Crowding out, brought to you by the Fed
JUSTIN LAHART has written an interesting post today looking at government job losses over the course of the recession and recovery. He runs some numbers and determines that had American managed to hold government employment constant from December of 2008 then, all else equal, its unemployment rate would now be 7.1%, rather than the current 8.1%. Mr Lahart is careful to note that "ceteris is rarely paribus". Rightly so; I am increasingly convinced that an effort to support government employment would not have led to a meaningful drop in unemployment. To conclude otherwise one would have to accept one of the following conjectures:
- That a full percentage point drop in unemployment would not meaningfully change America's inflation dynamics, or,
- That the Fed would tolerate a rate of inflation persistently above its 2% target.
Neither looks right to me. And Mr Lahart's exercise gives us a nice framework through which to see how the Fed is principally responsible for the level of unemployment.He includes in his post the attached chart, which shows the path of actual and but-for unemployment. Now, we know from research on persistent large output gaps that at high levels of unemployment, the Phillips curve relationship is quite strong. So we would expect a rise in the unemployment rate from 9.4% to 9.8%, like that observed from June to November of 2010, to have a pretty significant disinflationary impact. And indeed, inflation dropped sharply during this period. And it took that significant drop in inflation to cajole the Fed into introducing QE2. Looking at Mr Lahart's chart, we see that the bump in unemployment in the but-for line is smaller and occurs at a lower level than in the actual series, in which government job losses proceed apace. In the but-for case, inflation probably would not have fallen as much, and the Fed might have waited longer to intervene or have intervened more gently or not at all. And in the absence of intervention, private job growth would very likely have deteriorated more, leading to very little net improvement in unemployment.In other words, because the Fed appears to be overwhelmingly focused on keeping inflation at or just below 2%, efforts to boost employment on the public side may simply crowd out private employment growth.We can imagine a similar dynamic playing out last year. By last summer, the gap between the two series grows quite large; where the actual series hovers around 9% for most of the year, the but-for rate sinks to 8.5% and below. At that lower level, the Fed would probably have worried that energy-driven inflation would not quickly subside. It's much harder to imagine the Fed making the current long-term low-rate commitment. With the end-series plummet to 7.1%, it's almost impossible to imagine them sticking with it. The result, again, would be greater scope for private job loss, due to less activity in construction, less commercial investment, and less of a contribution to net exports from downward pressure on the dollar. Based on the way the Fed has behaved, it seems probable that less government job loss would translate directly into more private job loss. The unemployment rate could not now be 7.1%, because the economic path to that rate at this moment is inconsistent with the Fed's primary goals.Now there is an alternative story. One could argue that the Fed is primarily focused on deflation prevention and is unwilling to push inflation above 2%, but that if other factors drove and kept it there, it would not immediately act to slow growth. In this story, fiscal stimulus is a critical ingredient in recovery, accomplishing an important task that should fall to the Fed but which the Fed has determined not to complete. I am sceptical of this story. If the recovery continues to chug along, however, we may soon find out which is closer to the mark.