Long-Run Monetary Policy and Inequality

The following is a draft of my remarks from my meeting this afternoon with Philadelphia Federal Reserve President Patrick Harker and a group from Action United.

I appreciate and admire the Fed staff and officials who have done an excellent job in the very difficult economic environment of the past decade. I do not consider myself a highly political person, and as an academic, I am much more interested in trying to contribute to a better objective understanding of monetary policy than in involving myself in monetary politics. The idea of a politically independent Fed is so comforting to economists like me, within and outside of the Fed, who idealize technocratic merit and objective policymaking. But monetary policy has inescapable distributional implications, some real and some perceived, many of which are not fully understood in theory or empirically. And because monetary policy affects distribution, there are always going to be interest groups with a stake in the conduct of policy. The Fed cannot and need not hope to please every person all the time, but the democratic legitimacy of the institution requires that it make a real effort to understand the disparate impacts of its policies on different groups and to communicate with all segments of the public about the issues that concern them most.

So how does monetary policy affect inequality and the lives of low- to middle-income households? Since the employment, hours, and wages of low-to-middle-income workers are most sensitive to business cycle conditions, I think it is generally accepted that lower interest rates and higher employment reduce inequality in the short run.[1] Of course, monetary policy cannot be permanently expansionary; we can’t arrive at and stay permanently above full employment just by allowing slightly higher inflation. Economists who understand this distinction between the short-run and long-run Phillips Curve might then conclude that monetary policy has only cyclical effects on inequality.[2]

In the long-run, as John Taylor noted in 1979,[3] there is no long-run tradeoff between the level of output and the level of inflation, but, there is a tradeoff between output stability and inflation stability. If you think of the long-run monetary policy tradeoff as a production possibilities frontier showing different combinations of output and inflation stability that are possible, then the two big issues are (1) choosing which point on the frontier we want, in other words what relative value to place on output stability versus inflation stability, and (2) achieving a point on the frontier, rather than inside of it. These are the issues I use to frame my thinking on monetary policy and inequality, and I would like to talk about each of these issues for the next few minutes.

Regarding the first issue, Stephen G. Cecchetti and Michael Ehrmann show that since the rise of inflation targeting around the world in the 1990s, policymakers’ aversion to inflation volatility has risen in both inflation targeting and non-inflation targeting countries, with a resultant increase in output volatility.[4] In evaluating the relative emphasis to place on output stability versus inflation stability, it is worth trying to understand how this long-run tradeoff affects workers across the income distribution. If the relative harm of output volatility vs. inflation volatility is greater for low than for high-income households, than monetary policy could have lasting effects on inequality. This seems likely, given differences in savings and credit constraints that make it more difficult for lower-income households to smooth fluctuations in income. Output volatility could be especially harmful in the presence of scarring effects of unemployment, which mean that the harmful effects of downward fluctuations are not fully offset in upturns.

The long-run monetary policy tradeoff between output stability and inflation stability, may not only affect inequality, but also be affected by it. High inequality can impact the Federal Reserve’s ability to conduct monetary policy, for example through differences in interest rate sensitivity across the income distribution. This can worsen the sacrifice ratio, effectively moving the frontier inward.

Regarding the second issue, achieving some point on the frontier of output stability and inflation stability requires good credibility and also requires that monetary policy fully offset aggregate demand shocks, avoiding short-run errors.[5] Otherwise, both output volatility and inflation volatility will be unnecessarily high. Financial crises and the zero lower bound impede the ability to offset negative demand shocks, so preserving financial stability through regulatory and supervisory policy is especially important.

Offsetting fluctuations in aggregate demand is easier said than done, especially because monetary policy works with lags and because there are so many indicators to consider. Currently, the labor market shows signs that it is beginning to tighten. Even though inflation is below target, the FOMC chose to raise the federal funds rate, presumably to fend off any inflationary pressures that might begin to build. In considering the pace of future rate hikes, the Fed should keep in mind that the positive effects of a tighter labor market for reducing inequality are just beginning to appear. The unemployment rate for white men fell from 4.4 %to 4.2%.over the past year, and for black men fell from 11% to 8.7%,[6] so you can see the tighter labor market beginning to benefit African Americans, with plenty of room for further improvement.

Hourly pay grew 2.5% in 2015, compared to 1.8% in 2014. That is definitely an improvement, but it will take continued and stronger nominal wage growth to see the labor share of income regain lost ground and to get a real rise in living standards for the majority of households. Even as wages begin to rise more rapidly, I do not think that there should be too much concern that this will lead to strong inflationary pressures. Research by Federal Reserve Board economists Ekaterina Peneva and Jeremy Rudd, for example, points to a much weakened transmission from labor costs to price inflation.[7]

There are also several indications that labor markets still have room to tighten further. The number of persons employed part time for economic reasons hovers at 6 million, and the U-6 unemployment rate was unchanged at 9.9% in the latest jobs report. Labor force participation, at 62.6%, also has room to grow. Overall, to me it appears wise, given uncertainty about the global economy and inflation dynamics, to act cautiously, erring on the slow side for raising rates.[8]

[1] See, for example, Coibion, Olivier, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia. 2012. “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” IMF Working Paper 199.

[2] . As Romer and Romer (1998) explain, “Because of the short-run cyclicality of poverty, some authors have concluded that compassionate monetary policy is loose or expansionary policy…[T]his view misses the crucial fact that the cyclical effects of monetary policy on unemployment are inherently temporary. Monetary policy can generate a temporary boom, and hence a temporary reduction in poverty. But, as unemployment returns to the natural rate, poverty rises again.”

[3] Taylor, John. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations.” Econometrica 47(5): 1267-1286.

[4] Cecchetti, S. G. and Ehrmann, M. 2002. “Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes,” in N. Loayza and K. Schmidt-Hebbel (eds), Monetary Policy: Rules and Transmission Mechanisms, Proceedings of the 4th Annual Conference of the Central Bank of Chile, Santiago, Central Bank of Chile, pp. 247-274.

[5] See Cecchetti, Stephen. 1998. “Policy Rules and Targets: Framing the Central Banker’s Problem.” Economic Policy Review. Federal Reserve Bank of New York.

[6] BLS January 8, 2016 Employment Situation Summary

[7]Peneva, Ekaterina and Jeremy B. Rudd. 2015. "The Passthrough of Labor Costs to Price Inflation."

[8] See Brainard 1967 "Uncertainty and the Effectiveness of Policy," American Economic Review Papers and Proceedings 57(2); and Blinder, Alan. 1999. "Critical Issues for Modern Major Central Bankers."

The Limited Political Implications of Behavioral Economics

A recent post on Marginal Revolution contends that progressives use findings from behavioral economics to support the economic policies they favor, while ignoring the implications that support conservative policies. The short post, originally a comment by blogger and computational biologist Luis Pedro Coelho, is perhaps intentionally controversial, arguing that loss aversion is a case against redistributive policies and social mobility:

"Taking from the higher-incomes to give it to the lower incomes may be negative utility as the higher incomes are valuing their loss at an exaggerated rate (it’s a loss), while the lower income recipients under value it... 

...if your utility function is heavily rank-based (a standard left-wing view) and you accept loss-aversion from the behavioral literature, then social mobility is suspect from an utility point-of-view."

Tyler Cowen made a similar point a few years ago, arguing that "For a given level of income, if some are moving up others are moving down... More upward — and thus downward — relative mobility probably means less aggregate happiness, due to habit formation and frame of reference effects."

I don't think loss aversion, habit formation, and the like make a strong case against (or for) redistribution or social mobility, but I do think Coelho has a point that economists need to watch out for our own confirmation bias when we go pointing out other behavioral biases to support our favorite policies. Simply appealing to behavioral economics, in general, or to loss aversion or any number of documented decision-making biases, rarely makes a strong case for or against broad policy aims or strategies. The reason is best summarized by Wolfgang Pesendorfer in "Behavioral Economics Comes of Age":

Behavioral economics argues that economists ignore important variables that affect behavior. The new variables are typically shown to affect decisions in experimental settings. For economists, the difficulty is that these new variables may be unobservable or even difficult to define in economic settings with economic data. From the perspective of an economist, the unobservable variable amounts to a free parameter in the utility function. Having too many such parameters already, the economist finds it difficult to utilize the experimental finding.

All economic models require making drastic simplifications of reality. Whether they can say anything useful depends on how well they can capture those aspects of reality that are relevant to the question at hand and leave out those that aren't. Behavioral economics has done a good job of pointing out some aspects of reality that standard models leave out, but not always of telling us exactly when these are more relevant than dozens of other aspects of reality we also leave out without second thought. For example, "default bias" seems to be a hugely important factor in retirement savings, so it should definitely be a consideration in the design of very narrow policies regarding 401(K) plan participation, but that does not mean we need to also include it in every macroeconomic model.

Let's Not Give Up on Mobility

Gregory Clark, an economic historian at UC Davis, writes that "Social mobility barely exists but let’s not give up on equality." His research using rare surnames to track social mobility over several centuries finds that social mobility in England is still just as low in today's "modern noisy meritocracy" as it was in pre-industrial times. He concludes that "Lineage is destiny. At birth, most of your social outcome is predictable from your family history." He emphasizes that this is true not only in the UK, but also in Sweden, China, and the U.S.

The subtitle of Clark's article says that "Too much faith is placed in the idea of movement between the classes. Still, there are other ways to tackle the unfairness of society." He elaborates:

"Given that social mobility rates are immutable, it is better to reduce the gains people make from having high status, and the penalties from low status. The Swedish model of compressed inequality is a realistic option, the American dream of rapid mobility an illusion...While mobility seems governed by a social physics that defies easy intervention, the magnitude of social inequalities varies considerably across societies, and can be strongly influenced by social institutions. We cannot change the winners in the social lottery, but we can change the value of their prizes."

I agree that meritocracy alone does not guarantee high mobility, and therefore that making a society more meritocratic is not the silver bullet solution to inequality. But I wouldn't go so far as to say that social mobility rates are immutable. First, just because social mobility has not improved in the past doesn't mean that it's incapable of improving in the future. Second, the fact that social mobility varies across countries and even within countries implies that it should be possible to increase mobility.

Within the United States, there is substantial geographic variation in social mobility. Raj Chetty, Nathaniel Hendren, Patrick Kline, and Emmanuel Saez use administrative records on the incomes of 40 million children and their parents to study intergenerational mobility in 741 local areas. It turns out that the American dream is more viable in some places than in others. Chetty summarizes:

Looking at the probability that a child who grew up in a bottom-quintile income family reaches the top-quintile of the income distribution across areas of the U.S., we find substantial variation across regions. In some parts of the U.S. – such as the Southeast and the Rust Belt – children in the bottom quintile have less than a 5% chance of reaching the top quintile. In other areas, such as the Great Plains and the West Coast, children in the bottom quintile have more than a 15% chance of reaching the top quintile. 

There is substantial variation in upward mobility even among large cities that have comparable economies and demographics. Cities such as Salt Lake City and San Jose have rates of mobility comparable to Denmark and other countries with the highest rates of mobility in the world. Other cities – such as Charlotte and Milwaukee – offer children very limited prospects of escaping poverty. These cities have lower rates of mobility than any developed country for which data are currently available.

Not only does mobility vary across geographic regions, it varies in systematic ways. Chetty et al. find that proxies for the quality of the K-12 school system are positively correlated with mobility. So are social capital indices, which measure the strength of social networks and community involvement. For example, high upward mobility areas tend to have higher participation in local civic organizations and religious activity. Clark says that low social mobility is here to stay because of "strong transmission within families of the attributes that lead to social success." But certainly there are other methods of transmission, particularly in schools and communities, that could be developed or improved. 

Improving the living conditions of the poor is extremely important regardless of the level of mobility in a society. So I agree with Clark that we shouldn't give up on equality. But I think we shouldn't give up on mobility either. History tells us what has happened, not what can happen. We don't know what could happen under a sustained and ambitious effort to improve upward mobility.

Economic Inclusion and the Global Common Good

On July 11 and 12, Pope Francis met with a group of policymakers, economists, and other influential thinkers at a conference called “The Global Common Good: Towards a More Inclusive Economy.” The conference was sponsored by the Pontifical Council for Justice and Peace and held at the Pontifical Academy of Science in Vatican City.

Pope Francis spoke out against "anthropological reductionism" in the economy, echoing a tradition of Catholic social teaching that links economic inclusion to human dignity. The 1986 pastoral letter Economic Justice for All says:

"Every economic decision and institution must be judged in light of whether it protects or undermines the dignity of the human person...We judge any economic system by what it does for and to people and by how it permits all to participate in it. The economy should serve people, not the other way around... 

All people have a right to participate in the economic life of society. Basic justice demands that people be assured a minimum level of participation in the economy. It is wrong for a person or group to be excluded unfairly or to be unable to participate or contribute to the economy. For example, people who are both able and willing, but cannot get a job are deprived of the participation that is so vital to human development. For, it is through employment that most individuals and families meet their material needs, exercise their talents, and have an opportunity to contribute to the larger community. Such participation has special significance in our tradition because we believe that it is a means by which we join in carrying forward God's creative activity."

One participant at the conference was Muhammad Yunus, a pioneer of microcredit and microfinance and the founder of Grameen Bank in Bangladesh. Grameen Bank is called the bank of the poor because its borrowers, mostly poor and female, own 95% of the bank's equity. Yunus and the Grameen Bank jointly won the Nobel Peace Prize in 2006. Yunus has a PhD in economics from Vanderbilt and is the author of Banker to the Poor and Creating a World Without Poverty. At the conference, Yunus spoke about social business and about sharing and caring as basic human qualities.

Development economist Jeffrey Sachs also attended the conference. Sachs, author of The End of Poverty, founded the ambitious and controversial Millennium Villages Project. For a glimpse into the project from two different perspectives, I recommend Russ Roberts' interviews with Sachs and Nina Munk on the EconTalk podcast. 

Mark Carney, Governor of the Bank of England, attended the conference as well. Carney has spoken previously about economic inclusion. He gave a speech at the Conference on Inclusive Capitalism in London this May, in which he remarked:

"To maintain the balance of an inclusive social contract, it is necessary to recognise the importance of values and beliefs in economic life. Economic and political philosophers from Adam Smith (1759) to Hayek (1960) have long recognised that beliefs are part of inherited social capital, which provides the social framework for the free market. Social capital refers to the links, shared values and beliefs in a society which encourage individuals not only to take responsibility for themselves and their families but also to trust each other and work collaboratively to support each other.

So what values and beliefs are the foundations of inclusive capitalism? Clearly to succeed in the global economy, dynamism is essential. To align incentives across generations, a long-term perspective is required. For markets to sustain their legitimacy, they need to be not only effective but also fair. Nowhere is that need more acute than in financial markets; finance has to be trusted. And to value others demands engaged citizens who recognise their obligations to each other. In short, there needs to be a sense of society."

Also in attendance were Jose Angel Gurria, Secretary General of the OECD; Michel Camdessus, former managing director of International Monetary Fund; Ngozi Okonjo-Iweala, Finance Minister of Nigeria; Donald Kaberuka, President of the African Development Bank; and Huguette Labelle of Transparency International. A complete list of attendants and more detailed remarks from the conference should be up at the Pontifical Council for Justice and Peace website in the next few days.  I look forward to seeing what kinds of practical proposals might have been discussed.

Consumption Contagion and Income Inequality

The trends of rising income inequality and the declining national savings rate since the early 1980s may be related, according to a paper by Marianne Bertrand and Adair Morse. The authors find that higher levels of visible consumption by increasingly better-off households at the top of the income distribution induces consumers in the lower parts of the income distribution to spend a higher share of their disposable income. From "Consumption Contagion: Does the Consumption of the Rich Drive the Consumption of the Less Rich?":

"Our empirical strategy exploits variation across geographic markets and over time to identify the effect of expenditures by the rich on that of the non-rich. We ask whether, everything else held constant, higher levels of consumption by the rich living in a household’s relevant market (which we define to be either a state or an MSA in a given year) predicts a higher propensity to consume out of disposable income for the non-rich household. After establishing that such vertical consumption correlations occur, we then explore possible mechanisms. Our results are most consistent with the view that visible increased consumption by the rich induces status-seeking or status-maintaining consumption by the less rich."

Bertrand and Morse define the rich households in each state as those with above the 80th percentile of income in that state. Their baseline regression shows that a 1 percent increase in consumption (excluding housing) among the rich in a particular state translates into a 0.07 percent increase in consumption among the less-rich. They find no evidence that this could be explained by the permanent income hypothesis; rising consumption by the rich in a particular state is not predictive of faster future income growth by the state's less-rich. Thus, they conclude that "Our preferred explanation for the vertical consumption spillovers we observed in our basic results is that low and middle income households witness the higher consumption levels by the rich and are tempted to also consume more."

To test this explanation further, they use data from the Consumer Expenditure Survey and use the Ori Heffetz (2011) index to rank goods into seven categories of increasing visibility. Highly visible consumption items include cars, clothing (except underwear!), shoes, and cigarettes; minimally visible consumption items include health or legal accounting services and, yes, underwear. They replicate the analysis by goods category, and find strongest effects in the most visible consumption categories, consistent with a "consumption contagion" explanation.

As another test, they replicate the analysis using Census Metropolitan Statistical Areas (MSAs) instead of states. They use a measure of community segregation, indicating how closely the rich live to the less-rich in each MSA. In MSAs where the rich and less-rich live closer together, there is more consumption contagion.

Overall, the authors estimate that the savings rate of median-income households would be one to two percentage points higher in the absence of this "consumption contagion" effect. This is non-trivial but also not huge. What is most important is the empirical support of a particular type of departure from the Permanent Income Hypothesis. Many types of departures have been hypothesized, but quantifying their relative importance and carefully tracing out their implications for macro models is an ongoing task.

Who will Save Us from Inequality?

"Paul Krugman won't save us," writes Thomas Frank. (Neither, he adds for good measure, will Brad DeLong.) Frank is referring to economic inequality--in his opinion a "needlessly clinical" phrase and "a pleasant-sounding euphemism for the Appalachification of our world." Inequality, he believes, has gotten into the wrong hands:

"Who is called upon to speak on the subject [of inequality] today? Why, academics, of course. 'Inequality' is a matter for experts, a field for the playful jousting of rival economists, backed up by helpful professors of political science, and with maybe an occasional sociologist permitted into the games now and then...

The discovery of inequality has also compelled our leadership class to establish things like the Washington Center for Equitable Growth, which boasts a steering committee made up of six economists plus one Democratic foundation/policy type....But to look at its website, it’s just another platform for the trademark blog styling of the well-known economist Brad DeLong." 

Our ancestors, notes Frank, referred not to "inequality" but to "the social question." And they treated the question not with the "wonkery" and endless charts of today, but with wide and deep conviction. 

"'Inequality' is not some minor technical glitch for the experts to solve; this is the Big One. This is the very substance of American populism; this is what has brought together movements of average people throughout our history. Offering instruction on the subject in a classroom at Berkeley may be enlightening for the kids in attendance but it is fundamentally the wrong way to take on the problem...We owe the economists thanks for making the situation plain, but now matters must of necessity pass into other hands."

Whose hands? Frank isn't entirely explicit. His historical examples include an 1892 passage from the Omaha Platform of the Populist Party, a 1916 report of the Commission on Industrial Relations, and a 1932 testament of a socialist newspaper editor to a congressional committee. He highlights their "singing" language but not the fruits of their labors. He mentions that in the current day, a local union leader would be a more effective mouthpiece than a Nobel Laureate, and says that "This is a job we have to do ourselves." But how? 

Frank neglects any mention of religious figures and institutions that can speak to the social question. As I wrote in an earlier post, the Catholic Church has a very long history of teaching about economic justice. Pope Francis, thankfully, is bringing this tradition back into the forefront. Hopefully his words will influence not only Catholic believers who may have been unaware of the Church's position on inequality, but also members and leaders of other faiths who will see that economic and social justice are pressing moral issues. The moral issues involved in an economic system can be appreciated by thoughtful members of any religion, or of no religion, who share a concern for justice and for their neighbors. Ultimately, policy changes will be required, and these people can be the impetus.

Frank writes that "When President Obama declared in December that gross inequality is the `defining challenge of our time,' he was right, and resoundingly so. As is his habit, however, he quickly backed away from the idea at the urging of pollsters and various Democratic grandees." If Pope Francis' convictions were sufficiently widespread, maybe politicians wouldn't be able to back away.

Still, I don't think economists' work here is done. Economists are still learning new things about the causes and extent of inequality. They still disagree among themselves. (Minimum wage hikes, anyone?) Even if politicians and the public were 100% gung ho about reducing economic inequality, the best way to achieve it wouldn't be perfectly straightforward. Economists should keep at it. And while Frank may mock the "trademark blog styling of the well-known economist Brad DeLong," he is well-known for a reason. People read what he writes. They read it and they think about it. He should keep writing. Frank is dubious about the effectiveness of teaching Berkeley students about inequality-- but informed and ambitious young people seem like a pretty good demographic to reach. We should keep teaching them.

I agree with Frank that inequality, or call it the social question, is a big deal, The Big Deal. And I agree that it shouldn't be left solely in the hands of economists. But his disdain for the way economists treat inequality as a complex technical issue-- "Oh, it is extremely complex. It requires so many charts"-- is misplaced. It is both a technical issue and more than a technical issue. Let economists take on the technical issues in accordance with their expertise. Encourage others to take on the "more than technical" issues in accordance with their own. Paul Krugman won't save us, but he shouldn't stop trying.

Accounting for Changes in Inequality

The Berkeley macroeconomics reading group has three themes for this semester: (1) factor shares, wealth, and inequality, (2) misallocation, and (3) financial stability. Each week, a different student presents a paper from one of the topic areas. Today, as part of the first topic, I am presenting the paper "Accounting for Changes in Between-Group Inequality" by Ariel Burstein, Eduardo Morales, and Jonathan Vogel (2013).

Here are my slides. And here is the abstract:

We provide a framework with multiple worker types (e.g. gender, age, education), to decompose changes in aggregated and disaggregated between-group inequality into changes in (i) the supply of each worker type, (ii) the importance of different tasks, (iii) the extent of computerization, and (iv) other labor-specific productivities (a residual to match observed relative wages). The model features three forms of comparative advantage: between worker types and computers, between worker types and tasks, and between computers and tasks. We parameterize the model to match observed changes in worker type allocation and wages in the United States between 1984 and 2003. The combination of changes in the importance of tasks and computerization explain the majority of the rise in the skill premium as well as rising inequality across more disaggregated education types, whereas labor-specific productivity changes drive between-worker wage polarization.

The paper is motivated by the rise in the skill premium, fall in the gender premium, and rise in wage polarization (i.e. relative decline of wages in the middle.) The authors want to know about the role of computerization in these trends. An important idea of the paper is that certain types of workers (e.g. females) may either have a direct comparative advantage at using computers, or might have an indirect comparative advantage in the sense that they have a comparative advantage in occupations in which computers have a comparative advantage. In the first case, we would observe female workers using computers more than males within the same occupation. In the second case, we would observe females being over-represented in the occupations in which all workers use computers a lot.

Using data on computer use and occupations for several years between 1984 and 2003, the authors find that, while women use computers more than men, this is due to indirect comparative advantage. Women are more often in occupations in which all workers use computers more. In contrast, highly educated workers have direct comparative advantage with computers-- they use computers more than less educated workers within the same occupations.

As the price of computers falls, the relative wages of workers with direct comparative advantage in computers rises. So computerization can explain some of the rise in the skill premium (that is, the rise in wages of more educated compared to less educated workers.) A major part of the rise in the skill premium is also attributed to "task shifters," that is, factors like structural changes and international trade that alter the relative demands for workers across occupations.

Computerization does not raise the relative wages of workers with indirect comparative advantage in computers, so computerization does not explain the fall in the gender premium (that is, the fall in male compared to female wages). Both the fall in the gender premium and the relative decline of wages in the middle are attributed to changes in "labor productivity," which in this model is a residual term, meaning it is not actually explained by the model.