Stable Monetary Policy to Connect More Americans to Work
Introduction
Deep recessions are not only economic, but social disasters. Lost income makes it less affordable to start and maintain families. Layoffs disconnect people—often already-marginalized people—from the labor force, depriving them of the social ties, emotional stability, and structure that come with working life. Both financial and personal investment into the institutions of civil society decline. Some of these wounds heal with the labor market during recoveries. Others leave long-lasting—even permanent—scars.
After the longest expansion on record, culminating in low unemployment rates not seen in half a century, the coronavirus pandemic plunged the United States overnight into a severe recession. While the ongoing downturn was clearly produced by an external shock unrelated to the state of the economy or economic policy, such recessions have, in recent decades, tended to be the exception rather than the rule. Just as more effective public health policies might have headed off the current recession, better economic policies might have averted many recessions in the past, including the Great Recession, and could prevent future recessions.
Avoiding future costly downturns like the Great Recession should be a top priority of economic policy. This report will trace the ways that monetary policy, in particular, can be improved to avoid the mistakes of the recent past and the consequences of those mistakes. Monetary policy in the United States is implemented by a central bank, the Federal Reserve, with objectives established for it by Congress.
It might be ideal if federal policymakers could ignore monetary policy, or somehow put it on autopilot, leaving people free to exchange goods and services without government having to concern itself with the amount of currency in the economy or interest rates. Unfortunately, short term conditions can change in ways that cause spending to grow more slowly or fall, creating a shortage of currency in circulation. As discussed below, the long-term nature of contracts and the related tendency of prices and wages not to fall during downturns can prevent quick market corrections. Consumers, lenders, employers, and other market participants may then react by continuing to slow their spending, prolonging the downturn. Eventually, the economy will return to a healthy equilibrium and adjust to new price levels, though potentially with large temporary economic costs in the form of joblessness. These costs can be avoided if, early on, central banks increase the supply of currency in circulation.
At other times spending will rise too quickly relative to what the economy is producing. The currency issuer can head off painful disequilibria characterized by inflation by reducing the supply of currency.1
Thoughtful analysts bucking convention have envisioned a world of competing currency offerings by private and public institutions, and questioned the economic, policy, and constitutional underpinnings of the Federal Reserve. This report does not address those arguments; rather, it proceeds from the premise that the Federal Reserve will remain the monopoly issuer of currency. Given this role, it has to make decisions about how much currency to supply to the economy and when. Rules that anchor the currency supply to some economic benchmark promote predictability and stability for the consumers and investors who use the currency. They also remove discretion from Federal Reserve officials, whose decision-making is unavoidably influenced by the biases and pressures that affect even the most hard-headed analysts.
The best anchor for monetary policy decisions is nominal income or nominal spending—the amount of money people receive or pay out, which more or less equal out economy-wide. Under an ideal monetary regime, spending should not be too scarce (characterized by low investment and employment), but nor should it be too plentiful (characterized by high and increasing inflation). While this balance may be easier to imagine than to achieve, this report argues that stabilizing general expectations about the level of nominal income or nominal spending in the economy best allows the private sector to value individual goods and services in the context of that anchored expectation, and build long-term contracts with a reasonable degree of certainty. This target could also be understood as steady growth in the money supply, adjusted for the private sector’s ability to circulate that money supply faster or slower.
Unfortunately, Federal Reserve policy from 2007-2018 erred too far towards curbing the growth of nominal spending—a stance known colloquially as “too tight” monetary policy. The result was a long, persistent “output gap,” or shortfall in GDP relative to what the economy could have produced with more ample nominal spending. While not the only policy problem of the time period, the output gap was a clear consequence of the Federal Reserve’s choice of policy anchor and its level of commitment to the anchor.
The mass unemployment that followed the 2008 financial crisis was an economic disaster whose effects will be felt for years to come. Americans lost trillions of dollars of income and tens of millions of years of work. The job losses were also concentrated among disadvantaged groups, increasing inequality along the dimensions of both education and race.
This era is useful to study because it can inform policy in future recessions, including, to some extent, the current one. A well-chosen and consistent monetary policy anchor will not solve every problem—and certainly not ones directly related to public health—but it can facilitate the execution of financial and business contracts and shore up the social contract by lowering uncertainty about the future.
Characteristics of Output Gaps
Output gaps are the difference between actual output (what the economy produces) and potential output (the maximum amount the economy could produce sustainably over the long term with the general price level in equilibrium.)
The second half of this definition is a difficult counterfactual, one that can never be fully established as fact, but it is useful conceptually and at least somewhat measurable. The economy includes some long-run or “structural” unemployment; there was still some unemployment in 2007, and there was still some at the top of the 2020 economic peak. But there is also short-run or “cyclical” unemployment, which manifests in times of financial turmoil and then recedes as the economy improves.
Output gaps essentially involve the cyclical unemployment: the work and income lost to the business cycle. To the extent that output gaps are measurable, one could measure them in person-years of work lost, or cumulative GDP lost over time.
The most recent example of a typical large output gap comes from the 2008-2009 recession, when 8.7 million nonfarm jobs were shed. The output gap then persisted for about a decade; the jobs were not immediately regained, but rather, slowly added back over a period of many years.
Output gaps are frequently concurrent with—but distinct from—recessions. Recessions are typically defined through periods of output contraction (for example, two quarters of consecutive decline.) Output gaps are conceptually different from output contraction; they concern levels, not growth rates. An economy with an output gap is an economy that is smaller than it would be under normal financial conditions; and this could be the case regardless of whether it is growing or contracting at the moment.
It is possible to have a recession without an output gap; for example, an economy suffering from population loss could contract without having a problem of unemployed resources. It is also possible to have an output gap without a recession. For example, if many workers lost jobs due to a financial crisis, and the economy began gradually putting them back to work, one could see positive growth even as many were still jobless. There was an output gap well into the current recovery. Even an entirely recessionless period could include an output gap; for example, low aggregate demand could cause joblessness for many workers—and therefore, an output gap—even while productivity gains for other workers create enough growth to overcome that weakness and produce a positive aggregate growth number.
This report focuses on output gaps because they are undesirable, and they could be mitigated with commitment to a nominal income anchor.
Output Gaps Begin with Slowdowns in Spending
Output gaps tend to begin with a slowdown, or even a decrease, in spending throughout the economy. A sudden and sharp decrease, like that of 2007-2009, is known as an aggregate demand shock. Under such conditions, individuals and firms choose to hold more cash or government debt, and spend less on consumer goods or investments.
Spending is determined by both private-sector conditions and monetary policy conditions. For example, if new information shows that some private-sector investments or loans are riskier than people previously thought, they may respond by lending less to the risky private sector and holding more of their savings in riskless, government-issued financial assets. However, the government has some influence on this decision as well through the setting of short-run interest rates. If it sets interest rates higher than economic fundamentals warrant, people will park more of their money with the government to earn a risk-free return, and spend less money on investment and consumption; if the government sets interest rates relatively low, people will spend more.
Whatever the cause, a spending pullback in consumption and investment is almost by definition a reduction in nominal GDP, as those two components—consumption and investment—comprise the vast majority of GDP. Unless either foreigners or the government purchase more on net to offset a pullback in spending from the private sector, nominal GDP must necessarily fall.
While nominal GDP is not the same as real GDP, there is a strong correlation between the two measures in practice. A fall, or even a slowdown, in nominal GDP often results in an output gap.
Output Gaps are Disequilibria, Not Efficient Market Outcomes
The pre-shock prices in such a situation function like a price floor in a basic microeconomic supply-and-demand model; if a price is set above the point at which supply and demand meet, there will be a surplus of producers willing to sell at the price, but a shortage of buyers. Fewer goods and services will be purchased or sold.
The most important of the prices thrown out of equilibrium by an unstable market are the prices for labor: wages, salaries, and benefits. By the end of 2009, there was a surplus of producers willing to sell their labor at prevailing wage levels, but a shortage of buyers. Put more simply: there was unemployment.
The Market Cannot Adjust Immediately to Demand Shocks
Markets are often resilient to some shocks, updating prices quickly and reaching new equilibria. It is worth asking why markets do not update quickly in response to aggregate demand shocks. If the economy efficiently employs resources at one level of nominal spending, why is another not equally good? Why can’t prices just scale down by an appropriate factor, leaving the real economy—the amount of goods and services produced—entirely unchanged?
If this were possible, and every single dollar-denominated quantity changed by the same amount in the economy all at once, that would be fine and life would go on unchanged. However, in practice such immediate adjustment to a shock to nominal GDP is impossible. Free markets depend on long-run contracts, implicit and explicit. Job offers, mortgages, bonds, and leases all come with expectations—or even formal obligations—that last months, years, or decades into the future. Because these contracts cannot adjust, equilibria in the private sector cannot immediately adapt to unexpected changes in overall nominal spending.
Consider, in particular, the labor market, which is unusually slow to adapt. One might assume that it is at least legally possible for many employers to cut wages—and that their employees might, in the absence of better options, accept such cuts. In practice, this rarely happens. Empirically, wages are “sticky,” and especially, “sticky downward.” Research into wage changes for individual workers show that very few workers have their wages cut, but a large number of workers each year end up with a precisely zero change in their nominal wage.2 3 This distribution suggests that firms are reluctant to cut wages. While each employer has its own reasons, one clear reason to avoid cutting wages is that it is acrimonious to ask workers to accept the cuts.
Recent research extends the empirical evidence of sticky wages further, and shows that even for new hires—for employment contracts that do not even exist yet—employers are unlikely to cut wages for a particular job title during contractions.4 There are many plausible ways to explain this behavior, but the simplest is that employers value some sort of equity between the new hires and incumbent employees of the same job.
Even unemployed workers—at least, those not immediately desperate for money—may contribute to the sticky wage phenomenon through aversion to pay cuts when they take a new job. A worker who earned a particular salary in the past may expect that salary again, even from a new employer.
Whatever the reasons for the empirical fact of sticky wages, the evidence is clear that nominal wage levels can endure for years without reaching equilibrium; if a wage level is too high to be market-clearing, the labor market will wait as long as it takes for that level to clear markets once more. In the meantime, though, unemployment will endure.
The same sort of dynamics affect other prices. A landlord might want to offer new customers lower rent in order to take units off the market, but doing so might require her to lower prices for her existing renters. So instead, vacant apartments take longer to fill.
Finally, firms often require the useful information embodied in other firms’ prices in order to update appropriately. When a firm picks the optimum or equilibrium price for its own products, it does so not just based on the state of the economy as a whole, but also based on the asking prices of input goods used in the production process, or the listed prices of competing products. If all prices are thrown out of equilibrium at once—as happens in a recession—a firm cannot adjust completely to new conditions because of sluggish price adjustments from other firms.5
One feature—perhaps even the defining feature—of well-functioning free markets is that firms and individuals do not need to independently calculate the value of every good or service they purchase, sell, or compete with. They can instead take prices from others as a given and respond accordingly. This channel breaks down during recessions, because all prices are out of equilibrium at once.
For example, a retailer might see signs of a recession when sales fall. It knows it must adjust its prices downward to keep its inventory moving. However, the wholesale prices of its inventory remain—at least for now—unchanged. The retailer reduces its prices modestly, but not too much, in order to protect its margins. Later on, it becomes clear that the retailer’s suppliers are also struggling to move their products in the recession, and they cut prices as well. Then, and only then, can the retailer cut prices further, spurring sales while still making a reasonable margin on its sales. Rather than a single price adjustment to restore equilibrium, the retailer has to go through a slow, iterated process where firms react to each other’s price updates.
Simple economic models use a frictionless theory of the economy where smart agents update their prices immediately to address surpluses or shortages. Certainly, that is the rational thing to do, and people attempt to do it as fast as they can. However, it is more difficult than it looks on paper. Norms, contracts, loss aversion, and difficulties in gathering information all combine to create substantial inertia in overall price levels.Feedback Loops Compound the Problems of Demand Shocks
A second reason that markets struggle to handle aggregate demand shocks is that demand shocks generate what economists call general equilibrium effects; disequilibria in money and wages are powerful enough to change the nature of the whole economy. Therefore, in analyzing the problem, it is not enough to note that too-high prices result in over-supply and under-demand for labor. One must then consider the impact this unemployment has on the economy as a whole, and any second-order results springing from that impact. In the case of cyclical unemployment, some of the major second-order results reinforce, rather than mitigate, the original problem. Spending in the economy falls, demand for labor falls, people become unemployed because of sticky wages, and then spending in the economy falls further because unemployed people spend less.
This kind of feedback loop can be extraordinarily powerful; it is the primary mechanism by which problems in mortgages in the mid-2000s ultimately resulted in millions of job losses for people in unrelated industries. The cycle shown above is not the only feedback loop present in recessions; for example, businesses cut back spending on capital goods in addition to labor, out of natural fears that the capital good will not be a worthwhile investment with the economy in a downward spiral.
In fact, all throughout the economy, individuals and firms can respond to aggregate demand shocks by cutting back spending further. Savers shift their earnings from risky new investments in new or marginal capital to bidding up the prices of safer, less productive, assets. Consumers—even those who still hold jobs—decide to tighten their belts and hold more cash or cash equivalents, and eschew new loans.
One of the most powerful feedback loops can come from government policy; if the central bank is sluggish to respond to a demand shock, and maintains short-run interest rates at a too-high level, then government creates additional demand-side failure by offering lenders much better terms than the private sector; it then becomes increasingly advantageous for savers to park their money with the federal government, rather than putting it to work funding more productive private-sector investments.
While not all of the general equilibrium effects of demand shocks are self-reinforcing, many of them are—and powerful enough that the problem can quickly run away from policymakers and become painful to resolve.Summary
The description of output gaps above ultimately leads to two points about them: first, that output gaps are a considerable problem, and second, that they are related to the federal government policy choices in issuing currency.
Sharp, unexpected changes in the path of nominal spending—or demand shocks—throw prices out of equilibrium throughout the economy. Layoffs born of this problem are not efficient “creative destruction,” or the magic of efficient markets at work; instead, they are glitches in the system of currency issuance, interacting with contract law, norms leading to sticky prices, and individually rational behavior creating feedback loops. Government compounds, rather than alleviates, this problem, when it offers attractive risk-free returns—essentially, above-market rates—on government assets during demand shocks, crowding out or deterring private spending.
Conditional on a policy framework where the federal government issues financial assets and legal tender, there must be some rules—implicit or explicit, mandatory or discretionary—that determine when government-issued financial assets are issued, and what they can be redeemed for.6 These rules are monetary policy, and the government necessarily has one, whether it wants to or not.
Currency issuers must be aware of this consequence: the financial assets they issue create a “hurdle rate” for the currency’s users; holding onto those assets is a choice for households and firms, one that competes directly with the alternatives of holding private-sector financial assets or directly and immediately purchasing goods or services.
If government is to issue financial assets, it should do so in a way that minimizes distortions. As the harms of output gaps are severe, government should make sure that its issuance of financial assets does not unintentionally distort markets and create output gaps unnecessarily.
The Pain of Output Gaps is Intense and Concentrated among the Most Economically Disadvantaged
We can reliably make at least two quantitative claims about output gaps: the first is that they are especially large economic policy problems. The second is that the pain from output gaps is unevenly distributed; those who lose their jobs suffer a great deal more than those who retain their jobs, or had savings in cash or bonds.
Output Gaps Constitute a Large Economic Inefficiency
When economists speak of inefficiency, they usually think of suboptimal production; a worker produces one good rather than another, even though the second good would better maximize overall well-being. Inefficiency happens for a variety of reasons—regulations, taxes, monopolies restricting supply, environmental externalities—and it can be a serious problem.
However, suboptimal production is still production. It typically creates producer and consumer surplus—just not as much surplus as the most efficient outcome would have. By contrast, under an output gap, there are workers who remain unemployed entirely.
Output gaps are also more important than any industry-specific policy problem because they affect many or all industries simultaneously. The scale of job loss from the Global Financial Crisis—8.7 million lost, even as population grew—was orders of magnitude larger than other individual policy problems in the U.S. economy. More importantly, it remained large for years afterwards; the depressed levels of employment persisted.
Estimating the Total Cost of Last Decade’s Output Gap
One conventional measure of the cumulative cost of the output gap throughout the years quantifies the area between the curves from the start of the output gap to the end. By this measure of potential, the output gap began in the first quarter (Q1) of 2008 and ended in the third quarter (Q3) of 2017. By the CBO estimates, $4.3 trillion of income was foregone relative to potential.
This number is immense. It is also likely a deep underestimate. Recent research shows estimates of potential GDP are correlated with demand shocks; in other words, we misidentify some of the business cycle as permanent change in the economy and understate potential GDP during recessions.8 This would cause us to systematically underestimate the size of output gaps; for example, we might say a worker is structurally unemployed, only to see them return to work after the economy improves again.
There is good reason to believe this happened in the particular case of the 2007-2019 output gap. First, because the phenomenon described is actually visible on the chart of CBO’s estimate of potential GDP. Rather than continuing upward at a roughly-steady exponential pace, it actually bends a little bit down towards actual GDP during the recession. Second, because the CBO bases its estimate of potential output heavily on its assumptions about the natural state of the labor market, and it got those assumptions wrong. In the early 2010s, CBO raised its estimate of the long-run natural rate of unemployment, thereby assuming that the economy had less potential than it really did. This assumption proved incorrect by the late 2010s when unemployment fell to historic lows, so CBO revised it back downward.
With the benefit of hindsight, we can come up with a better estimate of the latent potential of the 2010s US economy. The graph below shows two simple estimates of how potential GDP may have been higher between Q4 of 2007 and Q3 of 2019. The first estimate is a simple exponential growth path between the CBO’s potential GDP estimates from those two quarters. In other words, it removes the “bend” in the CBO chart. A second, more aggressive estimate assumes the Q4 2007 and Q3 2019 figures are full employment, and draws an exponential growth path between them to estimate potential output.
Sources: U.S. Congressional Budget Office, Real Potential Gross Domestic Product [GDPPOT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDPPOT; U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDPC1
All three measures of potential output are reasonably similar for many purposes; however, if we do not allow potential output to “bend” downward—if we do not excuse possibly-cyclical unemployment as structural—we find the cumulative output gap to be larger than the CBO’s estimate would suggest. Under the smoothed-out version of CBO potential we find the cumulative cost of the output gap to be $5.6 trillion. Under the more aggressive assumption, the cumulative cost of the output gap was $6.8 trillion.
Even the aggressive assumption—that GDP should have grown smoothly between 2007 and 2019 rather than having a big hole in the middle—is reasonable, and in fact may be a conservative estimate of the costs of the output gap. If there is a “hysteresis” effect—that is, we missed out on skill-building and capital investment due to the crisis—then productive capacity could have been even higher in 2019 if that hysteresis had not occurred.
There is another way to quantify the output gap, though, one that may be more meaningful in a social sense: this measure is denominated in jobs for workers of prime working age. In both 2007 and 2019, the share of prime-age (that is, 25-to-54-year-old) individuals with a job reached 80.2 percent. While this was not an all-time high, it was relatively close to the all-time high set in 2000.
Figure 3. Employment-Population Ratio, Age 25-54
Source: U.S. Bureau of Labor Statistics, Employment-Population Ratio - 25-54 Yrs. [LNS12300060], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LNS12300060
Let us assume that this rate of employment is natural—that it would have been sustainable in the long run, absent the disequilibrium from the financial crisis. If this is the case, then 45 million person-years of work were lost among prime-age U.S. workers.
This estimate—despite its size—may be conservative: it does not include job losses for workers 55 and older—some of whom describe themselves as retired, but may have preferred to continue working under better circumstances. It also assumes—perhaps wrongly—that employment highs of the late 1990s and early 2000s are no longer an appropriate benchmark for full employment.
Nonetheless, even under conservative assumptions, the output gap in the United States since 2008 has been gargantuan; cumulatively over the period, in terms of both jobs and GDP, the lost output is greater than the annual output of Germany.
The Concentration of Output Gaps
It is also important to note that these losses were concentrated especially hard among particular Americans. One could imagine an evenly-distributed output gap—each individual loses two weeks a year worth of paid work, and suffers five percent lower income than they would have otherwise—but that is not the way that output gaps manifest in practice.
Instead, some people have their hours and income cut entirely through layoffs—or, more abstractly, through the absence of job offers that would otherwise have been extended in a better economy. Meanwhile, other workers are able to hold onto their existing jobs at their existing pay and hours.
One way to see the unequal distribution of unemployment is to observe the catastrophic rise in unemployment of 27 weeks or longer. At the peak of the output gap almost 7 million Americans reported being unemployed for more than half a year. In other words, of the 45 million person-years of employment lost due to the output gap, much of it was concentrated among especially unfortunate workers.
Figure 4. Unemployed 27 Weeks & Over, Thousands of Persons
Source: U.S. Bureau of Labor Statistics, Number Unemployed for 27 Weeks & Over [UEMP27OV], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UEMP27OV
It is also important to note that the unemployed are not a random cross-section of the population. Rather, unemployment is concentrated among particular groups—typically, ones that already start at a disadvantage. Output gaps have an outsize negative impact on lower-education individuals and minorities—but conversely, those same workers stand to benefit more from a recovery.
A chart of unemployment rate by education shows that the most recent business cycle had a larger impact on less-educated individuals than on more-educated individuals. For example, the unemployment rate for those without a high school diploma rose and fell by about ten percentage points during the recession and the subsequent recovery. For college graduates, this figure was about three percent. College graduates and less-educated individuals both felt the same effects directionally, but the magnitude for less-educated individuals was greater.
Figure 5. Unemployment Rate by Education
Source: U.S. Bureau of Labor Statistics, Unemployment Rate by Education [LNS14027662, LNS14027689, LNS14027660, LNS14027660], retrieved from FRED, Federal Reserve Bank of St. Louis
A similar story can be told by race. While unemployment rose for all groups during the financial crisis, and fell gradually throughout the recovery, the magnitude of the swing was considerably larger for black or Hispanic workers than for white ones. For example, while the business cycle involved about a five or six percentage point swing for white workers, it was a nine point swing for black ones.
Figure 6. Unemployment Rate by Race or Ethnicity
Source: U.S. Bureau of Labor Statistics, Unemployment Rate by Race [LNS14000003, LNS14000006, LNS14000009], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LNS14000003
Both the analysis by education and the analysis by race reveal a kind of “last in first out” labor market: the demographic groups that generally have higher levels of unemployment are the most sensitive to the business cycle.
This characteristic of the business cycle can unfortunately lend itself to some policy errors: one can credibly blame unemployment on structural factors, even when the cyclical component is more important. For example, one could say that the unemployed tend to be less-educated and have fewer skills. While this is true, unemployment can be multi-causal—both cyclical and structural—and to the extent that the cyclical component can be addressed, it should be.
The Social and Psychological Impact of Output Gaps
It is important to see the output gap as not just a loss of income, and not just as a loss of work, but also as a loss of the social capital that comes from financial stability and participation in working life.
As explored in previous research by the Joint Economic Committee’s Social Capital Project, there are social and psychological benefits from inclusion in the working world. In the project’s Wealth of Relations paper, we note that inclusion in the world of working adults helps people build other sorts of social ties.9
Robert Putnam’s bestseller Bowling Alone compiles a variety of evidence on the subject. Colleagues can account for a majority of a worker’s daily conversations, and a substantial fraction of their friends—though typically not as many close friends as from other sources. Workplaces can also serve as recruiting grounds for other organizations in civil society. While Putnam believes workplaces cannot replace the social ties that come from other civil society organizations, they do create connections to friends and organizations.10
In The Once and Future Worker, Oren Cass writes that work helps build skills useful in other areas of life, imposing structure and practice in “mundane but essential disciplines.” He also argues that skill-building and self-reliance help build a sense of worth and self-respect.11
The strongest evidence of the value of work is perhaps in the alternative: the absence of work. A report by the Social Capital Project examining the lives of prime-age men without jobs shows that they are likely to self-report poorer mental well-being, fewer friends, and even lower participation in civic activities such as churchgoing.12 One could hope that non-employment would free people’s time up to help them build more social ties. However, on average, this does not seem to be the case; the non-employed, and especially non-employed men, tend to struggle to find fulfilling uses of their time.13
In the relationship between employment and social capital, causality likely runs both ways; while those with more social capital are likely better at finding work, evidence also suggests that joblessness and income insecurity cause a decline in social relations. Job loss from recessions is associated with a rise in depressive symptoms.14 Output gaps are also associated with a fall in parenthood15 and delayed household formation.16
Furthermore, civil society more broadly suffers: the recent recession was associated with a decline in charitable giving, one that was slow to recover and even greater than would be expected by the drop in income alone.17 Furthermore, survey results from the National Conference on Citizenship show that 72 percent of respondents reported cutting back time spent on volunteer work in the recession, and that 66 percent of respondents felt people were responding to hard times by looking out for themselves, not others.18
In some studies, output gaps are associated with a rise in suicides,19 though this is contested.20 While overall alcohol use—like most economic activity—declines in recessions, binge drinking rises.21 The bulk of the evidence suggests that illegal drug use also increases in recessions due to personal stress, even despite a reduced ability to pay.22
All in all, output gaps cause not just lasting economic damage, but lasting social damage as well. The scars from our most recent output gap will take a long time to heal.
Monetary Failures of the Great Recession Output Gap
The output gap beginning in 2007 was unusually long-lasting and deep. By the Congressional Budget Office’s estimates, it lasted for ten years and reached six percent of GDP.23 Both of these problems were attributable in part to the Federal Reserve’s too-tight monetary policy, a decade-long series of errors. These errors all ran in the same direction, curbing spending too much. This helped cause, deepen, and lengthen the output gap. It is, of course, easier to identify these errors with the benefit of a dozen extra years of hindsight that contemporary decision-makers did not have. Indeed, many of the points below have already been acknowledged by past or current Federal Open Market Committee (FOMC) members. However, these mistakes are described here to better inform future choices.
2007-2008: Scope Creep and Underreactivity
In 2007-2008, the Federal Reserve made four major conceptual errors that contributed substantially to the crisis.
- Slow reaction to a worsening employment situation, starting in 2007;
- Overemphasis on oil prices, which are often (as in this case) un-representative of the overall demand-side situation;
- Scope creep: attempts to cut down the housing market in 2007, even at the expense of the rest of the economy; and
- Constricted credit for the public at-large even as financial institutions got emergency lending and bailouts.
Underreactivity to Struggling Labor Markets
In the abbreviated telling of the 2008 financial crisis, the financial turmoil precedes the mass unemployment. For the most part, this was true; the most harrowing months of job loss came after the collapse of Lehman Brothers in September 2008. However, the labor market had stalled by 2007 and was clearly weakening.
In fact, the weakening labor market likely caused some of the later financial turmoil; with better job prospects, more people could have repaid mortgages, bolstered falling house prices, and provided equity and risk tolerance to capital markets.
Consider how four different measures of employment fared between their 2007 peaks and December of 2008, when the Federal Reserve finally exhausted its conventional policy tools and lowered rates all the way to zero.
Beginning with the employment-to-population ratio among individuals age 25-54, or “prime-age employment-to-population ratio, in January of 2007, the ratio sat at 80.3 percent—off of its all-time highs, but strong. By March 2008, when Bear Stearns failed, it had dipped below 80 percent for good. By September 2008, when Lehman Brothers failed, the ratio had fallen below 79 percent. In December 2008, when rates finally hit zero, the figure stood at 77.6 percent.Figure 7. Employment Population Ratio (Age 25-54)
The civilian unemployment rate told a similar story; in May of 2007, it was 4.4 percent—again, not its all-time best, but still good. By the time of the Bear Stearns failure, it was 5.1 percent. A particularly bad month in 2008 with a half-percent rise was largely ignored.24 In September, when Lehman failed, the unemployment rate reached 6.1 percent, and by the time the Federal Reserve took interest rates to zero in December 2008, the unemployment rate was 7.3 percent.
Figure 8. Unemployment Rate
Nonfarm payrolls also showed distress: in the summer of 2007, two months showed negative payroll growth. In 2008, every single month except for January reported negative payroll growth—in other words, by December of 2008, when the Federal Reserve finally moved the federal funds rate to zero, the economy was in its eleventh consecutive negative-job-growth month.
The Federal Reserve consistently underreacted to deeply-troubling numbers in four different indicators of employment—all of which were telling the same story. Until the very last month of 2008, there were conventional policy tools available to slow or reverse these terrible job losses. In any month prior to December 2008, the Federal Reserve could have lowered rates by more, unleashed more spending into the economy, and saved some jobs.
Overemphasis on Inflation—Especially Oil
One reason the Federal Reserve reacted so slowly to a deteriorating employment situation in 2007-2008 was undue attention to inflation—and particularly, inflation in energy prices. While maintaining stable inflation is one of the two components of the Federal Reserve’s dual mandate, the Federal Reserve has long held that “core” personal consumption expenditures (PCE) inflation—which excludes volatile commodities like oil from its basket—is often more informative for determining the state of aggregate demand.25
While the Federal Reserve forgot this lesson during 2008 and focused strongly on rising oil prices, it is in fact a lesson worth remembering. To understand why Federal Reserve economists have often preferred the Core PCE measure, it is worth comparing the difference between it and the ordinary PCE measure.
Figure 11. PCE Price Indices (Percent Change from Year Ago)
One obvious way they differ is that Core PCE is a much more stable series. But to understand why Core PCE is genuinely more informative for the Federal Reserve’s purposes, it helps to consider what the Federal Reserve’s dual mandate is fundamentally about: it is about keeping a stable relationship between spending of the domestic currency and domestic productive capacity. For example, if too much spending chases too little productive capacity, inflation can run away from the central bank. In contrast, the converse can produce deflationary spirals and output gaps. Navigating a steady path between these two extremes is the principal challenge for any currency issuer.
Unlike the price of domestic services, commodity prices are not really about this domestic monetary balance. Commodity prices are defined by global supply and demand, and they can often move separately from demand-side price level trends. Oil does this—but oil is also such an important commodity that it can dramatically shift overall price levels. These idiosyncratic changes in oil prices create noise in inflation data that is not particularly correlated, in the long run, with the outcomes the Federal Reserve cares about. For these reasons, the Federal Reserve often ignores oil shocks. However, it failed to ignore them in 2008.
In Chairman Bernanke’s account, he describes the August 2008 meeting this way:
At the same time, we could not completely dismiss inflation concerns. Oil prices had fallen to $120 per barrel from their record high of $145 in July. However, staff economists still saw inflation running at an uncomfortable 3½ percent in the second half of the year. Even excluding volatile food and energy prices, the staff expected inflation to pick up to around 2½ percent, more than most FOMC members thought was acceptable.26
Bernanke did not completely agree with this view, but he did have to accommodate it. The Federal Reserve held interest rates steady in August 2008, with a single dissent favoring a rate increase. Bernanke writes that if anything, “the 10-1 vote understated rising hawkishness on the Committee.”27
It is true that all else equal, lower inflation would certainly have been better; but the Federal Reserve had a dual mandate, and collapsing financial markets and rising unemployment were far more unacceptable than slightly-off-target core inflation.
One particularly strong account of the Federal Reserve’s fixation on 2008’s oil-driven inflation comes from journalist Matt O’Brien. Counting the mentions of inflation and unemployment—the two halves of the dual mandate—he finds that the former dominated the discussion by a 10:1 ratio until the September meeting, followed by a 5:1 ratio at the September meeting.28 This is extraordinary because—as O’Brien notes—inflation expectations were not particularly high, and collapsed immediately after the Federal Reserve’s surprisingly-hawkish September statement was released. The statement contained the following passage:
The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.29
This statement came in the third straight quarter of recession, as unemployment had climbed 1.7 percentage points and two major financial institutions had failed. The predicted inflation never materialized, and the U.S. would experience substantial deflation by the following year.
Scope Creep
Housing prices rose substantially leading up to 2006. However, the housing market began to decline in 2006, as the Federal Reserve hiked interest rates to an eventual high of 5.25 percent. Housing starts peaked in January of that year, and residential construction employment in March.
A decline in housing starts or construction employment was not per se a problem; throughout 2006, growing employment in other sectors roughly compensated for the decline in housing employment. The Federal Reserve noted—likely correctly—that the late-2005 prices were too high, and saw the initial stall in housing markets in 2006 as a welcome development.
In 2007, though, economy-wide employment began suffering, suggesting that the rate hikes were beginning to constrict the overall economy, not just the housing market. The Federal Reserve, to its credit, noticed the reversal and began to cut rates in September 2007. However, it underreacted—as described above—in part because it had begun to see curbing the housing market as a goal in itself: a strange sidetrack into policy beyond the scope of the central bank’s mandate. As then-Chairman Bernanke recalls the September meeting:
While this particular view was not entirely representative of the Federal Reserve as an institution, moral hazard was discussed in the context of interest rate decisions. Moreover, in his book Shut Out, Kevin Erdmann notes that the Federal Reserve as a whole would issue statements describing the weakness in the housing market as a “correction,” suggesting a kind of normative view that housing prices should fall.31 The Federal Reserve kept this language even well into the decline of employment measures. The focus on moral hazard and housing prices largely detracted from attention to an ailing labor market.
Where’s My Bailout?
All of these problems with the 2007-2008 Federal Reserve came together—the underweight on employment, the overweight on inflation (particularly, dubious non-core inflation measures) and the tendency to micromanage rather than react to the broader picture—when banks began to struggle and fail.
The Federal Reserve clearly understood the need for monetary injections into struggling financial institutions. However, it actively rejected the idea that the rest of the economy—which was also struggling—might need the same.
In the middle of March 2008, Bear Stearns failed. The Federal Reserve made two choices that month: it chose to help finance the purchase of Bear Stearns by JPMorgan, injecting some liquidity into capital markets, but it almost simultaneously chose to set the federal funds rate at 2.25 percent for the rest of the country. Setting aside Bear Stearns for a moment, we should consider what that rate meant: it gave would-be spenders or would-be lenders the option of parking their money with the government for 2.25 percent, rather than spending or lending it to someone else in the private sector. It was a choice to constrain spending and credit. 2.25 percent was still a cut—a choice to constrain credit by less than before—but a choice to constrain credit nonetheless.
Injecting capital into financial markets does increase spending and stem job losses. What is curious, though, was the use of such extraordinary measures when ordinary measures were nowhere near exhausted. Consider how Bernanke aptly explained the reasoning for the Bear Stearns bailout:
Wall Street and Main Street are interconnected and interdependent, I explained. “Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain,” I said. And the damage would have surely extended beyond financial markets to the broader economy. Without access to credit, people would not be able to buy cars or houses, and businesses would not be able to expand, or in some cases, even cover current operating costs. The negative effects on jobs and incomes would be fast and powerful.32
This explanation is exactly correct, especially regarding access to credit: which is why it is all the more remarkable that the Federal Reserve was still constraining credit with its interest rate policy. Credit was constrained for any borrower who could not offer lenders better terms than the 2.25 percent risk-free return offered by the federal government—and in a time of financial turmoil and weak employment, lending was risky, so that risk-free 2.25 percent looked quite good. Creditors lent less for cars and houses and businesses, and the lack of credit had negative effects on all three of these sectors.
Much of the controversy over the economics of the Bear Stearns bailout focused on moral hazard. The real question is why the Federal Reserve took actions that, as Paul Volcker described it, “extend[ed] to the very edge of its lawful and implied powers”33 when perfectly ordinary, legal, and powerful operations for providing credit were also available. The most plausible explanation, based on Federal Reserve communications in 2008 and the description of the August meeting found in Bernanke’s memoir, was that rates were kept high because of inflation concerns.
Taken separately, the bailout and interest rate decisions are coherent. But together, it is difficult to square them. As the Federal Reserve told it, spending enabled by emergency below-market-rate liquidity injections to Bear Stearns was good spending that helps Main Street, while spending enabled by a federal funds rate of (for example) 1.75 percent would have been bad spending that would spur inflation.
This pattern of easier credit for troubled financial institutions but tighter credit than necessary for the rest of us continued throughout 2008: as George Selgin documents, the Federal Reserve actually took care to offset its emergency operations’ effect on overall demand. Increases in credit to troubled banks were matched with corresponding decreases in credit elsewhere in the system.34 In Bernanke’s words, this was done to “keep a lid on inflation.”35
One tool in this offsetting process was interest on excess reserves (IOER). In October of 2008, the Federal Reserve began paying IOER.36 This policy induced banks to hold reserves and earn interest from the government rather than lending to private-sector individuals or institutions. This constrained credit for the private sector, outside of the banks that were rescued with below-market-rate lending.37
Bernanke made an important point in his defense of the Bear Stearns bailout, about the interdependence of Wall Street and Main Street. Bernanke explains one direction of the dependence, but the opposite direction is just as valid; better credit to ordinary spenders on cars and houses could have helped many of the struggling financial institutions, and prevented the outcome that the Federal Reserve feared: additional bank failures and the need for additional bailouts.
Bernanke often notes that he had sympathy for those who asked him, “Where’s my bailout?”38 Perhaps the Chairman was constrained by the views of others on the Committee, but it was actually a perfectly reasonable question: there was indeed more that he could have done for them.
Instead, though, the Federal Reserve kept credit tight for the economy as a whole, while treating the symptoms of that tight credit individually with bespoke rescue packages for financial institutions. This inconsistent state of affairs persisted for about nine months until December 2008, when the Fed finally caved on policy rates and set them to zero.2009-2014: Overly-Hawkish Communications
Over the 2009-2014 period, the Federal Reserve’s actions w