Almost all recoveries from recession have included rapid employment growth — until now. Though advanced-country central banks have pursued expansionary monetary policy in the wake of the global economic crisis in an effort to boost demand, job creation has lagged. As a result, workers, increasingly convinced that they will be unable to find employment for a sustained period, are leaving the labor force in droves.
Nowhere is this phenomenon more pronounced than in the US, where the Federal Reserve has reduced interest rates to unprecedented levels and, through quantitative easing (QE), augmented bank reserves by buying financial assets.
However, inflation — which rapid money-supply expansion inevitably fuels — has stayed subdued, at roughly 2 percent, because banks are not using their swelling reserves to expand credit and increase liquidity. While this is keeping price volatility in check, it is also hindering employment growth.
Rather than changing its approach, however, the Fed has responded to slow employment growth by launching additional rounds of QE. Apparently, its rationale is that if expanding reserves by more than US$2 trillion has not produced the desired results, adding US$85 billion more monthly — another US$1 trillion this year — might do the trick.
The US’ central bankers need not search far to find out why QE is not working; evidence is published regularly for anyone to see.
During QE2 (from November 2010 to July 2011), the Fed added a total of US$557.9 billion to reserves, and excess reserves grew by US$546.5 billion. That means that banks circulated only 2 percent of QE2’s contribution, leaving the rest idle. Similarly, since QE3 was launched last September, total bank reserves have grown by US$244.1 billion, and excess reserves by US$239.4 billion — meaning that 99 percent of the funds remain idle.
Because banks earn 0.25 percent in interest on their reserve accounts, but pay very low interest to depositors, they may choose to leave the money idle, drawing risk-free interest, rather than circulate it through the economy.
At current interest rates, banks lend to the government, large stable corporations and commercial real-estate dealers; they do not extend credit to riskier borrowers, like start-up companies or first-time home buyers. While speculators and bankers profit from the decline in interest rates that accompanies the Fed’s asset purchases, the intended monetary and credit stimulus is absent.
At some point, the Fed must realize that its current policy is not working. However, developing a more effective alternative requires an understanding of the US economy’s actual problems — something that the Fed also seems to lack. Indeed, US Federal Reserve Chairman Ben Bernanke often says that his goal is to prevent another Great Depression, even though the Fed addressed that risk effectively in 2008.
The US economy has not responded to the Fed’s monetary expansion, because the nation‘s biggest problems are not liquidity problems. As every economics student learns early on, monetary policy cannot fix problems in the real economy; only policy changes affecting the real economy can.
The Fed should relearn that lesson.
One major problem, insufficient investment, is rooted in US President Barack Obama’s effort to increase the tax paid by those whose annual incomes exceed US$250,000 and, more recently, in his proposal to cap retirement entitlements. While such proposals have been met with opposition, Obama cannot be expected to sign a deficit-reduction bill that does not include more revenue. As long as that revenue’s sources, and the future effects of new regulations, remain uncertain, those whom the policies would most harm — the country’s largest savers — are unlikely to invest.
Likewise, Obama’s healthcare reform, the Affordable Care Act, has hampered employment growth, as businesses reduce their hiring and cut workers’ hours to shelter themselves from increased labor costs (estimates of the rise vary). Meanwhile, the faltering European economy and slowing GDP growth in China and elsewhere are impeding export demand.
While subdued liquidity and credit growth are delaying the inflationary impact of the Fed’s determination to expand banks’ already-massive reserves, the US cannot escape inflation forever. The reserves that the Fed — and almost all other major central banks — are building will eventually be used.
Allan Meltzer is a professor of political economy at Carnegie Mellon University and a distinguished visiting fellow at the Hoover Institution.
Copyright: Project Syndicate