Social Safety Nets, Inflation Fighting, and Market Discipline

I've had some differences with Barney Frank in the past over Fed policy, but here he makes an interesting point. Why do European central banks respond more aggressively to inflation than the US central bank? Could it be the difference in social safety nets?:

Frank Says Stronger Social Safety Net Would Free Fed, by  –Michael S. Derby, Real Time Economics: There are many reasons why the Federal Reserve is boxed in on monetary policy, but Rep. Barney Frank Wednesday found a new dimension to the central bank’s dilemma. ...

Ben Bernanke and his fellow policy makers are facing a worrisome mix of tepid growth, troubled financial conditions and rising price pressures... The weak economy and market tumult call for rate cuts. But the energy-driven price gains and deteriorating expectations for future prices call for rate increases.

That’s left the Fed stuck at its current rate of 2%, very likely for an extended period. But according to Frank, if the U.S. social safety net weren’t so miserly, the Fed might actually have more room to take on inflation. ... “The relative insufficiency of our social safety net vis-a-vis what you have in Western Europe constrains monetary policy,” Frank said.

If the U.S. offered more support for the unemployed and displaced, “the Federal Reserve would then be freer…to slow down the economy in the knowledge this would not have a disproportionately negative effect” on the working population. That part of the population is already losing notable ground in economic terms, he said. ...

And, contrary to what you might hear - sometimes based upon the argument that we are not in a technical recession - "families are facing hardship":

Bernanke: Recession or Not, Families Are Hurting, by Sudeep Reddy: ...At a House hearing, Mr. Bernanke — responding to a lawmaker’s question about Americans’ economic pain ...[and] whether a recession is underway. ...

“Whether it’s a technical recession or not is not all that relevant,” Mr. Bernanke said. “It’s clearly the case that for a variety of reasons families are facing hardship.” ...Mr. Bernanke recounted the “numerous difficulties” facing the economy: “ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities.” ...

As to whether this is a technical recession, “I don’t see why that makes a great deal of difference,” Mr. Bernanke said, adding that the terminology doesn’t play into the Fed’s policy decisions.

In other what are you whining about news, prices are up, and the ability of workers to buy goods and services is down:

U.S. consumer prices soared at their fastest annual pace in nearly two decades last month... Even more worrisome for policymakers than the headline inflation jump may be signs that food and energy prices are starting to filter through the broader economy, as evidenced by sharp price gains last month in housing, transportation and services. ...

The consumer price index jumped 1.1% in June..., the second-highest increase since 1982 and the highest since 2005. Excluding food and energy, it advanced 0.3%. ...

Consumer prices swelled 5% on a year-over-year basis, the highest rate since May 1991. The core CPI grew a more modest 2.4% compared to June 2007, though that's still well above the Fed's long-term goal of 1.5% to 2%. Over the past three months, core inflation rose at a 2.5% annual rate. ...

In a separate report, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, fell 0.9% in June, suggesting incomes aren't keeping pace with prices...

I'm not sure that I agree with Robert Reich that the episode we are currently experiencing proves that the Great Moderation was more luck than anything else, particularly that it disproves Fed policy made any difference. There is a lot of empirical evidence pointing to more aggressive inflation fighting as a key factor in the Great Moderation (e.g. Has Monetary Policy become More Effective? by Jean Boivin and Marc P. Giannoni, and On the Sources of the Great Moderation by Jordi Galí and Luca Gambetti are two recent contributions in this area), and we don't know how bad the current episode might have been had the Fed, say, followed a 1970s-type policy prescription (that is, even though we had bad luck - a large shock hit causing large effects - without moderation through Fed policy the state of the economy could have been much worse). But I do agree with his call for increased social insurance:

The End of the Great Moderation, the Bailouts of Freddie & Fannie and Wall Street, and the Tattered Safety Net for Everyone Else, by Robert Reich: As we bail out Wall Street along with Freddie and Fannie and all the top financial executives who have been pocketing tens of millions a year, yet allow millions of homeowners and jobless Americans to sink, it's worth contemplating what's happening to the American economy and to our social safety nets.

What economists have called "The Great Moderation" - a period when the business cycle evened out, and neither inflation nor recession posed much of a threat- began in the mid-1980s, and now appears to be over. It was good when it lasted. But it led the nation to think we didn't need much by way of social insurance.

No one knows for sure what caused the Great Moderation. Some had credited increased sophistication of financial markets and the wisdom of the Federal Reserve Board. Hindsight suggests it was more luck than anything else.

Well, folks, it turns out the great moderation was something of a fluke, and now tens of millions of Americans are in trouble with no safety net to help them.

That's because the apparent end of the boom and bust cycles led us to assume the economy would no longer impose huge, unexpected, and arbitrary losses on large numbers of Americans. So we basically got rid of the safety nets. We abolished welfare, let unemployment insurance wither, and paid scant attention when corporations eliminated defined-benefit pensions and cut health insurance benefits. We even stopped worrying about the safety of small investors, allowing federal deposit insurance to shrink as a proportion of total savings (witness the recent bank run in California).

But now we have to rethink safety nets. Right now, nets are being spread for the wrong people. The giants of Wall Street along with Fannie and Freddie get bailed out but there's still no relief in sight for most homeowners who can't pay their mortgages. Corporations that don't deliver on their pension obligations are helped but there's nothing for retirees and small investors whose savings are drying up because of Wall Street's decline. Small investors are losing their shirts but the Fed stands by to help the biggest.

Yet I have to believe the end of the Great Moderation will eventually result in a broader safety net. Maybe not the old forms of social insurance, but new ones like universal health insurance, earnings insurance, and savings accounts in which the dollars you put away are supplemented by government dollars.

The very rich, fattest investors, and the biggest corporations don't need safety nets. Now that the booms and busts are back, the rest of us do.

I don't advocate protecting the financial system to bailout the "very rich, fattest investors, and the biggest corporations," it's the people who would need the social safety net if the broader economy fails that are the concern. We need both enhanced social insurance and a stable financial system. For stabilizing the financial system, the trick going forward will be to develop mechanisms that are able to prevent financial meltdowns, but avoid rewarding the people who brought about the potential for collapse. I think regulation that prevents behaviors that lead to these kinds of problems is our best chance, but we can't anticipate everything possible problem that might occur and there are times when insuring against collapse requires us to hold our noses and clean things up as best we can. But that should be a last resort. As for how the social safety net fits into this, much like the ability to fight inflation, the ability to discipline market participants - to let those who made bad bets, bad decisions, etc. suffer losses or other penalties - is also enhanced when a stronger social safety net is present.