It's been three years since the financial crisis flared up and the recession began. Yet the unemployment rate is still over 9%—double what it was before the recession—and it's been stuck above 9% for 20 consecutive months. Why the extraordinarily high and prolonged unemployment? My research shows that discretionary government interventions—deviations from sound economic principles and policies—have been largely responsible.
Many government interventions occurred before the panic in the fall of 2008, but in the past two years the government doubled down. We have seen an $862 billion stimulus, an increase in federal spending to 25% from 21% of GDP, and a corresponding explosion of federal debt. We have the Fed's unconventional "quantitative easings": purchases of $1.25 trillion of mortgage backed securities and $900 billion of longer-term Treasury bonds. And we have seen hundreds of new regulations in the health and financial sectors.
The one-time stimulus payments to people did not jump-start consumption. The stimulus grants to states did not increase infrastructure spending. Cash for clunkers merely shifted consumption a few months forward. The Fed's purchases did not have a material impact on mortgage interest rates once changes in risks are taken into account. At best these actions had a small temporary effect that dissipated quickly, leaving a legacy of higher debt, a bloated Fed balance sheet and uncertainty—all of which slow growth and job creation.
None of this should be surprising. Well-known theories of consumption predict that temporary payments to households will not increase economic growth by much. Careful empirical studies of stimulus programs in the 1970s showed that stimulus grants to states did not increase infrastructure spending. A vast literature and experience from the 1970s show that discretionary monetary policy, as distinct from rules-based policy, leads to boom-bust cycles with ultimately higher unemployment and higher inflation. With sounder, more stable and more predictable monetary and fiscal policies in the 1980s and '90s we had long expansions and lower unemployment.
The best way to reduce unemployment is to restore sound fiscal and monetary policies. There are some welcome signs that the policy pendulum has begun to swing back in that direction. The recent election revealed deep concern about high debt, deficits and spending.
Three-fourths of business economists and one-half of academic economists say that easy monetary policy exacerbated the housing boom and bust that led to the financial crisis. Reactions to a second round of quantitative easing have been negative at home and abroad. The very word "stimulus" is now avoided by former proponents of spending stimulus. The recent agreement to extend existing income tax rates represents a shift to more predictable policies.
Unfortunately, the president's State of the Union speech raised doubts about the return to sound policy by stressing more government spending and criticizing further extensions of current personal income tax rates. So it is essential for policy makers to grab the policy pendulum, pull it back toward sound fiscal and monetary policy, and tie it in place so it never swings back again.
They should start by laying out a credible plan to reduce spending and stop the debt explosion. If spending as a share of GDP can be brought to 2000 levels and held there with entitlement reforms, then the budget can be balanced without employment-retarding tax-rate increases. A concrete goal should be to establish a long-term budget that the Congressional Budget Office (CBO) can credibly show would bring the debt-to-GDP ratio to 40%. If the plan is ready for this summer's CBO long-term projections, it will give an immediate boost to economic growth and job creation as uncertainty about debt sustainability falls. An example of what the CBO's next projection might look like is shown in the nearby chart of U.S. debt history along with the CBO's projections made in 2009, 2010 and, if the plan is ready, in 2011.
Some want to delay reducing government spending because of high unemployment and the fragile recovery. But there is no convincing evidence that a gradual and credible reduction in government purchases will increase unemployment. The history of the past two decades shows that lower government purchases as a share of GDP are associated with lower unemployment rates. A much better way to reduce unemployment is to encourage private investment. Over the past two decades, unemployment fell when investment increased as a share of GDP. (See the other nearby chart.)
Meanwhile, the Fed should lay out a plan for reducing its extraordinarily large balance sheet. To achieve a more predictable rules-based policy going forward, the Fed's objectives should be clarified. The Federal Reserve Act now says the Fed must "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." But too many goals blur responsibility and accountability and they allow for confusing changes in emphasis from one goal to another.
Recently the multiple objectives have been used as a rationale for interventionist policies, such as QE2, an approach that Fed officials avoided in the 1980s and '90s. Such interventions can have the unintended consequence of increasing unemployment—as illustrated by the decisions to hold interest rates very low in 2003-2005, which may have caused a bubble and led to the high unemployment today.
It would be better for economic growth and job creation if the Fed's objective was simply "long-run price stability within a clear framework of economic stability." Such a goal would provide a foundation for strong employment growth and would not prevent the Fed from providing liquidity, serving as lender of last resort, and cutting the interest rate in a financial crisis or recession.
The Fed should also be required to report in writing and in hearings its strategy for monetary policy. Such a requirement was removed by Congress in 2000 and should be restored. But rather than reporting only on the monetary aggregates as in the past, the renewed requirement should focus on the strategy for setting interest rates. The Fed should establish its own strategy and report it to Congress.
The Fed would have the discretion to deviate from its strategy in a crisis. But if it does deviate it should be required to report the reasons. This approach provides a degree of political control and accountability appropriate for an independent agency without interfering in day-to-day operations. Such reforms will reverse the short-term focus of policy and help achieve sustained growth and job creation.
Mr. Taylor, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of "Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis" (Hoover Press, 2009). This op-ed was adapted from his testimony before the House Committee on Financial Services this week.
