09/15/2012 01:13 pm ET Updated Nov 15, 2012

Daddy, Where Do Jobs Come From?

In discussions about the Fed actions, it occurred to me that many of the explanations that link the Fed's moves to stronger job growth leave out a number of steps in the middle. It's of course not the case that the Fed buys MBS or announces they'll keep rates low and jobs that weren't there before suddenly appear. There's a chain of events that needs to occur and there's plenty of slip twixt the cup and the lip.

So let's talk about the process of job creation, both in normal times and in times like these.

Demand for labor is so-called "derived demand," derived from the demand for goods and services that firms sell to consumers and investors. That can be anything from a Snickers bar (consumer good) to a steel bar (intermediate good) to barroom (investment good). As I explained in greater detail here, in normal times, job creation is a function of a virtuous cycle where growth generates income which drives consumption, signaling investors to new opportunities, generating more growth, etc.

But, of course, stuff happens and the cycle breaks down. There are big market failures, like the Great Recession. There are high levels of inequality that divert growth from reaching enough consumers to generate robust demand throughout the economy. There are inflationary supply shocks (e.g., an oil disruption) that sharply reduce real incomes.

When that stuff happens, monetary and fiscal policies are needed to reset the cycle and a key part of that process is avoiding layoffs and adding new jobs. So how does that work?

With the Fed, it works through lower interest rates. The Fed has a number of tools to lower the cost of borrowing, the idea being that this leads people to take out loans and make new investments that they wouldn't have undertaken at higher interest rates. And those new investments are associated with new jobs.

So, a homebuyer takes advantage of a low mortgage rate, leading to jobs for homebuilders and real estate agents and furniture suppliers. A factory owner takes advantage of low rates to replace old equipment, creating jobs for machine manufacturers. An auto dealer invests in a redesigned show room, a buyer takes advantage of that dealer's low rates and buys a new car there, employing designers, salespeople, and auto suppliers.

And those are just the direct jobs. The newly employed construction worker goes out for lunch near the job site, and the diner needs to add another worker (the jobs multiplier effect).

Those are the links in the chain between monetary policy and jobs, but there are weak links. Low mortgage rates won't do much if the recession itself was a function of a housing bubble that left us with excess housing stock and deleveraging households (relatedly, with millions of homeowners underwater, the opportunity to refi into lower rates-another source of new demand-is also blocked). Even with very low borrowing costs, unless they see more consumer demand, investors won't see much return from taking on new projects. And with global opportunities, they can span the globe for better returns in economies where demand is stronger. In fact, corporate profitability in this recovery has largely been driven by foreign, as opposed to domestic, profits.

What about fiscal policy? How does that chain work to create jobs and what are the weak links?

Well, though economists tend to discuss fiscal policy as a lump, it actually comes in a lot of different flavors and they're not all created equal in terms of bang-for-buck job creation. Basically, the more indirect they are -- the more links in the chain between the policy and job creation--the less effective they are.

For example, for a stimulative tax cut to create a job, a) the recipient must spend, not save, the money from the cut, and b) she must spend it on domestic goods (I mean, of course, that's what has to happen for the tax cut to create a job here as opposed to in China). Again, if you're in a deleveraging cycle, step "a" is a problem. Also, if your tax cuts go to wealthy people who are not income constrained in the first place, don't expect much in terms of job creation.

Other fiscal measures have more reliable job-creation chains. Increasing unemployment benefits or food stamps helps because those folks typically spend the money. And new infrastructure is a pretty direct way to go. Same with state fiscal relief. I remember during the Recovery Act, mayors cancelling planned layoffs the day they received Recovery Act funds.

The punch line is a simple one, but it's one that seems to have been forgotten amidst our increasing love affair in America with laissez-faire economics: the more direct the policy measure -- i.e., the fewer links in the chain between the policy and the job -- the better it will work.

I've seen these processes at work close up and I've come to view this simple insight as a lot more important than I think most economists realize. Even Keynes had relatively little to say about implementation and the relative effectiveness of different types of stimulus. He famously quipped that if the government can't find something useful for people to do, just pay one group to bury bags of money and another group to dig them up.

Ha-Ha. Very helpful, Sir K. But I actually think the great man was onto something. The most direct way to create jobs, the only surefire way to be sure that stimulus will work, is direct job creation. Everything else, including all the Federal Reserve stuff, involves crossing your fingers and hoping the chain holds.

Of course, we live in a dark age where any fiscal policy to create jobs is viewed as European socialism, despite the fact that Europe's gone even more austere than we have. And even among the majority of economists who understand the need for stimulus, direct job creation by the government reeks of an earlier age, invokes boondoggles, and is way too interventionist. They'd rather give a tax cut and let consumer sovereignty and market forces take over.

They're not crazy to feel that way. It would be better for consumer demand to signal which industries should expand and which should shrink. But we just don't always have that luxury, especially in a global economy where investments can flow abroad and import leakage dampens the impact of domestic tax cuts on job growth. And we especially can't count on that sort of stimulus when households are deleveraging.

So, the next time we hit a recession, I'm going to be out there advocating for, if not direct jobs in the public service, something as close to that as we can get, like infrastructure, fiscal relief to states, and subsidized jobs for the disadvantaged.

In fact, I'm not going to wait until the next recession. I'm starting now!

This post originally appeared at Jared Bernstein's On The Economy blog.