It hasn’t really made the front pages, but the United States recently began carrying out a massive and nearly unprecedented economic experiment, and 2013 looks to be the year when the results come in. The question is straightforward: When the economy is in a deep slump, and the government makes things worse by cutting spending, how much can monetary policy do to help? The answer could reshape the way we argue about economic policy, with profound implications for progressives’ economic priorities — and big opportunities, if they can seize them.

First, a quick refresher. Just like blood carries nutrients to the cells of the body, enabling them to function, the flow of money through an economy enables people to keep buying, selling, and earning incomes. Keeping the supply of money in line with the economy’s changing needs is the job of the Federal Reserve, and normally it does so by adjusting interest rates. Raising them sucks money out of the economy and reins in inflation. Cutting them pumps money into the economy, boosting wages and job growth. And most of the time, most economists agree this is the primary tool for guiding the economy out of its periodic slumps.

But with the 2008 crash the United States entered largely uncharted economic waters, and that agreement blew apart. That’s because the Great Recession was so deep that cutting interest rates all the way to zero still wasn’t enough to boost the economy into a recovery. Economists call it the “zero lower bound.” And while it’s a wall that modern western economies don’t hit often, 2013 will be the fifth year running the United States has been up against it.

So far, progressives have tended to side with economists like Paul Krugman and bloggers like Mike Konczal. They argue that monetary policy is severely weakened at the zero lower bound, when government must take over the job of pumping money into the economy by borrowing and spending. They point out that economic growth was a measly 2.5 percent for 2013’s first quarter, and market data suggests the Fed has failed to convince anyone it’s willing to let inflation get unusually high before it hits the brakes. This despite multiple rounds of “quantitative easing,” an attempt by the Fed to get around the zero lower bound by purchasing huge numbers of financial instruments, thus injecting money into the economy

But economists like David Beckworth and Scott Sumner countered that the economy’s 2.5 percent growth rate stuck around despite blows from multiple rounds of spending cuts, the European crisis, and worries about China. In fact, as Beckworth pointed out, government spending began shrinking by the start of 2010 — yet the economy just kept puttering along at 2.5 percent.

Other points in Beckworth and Sumner’s favor: Before sequestration, the latest round of across-the-board spending cuts, began, the group Macroeconomic Advisors projected growth for the first quarter below 2.5 percent if sequestration didn’t happen. Then the May 3 jobs report, which came out after Konczal’s piece, was so good it was almost shocking. Matt Yglesias and Ryan Avent, two other fans of monetary policy’s salutary effects, pointed to other data sources that suggest the Fed actually has been able to raise long-term inflation expectations.

So this looks like at least a preliminary win for team monetary policy. Granted, the evidence is also very preliminary. Getting economic data in real time is tough, and the full force of sequestration still hasn’t hit. So at a minimum, we won’t have a better idea until at least the second half of this year. But there’s a real possibility monetary policy has put a floor under economic growth — despite the government’s demented insistence on spending cuts and sequestration — and might even be able to do more if the Fed gets more ambitious.

So what if QE3 continues apace, sequestration remains in effect, and economic growth just keeps chugging along around 2.5 percent? What should our take-away be?

Well, Beckworth and Sumner tend to be fans of austerity and small government, for obvious reasons: if fiscal drag can always be offset by monetary policy, why not cut away? But this logic can be turned on its head, because recessions drive up spending and drive down revenues, even when policy itself remains unchanged. Far more than the real-but-modest imbalance between tax and spending left by the Bush presidency, the 2008 crash is what drove the federal government deep into the red. Employment and incomes dropped, so tax receipts dried up. But more people became impoverished and unemployed, thus qualifying for safety net programs, meaning spending automatically increased. Conversely, nothing balances a budget like economic growth. If monetary policy really has the power to guide us back out of even the steepest recession, then that is the way to reduce deficits, not austerity.

Progressives need to make monetary policy something politicians have to answer for. The Fed’s policy is set by the 12 voting members of the Federal Open Market Committee (FOMC), seven of whom are appointed by the president and confirmed by the Senate. This process, and the views on monetary policy of the people who are appointed by it, deserves every bit as much scrutiny from activists, organizations, and politicians as Supreme Court nominations. Republicans and Tea Partiers have relentlessly warn of runaway inflation and denounced quantitative easing, even in the midst of the slump. But outside a rarified group of bloggers, there’s been no serious pushback from the left, or even any real sense that monetary policy is understood as a specific issue worth getting mad about.

Unfortunately, the other five voting members are not vetted by democratically elected officials, and are instead drawn from the Fed’s district banks. That means they come from a social and professional milieu likely to bias them in favor of the worldview of the financial industry, business owners, and the wealthy. Those groups all have vested interests in minimizing inflation while ignoring job growth.

Still, the Fed’s recent announcement — that quantitative easing will be open-ended, with an eye to getting unemployment below 6.5 percent, and allowing inflation to go as high as 2.5 percent — was step in the right direction. But the inflation threshold is too low. Arguably, 4 percent would better balance stable prices with the need for job growth. The Fed is also limiting its purchases to the same amount every month: $85 billion. It’s hinted it might start varying that based on how it reads the economy’s needs, and progressives should pressure it to do so. As Beckworth put it, buying the same amount every month is like putting the same amount of pressure on the gas pedal, no matter what sort of terrain you’re driving over.

Finally, we need a wholesale reform of the way the Fed does business, making the institution more accountable to the needs of everyday working Americans. The simplest way, as Matt Yglesias recommended, would be to cut the five un-appointed members out of the FOMC’s decision-making process. That, or find some other way to bring the entire board under direct accountability to elected officials.

The Fed’s mandate could use a touch up as well. Right now, it merely instructs that inflation be kept down, and employment be kept up. All the Fed’s actual targets are of its own devising, and it can change them as it sees fit. It’s not obvious when economic trends are above or below where the Fed wants them to be, or how it intends to move in response. So Fed watchers pour over its pronouncements in a recurring act of glorified tea leaf reading, parsing the statements for clues of intent or disagreement amongst the FOMC members.

The process is so absurdly vague that, as Konczal noted, the bursts of news from the FOMC’s internal divisions undermine the Fed’s ability to credibly promise sustained monetary stimulus. In the vacuum of certainty, economic players often assume the Fed will put the brakes on the economy as soon as inflation begins to tick up. (There’s that bias in favor of the wealthy again.) The Fed’s targets and its obligation to hit them should be explicitly given to it by law. That could be an explicit inflation target, or a nominal gross domestic product target — which combines the level of inflation and GDP growth — as Sumner and Beckworth have suggested.

Zooming back out to the big picture, the fact is that the political forces pushing for fiscal austerity are the same ones pushing for monetary austerity. Movement in progressives’ favor on one issue is likely to bleed into the other. So while Krugman was wrong to dismiss the case for monetary policy as quickly as he did, his final conclusion was right: we should be throwing every policy tool we’ve got at the economic slump.

It’s just that up until now, progressives haven’t been giving monetary policy the respect it deserves. 2013 is the year they should start.

This morning’s report that the U.S. economy grew 2.5 percent in 2013′s first quarter wasn’t horrible, although it was still disappointing. But there was an even more discouraging number Americans should also pay attention to: inflation was a mere 1.1 percent.

While many think low inflation is a good thing, Johns Hopkins economist Laurence Ball published a new paper that argues two percent inflation, which American policy is currently targeting, is too low and that we should be aiming for four percent.

The key factor here is the Federal Reserve’s control over interest rates, which is an important tool for guiding the economy. When the Fed wants to boost the economy out of a recession, it cuts interest rates. When it wants to rein in inflation, it raises them. And for the last two decades, it’s done very well at keeping inflation to a historically low two percent.

That’s doing more harm than good, according to Ball, because it prevents the Fed from fighting economic slumps. The Fed can’t cut interest rates below zero, so there’s a floor on how much help it can provide in a depression, called the “zero lower bound.” And if the Fed keeps inflation low over the long-term, that will leave it less room to cut rates when another recession hits. Ball found the zero lower bound held Fed policy far back from where it should’ve been after the 2008 crash. He also looked at seven other recessions since 1960; in three of them, if inflation had only been two percent, the Fed would’ve also hit the zero lower bound.

Ball calculated that if inflation had been 4 percent going into 2008, giving the Fed two extra percentage points to cut from interest rates, the resulting shot in the arm would’ve increased the size of the economy by 5.9 percent in 2013. More importantly, the unemployment rate would be five percent instead of 7.6 percent — meaning just over four million fewer Americans would be out of work.

Furthermore, history shows that four percent inflation isn’t particularly dangerous. After reviewing the literature on high inflation across countries, Ball concluded genuine economic damage didn’t happen until the rate hit 8 percent. The calamitous inflation Americans remember from the 1970s, for example, peaked at 12.5 and 15 percent. As Matt Yglesias once quipped, Ronald Reagan’s “Morning in America” economic boom came with about four percent inflation.

The Washington Post flagged a new study today from a Dartmouth professor and co-authors, which found that high unemployment causes much more misery for the average person than high inflation. That’s significant, in a really discouraging way, because American policy over the last few decades — and especially since the Great Recession — has focused overwhelmingly on keeping inflation low.

The research used several different surveys of well-being and self-reported happiness — cross-referenced with other measures to try to control for the inherent subjectivity — done across both the United States and Europe since the 1970s. This sort of research certainly isn’t the end-all measurement of the effects of economic policy, but well-being and happiness research are relatively well-developed now. They’re worth taking seriously “as a complement to standard approaches,” as the authors put it.

At any rate, when they broke down the numbers for periods of high inflation and high unemployment, and how the two interact, the researchers found human beings are hurt far more by unemployment than inflation:

We estimate the unemployment/inflation trade-off as approximately 3.8. That is to say a one percentage point increase in unemployment lowers well-being nearly four times more than an equivalent rise in inflation. Excluding the five main euro area countries that are especially worried about inflation — Germany, Austria, France, Finland and Austria — the elasticity rises to over six times.

A big reason for this, as the Washington Post sums it up, is that unemployment not only effects people who lost their jobs, “it also generates fear among that person’s family, friends and neighbors over their own job security. The unemployed person may also turn to them for financial or other help, further affecting their well-being.” Meanwhile, inflation is a rise in the general level of prices in the economy — which includes labor more than anything else — so it can’t push up the cost of goods and services without also pushing up incomes. In fact, the single biggest cause of inflation is upward pressure put on consumer prices by growing wages. So there’s a largely unavoidable trade-off between controlling inflation and growing the economy.

Unfortunately, over the last few decades, and especially since the 2008 collapse, the United States has done a much better job minimizing inflation then maximizing employment:

We’ve been consistently hitting our two percent inflation target, even though unemployment remains over seven percent, and an inflation level of three or even four percent is perfectly compatible with (perhaps even better for) a robustly growing economy.

There are several reasons for this imbalance. The Federal Reserve — which controls interest rates and the money supply, and is tasked with the dual mandate to control inflation and boost employment — is intertangled with the banking and financial industry, which has much more interest in lowering inflation. Republicans have also brought a lot of pressure to bear on the Fed to fight inflation, with no serious opposing push-back to prioritize employment. Finally, the decades-long drive to stabilize inflation at two percent has arguably gotten the economy into a rut; it’s now more difficult for job growth to rebound from a recession, and the Fed itself is left with fewer tools to help.

The Federal Reserve released its statement from the latest Federal Open Market Committee meeting this past week. Its projections see economic growth reaching 3.8 percent at best over the next three years, hovering between two and three percent per year after that, and finally driving unemployment down to between five and six percent after 2015.

None of that is especially new or encouraging. But on Wednesday, Ryan Avent at The Economist pointed out another number in the report that hints at a more subtle, but possibly more pernicious problem. It’s the federal funds rate, which is the interest rate the Fed charges other banks when it lends them money — thereby guiding interest rates throughout the economy — and which has basically been at zero since the Great Recession:

If recovery proceeds as the Fed anticipates, its interest-rate target will remain at near zero until at least 2015. Perhaps more worrying, the FOMC’s best guess at the appropriate, long-run value of the fed funds rate is about 4 percent. That is strikingly low. In each of the past three recessions the Fed has responded by cutting the fed funds rate more than 4 percentage points. A fed funds rate at that level virtually guarantees that the next downturn will result in a relapse into [zero lower bound] territory.

The Fed has a dual mandate to control inflation and maximize employment, and the federal funds rate is the mechanism by which it does both. It can boost the economy by cutting the rate, or rein in inflation by raising the rate. So there’s an inherent balancing act, and the Fed needs room to go in both directions. That’s why, over the past 40 years, the rate only briefly dipped below the four percent mark, and spent most of the boom-time 90s at over five percent:

There’s an imbalance in the Fed’s policy toolkit, in that it can raise the rate as high as it wants to fight inflation, but it can’t cut it past zero to boost the economy and job growth. That’s the problem of the “zero lower bound” Avent refers to. If the rate doesn’t get above four percent, but the Fed needs to cut at least that much to boost the economy, then there’s just not going to be much room to maneuver when the next recession rolls around.

Some economists such as Paul Krugman argue that when monetary policy hits the zero lower bound, fiscal policy (i.e. stimulus spending) becomes the primary tool to help the economy. But others, like Scott Sumner, argue that quantitative easing and other forms of unconventional monetary policy can still work just as well if not better than fiscal policy when the federal funds rate is at zero.

Unfortunately, Republicans are vociferously opposed to both policies. They’ve relentlessly pressured the Fed and Chairman Ben Bernanke to end quantitative easing or even hike the federal funds rate, incessantly warning of runaway inflation that never materializes. There’s also been no real opposing pressure from Democrats or progressives to prioritize job growth. The Fed’s latest form of quantitative easing has been a big step in the right direction, but several members of the governing committee or so skittish they’ve proposed ending it as early as this year.

On top of that, the way the Fed is designed and governed saddles it with additional biases towards cutting inflation over pushing up employment. As an institution, it’s more attuned to the concerns of the financial industry, business owners and the wealthy. Those groups are generally indifferent to sluggish economic growth — they’re the last to lose their homes or livelihoods if the economy implodes or unemployment spikes — but they all have a vested interest in low and stable inflation.

So not surprisingly, for the last twenty years or more, low and stable inflation is exactly what the country got. Even after the Great Recession, the Fed consistently hit its two percent inflation target, even as its counterbalancing mandate to boost employment was essentially ignored:

Arguably, the fundamental problem is the Fed did too good a job at reining in inflation.

Inflation is the natural response of an economy to robust growth, as rising wages put upward pressure on other prices. A Fed devoted to controlling inflation above all else will inevitably also weigh down jobs and wages for working Americans. “Morning in America,” the economic boom of the Reagan years, was accompanied by four percent inflation on average — twice the level we’re seeing now.

The last few decades of low inflation also came alongside stagnating median wages, and a new form of “jobless” recovery that brings back economic growth, but not the job growth of previous post-war recoveries. The result has been a self-reinforcing downward spiral, as stalled wages bring more inequality and less inflation, eliminating the need for a higher federal funds rate and ultimately leaving the Fed with ever less ammunition to boost employment with each successive recession.

Certainly, the Fed’s preference for exceedingly low inflation is not the whole cause behind slow wage growth and rampant inequality. But it’s most likely a big part.

The Federal Reserve — which has a dual mandate to ensure price stability and maximum employment — recently adopted an explicit target for the labor market, saying it will not end its efforts to boost the economy until unemployment is around 6.5 percent. Members of the Federal Reserve Board and economists had been pushing for the central bank to adopt such a target in light of the fact that unemployment was staying stubbornly high while inflation wasn’t increasing.

But some GOP senators want the Fed to toss aside the employment part of its mandate and focus exclusively on inflation:

Sen. Bob Corker (R-Tenn.) said Monday that he and Sen. David Vitter (R-La.) were introducing a bill to make it clear that the Federal Reserve should focus on a single mandate — stabilizing prices by keeping inflation low.

On the Senate floor Monday, Corker said the Federal Reserve Single Mandate Act would reestablish price stability as the Federal Reserve’s single mandate rather than also having the Fed work on reducing unemployment.

“Providing the Fed with a clear and explicit focus on keeping inflation low will serve America better than the broad, bipolar mandate it has today,” Corker said. “The dual mandate blurs the line between fiscal and monetary policy and allows Congress to shirk its responsibility to enact sound budgets and policies that produce economic growth.”

This has been an idea Republicans have floated a few times in recent years. But doing so would remove the one big lever left to combat joblessness, since the GOP has made it abundantly clear that Congress will not be engaging in any fiscal stimulus any time soon.

As Federal Reserve Chairman Ben Bernanke explained when defending the Fed’s recent efforts, “The conditions now prevailing in the job market represent an enormous waste of human and economic potential…Meanwhile, apart from some temporarily fluctuations, largely reflected swings in energy prices, inflation has remained tame…Against a macro economic backdrop that includes both high unemployment and subdued inflation, the FOMC will maintain its highly accommodative policy.” But the GOP would prefer that the Fed continue to fixate on non-existent inflation, at the expense of the unemployed.

While America’s recovery from the 2008 recession has hardly been booming — economic growth remains sluggish and unemployment is still a discouragingly high 7.8 percent — it’s actually been better than Europe’s. “The economy of the European Union will shrink by 0.2 percent this year, according to the International Monetary Fund. It is smaller than it was five years ago, while the American economy is 2.9 percent bigger,” noted New York Times reporter Eduardo Porter. Even two of Europe’s most impressive economies, Germany and Austria, are predicted to grow at half the U.S. rate over the next two years.

More strikingly, for all the stereotypes of Europe as a liberal haven, the United States actually hewed closer to the activist, Keynesian responses advocated by the American left-wing than did European policy makers:

Germany’s insistence that indebted Mediterranean countries cut government spending deepened recessions in those nations. [...]

[The United States Federal Reserve was] far more aggressive than the European Central Bank, quicker to drop interest rates to zero and pump money into the economy, buying government debt and other bonds. Fiscal stimulus — an initial $800 billion package in 2009 followed by about $600 billion in payroll tax cuts and other efforts — was bigger and more sustained than in other advanced countries. Banks in the United States were forced to raise billions in new capital, which allowed them to cope with the turbulent financial markets better than their European peers. [...]

Today, most economists say they believe that these policies provided vital support to the economy. In its most recent World Economic Outlook, published this month, the I.M.F. acknowledged that the fiscal stimulus was probably much more effective at bolstering growth than it had previously allowed.

While the sample size of developed western countries is small, comparing the different stimulus packages as a share of the economy with how much economic growth followed produces a positive correlation.

Of course, the effects of the 2008 crash were not distributed evenly across the international stage, and a few countries have bounced back faster than the United States. But those nations tend to be outliers in terms of their banking system or their reliance on exports. The Times article cites recent work by economists Carmen Reinhart and Kenneth Rogoff, which attempts to disentangle economies that suffered a systemic financial crisis from ones that merely suffered a boderline crisis. Under that apples-to-apples comparison, America’s per capita GDP has done noticeably better.

Higher economic growth does not necessarily translate directly into higher job growth, and as Porter also observes, one area where the United States has generally underperformed Europe is employment. But that’s largely because Europe has stronger unions, more regulations making it harder to fire workers, and because several European countries subsidize wages or subsidize companies to encourage them to keep workers on — hardly approaches advocated by American critics of left-wing economic policy.

Generally speaking, while the United States’ policy response to the recession was a watered-down version of what left-wing economists and advocates preferred, it came closer to meeting that model than the European response — which hewed closer to the right-wing austerity model. And since then, the U.S. recovery has noticeably outperformed Europe’s.

Federal Reserve Board Governor Daniel Tarullo called for placing limits on bank size in a speech yesterday, making him one of the highest ranking economic officials to propose a remedy to reduce big bank dominance of the economy. Tarullo said that, in order to keep big banks from growing so large that they threaten the entire financial system, they should be limited in size to a certain percentage of the overall economy:

The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis. In addition to the virtue of simplicity, this approach has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm’s dependence on funding from sources other than the stable base of deposits. While Section 622 of [the Dodd-Frank financial reform law] contains a financial sector concentration limit, it is based on a somewhat awkward and potentially shifting metric of the aggregated consolidated liabilities of all “financial companies.”

Tarullo also said that “the Fed should block any merger or acquisition this group of big banks attempts to make,” which it is allowed to do under Dodd-Frank.

Last month, former Bank of America executive Sallie Krawcheck said that the complexity of today’s Wall Street banks “makes you weep blood out of your eyes.“ She joined a parade of former Wall Street bankers calling for limiting the size and systemic importance of the nation’s biggest financial firms. Even former Citigroup CEO Sandy Weill, who is credited with creating the superbank, said, “What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail.”

The Federal Reserve last week announced a new round of so called quantitative easing, or QE3, in an attempt to boost the still sluggish economy. The Fed, for the first time, opened the door to continuous easing until labor market conditions improve.

Republicans predictably took issue with the move (even as they admitted that it could be good for economic growth). But in a speech today, New York Federal Reserve President William Dudley defended the Fed’s action, saying that it is consistent with the Fed’s mandate to produce full employment:

In my view, the decision to ease policy further is fully consistent with our dual mandate and policy framework. As I mentioned earlier, we have two goals—to promote maximum employment and price stability. We therefore seek to minimize how far employment is from its long run normal level and inflation is from our longer-run goal of 2 percent on the PCE measure. [...]

Looking ahead, in the absence of further monetary easing, I concluded that growth would remain too subdued over the next several years to make big inroads into the spare capacity that remains from the Great Recession. As a result, unemployment would remain unacceptably high, with economic risks skewed to the downside. Meanwhile, with substantial slack in labor markets and inflation expectations stable, inflation was likely to remain a bit below our 2 per cent longer-run objective.

In this situation, I concluded that our policy framework means that further monetary policy easing was appropriate provided that the benefits of using the tools available outweighed the costs.

As ThinkProgress has noted, the Fed has consistently failed to meet its dual mandate of low inflation and full employment, as inflation has stayed low but unemployment has remained high. Federal Reserve Chairman Ben Bernanke estimated that the first two rounds of quantitative easing created two million jobs.

Last week, Federal Reserve Chairman Ben Bernanke announced his institution would launch a third round of quantitative easing — the monetary stimulus the Fed has used intermittently to boost the economy since 2008 — in an effort to finally fulfill the “reduce unemployment” half of the Fed’s dual mandate. In response, Vice Presidential Candidate Paul Ryan denounced the move as “sugar high economics” and repeated to the Christian Broadcasting Network his assertion that “the costs outweigh the benefits” of QE:

I’m not a fan of QE3. I wasn’t a fan of QE2 either. I think in the long run it will do more harm than good. But what this is is it’s the Federal Reserve and the monetary policy trying to bail out the fact that we have terrible leadership on fiscal policy from President Obama…

I fear that it undermines the ultimate credibility of our currency, of our money and you need to have sound money. It’s a necessary pre-condition for economic growth. We have loose money already so it’s not a question of having too tight of a monetary policy. We have exceptionally loose monetary policy… This kind of easing hurts savers, questions the credibility of our currency, and I think ultimately the costs outweigh the benefits.

Watch it:

ThinkProgress already reported on the problems in Paul Ryan’s cost/benefit analysis: Inflation remains at a near-historic low of 2 percent — far below the 12 percent inflation of the 1970s — while unemployment is still at 8 percent. The Fed’s interest rates have nowhere to go but up, meaning inflation could be easily reined in if it began to dangerously rise.

Bernanke himself has already estimated the initial rounds of QE created as many as 2 million jobs. And the “savers” that Ryan says could be hurt are in fact a very narrow group, according to Dean Baker of the Center for Economic and Policy Research: “Realistically there are not a lot of people who both have substantial savings (enough that the interest makes up a big share of their income) and who kept it exclusively in short-term assets… The winners from a policy to boost growth through lower interest rates vastly outnumber the losers.”

Ryan’s claim that monetary policy is already “exceptionally loose” is also questionable. Milton Friedman, the 20th century economist beloved by many conservatives, argued that interest rates are actually poor indicators of monetary policy. Better indicators are inflation and nominal GDP growth, a view with which Bernanke has concurred. Both the inflation and NGDP growth trends suggest monetary policy is actually too tight.

Ryan is certainly right that monetary stimulus is a second-best option for boosting the economy after better fiscal policy. But the international and domestic evidence shows that Ryan’s preferred fiscal policy would drive the economy further into the ground. Meanwhile, the Republicans’ control of the House and their filibuster in the Senate have enabled them to torpedo fiscal policy that would actually help.