Chinese state intervention widened inequality for decades. Could Fed actions pose similar risks?
Amid the national crisis on race, this debate on the distributional consequences of monetary policies is certainly an important one.
The recent attention toward the Fed’s role in widening economic inequality is hardly unfounded. The stock market is rebounding at breakneck pace thanks to swift actions by the Fed to ease monetary conditions, yet unemployment remains at its decade high of 10.2%. That figure is even worse for Blacks and Latinos, whose unemployment rates remain at 15.4% and 14.5%.
Meanwhile, the Fed continues to be cautious about the limits of its authority. According to current Fed Chair Jay Powell,
“Inequality is something that’s been with us increasingly for more than four decades and it’s not really related to monetary policy.”
Instead, he’s focusing on the Fed’s dual mandate of maximum employment and price stability to justify government purchases of corporate bonds, despite fears that this could lead to a massive bubble in the stock market.
Amid the national crisis on race, this debate on the distributional consequences of monetary policies is certainly an important one. On one hand, swift interventions by the Fed indeed helped to slow the recession, but inflated stock prices are least likely to benefit working-class Americans, who will also be the hardest hit when markets crash.
In this context, how should we think about the Fed’s role in reducing economic inequality?
INEQUALITY IS A UNIVERSAL PROBLEM
To start, it’s important to recognize that what Jay Powell said is partly true. Economic inequality in the United States has risen dramatically since the late 1970s, a result of wage stagnation and rise in corporate profit share that effectively redistributed income from low- to high-savings households. Over time, the income gap between the rich and poor becomes a self-perpetuating cycle, creating other problems like an education gap or wealth gap that monetary policies do not have control over.
Where monetary policies do have an impact is on broad economic variables like inflation, employment, interest rates, and outputs — but these are factors that affect everyone. This is especially true during times of crisis, as good monetary policies help to lift all boats by making recessions less severe.
Yet, this still doesn’t help the fact that lower-income households are disproportionately affected by an economic crisis. Economists refer to this phenomenon as the “ratchet effect”, which means that inequality tends worsen rapidly for workers during a recession due to loss of jobs, cuts in social services, and other structural adjustments that inevitably occur as economies try to rebound from these shocks. But who is responsible for this problem?
At this point, the argument often goes that only fiscal power can solve inequality — through policies that provide workers with more welfare, cheaper credit, and a bigger share of the pie. Meanwhile, monetary policy gets to take a backseat, content with focusing on the pie as a whole rather than the distributional consequences of its actions. As long as aggregate unemployment remains low, should the Fed reconcile with the fact that even before the pandemic, the Black jobless rate was nearly double that of whites?
THE DANGER OF NARROW POLICY GOALS
Speaking on racial gaps in monetary policies, Atlanta Fed President admitted that economic models often don’t have “reachback” loops for things that happened in the past to guide the optimal strategy for today. Assessing the impact of our policy decisions on inequality is only done retroactively — but this can lead to severe consequences down the road.
Take China, for example. Between the 1990s until late 2000s, the Chinese government embraced a new economic model for the country that heavily emphasized investment-driven growth. Investments of any kind were prioritized at the expense of household savings, leading to a financial system that produced a massive and sustained transfer of money from the Chinese people to party elites.
Eventually though, the massive scale of investments became less and less productive, a result of widespread corruption and credit misallocations as party officials began writing checks for personal gains. To keep capital flow going, China then implemented regressive social policies (like the Hukou system) that further suppressed spending. These forces led to massive imbalances in China’s economy that officials are still contending with today.
Ultimately, the focus on boosting investment at all cost meant that there was no mechanism to constrain, or even identify, wasted investments. As vested interests who benefit from that growth model become more determined to maintain their access to cheap credit, policy goals become distorted and meaningful adjustments are delayed — all for the sake of economic growth.
The lesson here is that there is a danger in policies made solely to prop up markets, while other priorities like inequality are consistently diminished. Whether the outcome is intentional or not, the Fed’s extraordinary measures in response to the pandemic will inevitably lead to higher household debt and greater inflation risks — both problems that will be disproportionately borne by working-class Americans in the future.
OPTIMAL MONETARY POLICY FOR THE MASSES
So how can the Fed fight inequality? According to current New York Fed President William Dudley, the Fed’s tools are “just not suited to address the inequality problem.” As he sees it, the Fed have two choices: not have a recovery and have less inequality or have a recovery with inflated financial asset prices and more inequality.
However, many disagree with these binary choices and believe there are more policy options the Fed can explore. Scott Sumner, director of the Program on Monetary Policy at George Mason University, argued that the Fed could step up its regulatory power and address racial bias in lending, which would support Black-owned firms who are more likely to be found in COVID-19 hotspots. These Black-owned firms also apply for financing at equal or higher rates than white-owned firms but are denied at higher rates, according to a study by the Federal Reserve.
Regulatory reforms would include tighter quotas in bank lending to support minority groups, ensuring that banks are giving everyone the same level of encouragement and diversity in terms of the products offered. There could also be more ambitious overhaul like allowing banks to repackage low-balance loans through a process called “internal securitization”, thereby creating positive incentives for providing loans to lower-income borrowers.
Rather than working through banks, the Fed could also move to support low-income communities directly by buying municipal bonds in those areas. Mehrsa Baradaran, a University of California Irvine law professor, believes this would provide additional credit lines to struggling communities who are facing budget cuts as a result of the pandemic. The Fed has already taken bold steps to buy corporate bonds, so why not take others as well?
At the very least, the Federal Reserve can take symbolic gestures to signal its commitment to addressing economic disparities. Atlanta Fed President Raphael Bostic and Jared Bernstein, an advisor to Joe Biden when he was Vice President and well known progressive economic policy thinker, proposed that the Fed explicitly target Black unemployment rate as a measure of labor market strength. Building these racial metrics into its interest rate decisions would be crucial in expanding the Fed’s institutional capacity to look at race more closely.
In the long-run, inequality can’t be solved by monetary policies alone; it must be accompanied by other reforms in our education system, our union laws, and our Congress. Still, an important first step is to recognize that our policies must focus not only on the overall health of the economy, but the economic well-being of different communities — particularly the most vulnerable — as well.