Bubbles and Jobless Recoveries

On Tuesday, I reviewed Raghuram Rajan’s Fault Lines on Tuesday and as I said he argues persuasively for a connection between the rise of the “jobless recovery” and the bubble economy. Specifically he says that in recent business cycles the Fed engages in massive easing to break a recession (so far so good) but then doesn’t pull away from that easing even when growth has returned, since there’s still high unemployment and no sign of inflation. This is intended to stimulate business investment and therefore employment, but in practice it creates massive asset price bubbles. Rajan thinks the Fed should target not just inflation but assets as well, tighten earlier, and that we should deal with the plight of the unemployed with longer and more generous unemployment benefits.

As I said previously, that sounds to be like a recipe for massive structural long-term unemployment and an economy that’s permanently operating at a depressed level of output. What’s more, when you think about putting this into practice there are major macroeconomic risks related to deflation. As I understand him, Rajan’s theory implies that right now the Fed should be tightening—GDP is growing and asset prices are rising, so never mind inflation or unemployment. But look at inflation:

By either the Cleveland or the standard core CPI measure, it seems to me that following Rajan’s prescription would seriously imperil the economy.

My question is whether there isn’t some more direct way of taking on his diagnosis. It seems to me that economic researchers don’t really understand why recoveries have turned “jobless” very well. If we knew what the issue was exactly, then maybe we could target it more precisely. Alternatively, the issue may be that the automatic fiscal stabilizers we have in place don’t do a good enough job of targeting employment. Could we make the payroll tax rate vary countercyclically? Would changes in tax policy do a better job of channeling loose money into real business investment rather than speculation? I don’t have the answers to these questions, but I wish Rajan had considered more alternative prescriptions and that in general I was seeing more people writing on how we should be responding to the jobless recovery trend.