Tag: inflation

End the Fed: More than Just a Bumper Sticker Slogan?

To put it mildly, the Federal Reserve has a dismal track record. It bears significant responsibility for almost every major economic upheaval of the past 100 years, including the Great Depression, the 1970s stagflation, and the recent financial crisis. Perhaps the most damning statistic is that the dollar has lost 95 percent of its value since the central bank was created.

Notwithstanding its poor performance, the Federal Reserve seems to get more power over time. But rather than rewarding the central bank for debasing the currency and causing instability, perhaps it’s time to contemplate alternatives. This new video from the Center for Freedom and Prosperity dives into that issue, exposing the Fed’s poor track record, explaining how central banking evolved, and mentioning possible alternatives.

This video is the first installment of a multi-part series on monetary policy. Subsequent videos will examine possible alternatives to monopoly central banks, including a gold standard, free banking, and monetary rules to limit the Fed’s discretion.

As they say, stay tuned.

Misunderstanding Inflation through the Years

NPR reports on rising food prices across the world. They may have played some role in the revolts in Tunisia and Egypt, and if so, those wouldn’t be the first revolutions sparked by inflation. NPR reporter Marilyn Geewax mentioned several reasons that food prices are rising – droughts, floods, oil prices, financial speculation – but not the obvious one: the continuing creation of unbacked money by central banks around the world. As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” And as Jerry O’Driscoll wrote just two weeks ago, about rising food prices, “Inflation is here.” But that point isn’t yet universally understood, at least not at our government radio network.

Anyway, I turned off the radio and turned on the television, where TCM was just broadcasting the 1942 MGM propaganda film “Inflation” (made at the request of the Office of War Information but then never released because it was too anti-capitalist even for wartime propaganda). Edward Arnold plays the Devil, in league with Hitler and posing as a businessman who who encourages people to buy more, evade price controls, stockpile goods, and use the black market. (The film was made by Cy Endfield, who had been a member of the Young Communist League at Yale and went on to make such films as Zulu and Universal Soldier.) The film features what appears to be President Franklin D. Roosevelt’s April 28, 1942, radio speech, “Total War and Total Effort.” As the young couple in the film go to buy a new radio, the shopkeeper turns on the radio and they hear FDR say:

You do not have to be a professor of mathematics or economics to see that if people with plenty of cash start bidding against each other for scarce goods, the price of those goods (them) goes up.

Yesterday I submitted to the Congress of the United states a seven-point program, a program of general principles which taken together could be called the national economic policy for attaining the great objective of keeping the cost of living down. I repeat them now to you in substance:

First. we must, through heavier taxes, keep personal and corporate profits at a low reasonable rate.
Second. We must fix ceilings on prices and rents.
Third. We must stabilize wages.
Fourth. We must stabilize farm prices.
Fifth. We must put more billions into War Bonds.
Sixth. We must ration all essential commodities which are scarce.
Seventh. We must discourage installment buying, and encourage paying off debts and mortgages.

As it happens, I have a 1942 OWI poster with that same message hanging in my kitchen:

In fact, of course, price inflation was the natural result of a substantial increase in the money supply before and during the war. All of FDR’s policies – cartels, destruction of crops, wage and price controls, rationing – were misguided attempts to deal with the consequences of monetary manipulation and other bad policies.

By the way, FDR famously said, “The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.” Which might explain another propaganda film produced by MGM, this one in 1933, that extolled the virtues of FDR’s policy of inflation, utilizing the argument that is variously called “stimulus” or “the broken window fallacy.” The film cited the successful results of Civil War inflation. “What inflation has done before it will do again! … What a man! And what a leader! Yowzer! Happy days are here again!” Yeah, that went well. And by 1942 MGM was back on board, making a government propaganda film opposing inflation.

For background on inflation, read Cato adjunct scholar Lawrence H. White at the Concise Encylopedia of Economics.

Fannie & China: 2 Birds, 1 Stone

Chinese President Hu Jintao’s visit to Washington brought renewed focus on China’s currency.  It was likely the largest point of discussion between President Obama and President Hu.  I suspect a less public, but related, issue was China looking for some certainty that America would make good on its obligations; after all, China is our largest lender.

What is often missed is the connection between these two issues:  currency and debt.  When China receives dollars for the many goods it sells us, instead of recycling those dollars into the purchase of US goods, it uses that money mostly to buy US Treasuries and Agencies (Fannie/Freddie securities).  These large Treasury/Agency purchases (foreign holdings of GSE debt are over $1 trillion) have the effect of increasing the demand for dollars and depressing that for yuan, resulting in an appreciation of the dollar relative to the yuan.  This connection exposes the hypocrisy of President Obama’s complaints about China currency manipulation - without massive US budget deficits, China would not be able to manipulate its currency to the extent it does.  If the US wants to end that manipulation, it can do so by simply reducing the outstanding supply of Treasuries and Agency debt.

Another solution, which would also do much to end the “implicit guarantees” of Fannie Mae and Freddie Mac, is to take Fannie and Freddie into a receivership, stop the US taxpayer from having to cover their losses, and shift those losses to junior creditors, which include the Chinese Central Bank.  Were the Chinese to actually suffer credit losses on their GSE debt, they would quickly start to reduce their holdings of such.  They might also cut back on Treasury holdings.  These actions would force the yuan to appreciate relative to the dollar.  And best of all, it would end the bottomless pit that Fannie and Freddie have become.  It is worth remembering that even today, under statute, the Federal government does not back the debt of Fannie and Freddie.  It is about time we also teach the Chinese a lesson about the rule of law, by actually following it ourselves. 

Of course this would increase the borrowing costs for Agencies (and maybe Treasuries), but then if China were to free float its currency, that would also reduce the demand for Treasuries/Agencies with a resulting increase in borrowing costs.  We cannot have it both ways.

Appreciating China’s Currency

China’s President Hu Jintau arrives in Washington today for a state visit, turning the spotlight once again on U.S.-China trade and China’s allegedly undervalued currency, the yuan. Not one to let such an opportunity go to waste, Sen. Charles Schumer (D-N.Y.) is introducing legislation that would threaten to impose duties on imports from China if the yuan does not appreciate quickly.

Count me skeptical that a more expensive yuan relative to the U.S. dollar would make much of a dent in our bilateral trade deficit with China, or that it would have any positive effect on U.S. economic growth and employment. But even if those assumptions were true, the big story is how much the yuan as already appreciated against the dollar.

It has been a mantra of Sen. Schumer and other critics of U.S.-China trade that the yuan is undervalued by 15 to 40 percent. They were saying that before the 2005 appreciation, and they’re saying that now, as though nothing has changed.

Yet a lot has changed. In nominal terms, the yuan appreciated by more than 20 percent between 2005 and 2008. That’s when China relaxed its hard peg with the dollar and allowed its currency to gradually appreciate. After holding the peg steady again during the recent financial turmoil, China has again allowed it to rise another 3 percent since last June.

The nominal rate is just part of the story, however. Price levels in the United States and China determine the real exchange rate–the actual amount of goods that can be bought with each currency. A big story in China recently is its rising inflation rate, which makes Chinese goods relatively more expensive at any given exchange rate. In this way, a relatively higher inflation rate in China compared to the United States acts in the same was as a nominal increase in the exchange rate of the yuan.

When you combine the effect of rising prices in China with the higher nominal value of the yuan, you get a double boost to the real exchange rate. According to a chart on the front page of this morning’s Wall Street Journal, the real value of the yuan has appreciated by 50 percent since the beginning of 2005. In early 2005, 100 Chinese yuan could be exchanged for about $12; today it can be exchanged for $18 (in real, inflation adjusted dollars).

Rather than complain, Sen. Schumer and his allies should congratulate themselves on achieving their goal of a much stronger yuan and a much weaker dollar, even if we are still waiting for the tonic effect they predicted it would have on jobs and growth.

Inflation Is Here

“Faced with rising international food prices,” Steven Mufson writes in the Washington Post, “governments around the world are cooking up measures to protect domestic supplies and keep a lid on prices at home.” Instead of export bans, subsidies, and price controls, governments might better consider the role of their central banks in creating money out of thin air and causing price inflation. Cato senior fellow Gerald P. O’Driscoll, Jr., made that point at the blog ThinkMarkets:

“Prices Soar on Crop Woes” reads the headline in today’s Wall Street Journal.

Global output of key crops such as corn, soybeans and wheat is down, and their prices are up, respectively, 94%, 51% and 80% from June lows. Today’s PPI report has wholesale prices up 1.1% in December after rising 0.8% in November. The Journal reminds us that in 2008 high food prices sparked riots around the world.

Meanwhile Fed officials tell us they don’t expect inflation.  It is not an issue of expecting inflation, but of observing it here and now.  The Fed prefers, of course, to look at “core” inflation rates, which are much lower. A former Fed colleague explained to me the central bank does so on the theory that people do not need to drive to work and can stop eating.

In our global economy, easy US monetary policy has thus far mainly affected commodity prices (including now food), real-estate in Asia and now broader price measures in Asia. It is implausible that the US would remain unaffected. Food, energy and clothing prices are all rising. I don’t think many households are presently gripped with a fear of deflation.

In the Mises/Hayek theory of economic fluctuations, the transmission of monetary shocks works through producer prices and incomes, and only later consumer prices. No measure of consumer prices, and certainly not a subset of consumer prices, is an adequate gauge of inflation.

(For another take on rising food prices, you can read the views of Paul Krugman and Lester Brown, who say that at last – at last! – we really are running into those “binding resource constraints” that Brown has been predicting for his entire life and that will finally require us to start living at Chinese levels.)


Do Inflation Expectations Drive Consumption?

After proponents of the Federal Reserve’s second round of quantitative easing (QE2) abandoned the argument that QE2 would spur growth by bringing down interest rates (only after rates increased), the new defense became “we intended for rates to go up all along, as a result of increased inflation expectations.”  Since few would argue for increased inflation, or expectations of such, as an end in itself, the claim was that increases in inflation expectations would drive households to consume more, which would in turn causes businesses to hire more, bringing down the unemployment rate.  But does this chain of reasoning withstand empirical scrutiny?

It turns out looking at the historical data on inflation expectations, as collected at the University of Michigan, that inflation expectations and household savings rates (the inverse of consumption rates) are positively correlated.  Now of course correlation doesn’t mean causality,but what the data suggest is that instead of consuming more when inflation expectations increase, households have actually saved more.  This positive correlation also holds for the second half of the data series, so it’s not simply the result of a downward trend in either inflation or savings.

To review, the latest argument for QE2:  increase inflation expectations, which is assumed to increase consumption, which is hoped to increase employment.  The problem I’ve had all along with this position is that the only thing we know for certain is the first part, QE2 would increase inflation expectations.  The hope that it would increase consumption and hence employment was just that:  hope.  Given the disconnect we’ve seen between consumption and unemployment over the past 18 months, the third link in that chain is also a weak one.   So what do we have at the end of the day:  certain costs with fairly speculative and uncertain benefits.  And here I was thinking that reckless speculation was the sole province of the private sector.

Economic Slack and Inflation

While listening to NPR this morning, I was subjected to yet another economist claiming that we cannot have inflation in an environment of such high economic slack.  Setting aside the fact that perhaps this economist missed the 1970s, this is a vital question to examine, because it is the foundation of so much of Bernanke and the Federal Reserve’s current thinking.  That is, the notion that inflation is always and everywhere the result of an over-heating, or excess demand, economy.

One of the measures commonly followed by the Fed, and others of the slack-restrains-inflation school, is the measure of capacity utilization rate.  Setting aside some of the problems with this measure, are increases in capacity utilization associated with increasing inflation, as would be suggested by the slack-restraint school?  It turns out not.  Since 1967, when the data series begins, the correlation between capacity utilization and inflation, as measured by the consumer price index (CPI), has been negative.  That is, as more and more industrial and economic resources have been brought into use, inflation has actually fallen, rather than risen (as would be predicted).  A negative correlation also implies that low or falling capacity utilization does not mean low inflation.

Now what is positively correlated with inflation is the growth in the money supply.   The chart below shows annual changes in both CPI and M2.  Even just eye-balling the chart, one can see the positive correlation, which also shows up under statistical analysis. 

Another question one often hears in today’s economic discussions is what would Milton Friedman say?  I won’t claim to be able to channel Milton (or anyone else), but I do think the empirical evidence continues to support the conclusion that inflation is always and everywhere a monetary phenomenon.