The Federal Reserve’s Timid Monetary Policy is Contributing to Weak Productivity Growth
One of the basic tenets of neoclassical monetary theory is something that economists call the Neutrality of Money. Its precise definition is fairly complex, but the core idea is that money in and of itself has no real value. The value of money comes from the ability to use it to buy the goods and services that we want. Hence, when I think about of how much a one hundred dollar bill is worth, I am necessarily taking into account the prices of the various things I could buy with it. If those prices go up, then the value of my one hundred dollar bill goes down.
For example, if prices were to double, then the value of my one hundred dollar bill would be cut in half. I would then need two hundred dollar bills to have the same value of money that I had before. Now, when the Federal Reserve prints additional money, it tends to drive up prices. If prices rise enough, then there may be more money in the economy—but the value of that money is essentially the same as it was before the Federal Reserve increased its printing. Thus, the effect of the additional money had a neutral effect on the total economic wealth.
All monetary economists are taught this principle, and it has a deep and compelling logic. But it’s also almost certainly wrong. The question though is: how wrong is it?
One theory goes as follows: actors in the economy suffer from ‘Money Illusion’. When the Federal Reserve first increases the amount of money in circulation, those actors think they are richer, or at least that the economy has somehow found an extra source of wealth. They employ more workers and invest in more advanced equipment to get a greater share of that wealth. This increase in economic activity leads to a boom, and is what allows the Federal Reserve to influence the rate of economic growth.
While a few Real Business Cycle types reject the notion that the Federal Reserve can control the economy at all, the broad swath of mainstream economists accept the story as I’ve told it so far. Yet—as most of them believe—the situation changes as the economy moves forward in the long run. This increase in employment and investment is not sustainable. Being in high demand, workers ask for higher wages. The flood of investment increases asset prices. Those factors force prices to begin to rise. Prices keep on rising until the value of money in circulation has been reduced enough to cool the extra demand for workers, and slow the rate of investment. The economy returns to where it was before. The Fed, by printing money, was able to goose things in the short run. But in the long run the effect of money most mainstream economists believe, is still neutral.
In the wake of the financial crisis, a few economists and economic journalists began to question this effect. My first recollection of widespread questioning of this narrative came in a conversation between myself, Mark Thoma, Matt Yglesias, Ryan Avent, and Felix Salmon at the Kauffman Center’s 2012 bloggers conference. Soon after, the argument that monetary policy could have real effects on productivity began popping up around the blogosphere.
My version went something like this: when investment increases—or decreases for that matter—it doesn’t do so across the board. In a contraction, you continue investing in the most crucial equipment. By contrast, the beginning of a monetary boom is precisely when firms have the resources to buy into advanced technologies they were previously hesitant about. These techs tend to be expensive and have high learning curves. Yet, as more folks buy them, the prices go down and experience with them goes up. Pools of workers who know how to use the technologies are created, making it easier for firms who are not as naturally tech savvy to invest in it as well. These effects are real and long-lasting. They will make the entire economy more productive, not just during the monetary boom, but into the future.
Ryan Avent expanded on a parallel theme in his book The Wealth of Humans. Avent argued the ultimate source of wealth in an economy—the scarce factor—isn’t capital investment. It is people. This, it turns out, has implications for our theory of about monetary neutrality. As Avent lays out in a Medium post on economic productivity:
…it was not the case that James Watt developed his steam engine and everyone said “great, this technology is clearly superior to everything else and we will therefore use it all across the economy”. Rather, it was used in a small number of contexts in which the economics (expensive labour, cheap energy) pushed business owners to experiment. Then, over time, engineers improved the technology and firms built up a wealth of knowledge about how to use it to make a buck. Then eventually the technology was so good that it began to be adopted in places where labour costs were not all that high.
Inexpensive labor, Avent argues, is preventing the widespread adoption of advanced technologies. His argument is one about long term prospects for economic growth, but it has implications for the effects of monetary policy. Again, mainstream economists agree that the Fed can cause a temporary bulge in economic activity by printing more money. What makes the bulge temporary, among other things, is that wages are driven up by the efforts of all companies to increase production immediately. However, if low wages are holding back the deployment of new technology, then that temporary bulge could lead to rising productivity. Rising productivity would provide the real economic resources to support those higher wages, thus turning the temporary increase in economic activity into a permanent one.
As Neil Irwin reports, these types of ideas are gaining steam.
[The Roosevelt Institute’s] J. W. Mason, the author of the report, argues that soft productivity growth reflects not some unlucky dearth of new innovations, but rather is a consequence of depressed demand for goods and services and a slack labor market that has depressed wages.
Maybe if the labor market were tighter and wages were rising faster, it would induce companies to invest more heavily in new labor-saving innovations.
What’s particularly interesting is that this diagnosis — though decidedly not the policy prescriptions — has some overlap with the arguments of influential conservative economists.
The last piece is crucial. This is one area where conservative and progressive economists may be converging on the same policy prescription. More aggressive monetary policy from the Fed may not only boost growth in the short term, but bring about the productivity revolution that we are all waiting for. That type of bipartisan support is crucial to give the Fed cover to move out of its comfort zone and take a chance on improving the economic prospects of the next generation of Americans.
Karl Smith is the Director for Economic Research at the Niskanen Center