For today, I want to highlight what I said about monetary policy.
The above segment is less than three minutes, and I tried to make two points.
First, as I’ve previously explained, the Federal Reserve goofed by dramatically expanding its balance sheet (i.e., buying Treasury bonds and thus creating new money) in 2020 and 2021. That’s what produced the big uptick in consumer prices last year.
And it’s now why the Fed is raising interest rates. Part of the boom-bust cycle that you get with bad monetary policy.
Second, I speculate on why we got bad monetary policy.
I’ve always assumed that the Fed goofs because it wants to stimulate the economy (based on Keynesian monetary theory).
But I’m increasingly open to the idea that the Fed may be engaging in bad monetary policy in order to prop up bad fiscal policy.
To be more specific, what if the central bank is buying government bonds because of concerns that there otherwise won’t be enough buyers (which is the main reason why there’s bad monetary policy in places such as Argentina and Venezuela).
In the academic literature, this is part of the discussion about “fiscal dominance.” As shown in this visual, fiscal dominance exists when central banks decide (or are forced) to create money to finance government spending.
The visual is from a report by Eric Leeper for the Mercatus Center. Here’s some of what he wrote.
…a critical implication of fiscal dominance: it is a threat to central bank success. In each example, the central bank was free to choose not to react to the fiscal disturbance—central banks are operationally independent of fiscal policy. But that choice comes at the cost of not pursuing a central bank legislated mandate: financial stability or inflation control. Central banks are not economically independent of fiscal policy, a fact that makes fiscal dominance a recurring threat to the mission of central banks and to macroeconomic outcomes. …why does fiscal dominance strike fear in the hearts of economists and financial markets? Perhaps it does so because we can all point to extreme examples where fiscal policy runs the show and monetary policy is subjugated to fiscal needs. Outcomes are not pleasant. Germany’s hyperinflation in the early 1920s may leap to mind first. …The point of creating independent central banks tasked with controlling inflation…was to take money creation out of the hands of elected officials who may be tempted to use it for political gain instead of social wellbeing.
A working paper from the St. Louis Federal Reserve Bank, authored by Fernando Martin, also discusses fiscal dominance.
In recent decades, central banks around the world have gained independence from fiscal and political institutions. The proposition is that a disciplined monetary policy can put an effective brake on the excesses of political expediency. This is frequently achieved by endowing central banks with clear and simple goals (e.g., an inflation mandate or target), as well as sufficient control over specific policy instruments… Despite these institutional advances, the resolve of central banks is chronically put to the test. … the possibility of fiscal dominance arises only when the fiscal authority sets the debt level.
The bottom line is that budget deficits don’t necessarily lead to inflation. But if a government is untrustworthy, then it will have trouble issuing debt to private investors.
And that’s when politicians will have incentives to use the central bank as a printing press.
P.S. Pay attention to Italy. The European Central Bank has been subsidizing its debt. That bad policy supposedly is coming to an end and things could get interesting.
Because the central bank’s easy-money policy created artificially low interest rates, but those policies also produced high inflation, and now interest rates are going up as the Fed tries to undo its mistake.
By the way, the center box (higher prices) also includes asset bubble since bad monetary policy sometimes leads to financial bubbles instead of (or in addition to) higher consumer prices.
And higher interest rates can occur for two reasons. Most people focus on the Federal Reserve tightening monetary policy as it tries to reverse its original mistake of easy money. But don’t forget that interest rates also rise once lenders feel the pinch of inflation and insist on higher rates to compensate for the falling value of the dollar.
But let’s not digress too much. The focus of today’s column is that the Fed goofed by creating too much money in 2020 and 2021. That’s what set the stage for big price increases in 2022 and now economic instability in 2023.
Joakim Book of Reason shares my perspective. Here are excerpts from his article.
The Federal Reserve is in the unenviable position of achieving its mandate by crashing the economy. …it’s something that happens as an unavoidable outcome of slowing down an economy littered with excess money and inflation. …This hiking cycle, the fastest that the Fed has embarked upon in a generation, was always likely to break something. And break something they did over the weekend…Silicon Valley Bank (SVB), which faced the second-largest bank run in U.S. history. …this pushes the Fed into a very delicate position: risk systemic bank runs, or roll back the hikes and quantitative tightening that caused this mess, printing money for an even hotter inflation.
The Wall Street Journal also has the right perspective, editorializing that the current mess was largely caused by bad monetary policy.
Cracks in the financial system emerge whenever interest rates rise quickly after an easy-credit mania, and the surprise is that it took so long. …This week’s bank failures are another painful lesson in the costs of a credit mania fed by bad monetary policy. The reckoning always arrives when the Fed has to correct its mistakes. …We saw the first signs of panic in last year’s crypto crash and the liquidity squeeze at British pension funds. …nobody, least of all central bank oracles, should be surprised that there are now bodies washing up on shore as the tide goes out.
This tweet also notes that monetary policy is to blame.
What's the main monetary lesson from SVB?
Wrong: See what inflation-fighting does? It can cause a financial crisis. So give up and adjust the inflation target to 4%.
Right: Inflation must be fought ASAP. The longer the delay, the bigger the pain. P.S. Don't print so much money! pic.twitter.com/2XgkpTXiO0
Finally, I can’t resist sharing some excerpts from Tyler Cowen’s Bloombergcolumn. He pointed out last November that the Austrian School has some insights with regards to the current mess.
The Austrian theory…works something like this: Investors expected that very low real interest rates would hold. They committed resources accordingly, and now forthcoming rates are likely to be much higher. That means the economy is stuck with malinvestment and will need to reconfigure in a painful manner. …The basic story here fits with the work of two economists from Austria, Ludwig Mises and Nobel laureate Friedrich von Hayek, and thus it is called the Austrian theory of the business cycle. The Austrian theory stresses how mistaken expectations about interest rates, brought on by changes in the rate of inflation, will lead to bad and abandoned investment projects. The Austrian theory has often been attacked by Keynesians, but in one form or another it continues to resurface in the economic data.
The simple message is that budget deficits are not necessarily inflationary. It depends how budget deficits are financed.
If a government finances its budget deficits by selling bonds to private savers and investors, there is no reason to expect inflation.**
But if a government finances its budget deficits by having its central bank create money, there is every reason to expect inflation.
So why would politicians ever choose the second option? For the simple reason that private savers and investors are reluctant to buy bonds from some governments.
Consider the example of Japan. It has been running large deficits for decades, resulting in an enormous accumulation of debt. But Japan has very little inflation by world standards. Why? Because governments bonds are financed by private savers and investors, who are very confident that the Japanese government will not default..
Consider the example of Argentina. It has been running large deficits for decades. But even though its overall debt level if much lower than Japan’s, Argentina suffers from high inflation. Why? Because the nation’s central bank winds up buying the bonds because private savers and investors are reluctant to lend money to the government.
If you want some visual evidence, I went to the International Monetary Fund’s World Economic Outlookdatabase.
Here’s the data for 1998-2022 showing the average budget deficit and average inflation rate in both Japan and Argentina.
The bottom line is that prices are very stable in Japan because the central bank has not been financing Japan’s red ink by creating money.
In Argentina, by contrast, the central bank is routinely used by politicians as a back-door way of financing the government’s budget.
*To make sure that my libertarian credentials don’t get revoked, I should probably point out that all governments are untrustworthy. But some are worse than others, and rule-of-law rankings are probably a good proxy for which ones are partially untrustworthy versus entirely untrustworthy.
**Borrowing from the private sector is economically harmful because budget deficits “crowd out” private investment. Though keep in mind that all the ways of financing government (taxes, borrowing, and money creation) are bad for prosperity.
While I have profound worries about the future of fiscal policy, I wonder if developments in monetary policy are an even greater threat to individual liberty.
More specifically, I’ve written a five-part series about governments and their “War Against Cash.”
In Part I, I explained that politicians and bureaucrats want to get rid of cash so that governments could increase taxes.
In Part II, I warned that abolition of cash would enable a further shift to irresponsible and inflationary monetary policy.
In Part III, I showed why proponents are dishonest when they claim that a cashless society will somehow reduce criminal activity.
In Part IV, I debunked the arguments made by Kenneth Rogoff, a Harvard professor and leading advocate for cash prohibition.
In Part V, I pointed out how the Canadian government abused its power to restrict access to money for political opponents.
Let’s build upon those arguments by reviewing some additional material.
In a column yesterday for the Wall Street Journal, Sean Fieler warns that abolishing cash will empower government.
Neel Kashkari, president of the Minneapolis Federal Reserve, questioned why Americans would support a CBDC. “If they want to monitor every one of your transactions . . . you can do that with a central bank digital currency,” Mr. Kashkari said at a conference last year. “I get why China would be interested. Why would the American people be for that?” …For Democrats, the party of big government, the appeal is obvious. A CBDC would allow the federal government to spend more money, manage outcomes… It’s naive to think that a government that is currently combing through individual financial information will stop doing so when it has the formidable power of a CBDC. …Policy makers in Washington have a choice between preserving a bloated federal government or putting America back on a path to limited government. By uniting to stop a CBDC, Republicans can take the side of the American people.
Well stated, though I have learned through painful experience not to rely on Republicans to protect freedom.
Writing last year for the Foundation for Economic Education, Brad Polumbo also warns against digital currency.
…many governments have floated the idea of a “central bank digital currency,”…and new reporting suggests the Biden Administration may soon press forward with efforts to create a so-called “digital dollar.” …At first glance, government getting in on the crypto craze might sound fun, novel, or harmless. But it’s actually cause for serious alarm. …it would offer governments new, unprecedented ways to control citizens. To call the idea rife for abuse is an extreme understatement. After all, a central bank digital currency would allow the government to track your every purchase. It could also be easily used to restrict purchases. For example, imagine a future government deciding that gasoline must be rationed in order to address climate change. Your “digital dollars” could be made to stop working at the gas pump once you’ve purchased a certain amount of gasoline in a week. …If any of this sounds extreme, fantastical, or otherwise far-fetched… well, just look at China.
Last but not least, here are some excerpts from Elaine Ou’s 2016 column for Bloomberg.
…in a cashless society every transaction must pass through a financial gatekeeper. …This means that politically unpopular organizations could easily be deprived of economic access. Past attempts to curb money laundering have already inadvertently cut off financial services for legitimate individuals, businesses, and charities. The removal of paper currency would undoubtedly leave similar collateral damage. The crime-fighting case against cash is overstated. …if we’re going to cite unlawful transactions as a rationale for banning cash, it only makes sense to ban banks and accounting firms first. The one benefit of replacing cash with claims on cash is that a claim can be discounted, canceled or seized. That doesn’t sound terribly beneficial to most people, but this attribute is attractive to a growing contingent that wants to send interest rates into negative territory. …Physical currency gets in the way of negative-interest-rate policy because people who don’t want to accrue negative interest can simply store their cash in a safe. By confining the national currency to regulated account holdings, the government can impose a tax on savings in the name of monetary policy.
The last sentence in that excerpt should be etched in stone. Replacing cash with a digital currency gives governments the ability to engage in “financial repression.”
Is it possible that politicians and central bankers to get hold of this power and not abuse it?
Yes, that’s theoretically possible, but it’s very unlikely.
That’s a lesson everyone should have learned about 50 years ago when the Federal Reserve unleashed the inflation in the 1960s and 1970s (also blame Lyndon Johnson and Richard Nixon for appointing the wrong people).
And we should have learned another lesson when the Fed (with strong support from Ronald Reagan) then put the inflation genie back in the bottle in the 1980s.
But today’s central bankers must have been very bad students.
Writing for National Review, E.J. Antoni explains that we are once again bearing the inevitable cost of bad monetary policy.
…central banks are allowing interest rates to rise in an effort to belatedly respond to a crisis they helped cause. …the global economic downturn has been baked into the cake for months. …central banks around the world laid the groundwork for economic pain when they decided to finance trillions of dollars in unfunded government spending in 2020. As those central banks continued — and in some cases accelerated — their excessive money creation throughout 2021 and into 2022, a global downturn became inevitable. …History shows that high levels of inflation almost always lead to recession …once inflation became apparent central bankers persisted with their earlier course, feeding inflation, rather than starving it. If they had acted earlier, far less drastic treatment would now be required. …there is no way around the harsh reality that the bill is coming due for the last two years of monetary malfeasance.
However, while I agree with the above article, I don’t agree with the title. It should be changed to: “Economies Can’t Avoid the Consequences of Central Bank Actions.”
Why the new title?
For the simple reason that central bankers are actually very capable of dodging responsibility for their mistakes.
For instance, has anyone heard the head of the Federal Reserve, Jerome Powell, apologize for dumping $4 trillion of liquidity into the economy in 2020 and 2021, thus creating today’s big price increases in the United States?
A more glaring example comes from the United Kingdom, where the former Governor of the Bank of England wants to blame Brexit. I’m not joking. Here are some excerpts from a Bloombergstory.
Former Bank of England Governor Mark Carney pointed to Brexit as a key reason why the UK central bank is now having to hike interest rates in its struggle to contain inflation. Alongside rising energy prices and a tight labor market, Britain’s exit from the European Union added to the economic headwinds for the UK, according to Carney. “In the UK, unfortunately, we’ve also had in the near term the impact of Brexit, which has slowed the pace at which the economy can grow,” Carney said in an interview with BBC Radio 4’s “Today” program on Friday. …“The economy’s capacity would go down for a period of time because of Brexit, that would add to inflationary pressure, and we would have a situation, which is the situation we have today, where the Bank of England has to raise interest rates despite the fact the economy is going into recession.”
This is galling.
Brexit did not cause inflation. The finger of blame should be pointed at the Bank of England.
Like the Fed, the BoE dramatically expanded its balance sheet starting in the spring of 2020.
And, like the Fed (and the European Central Bank), it maintained an easy-money policy for the remainder of the year and throughout 2021 – even after it became very clear that the pandemic was not going to cause an economic crisis.
To be fair, Carney left the Bank of England in early 2020, so it’s possible he might not have made the same mistake as Andrew Bailey, who took his place.
But Carney blaming Brexit shows that, if nothing else, he is willing to prevaricate to protect the BoE’s reputation.
What makes his analysis so absurd is that he almost surely would have made the same claims regardless of what happened after Brexit.
Boris Johnson delivered Brexit, but then proceeded to enact bad policies such as higher taxes and more spending. The economy weakened and Carney says this is why the BoE is being forced to raise interest rates.
But if Johnson had enacted good policy (the Singapore-on-Thames scenario), the economy would be performing much better. In that case, Carney doubtlessly would have claimed interest rates needed to rise because of overheating.
In reality, of course, interest rates are going up because the BoE is trying to undo its easy-money mistake.
Too bad Carney isn’t man enough to admit what’s really happening. Maybe a woman would be more honest.
P.S. The current Governor of the BoE, Bailey, also likes shifting blame since he wants people to think that Liz Truss’ proposed tax cuts were responsible for financial market instability – even though his easy-money policies are the real culprit.
As part of my “European Fiscal Policy Week,” let’s take a closer look at what happened and analyze the pernicious role of the Bank of England (the BoE is their central bank, akin to the Federal Reserve in the U.S.).
Let’s start with a reminder that the Bank of England panicked during the pandemic and (like the Federal Reserve and the European Central Bank) engaged in dramatic monetary easing.
That was understandable in the spring of 2020, perhaps, but it should have been obvious by the late summer that the world was not coming to an end.
Yet the BoE continued with its easy-money policy. The balance sheet kept expanding all of 2020, even after vaccines became available.
And, as shown by the graph, the easy-money approach continued into early 2021 (and the most-recent figures show the BoE continued its inflationary policy into mid-2021).
Needless to say, all of that bad monetary policy led to bad results. Not only 10 percent annual inflation, but also a financial system made fragile by artificially low interest rates and excess liquidity.
So how does any of this relate to fiscal policy?
As the Wall Street Journal explained in an editorial on October 10, the BoE’s bad monetary policy produced instability in financial markets and senior bureaucrats at the Bank cleverly shifted the blame to then-Prime Minster Truss’ tax plan.
Bank of England Governor Andrew Bailey is trying to stabilize pension funds, which are caught on the shoals of questionable hedging strategies as the high water of loose monetary policy recedes. …The BOE is supposed to be tightening policy to fight inflation at 40-year highs and claims these emergency bond purchases aren’t at odds with its plans to let £80 billion of assets run off its balance sheet over the next year. But BOE officials now seem confused about what they’re doing. …No wonder markets doubt the BOE’s resolve on future interest-rate increases. Undeterred, the bank is resorting to the familiar bureaucratic imperative for self-preservation. Mr. Cunliffe’s letter is at pains to blame Mr. Kwarteng’s fiscal plan for market ructions. His colleagues Jonathan Haskel and Dave Ramsden —all three are on the BOE’s policy-setting committee—have picked up the theme in speeches that blame market turbulence on a “U.K.-specific component.” This is code for Ms. Truss’s agenda. …Mr. Bailey doesn’t help his credibility or the bank’s independence by politicizing the institution.
In a column for Bloomberg, Narayana Kocherlakota also points a finger at the BoE.
And what’s remarkable is that Kocherlakota is the former head of the Minneapolis Federal Reserve and central bankers normally don’t criticize each other.
Markets didn’t oust Truss, the Bank of England did — through poor financial regulation and highly subjective crisis management. …The common wisdom is that financial markets “punished” Truss’s government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting Sept. 23, when the Truss government announced its mini-budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to bring a government to its knees. The big change came in the price of 30-year UK government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds. …The Bank of England, as the entity responsible for overseeing the financial system, bears at least part of the blame for this catastrophe. …the Truss government…was thwarted not by markets, but by a hole in financial regulation — a hole that the Bank of England proved strangely unwilling to plug.
Last but not least, an October 18 editorial by the Wall Street Journal provides additional information.
When the history of Britain’s recent Trussonomics fiasco is written, make sure Bank of England Governor Andrew Bailey gets the chapter he deserves. …The BOE has been late and slow fighting inflation… Mr. Bailey’s actions in the past month have also politicized the central bank…in a loquacious statement that coyly suggested the fiscal plan would be inflationary—something Mr. Kwarteng would have disputed. …Meanwhile, members of the BOE’s policy-setting committee fanned out to imply markets might be right to worry about the tax cuts. If this was part of a strategy to influence fiscal policy, it worked. …Mr. Bailey may have been taking revenge against Ms. Truss, who had criticized the BOE for its slow response to inflation as she ran to be the Conservative Party leader this summer. Her proposed response was to consider revisiting the central bank’s legal mandate. The BOE’s behavior the past month has proven her right beyond what she imagined.
So what are the implications of the BoE’s responsibility-dodging actions?
First, we should learn a lesson about the importance of good monetary policy. None of this mess would have happened if the BoE had not created financial instability with an inflationary approach.
Second, we should realize that there are downsides to central bank independence. Historically, being insulated from politics has been viewed as the prudent approach since politicians can’t try to artificially goose an economy during election years. But Bailey’s unethical behavior shows that there is also a big downside.
Sadly, all of this analysis does not change the fact that tax cuts are now off the table in the United Kingdom. Indeed, the new Prime Minister and his Chancellor of the Exchequer have signaled that they will continue Boris Johnson’s pro-tax agenda.
That’s very bad news for the United Kingdom.
P.S. There used to be at least one sensible central banker in the United Kingdom.
America’s central bank created dramatically expanded its balance sheet starting in early 2020. This meant lots of extra liquidity sloshing around the economy and that inevitably led to rising prices.
As Milton Friedman explained, inflation is “always and everywhere on monetary phenomenon.”
So why am I regurgitating this type of analysis? Because someone sent me a PolitiFact article from April that supposedly does a “fact check” on the claim that Biden’s spending contributed to inflation.
What shocked me is that the article never mentions the Federal Reserve or monetary policy. I’m not joking.
We decided to look at how much of an impact Biden’s spending had on prices. …some economists, including Larry Summers, a top official under President Barack Obama, warned that the bill would lead to inflation. Fiscal conservatives joined in the warning. …How much of this can be put at Biden’s feet? Some, but not all of it, experts say. …The post-COVID-19 inflation story is more complicated than just federal spending. Other forces, including changes in the labor market, rising global energy and commodity prices, supply chain dysfunction and the war in Ukraine have all contributed to higher prices. …Russia’s attack on Ukraine disrupted a world economy that was still sorting itself out after COVID. Sanctions aimed at cutting Russia’s energy revenues sent oil and gas prices soaring. The war’s crippling hit on Ukraine’s agricultural sector, combined with sanctions (Russia is a major wheat producer), has raised the prices of basic goods like wheat and sunflower oil. …none of the experts we reached, liberal and conservative, said Biden’s actions were responsible for all of the inflation. Past government spending, COVID’s disruptions to labor markets, energy prices and supply-chains also played significant roles. Most recently, the war in Ukraine has made a challenging situation worse.
This is nonsense. At the risk of being boring and wonky, the factors mentioned in the article are important, but they will only change relative prices in the absence of bad monetary policy.
In other words, energy prices may increase, but that will be offset by declines in other prices. Unless, of course, the central bank is creating too much liquidity, thus enabling an increase in the overall price level.
I’ll close with a caveat. Bad monetary policy sometimes will cause rising asset prices (a bubble) rather than rising consumer prices. Both outcomes are examples of inflation, but only the latter shows up when the government releases monthly data on the consumer price index.
That being said, is it possible that some of Biden’s (and Trump’s) spending policies led to more price inflation rather than more asset inflation?
Yes, but that’s merely shifting the deck chairs on the monetary Titanic. And it doesn’t change the fact that it is gross economic malpractice for PolitiFact to write about inflation without mentioning the Federal Reserve or monetary policy.
This topic deserves more attention, particularly given the depressing inflation numbers just released this morning by the Bureau of Labor Statistics.
Some of our friends on the left want to downplay these bad numbers. In large part, they are motivated by a desire to shield President Biden from political damage. And I sympathize with them since Biden was not in the White House when the Federal Reserve decided to dump lots of liquidity into the U.S. economy.
But I don’t sympathize with folks who claim that inflation is just something random.
Some of them want to blame Putin. Or the pandemic. Or “corporate greed.” Or maybe even space aliens.
I also wonder about this tweet from Ian Bremmer. He points out that inflation is showing up everywhere, regardless of which political party (or coalition) is running a government.
But I can’t tell what he means by his final line (“wild guess it’s not the govt”).
Is he saying that we should focus on the actions of central banks, not the partisan composition of a nation’s government? If so, I agree.
Or is he saying that we should not blame any part of government? If so, I completely disagree.
Central banks may have varying levels of day-to-day independence, but they are government entities. They were created by politicians and run by people appointed by politicians.
And inflation is happening in many nations because various central banks all made similar mistakes.
For instance, Bremmer mentions Germany and Italy. Those are euro countries and you can see that the European Central Bank made the same mistake as the Fed. It panicked at the start of the pandemic and then never fixed its mistake.
Bremmer also mentioned the United Kingdom. Well, here’s the balance sheet data from the Bank of England.
Once again, you can see a big spike in the amount of liquidity created when the BoE expanded its balance sheet.
And, just as was the case with the Fed and the ECB, the BoE did not fix its mistake once it became apparent than the pandemic was not going to cause a global economic collapse.
P.S. I suggested in the video that the ECB is partly motivated by a desire to prop up decrepit welfare states in nations such as Italy and Greece. This is a point I’ve been warning about for many, many years.
P.P.S. While Biden is not to blame for the outbreak of inflation, it’s also true that he is not part of the solution and has not used his appointment power to push the Fed in a more sensible direction.
P.P.P.S. If you have the time and interest, here’s a 40-minute video explaining the Federal Reserve’s track record of bad monetary policy.
P.P.P.P.S. If you’re constrained for time, I recommend this five-minute video on alternatives to the Federal Reserve and this six-minute video on how people can protect themselves from bad monetary policy.
The Federal Reserve is not the only central bank to make this mistake.
Here’s the balance sheet for the Eurosystem (the European Central Bank and the various national central banks that are in charge of the euro currency). As you can see, there’s also been a dramatic increase in liquidity on the other side of the Atlantic Ocean.
Why should American readers care about what’s happening with the euro?
But this is more than a lesson about monetary policy. What’s happened with the euro may have created the conditions for another European fiscal crisis (for background on Europe’s previous fiscal crisis, click here, here, and here).
In an article for Project Syndicate, Willem Buiter warns that the European Central Bank sacrificed sensible monetary policy by buying up the debt of profligate governments.
…major central banks have engaged in aggressive low-interest-rate and asset-purchase policies to support their governments’ expansionary fiscal policies, even though they knew such policies were likely to run counter to their price-stability mandates and were not necessary to preserve financial stability. The “fiscal capture” interpretation is particularly convincing for the ECB, which must deal with several sovereigns that are facing debt-sustainability issues. Greece, Italy, Portugal, and Spain are all fiscally fragile. And France, Belgium, and Cyprus could also face sovereign-funding problems when the next cyclical downturn hits.
Mr. Buiter shares some sobering data.
All told, the Eurosystem’s holdings of public-sector securities under the PEPP at the end of March 2022 amounted to more than €1.6 trillion ($1.7 trillion), or 13.4% of 2021 eurozone GDP, and cumulative net purchases of Greek sovereign debt under the PEPP were €38.5 billion (21.1% of Greece’s 2021 GDP). For Portugal, Italy, and Spain, the corresponding GDP shares of net PEPP purchases were 16.4%, 16%, and 15.7%, respectively. The Eurosystem’s Public Sector Purchase Program (PSPP) also made net purchases of investment-grade sovereign debt. From November 2019 until the end of March 2022, these totaled €503.6 billion, or 4.1% of eurozone GDP. In total, the Eurosystem bought more than 120% of net eurozone sovereign debt issuances in 2020 and 2021.
Other experts also fear Europe’s central bank has created more risk.
Two weeks ago, Desmond Lachman of the American Enterprise Institute expressed concern that Italy had become dependent on the ECB.
…the European Central Bank (ECB) is signaling that soon it will be turning off its monetary policy spigot to fight the inflation beast. Over the past two years, that spigot has flooded the European economy with around $4 trillion in liquidity through an unprecedented pace of government bond buying. The end to ECB money printing could come as a particular shock to the Italian economy, which has grown accustomed to having the ECB scoop up all of its government’s debt issuance as part of its Pandemic Emergency Purchase Program. …the country’s economy has stalled, its budget deficit has ballooned, and its public debt has skyrocketed to 150 percent of GDP. …Italy has had the dubious distinction of being a country whose per capita income has actually declined over the past 20 years. …All of this is of considerable importance to the world economic outlook. In 2010, the Greek sovereign debt crisis shook world financial markets. Now that the global economy is already slowing, the last thing that it needs is a sovereign debt crisis in Italy, a country whose economy is some 10 times the size of Greece’s.
Over the past two years, the ECB’s bond-buying programs have kept countries in the eurozone’s periphery, including most notably Italy, afloat. In particular, under its €1.85 trillion ($2 trillion) pandemic emergency purchase program, the ECB has bought most of these countries’ government-debt issuance. That has saved them from having to face the test of the markets.
The ECB engaged in a large-scale bond-buying program over the past two years…, as did the U.S. Federal Reserve. The size of the ECB’s balance sheet increased by a staggering four trillion euros (equivalent to $4.4 billion), including €1.85 trillion under its Pandemic Emergency Purchasing Program. …The ECB’s massive bond buying activity has been successful in keeping countries in the eurozone’s periphery afloat despite the marked deterioration in their public finances in the wake of the pandemic.
Unlike bailouts and easy money, which exacerbate the underlying problems.
P.S. For what it is worth, I do not think a common currency is necessarily a bad idea. That being said, I wonder if the euro can survive Europe’s awful politicians.
P.P.S. While I think Mr. Buiter’s article in Project Syndicate was very reasonable, I’ve had good reason to criticize some of his past analysis.
It’s now 2022 and my argument is even more relevant.
That’s because the Federal Reserve panicked at the start of the pandemic and dumped a massive amount of money into the economy (technically, the Fed increased its balance sheet by purchasing trillions of dollars of government bonds).
As the late, great Milton Friedman taught us, this easy-money, low-interest-rate approach produced the rising prices that are now plaguing the nation.
But that’s only part of the bad news.
The other bad news is that easy-money policy sets the stage for future hard times. In other words, the Fed causes a boom-bust cycle.
Desmond Lachman of the American Enterprise Institute explains how and why the Federal Reserve has put the country in a bad situation.
Better late than never. Today, the Federal Reserve finally took decisive monetary policy action to regain control over inflation that has been largely of its own making. …The Fed’s abrupt policy U-turn is good news in that it reduces the likelihood that we will return to the inflation of the 1970s. However, this does not mean that we will avoid paying a heavy price for the Fed’s past policy mistakes in lost output and employment. …One might well ask what the Fed was thinking last year when it kept interest rates at their zero lower bound and when it let the money supply balloon at its fastest pace in over fifty years at a time especially when the economy was recovering strongly… One might also ask what the Fed thought when it continued to buy $120 billion a month in Treasury bonds and mortgage-backed securities throughout most of last year when the equity and the housing markets were on fire?
The relevant question, he explains, is whether we have a hard landing…or a harder landing.
If the Fed sticks to its program of meaningful interest rate hikes and balance sheet reduction over the remainder of this year, there would seem to be an excellent chance that we do not return to the inflation of the 1970s. However, there is reason to doubt that the Fed will succeed in pushing the inflation genie to the bottle without precipitating a nasty economic recession. One reason for doubting that the Fed will succeed in engineering a soft economic landing is that there is no precedent for the Fed has done so when it has allowed itself to fall as far behind the inflation curve as it has done today. …there is a real risk that higher interest rates might be the trigger that bursts today’s asset and credit market bubbles. Should that indeed happen, we could be in for a tough landing. Milton Friedman was fond of saying that there is no such thing as a free lunch. This is a lesson that the Fed might soon relearn as last year’s economic party gives way to a painful economic slump.
Let’s hope we have a proverbial “soft landing,” but I’m not holding my breath.
P.S. As explained in this video from the Fraser Institute, Friedrich Hayek understood a long time ago that feel-good government intervention leads to a feel-bad economic hangover.
P.P.S. Here’s my video on the Federal Reserve, which also explains that there might be a good alternative.
Unfortunately, many politicians lack common sense (or, more accurately, they are motivated by short-run political ambition rather than what’s in the long-run best interest of their nations).
So if they decide that they politically benefit by spending lots of other people’s money, they have to figure out how to finance that spending.
One option is to use the central bank. In other words, finance big government with the figurative printing press.
From a theoretical perspective, it’s crazy. And if Sri Lanka is any indication, it’s also crazy based on real-world evidence.
In an article for The Print, based in India, Mihir Sharma looks at that government’s foolish monetary policy.
Cranks are considered cranks for a reason. That is the lesson from Sri Lanka… How did this tiny Indian Ocean nation end up in such straits? …the Rajapaksas turned Sri Lanka’s policymaking over to cranks… The central bank governor at the time, Weligamage Don Lakshman, informed the public during the pandemic that nobody need worry about debt sustainability…since “domestic currency debt…in a country with sovereign powers of money printing, as the modern monetary theorists would argue, is not a huge problem.” Sri Lanka is the first country in the world to reference MMT officially as a justification for money printing. Lakshman began to run the printing presses day and night; his successor at the central bank, Ajith Nivard Cabraal, who also denied the link between printing money and inflation or currency depreciation, continued the policy. …Reality did not take long to set in. By the end of 2021, inflation hit record highs. And, naturally, the clever plan to “increase the proportion of domestic debt” turned out to be impossible… Proponents of MMT will likely say that this was not real MMT, or that Sri Lanka is not a sovereign country as long as it has any foreign debt, or something equally self-serving.
Professor Steve Hanke of Johns Hopkins University also discussed Sri Lanka’s crazy monetary policy in an article for National Review. And he also offered a way to reverse the MMT mistake.
This slow-motion train wreck first began in November 2019 when Gotabaya Rajapaksa won a decisive victory in the country’s presidential elections. …In total control, President Rajapaksa and his brother Mahinda, the prime minister, went on a spending spree that was financed in part by Sri Lanka’s central bank. The results have been economic devastation. The rupee has lost 44 percent of its value since President Rajapaksa took the reins, and inflation, according to my measure, is running at a stunning 74.5 percent per year. …What can be done to end Sri Lanka’s economic crisis? It should adopt a currency board, like the one it had from 1884 to 1950… Most important, the board could not loan money to the fiscal authorities, imposing a hard budget on Ceylon’s fiscal system. The net effect was economic stability — and while stability might not be everything, everything is nothing without stability.
For readers who are not familiar with currency boards, it basically means creating a hard link with another nation’s currency – presumably another nation with a decent history of monetary restraint.
A currency board is not quite the same as “dollarization,” which is actually adopting another nation’s currency, but it’s a way of making sure local politicians have one less way of ruining an economy.
Let’s conclude with a story from the U.K.-based Financial Times, written by Tommy Stubbington and Benjamin Parkin. They provide some grim details about Sri Lanka’s plight.
Sri Lanka owes $15bn in bonds, mostly dollar-denominated, of a total $45bn long-term debt, according to the World Bank. It needs to pay about $7bn this year in interest and debt repayments but its foreign reserves have dwindled to less than $3bn. …Sri Lanka has never defaulted and its successive governments have been known for a market-friendly approach. …Sri Lanka has previously entered 16 programmes with the IMF.
By the way, I can’t help but comment about a couple of points in the article.
The reporters claim that Sri Lanka has been “known for a market-friendly approach.”
To be blunt, this is nonsense. I’ve been dealing with international economic policy for decades and no supporter of free markets and limited government has ever claimed the country was anywhere close to being a role model for good policy.
And if you peruse the latest edition of Economic Freedom of the World, you’ll see that Sri Lanka has very low scores, far below Greece and only slightly ahead of Russia.
And you can click here to see that it has always received dismal scores.
But maybe it’s “market-friendly” by the standards of left-leaning journalists.
I also can’t resist noting that Sri Lanka has already received 16 bailouts from the International Monetary Fund, according to the article.
This is further evidence that it’s not a market-oriented nation.
P.S. The Mihir Sharma article also discusses the Sri Lankan government’s crazy approach to agriculture.
Last April, the government followed through on a campaign promise to transition Sri Lanka to organic farming by banning the import and use of synthetic fertilizers. More than two-thirds of Sri Lanka’s people are directly or indirectly dependent on agriculture; economists and agronomists warned that a transition to organic farming on that scale would destroy productivity and cause incomes to crash. …Unsurprisingly, the cranks were wrong. The production of rice — the basic component of Sri Lankans’ diet — and of tea — the country’s main export — sank precipitously.
Needless to say, it’s not a good idea for politicians to deliberately hurt a nation’s agriculture sector.
Many of my left-leaning friends, by contrast, assert that “Wall Street greed” was the real culprit.
I have no problem with the notion that greed plays a role in financial markets, but people on Wall Street presumably were equally greedy in the 1980s and 1990s. So why didn’t we also have financial crises during those decades?
Isn’t it more plausible to think that one-off factors may have caused markets to go awry?
I took that trip down Memory Lane because of a rather insipid tweet from my occasionalsparringpartner, Robert Reich. He wants his followers to think that inflation is caused by “corporate greed.”
For what it’s worth, I agree that corporations are greedy. I’m sure that they are happy when they can charge more for their products.
But that’s hardly an explanation for today’s inflation.
After all, corporations presumably were greedy back in 2015. And in 2005. And in 1995. So why didn’t we also have high inflation those years as well?
If Reich understood economics, he could have pointed out that today’s inflation was caused by the Federal Reserve and also absolved Biden by explaining that the Fed’s big mistake occurred when Trump was in the White House.
I don’t expect Reich to believe me, so perhaps he’ll listen to Larry Summers, who also served in Bill Clinton’s cabinet.
But I won’t hold my breath.
As Don Boudreaux has explained, Reich is not a big fan of economic rigor and accuracy.
P.S. Reich also blamed antitrust policy, but we have had supposedly “weak antitrust enforcement” since the 1980s. So why did inflation wait until 2021 to appear?
P.P.S. In addition to being wrong about the cause of the 2008 crisis, my left-leaning friends also were wrong about the proper response to the crisis.
But as I discuss in this segment from a recent interview, he bears very little blame for today’s high inflation rate.
If you want to know who is responsible for 8.5 percent inflation, the highest in four decades, this chart tells you everything you need to know.
Simply stated, the Federal Reserve has created a lot more money by expanding its balance sheet (which happens, for example, when the central bank purchases government bonds using “open market operations”).
Notice, by the way, that the Fed dramatically expanded its balance sheet beginning in March 2020. That was almost one year before Biden was inaugurated.
It also means I don’t believe in blaming politicians for things that are not their fault. For example, NBC just released a poll showing that Joe Biden has low marks for economic policy.
Some of that is appropriate (his fiscal policy is atrocious, to cite one reason), but I think the answers to this question show that the president is getting a bum rap on one issue.
Why am I letting Biden off the hook about monetary policy?
For the simple reason that the Federal Reserve (the “Fed”) deserves the blame. The central bank’s inflationary policies are the reason that prices are rising.
One can claim that Joe Biden is partly to blame because he recently re-nominated Jay Powell, the current Chairman of the Fed. But, if that’s the case, then Donald Trump also is partly to blame – or even more to blame – because he nominated Powell in the first place.
Moreover, as illustrated by this chart, the Fed’s mistake that led to rising prices occurred in early 2020.
Simply stated, the Fed pumped lots of liquidity into the system. That set the stage for today’s price increases (as Milton Friedman told us, there’s always a lag between decisions about monetary policy and changes in prices).
If you look closely, you’ll notice that this massive monetary intervention began nearly one year before Biden took office.
In other words, Biden would have been just like Trump. At least on this issue.
But none of that changes the fact that Biden’s actions since becoming president have very little to do with today’s price increases.
Let’s close with a few additional observations about the aforementioned polling results.
The folks at NBC deserve some criticism for failing to give people the option of choosing the Federal Reserve’s monetary policy. I’m guessing this was because of ignorance rather than bias.
The people who blamed “corporations increasing prices” obviously didn’t pay attention in their economics classes. Rising prices are a symptom of inflation, not the cause.
The people who blamed Putin for inflation are even more ignorant. At the risk of stating the obvious, a Russian invasion in February of 2022 obviously wasn’t responsible for rising prices in 2021.
P.S. The inflation-recession cycle caused by bad monetary policy could be avoided if the Fed was constrained by some simple rules.
That’s not a smart strategy when inflation already is at 40-year highs.
President Biden did address the topic of rising prices during his speech, but his approach was so incoherent that even Larry Summers (Treasury Secretary for Bill Clinton and head of the National Economic Council for Barack Obama) felt compelled to share some critical tweets.
This is remarkable. I’ve spent the past three decades fighting against some of Summers’ bad ideas on fiscal policy (he was a big supporter of the OECD’s anti-tax competition project, for instance).
But now we’re sort of on the same side (at least on a few issues) because Biden has embraced a reckless Bernie Sanders-type agenda of budget profligacy, class-warfare taxes, regulatory excess, and crass protectionism that is too extreme for sane people on the left.
Along with a head-in-the-sand view of monetary policy.
In a column for Canada’s Fraser Institute, Robert O’Quinn and I addressed Biden’s strange comments on inflation.
Here’s some of what we wrote on that topic.
After a disastrous first year pursuing an agenda that became increasingly unpopular, President Biden had an opportunity to reset his administration in a centrist direction as part of his first State of the Union Address. But he didn’t. On every domestic issue, he catered to the Democratic Party’s hardcore left-wing activists… Inflation, as Nobel laureate Milton Friedman observed, is always and everywhere a monetary phenomenon. …In his speech, Biden ignored the true cause of inflation. Instead, he offered a grab bag of statist ideas such as aggressive antitrust enforcement, price controls on prescription drugs, and tax credits for energy conservation and green energy—policies that, whatever their merits, have little or nothing to do with inflation.
Our basic message is that Biden ignored the real cause of inflation (bad monetary policy by the Federal Reserve) and instead came up with ideas (either bad or irrelevant) to addresses the symptom(s) of inflation.
We also noted that Biden’s nominees to the Federal Reserve are underwhelming.
Moreover, he has been pushing three controversial nominees to the Federal Reserve Board—Sarah Bloom Raskin, Lisa Cook and Philip Jefferson—who lack monetary expertise and are generally regarded as inflation doves. Raskin’s primary “qualification” is her support for using the Fed’s regulatory powers to divert credit away from oil and natural gas production. Cook and Jefferson have primarily written about poverty and race, which are outside of the Fed’s legislative mandate.
Instead, we have a president who thinks it’s a place where left-leaning activists should get patronage appointments.
P.S. If you have the time and interest, here’s an 40-minute video explaining the Federal Reserve’s track record of bad monetary policy.
P.P.S. If you’re constrained for time, I recommend this five-minute video on alternatives to the Federal Reserve and this six-minute video on how people can protect themselves from bad monetary policy.
My friends sometimes tell me that libertarians are too extreme because we tend to make “slippery slope” arguments against government expansions.
I respond by pointing out that many slopes are very slippery. Especially when dealing with politicians and bureaucrats.
Consider the federal income tax, which started as a simple 2-page form with a top rate of 7 percent, but now has become a 75,000-page monstrosity with confiscatory rates.
Consider Medicaid, which the Washington Post reported, “was supposed to be a very small program with annual expenditures of about $1 billion,” but now costs taxpayers more than $500 billion per year.
Today, we’re going to look at how some politicians want to push us down the slope as part of their war against cash.
I’ve already written about this topic four times (here, here, here, and here), but it’s time to revisit the topic because of what has just happened in Canada.
Kevin Williamson of National Review is properly disgusted by Prime Minister Trudeau’s decision to deploy financial repression against protesting truckers.
Prime Minister Trudeau has invoked, for the first time in his country’s history, Emergency Measures Act powers to shut down a domestic political protest, the so-called Freedom Convoy movement… Trudeau is not sending in the troops. He is cutting off the money. …And so he is using the Emergency Measures Act to invest himself with the unilateral power to freeze bank accounts and cancel insurance policies, without so much as a court order and with essentially no recourse for those he targets. Canadian banks and financial-services companies will be ordered to disable clients suspected of being involved in the protests. …Using financial regulation to crush freedom of speech isn’t financial regulation — it is crushing freedom of speech by abusing the powers of a government office. …financial regulators enjoy powers that no FDR — or Napoleon, or Lenin — ever dreamt of possessing. The opportunities for mischief are serious and worrisome — and so are the opportunities for tyranny. …When the laws are enforced exclusively (or with extra vigor) against political enemies, that is not law enforcement — that is political repression. …we don’t have to send men with jackboots and billy clubs to break up protests — we have very polite Canadian bankers to do that for us.
Kevin then points out that Trudeau’s despicable actions are a very good argument for cryptocurrency.
It can be no surprise, then, that people are looking for digital platforms that protect their anonymity and keep their communications slightly beyond the reach of the long arm of the state. …And it’s even less surprising that cryptocurrencies and other escape routes from the banking system increasingly appeal to people who are neither cartel bosses nor international men of mystery. In a world in which unpopular political views can cut an individual or an organization off from the financial main stream, such innovations are necessities.
Liz Wolfe wrote about Trudeau’s overreach for Reason and also pointed out that cryptocurrencies are a valuable tool against oppressive government.
Canadian Prime Minister Justin Trudeau invoked his country’s Emergencies Act of 1988 in an attempt to snuff out anti-vaccine mandate protests that have roiled Canadian domestic politics for weeks. Invoking the act allows Trudeau to broaden Terrorist Financing Act rules to bring crowdfunding platforms and payment processors under greater government scrutiny. …cryptocurrency exchanges and crowdfunding platforms must now report large and “suspicious” transactions to the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), thus allowing more government surveillance of who’s forking over money to the protesters. The government will also be using its expanded powers to allow financial institutions to freeze the corporate accounts of companies that own trucks used in the blockades, while suspending their insurance… This type of situation—one in which protesters are being freezed out by crowdfunding platforms, one in which the government is threatening to suppress demonstrations and surveil financial transactions—is precisely the use case for crypto, which may be why Canadian officials namechecked it in their Terrorist Financing announcement. …crypto’s real value lies in the fact that it’s much harder to trace back to its sender, allowing pseudonymous donors to support whichever political causes they want to…the liberatory promise of crypto lies in the fact that it can bypass these intermediaries and make transactions more discreet—something Trudeau’s lackeys surely know, and seem a bit threatened by.
Coercive anti‐cash policies abridge the freedom and reduce the welfare of peaceful individuals who prefer to use cash. …They compromise financial privacy and enable the prosecution of victimless crimes wherever banks are required to “know their customers” and to provide transaction records to government officials. They impose an unlegislated tax on money‐holders, and leave them no means of escape into untaxed media of exchange, whenever the central bank decides to pursue a negative interest rate policy. They harm the livelihood of small businesspeople who rely on cash sales, particularly those serving the unbanked or operating in outdoor markets, and reduce the welfare of their (mostly poor) customers by raising transaction costs.
And here are some excerpts from William Luther’s column for Reason in the same year.
The case for cash presumes that we should be free to go about our lives so long as our actions do not harm others. It maintains that governments are not entitled to the intimate details of people’s lives. …demonetization advocates hold a progressive view of government. They think that existing laws and regulations have been rationally constructed by enlightened experts… There is, of course, an alternative view of government—one that is skeptical that laws and regulations are so rationally designed. …Some of these rules…were constructed to benefit some at the expense of others… Physical currency enables one to disobey the government. …Importantly, this argument…is a case for due process and financial privacy—bedrock jurisprudential principles in the West.
I’ll close with a few comments about what Trudeau should have done. Particularly after the road blockages lasted more than one or two days.
Instead of invoking a draconian emergency law, local Canadian governments should have used regular police powers to impose fines on truckers and- if necessary – impound their vehicles.
And if any of the truckers responded with violence, they should have been arrested and prosecuted.
For what it’s worth, this is how local governments in the United States should have responded (and should respond) to protests by Antifa and Black Lives Matter. Or to protests by any right-wing group.
The bottom line is that I’m a big believer in civildisobedience, but my tolerance drops when ordinary people are harassed, inconvenienced, and intimidated.
P.S. Luther’s point about the “progressive view of government” is not just a throwaway line. He’s referring to the mindset that first appeared during the “Progressive Era” of the early 1900s, when politicians such as Teddy Roosevelt and Woodrow Wilson decided that government was a force for good (unlike America’s Founders, who gave us a Constitution based on the notion that government was a threat to liberty and needed to be restrained).
If asked to contribute, what would I have suggested?
Being a curmudgeonly libertarian, I would have channeled the spirit of Milton Friedman and pointed out that bad monetary policy by central banks is the cause of inflation. Simply stated, it is appropriate to blame central banks if there are sustained and permanent increases in the overall price level.
And the only way to fix inflation is for central banks to unwind the policy mistakes that caused the problem in the first place.
Some of the respondents did mention the need for Federal Reserve to rectify its mistakes, so I’m not the only one to think monetary policy is important.
But I’m very fixated on assigning blame where it belongs, so I would not have mentioned any other factor.
For instance, in an article just published by the Austrian Economics Center in Vienna, Robert O’Quinn and I explain that bad fiscal policy does not cause inflation.
Are we seeing higher levels of price inflation because of fiscal profligacy? Some Republican U.S. Senators and Representatives have blamed this acceleration of price inflation on Biden’s blowout of federal spending. There are many good reasons to criticize Biden’s spending spree. It is not good for the economy to increase the burden of government spending and push for higher tax rates… But that does not necessarily mean deficit spending is inflationary. …Price inflation occurs when the supply of money exceeds the demand for money… Notably, none of the mechanisms that central banks use for monetary policy (buying and selling government securities, setting interest rates paid on reserves, loans to financial institutions, etc) have anything to do with federal spending or budget deficits. The Fed and other central banks can maintain price stability regardless of whether governments are enacting reckless fiscal policies.
In the article, we cited Japan as an example of a country with huge levels of debt, yet prices are stable.
By contrast, prices are rising in the United States because of Keynesian monetary policies by the Federal Reserve (often with the support of politicians).
What’s causing inflation, if not budget deficits and government debt? …central banks have been pursuing an inflationary policy. But they’ve been pursuing that approach not to finance budget deficits, but instead are motivated by a Keynesian/interventionist viewpoint that it is the role of central banks to “stimulate” the economy and/or prop up the financial market with easy-money policies.
I’ll close by observing that there can be a link between bad fiscal policy and inflation.
In basket-case nations such as Venezuela, Zimbabwe, and Argentina, politicians periodically use central banks to finance some of their excessive spending.
Some governments, particularly in less-developed countries, cannot easily borrow money and they rely on their central banks to finance their budget deficits. And that is clearly inflationary.
But the United States hasn’t yet reached that “tipping point.” There are still plenty of investors willing to buy the federal government’s debt (especially since the dollar is the world’s reserve currency).
The bottom line is that we should pursue good fiscal policy because it makes sense. And we should pursue good monetary policy because it makes sense. But the two are not directly connected.
P.S. On the topic of inflation, Ronald Reagan deserves immense praise for standing firm for good policy in the 1980s.
P.P.S. On the topic of the Federal Reserve, the central bank also should be criticized for interfering with the allocation of credit. And financial repression as well.
P.P.P.S. On the topic of basket-case economies, let’s hope that the American policy makers don’t embrace “modern monetary theory.”
And I should point out that I goofed around the 3:28 mark of the video, when I meant to say “not planning to take it all out in 2009” (a dumb mistake, but not as bad as the time I said “anals” rather than “annals” on live TV).
That correction aside, I was tasked with discussing how people can prosper in spite of bad government policy, and, as you can see, I did not pretend to have any uniquely brilliant investment strategies.
If I had more time, I could have talked about additional threats, such as the crackpot idea of “modern monetary theory.”
And I probably should have found some time to explain the notion of “financial repression” since that’s a government policy that has a very direct adverse effect on people trying to build wealth.
One final point. While I’m very hopeful that they may somehow help people protect their personal finances, you’ll notice that I didn’t recommend cryptocurrencies such as Bitcoin. This is for two reasons.
I don’t know enough about how they work to competently discuss the issue.
I fear that governments will have the power, desire, and ability to squash the market.
Needless to say, I hope I’m wrong about the second point.
P.S. A classical gold standard could block central banks from engaging in bad monetary policy, but returning to that type of system is almost as unlikely as a shift to private currencies.
P.P.S. While I’m obviously not a big fan of the Federal Reserve, other nations have even worse experiences with their central banks, which is why “dollarization” makes sense for many developing countries.
Incumbent politicians often applaud when the central bank intervenes to create excess liquidity and artificially low interest rates. That’s because the Keynesian approach produces a short-run “sugar high” that seems positive.
Indeed, the Federal Reserve deserves considerable blame for some of the economy’s worst episodes of the past 100-plus years – most notably the Great Depression, 1970s stagflation, and the 2008 financial crisis.
So what’s the solution?
I’ve previously pointed out that the classical gold standard has some attractive features but is not politically realistic.
But perhaps it’s time to reassess.
In a column for today’s Wall Street Journal, Professors William Luther and Alexander Salter explain the differences between a gold standard and today’s system of fiat money (i.e., a monetary system with no constraints).
Under a genuine gold standard, …Competition among gold miners adjusts the money supply in response to changes in demand, making purchasing power stable and predictable over long periods. The threat of customers redeeming notes and deposits for gold discourages banks from overissuing… Fiat dollars aren’t constrained by the supply of gold or any other commodity. The Federal Reserve can expand the money supply as much or as little as it sees fit, regardless of changes in money demand. When the Fed expands the money supply too much, an unsustainable boom and costly inflation follow.
They then compare the track records of the two systems.
…nearly all economists believe the U.S. economy has performed better under fiat money than it would have with the gold standard. This conventional wisdom is wrong. The gold standard wasn’t perfect, but the fiat dollar has been even worse. …in practice, the Fed has failed to govern the money supply responsibly. Inflation averaged only 0.2% a year from 1790 to 1913, when the Federal Reserve Act passed. Inflation was higher under the Fed-managed gold standard, averaging 2.7% from 1914 to 1971. It has been even higher without the constraint of gold. From 1972 to 2019, inflation averaged 4%. …the Fed…has also become less predictable. In a 2012 article published in the Journal of Macroeconomics, George Selgin, William D. Lastrapes and Lawrence H. White find “almost no persistence in the variance of inflation prior to the Fed’s establishment, and a very high degree of persistence afterwards.” …One might be willing to accept the costs of higher inflation and a less predictable price level if a Fed-managed fiat dollar reduced undesirable macroeconomic fluctuation. But that hasn’t happened. Consider the past two decades. The early 2000s had an unsustainable boom, as the Fed held interest rates too low for too long.
There was also a column on this issue in the WSJ two years ago.
James Grant opined about (the awful) President Nixon’s decision to make Federal Reserve policy completely independent of the gold anchor.
Richard Nixon announced the suspension of the Treasury’s standing offer to foreign governments to exchange dollars for gold, or vice versa, at the unvarying rate of $35 an ounce. The date was Aug. 15, 1971. Ever since, the dollar has been undefined in law. …In the long sweep of monetary history, this is a new system. Not until relatively recently did any central bank attempt to promote full employment and what is called price stability (but is really a never-ending inflation) by issuing paper money and manipulating interest rates. …a world-wide monetary system based on the scientifically informed discretion of Ph.D. economists. The Fed alone employs 700 of them.
But Grant says the gold standard worked reasonably well.
A 20th-century scholar, reviewing the record of the gold standard from 1880-1914, was unabashedly admiring of it: “Only a trifling number of countries were forced off the gold standard, once adopted, and devaluations of gold currencies were highly exceptional. Yet all this was achieved in spite of a volume of international reserves that, for many of the countries at least, was amazingly small and in spite of a minimum of international cooperation . . . on monetary matters.” …Arthur I. Bloomfield wrote those words, and the Federal Reserve Bank of New York published them, in 1959.
The new approach, which Grant mockingly calls the “Ph.D. standard,” gives central bankers discretionary power to do all sorts of worrisome things.
The ideology of the gold standard was laissez-faire; that of the Ph.D. standard (let’s call it) is statism. Gold-standard central bankers bought few, if any, government securities. Today’s central bankers stuff their balance sheets with them. In the gold-standard era, the stockholders of a commercial bank were responsible for the solvency of the institution in which they held a fractional interest. The Ph.D. standard brought the age of the government bailout and too big to fail.
By the way, the purpose of today’s column isn’t to unreservedly endorse a gold standard.
Such as system is very stable in the long run but can lead to short-term inflation or deflation based on what’s happening with the market for gold. And those short-term fluctuations can be economically disruptive.
I was messaging earlier today with Robert O’Quinn, the former Chief Economist at the Department of Labor (who also worked at the Fed) and got this reaction to the Luther-Salter column.
Which is better matching the long-term growth of the economy and the demand for money? The profitability of gold mining or central bank decision-making? A good monetary rule may be better than a classical gold standard. The difficulty is sustaining a good rule.
The ;problem, of course, is that I don’t trust politicians (and their Fed appointees) to follow a good rule.
Especially in a world where many of them think the Fed should prop up or bailout Wall Street.
Especially in a world where many of them might use the central bank to finance big government.
Especially in a world where many of them support a “war against cash” to empower politicians.
The bottom line is that we have to choose between two imperfect options and decide which one has a bigger downside.
P.S. Since a return to a classical gold standard is highly unlikely (and because the libertarian dream of “free banking” is even more improbable), the best we can hope for is a president who 1) makes good appointments to the Fed, and 2) supports sound-money policies even when it means short-run political pain. We’ve had one president like that in my lifetime.
Unfortunately, there’s no reason to think Biden will try to reverse those mistakes.
Indeed, he wants expand the burden of federal spending. And, regarding monetary policy, appointing Janet Yellen as Secretary of Treasury certainly suggests he is comfortable with the current approach.
And to make matters worse, he definitely wants a more punitive tax system. We will shortly learn whether Democrats take control of the Senate, which presumably would give Biden more leeway to enact his class-warfare tax agenda.
P.S. I mentioned in the interview that we have “three Americas” with regards to coronavirus. I’m not sure I was completely clear, so here’s what I was trying to get across.
Tourism-reliant states – They are going to be in bad shape until coronavirus is in the rear-view mirror and people feel comfortable with traveling and socializing.
Lock-down states – They have higher unemployment rates because more businesses are shut down.
Laissez-faire states – These are the states that generally allow businesses to remain open and have lower unemployment rates.
For what it’s worth, I think it’s best to let businesses stay open and to allow them and their customers to assess safety risks. It will be interesting to see whether any link is discovered between state policy and coronavirus rates.
I’m not a fan of the European Union, which has morphed from something good (a free-trade pact) to something bad (a pro-centralization,wannabe United States of Europe that exacerbates the continent’s tax-and-spend mentality).
Indeed, that’s why I’m a huge fan of Brexit. The United Kingdom is wise to escape the sinking ship.
Why? Because many of the nations that joined that common currency did a lousy job when they had national currencies. Italy and Greece, for instance, routinely used their central banks as printing presses to help finance bloated budgets.
And that inflation exacerbated all the other economic problems that existed.
The bottom line is that many nations would benefit if they took monetary policy away from their politicians and instead adopted the currency of a nation with a better track record.
That happened in Europe when the euro was adopted since it means – for all intents and purposes – that Mediterranean nations use a currency that is controlled by Germany.
This lesson should be applied elsewhere in the world, which is why “dollarization” can be a good idea.
Professor Steve Hanke of Johns Hopkins University wrote a good description of this concept for National Review.
Before the rise in central banking (monetary nationalism), the world was dominated by unified currency areas, or blocs, the largest of which was the sterling bloc. As early as 1937, the great Austrian economist and Nobel winner Friedrich von Hayek warned that the central banking fad, if it continued, would lead to currency chaos and the spread of banking crises. …Indeed, for most emerging‐market countries with central banks, hot money flows are frequent and so are exchange‐rate and domestic banking crises. What to do? The obvious answer is for vulnerable emerging‐market countries to do away with their central banks and domestic currencies, replacing them with a sound foreign currency. Today, 32 countries are “dollarized” and rely on a foreign currency as legal tender. …Panama, which was dollarized in 1903, illustrates the important features of a dollarized economy. …The results of Panama’s dollarized money system and internationally integrated banking system have been excellent when compared with other emerging-market countries… Emerging-market countries should follow Panama’s lead and “dollarize.” Most central banks in emerging countries produce junk currencies, banking crises, instability, and economic misery. These central banks should have been mothballed and put in museums long ago.
And there are many nations that would benefit if they used the U.S. dollar.
Back in 2018, Mary Anastasia O’Grady opined in the Wall Street Journal that Argentina should dollarize.
Another currency crisis is roiling Argentina… The question that seems to be on everyone’s lips: Why is this happening again… The answer: Because Argentina still has a central bank. To fix the problem once and for all, it should dollarize. …an IMF package can’t cure what ails the peso. This is a long-term political problem that has manifested itself in repeated economic crises since the mid-20th century. The government lives beyond its means while taxes and regulations, particularly on labor, make many businesses uncompetitive. The net effect is always the same: ballooning debt and a lethargic economy followed by devaluation or default or both. …The fastest way to restore confidence would be to put an end to the misery caused by the peso and to adopt the dollar. Argentines could then get on with the business of saving and investing in their beautiful country.
The Wall Street Journal has editorialized in favor of dollarization in Argentina.
Dollarizers face resistance from the Peronist party, which relies on the inflation tax to fund its populism when revenues run low. Yet demand for dollars suggests…popular backing for adopting the greenback as the national currency. …Panama has used the dollar as legal tender since 1904, and El Salvador and Ecuador dollarized in 2000. Ecuador did it to resolve a banking crisis and El Salvador did it to bring down interest rates. El Salvador and Panama now have the lowest domestic borrowing rates in Latin America and the longest maturities. Ecuador has price stability not seen in at least a half century.
Here’s the real shocker. As reported by Reuters, Venezuela is on the verge of dollarizing.
Venezuelan President Nicolás Maduro embraced the currency of his bitter rival the United States on Sunday, calling it an “escape valve” that can help the country weather its economic crisis… The official currency, the bolivar, has depreciated more than 90% this year, while hyperinflation in the first nine months of the year clocked in at 4,680%… “I don’t see it as a bad thing … this process that they call ‘dollarization,’” Maduro said in an interview broadcast on the television channel Televen. “It can help the recovery of the country, the spread of productive forces in the country, and the economy … Thank God it exists,” the socialist leader said.
Writing for National Review, Professor Steve Hanke explains that Maduro has no choice but to move in the right direction.
Maduro, in a rare display of good judgment, is taking a necessary step toward what I have been advocating for many years: official dollarization in Venezuela. …Venezuela’s bolivar is worthless, and its annual inflation rate is the world’s highest…2,156 percent per year. Not surprisingly, Venezuelans get rid of their bolivars like hot potatoes and replace them with U.S. dollars. So, Venezuela is, to a large extent, unofficially dollarized. Official “dollarization” is a proven elixir. I know because I operated as a state counselor in Montenegro when it dumped the worthless Yugoslav dinar in 1999 and replaced it with the Deutsche mark. I also watched the successful dollarization of Ecuador in 2001… Countries that are officially dollarized produce lower, less variable inflation rates and higher, more stable economic growth rates than comparable countries with central banks that issue domestic currencies. There is a tried-and-true way to stabilize the economy…since more than 80 percent of transactions in Venezuela take place in U.S. dollars, it doesn’t seem unreasonable to think that the approval rating would now exceed 80 percent. So, it’s not surprising that Maduro has embraced the dollarization idea. After all, the public already does.
In another column for National Review, Steve Hanke and Craig Richardson cite what’s been happening in Zimbabwe.
They begin by pointing out that part of that nation has avoided problems by using the dollar.
Zimbabwe’s economy has gone through the wringer. In just 20 short years, it has witnessed two episodes of hyperinflation. And, if that wasn’t bad enough, Zimbabwe’s real GDP per capita has plunged by 21 percent over that same period. …But,…when you enter the town of Victoria Falls, it’s as if you have walked into an alternative African economic universe. Victoria Falls is an island of stability in Zimbabwe, a country that has descended into monetary and fiscal chaos. How could this be? …Victoria Falls…has long operated under very different monetary rules. …the glue that holds Victoria Falls together is the U.S. dollar. It’s the coin of the realm in Victoria Falls. Yes, Victoria Falls is officially dollarized. It only accepts U.S. dollars for payment of property taxes and keeps its books in U.S. dollars as well.
But they also note that the entire nation enjoyed the benefits of dollarization, at least until venal politicians opted out because they wanted the power to finance more spending by printing money.
…in February 2009, a unity government was formed. …In one of its first acts, the unity government scrapped the Zimbabwe dollar and officially dollarized the country. In so doing, the printing presses were shut down; the U.S. dollar became legal tender, taxes were required to be paid in dollars, and government accounts were kept in dollars. With the imposition of a hard budget constraint, the fiscal deficit disappeared, and the economy boomed. That rebound persisted during the term of the national unity government, which lasted until July 2013. Indeed, during this period, real GDP per capita surged at an average annual rate of 11.2 percent. Zimbabwe’s period of stability was short lived, however. With the collapse of the unity government and the return of Mugabe’s ZANU-PF party, government spending and fiscal deficits surged, resulting in economic instability. To finance its deficits, the government created a “New Zim dollar,” and Zimbabwe de-dollarized. …The money supply exploded, as did inflation.
This column has focused on dollarization, but there are other currencies that are serve the same role. And there are currency boards/pegs as well.
This map from Wikipedia provides a helpful summary.
There will be many lessons that we hopefully learn from the current crisis, most notably that it’s foolish to give so much regulatory power to sloth-like bureaucracies such as the FDA and CDC.
Are current debt levels excessive? Let’s look at some excerpts from a column in the Washington Post, which was written by David Lynch last November – before coronavirus started wreaking havoc with the economy.
Little more than a decade after consumers binged on inexpensive mortgages that helped bring on a global financial crisis, a new debt surge — this time by major corporations — threatens to unleash fresh turmoil. A decade of historically low interest rates has allowed companies to sell record amounts of bonds to investors, sending total U.S. corporate debt to nearly $10 trillion… Some of America’s best-known companies…have splurged on borrowed cash. This year, the weakest firms have accounted for most of the growth and are increasingly using debt for “financial risk-taking,”… “We are sitting on the top of an unexploded bomb, and we really don’t know what will trigger the explosion,” said Emre Tiftik, a debt specialist at the Institute of International Finance, an industry association. …The root cause of the debt boom is the decision by the Federal Reserve and other key central banks to cut interest rates to zero in the wake of the financial crisis and to hold them at historic lows for years.
Needless to say, Emre Tiftik didn’t know last November what would “trigger the explosion.”
Now we have coronavirus, and George Melloan explained a few days ago in the Wall Street Journal that the “unexploded bomb” has detonated.
The Covid-19 pandemic…will do further damage to the global economy… The danger is heightened by the heavy load of debt American corporations have piled up as they have taken advantage of low-cost borrowing. …Cheap credit brought on the heavy overload of corporate debt. The Federal Reserve has responded to the virus by—what else?—making credit even cheaper, cutting its fed funds lending rate all the way to 0%-0.25% on Sunday. …Rate cuts in response to crises are programmed into the Fed’s software. There is no compelling evidence that they are a solution or even a remedy. …the low interest rates of the past decade have ballooned all forms of debt: government, consumer, corporate. Corporate debt, the most worrisome type at the moment, stands at about $10 trillion and has made a steady climb to 47% of gross domestic product, a record level… But even cheap borrowing and securitized debt obligations have to be paid back. It becomes harder to make payments when a global health crisis is killing sales and your company is bleeding red ink. …the increased political bias toward easy money remains a problem. The Federal Reserve Act of 1913 was political from the day Woodrow Wilson signed it. It has gotten more political ever since, increasingly becoming an instrument for robbing the poor—savers and pensioners—and giving to often profligate borrowers.
But let’s keep our focus on the topic of government-encouraged debt and how it contributes to economic instability.
It’s not just an issue of bad monetary policy. We also have a tax code that encourages companies to disproportionately utilize debt.
But the 2017 tax bill addressed that flaw, as Reihan Salam explained two years ago in an article for National Review.
…one of the TCJA’s good points…limits that the legislation places on corporate interest deductibility, which…could change the way companies in the United States do business and make the U.S. economy more stable. …By stipulating that companies cannot use the interest deduction to reduce their earnings by more than 30 percent, the law made taking on debt somewhat less attractive compared to seeking financing by offering equity to investors. …equity is more flexible in times of crisis than debt, which means that problems are less likely to spiral out of control.
The bad news is that the 2017 law only partially addressed the bias for debt over equity. Companies still have a tax-driven incentive to prefer borrowing.
Here’s the Tax Foundation’s depiction of how the pre-TCJA system worked, which I’ve altered to show how the new system operates.
I’ll close with the observation that there’s nothing necessarily wrong with private debt. Families borrow to buy homes, for instance, and companies borrow for reasons such as financing research and building factories.
But debt only makes sense if it’s based on market-driven factors (i.e., will borrowing enable future benefits and will there be enough cash to make payments). And that includes planning for what happens if there’s a recession and income falls.
Unfortunately, government intervention has distorted market signals and the result is excessive debt. And now the economic damage of the coronavirus will be even higher because more companies will become insolvent.
P.S. Even the International Monetary Fund is on the correct side about the downsides of tax-driven debt.
P.P.S. In addition to eliminating the bias for debt over equity, it also would be a very good idea to get rid of the bias for current consumption over future consumption (i.e., double taxation).
The coronavirus is a genuine threat to prosperity, at least in the short run, in large part because it is causing a contraction in global trade.
The silver lining to that dark cloud is that President Trump may learn that trade is actually good rather than bad.
But dark clouds also can have dark linings, at least when the crowd in Washington decides it’s time for another dose of Keynesian economics.
Fiscal Keynesianism – the government borrows money from credit markets and politicians then redistribute the funds in hopes that recipients will spend more.
Monetary Keynesianism – the government creates more money in hopes that lower interest rates will stimulate borrowing and recipients will spend more.
Critics warn, correctly, that Keynesian policies are misguided. More spending is a consequence of economic growth, not the trigger for economic growth.
But the “bad penny” of Keynesian economics keeps reappearing because it gives politicians an excuse to buy votes.
The Wall Street Journalopined this morning about the risks of more Keynesian monetary stimulus.
The Federal Reserve has become the default doctor for whatever ails the U.S. economy, and on Tuesday the financial physician applied what it hopes will be monetary balm for the economic damage from the coronavirus. …The theory behind the rate cut appears to be that aggressive action is the best way to send a strong message of economic insurance. …Count us skeptical. …Nobody is going to take that flight to Tokyo because the Fed is suddenly paying less on excess reserves. …The Fed’s great mistake after 9/11 was that it kept rates at or near 1% for far too long even after the 2003 tax cut had the economy humming. The seeds of the housing boom and bust were sown.
And the editorial also warned about more Keynesian fiscal stimulus.
Even if a temporary tax cuts is the vehicle used to dump money into the economy.
This being an election year, the political class is also starting to demand more fiscal “stimulus.” …If Mr. Trump falls for that, he’d be embracing Joe Bidenomics. We tried the temporary payroll-tax cut idea in the slow growth Obama era, reducing the worker portion of the levy to 4.2% from 6.2% of salary. It took effect in January 2011, but the unemployment rate stayed above 9% for most of the rest of that year. Temporary tax cuts put more money in peoples’ pockets and can give a short-term lift to the GDP statistics. But the growth effect quickly vanishes because it doesn’t permanently change the incentive to save and invest.
Given the political division in Washington, it’s unclear whether politicians will agree on how to pursue fiscal Keynesianism.
But that doesn’t mean we can rest easy. Trump is a fan of Keynesian monetary policy and the Federal Reserve is susceptible to political pressure.
Just don’t expect good results from monetary tinkering. George Melloan wrote about the ineffectiveness of monetary stimulus last year, well before coronavirus became an issue.
The most recent promoters of monetary “stimulus” were Barack Obama and the Fed chairmen who served during his presidency, Ben Bernanke and Janet Yellen. …the Obama-era chairmen tried to stimulate growth “by keeping its policy rate at zero for six-and-a-half years into the economic recovery and more than quadrupled the size of the Fed’s balance sheet.” And what do we have to show for it? After the 2009 slump, economic growth from 2010-17 averaged 2.2%, well below the 3% historical average, despite the Fed’s drastic measures. Low interest rates certainly stimulate borrowing, but that isn’t the same as economic growth. Indeed it can often restrain growth. …Congress got the idea that credit somehow comes free of charge. So now the likes of Elizabeth Warren and Bernie Sanders think there is no limit to how much Uncle Sam can borrow. Easy money not only expands debt-service costs but also encourages malinvestment. …when Donald Trump hammers on the Fed for lower rates, …he is embarked on a fool’s errand.
Since the Federal Reserve has already slashed interest rates, that Keynesian horse already has left the barn.
That being said, don’t expect positive results. Keynesian economics has a very poor track record (if fiscal Keynesianism and monetary Keynesianism were a recipe for success, Japan would be booming).
So let’s hope politicians don’t put a saddle on the Keynesian fiscal horse as well.
If Trump really feels he has to do something, I ranked his options last summer.
Yesterday’s column was my annual end-of-year round-up of the best and worst developments of the concluding year.
Today I’ll be forward looking and give you my hopes and fears for the new year, which is a newer tradition that began in 2017 (and continued in 2018 and 2019).
With my glass-half-full outlook, we’ll start with the things I hope will happen.
Supreme Court strikes down civil asset forfeiture – It is nauseating that bureaucrats can steal property from citizens who have never been convicted of a crime. Or even charged with a crime. Fortunately, this disgusting practice already has attracted attention from Clarence Thomas and other sound-thinking Justices on the Supreme Court. Hopefully, this will produce a decision that ends this example of Venezuela-style government thuggery.
Good free-trade agreements for the United Kingdom – This is a two-pronged hope. First, I want a great agreement between the U.S. and the U.K., based on the principle of mutual recognition. Second, I want the best-possible agreement between the U.K. and the E.U., which will be a challenge since the political elite in Brussels has a spiteful desire to “punish” the British people for supporting Brexit.
Maduro’s ouster in Venezuela – I already wished for this development in 2018 and 2019, so this is my “Groundhog Day” addition to the list. But if I keep wishing for it, sooner or later it will happen and I’ll look prescient. But I actually don’t care about whether my predictions are correct, I just want an end to the horrible suffering for the people of Venezuela.
Here are the things I fear will happen in 2020.
A bubble bursts – I hope I’m wrong (and that may be the case since I’ve been fretting about it for a long time), but I fear that financial markets are being goosed by an easy-money policy from the Federal Reserve. Bubbles feel good when they’re expanding, but last decade should have taught us that they can be very painful when they pop.
A loss of economic liberty in Chile and/or Hong Kong – As shown by Economic Freedom of the World, there are not that many success stories in the world. But we can celebrate what’s happened in Hong Kong since WWII and what’s happened in Chile since the late 1970s. Economic liberty has dramatically boosted prosperity. Unfortunately, Hong Kong’s liberty is now being threatened from without and Chile’s liberty is now being threatened from within.
Repeal of the Illinois flat tax – The best approach for a state is to have no income tax, and a state flat tax is the second-best approach. Illinois is in that second category thanks to a long-standing provision of the state’s constitution. Needless to say, this irks the big spenders who control the Illinois government and they are asking voters this upcoming November to vote on whether to bust the flat tax and open the floodgates for an ever-growing fiscal burden. By the way, it’s quite likely that I’ll be including the Massachusetts flat tax on this list next year.
I’ll also add a special category for something that would be both good and bad.
It would be much better, as I discuss in this interview with Yahoo Finance, if Trump instead declared a ceasefire in the trade wars he’s started.
The interview largely revolved around trade policy and monetary policy, so I was mostly critical of Trump.
But I want to focus on the point I made midway through the discussion, when I said that Trump is undermining and offsetting some of his Administration’s good policies – most notably tax reform and regulatory easing.
As an economist, I’m frustrated by this inconsistency. It’s akin to a watching a kid get good grades in some classes and bad grades in others (and I worry his GPA is declining).
Though I suppose I shouldn’t be surprised. This is what the theory of “public choice” tells us to expect.
I can only imagine, though, how frustrating this must be for Republican political operatives. They’re focused on winning in 2020 and the President is sabotaging that goal with bad trade policy.
Having been exposed to scholars from the Austrian school as a graduate student, I have a knee-jerk suspicion that it’s not a good idea to rely on the Federal Reserve for macroeconomic tinkering.
Since I don’t pretend to be an expert on monetary policy, I’ll do an appeal to authority.
Claudio Borio of the Bank for International Settlements is considered to be one of the world’s experts on the issue.
Here are some excerpts from a study he recently wrote along with three other economists. I especially like what they wrote about the risks of looking solely at the price level as a guide to policy.
The pre-crisis experience has shown that, in contrast to common belief, disruptive financial imbalances could build up even alongside low and stable, or even falling, inflation. Granted, anyone who had looked at the historical record would not have been surprised: just think of the banking crises in Japan, the Asian economies and, going further back in time, the US experience in the run-up to the Great Depression. But somehow the lessons had got lost in translation… And post-crisis, the performance of inflation has repeatedly surprised. Inflation…has been puzzlingly low especially more recently, as a number of economies have been reaching or even exceeding previous estimates of full employment. …the recent experience has hammered the point home, raising nagging doubts about a key pillar of monetary policymaking. …Our conclusion is that…amending mandates to explicitly include financial stability concerns may be appropriate in some circumstances.
Here’s a chart showing that financial cycles and business cycles are not the same thing.
Some recent work with colleagues sheds further light on some of the possible mechanisms at work (Borio et al (2016)). Drawing on a sample of over 40 countries spanning over 40 years, we find that credit booms misallocate resources towards lower-productivity growth sectors, notably construction, and that the impact of the misallocations that occur during the boom is twice as large in the wake of a subsequent banking crisis. The reasons are unclear, but may reflect, at least in part, the fact that overindebtedness and a broken banking system make it harder to reallocate resources away from bloated sectors during the bust. This amounts to a neglected form of hysteresis. The impact can be sizeable, equivalent cumulatively to several percentage points of GDP over a number of years.
Here’s a chart quantifying the damage.
And here’s some more evidence.
In recent work with colleagues, we examined deflations using a newly constructed data set that spans more than 140 years (1870–2013), and covers up to 38 economies and includes equity and house prices as well as debt (Borio et al (2015)). We come up with three findings. First, before controlling for the behaviour of asset prices, we find only a weak association between deflation and growth; the Great Depression is the main exception. Second, we find a stronger link with asset price declines, and controlling for them further weakens the link between deflations and growth. In fact, the link disappears even in the Great Depression (Graph 4). Finally, we find no evidence of a damaging interplay between deflation and debt (Fisher’s “debt deflation”; Fisher (1932)). By contrast, we do find evidence of a damaging interplay between private sector debt and property (house) prices, especially in the postwar period. These results are consistent with the prevalence of supply-induced deflations.
I’ll share one final chart from the study because it certainly suggest that the economy suffered less instability when the classical gold standard was in effect before World War I.
I’m not sure we could trust governments to operate such a system today, but it’s worth contemplating.
P.S. I didn’t like easy money when Obama was in the White House and I don’t like it with Trump in the White House. Indeed, I worry the good economic news we’re seeing now could be partly illusory.
Being a policy wonk in a political town isn’t easy. I care about economic liberty while many other people simply care about political maneuvering. And the gap between policy advocacy and personality politics has become even larger in the Age of Trump.
One result is that people who should be allies periodically are upset with my columns. Never Trumpers scold me one day and Trump fanboys scold me the next day. Fortunately, I have a very simple set of responses.
If you would have loudly cheered for a policy under Reagan but oppose a similar policy under Trump, you’re the problem.
If you would have loudly condemned a policy under Obama but support a similar policy under Trump, you’re the problem.
Today, we’re going to look at an example of the latter.
The New York Timesreported today on Trump’s advocacy of easy-money Keynesianism.
President Trump on Friday called on the Federal Reserve to cut interest rates and take additional steps to stimulate economic growth… On Friday, he escalated his previous critiques of the Fed by pressing for it to resume the type of stimulus campaign it undertook after the recession to jump-start economic growth. That program, known as quantitative easing, resulted in the Fed buying more than $4 trillion worth of Treasury bonds and mortgage-backed securities as a way to increase the supply of money in the financial system.
Simply stated, the Keynesians are all about artificially boosting consumption, but sustainable growth is only possible with policies that boost production.
There are two additional passages from the article that deserve some commentary.
First, you don’t measure inflation by simply looking at consumer prices. It’s quite possible that easy money will result in asset bubbles instead.
That’s why Trump is flat-out wrong in this excerpt.
“…I personally think the Fed should drop rates,” Mr. Trump said. “I think they really slowed us down. There’s no inflation. I would say in terms of quantitative tightening, it should actually now be quantitative easing. Very little if any inflation. And I think they should drop rates, and they should get rid of quantitative tightening. You would see a rocket ship. Despite that, we’re doing very well.”
To be sure, many senior Democrats were similarly wrong when Obama was in the White House and they wanted to goose the economy.
Which brings me to the second point about some Democrats magically becoming born-again advocates of hard money now that Trump is on the other side.
Democrats denounced Mr. Trump’s comments, saying they showed his disregard for the traditional independence of the Fed and his desire to use its powers to help him win re-election. “There’s no question that President Trump is seeking to undermine the…independence of the Federal Reserve to boost his own re-election prospects,” said Senator Ron Wyden of Oregon, the top Democrat on the Finance Committee.
Notwithstanding what I wrote a few days ago, I agree with Sen. Wyden on this point.
Though I definitely don’t recall him expressing similar concerns when Obama was appointing easy-money supporters to the Federal Reserve.
To close, here’s what I said back in October about Trump’s Keynesian approach to monetary policy.
Back in January, I spoke with Cheddar about market instability and put much of the blame on the Federal Reserve. Simply stated, I fear we have a bubble thanks to years and years (and years and years) of easy money and artificially low interest rates.
To be sure, I also noted that there are other policies that could be spooking financial markets.
Mistakes by Congress, by contrast, “merely” cause slower growth.
In this next clip from the interview, I offer guarded praise to the Fed (not my usual position!) for trying to unwind the easy-money policies from earlier this decade and therefore “normalize” interest rates (i.e., letting rates climb to the market-determined level).
For those interested in the downside risks of easy money, I strongly endorse these cautionary observations from a British central banker.
My modest contribution to the discussion was when I mentioned in the interview that we wouldn’t be in the tough position of having to let interest rates climb if we didn’t make the mistake of keeping them artificially low. Especially for such a long period of time.
My motive for addressing this topic today is that Robert Samuelson used his column in the Washington Post to launch an attack against Steve Moore.
Stephen Moore does not belong on the Federal Reserve Board… Just a decade ago, the U.S. and world economies suffered the worst slumps since World War II. What saved us then were the skilled interventions of the Fed under Chairman Ben S. Bernanke… Do we really want Moore to serve as the last bulkhead against an economic breakdown? …as a matter of prudence, we should assume economic reverses. If so, the Fed chief will become a crisis manager. That person should not be Stephen Moore.
I’ve been friends with Steve for a couple of decades, so I have a personal bias.
That being said, I would be arguing that Samuelson’s column is problematic for two reasons even if I never met Steve.
First, he doesn’t acknowledge that the crisis last decade was caused in large part by easy-money policy from the Fed. Call me crazy, but I hardly think we should praise the central bank for dousing a fire that it helped to start.
Second, he frets that Steve would be bad in a crisis, which presumably is a time when it might be appropriate for the Fed to be a “lender of last resort.”* But he offers zero evidence that Steve would be opposed to that approach.
For what it’s worth, I actually worry Steve would be too willing to go along with an easy-money approach. Indeed, I look forward to hectoring him in favor of hard money if he gets confirmed.
But this column isn’t about a nomination battle in DC. My role is to educate on public policy.
So let’s close by reviewing some excerpts from a column in the Wall Street Journal highlighting the work of Claudio Borio at the Bank for International Settlements.
In a 2015 paper Mr. Borio and colleagues examined 140 years of data from 38 countries and concluded that consumer-price deflation frequently coincides with healthy economic growth. If he’s right, central banks have spent years fighting disinflation or deflation when they shouldn’t have, and in the process they’ve endangered the economy more than they realize. “By keeping interest rates very, very, very low,” he warns, “you are contributing to the buildup of risks in the financial system through excessive credit growth, through excessive increases in asset prices, that at some point have to correct themselves. So what you have is a financial boom that necessarily at some point will turn into a bust because things have to adjust.” …It’s not that other economists are blind to financial instability. They’re just strangely unconcerned about it. “There are a number of proponents of secular stagnation who acknowledge, very explicitly, that low interest rates create problems for the future because they’re generating all these financial booms and busts,” Mr. Borio says. Yet they still believe central banks must set ultralow short-term rates to support economic growth—and if that destabilizes the financial system, it’s the will of the economic gods.
Amen. I also recommend this column and this column for further information on how central bankers are endangering prosperity.
P.S. For a skeptical history of the Federal Reserve, click here. If you prefer Fed-mocking videos, click here and here.
P.P.S. I fear the European Central Bank has the same misguided policy. To make matters worse, policy makers in Europe have used easy money as an excuse to avoid the reforms that are needed to generate real growth.
As I warn in this interview, something similar could happen if the federal government convinces other nations to reject the dollar because they no longer want to acquiesce to the extraterritorial imposition of U.S. laws.
This is a wonky issue, but the bottom line is that the United States benefits enormously because the rest of the world uses the dollar.
The best article I can recommend was published earlier this year by the Cayman Financial Review. It’s a good tutorial on the issue and it explains why the United States enjoys an “exorbitant privilege” because the dollar is the world’s reserve currency.
A reserve currency is a currency that governments hold in their foreign exchange reserves to settle international claims and intervene in foreign exchange markets. …Governments overwhelmingly choose one currency – the U.S. dollar… U.S. dollar-denominated assets comprised 63.79 percent of disclosed foreign exchange reserves… The Bank for International Settlements (BIS) reported that 88 percent of all foreign exchange transactions in 2016 involve the U.S. dollar on one side. …In 2014, 51.9 percent of international trade by value and 49.4 percent of international trade by volume of transactions were invoiced in U.S. dollars. …Major internationally traded commodities such as oil are priced in U.S. dollars. …The status of the U.S. dollar as the world’s reserve currency and the resulting foreign demand for U.S. dollars creates what French Finance Minister Valéry Giscard d’Estaing described in 1965 as an “exorbitant privilege” for the United States. …While difficult to measure, empirical studies suggest the privilege is worth about ½ percent of U.S. GDP (or roughly $100 billion) in a normal year.
And Peter Coy’s column for Bloomberg does a good job of explaining why the rest of the world is tempted to abandon the dollar.
America’s currency makes up two-thirds of international debt and a like share of global reserve holdings. Oil and gold are priced in dollars, not euros or yen. …threats to be cut off from the dollar-based global payments system strike terror into the likes of Iran, North Korea, and Russia. …Political leaders who once accepted the dollar’s hegemony, grudgingly or otherwise, are pushing back. …In March, China challenged the dollar’s dominance in the global energy markets with a yuan-denominated crude oil futures contract. …French Finance Minister Bruno Le Maire told reporters in August that he wants financing instruments that are “totally independent” of the U.S. …This disturbance in the force isn’t good news for the U.S. …As it is now, when trouble breaks out, investors flood into U.S. markets seeking refuge, oddly enough even when the U.S. itself is the source of the problem, as it was in last decade’s global financial crisis. …The most immediate risk to the dollar is that the U.S. will overplay its hand on financial sanctions, particularly those against Iran and countries that do business with Iran. …European leaders, in response to what they perceive as an infringement on their sovereignty, are openly working on a payments system that would enable their companies to do business with Iran without getting snagged by the U.S. Treasury Department and its powerful Office of Foreign Assets Control. …dissatisfaction with the dollar’s dominance…is only mounting. …Lew said in 2016, “the more we condition use of the dollar and our financial system on adherence to U.S. foreign policy, the more the risk of migration to other currencies and other financial systems in the medium term grows.”
Here’s some of what I said on the issue of sanctions in a different interview.
Anyhow, let’s review some additional analysis, starting with this editorial from the Wall Street Journal.
More than any recent U.S. President, Mr. Trump is willing to use economic leverage for coercive diplomacy. He’s now targeting Turkey… Turkey is vulnerable because of Mr. Erdogan’s economic mismanagement. In the runup to June elections, he blew out the fisc on entitlements and public works. …As tempting as sanctions often are, they should be used sparingly and against the right targets. They make sense against genuine rogue states like Iran and North Korea, as well as to show Vladimir Putin that there are costs… But sanctions against allies should be used only in rare cases. They would also be less risky if they weren’t piled on top of Mr. Trump’s tariff war. …If Mr. Trump is determined to use coercive economic diplomacy, including tariffs and sanctions, then the Treasury will have to be ready to deal with the collateral financial damage.
The United States is increasingly using sanctions as a form of warfare. …It’s a form of soft warfare that targets a country’s economy and its ability to transact business and safeguard its financial wealth in today’s dollar-based economy. Do you know what the result of these sanctions will be? The dollar will get crushed. Something like 80% of all international transactions take place in dollars. The global financial system rests on a dollar architecture. That includes funds transfer, clearing, payments, etc. …How long do you think the rest of the world will operate under such a risk? A risk that at any moment if you fall out of favor with the fools in Washington your entire economy and lifeline to the world’s financial system can be shut down? That is too much risk. No country and no citizen wants that risk hanging over them.
…the Trump administration is eroding the dollar’s global role. Having unilaterally reimposed sanctions on Iran, it is threatening to penalize companies doing business with the Islamic Republic by denying them access to US banks. The threat is serious because US banks are the main source of dollars used in cross-border transactions. …In response to the Trump administration’s stance, Germany, France, and Britain, together with Russia and China, have announced plans to circumvent the dollar, US banks, and US government scrutiny. …This doesn’t mean that foreign banks and companies will shun the dollar entirely. US financial markets are large and liquid and are likely to remain so. US banks operate globally. …But in an era of US unilateralism, they will want to hedge their bets. …there will be less reason for central banks to hold dollars in order to intervene in the foreign exchange market and stabilize the local currency against the greenback. …In threatening to punish Europe and China, Trump is, ironically, helping them to achieve their goals. Moreover, Trump is squandering US leverage.
And Michael Maharrey elaborates on the warning signs in a column for FEE.
…the U.S….weaponizes the U.S. dollar, using its economic dominance as both a carrot and a stick. …”enemies” can find themselves locked out of the global financial system, which the U.S. effectively controls using the dollar. …It utilizes the international payment system known as SWIFT…the Society for Worldwide Interbank Financial Telecommunication. …SWIFT and dollar dominance give the U.S. a great deal of leverage over other countries. …China, Russia, and Iran, have taken steps to limit their dependence on the dollar and have even been working to establish alternative payment systems. A growing number of central banks have been buying gold as a way to diversify their holdings away from the greenback. …even traditional U.S. allies have grown weary of American economic bullying. On Sept. 24, the E.U. announced its plans to create a special payment channel to circumvent U.S. economic sanctions… De-dollarization of the world economy would likely perpetuate a currency crisis in the United States, and it appears a movement to dethrone the dollar is gaining steam.
All of the above articles could be considered the bad news.
So I’ll share one small bit of good news from Coy’s column. The one thing that may save the dollar is that there aren’t any good alternatives.
The best thing the dollar has going for it is that its challengers are weak. The euro represents a monetary union… Italy’s recent woes are only the latest challenge to the euro zone’s durability. China is another pretender to the throne. But China’s undemocratic leadership is wary of the openness to global trade and capital flows that having a widely used currency requires.
I agree. Indeed, I wrote way back in 2010 and 2011 that the euro lost a lot of credibility when the European Central Bank surrendered its independence and took part in the bailouts of Europe’s welfare states.
So why jump from the dollar to the euro, especially since Europe will be convulsed by additional fiscal crises when the next recession occurs?
That being said, the moral of today’s column is that the crowd in Washington shouldn’t be undermining the attractiveness of the dollar. Here’s a chart to give you some idea of what’s been happening.
P.S. I want to close with a point about trade deficits. It turns out that being the world’s reserve currency requires a trade deficit. That was explained in the Cayman Financial Review column.
A significant part of the U.S. current account deficit and the U.S. trade deficit (whether measured as goods and services or as goods only) is attributable to the U.S. dollar’s status as the world’s reserve currency. Even if every country in the world were to practice free trade and not to engage in any currency manipulation, the United States would still record persistent current account deficits so long as the U.S. dollar remains the world’s reserve currency.
Likewise, here’s the relevant portion from the Real Money column.
Since most of of the world’s commerce is denominated in dollars and because oil was priced in dollars, it necessitated that the rest of the world ran trade surpluses with the U.S. in order to get dollars. Therefore, our trade deficits were an expression of high demand for dollars, not vice-versa. …We never understood, or at least our policy makers never understood, that we had the better part of the deal. When the rest of the world labors for low wages to build finished goods that they send to us for our paper currency, that is a benefit to us, not a cost.
Last but not least, here are excerpts from Peter Coy’s column.
…for the U.S. to supply dollars to the rest of the world, it must run trade deficits. Trading partners stash the dollars they earn from exports in their reserve accounts instead of spending them on American goods and services. …the U.S. gets what amounts to a permanent, interest-free loan from the rest of the world when dollars are held outside the U.S. As Eichengreen points out, it costs only a few cents for the U.S. Bureau of Engraving and Printing to produce a $100 bill, but other countries have to pony up $100 worth of actual goods and services to obtain one.
I share all these excerpts to reinforce my oft-made point that there is nothing wrong with a trade deficit. Not only does it represent a financial surplus (formerly known, and still often referred to, as a capital surplus), it also reflects the benefit the U.S. enjoys from having the dollar as a reserve currency.
I periodically explain that you generally don’t get a recession by hiking taxes, adding red tape, or increasing the burden of government spending. Those policies are misguided, to be sure, but they mostly erode the economy’s long-run potential growth.
If you want to assign blame for economic downturns, the first place to look is monetary policy.
When central banks use monetary policy to keep interest rates low (“Keynesian monetary policy,” but also known as “easy money” or “quantitative easing”), that can cause economy-wide distortions, particularly because capital gets misallocated.
And this often leads to a recession when this “malinvestment” gets liquidated.
By the way, doesn’t the other guest have amazing wisdom and insight?
But let’s not digress.
Back to the main topic, I’m not the only one who is worried about easy money.
Desmond Lachman of the American Enterprise Institute is similarly concerned.
Never before have the world’s major central banks kept interest rates so low for so long as they have done over the past decade. More importantly yet, never before have these banks increased their balance sheets on anything like the scale that they have done since 2008 by their aggressive bond-buying programmes. Indeed, since 2008, the size of the combined balances sheet of the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England has increased by a mind-boggling US$10tn. …in recent years, if anything central bank monetary policy might have been overly aggressive. By causing global asset price inflation as well as the serious mispricing and misallocation of global credit, the seeds might have been sown for another Lehman-style economic and financial market crisis down the road. …the all too likely possibility that, by having overburdened monetary policy with the task of stabilizing output, advanced country governments might very well have set us up for the next global boom-bust economic cycle.
If you want the other side of the issue, the Economist is more sympathetic to monetary intervention.
And if you want a very learned explanation of the downsides of easy money, I shared some very astute observations from a British central banker back in 2015.
The bottom line is that easy money – sooner or later – backfires.
By the way, here’s a clip from earlier in the interview. Other than admitting that economists are lousy forecasters, I also warned that the economy is probably being hurt by Trump’s protectionism and his failure to control the growth of spending.
Central banks are not economically independent of fiscal policy, a fact that makes fiscal dominance a recurring threat to the mission of central banks and to macroeconomic outcomes. …why does fiscal dominance strike fear in the hearts of economists and financial markets? Perhaps it does so because we can all point to extreme examples where fiscal policy runs the show and monetary policy is subjugated to fiscal needs. Outcomes are not pleasant. Germany’s hyperinflation in the early 1920s may leap to mind first. …The point of creating independent central banks tasked with controlling inflation…was to take money creation out of the hands of elected officials who may be tempted to use it for political gain instead of social wellbeing.
This is frequently achieved by endowing central banks with clear and simple goals (e.g., an inflation mandate or target), as well as sufficient control over specific policy instruments… Despite these institutional advances, the resolve of central banks is chronically put to the test. … the possibility of fiscal dominance arises only when the fiscal authority sets the debt level.
Especially in a world where many of them think the Fed should prop up or bailout Wall Street.
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