Well-Designed Fiscal Tightening Need Not Adversely Impact Economic Activity, Says Yellen
Former Chair of the U.S. Federal Reserve Janet Yellen was recently interviewed by her predecessor Ben Bernanke on her career, her time at the central bank, her observations about the current state of the economy and the challenges that confront it. Yellen recently joined the Hutchins Center on Fiscal and Monetary Policy at Brookings as a Distinguished Fellow in Residence in Economic Studies alongside Bernanke.
Here are edited excerpts from that conversation.
How did you take economics as a profession?
I decided in college to major in economics, and then stayed in economics. I didn’t know a lot about economics before college. I was interested in math and I enjoyed it. I suppose when I went to college I would have written down that I though math would be my likely major. When I exposed to economics, I was really impressed that this was a discipline that relies on mathematical thinking, logical thinking but rigorous analysis but, is very much disciplined, concerned with human welfare. That was a combination which greatly appealed to me. I must admit that after my first economics course, that was kind of love at first sight and I stuck with it.
I studied macro economics in my first course when I was exposed to Keynesian thinking. I studied about the great depression and very impressed that capitalist economies were capable of occasional breakdowns in the functioning of labor markets that could result in such prolonged misery for such a large section of the population. I was impressed that there did absolutely seem to be a great deal to be learnt of what can be done to address such episodes. So, that was my early interest which continued.
Herschel Grossman was one of my first macroeconomics teachers. James Tobin was my teacher in graduate school, but he was more than my teacher. He was an inspiration to me. I think what impressed me was not only his analytic skills and his knowledge of macroeconomics and the work that he did, but also his very strong commitment to social justice and the view that economics is about making the world a better place. Economists use more and more these days, a great deal of math. Sometimes people joke or criticise economists for treating it like it's recreational math. Some of it, not really, and I think for me what Tobin stood for was always doing work that was about something devoted to advancing human welfare. In that sense, he was very influential in terms of what I wanted to do and in terms of the subjects I was interested in. I worked very closely with him. I was his teaching assistant in the core graduate macro class. We thought about - came close to writing that up as a book, but the rational expectations revolution intervened and changed our thinking quite a bit about what should be in a core course.
Were you the only woman in class in graduate school?
I was one of the two women in the class. There were not a lot of women at that time. It wasn’t a problem for me. I was always treated fairly. Tobin and Stiglitz, with whom I worked, were always very strong mentors for me. I enjoyed the graduate program very much. But it is sometimes a problem. I think it’s sometimes a problem for women being in such a small minority.
What is the most exciting thing that you did, that you are the most proud of?
I held a number of academic jobs and ended up in Berkeley. I also ended up marrying somebody that I met in Fed cafeteria by the name of George Akerlof, who shared my interest in the topic of employment, economic theory bearing on unemployment. The most significant work that I did before becoming a Fed governor was with George. Our work was both theoretical and empirical.
On the theoretical front, we were very concerned with what I think has long, maybe 100 years, been the core question in macroeconomics, which is, can there be such a thing as involuntary employment. This is an important strand of the real business cycle versus Keynesian debate.
We questioned, why on earth if someone says I am involuntarily employed, I would like to get a job, goes to a firm and says, you have these workers and I have exactly the same skills, and I am willing to work for less than you are paying them as an employer. Why shouldn’t I be able to get that job? If I am not willing to make that offer, am I not in essence saying that I don’t really want the job and I am voluntarily unemployed?
So, that has always been a puzzle of why in a market system,someone who is qualified for a job and willing to work a little bit low what others are getting, shouldn’t they be able to bid for jobs? That was a theoretical puzzle that we attacked in our work.
The theory we developed falls into a general class of theories, I call efficiency wage theory. This theory says that firms have to set very good reasons when you come to the door and say replace your existing workers with me, I am willing to work for less. Those firms have to set very good reasons for turning you away and be unwilling to cut wages and replace their existing workers with you. There are a set of the theories, some based on information and turnover cost. What they have in common is the idea that if they were to take you up on your offer and cut wages for you, and everyone else, the productivity or efficiency would suffer.
Therefore, it will be not a cost saving move on part of these firms. I think a lot of our contributions to that theory fell in terms of the sociological models, violations of fairness and the consequence of what happens in firm to productivity and worker morale when an employer violates norms of fairness. There were also more neoclassical considerations. These theories essentially explain why it is that wages may be set at levels above those consistent with market clearing.
This is not necessarily an explanation of business cycles. And an important question that existed at the time is, is there anything monetary policy can do to combat unemployment? The theory I just described does not automatically have any role for monetary policy, this kind of wage-setting is referred to as “real wage rigidity.” To explain how monetary policy might work, it was necessary to explain why money wages, or nominal wages or prices might be sticky. We worked on a theory we referred to as neo rationality. What we tried to show was that in a world where efficiency wage type considerations were prevalent, firms could follow rules of thumb in adjusting wages and prices that would lead to slow adjustment. While these rules might not be exactly optimal or profit-maximizing from their point of view, the cost to them of following these rules would be second-order small or miniscule. But consequences to the aggregate level of wages and prices and adjustments would be substantial and therefore monetary policy could work.
Those micro-foundations became important in new Keynesian models. We also did empirical work. We contributed to the Brookings papers in the 1990s. We tried to document the benefits of greater turnover in a strong labor market. We also did a paper looking when German unification took place. We were quite concerned that under the arrangements that were put in place, there would be pretty high unemployment in East Germany. We undertook research that determined why that would be true and tried to suggest a scheme, that of course was not adopted, that would be helpful in minimising unemployment.
What lessons did you take from 1990s?
I guess I took away two lessons. One is that Clinton’s first steps, first economic policies, put in place a plan that would lower budget deficits. There had been great concern about out of control budget deficit. I think it was reflected in high long-term interest rates. The Clinton administration was rightly very concerned about tightening fiscal policy. You had an economy that was just recovering, unemployment remained high, and they were worried about the negative impacts of fiscal tightening. I think -- let me just say at the outset in general, the view that tight fiscal policy tends to depress employment and economic activity -- I believe that to be correct. I am not questioning that. The Clinton policy phased in slowly over time a tightening of fiscal policy, so it was not tightening in one day or one year. I believe it was a very credible multi-year commitment, which served to quickly bring down dramatically long-term interest rates. I think for several years this was a fiscal tightening that was expansionary, because the decline in spending or increase in taxes did not occur immediately and the long-term rates came down very quickly. The economy continued to recover. The notion that a very well-designed fiscal tightening policy need not have adverse impact on economic activity was one lesson we took away.
Another lesson -- we looked at why was it possible for unemployment to decline as low as 4 percent and inflation stayed so low? We have a similar situation where inflation is not even up to the Fed’s 2 percent target. Our conclusion was that good experience reflected a set of favourable supply shocks, the most important was that productivity was really increasing dramatically, unfortunately temporarily, but dramatically. That was holding down prices. In addition to that, there was a strong dollar. The appreciation of the dollar was holding inflation down. Oil prices also plummeted. Those things have been operative in the U.S. recently. On top of that, we pinpointed a decline in the pace of health care cost increases. This was a period in which there was a restructuring. Many people moving from fee for service to managed care type plans, and at least for a period, it held down the growth of health care costs significantly. All of these were supply shocks. We concluded that was important. I think in the present situation, some of those things are present as well.
You were early identifying problems in housing and banking before the 2008 financial crisis. Tell us how you saw those issues from San Francisco.
I was in San Francisco starting in 2004 and then came and joined you (Ben Bernanke) in Washington in 2010. I was out in an area that was the centre of these problems, developing while that was happening. I saw a lot and I reported on a lot that was very worrisome. From day one, when I walked into the bank, I met with our banking supervision folks. They told me how concerned they were about commercial real estate lending. We had booming housing markets. We supervised small community banks. Their commercial real estate lending, especially for land acquisition and development, was growing at a very rapid pace. Lending was growing more rapidly than deposits. They were beginning to rely heavily on brokered deposits. Very high concentrations often in small geographic areas that were the centre of what became housing boom and bust. Quite a few of them ended up failing later. My staff was very worried about that. I had many directors and business contacts involved in housing. In San Francisco you could not go to a cocktail party without people telling eye-popping tales about deals that had been struck on house prices. I heard all of that and my contacts were quite concerned. My supervisory folks were alerting me to underwriting practices that were of huge concern. They were telling me about low doc and no doc loans, about the prevalence of ninja loans - no income, no jobs, no asset type loans. We supervised countrywide for a while and looked at their mortgage business, which was growing enormously. I met regularly with Angelo Mozilo, and the San Francisco Fed was quite concerned about what was going on. We tried to insist on tighter risk controls. One day we had our quarterly meeting and Angelo said, Janet, I have to tell you, it has been terrific to be supervised by you. You guys are on top of your game. We appreciate all the valuable advice you have given us. But, you know, we have realised that we don’t actually need to be a bank holding company. We realised we would be okay to be a thrift holding company. We are changing our charter. Indeed, they did so, and decided it would be nice to be supervised by the office of thrift supervision. That gave me a sense of what was happening.
What were the concerns apart from housing?
Beyond housing, as we got closer to 2007, I had directors who were telling me about broad-based financial excess. The way one person put it was, the banks and financial institutions are absolutely throwing money at us. Never seen anything like it. One day I met with a member of my advisory council who was a principal in a major private equity fund. He told me a story that I found simply terrifying. He says, there is a well-known company, I won’t mention the name of, there are many big private equity companies that are competing to take this company private. We’ve looked at this firm and I just don’t see any way in which we can win this. But the head of our firm encouraged us to see if we could put together a bid. We sat down, looked at, what on earth would it take to win a bid to take this company private? We would have to get the most incredible financing terms from a bank. Not only would the rate have to be low, but even if the economy stumbles, we might be unable to make the interest payments on our loan. We would have to have a deal by which if we could not make the interest payment on our loan, we would be able to add that unpaid interest to the principal balance and automatically borrow to get through these hard times. No bank is going to give us a deal like that. Lo and behold, the head of the firm said, why don’t you just try it? So they went to a bank and the bank just fell all over itself and was delighted to agree to these terms. This type of arrangement became known as a payment inclined toggle. When I heard, I thought, this is broad-based financial excess. I was quite concerned about it. I failed to appreciate that if housing prices began to fall, I really did not understand how vulnerable the financial system and particularly the shadow banking system had leveraged it was, how much maturity transformation there was, how much of this risk we thought was being dispersed through the economy was really remaining on the books of these institutions. I wrongly thought, if housing prices fell a medium amount, it would do damage to the economy and the outlook. But it would not destroy the core of the financial system. I think that was a failure to appreciate the weaknesses.
What was your thinking at that time?
You and I were probably looking at things very much alike. I think by the summer of 2007 before, we never really encountered with Lehman or Bear Stearns or any of that. House prices were already falling. I think it was becoming clear that credit was growing quite tight. While the unemployment rate was very low, we had tightened monetary policy, inflation had risen a little bit above 2 percent. I thought, downside risks to the economy and the labor market were beginning to dominate the outlook. Certainly by 2008, after Lehman, even though later on there was another surge in oil prices that took inflation up, we had a real economic situation that was simply becoming so dire that to my mind, there was no question that that was the dominant matter of concern. And that if unemployment rose to the levels it looked likely to rise, and I think we are lucky it rose no higher than 10 percent, if you had not done all the interventions that you supported, god knows what would have happened to unemployment. I had no doubt that was the primary -- what our primary focus had to be. Inflation surely would come down in that kind of context.
Is inequality a constraint on demand growth?
I would not say it is a constraint. I would say it is an influence that such a large share of income gains have gone to high-income consumers. Probably with lower marginal propensities to consume. In spite of that, we have had a very healthy growth in consumer spending. It is something that has been driving the economy this year and for several years. I‘m not sure I see it as a constraint, but it certainly is something that is a significant influence. Probably will continue to be on consumer spending.
Are we ever going to get inflation?
My view has been that the shortfall of inflation from 2 percent is something that is likely transitory. Now with unemployment as low as it is and having fallen below most estimates of its longer-run natural rate, with neither the dollar nor oil prices holding inflation down, the median of the SEP in December expected that in 2018 inflation would move up to 1.9 percent and reach 2 percent in 2019. Although we’ve had a shortfall, and I think the most recent 12-month change in the core is still running at 1.5 percent. I do believe it is going to move up in the coming months as outsized declines in inflation that occurred one year ago that were associated with plummeting mobile phone prices and other idiosyncratic declines, as they drop out of the index. I expect that this spring, inflation will move up back to not to 2 percent, but a little bit closer to that. What I said is that I see the standard framework that sees inflation as being largely determined by inflation expectations, labor market slack, a variety of supply shocks, as a reasonably sound framework for thinking about inflation. I don’t think it has exhibited massive failures in recent years. Yes, inflation has been now for many years below 2 percent. Such a framework would have attributed that to a lot of slack in the labor market, plummeting oil prices and a depreciation of the dollar. For many years, low inflation has not been mysterious in terms of its causes. 2017, the models saw no reason for inflation to be as low as it was. In 2016, exactly the opposite was true. Inflation hit 2 percent. The model did not expect it to be at 2 percent. Of course there are errors. I’m not saying we have a perfect understanding of inflation.
There are a whole variety of shocks that cause actual inflation to depart from the protections, the model. It is not as though the errors involved would cause you to say, this model just isn’t working, we need to rethink it. So my scenario, having a very open mind and knowing that perhaps this framework needs to be amended in some critical way, my baseline assumption is that the shocks that held down inflation last year are likely to prove transitory. I would see inflation as moving up. You should never make too much of any month or two of data on either prices or wages. I see incoming data as not inconsistent with inflation moving in-line with the committee’s assessment that it is going to go back up to 2 percent. Wages have been gradually edging up the rates of increase. The relationship between wages and prices is not tight.
Does the recent volatility in the market have anything to do with the degree of transparency from the Fed?
Bernanke: The recent volatility is nothing exceptional. The veterans are quite aware. The purpose of Fed communication is not to eliminate or suppress volatility. The purpose is to eliminate unnecessary understandings, unnecessary communications problems that lead to extra volatility, more than otherwise would be coming from the fundamental economy. I think communication has come a very long way. It has only been a quarter-century since the Fed began issuing a statement after its meetings. Now we have far more information provided about the outlook for the economy, even what the Fed or FOMC members think are going to be the interest rates. It is a work in progress. I would compare Janet’s handling of the balance sheet with my handling of the balance sheet as an example of technological progress. I think there is still a lot to be learned. I do feel that transparency and communication have been very positive. It is continuing to improve. We are meeting this afternoon instead of this morning because of Chairman Powell’s inaugural testimony, he emphasized very strongly his commitment to expanding transparency and explaining what the Fed does, which is good, not only from a policy point of view but also good from a democratic accountability point of view.
So the economy is in good shape. GDP is growing. Inflation is gradually moving up to target. What is it we should worry about most that might bring an end to this remarkable expansion?
Bernanke: I would call them, broadly speaking, international or geopolitical risks in terms of the international geopolitical situation, concerns about trade, concerns about international cooperation. The economy itself, as you say, is growing in a healthy way. I don’t know if markets are fully incorporating the risks that might exist in the global system.
Yellen: I would certainly agree that those are significant risks that could cause a future downturn. I guess as Chair Powell mentioned this morning in his testimony, what the Fed needs to do at this point is guard against a risk of overheating while recognizing
that inflation continues to run below 2 percent. We have an economy that is operating below estimates of its normal longer-run unemployment rate. Job growth has been running at about 175,000 a month. It is important to stay on the path where the economy does not overheat to the point that the Fed is forced into a rapid increase in interest rates that could cause a recession. I don’t expect that to happen. There is no reason why it should happen. It is just important to guard against it.
Watch the full conversation here.