Using Fiscal Policy and Monetary Policy to Foster Inclusive Economic Growth
Comments for Radcliffe Day
Dean Douglas Elmendorf
May 27, 2016
Thank you. I am delighted to be here for Radcliffe Day and honored to be included in this celebration of Janet Yellen.
I will use my few minutes to draw out some implications of the other panelists’ remarks for fiscal policy and monetary policy. These are two areas of policymaking where Janet has played crucial roles. They are also two areas where I have had the privilege of working for Janet. I was on the staff of the Federal Reserve Board when Janet was a governor in the mid-1990s, and then I was on the staff of the President’s Council of Economic Advisers when Janet was the chair in the late 1990s. I probably should have kept following her around because I was learning so much from her, but other jobs intruded.
I want to highlight three ways that I think fiscal policy—in particular, federal fiscal policy—should be used to help generate inclusive economic growth, and then highlight one recommendation for monetary policy.
For fiscal policy, first, we should increase federal investments in education and training. Under the current caps on annual appropriations, federal investments of all sorts—in infrastructure, research and development, and education and training—will soon be smaller relative to our total economic output, or GDP, than at any time in at least 50 years. That is not forward-looking, growth-oriented policy, and it is certainly not a way to generate inclusive growth. Federal spending for education and training, if directed well, is especially important for people who come from lower-income families or live in places with lower average incomes and therefore cannot rely on their families or their communities to make high-quality education and training available to them. I do not want to pretend that spending more on education and training is a panacea, because it is not. But if we want a society in which everyone has an opportunity to advance, we need to provide the foundation for that advancement to everyone. Doing so involves many steps, but a straightforward starting point is to raise federal spending for education and training rather than cutting it as will occur under current law.
Increasing federal investment is especially appropriate now because Treasury interest rates will probably stay exceptionally low for years to come. Such low rates represent a sea change in the backdrop for fiscal policy. Louise Sheiner and I have shown, in research we are doing together, that low rates generally imply, as one might expect, that the federal government should issue more debt and undertake more investment than it would otherwise.
A second way in which federal fiscal policy should be used to help generate inclusive growth is to maintain existing benefits for lower- and middle-income people, rather than cutting them as part of a deficit-reduction effort or for other reasons. Federal benefits matter in two ways: One is that they help children who grow up in families with modest means get a stronger start in life. There is a growing body of evidence that certain subsidies for health care, housing, education, and other things raise future incomes of children whose families receive those subsidies today. In other words, portions of federal benefits constitute true investments.
Federal benefits also matter because they partially insulate people’s living standards from the vicissitudes of market forces. During the past few decades, the market incomes of people in the lower and middle parts of the distribution—that is, their incomes before taking account of taxes and transfers—have risen much less than GDP. However, their incomes after including taxes and transfers have increased notably more rapidly, albeit by less than the incomes of people at the top of the distribution. Therefore, our tax and transfer system has ensured that living standards have diverged much less than market incomes. Moreover, the tax and transfer system provided a crucial buffer during the recent downturn, when average market incomes in the bottom and middle parts of the distribution fell markedly but average incomes after taxes and transfers were more stable.
A third way in which federal fiscal policy should be used to help generate inclusive growth is to keep total demand for goods and services high enough to achieve full employment. The economic and social advantages of full employment are tremendous. Tight labor markets pull people into the labor force and boost wage growth—effects that are especially important for people of modest means, who are more likely to lose their jobs when labor demand is weak and who have fewer resources to fall back on when they lose their jobs. So, full employment creates income for people who need it. It also fulfills our social commitment to have an economy in which willing workers can find work.
Unfortunately, maintaining full employment in the coming years will probably be quite difficult. In each of the past three recessions, the Federal Reserve has cut the federal funds rate by more than 5 percentage points. But with market interest rates likely to stay very low, the funds rate will probably be well below 5 percent when the next recession arrives, so the Fed will have less room to cut. As a result, countercyclical fiscal policy will be more important than it was in the 1970s, 80s, and 90s. We should strengthen the automatic fiscal stabilizers and prepare additional countercyclical policies that could be put into action when needed. A rush to reduce federal budget deficits was the biggest policy error in this country during the past half-dozen years, and we should not repeat that error.
My last point is about monetary policy. To help generate inclusive economic growth, the Federal Reserve should continue to focus on achieving maximum employment as well as price stability—that is, it should continue to address both parts of its so-called “dual mandate.” To be sure, monetary policy cannot usually achieve full employment by itself, in part for the longstanding reason that structural problems in labor markets can be important and in part for the new reason that low market interest rates give the Fed less scope to cut the federal funds rate.
But that lesser scope for cutting the funds rate does not let the Federal Reserve off the hook to do what it can. Since the financial crisis, the Fed has developed creative new tools for trying to achieve maximum employment and price stability. We should be very grateful for what the Federal Reserve has done, and we should expect it to undertake similar actions when future conditions warrant.