The Fed Chair Should Be a 'Principled Populist'
Op-Ed Contributors
By Stephanie Kelton and Paul Mcculley
Stephanie Kelton, a former chief economist for the Senate Budget Committee Democratic staff and a professor of public policy and economics at Stony Brook University, met with Paul McCulley, a senior fellow and professor at Cornell University Law School and former chief economist at Pacific Investment Management Company, to discuss the Federal Reserve and who should be its chair, the 2 percent inflation target, President Trump and the debate over tax cuts, and what a "populist" Fed might look like.
Stephanie Kelton: We've heard news that President Trump will announce his choice for Federal Reserve chair this week, and that he has decided against reappointing Janet Yellen. Gary Cohn is also reportedly out. That leaves Jerome Powell, a current Fed governor; Kevin Warsh, a former Fed governor; and John Taylor, a Stanford professor, still under consideration.
First, do you think it would be a mistake not to reappoint Yellen?
Paul McCulley: Chairman Yellen would be an inspired choice: She resolutely believes in the Fed's dual mandate to pursue maximum employment in the context of low and stable inflation. She is not a closet believer that the Fed's inflation objective — which the Fed has most often actually missed on the south side of 2 percent for half a decade running — should be given priority over its employment objective, as Taylor and Warsh implicitly do.
And she openly worries about our nation's ever-larger wealth and income inequality. She wants workers to have not only a job, but rising real wages.
Kelton: Has Yellen been a populist chairwoman?
McCulley: She is a principled populist, rooted in a strong belief in social justice. She would be a wonderful counterbalance to the Trump administration's half-baked, wild-eyed populism. But alas, Mr. Trump is unlikely to choose her. She's a Democrat.
Kelton: Yes, but President Obama and President Clinton both reappointed Republican Fed chairs.
You view wage stagnation and inequality as problems for the broader economy. You wrote that labor gets its fair share of productivity growth only when the Fed allows "the economy to rip for a long, long time." The Fed has begun its tightening cycle. Did it let the economy rip long enough, and is labor getting its fair share?
McCulley: Yellen has been willing to let the economy run "hotter" than the consensus, particularly the Wall Street consensus, thought prudent. And she does not have a religious belief as to how low the unemployment rate can fall without triggering unacceptable inflationary risks. She has been, and is, willing to probe lower and lower, and let the wage response inform how low is too low.
To date, the wage response has been notedly punk. So she hasn't gotten wrapped around the inflation-risk axle about the unemployment rate falling below where many think it can prudently go. I'm a huge fan of Janet Yellen.
Kelton: Do you think we're at full employment?
McCulley: No, I don't. And in fact, I think the whole concept of full employment needs to be redefined. It is not some precise unemployment rate. Or even some numerical increase in wages in response to ever lower unemployment.
To me, full employment will be when labor has pricing power relative to capital — meaning asking the boss for a raise and getting it — such that corporate profit margins shrink relative to labor's share of national income. Yes, I know that sounds radical.
Kelton: It sounds radical because you're talking about income distribution, which is always a thorny issue. As someone who made a career on Wall Street, it sounds especially radical because people expect you to be on the other side of that issue, right?
McCulley: Yes, for both reasons, though the matter of discussing income distribution is far more important than where I hung my hat for three decades. In both theory and practice, the Fed — and therefore Wall Street, which apes the Fed — has always shied away from talking about income distribution, arguing that is a "political question," that inflation is the only thing that the Fed should be held accountable for in the long run. Because that's putatively the only thing it can control in the long run.
Kelton: But it's not just a political question. It's an economic question — at least that is what the evidence coming out of the San Francisco Fed, the International Monetary Fund and elsewhere tells us. Widening income and wealth inequality appears to slow economic growth. Shouldn't the Fed care about that?
McCulley: Of course the Fed should care. The more skewed national income is toward the rich, the more difficult it is to maintain a robust aggregate demand growth. Rich people spend a lot, absolutely, but they have a lower marginal propensity to spend than less-affluent citizens. Put differently, give a rich man another dollar, and he'll spend very little of it. Give a man living paycheck to paycheck another dollar, and he'll spend all of it.
Kelton: You mentioned the Fed's 2 percent inflation target. You've called 2 percent an arbitrary goal.
McCulley: There is no theoretical foundation for saying that 2 is better than 3 or 4. The 2 number was picked by the Fed itself, not a mandate from Congress — which, remember, has constitutional authority over monetary policy; the Fed is not enshrined in the Constitution. The 2 percent inflation target is an accident of history.
Kelton: How is it an accident of history?
McCulley: The Federal Open Market Committee — the key policymaking body — gravitated to 2 percent as part of a process of getting Alan Greenspan, a former Fed chairman, to actually specify a definition of "price stability" above zero. And for the record, Janet Yellen was a key player in getting Greenspan off the latent notion (born of the long-abandoned gold standard, which Greenspan espoused as a younger man) that price stability actually means zero inflation.
Kelton: How would you like to see it change?
McCulley: There is now a not-so-silent consensus in our community that, in light of experience since the 2008 financial crisis, 2 percent is too low, as a fundamental economic matter. It is too close to zero, implying that in times of recessions, the Fed will have too little room to respond with countercyclical easing, running into the zero lower nominal bound for its policy rates, preventing a needed larger fall in real rates.
The Fed, as an institution, has pushed back against the idea that its 2 percent inflation target should be raised, on the notion that the transition to a higher target would be fraught with too much risk. I fully acknowledge that doing so would heighten uncertainty and thus volatility — triggering upward pressure on long-term interest rates relative to the Fed's short-term policy rate, as well as downward pressure on price-to-earnings multiples for stocks — but I do not see that as a compelling reason not to lift it.
Kelton: Who should pick the number, and how should they decide on it? You've suggested that the Fed probably shouldn't be picking its own inflation target.
McCulley: I think it should be a collaborative venture between the Fed and Congress. Yes, I used the word "collaborative," which I think applies in a more general way to the relationship between Congress and the Fed.
The Fed's operational independence is grounded in the thesis that the legislature cannot be trusted with monetary policy, as the electoral process is inherently biased to inflation, of overstimulating the economy with too much spending relative to taxation, running inflationary budget deficits.
That simply has not been the case for a long, long time. Yes, we've had large deficits, but inflation has been too low, not too high. Thus, I'm not convinced by the argument that strict Fed independence is always and everywhere needed to discipline the fiscal authorities' inflationary bias.
Kelton: What about policy today?
McCulley: If President Trump wants to try to boost real growth from 2 percent to 3 percent, there is no reason that the Fed should actively push back. That doesn't mean that the Fed shouldn't or wouldn't respond if such an acceleration in growth were to finally drive unemployment low enough to generate a loud wage and inflationary response.
My point is that there is no reason for the Fed to prevent the "experiment," if Mr. Trump and the Republican Congress want to run it.
Kelton: So then, what's your biggest macro concern?
McCulley: My biggest macro concern, longer term, is that we hit the next recession with the inflation rate somewhere near where it is now (about 2 percent). There needs to be room in the inflation rate for it to fall in recessions without turning inflation into deflation. And unless we repeal human nature, the business cycle is not going away.
Kelton: I'm sort of confused. You're worried that inflation is too low, and you say that the economy still hasn't reached full employment — two signs that the Fed should hold off on further rate hikes — but you want the Fed to get interest rates up quite a bit more so that it has the ammo to fight the next recession.
McCulley: I do not want the Fed to get rates up for the sake of getting rates up. Rather, I want the Fed, working tacitly with the fiscal authority, i.e., Congress, to get inflation up. If, and only if, the Fed gets inflation up will there be reason to get rates up, in lagged response. The concept of pre-emptive Fed tightening is anathema to me.
Kelton: I see. So you'd like to see Congress help the Fed get the economy running a little hotter by flexing its own policy lever. I remember that you were one of the most forceful voices calling on Congress to use its fiscal (tax and spending) authority to help the Fed out during and after the last recession. You said that the economy "needed some help with larger budget deficits."
President Trump is proposing enormous tax cuts that would add significantly to the deficit. His budget director, Mick Mulvaney, says "we need new deficits" in order to get the 3 to 4 percent growth the White House is looking for. What do you think? Do we need deficits, and would Trump's tax cuts give us the right kind of deficits to spur growth?
McCulley: As much as I am not a Trump supporter, I cannot in good analytical conscience say that his tax plan is intellectually bankrupt. It is not. Purposely increasing the budget deficit to stimulate aggregate demand is a textbook technique to stimulate growth.
But I vehemently disagree with the idea that cutting taxes for the rich is the best way to go about increasing the budget deficit to boost growth. Increased public investment and tax cuts for budget-constrained families would have a far higher bang-for-the-deficit-dollar effect on growth. And even more important to me, personally, such an approach would be pass a smell test of social justice.
Kelton: That makes a lot of sense to me. Trump's deficits will largely benefit those at the very top. But as I recently wrote, you could easily turn the firepower of deficit spending into a potent weapon in the fights against inequality, poverty and economic stagnation.
McCulley: And there is plenty of room for the fiscal authority to run larger deficits. Deficit hawks are simply wrong. The debate should be about how fully various higher-deficit choices pass a smell test of social justice.
Kelton: This week, the Senate voted to shield Wall Street from consumer lawsuits. Does that concern you?
McCulley: Speaking of smell tests of social justice: This Senate action flunks, very bigly!
Banks are many things, but at their core, they have a public utility function, access to the payments system — the highway, if you will, on which you get paid and pay your bills.
In that sense, banks are not different than the gas company or the electric company, connecting you to the grid — a natural oligopoly. Accordingly, I take offense with the notion that banks should have the right to put cram-down arbitration clauses into every citizen's "hook up" to the payment system.
You really don't have a choice but to do business with a financial institution connected to the grid. In fact, unless you pay in person at a local I.R.S. office, you actually must have access to pay your taxes.
Kelton: So Donald Trump rode a wave of populist anger — some of it aimed at Wall Street — but when push comes to shove, the Republicans aren't there for the little guy?
McCulley: I think it took a lot of brass, as former Vice President Biden might say, for the Republicans — including current Vice President Mike Pence — to stand up for the banks against consumers in the wake of the Wells Fargo and Equifax debacles. Access to the court system is a constitutional right, and requiring citizens to relinquish that right in order to get access to the payments grid is repugnant to me.
There is nothing voluntary about needing access to the payments grid, any more than there is anything voluntary about needing access to core household utilities. Social justice — a theme to which I return again and again — demands that citizens have access to the court system for redress in the purchases of services where they have no choice but to buy.
Kelton: We also learned last week that President Trump's Treasury Department isn't a fan of the term "shadow banks." That's a term you coined to describe some of the opaque financial institutions that drove the 2008 financial crisis. You added the word to our lexicon, and now the Treasury Department wants to annex it. They're actually calling on global regulators to stop using the s-word. What are "shadow banks," and can we safely ignore them?
McCulley: "Shadow banks" engage in regular bank behavior, but without access to government safety nets.
A fiery run on the shadow bank Lehman Brothers triggered the financial crisis. Our government had no choice but to rescue, then transform, Lehman's too-big-to-fail shadow bank brethren into conventional banks, with access to the government's safety nets.
But that access came with the quid pro quo of the same regulatory restrictions as conventional banks, reducing the fun and profitability of their shadow banking game.
Dodd-Frank imposed additional restraints on playing with maturity-transformation nitro. But bankers, of all stripes, still just want to have fun. They would now like not only a relaxation of the Dodd Frank quid pro quo, but also to be rid of the term "shadow banking."
Bad Karma, you know. And they now have both a Congress and a Treasury friendly to their interests.
I don't worry about efforts to take the term shadow banking out of the lexicon. I actually use the term "market-based finance" myself frequently. I do worry, however, about what the erase-it effort represents: a cyclical turn to regulators once again being enthralled and captured by the regulated.
Kelton: Thanks so much, Paul. I could talk policy and economics with you all day.
McCulley: As could I! Here's to hoping that our profession never forgets that we have a role in bending Martin Luther King's arc of history toward justice.
Stephanie Kelton, a former chief economist for the Senate Budget Committee Democratic staff, is a professor of public policy and economics at Stony Brook University. Paul McCulley, former chief economist at Pacific Investment Management Company, is a senior fellow and professor at Cornell University Law School.
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