Although production recovered much faster than many expected following the COVID-19 contraction, real gross domestic product declined in the first two quarters of 2022. Naturally, this has left many wondering what can be done to boost economic growth.
“After the 2008 financial crisis,” Nick Timiraos recently wrote in the Wall Street Journal, “the U.S. relied heavily on the Federal Reserve to stimulate growth, leading to a frequent quip that monetary policy had become the ‘only game in town.’” In contrast, he considers several supply-side reforms that would increase immigration, boost labor force participation, and make America less dependent on foreign energy.
If these supply-side reforms improve our ability to produce valuable goods and services with the available physical and human capital, then they should be implemented—not because output growth is sluggish and inflation is high at the moment, but because such reforms are always worth doing. They make us more productive.
The case for the Fed to stimulate growth, on the other hand, is not so clear.
In general, I think we should dispense with the notion that the Federal Reserve’s job is to stimulate growth. That framing obscures the fact that growth can be too high, as it probably has been over much of the last year. It also exaggerates the effect of monetary policy on growth. Instead of trying to stimulate growth, the Fed should do its best to ensure the economy is neither over- nor under-producing.
Fundamental Driver of Economic Growth
Production ultimately depends on the available physical and human capital (or, factors of production) and total factor productivity—that is, our ability to use physical and human capital to produce valuable goods and services. Total factor productivity increases when we discover new and better ways of doing things. These increases in total factor productivity enable us to produce more output with fewer inputs. Total factor productivity growth is the fundamental driver of long run economic growth.
Monetary policy can bolster total factor productivity to some extent, by reducing the risk and cost of inflation. Individuals change prices and recontract more frequently in countries where inflation tends to be high or difficult to predict. These activities use up real resources that could be used to produce other goods and services—and would be used to produce other goods and services if monetary policy were better. By reducing the resource costs associated with inflation, sound money promotes long run economic growth.
Although sound money is pro-growth, the effect of better monetary policy on long run economic growth in rich countries is probably small. How much more frequently do we change prices or recontract as a result of less-than-ideal monetary policy? What’s the potential cost savings?
Real GDP was nearly $20 trillion last year. If better monetary policy reduced costs by $20 billion, it would boost GDP by roughly one tenth of one percent. If it reduced costs by $100 billion, it would add one half of one percent. I doubt the potential gains are that big. To be clear, we should make the necessary monetary reforms and enjoy the gains. But we should also be realistic about the likely size of those gains. Monetary reform is not going to add one to two percentage points to real GDP growth, as some people claim.
Booms and Busts
Although monetary policy probably has a small effect on long run economic growth, it can have very large effects over short periods of time. When monetary policy is loose, people are fooled into overproducing. When monetary policy is tight, they are fooled into underproducing. You can’t fool all of the people all of the time, of course. They eventually wise up. You can fool them some of the time, but you shouldn’t.
Sound monetary policy accommodates changes in the demand to hold money, so that nominal spending grows at a steady, predictable rate. This bolsters the information content of prices, which will rise and fall to reflect genuine changes in relative scarcity, and thereby supports businesses engaged in long term planning and workers considering long term contracts. Rather than fooling people into over- or under-producing, sound monetary policy helps them produce as much as they want given their preferences and the available technology.
On Stimulating Growth
I understand why some say the Fed should stimulate growth. When the economy is underproducing, the Fed should boost nominal spending so that production rises to a level in line with the economy’s sustainable potential. Still, the phrase is misleading. By highlighting the increase in production, it obscures the below-optimal starting point that is necessary for such a policy to be desirable.
The stimulate-growth framing also perpetuates a mistaken tendency to think economic growth is always good and more economic growth is always better. It is possible to produce too much, as people do when they believe the dollars received in exchange will be worth more than they actually will.
Whether the Fed should stimulate growth is contingent on how output compares to the economy’s sustainable potential. It is best to be clear about that. Rather than consider whether the Fed should stimulate growth, we should recognize that its primary task is to prevent over- and under-production.
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