There have been a litany of rationalizations the Fed has employed to justify zero interest rates over the past few years: the financial sector was still too weak, the Greek debt crisis, the unemployment was still too high, underemployment was too high, labor force participation was too low and, earlier this year, a sharp drop in stock prices. Now, this week, the excuses are uncertainty over Britain’s exit from the European Union, a one-month blip in job numbers and structural changes in the economy that that have reduced the “neutral” interest rate to zero.
Fed Chairman Janet Yellen and her colleagues are right about a couple of things. Raising rates toward something closer to two percent over the next two years will cause a sharp, downward correction in the price of real estate and financial assets that have been artificially inflated by extraordinarily low interest rates. And falling asset prices will, in turn, slow economic growth at home and around the world, pushing downward pressure on output, employment, income growth and even prices. Even so, slowly by steadily raising rates is the right thing to do.
The reason is best explained by analogy: Monetary stimulus has long since accomplished its Keynesian purpose of stabilizing a very sick patient and putting her on the path to recovery. But at this point, there’s been so much of it, and it’s gone on for so long, that the full range of the economy’s natural healing processes have been prevented from kicking in.
That means two things. First, it means giving the patient more medicine won’t really do much good—it’s done just about all it can do. But even worse, administering more medicine is actually harmful because the patient is now addicted to it. It’s time to begin the withdrawal process even as we take other steps to reduce the painful side effects.
It is not just the Fed, by the way, that has been administering the monetary stimulus. It has also come from the central banks of Japan and Britain and, in the last few years, from the European Central Bank, which has already pumped so much money into the European financial system that it is now on pace to own 25 percent of the sovereign bonds of the euro area countries by this time next year. And if that weren’t enough, the ECB has just begun buying $5 billion to $10 billion a month in high-grade corporate bonds. Now, having driven European interest rates below zero, the ECB is actually paying governments and corporations to increase their borrow.
(If you are wondering where the ECB and other central banks get the money to do all this stimulative bond buying, the answer is simple: As central banks, they just print it.)
Until a year or two ago, there was good reason for the Fed to continue with its extraordinary monetary policy. But with the U.S. economy nearly back to full employment, and incomes rising, and core inflation running close to 2 percent, it’s well past the time to start easing back on the stimulus by raising rates. This isn’t about preventing future inflation—right now, all the signals are that that risk is pretty low. But it is about weaning the U.S. and global economy off an addiction to zero interest rates that have badly distorted the price of financial assets relative to the price of everything else.
Yellen’s fallacy is that it is necessary to wait until the economy is growing even faster, and inflation is even higher, and risks to the global economy have totally disappeared before moving toward more normal interest. What should be obvious at this point is that administering more monetary medicine won’t get us there. Indeed, the economy won’t be able to grow any faster than it is now until is weaned off the easy-money medicine and allowed to find a new and more sustainable equilibrium, one that can act as a foundation for higher growth.
Certainly there are other things we can do to soften the blow to markets and the economy during that withdrawal process. Governments could borrow heavily while interest rates are still near zero and invest that money in things that are proven to increase long-term growth—infrastructure, education, early childhood development, basic research. Governments could eliminate regulations in financial, product and labor markets that would allow economies to become more flexible, more efficient and more innovative. Governments could increase taxes on high-saving households at the top of the income scale, and redistribute it to high-spending households at the bottom.
Those aren’t my ideas—they are policies that have long been recommended by very sober economists, including those at the International Monetary Fund. And at this point, they are the best things— in my opinion, the only things—that can lead to higher growth rates. They are also politically controversial, which means they won’t be adopted as long as central banks continue to act as our enablers and allow us to avoid the hard choices.
It is not, as Yellen said yesterday, an abundance of caution that keeps the Fed from beginning to withdraw monetary stimulus. It is a lack of courage—the courage to stand up to financial markets and the courage to force business and political leaders to finally deal with the economy’s underlying problems.