Skip to main content

Kennedy School Review

Topic / Public Finance

Misdiagnosis and Malaise: Why the Fed Has Failed to Aid the Job Market


In September 2012, the U.S. Federal Reserve announced the third round of quantitative easing (QE3) since the onset of the financial crisis. Quantitative easing refers to the Federal Reserve’s policy of digitally printing dollars to buy long-term bonds and mortgage-backed securities (MBS) to drive interest rates down. In contrast to previous rounds where the Fed announced the program’s size (QE2 was $600 billion, for example), this round the Fed upped its commitment by calling for “indefinite QE.” The Fed is now buying $85 billion in U.S. Treasuries and MBS every month, or just over $1 trillion a year, and the plan is to continue at this pace until unemployment hits 6.5 percent (as long as inflation isn’t too high). To put this in perspective, in late 2007, the country’s entire monetary base stood at approximately $800 billion. It has increased fourfold in fewer than five years as a result of QE—an unprecedented growth rate in the United States’ monetary history.

The assumption underpinning the Federal Reserve’s action is that lowering interest rates raises asset prices (buying bonds pushes bond prices up and yields/interest rates down), making consumers feel richer, which means they’ll spend more. And it encourages businesses to expand. Those two elements will increase demand. These benefits, the Federal Reserve contends, justify the massive increase in the monetary base and outweigh the costs associated with QE. However, it is far from clear that these assumptions hold.

Two days before the Federal Reserve announced QE3, Duke University published the quarterly results from an ongoing research project survey that included 887 chief financial officers (CFOs) from large U.S. companies. The survey asked how the CFOs would respond to falling interest rates. Ninety-one percent indicated that a 1 percent fall in interest rates would have no impact on their business plans, and 84 percent said a 2 percent fall would have no impact.[i] The results of the poll are notable because a 1-2 percent drop in interest rates is far more than the Federal Reserve can hope to achieve with even massive amounts of QE, given that ten-year treasuries were yielding under 2 percent prior to the QE3 announcement. Campbell Harvey, the founding director of the survey and a finance professor at Duke, concluded, “The CFOs are saying that it is naïve for the Federal Reserve to think that dropping interest rates will spur investment in current economic conditions.” He added that it was “amazing that all the focus is on interest rates when they are already at fifty-year lows.”[ii]

And yet, the official line from the Federal Reserve was that QE was being deployed to address the ailing labor market. Furthermore, members of the Federal Open Market Committee (FOMC), the group that meets to shape monetary policy, stated that “if the outlook for the labor market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases . . . until such improvement is achieved.”[iii] In other words, if the strategy doesn’t appear to be working, the Federal Reserve plans to do a whole lot more of it.

So why exactly has the Federal Reserve concluded that QE will translate to more jobs, given that the country’s top CFOs say that it won’t? The ideological background of the Federal Reserve’s leadership sheds some light. Chairman of the Federal Reserve Ben Bernanke is often depicted as a Keynesian; in reality, Bernanke is a monetarist, a disciple of Milton Friedman. Bernanke gave the keynote speech at Friedman’s ninetieth birthday. “Among economic scholars,” he began, “Friedman has no peer. . . . [His work] has become the leading and most persuasive explanation of the . . . Great Depression.” Bernanke continued that his own work was always “an embellishment of the Friedman-[Anna] Schwartz story; it in no way contradicts the basic logic of their analysis.”[iv]

The crux of the Friedman and Schwartz story is that the Fed caused the Great Depression by inappropriately raising interest rates in 1928 and keeping monetary policy too tight throughout the Great Depression. The Fed raised rates in 1928 to curb what it saw as rampant speculation on Wall Street. It also raised rates at several points during the Great Depression (after lowering them) to protect the dollar and limit gold outflows. Although the Fed doubled its government holdings after the market crash of October 1929 and gradually lowered interest rates thereafter[v] (save the increases mentioned above), it was too little, too late as far as Friedman and Schwartz were concerned.

What Friedman and Schwartz chose not to emphasize in their analysis is interesting. A free-market enthusiast to his death in 2006, Friedman ruled out the rampant speculation the Fed observed on Wall Street as a core cause of the Great Depression. Private banks were lending to speculators on only a 10 percent margin.[vi] When the market crashed, many of these loans went bad, contributing to bank failures.[vii] Moreover, the market crash had a profound impact on the national psyche. It stoked fear, the lifeblood of bank runs. Bank runs led to bank failures, more fear, hoarding, and deflation.

Friedman also considered unemployment largely unimportant because he believed it had little impact on consumption/demand. The permanent income hypothesis (PIH), an abstract theory of consumption he pioneered, posits “transitory” events such as temporary job loss have little impact on consumption. For this to be true, Friedman had to further assume households face no liquidity constraints. In other words, they would have no trouble getting a bank to lend them money to finance their consumption if they lost their job. Friedman had a brilliant mathematical mind but a weakness for making questionable assumptions that were necessary for his abstract theories’ tractability.

Because they believed the Great Depression was caused by a mismanaged/declining money supply, Friedman and Schwartz’s policy prescriptions dealt solely with the money supply—not financial regulation or job creation. They argued the Fed could have avoided the Great Depression by increasing the money supply via printing money, buying assets, and preventing bank failures.

In light of Bernanke’s subscription to Friedman’s narrative, the Federal Reserve’s previously mystifying strategy makes sense. They are following Friedman’s playbook, which amounts to printing money to make up for the money supply contraction caused by private loans going bad and supporting the banks to avoid bank failures. That’s precisely what the Federal Reserve policy has done through QE and a variety of other policy interventions.

Bernanke should be basing the massive QE expansion he’s spearheading on more than just theory, though, because it relies on unrealistic assumptions and is not supported by recent experience. In 1998, Friedman offered the same diagnosis and prescription to Japan as he did to the Great Depression–era United States. Japan followed his advice to a tee. It doubled its monetary base to buy bonds in the early 2000s. But growth did not follow. Jobs did not follow. In an article on the subject, op-ed columnist for the New York Times Paul Krugman observed, “Friedman was all wrong about Japan—you can argue that he was also wrong about the Great Depression, for the same reason.”[viii] And you can argue for the same reason that Ben Bernanke is all wrong today. So four years out, what evidence does Bernanke have—outside of demonstrably faulty theory—to support the claim that QE will boost demand and can be used to target the job market (a claim not even Friedman made)? Not a lot.

In the press conference announcing QE3, one reporter asked why Bernanke expected QE to help job growth now when it appears that similar Federal Reserve actions taken earlier had not. Bernanke referred to a speech he had made in Jackson Hole, Wyoming, saying his assessment of the research literature was that QE was working.[ix]

Going through the research reports cited in the relevant section of his Jackson Hole speech, the first thing that stood out was that all the papers that touched on employment and consumption (some did not) were highly theoretical. Their models assumed consumption smoothing and a range of other assumptions whose assessment is beyond the discussion in this article. None of them dealt with empirical or survey jobs data. Their results should be taken with a huge grain of salt given theoretical economic models’ abysmal performance leading up to—and during—the crisis. As Jean-Claude Trichet, president of the European Central Bank through 2011, observed, “Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner.”[x] After leafing through these highly theoretical research reports, it became apparent that the original question—why QE would work now when it hadn’t earlier—was completely outside the scope of any of them.

Later in the press conference, a Reuters reporter pointedly asked about the transmission mechanism from QE to benefits in the real economy, stating that whilst many people agreed that QE caused interest rates to drop and the stock market to rise, they had not seen evidence that it helped the broader economy; Bernanke responded, “[w]hat we’re about here is trying to get jobs going.”[xi] Bernanke explained that the transmission mechanism was higher in home and stock prices, which should make consumers feel wealthier and get them to spend more. He added that “the issue here is whether or not improving asset prices generally will make people more willing to spend.”[xii] Indeed, that is the question. What Bernanke is notably lacking is any data or survey evidence to suggest that it does. The poor and the middle class are the big spenders (relative to their incomes) compared to the wealthy,[xiii] so in order for Bernanke’s proposed transmission mechanism to be remotely efficient, the country’s poor and middle class would have to own a significant percentage of the country’s assets. But they don’t. The bottom 50 percent of Americans owned a paltry 1.1 percent of the nation’s wealth in 2010.[xiv] And the bottom 60 percent owned an astonishingly low 0.3 percent of the nation’s non-housing wealth.[xv]

Although the distribution of QE’s benefits is not something the Federal Reserve has investigated, the Bank of England (BOE) has. According to its report, “the total increase in household wealth stemming from the Bank’s £325 billion of asset purchases up to May 2012 of just over £600 billion [is] equivalent to around £10,000 per person if assets were evenly distributed across the population.”[xvi] It continues, “In practice, the benefits from these wealth effects will accrue to those households holding most financial assets. Evidence from the 2011 survey by NMG Financial Services Consulting . . . suggested ‘the median household held only around £1,500 of gross assets, while the top 5 percent of households held an average of £175,000.’”[xvii]

In other words, the average household in the top 5 percent benefited at least a staggering one hundred times more than the median British household from QE-induced asset appreciation. Taken together with the wealthy’s lower propensity to spend, this helps explain why the United Kingdom has not seen meaningful job growth, despite a QE program totaling more than 20 percent of GDP.[xviii] Most of the benefits are flowing to the wealthiest, but they aren’t spending it.

In an independent study released a year earlier, BCA Research, a private British research firm, reported that “the evidence suggests that QE ends up overwhelmingly in profits, thereby exacerbating already extreme income inequality and the consequent social tensions.”[xix] BCA explicitly says what the BOE’s data suggests: QE is increasing the country’s already high inequality. This is a notable issue because—as a growing body of literature suggests—inequality stifles economic growth and stokes political and social dysfunction.[xx]

Nobel Prize–winning economist Joseph Stiglitz is leading the charge on bringing awareness to the economic costs of inequality. In his recent New York Times op-ed titled “Inequality Is Holding Back the Recovery,” Stiglitz explains that there are four primary reasons why inequality hampers economic growth: it reduces demand, it leaves the middle class less able to invest in their future, it lowers tax receipts, and it is associated with more violent boom and bust cycles.[xxi] A study undertaken by Andrew Berg at the International Monetary Fund (IMF) also asserts that inequality prevents sustained growth. According to Berg, starting growth via stimulus measures is fairly easy, but in a sufficiently unequal economy, growth often falters when government support stops. His research suggests that America’s high level of inequality is playing a role in its inability to turn the boost from stimulus efforts into self-sustaining growth.[xxii]

And by most measures, U.S. inequality is growing. If the numbers are bad, the trends are worse. The percentage of the nation’s wealth controlled by the bottom 50 percent plummeted almost 60 percent between 2007 and 2010, from an already low 2.5 percent to 1.1 percent.[xxiii] The middle class and the poor are struggling. National Public Radio recently reported that 44 percent of Americans don’t have enough savings to stay out of poverty for more than three months if they lose their jobs, and almost one-third of Americans don’t even have savings accounts.[xxiv] At the same time, a weak job market is putting pressure on wages, which were already on a downward trajectory, falling from 49 percent of gross domestic product (GDP) in 2000 to 46 percent prior to the crisis to under 44 percent today.[xxv] A recent study found that 40 percent of Americans make less than the 1968 inflation-adjusted minimum wage.[xxvi] And fewer Americans are working—the labor force participation rate is down from over 66 percent in early 2007 to just over 63 percent today.[xxvii] Meanwhile, corporate profits in absolute terms and as a percentage of GDP are at all-time highs.[xxviii] The bottom line is less and less of the country’s economic benefits are being delivered to labor and more are going to capital, which is held by the wealthy. And QE is reinforcing this troubling trend.

The Federal Reserve is convinced if it can get Americans to feel rich via higher asset prices and borrow at pre-crisis levels again by pushing interest rates to rock-bottom levels, it will get the economy back on track. But borrowing and spending prior to the crisis was wildly unsustainable, with the bottom 80 percent of Americans spending 110 percent of their incomes pre-crisis.[xxix] Furthermore, the middle class’s wealth has deteriorated significantly in the last five years, leaving them less capable of shouldering higher debt levels. With wages declining, a weak job market and debt levels still relatively high, pushing Americans to take on more debt is nothing short of irresponsible. Americans need more income, not more debt.

If the problem is a lack of income and jobs (which even the Federal Reserve now publicly admits), we should enact direct and measurable job-creating policies. We’ve tried policies based on abstract theory with vague transmission mechanisms. It hasn’t worked. It’s time to get less clever and more concrete. The Federal Reserve does not have fiscal authority, but it can promote job creation via targeted bond buying/asset purchases. When you buy debt, you are supporting the activity that debt finances. (The Federal Reserve obviously understands this because when targeting the housing market, it bought mortgage-backed securities.) If the Federal Reserve is serious about supporting jobs, it should buy bonds financing projects that create new American jobs.

Our crumbling infrastructure provides an ideal opportunity. Economists can’t agree on much, but the necessity of good infrastructure to seed future economic growth is fairly uncontroversial. That American infrastructure is in need of serious investment is equally uncontentious. The American Society of Civil Engineers (ASCE) gave the United States a D+ grade in its 2013 Report Card for America’s Infrastructure and estimated we need to invest $3.6 trillion in infrastructure by 2020.[xxx] Yet the Build America Bonds program totaled $181 billion, less than 8 percent of QE to date. But it’s not too late to change course.

A Put America to Work bond buying program should be a collaborative effort between the Obama administration and Federal Reserve officials. There are a number of forms the program could take, but critically, these bonds should require a quota of new jobs created per $1 million of bonds purchased and specify a minimum percentage of the funds that must be spent on payroll. If the Fed targeted the $1 trillion of QE it’s on pace to spend this year on infrastructure bonds and required one-third of the funds to go to payroll, assuming an average salary of $75,000, that would create between four and five million jobs. The funds could be distributed across states based on population, unemployment metrics, and poverty statistics. The ASCE’s Web site provides a comprehensive state-by-state rundown of top infrastructure priorities, which is a great starting point for organizing this nationwide infrastructure initiative.[xxxi] Detailed, though not onerous, surveys for workers could be included in the terms of employment, giving Federal Reserve researchers and other academics valuable data to study the program, assess its effectiveness, and work to improve it.

Such a program would not be a silver bullet, but it could help soften the blow to the middle class while providing the United States with an infrastructure upgrade it desperately needs. It should also be noted there are real risks to dramatically expanding the monetary base through any QE program. How long and to what degree QE should be continued are important questions that are beyond the scope of this article. If we are going to take the risks inherent in QE, though, we should be reasonably confident the policy is having the intended effect of improving unemployment.

Given it’s a relatively short mental hop from supporting the housing market by buying mortgage bonds to supporting the job market by buying job bonds, it is surprising that no prominent politicians or economists have publicly proposed the idea. A chorus of voices made up of politicians, journalists, and even some economists—from former U.S. President Bill Clinton to researchers at the San Francisco Federal Reserve—have called for more infrastructure spending to boost jobs and aid the recovery. And there is much discussion about QE, but few have married the two. A couple of journalists have recently proposed the idea, though, suggesting that it’s beginning to percolate into the public consciousness.[xxxii]

That QE is providing little help to the middle class and poor is increasingly uncontroversial. One definition of insanity is doing the same thing over and over again and expecting different results. If buying government bonds hasn’t fired up the job market after two years, it’s unlikely to start working now. So isn’t it time to try something new?

Lauren Paer is an economist pursuing interdisciplinary alternatives to neoclassical economics, including complexity economics, institutional economics, and behavioral economics. She has worked as a research associate at the Federal Reserve Bank of New York and most recently worked as a senior analyst at a multi-strategy New York hedge fund.

[i] Duke University Fuqua School of Business. 2012. CFOs: Hiring and spending plans weaken, Fed policy viewed as ineffective. News release, 11 September.

[ii] Ibid.

[iii] Board of Governors of the Federal Reserve System. 2012. FRB: Press release—Federal Reserve issues FOMC statement, 24 October.

[iv] Bernanke, Benjamin. 2002. Remarks by Governor Ben S. Bernanke at the Conference to Honor Milton Friedman: On Milton Friedman’s ninetieth birthday. University of Chicago, 8 November.

[v] Rothbard, Murray. 2000. America’s great depression. Auburn, AL: Ludwig von Mises Institute.

[vi] Wikipedia. 2013. Entry on “Great depression.” Wikipedia: The free encyclopedia. Last modified 4 April.

[vii] Rothbard, 2000.

[viii] Krugman, Paul. 2010. More on Friedman/Japan. New York Times, 29 October.

[ix] Bernanke, Benjamin. 2012. Transcript of Chairman Bernanke’s press conference, 13 September.

[x] Trichet, Jean-Claude. 2010. Reflections on the nature of monetary policy non-standard measures and finance theory, Opening address at the ECB Central Banking Conference. Frankfurt, Germany, 18 November.

[xi] Bernanke, 2012.

[xii] Ibid.

[xiii] Dynan, Karen E., Jonathan Skinner, and Stephen P. Zeldes. 2004. Do the rich save more? Journal of Political Economy 112(2): 397-444.

[xiv] Levine, Linda. 2012. An analysis of the distribution of wealth across households, 1989-2010. Congressional Research Service, CRS Report for Congress, 17 July.

[xv] Wolff, Edward N. 2010. Recent trends in household wealth in the United States: Rising debt and the middle-class squeeze–an update to 2007. Levy Institute of Economics, Bard College working paper.

[xvi] The Bank of England. 2012. The distributional effects of asset purchases, 12 July.

[xvii] Ibid.

[xviii] Summers, Graham. 2012. QE doesn’t create jobs . . . so why is the Fed targeting employment with it? Zero Hedge, 18 December.

[xix] Stewart, Heather. 2011. Quantitative easing “is good for the rich, bad for the poor.” Guardian, 13 August.

[xx] See Stiglitz, Joseph E. 2012. The price of inequality: How today’s divided society endangers our future. New York: W.W. Norton; Rajan, Raghuram G. 2011. Fault lines: How hidden fractures still threaten the world economy. Princeton: Princeton University Press; Pickett, Kate, and Robert Wilkinson. 2011. The spirit level: Why greater equality makes societies stronger. New York: Bloomsbury Press; and Bartels, Larry M. 2010. Unequal democracy: The political economy of the new Gilded Age. Princeton: Princeton University Press.

[xxi] Stiglitz, Joseph E. 2013. Inequality is holding back the recovery, New York Times, 19 January.

[xxii] Harkinson, Josh. 2011. Study: Income inequality kills economic growth. Mother Jones, 4 October.

[xxiii] Levine, 2012.

[xxiv] Fessler, Pam. 2013. Study: Nearly half in U.S. lack financial safety net. National Public Radio, 30 January.

[xxv] Federal Reserve Bank of St. Louis. 2013. Economic research. Graph: Compensation of employees: Wages and salary accruals (WASCUR)/Gross domestic product, 1 decimal (GCP).

[xxvi] Johnson, Dave. 2013. 40% of Americans now make less than 1968 minimum wage. Contributor, 20 February.

[xxvii] Bureau of Labor Statistics data. 2013. Labor force statistics from the current population survey. Data extracted 7 April.

[xxviii] Clawson, Laura. 2012. Corporate profits are highest-ever share of GDP, while wages are lowest-ever. Daily Kos, 3 December.

[xxix] Stiglitz, 2013.

[xxx] American Society of Civil Engineers. 2013 report card for America’s infrastructure.

[xxxi] Ibid.

[xxxii] Long, Cate. 2012. Why the Federal Reserve should buy national infrastructure bonds. Reuters, 28 December.