The “appropriate monetary policy” to tackle the Long Term Unemployment problem

At the Brookings Conference the Krueger et al paper – “Are the Long-Term Unemployed on the Margins of the Labor Market?” – made waves, being mentioned, summarized and commented in a large number of posts.

One year ago I did a post on the topic of long term unemployment which I titled “Chilling”, and that, I think, is the best description possible.

In this post, my point of departure is the very last words from the Krueger et al paper´s conclusion:

Some may wish to draw macroeconomic policy implications from our findings. Only time will tell if inflation and real wage growth are more dependent on the short-term unemployment rate than total unemployment rate. To us, the most important policy challenges involve designing effective interventions to prevent the long-term unemployed from receding into the margins of the labor market or withdrawing from the labor force altogether, and supporting those who have left the labor force to engage in productive activities.

Overcoming the obstacles that prevent many of the long-term unemployed from finding gainful employment, even in good times, will likely require a concerted effort by policy makers, social organizations, communities and families, in addition to appropriate monetary policy.

“Appropriate monetary policy” was an expression that at one time Greenspan used with some frequency to “calm markets”. When he used it the meaning was: “Trust me to get things right”. But Krueger et al don´t give it any particular meaning. Maybe they are just hinting that they support a continued Fed policy of low interest rates.

Given that the game has changed to bets on the date rates will start to move up, there´s not much hope there. In fact, the big problem is that the Fed has no monetary policy regime in place. The Fed is in practice groping in the dark. Not being able to say so they say things like “we  will monitor “a wide range of information” on the job market, inflation and the economy before approving any rate increase.”

As Scott Sumner argues:

Changes in aggregate demand impact housing, retail sales, industrial production, business investment and exports.  Those are all components of RGDP.  Aggregate demand also affects prices.  Both RGDP and prices are components of NGDP.  So in a sense NGDP is the most comprehensive measure of AD.  It’s the total dollar value of all spending on all domestically produced final goods and services.

Would NGDP (something the Fed could closely control) have any bearing on long term unemployment? Let´s appeal to our visual senses.

The chart shows NGDP growth and the long term unemployment rate (LTU) for the past 60 years. Note that in the 1950s NGDP growth bounces quite a bit. Long term unemployment “bounces” in close tandem and in the opposite direction.

LTU_1

Beginning in the mid-1960s and extending to the late 1970s we have a strong upward trend in NGDP growth (that was the age of the Great Inflation). Note, however, that long term unemployment remains relatively low and that happens despite some serious supply shocks (oil and commodity prices).

The Volcker “war on inflation” brings down NGDP growth. Long term unemployment jumps but quickly comes back to “normal” levels.  And throughout the Great Moderation from the mid-1980s the pattern is the same. LTU goes up during and immediately following recessions (shaded areas) but comes down to “normal” levels (around 10%).

In the 2001 cycle the Fed tightened excessively and before the positive effects on LTU from the Fed´s correction could be completed the Great Recession came about…

The next chart singles out the post 1985 period which encompasses both the Great Moderation and the Great Recession that follows it.

There´s a close correspondence between LTU and the NGDP gap. For example, the 1991 recession came about when the Fed worked to close the positive NGDP gap that had opened up. For most of the rest of the decade NGDP evolved close to its trend level path (“zero” gap) and LTU decreased continuously.

LTU_2

The excessive monetary tightening in the early 00s clearly shows up in NGDP falling below trend and in the rise in LTU, but in mid-2003 the Greenspan Fed (through “appropriate monetary policy”) moved to correct the error, bringing NGDP back to trend. LTU immediately backs down.

But then Bernanke came along and by adopting a rigid IT focused monetary policy – clearly the wrong policy for a country that had long before “conquered” the inflation beast and had the alternative of introducing an explicit NGDP targeting monetary regime – aborted the fall in LTU.

Later, by letting NGDP fall into the abyss, it caused the massive rise in LTU. And by not moving to close the gap it has maintained LTU at record high levels with all the economic and human costs that entails.

I wish Kevin Sheedy´s paper on “The case for NGDP targeting” also presented at the Brookings Conference had made more of a splash. It would help make clear the “solution” to the problem tackled in Krueger´ paper!

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