If you haven’t read economist Arthur Laffer’s Op Ed in today’s Wall Street Journal you should. Mr. Laffer explains how the Federal Reserves unprecedented expansion of the money supply could lead to rising inflation and interest rates that would make the ’70s look benign:
Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be “wasted.” Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.
Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.
With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.
But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.
About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.
The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!
I really don’t have anything to add… Read the whole thing and then start asking your elected representatives some though questions about government spending, taxes and the economy.
- 45% Say Cancel Rest of Stimulus Spending – Rasmussen Reports
Larry Fassio says
To begin with, Laffer did not claim this expansion could lead to inflation, but that it WILL lead to inlation, and implied this would be considerably worse than in the ’70s. Unfortunately, Laffer’s reasoning as related in the article is flawed in some regards and incorrect in others. The huge expaqnsion in the monetary base (by over 1000%!) is certainly reason for concern, as is the 2000%! expansion of bank reserves. However, before jumping to the unexplained assumption that this must lead to inflation, I cannot help but ask the question Laffer left unexplained: where did these reserves come from? Therein would show what impact that reserve expansion would have. There are several other points that I disagree with Laffer on, but I will restrict these comments to the actual likelihood of bothersome inflation. The classic scenario of too much money chasing a static supply of goods resulting in inevitable inflation does not necessarily apply in this scenario. To begin with, capacity utilization in most industries is near or at record lows. Ramping up production would likely result in an even lower unit cost. There is also very little upward pressure on the wage component. Furthermore, that money expansion/supply/demand equation requires that the amount of money increases in the accounts of consumers, not banks holding reserves with the Fed. There is no such increase, or we would not have the current financial crisis.
Thanks Larry, as Laffer notes we’re in largely uncharted territory here. The closest historical parallel I can find to our current situation is the Weimar Republic government of Germany that preceded the Nazis. As I’m sure you’ll recall they deliberately printed money and devalued their currency in order to pay off the crushing national debt imposed on them by the Treaty of Versailles… and as I’m sure you know some suggested that the U.S. will have to follow that model to pay off the rather sizable debt we’re know accumulating.
Anyway, that said, I sincerely hope Laffer is wrong… I’m not optimistic however.
Larry Fassio says
I would like to point out where Laffer is demonstrably wrong. His article notes that “panic-driven monetary policies portend…a concomitant deleterious impact on output and employment not unlike the 1970s”. So, I looked up BLS seasonally adjusted employment stats from 1976-1979. Out of those 48 months, total nonfarm employment dropped in only ONE month, in 4/79, by 62,000. The following month, it grew by 372,000. From 1/76 through 1/80, total employment grew 11.3M, or 14.4%. Just to note the Bush years, from 1/01-1/09, total employment grew by 1.9M or 1.4%. As of 5/09, total employment actually fell below the total on Bush’s initial Inauguration Day. So then I looked up real GDP through another website that showed BEA quarterly stats. For the last 16 quarters of the 1970s, real GDP fell in only ONE quarter, Q3,’77, by $500M. The following quarter, it grew by $15.5B. From Q1,’76 to Q1,’80, real GDP grew by 724.5B, or 16.1%. So, Laffer’s quote is either wrong or a lie.
Larry Fassio says
Laffer’s article inspired me to research what has caused this rapid and large expansion in the monetary base. Looking at stats from the St. Louis Fed and the Federal Reserve itself, one can see several areas that account for the almost $800B expansion in the monetary base between 9/08 and 5/09. Almost $75B came from securities of Bear Stearns and AIG. Over $300B came from the Fed’s purchase of highly rated commercial paper. And about $500B from currency swaps with central banks. Excess reserves held on deposit at the Fed amounted to $877B on 5/20/09, compared to less than $2B last August. While those reserves pay merely 0.25% interest, that rate is above the current T Bill rate, while providing liquidity and security. There are also other areas used by the Fed that increased the monetary base, that have been countered by some actions that have mitigated the increase. Considering the focus of these actions, they are unlikely to stimulate inflation. They certainly have not done so now, as the CPI is lower than a year ago, nor do they seem likely in the future, unless the Fed or banks acted unwisely.