With both the ebbing tax stimulus and the lagging effects of last year’s less accommodative monetary policy, the economy’s potential output will likely decline to an annual growth rate towards 2% by year-end. Economists generally define the economy’s potential output as the normal level of production given the economy’s resources and technology. In estimating the potential output growth rate, they generally focus on the growth of both the labor force and most importantly, productivity. Since the Great Financial Crisis (GFC,) neither the labor force nor productivity grew faster than rates prior to that period (See Figures 1 and 2).
Studies, such as Long-term Damage from the Great Recession in OECD Countries by Laurence M. Ball, show that deep recessions produce continuing negative effects on the economy’s potential output long after they end. These long-term effects result in under-investment in both capital plant and research and development as well as causing skills of unemployed workers to erode. Deep recessions also tend to alter consumers’ attitudes towards saving, spending, and borrowing.
Figure 3 compares the Congressional Budget Office’s (CBO) rough estimates of potential growth in the ensuing years after the GFC with estimated potential growth in 2007. As the graph illustrates, despite very accommodative monetary policies, the U.S. generated much lower levels of potential economic growth than that prior to the GFC.
In our long-held view, central banks’ models and policies do not fully reflect the increasing impact of financial markets on credit and business cycles. This shifting influence likely came with the massive buildup of non-financial business debt as the result of low-interest rates (see Figure 4). If so, it may represent one reason for the Fed to reconsider how it formulates its policies to affect the economy’s potential growth. In a recent speech by Lael Brainard, a member of the Board of Governors of the Federal Reserve she said, “….policymakers may need to think differently about the interplay of the financial and business cycles due to the combination of a low neutral rate, a flat Phillips curve, and low underlying inflation.” Ultimately, this could mean the Fed would make an effort to use countercyclical capital tools to temper financial cycles. Such efforts to moderate financial upside excesses might not initially please investors.
The modest recent success of central bank monetary policies to raise long-term potential economic growth created an audience looking for new and perhaps better answers. In that direction, proponents of Modern Monetary Theory (MMT) seem to be receiving the greatest attention. We will let smart people debate its virtues. No doubt, however, politicians will seek out answers such as MMT that will sell well to their electorate.
As part of this rethinking, MMT once again recognizes that monetary policy represents a shotgun approach to macro-economic management. Therefore, MMT, in part, represents an outgrowth that monetary policies need support from more directed government efforts. Fiscal policies can fill that need by providing more rifle shot remedies in helping to solve our economic issues. In the short-run, MMT proponents will likely rely more on fiscal policy and less on monetary policy to achieve balanced growth.
Longer-term, MMT will enable the Federal Government to issue debt to the Fed with a combination of both zero interest rates and maturities. The Fed would then increase the Treasury’s balances at the Federal Reserve Banks. With those deposits, Treasury could fund various programs. Ultimately, this may lead to reducing the role of the central bank as the Treasury Department regularly issues such debt of questionable value substantially increasing the size of the Fed’s balance sheet. By directing the spending of those balances, Treasury, in effect, becomes the prime allocator of credit to the economy-both public and private. In doing so, it might lead to Treasury assuming the central planning role for the U.S. economy. That possibility could lead to unknown consequences. Certainly, the key to ensuring proper management of MMT lies, in part, with timely oversight and response from Congress. We leave it to the reader to judge that probability.
One important difference from other countries, the U.S. dollar acts as the global reserve currency. It confers on the United States, to quote a former French Finance Minister, “America’s exorbitant privilege.” Therefore, MMT policymakers must keep the confidence of international holders of U.S. dollar reserves in mind. Finally, in our view, MMT may ultimately run up against, what some may describe as a fundamental law of economics – T.N.S.T.F.L. – meaning there is no such thing as a free lunch.
In addition to new approaches to macro-economic policies, encouraging legal immigration would also help to stimulate long-term potential economic growth. Figure 5 shows immigration makes up a growing component of population growth. The obvious need for comprehensive immigration legislation runs up against the sharp political split in Washington which stands in the way of any compromise.
In the past, we expressed the view that D.C. politics resembles that of a small town rather than the capital of the world’s leading economic and military power. Absent a shock to the economic or political system, political compromise necessary to implement timely fiscal policies or adopt comprehensive immigration legislation seems unlikely. Former European Commission President Jean-Claude Juncker’s quote probably describes best the politician’s dilemma, “We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
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