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Using Fiscal and Monetary Policy to Reduce the Harmful Effects of Inequality

Remarks delivered by Dean Douglas Elmendorf
Special Event: “Ten Big Ideas on Inequality”
Harvard Kennedy School
October 13, 2016

Thank you, I’m delighted to be here.

Here’s the idea I want to emphasize: To reduce the harmful effects of inequality on our economy and society, we should use fiscal policy and monetary policy vigorously to keep unemployment low.

Why is low unemployment important? Because people who are lower on the economic and social ladder are much more likely to lose their jobs when unemployment rises, and much more likely to suffer hardship when they lose their jobs. In the Great Recession from 2007 to 2009, the unemployment rate for people with a bachelor’s degree or higher rose 3 percentage points, while the unemployment rate for people with less than a high school diploma rose 8 percentage points. Similarly, the unemployment rate for whites rose 5 percentage points, while the unemployment rate for African Americans rose 8 percentage points. The unfortunate fact is that increases in unemployment are not distributed evenly across the population but are concentrated among people who have lower incomes to start with.

That job loss is very harmful. Because people with low incomes generally have very little savings and very little income apart from what they earn at their jobs, job loss usually has an immediate, large, negative effect on their standard of living. Unemployment is also associated with worsening physical and mental health, and it can create a sense of separation from the broader society. In addition, the effects of unemployment are often long-lasting. Workers who lose jobs tend to have lower earnings for many years, because they have trouble finding new jobs, and even when they do, they work fewer hours and receive lower hourly wages. Research also shows that when a parent loses a job, his or her children tend to have more trouble in school and lower earnings when they grow up.

Thus, high unemployment is very costly for people of modest means. Correspondingly, low unemployment helps them a lot. The decline in overall unemployment in the past six years has pulled the unemployment rates of people without high school diplomas and of African Americans back down by 8 percentage points. It has put upward pressure on wages, which is generating faster income growth for people who badly need more income. And it has kept in the labor force many workers who would otherwise have given up looking for jobs—especially less-educated workers. The overall rate of labor force participation is being pushed down about ¼ percentage point per year by the retirement of the baby boom generation and other structural factors. Yet, during the past three years of strong demand for workers, the actual participation rate has been about flat. So, relative to the trend, we have seen an increase in labor force participation amounting to roughly a million people.

In sum, low unemployment has very important advantages for people who are lower on the economic and social ladder. Can we achieve low unemployment through monetary policy and fiscal policy without creating larger economic problems? Yes.

For monetary policy, the willingness of the Federal Reserve to keep interest rates low for an extended period has been a very positive force. If the Fed had raised interest rates 2 or 4 or more years ago, as some commentators were urging, we would not have seen the strong demand for workers that has given many people jobs, kept many in the labor force, and created faster wage growth.

The two possible negative consequences of low interest rates that have received the most attention are higher inflation and greater risk in financial markets. But those possible consequences have not materialized in an important way. Inflation remains below the Federal Reserve’s target, as it has been for nearly a decade. Indeed, an increase in inflation now would be good, in part because it would raise market interest rates and give the Fed more room to cut rates when the next recession hits. Of course, inflation might rise so much that the Fed would need to slow the economy—but people who have focused on that danger in recent years have been like generals fighting the last war.

Risk in financial markets is somewhat higher than it would be without low interest rates, but it is not especially high. Asset prices have increased considerably, and the resulting spur to consumer spending and investment is part of how low rates boost economic growth. That increase in asset prices does raise risk, but the greatest dangers can be addressed by regulatory policy. For example, rapidly rising prices for commercial real estate led regulators last year to warn lenders about the dangers of lax lending standards, and in response to that warning and their own assessments, lenders have tightened standards for commercial real estate loans.

Therefore, the Federal Reserve should not rush to raise interest rates now but should instead allow the unemployment rate to fall further. And when the next recession arrives and unemployment starts to move up, the Fed should cut the federal funds rate from whatever level it has reached down to zero if necessary. If that cut is not enough to keep unemployment low, the Fed should again use quantitative easing and other measures. Although those newer tools are less familiar than changes in interest rates, the differences involve the mechanics of policy and not fundamental principles, so we should not let their relative novelty deter us.

For fiscal policy, a rush to “normalize” the size of budget deficits was the biggest policy error in the United States during this recovery. The increases in federal taxes and reductions in federal spending that came into effect in 2012 through 2014 slowed the recovery significantly and kept unemployment significantly elevated.

Those policy changes did reduce budget deficits, which will have long-term economic benefits. But they reduced deficits at precisely the wrong time. Our true fiscal challenge is a long-term imbalance between the cost of the federal services and benefits we will receive under current law and the taxes we are scheduled to pay. Ultimately we need to address that imbalance, and enacting the needed changes sooner rather than later makes good sense. But having spending cuts and tax increases take effect when output and employment are constrained by weakness in demand for goods and services is terribly counterproductive.

Moreover, the need for countercyclical fiscal policy will be even greater in the future than in the past because the low level of market interest rates means that the Federal Reserve will have less room to cut rates than it had in previous downturns.

Therefore, when the next recession arrives and unemployment starts to move up, the president and Congress should enact temporary spending increases and tax cuts. And, in advance of the next recession, they should strengthen the automatic fiscal stabilizers. For example, if we established unemployment-rate triggers for cuts in payroll taxes and increases in the federal share of Medicaid spending, we could limit the run-up in unemployment and the harm that will be done to lower-income people in the next recession.

Thank you.