead of relying on complex macroeconomic calculations, let’s take a hard look at some of our microeconomic realities. It is no secret that President Obama thinks that we need a wealth of government interventions in the economy to improve the position of the middle class. As he said at the White House Worker Voice Summit: “Labor unions were often the driving force of progress,” and “the middle class itself was built on a union label.” It is also no secret that the current populist agenda favors a push of the minimum wage to $15, mandatory paid-leave policies, the repeal of right-to-work laws, treating franchisors like McDonald’s as employers subject to the National Labor Relations Act, and expanded overtime coverage under the Fair Labor Standards Act.

The President’s pro-union policies are deeply regressive. They hearken back to a clunky and rigid legal regime from an older economy defined by large assembly lines. That regime cannot keep pace with the dynamic technological innovations that define today’s economy. The President’s harsh rhetoric may play well to a gallery of like-minded enthusiasts. But it strikes terror in the hearts of those individuals who are on the fence about opening a new business or expanding an old one. This entire class of potential employers includes, of course, many people who regard themselves as part of the shrinking and beleaguered middle class. To them any restriction on their freedom to set the terms and conditions of their employment is a good reason not to start a business in the first pace. Yet it is just policies of this sort that receive legislative enactment, such as the misnamed California Fair Pay Act. These policies pose a serious threat to the vitality of their respective labor markets.

There is, unfortunately, a close relationship between the Fed’s effort to make labor markets whole and the unending array of government initiatives targeted at the labor market. It is easier to the supposed reformers of labor markets to think that their job is to ensure equity so long as it is tacitly understood that the push toward full employment can be handled best by the Fed. The role of the Fed thus makes it possible to debate labor reform measures in terms of their distributional aspirations, given that the institution is supposedly there to set interest rate policies that will return labor markets to the full employment of the post-World War II era.

This sorry combination gets both sides of the equation wrong. There is almost nothing that monetary policy can do to get the cobwebs out of the labor markets. The Fed should stop acting as though its interest rate decisions can do any good. At the same time, everyone must understand that the current stagnation in labor markets is driven by policies to tighten government control. No amount of political rhetoric can conceal the central point about the sound operation of labor markets. The key government role is to reduce the barriers to voluntary contracts in order to maximize economic activity. Tighter regulation pushes in exactly the wrong direction. It’s like feeding sugar to a diabetic. There is little support for deregulating labor markets so we should expect the stagnation to continue for some time, regardless of what the Fed chooses to do. 

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.