Coordinated Macroeconomic Management Tools
(The focus of current IEA research)

If economics is ever to become an integrated science that contributes to the ongoing well-being of society, it needs a toolbox of effective analytical and policy management tools. Five of those tools are described here.

  1. Potential GDP -- a 4% unemployment version
  2. NBER / Conference Board "Leading" Indicators
  3. Standardized "Dual-Deficit" Federal Budget
  4. Social Security "Unemployment Insurance"
  5. The Money-Growth / Economic-Growth Relationship

1.  Potential GDP -- a 4% unemployment version

For targeting macroeconomic policy, analyzing structural economic ratios, and many other purposes, economists (and the public) need a credible estimate of Potential ("full-employment") GDP. The "Operating Rate of the Economy" (ORE) -- the ratio of actual to Potential GDP, is, in effect, a mirror image of the unemployment rate, but more useful for many analytical and policy purposes.

Today, the CBO still calculates the only "official" version of Potential GDP -- based on the now-highly-dubious NAIRU (Non-Accelerating-Inflation Rate of Unemployment), which is now 5.2%. Social Security and the President even assume 5.5% as the most likely long-run average. But after five years of stable "soft landing" recovery growth, the unemployment rate actually fell to 4% in 1999-2000, with the economy operating well above the CBO's "Potential" -- with no significant inflation.

Before 1973, 4% was the implicit target of macro policy, and that is the "preliminary" policy target mandated by the Humphrey/Hawkins "Full Employment and Balanced Growth Act of 1978." Moreover, after WW II, Europe and Japan even had 2% or less unemployment for 14 straight years. More important, as recent European experience demonstrates even more vividly, a modern economy simply can't afford continuous unemployment over 5%, and IEA's macro analytical and policy tools should reflect that fact. There is no sound reason to doubt that our "normal" unemployment rate could gradually be further reduced to well below 4% by responsible macroeconomic policy.

Research needed.  Therefore, one of IEA's primary research objectives has been to make an unofficial adjustment of the CBO's NAIRU (5.2%) version of "full employment" to a 4% basis, while developing analytical tools to facilitate an even higher standard later -- hoping that a more responsible government after 2008 will urge the CBO or the Administration's Bureau of Economic Analysis to develop a 4% official version.

2.  NBER / Conference Board "Leading" Indicators

Their present title claim is false. They are generally assumed to "forecast" the economy 6 to 9 months ahead. But when calculated on a growth-trend standard of reference, such as ratios to Potential GDP, that are conceptually appropriate to a growing economy, most NBER "leaders" have no functional lead and are merely coincident with overall GDP fluctuations.

And because the NBER's obsolete (80-year-old) system of "business cycle" analysis is based on the same inappropriate absolute (non-growth) standard of reference, its dating of recession and recovery turning points is often equally faulty, analytically, and tends to cause inappropriate policy decisions. For instance, the "Bush recession" actually began in mid-2000 and lasted until mid-2003 -- not the short March-to-December 2001 interval as officially dated by the NBER.

The continued general acceptance of this basically flawed conceptual system epitomizes the general disarray of present mainstream macroeconomic analysis and policy. Hopefully, IEA's analysis of the present (mis)leading indicators will induce the NBER to revise its basic business-cycle analysis.

Research needed.  A more analytically useful list of leading indicators would focus on economy-destablizing structural distortions -- serious deviations from "normal" structural relationships -- in such key areas as interest rates, the stock market, housing and energy prices, corporate profits, real wage rates, commodity reserve stocks, manufacturing operating rates, consumer debt/income and borrowing/spending ratios, Federal spending, balance of international payments, and the money supply growth rate.

3.  Standardized "Dual-Deficit" Federal Budget

This requires two basic reforms:

  1. Remove Social Security entirely from the present analytically- and policy-misleading "unified" budget.
  2. Developa 4%-unemployment version of the CBO's now-NAIRU-based (5.2%) "Standardized" dual-deficit Federal Budget:

This Dual Deficit Format suggests a further significant functional distinction. A deficit that Congress enacts explicitly as a temporary Recovery Stimulant (such as the 2001 "tax rebates" and temporary unemployment insurance improvements) should be treated as a pro-active part of the automatic-stabilizer Hi-UE Deficit, rather than as an anomalous aspect of the Policy Deficit. For this purpose, a cash "Recovery Bonus" to all workers with a Social Security number would be more effective than a tax rebate.

In effect, this is a profitable federal investment, just as a business expense for more efficient equipment is used to cut the cost of production and increase profits. Treating it this way tends to make systematic coordination of fiscal and monetary policy more politically understandable. By the same token, it should also tend to make it politically easier to oppose fiscally irresponsible permanent tax-cuts (which produce much less recovery "bang for the buck").

A main purpose of the 4% unemployment version of the CBO's standardized budget estimates is to demonstrate more clearly how useful this Dual Deficit Format is, and to build pressure on the CBO to calculate their more precise official version on this basis.

To illustrate its practical importance, IEA's scatter-diagram estimate indicate that each 1% higher unemployment tends to increases the total non-Social Security deficit by between 0.7% and 0.8% of GDP. This "rule-of-thumb" indicates that using a 4% unemployment rate for separating the Policy and Hi-UE standardized budget components would make the Hi-UE deficit about $100 billion larger and the politically charged Policy deficit about $100 billion smaller than the CBO's present NAIRU divider.

Public understanding of these functional budget relationships is particularly needed in election years because it greatly increases budget "transparency" and facilitates allocation of functional responsibility for the deficit components, thus tending to induce a more fiscally responsible political debate and budget policy

4.  Social Security "Unemployment Insurance"

Social Security's much ballyhooed apparent financial problems stem primarily from the Trustees' inappropriately-high unemployment assumption, rather than from actuarial relationships or any basic structural deficiencies of the 1983 Greenspan Commission's reforms that provided for the present Baby-Boom buildup of the Social Security Trust Fund.

The Commission publishes three projections of the Trust Fund for the next 75 years, based on 6.5%, 5.5% and 4.5% official unemployment rates. The 5.5% projection -- the only one most of the public ever learns about -- "goes bankrupt" about 2042. In sharp contrast, the 4.5% projection is financially sound for the whole 75 years and beyond. This suggests strongly that Social Security's main financial problem is the inappropriate 5.5% unemployment assumption.

In fact, IEA's empirical research reveals an extremely close "cyclical" correlation between the unemployment rate and Social Security finances -- not only the overall net current increase in the Trust Fund, but also the separate financial and non-financial factors used in making the projections.

Apparently, the main reason Social Security economists have paid so little attention to this correlation is the fact that the Trustees publish the data for most elements of the system in the form of ratios to taxable payroll, for easier comprehension of the huge amounts. But since there is also a close "cyclical" correlation between the unemployment rate and taxable payroll, this presentation conceals the underlying correlation between the raw data and the unemployment rate.

To accept the assumption of average 5.5% unemployment for the next 75 years is highly irresponsible, morally, politically and economically. (And that official 5.5% doesn't even include the crucial 3% of potential workers who are excluded from the official labor force estimate because they have become too discouraged about job possibilities to continue active job seeking.) This irresponsibility is wrecking our center cities, overflowing our prisons, and causing unnecessary apparent conflict between environmental progress and job security. And it is completely unnecessary. The "soft landing" recovery of 1995-2000 brought unemployment down to 4%, with no significant inflation. And that can easily be repeated with the kind of genuinely responsible macroeconomic management outlined elsewhere in this summary of IEA's research projects.

A key difference between the Trustees' 5.5% and 4.5% projections is the resulting interest income. The 4.5% projection's higher FICA income generates a steadily increasing level of interest. By the time the Trust Fund reaches the peak benefit years (about 2035), the interest income -- then equal to about 25% of the FICA income -- continues to finance the gap between FICA income and benefit costs, while that gap in the 5.5% projection eats away its much smaller interest income to zero.

So the obvious -- and most responsible -- solution for Social Security's apparent financial problem is give the system effective "unemployment insurance".

  1. Take Social Security completely out of the Policy (structural, operating) Budget -- as required of corporate pension funds -- to prevent use of its Baby Boom surpluses to offset irresponsible Policy and High-Unemployment deficits, and to prevent Trust Fund's Treasury bonds from being falsely characterized as worthless IOU's.
  2. Require the Social Security trustees to use the 4.5% unemployment assumption as the basic publicized version, and revise their actuarial analysis accordingly.
  3. Then, whenever irresponsible macro management permits the official unemployment rate to rise above 4.5%, the resulting shortfall of current Trust Fund income from the amount in the 4.5% financially-sound projection should be made up by an automatic transfer of that amount from the "main" budget to the Trust Fund.

Result: Social Security's financial problem is solved -- with no tax increase or benefit reductions.

Where does the amount of this transfer show up in the non-Social Security aspects of the federal budget? That depends on the budget format:

  1. With the present functionally irresponsible "unified" budget, there would be no change in the (unified) budget deficit because the deficit increase in its non-Social Security aspects will be precisely offset by the income increase of Social Security Trust Fund.
  2. With the Dual-Deficit Budget, the amount of the shortfall transfer would become part of the High-Unemployment Deficit (along with all the other "automatic stabilizer" budget impacts of the recession) -- and would be completely eliminated whenever unemployment falls below 4.5%.

Research needed.  Estimating the actual amount of "unemployment insurance" transfer needed with various unemployment rates.

5.  The Money-Growth / Economic-Growth Relationship

Money definition.  Money is the economy's "medium of exchange" and "media of payment" -- the checking accounts and currency we use to pay bills and buy things. In a sense, it's the "blood" of the economy, and its growth rate is the key factor controlling economic growth. That's why the Federal Reserve, which controls that growth rate, gets so much attention.

Money creation and "multiplier" effect.  Under our present "fractional-reserve" monetary system, new money is created "out of thin air" by banks in the process of making loans, with the amount they can create limited by a legal reserve requirement. To increase the money supply, the Federal Reserve supplies the banks with additional reserves by buying Treasury securities "on the open market." Banks lend newly created money to borrowers by crediting it to their checking accounts.

When new money is spent by the borrower, it adds to the economy's total "circular flow" of spending and income (GDP). But new money also has a powerful "multiplier effect," because, as it continues to circulate around the economy, it continues to increase GDP each time it is spent and re-spent -- until it becomes "locked into" the larger checking account balances needed to service the larger GDP.

To clearly understand the relationship between money growth and GDP growth -- and to manage these growth rates precisely -- there must be a clear-cut conceptual and empirical definition of "money" and a clear-cut distinction between money and other financial assets. Before the destructive OPEC-induced inflation of 1973 and 1979, this distinction was maintained by the simple means of prohibiting interest payments on checking accounts.

The money-growth/economic growth formula.  This precise empirical definition of money made it possible for the Fed to manage the money supply-- and the economy -- directly (though implicitly) on the basis of the simple functional formula that relates money growth to economic (GDP) growth:

E = M - MDR

where E is the Economic growth rate, M is the Money growth rate, and MDR is the current trend growth rate of the Money Demand Ratio (M/GDP) -- the structural, stock/flow ("inventory sales") ratio between money stock and NIPA spending.

The 1980 dismantling of direct money control tools.  But the crucial "wall" between money and other financial assets was fatally breached about 1980 when the Fed started permitting interest payments on non-business ("NOW") checking accounts, and permitted limited checking on money market accounts. Since then, the Fed's now-more-anomalous M1 is the nearest empirical approach to the pre-1980 definition. But the Fed now almost ignores M1. and tries to persuade the public (and itself) to use its M2 as the main definition of "money." But about three-fourths of M2 is "non-money" -- interest-earning savings accounts and other investments that are neither bank-created nor serve as direct means of payment.

Post-1980 monetary policy confusion and charade of interest rate control.  With no precise definition of "money" to use in the formula, the Fed has resorted to a pretense of controlling the economy by controlling the inter-bank overnight fed-funds interest rate. Interest rates do affect economic growth -- especially the interest-sensitive housing market. But the functional connection between the fed funds rate and the economic growth rate is indirect, complex, unreliable and largely uncontrollable. As a result the Fed has, in effect, had to resort to "seat of the pants" monetary policy judgments based on the multitude of available economic data that are often confusing and contradictory.

The same "open market" operations" that that the Fed uses to affect the fed funds rate also affect the supply of bank reserves. But the Fed can't now use reserve control to control money growth because the ratio of bank reserve balances at the Fed bank-created checkable deposits has now been allowed to drop to only about 1.5%. This creates a "leverage" ratio of about 60 to one -- far to high for effective direct management.

The needed monetary management reforms.  Ironically, the most basic need is to return to the pre-1980 definition of money and tools of monetary management.

  1. Prohibit interest payments on checkable deposits and 3rd-party checking on interest-paying deposits -- to re-establish a clear-cut definition and empirical measure of money.
  2. Sharply increase the ratio of required bank reserve deposits at the Fed to checkable accounts -- preferably to 100% -- to provide the Fed with more precise direct control of money growth (and resulting economic growth).
  3. Pay banks appropriate interest on their reserve deposits to avoid bank opposition to this basic reform. (This will involve very little net cost to the Treasury because of the extremely small amount of the banks' present interest-free reserves.)
  4. Require the Fed to develop and publish a soft-landing (asymptotic) target GDP growth track to the 4% unemployment environment the economy had reached in 1999-2000. (This is an alternative to its present 1% to 2% target for inflation.) And prohibit the Fed from using increased unemployment as its main anti-inflation tool.
  5. Require the Fed to analyze the structural and other causes of inflation, and make specific recommendations for non-Fed policy actions to offset these causes and maintain a more structurally balanced economy.

Monetary/Fiscal policy coordination.  The Standardized Dual-Deficit Budget and tools for precise monetary control make the relationship between monetary and fiscal policy much more transparent and greatly facilitate the badly needed systematic coordination between them, both economically and politically.

Research needed.  The most analytically- and policy-useful expression of the money growth / economic growth formula.

Posted: August 23, 2006
Last revised: November 12, 2010
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