Monetary Policy and Unemployment

Willi Semmler

• Publisher: Routledge
• Year: 2004
• ISBN:
  9781135993801
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book pulls together papers presented at a conference in honour of the 1981 Nobel Prize Winner for Economic Science, the late James Tobin. Among the contributors are Olivier Blanchard, Edmund Phelps, Charles Goodhart and Marco Buti.
One of the main aims of the conference was to discuss what potential role monetary policy has on economic activity and unemployment reduction in three key currency zones - the United States, European Union and Japan.

1

Introduction

Willi Semmler

“Monetary Policy and Unemployment: US, Euro-area and Japan”

The Economics Department and the Bernard Schwartz Center for Economic Policy Analysis at New School University have hosted a conference on “Monetary Policy and Unemployment in the US, Euro-area and Japan.” The conference, in honor of James Tobin, Nobel Laureate in Economics, has discussed what potential role monetary policy has on economic activity and unemployment reduction in the three currency zones. This event took place on November 22–23, 2002, and was made possible with financial support of the Bernard Schwartz Center for Economic Policy Analysis. The subsequent papers have been presented at the conference. The conference has brought together distinguished macroeconomists from the United States, the Euro-area, and Japan. It has also included practitioners from the Federal Reserve System of the United States, the European Central Bank (ECB), and the European Commission. Some of the macroeconomists included in this volume have made path-breaking contributions to the analysis of the role of monetary policy and unemployment, and the practitioners of monetary policy have brought in their extensive practical experience in effectively implementing the monetary policy The conference, organized in honor of the late James Tobin, follows up some major themes in his latest work. Encouraged by the work of James Tobin, it is part of an ongoing effort of the Economics Department and the Bernard Schwartz Center for Economic Policy Analysis at New School University to improve our understanding of growth and unemployment in the contemporary world economy At the conference, there were discussants for each paper, whose work however could not be included in this book because of space limitation. The papers were rewritten after the conference, taking into account the conference discussions and the discussants’ comments.

From the beginning of the 1990s, until the beginning of the year 2000 the US economy went through a considerable boom with annual real growth rate as high as 4–5 percent, low rates of unemployment, and historically very low inflation rates. The other two currency zones, the Euro-area and Japan, also had low inflation rates but suffered from low growth rates and high rates of unemployment: in particular, the Euro-area. The latter two areas did not share the boom with the United States, but they have shared the recession in the years 2001–03. Academics and politicians have divided opinions on what the real causes of those different performances were and what policies should have been and should be employed to improve the economic performance in those three currency areas.

One view is that the US economy has shown impressively high growth rates in the 1990s because of flexible product, financial, and labor markets, low tax rates, and welfare payments. Consequently the unemployment rates reached such low levels as 4 percent, in particular in the 1990s. These results have then often been contrasted with the relatively poor performance of European countries and Japan during the same period of time. In Europe, in the same time period, low economic growth has been accompanied by high unemployment rates of up to 10 percent on average. Overregulated product and financial markets, less flexible labor markets, generous welfare programs, expansionary fiscal policies, and high public debt have been seen as the main causes of the weak economic performance of the Euro-area. The policy conclusion is then—one to which many European Central Banks adhered to in the 1990s—that there should be labor market and structural reforms in these regions aimed at enhancing the performance of labor markets. This view emphasized that monetary and fiscal policies should not be implemented before adequate labor market and structural reforms are undertaken.

On the other hand, it has been argued that these regions have historically always shown generous welfare state measures, social security systems, and employment practices that had not affected much economic growth performance in earlier times. In addition, those measures have generated less inequality in the long run. Moreover, supporters of this view are confident that such a strategy will pay off in the long run as the Euro has stabilized now and the increasing potential of large markets in Europe crystallizes. Within this view, the European welfare state, the region’s developed infrastructure, and its educated labor force are favorably assessed. A similar optimism is shared for the long run potential growth of the Japanese economy The view of some observers is that the causes of the weak economic performance in these regions, and particularly in the Euro-area, are found in the tightness of fiscal and monetary policies, which are seen to be an obstacle for growth and job creation.

Another important view sees the problems of European unemployment as arising from structural, in particular nonmonetary factors. Such a structuralist perspective is taken by Edmund Phelps and his coauthors who employ a broader framework to incorporate the role of asset markets and exchange rates. Yet, not only asset prices and exchange rate arrangements are important in their framework, but also business asset investment, expectations and parameter shifts, world interest rates, workers’ wealth and entitlements, and tax rates. They also discuss the role of expectations about technical change (and thus productivity growth), confidence in the political climate, and investors’ thrust. Many of these forces are not easily measured in empirical studies. However, they are likely to go a long way in explaining differences in growth and labor market performance among the United States, the Euro-area, and Japan. In Japan there are also, as Masanao Aoki, Hiroshi Yoshikawa, and Toshihiro Shimizu argue, other forces that have contributed to the structural problems of the Japanese economy. The main factors pointed out by Yoshikawa and his coauthors are debt overhang, the increase in deflation pressures, and the increase in uncertainty in the Japanese economy.

James Tobin, in his late papers and talks, has shared the concern of monetary economists on a secular decline of growth rates and rising unemployment in the three currency zones. As concerns monetary policy though he found the non-accelerating inflationary rate of unemployment (NAIRU) a useful economic concept, he was skeptical about what has been called the natural rate of unemployment. He was strongly involved in discussions on the issue of unemployment in those three areas and the entailing policy questions. Among others, it has been in particular the late James Tobin who has pointed to the too tight monetary and fiscal policies, in particular in the Europe-area and Japan, as having caused such an unimpressive growth performance. In the spirit of James Tobin’s work this volume intends to elaborate on the earlier views and policy prescriptions by pursuing carefully crafted studies on the labor market and monetary policy in the three currency zones.

In Part I of the book, a more general overview on the trends and problems of economic growth, monetary policy and unemployment is given by short summary chapters by Olivier Blanchard, Edmund Phelps, and Hiroshi Yoshikawa. They refer in their presentations to all three currency areas—to the United States, the Euro-area, and Japan. One major controversy is to what extent monetary policy has not only short run but also persistent, that is, long run effects on growth and employment. Olivier Blanchard strongly stresses that the NAIRU changes in the long run due to the impact of monetary policy On the other hand, as Edmund Phelps stresses, there may have been structural, non-monetary factors at work particularly in Europe. A related issue is, whether monetary policy in Europe but also in Japan, facing the long stagnation of the economy could have been different from what it actually was. A last issue is, if there are tendencies toward deflation, what role not only monetary but also fiscal policy may play to keep them effective under such circumstances.

In Part II labor market institutions, especially those of the United States and the Euro-area are contrasted and their effects on the performance of the labor market discussed. The view presented here is similar to the earlier first view. Chapters in this part assess the extent to which these institutions have contributed to the differences in the performance of labor markets and persistent unemployment among the two regions. The role of labor market institutions for the long run unemployment in Europe is studied by Olivier Blanchard and Justin Wolfers. David Howell provides a critical evaluation of this view. The macroeconomic research group of the ECB, Alistair Dieppe, Jérôme Henry and Peter McAdams provide an empirical study on whether the high European unemployment rate can be explained by the natural rate hypothesis or by the hysteresis theory The effects of monetary policy on the labor market are explored under alternative assumptions on the structure of the labor market in Europe. The study of the causes for the long run stagnation of the Japanese economy and the implications for the labor market, studied by Masanao Aoki, Hiroshi Yoshikawa, and Toshihiro Shimizu is left for Part III of this volume.

Part III extends the framework discussed earlier to incorporate factors other than monetary policy and labor market institutions. The chapters collected here show that also business asset investment, expectations, parameter shifts, real exchange rates, world interest rates, workers’ wealth and entitlements, and tax rates and productivity growth are important for the evolution of employment. Edmund Phelps, Hian Teck Hoon, and Gylfi Zoega underline those as important forces behind economic growth and employment. They also discuss the role of confidence in the political climate and investors’ thrust. Many of these forces may explain differences in growth and labor market performance between the United States, the Euro-area, and Japan. For Japan, there were, beside the financial market and the debt overhang, as Masanao Aoki, Hiroshi Yoshikawa, and Toshihiro Shimizu argue, other forces that have contributed to the structural problems of the Japanese economy Among the main factors, as the authors point out, is the increased uncertainty In a stochastic version of a model with multiple equilibria, they show that the economy got stuck, due to the rise of uncertainty in a bad equilibrium. In the chapter by Peter Flaschel, Gang Gong, and Willi Semmler, it is shown, using the example of the German economy that both the dynamics of the economy as well as monetary policy rules are significantly impacted and constrained by the exchange rate system. The core of their model is an estimated open economy price and wage Phillips curve for Germany which allows evaluating the different monetary policy rules and their success to impact employment and inflation in the open economy context.

In Part IV monetary policy rules and fiscal policy are discussed more specifically Charles Goodhart describes the institutional changes that, in his opinion, have affected both monetary and fiscal authorities in Europe. He argues that monetary policy has to be considered in the context of fiscal policy and macromonetary policies against asset price movements. There were many constraints to effective monetary policy in the Euro-area such as the lack of reputation of the new ECB, the decentralization of fiscal policies, and the absence of real labor mobility across regions. Recent academic studies have proposed direct inflation targeting as a possible optimum solution for the threat of high inflation. Many of these studies suggest replacing traditional rules, based on the control of money growth, by other rules such as the Taylor Rule. The Taylor Rule sets both output and inflation targeting goals for the monetary authorities, although in practice they mostly emphasize the latter. Chapters by Orphanides and Moreno concentrate on these new monetary policy rules and study the new policy rules in action. The last chapter studies the constraints on fiscal policy Marco Buti and Paul Van den Noord, by discussing the currently ongoing tax reform as a policy tool in the Euro-area countries, suggest that there may be a trade-off between efficiency and stability in the Euro-area economies. An increase in economic efficiency—through tax cuts and a reduction in public spending—may lead to a rise in the long run instability of the Euro-area economies.

Finally we want to note that frequently the most important cause for a constrained monetary policy which was also initially stressed by the Bundesbank and more recently by the ECB, has been seen in the lack of reputation of the ECB and the threat of high inflation. Yet, as also the chapters in Part I of the volume confirm, there may be considerable risk of deflation rather than inflation in the three currency areas. If this is so, as Olivier Blanchard in his contribution in Part I argues, this appears as a new challenge to monetary as well as fiscal policies in the three currency zones.

Part I

Overview

Unemployment and monetary policy in the three currency areas

2

Monetary policy and unemployment

Olivier Blanchard

I was asked for my thoughts on monetary policy and unemployment. I shall build on the themes developed at this conference, and do my best to be provocative.

1. Monetary policy can have large and long-lasting effects on real interest rates, and by implication, on activity. What I mean here is really large, and really long lasting, a decade or more. This conclusion is at odds with much of both the recent empirical work and the recent theoretical work on the topic:

The large empirical literature based on structural vector autoregressions (VARs) suggests that the effect of an innovation in money on activity peaks after a year or so, and is largely gone within 2 or 3 years.

The large theoretical literature based on an equation for inflation derived from Taylor-Calvo foundations gives roughly the same results. A change in money growth has its maximum effect on activity after a year or so, and the effect is again largely gone within 2 or 3 years.

Neither literature is totally convincing.

The type of money shocks whose effects are traced by VAR impulse responses are deviations from normal monetary behavior, and thus (even if identification is convincingly achieved and these are truly deviations, rather than noise) are likely to have different effects from the nondeviation part of policy

The Taylor-Calvo inflation equations have many merits. They capture something essential, namely the staggering of price and wage decisions. They can be derived from microfoundations. They provide a simple and elegant characterization of the relation between inflation and activity But, as we all know, they do not fit the data. There is much more inertia in the behavior of inflation than these equations imply

And, taking a step back, I see the evidence on the relation between monetary policy and real interest rates as speaking very strongly and very differently Think of the evolution of ex ante real interest rates (use your favorite measure of inflation expectations to do that; my point is robust to all plausible variations) over the last 30 years in OECD countries:

For most of the 1970s, ex ante real rates were very low in most countries. This was due—as a matter of accounting, not in a causal sense—to a large increase in inflation, and a less than one-for-one increase in nominal interest rates. Who can doubt that the evolution of real rates was due to monetary policy? That, faced with an increase in inflation triggered by supply-side shocks, central banks were too slow and too reluctant to increase nominal interest rates, leading to low or even negative real interest rates for a good part of the decade. There may be other interpretations, arguing that the evolution of real interest rates was the result of shifts in investment or saving, and had nothing to do with monetary policy I have not seen a plausible account along those lines.

For most of the 1980s, ex ante real rates were high in most countries. This was due, again as a matter of accounting, to a large increase in nominal interest rates, together with a decrease in the rate of inflation. Again, who can doubt that this evolution was primarily due to monetary policy? In every country one can trace the sharp increase in interest rates to an explicit change in monetary policy be it the change under Margaret Thatcher in the United Kingdom in the late 1970s, the Paul Volcker disinflation in the United States in the early 1980s, the competitive disinflation strategy in France a few years later. The case can also be made a contrario: The experience of Germany with a much more stable monetary policy and little change in real interest rates, either in the 1970s or the 1980s, reinforces the argument.

Again, there may be plausible nonmonetary accounts for these high real rates (Here, for the sake of internal consistency I must mention one, that I explored in a paper with Larry Summers in the mid-1980s, in the face of the joint increase in interest rates and stock prices: An increase in anticipated profitability increasing present values and putting pressure on long real rates. I still believe that this was a relevant factor. But I also believe that much of the evolution of real interest rates in the United States during the decade had to do with monetary policy).

If we accept those two facts, we must reach the conclusion that, while money is eventually neutral, and the Fisher hypothesis holds in the long run, it takes a long time to get there. (This was indeed Milton Friedman’s view.) But, if we accept the fact that monetary policy can affect the real interest rate for a decade and perhaps more, then, we must accept, as a matter of logic, that it can affect activity be it output or unemployment, for a roughly equal time. (Maybe one can think of models where the real rate returns to the natural real rate slowly but output returns to its natural level faster. The models we use imply that the two should return to their natural level at roughly the same speed.)

In short, monetary policy is potentially much more powerful (although we may not want to use that power) than is often assumed in current debates.

2. Monetary policy affects both the actual and the natural rate of unemployment. The first part of the proposition is obviously not controversial. But, studying the evolution of European unemployment, I have become convinced that the second part is also true, that monetary policy can, and does, affect the natural rate of unemployment:

Again for the sake of internal consistency let me start with a channel I explored, again with Larry Summers, in the late 1980s, namely hysteresis. There, we argued that anything that increased the actual rate of unemployment for sufficiently long—such as, for example, a sustained increase in real interest rates induced by monetary policy—was likely to lead to an increase in the natural rate. Our original explanation, that the goal of those employed was simply to keep their jobs, not create jobs for the unemployed, was too crude. It ignored the pressure that unemployment puts on wages, even when bargaining is only between employed workers and firms. But, even if full hystere...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• List of contributors
• 1 Introduction
• Part I Overview: unemployment and monetary policy in the three currency areas
• Part II Labor market institutions and unemployment
• Part III Structuralist causes of unemployment and monetary policy
• Part IV Monetary policy rules, fiscal policy, and unemployment
• Index