The Federal Reserve: “erring on the side of laxity”?

Chris Dillow explores the Rajan‘s interesting idea that a deficient Welfare State makes high public debt an inevitability.


Looking at a cross section of countries Chris highlights the correlation between small welfare states – Ireland, Iceland, the US and UK – and bigger rises in public debt than that seen in countries with more generous welfare states, such as Sweden. This is a rather interesting ideas for a number of reasons.

First of all, if true it confirms Martin Wolf‘s claim that “whatever the rhetoric, I have long considered the US the advanced world’s most Keynesian nation – the one in which government (including the Federal Reserve) is most expected to generate healthy demand at all times, largely because jobs are, in the US, the only safety net for those of working age.” Secondly, contra Marxist protests, it suggests that capitalism can be reformed to create a polity which weathers slumps so well it does not seek help extra in times of need. And, to the surprise of no one, it is the Nordic model which seems to come out top.

Those points are incidental to me at the moment; the Marxists can buy Martin Wolf a pint in Stockholm if they can find a mutually convenient time (and afford one given Sweden’s level of alcohol and consumption taxes).

What is most interesting in this theory is that this relationship appears to be breaking down, at least  in the US, and possibly in the UK. If a weak Welfare State is meant to promote countercyclical policies where are they now?

Obama of course produced a large stimulus Bill. However, in a massive economy hit by a huge recession “large” doesn’t quite cut it. As Paul Krugman argues, spending as a percentage of potential GDP barely budged under Obama and total spending only spiked because America’s weak Welfare State went into overdrive. Weak automatic stabilisers have not thrown the US into stimulus overdrive. In fact, quite the opposite is happening when you consider the contractionary policies of the individual states who must balance their budgets and the difficulty with which unemployment insurance was extended. Debt is up, but that is because growth is down, not because of a countercyclical spree.

Something which annoys me in Chris’s and Rajan’s argument is the suggestion that the Federal Reserve is now responding with a policy of loose money, similar, I suppose, to that in the early 1980s.

Sure interest rates are close to 0%, but you should ignore interest rates. Lots of other things impact monetary policy apart from the headline interest rate, for example the Federal Reserve is currently paying interest on its reserves and this is a contractionary policy which pulls in the opposite direction to low interest rates. Moreover, when you look at interest rates you are looking at only one side of the equation, if demand is low enough then perhaps loans supplied at 0% interest are still too expensive (don’t believe me? People are already borrowing at negative interest rates).

For Chris’s and Rajan’s theory to hold, that a weak Welfare State leads to stimulus, you would assume that today would be the ultimate test of that. It seems that this test has been failed. Chris and Rajan suggest that a weak Welfare State “encourages central banks to err on the side of laxity.” I see no signs of this in the US. Although interest rates are low, we have continued to see inflation expectations drop (one of the signs money is tight, not loose). The US political class is playing a different game to the one which was played when Rajan’s correlation was constructed.

expectations2 1

Today the Federal Reserve is acting as though it wants to push inflation down to 1% through “opportunistic disinflation” without regard to the misery inflicted on the unemployed. On top of a recalcitrant Fed, the Republican Party seems resurgent and even its most nonsensical plans are given a fair hearing; a resurgent Republican Party will never promote further stimulus (sarcastically I might suggest they could through an winnable war, but I hope they aren’t really that stupid).

If we are seeing the breakdown of this historic relationship then it poses some interesting questions.

If the US’s weak Welfare State prompted the stratospheric recovering from their early 1980s recession, why is it not doing so now? What does it mean for the American Working Classes if this relationship has broken down and Martin Wolf has stopped being right? Are we seeing a crisis of capitalism and a paradigm shift similar to that following the second world war and the 1970s Oil Crises?

One thought on “The Federal Reserve: “erring on the side of laxity”?

  1. You’re quite right to question whether monetary policy is loose right now. But I don’t think this is quite my or Rajan’s point. The point is rather that in the past – most especially in 2002-04 – the Fed ran too loose a monetary policy, which stoked up the housing boom, and this (in part) was a response to the weak welfare state.
    It is quite reasonable to suspect that monetary policy now is too tight, and yet at the same time to suspect that there might come a point when it will be too loose, thus stoking up the next bubble.

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