Last week Janet Yellen testified before Congress, and said basically much of the same things she has said before. The one new thing she said that I stood up and took note of was her passionate defense of the importance of fighting progressive inflation such as we experienced during the 70's. All the members of the Fed she said, have a complete understanding of the dangers of allowing the inflation genie out of the bottle; and that the heroic efforts of Paul Volker to contain runaway inflation in the 1980’s was an exercise that none of them ever want to have to confront again.
I believe her. As a matter a fact I also believed Alan Greenspan and Ben Bernanke when they said the same thing. And since Volker, inflation has fallen from 14% to .07 last year, the lowest rate since WWII. Of course prices have still gone up because inflation has gone up every year, so it's just a matter of degree of price increases. I am on the record as of the first of the year with my “Looking Forward” article predicting that would change this year and that inflation would turn up again with gold leading the way.
We are not yet in the position, as much as many would like us to, to intentionally foster or allow years of deflation as a matter of monetary policy. The Fed can not take a "hands off" stance. Japan did that. It didn't work out well for them. A monetary policy that intentionally allows prices to deflate in the middle of a process of de-leveraging is like adding gasoline to a burning fire. The Fed’s actions during the Great Depression are testimony to that. Yellen’s statement indicates that the Fed will neither make the mistake of deflating as they did during the deflationary depression of the 30’s, or inflate as they did during the inflationary years of the 60’s and 70’s.
The best the Fed can do under present circumstances is to foster a little inflation, but not progressive inflation. They pursued a progressively inflationary policy in the 70's, and increased the money supply and credit allowing the inflation rate to rise yearly from 2% to 14%. This nearly destroyed the economy of the United States. It took a contraction of the rate of increase in the money supply, and 21% interest rates which led to a severe two year recession to save the dollar and stabilize the situation. But that was then and this now ,and there is no comparison between the two eras.
It irritates me to no end when Libertarians and Conservatives draw on the theories of Ludwig von Mises and Milton Friedman, two great economists, to denounce the Fed from Greenspan to Yellen for inflating even as inflation has fallen for over three decades. Let me say that there is nothing wrong with the monetary theories of von Misses and Friedman; what's wrong is how many free market advocates interpret those theories in today's world. Before you click off this article in total disagreement, read this from Milton Friedman:
Over the course of a long friendship, Alan Greenspan and I have generally found ourselves in accord on monetary theory and policy, with one major exception. I have long favored the use of strict rules to control the amount of money created. Alan says I am wrong and that discretion is preferable, indeed essential. Now that his 18-year stint as chairman of the Fed is finished, I must confess that his performance has persuaded me that he is right—in his own case. His performance has indeed been remarkable...There is no other period of comparable length in which the Federal Reserve System has performed so well…
Inflation averaged 3.7% per year from the end of World War II to the Volker era, but only 2.4% per year during the Greenspan era. Even more important, inflation was much less variable. ... Greater price stability had far-reaching effects. By greatly reducing the uncertainties, enterprises could use their resources more efficiently and steadily. Price stability fostered innovation and supported a high level of productivity...…It has long been an open question whether central banks have the technical ability to maintain stable prices. Their repeated failures to do so suggested that they did not -- whence, in part, my preference for rigid rules. Alan Greenspan's great achievement is to have demonstrated that it is possible to maintain stable prices. He has set a standard. Other central banks around the world, whether independently or by following his example, are following suit. The timeworn excuses for central bank failure to stem inflation will no longer do. They will have to put up or shut up. - Milton Friedman WSJ essay Jan 31, 2006
Let me add that since that article was written, inflation continued to fall to nearly zero. Yet throughout the years, it is the Fed that has been the main target and alleged villain of the Right.
Von Misses lived in the days of a gold standard, in one form or another, and his theories endeavored to improve that particular monetary system and deter us from imposing a total fiat standard. Friedman lived in the days of a fiat standard and advocated a monetary theory that was designed to control an out of control Fed. He advocated a controlled, rule-based fiat standard under free market capitalism. Both economists were right in their particular time and context but I am sure, after being a life-long student of both, that neither economist would apply their theories, valid as they were, to today's economic landscape. Today’s problems are distinctly different from those of the past.
Today, deflation is the major threat. We have most Americans reducing debt, consuming less, and rarely using credit. There is no artificial or excessive credit expansion such as the 20’s or the 70’s. Money supply is dormant. The velocity of money is non-existent. You can't get a loan on a home unless you are very well off and your credit is perfect; and while the Fed has pumped trillions into the banking system and mortgage markets the money lays dormant neither being used for business expansion nor for consumer consumption. We have a broken credit system. We certainly do not have easy money except what the government doles out and the Federal Reserve is not in control of the Federal or the States budgets.
Think about it; as the Federal government runs out of control fiscally, running up the highest deficits, national debt, and unfunded liabilities in history, hurdling us toward bankruptcy, the Fed gets the blame as inflation fell to almost zero last year.
The daily bashing of the Fed alleges we are inflating and distorting the economy and that mal-investment is being caused by the Fed which is feeding the banking system, causing bubbles everywhere. They blame the Fed for the high stock market, the low interest rates, and an inflation that will ravish this country, yet never comes. They are wrong. Today it is the absence of credit expansion and investment that is the problem. Those insisting that because of the Fed, we will endure terrible consequences in the future are propagating theories tied to nothing.
The classical theories of money and economics are still as true today as they ever were, but few understand the application of such theories in today's unique context. It makes no sense to predict runaway inflation in an economy that is seeing money supply stagnant, credit expansion tepid, and velocity of money flat on its back. The failure to think outside of the box has led to very smart people being continuously wrong in their evaluations year after year. The shame is that they refuse to adjust their thinking regardless of the facts all around them. This is not the 1920’s or the 1970’s.
The increase in excess reserves is not equivalent to an increase in money supply.
Money supply is lower today in terms of percentage increase than before the excess reserves were created. M2 fell from over 10% increases at the beginning of QE to under 5% last year and stands at this writing at 6.45%. There is no statistical evidence that the trillions of dollars supplied by the Fed have progressively increased the nation’s money supply. And I might add that at the push of button, that money held as excess reserves, can be withdrawn instantly from the banking system, if the Fed chose to do so. There is no imminent inflationary threat.
The allegation that the Fed is dramatically affecting interest rates is also overstated. It flies in the face of the low interest rates in the eurozone which has not yet even embarked on QE. If the Fed’s QE is responsible for our low interest rates, why are interest rates in Germany lower than US rates? Germany, which has a tight monetary policy and a money supply that has been contracting lately, has interest rates across the board that are substantially lower than ours.
The two nation’s interest rates have one thing in common – a low inflation rate. (Do you think maybe they’re connected?) The rate of inflation is the major component of interest rates. Yet, most free market advocates insist that the Fed is holding down interest rates artificially and distorting the economy. There is no empirical evidence to support this; only theory that is contradicted by the facts. It should not be surprising that as inflation fell over the last couple of years, so have interest rates.
If the Fed allowed interest rates to float, something I advocate, it is very possible that rates would stay low, just as they are in Germany and for the same reasons. Look what happened to the yuan which went down as soon as the Chinese government let its grip on its currency loosen, instead of up as so many free-market economists predicted. What was their reaction to this contradiction in their expectations and theories? Blank-out.
Economics and monetary theory is not religion. You don't apply blind faith to theory or the economy, you apply logic. You have to think your way through what is happening based on evidence and analytical reasoning. This is not being done today by many of our best and brightest, and it is an embarrassment to free market economics and great economists like Ludwig von Mises and Milton Friedman.
We are teeter-tottering between the forces of deflation and recession on the one hand, and growth and inflation on the other; and have been for over 6 years now. Instead of bashing the Fed on a daily basis I suggest that those for free markets and monetary stability work to eliminate the Fed’s mandate to work towards full employment, something they can’t do, and concentrate on monetary stability, something they’ve proven they can do.
It’s time to end the war against the Fed.