How the Fed can fix one way the economy really is rigged: Restore the pursuit of full employment as their job number one
The election of Donald Trump alerted many to what should have been obvious long ago: the U.S. economy has failed to deliver the goods to vast swathes of American families for decades. In the context of Trump’s election, this economic failure was often characterized as being unique to white working-class voters in the upper Midwest. But this is wrong. Income growth has been sluggish, and hourly wage growth near-zero, for low and middle-income families across-the-board in recent decades. And many measures of racial income and wage gaps have actually worsened in recent years. In short, the income not going to white working-class residents of the upper Midwest has not been accruing to black and Latino workers; it’s instead just been funneled to the very top of the income distribution.
It’s not just politically important to realize that the economy’s failure to deliver income growth is not just a niche problem of white working-class voters in former manufacturing regions. This realization should also tell us something important about the economics of how to fix this. Too many have jumped to the conclusion that there’s just not much we can do for those workers that have been left behind in recent decades, because their troubles are mostly driven by huge, untamable forces like technological change and globalization. Here’s the astute economics writer Adam Davidson on Slate’s Political Gabfest podcast:
I know Hillary Clinton’s economic team fairly well, and I’m very impressed by them. They really are top-notch economists and economic policy thinkers. They don’t have anything for a 55-year-old laid-off factory worker in Michigan or northeastern Pennsylvania. Or whatever. They don’t have anything to offer them. And so I think it’s intuitively understandable that a screaming, loud, wrong answer is more compelling than a calm, reasonable, accurate, right answer: Your life is going to be worse for the rest of your life.
And to be clear, Davidson is not arguing that Clinton should have had answers for these workers, he’s claiming that there are no good policy levers to help them. This is wrong. Their economic suffering has largely been caused by policy decisions, and they can be fixed by (different) policy decisions.
In the next two days, the Federal Reserve will meet to decide whether or not to raise interest rates to slow economic growth, or keep rates low to hopefully spur growth. If they raise rates, they will be throwing away a key tool that could actually help these left-behind workers. Skeptics will note that the Fed is likely to just raise rates by 0.25 percent—how big a deal could that be? Big.
The mechanical effect of a 0.25 percent rate increase will be small. But what this rate increase tells us is that the Fed is convinced that the economy is near the absolute limits of capacity. Any further decline in unemployment will hence put inexorable upward pressure on workers’ bargaining power and wage growth, and this will feed into future price inflation. This conviction has no basis—wage growth continues to be extraordinarily weak and is actually putting downward, not upward, pressure on the Fed’s long-term price inflation target. They should be actively encouraging faster wage growth (by keeping rates low) rather than trying to slow it down with rate increases.
But because the Fed seems convinced (despite data telling them otherwise) that unemployment cannot fall further without sparking accelerating inflation, they are poised to raise rates and slow recovery prematurely. If they do this, the Fed will choke off any promising boost in workers’ bargaining power that we have seen over this recovery from the Great Recession.
This Fed vigilance in ensuring that the economy never sees wage growth rapid enough to push up price inflation is a deeply damaging example of fighting the last policy war (the war in this case was the wage and price inflation of the 1970s). The consequence of this excess vigilance has been decades of near-stagnant growth in inflation-adjusted wages for the vast majority of American workers. This inflation-phobic and unemployment-tolerant policy has not been the only reason why wage growth has been so awful in recent decades, but it’s a really important part of the story.
Put simply, low and middle-wage workers need very low rates of unemployment if they’re going to have any leverage at all in negotiating wage increases from employers. The intuition is clear: when you ask your employer for higher wages, the threat (implicit or otherwise) is that if they turn you down, you will quit and find another job. This threat is not credible when unemployment is high. When unemployment is very low, this threat starts to gain some credibility.
We saw this in action in the late 1990s, when the Fed chose to tolerate unemployment rates that reached 4.1 percent for two straight years. Wages grew across-the-board for American workers. And the intuition for why this is even good for laid-off factory workers is obvious. Losing a job is always economically traumatic. But it’s much worse when overall unemployment is high and prospects for finding alternative work are bleak. When the economy is hot and hiring is rapid everywhere, finding new work at comparable pay is much less challenging (yes, some workers will have always have a terrible time finding alternative work, but most will do much better when labor markets are tight).
So, what can policymakers offer the bottom 70 percent of workers who have seen near-zero wage growth in recent decades? A commitment to aggressively push down unemployment as low as it can go, and to not worry about too-fast wage growth until it actually emerges. Many take it on faith that this is what the Fed is doing, and has done in the past. It’s not. For too long they have affirmatively kept unemployment higher than it needs to be to insure inflation stability. The casualties of this strategy have been millions of workers without as much work as they need, and tens of millions of workers who have seen too-slow wage growth. A genuine commitment to full employment is possibly the most powerful inequality-fighting tool we have, and one that would much to help the workers left behind by the American economy in recent decades.