Tag Archives: Monetary policy

A Fiscal Real-Bills Doctrine? No Such Thing As Painless Inflation Tax

14 Tuesday Jun 2022

Posted by in Fiscal policy, Inflation, Uncategorized

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A remarkable proposal made recently by Representative Ro Khanna (D -CA) would have the Biden Administration impose price controls, which would be bad enough. Khanna also would like the federal government to cover the inflation losses incurred by Americans by having it directly purchase certain goods and services and resell them “cheap” to consumers. In fairness, Khanna says the government should attempt to take advantage of dips in prices for oil, food commodities, and perhaps other necessities, which of course would limit or reverse downward price changes. When asked about Khanna’s proposal, Pete Buttigieg, Joe Biden’s Transportation Secretary, replied that there were great ideas coming out of Congress and the Administration should consider them. Anyway, the idea is so bad that it deserves a more thorough examination.

Central Planners Have No Clothes

First, such a program would represent a massive expansion in the scope of government. It would also present ample opportunities for graft and cronyism, as federal dollars filter through the administrative layers necessary to manage the purchases and distribution of goods. Furthermore, price and quantity would then be shaded by a heavy political component, often taking precedence over real demand and cost considerations. And that’s beyond the crippling “knowledge problem” that plagues all efforts at central planning.

One of the most destructive aspects of allowing government to absorb a greater share of total spending is that government is not invested with the same budgetary discipline as private buyers. Take no comfort in the notion that the government might prove expert at timing these purchases to leverage price dips. Remember that government always spends “other people’s money”, whether it comes from tax proceeds, lenders, or the printing press (and hence future consumers, who have absolutely no agency in the matter). Hence, price incentives take on less urgency, while political incentives gain prominence. The loss of price sensitivity means that government expenditures are likely to inflate more readily than private expenditures. This is all the more critical at a time when inflation is becoming embedded in expectations and pricing decisions. Khanna thus proposes an inflation “solution” that puts less price-sensitive bureaucrats in charge of actual purchases. That’s a prescription for failure.

If anyone in Biden’s White House is seriously considering a program of this kind, and let’s hope they’re not, they should at least be aware that direct subsidies for the purchase of key goods would be far more efficient. It’s also possible to hedge the risk of future price increases on commodities markets, perhaps simply distributing hedging gains to consumers when they pay off. However, having the federal government participate as a major player in commodities options and futures is probably not on the table at this point … and I shudder to think of it, but it might be more efficient than Khanna’s vision.

A Fiscal Real Bills Doctrine

Khanna’s program would almost surely cause inflation to accelerate. Inflation itself a form of taxation imposed by profligate governments, though it’s an inefficient tax since it creates greater uncertainty. Higher prices deflate the real value of most government debt (borrowed from the public), assets fixed in nominal value, and incomes. Read on, but this program would have the government pay your inflation tax for you by inflating some more. Does this sound like a vicious circle?

Khanna’s concept of inflation-relief is a fiscal reimagining of a long-discredited monetary theory called the “Real Bills Doctrine”. According to this doctrine, rising prices and costs necessitate additional money creation so that businesses have the liquidity to pay the bills associated with ongoing productive efforts. The “real” part is a reference to the link between business expenses and actual production, despite the fact that those bills are expressed in nominal terms. The result of this policy is a cycle of ever-higher inflation, as ever-more money is printed. This was the policy utilized by the Reichsbank in Weimar Germany during its hyperinflation of 1922-23. It’s really quite astonishing that anyone ever thought such a policy was helpful!

In Khanna’s version of the doctrine, the government spends to relieve cost pressure faced by consumers, so the rationale has nothing to do with productive effort.

Financing and the Central Bank Response

It’s reasonable to ask how these outlays would be financed. In all likelihood, the U.S. Treasury would borrow the funds at interest rates now at 10-15 year highs, which have risen in part to compensate investors for higher inflation.

My bet is that Khanna imagines the Fed would simply “print” money (i.e., buy the new government debt floated by the Treasury to pay for the program). This is the prescription of so-called Modern Monetary Theory, whose adherents have either forgotten or have never learned that money growth and inflation is a costly and regressive form of taxation.

Most economists would say the response of the Federal Reserve to this fiscal stimulus would bear on whether it really ignites additional inflationary pressure. Of course, rather than borrowing, Congress could always vote to levy higher taxes on the public in order to pay the public’s inflation tax burden! But then what’s the point? Well, taxing at least has the virtue of not fueling still higher inflation, and the Fed would not have a role to play.

But if the government simply borrows instead, it adds to the already bloated supply of government debt held by the public. This borrowing is likely to put more upward pressure on interest rates, and the federal government’s mounting interest expense requires more financing. What then might the Fed do?

The Fed is an independent, quasi-government entity, so it would not have to accommodate the additional spending by printing money (buying the new Treasury debt). Either way, investors are increasingly skeptical that the growing debt burden will ever be reversed via future surpluses. The fiscal theory of the price level holds that something must reduce the real value of government debt (in order to satisfy the long-term fiscal budget constraint). That “something” is a higher price level. This position is not universally accepted, and some would contend that if the Fed simply set a nominal GDP growth target and stuck to it, accelerating inflation would not have to follow from Khanna’s policy. The same if the Fed could stick to a symmetric average inflation target, but they certainly haven’t been up to that task. Hoping the Fed would fully assert its independence in a fiscal hurricane is probably wishful thinking.

Conclusion

There are no choke points in the supply chain for bad ideas on the left wing of the Democratic Party, and they are dominating party centrists in terms of messaging. The answer, it seems, is always more government. High inflation is very costly, but the best policy is to rein it in, and that requires budgetary and monetary discipline. Attempts to make high inflation “painless” are misguided in the first instance because they short-circuit consumer price responses and substitution, which help restrain prices. Second, the presumption that an inflation tax can be “painless” is an invitation to fiscal debauchery. Third, expansive government brings out hoards of rent seekers instigating corruption and waste. Finally, mounting public debt is unlikely to be offset by future surpluses, and that is the ultimate admission of Modern Monetary Theory. A fiscal real bills doctrine would be an additional expression of this lunacy. To suggest otherwise is either sheer stupidity or an exercise in gaslighting. You can’t inflate away the pain of an inflation tax.

The Fed’s Balance Sheet: What’s the Big Deal?

08 Sunday May 2022

Posted by in Government Failure, Inflation, Monetary Policy

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The Federal Reserve just announced tighter monetary policy in an attempt to reduce inflationary pressures. First, it raised its target range for the federal funds rate (on overnight loans between banks) by 0.5%. The new range is 0.75% – 1%. Second, on June 1, the Fed will begin taking steps to reduce the size of its $9 trillion portfolio of securities. These holdings were acquired during periods of so-called quantitative easing (QE) beginning in 2008, including dramatic expansions in 2020-21. A shorthand reference for this portfolio is simply the Fed’s “balance sheet”. It includes government debt the Fed has purchased as well as privately-issued mortgage-backed securities (MBS).

What Is This Balance Sheet You Speak Of?

Talk of the Fed’s balance sheet seems to mystify lots of people. During the 2008 financial crisis, the Fed began to inject liquidity into the economy by purchasing large amounts of assets to be held on its balance sheet. This was QE. It’s scope was unprecedented and a departure from the Fed’s pre-crisis reliance on interest rate targeting. QE had the effect of increasing bank reserves, which raised the possibility of excessive money supply growth. That’s when the Fed began to pay interest to banks on reserves, so they might be content to simply hold some of the reserves over and above what they are required to hold, rather than using all of that excess to support new loans and deposits (and thus money growth). However, that interest won’t stop banks from lending excess reserves if better opportunities present themselves.

The Fed has talked about reducing, “normalizing”, or “tapering” its balance sheet for some time, but it only recently stopped adding to it. With inflation raging and monetary policy widely viewed as too “dovish”, analysts expected the Fed to stop reinvesting proceeds from maturing securities, which amounts to about $95 billion per month. That would shrink or “taper” the balance sheet at a rate of about $1.1 trillion per year. Last week the Fed decided to cap the “runoff” at $47.5 billion per month for the first three months, deferring the $95 billion pace until September. Monetary policy “hawks” were disappointed by this announcement.

Monetizing Government

So, one might ask, what’s the big deal? Why must the Fed taper its securities holdings? Well, first, the rate of inflation is far above the Fed’s target range, and it’s far above the “average Joe’s” comfort range. Inflation imposes significant costs on the economy and acts as a regressive form of taxation, harming the poor disproportionately. To the extent that the Fed’s huge balance sheet (and the corresponding bank reserves) are supporting incremental money growth and fueling inflation, the balance sheet must be reduced.

In that connection, the Fed’s investment in government debt represents monetized federal debt. That means the Fed is essentially printing money to meet the Treasury’s financing needs. Together with profligate spending by the federal government, nothing could do more to convince investors that government debt will never be repaid via future budget surpluses. This dereliction of the government’s “full faith and credit”, and the open-armed acceptance of the inflation tax as a financing mechanism (à la Modern Monetary Theory), is the key driver of fiscal inflation. Reducing the balance sheet would represent de-monetization, which might help to restore faith in the Fed’s ability to push back against fiscal recklessness.

Buyer of First Resort

Perhaps just as critically, the Fed’s heavy investment in government debt and MBS represents an ongoing distortion to the pricing of financial assets and the allocation of capital. Some call this interference in the “price discovery process”. That’s because the Fed has represented a market-altering presence, a willing and inelastic buyer of government debt and MBS. Given that presence, it’s difficult for buyers and sellers to discern the true values of alternative uses of capital, or to care.

QE was, among other things, a welcome institutional development for the U.S. Treasury and for those who fancy that fresh money printing is an ever-valid form of government payment for scarce resources. The Fed’s involvement also means that other potential buyers of Treasury debt need not worry about interest rate risk, making public debt relatively more attractive than private debt. This is a dimension of the “crowding out” phenomenon, whereby the allocation of capital and flows of real resources between public and private uses are distorted.

The Fed’s presence as a buyer of MBS depresses mortgage rates and makes mortgage lending less risky for lenders and investors. As a result, it encourages an over-investment in housing and escalating home prices. This too distorts the allocation of capital and real resources, at the margin, toward housing and away from uses with greater underlying value.

Conclusion

The magnitude of the Fed’s balance sheet is an ongoing testament to an increasingly dominant role of central authorities in the economy. In this case, the Fed has served as a conduit for the inflation tax. In addition, it has unwittingly facilitated crowding out of private capital investment. The Fed’s purchases of MBS have distorted the incentives (and demand) for residential investment. These are subtle effects that the average citizen might not notice, just as one might not notice the early symptoms of a debilitating disease. The long-term consequences of the Fed’s QE activities, including the inflation tax and distorted allocations of capital, are all too typical of failures of government intervention and attempts at central planning. But don’t expect anyone at the Fed to admit it.

Fiscal Inflation Is Simple With This One Weird Trick

03 Thursday Feb 2022

Posted by in Fiscal policy, Inflation

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I’ll get to the weird trick right off the bat. Then you can read on if you want. The trick really is perverse if you believe in principles of sound credit and financial stability. To levy a fiscal inflation tax, all the government need do is spend like a drunken sailor and undermine its own credibility as a trustworthy borrower. One way to do that: adopt the policy prescriptions of Modern Monetary Theory (MMT).

A Theory of Deadbeat Government

That’s right! Run budget deficits and convince investors the debt you float will never be repaid with future real surpluses. That doesn’t mean the government would literally default (though that is never outside the realm of possibility). However, given such a loss of faith, something else must give, because the real value government debt outstanding will exceed the real value of expected future surpluses from which to pay that debt. The debt might be in the form of interest-bearing government bonds or printed money: it’s all government debt. Ultimately, under these circumstances, there will be a revised expectation that the value of that debt (bonds and dollars) will be eroded by an inflation tax.

This is a sketch of “The Fiscal Theory of the Price Level” (FTPL). The link goes to a draft of a paper by John Cochrane, which he intends as an introduction and summary of the theory. He has been discussing and refining this theory for many years. In fairness to him, it’s a draft. There are a few passages that could be written more clearly, but on the whole, FTPL is a useful way of thinking about fiscal issues that may give rise to inflation.

Fiscal Helicopters

Cochrane discusses the old allegory about how an economy responds to dollar bills dropped from a helicopter — free money floating into everyone’s yard! The result is the classic “too much money chasing too few goods” problem, so dollar prices of goods must rise. We tend to think of the helicopter drop as a monetary policy experiment, but as Cochrane asserts, it is fiscal policy.

We have experienced something very much like the classic helicopter drop in the past two years. The federal government has effectively given money away in a variety of pandemic relief efforts. Our central bank, the Federal Reserve, has monetized much of the debt the Treasury issued as it “loaded the helicopter”.

In effect, this wasn’t an act of monetary policy at all, because the Fed does not have the authority to simply issue new government debt. The Fed can buy other assets (like government bonds) by issuing dollars (as bank reserves). That’s how it engineers increases in the money supply. It can also “lend” to the U.S. Treasury, crediting the Treasury’s checking account. Presto! Stimulus payments are in the mail!

This is classic monetary seigniorage, or in more familiar language, an inflation tax. Here is Cochrane description of the recent helicopter drop:

“The Fed and Treasury together sent people about $6 trillion, financed by new Treasury debt and new reserves. This cumulative expansion was about 30% of GDP ($21,481) or 38% of outstanding debt ($16,924). If people do not expect that any of that new debt will be repaid, it suggests a 38% price-level rise. If people expect Treasury debt to be repaid by surpluses but not reserves, then we still expect $2,506 / $16,924 = 15% cumulative inflation.”

FTPL, May I Introduce You To MMT

Another trend in thought seems to have dovetailed with the helicopter drop , and it may have influenced investor sentiment regarding the government’s ever-weakening commitment to future surpluses: that would be the growing interest in MMT. This “theory” says, sure, go ahead! Print the money government “must” spend. The state simply fesses-up, right off the bat, that it has no intention of running future surpluses.

To be clear, and perhaps more fair, economists who subscribe to MMT believe that deficits financed with money printing are acceptable when inflation and interest rates are very low. However, expecting stability under those circumstances requires a certain level of investor confidence in the government fisc. Read this for Cochrane’s view of MMT.

Statists like Bernie Sanders, Alexandria Ocasio-Cortez, and seemingly Joe Biden are delighted to adopt a more general application of MMT as intellectual cover for their grandiose plans to remake the economy, fix the climate, and expand the welfare state. But generalizing MMT is a dangerous flirtation with inflation denialism and invites economic disaster.

If This Goes On…

Amid this lunacy we have Joe Biden and his party hoping to find avenues for “Build Back Better”. Fortunately, it’s looking dead at this point. The bill considered in the fall would have amounted to an additional $2 trillion of “infrastructure” spending, mostly not for physical infrastructure. Moreover, according to the Congressional Budget Office, that bill’s cost would have far exceeded $2 trillion by the time all was said and done. There are ongoing hopes for separate passage of free community college, an extended child tax credit for all families, a higher cap for state and local income tax deductions, and a host of other social and climate initiatives. The latter, relegated to a separate bill, is said to carry a price tag of over $550 billion. In addition, the Left would still love to see complete forgiveness of all student debt and institute some form of universal basic income. Hey, just print the money, right? Warm up the chopper! But rest easy, cause all this appears less likely by the day.

Are there possible non-inflationary outcomes from ongoing helicopter drops that are contingent on behavior? What if people save the fresh cash because it’s viewed as a one-time windfall (i.e., not a permanent increase in income)? If you sit on such a windfall it will erode as prices rise, and the change in expectations about government finance won’t be too comforting on that score.

There are many aspects of FTPL worth pondering, such as whether bond investors would be very troubled by yawning deficits with MMT noisemakers in Congress IF the Fed refused to go along with it. That is, no money printing or debt monetization. The burgeoning supply of debt would weigh heavily on the market, forcing rates up. Government keeps spending and interest costs balloon. It is here where Cochrane and critics of FTPL have a sharp disagreement. Does this engender inflation in the absence of debt monetization? Cochrane says yes if investors have faith in the unfaithfulness of fiscal policymakers. Excessive debt is then every bit as inflationary as printing money.

Real Shocks and FTPL

It’s natural to think supply disruptions are primarily responsible for the recent acceleration of inflation, rather than the helicopter drop. There’s no question about those price pressures in certain markets, much of it inflected by wayward policymakers, and some of those markets involve key inputs like energy and labor. Even the median component of the CPI has escalated sharply, though it has lagged broader measures a bit.

Broad price pressures cannot be sustained indefinitely without accommodating changes in the supply of money, which is the so-called “numeraire” in which all goods are priced. What does this have to do with FTPL or the government’s long-term budget constraint? The helicopter drop certainly led to additional money growth and spending, but again, FTPL would say that inflation follows from the expectation that government will not produce future surpluses needed for long-term budget balance. The creation of either new money or government debt, loaded the chopper as it were, is sufficient to accommodate broad price pressures over some duration.

Conclusion

Whether or not FTPL is a fully accurate description of fiscal and monetary phenomena, few would argue that a truly deadbeat government is a prescription for hyperinflation. That’s an extreme, but the motivation for FTPL is the potential abandonment of good and honest governing principles. Pledging an inflation tax is not exactly what anyone means by the full faith and credit of the U.S. government.

Break the Market, Blame It, Then Break It Some More

28 Sunday Nov 2021

Posted by in Energy, Environmental Fascism, Free markets, Uncategorized

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Much of what is labeled market failure is a consequence of government failure, or rather, failure caused by misguided public intervention, not just in individual markets but in the economy more generally. Misguided efforts to correct perceived excesses in pricing are often the problem, but there are myriad cases of regulatory overreach, ham-handed application of taxes and subsidies for various enterprises, and widespread cronyism. But it is often convenient for politicians to appear as if they are doing something, which makes activism and active blame of private enterprise a tempting path. The Biden Administration’s energy crisis offers a case in point. First, a digression on the efficiency of free markets. Skip the next two sections to get straight to Biden’s mess.

Behold the Bounty

I always spent part of the first class session teaching Principles of Economics on some incredible things that happen each and every day. Most college freshmen seem to take them for granted: the endless variety of goods that arrive on shelves each day; the ongoing flow of services, many appearing like magic at the flick of a switch; the high degree of coincidence between specific wants and all these fresh supplies; the variety and flow of raw materials and skills that are brought to bear; the fantastic array of sophisticated equipment deployed to assist in these efforts; and the massive social coordination necessary to accomplish all this. How does it all happen? Who collects all the information on what is wanted, and by whom? On the feasibility of actually producing and distributing various things? What miracle computer processes the vast set of information guiding these decisions and actions? Does some superior intelligence within an agency plan all this stuff?

The answer is simple. The seemingly infinite set of knowledge is marshaled, and all these tasks are performed, by the greatest institution of social cooperation to ever emerge: decentralized, free markets! Buying decisions are guided by individual needs and wants. Production and selling decisions are guided by resource availability and technology. And all sides react to evolving prices. Preferences, resources, and technology are in a constant state of flux, but prices react, signaling producers and consumers to make individual adjustments that correct larger imbalances. It is tempting to describe the process as the evolving solution to a gigantic set of dynamic equations.

The Impossible Conceit

No human planner or government agency is capable of solving this problem as seamlessly and efficiently as markets, nor can they hope to achieve the surplus welfare that redound to buyers and sellers in markets. Central planners or intervening authorities cannot possess the knowledge and coordinating power of the market mechanism. That doesn’t mean markets are “perfect”, of course. Things like external costs and benefits, dominant sellers, and asymmetric information can cause market outcomes to deviate from the competitive “ideal”. Inequities can arise from some of these imperfections as well.

What can be much worse is the damage to market performance caused by government policy. Usually the intent is to “correct” imperfections, and the rationale might be defensible. The knowledge to do it very well is often lacking, however. Taxes, subsidies, regulations, tariffs, quotas, capital controls, and manipulation of interest rates (and monetary and credit aggregates) are very general categories of distortion caused by the public sector. Then there is competition for resources via government procurement, which is frequently graft-ridden or price-insensitive.

Many public interventions create advantages for large sellers, leading to greater market concentration. This might best serve the private political power of the wealthy or might convey advantages to investments that happen to be in vogue among the political class. These are the true roots of fascism, which leverages coercive state power for the benefit of private interests.

Energy Vampires

Now we have the curious case of the Biden Administration and it’s purposeful disruption of energy markets in an effort to incentivize a hurried transition from fossil fuels to renewable energy. As I described in a recent post on stagflation,

“… Biden took several steps to hamstring the domestic fossil fuel industry at a time when the economy was still recovering from the pandemic. This included revoking permits for the Keystone pipeline, a ban on drilling on federal lands and federally-controlled waters in the Gulf, shutting down production on some private lands on the pretext of enforcing the Endangered Species Act, and capping methane emissions by oil and gas producers. And all that was apparently just a start.

As Mark Theisen notes, when you promise to destroy a particular industry, as Joe Biden has, by taxing and regulating it to death, who wants to invest in or even maintain production facilities? Some leftists with apparent influence on the administration are threatening penalties against the industry up to and including prosecution for ‘crimes against humanity’!”

In addition to killing Keystone, there remains a strong possibility that Biden will shut down the Line 5 pipeline in Michigan, and there are other pipelines currently under federal review. Biden’s EPA also conducted a purge of science advisors considered “too friendly” to oil and gas industry. This was intertwined with a “review” of new methane rules, which harm smaller, independent oil and gas drillers disproportionately.

Joe Biden’s “Build Back Better” (BBB) legislation, as clumsy in policy as it is in name, introduces a number of “Green New Deal” provisions that would further disadvantage the production and use of fossil fuels. Hart Energy provides descriptions of various tax changes that appeared in the Treasury’s so-called “Greenbook”, a collection of revenue proposals, many of which appear in the BBB legislation that recently passed in the House. These include rollbacks of various deductions for drilling costs, depletion allowances, and recovery rules, as well as hikes in certain excise taxes as well as taxes on foreign oil income. And all this while granting generous subsidies to intermittent and otherwise uneconomic technologies that happen to be in political favor. This is a fine payoff for cronies having invested significantly in these rent seeking opportunities. While the bill still faces an uphill fight in the Senate, apparently Biden has executive orders, held in abeyance, that would inflict more pain on consumers and producers of fossil fuels.

Biden’s energy policies are obviously intended to reduce supplies of oil, gas, and other fossil fuels. Prices have responded, as Green notes:

“Gas is up an average of 57% this year, with corresponding increases of 44% for diesel and a whopping 60% for fuel oil.”

The upward price pressure is not limited to petroleum: electricity rates are jumping as well. Consumers and shippers have noticed. In fact, while Biden crows about wanting “the rich” to pay for BBB, his energy policies are steeply regressive in their impact, as energy absorbs a much larger share of budgets among the poor than the rich. This is politically suicidal, but Biden’s advisors have chosen a most cynical tact as the reality has dawned on them.

Abusive Victim Blaming

Who to blame? After the predictable results of cramping domestic production and attacking fossil fuel producers, the Biden team naturally blames them for rising prices! “Price gouging” is a charge made by political opportunists and those who lack an understanding of how markets allocate scarce resources. More severe scarcity means that prices must rise to ration available quantities and to incentivize those capable of bringing forth additional product under difficult circumstances. That is how a market is supposed to function, and it mitigates scarcity!

But here comes the mendacious and Bumbling Buster Biden. He wants antitrust authorities at the FTC to investigate oil pricing. Again from Stephen Green:

“… the Biden Administration has decided to launch a vindictive legal campaign against oil producers in order to deflect blame for the results of Biden’s policies: Biden’s Solution to Rising Gas Prices Appears to Be Accusing Oil Companies of Price Gouging.”

There’s nothing quite like a threat to market participants to prevent the price mechanism from performing its proper social function. But a failure to price rationally is a prescription for more severe shortages.

Biden has also ordered the Strategic Petroleum Reserve (SPR) to release 50 million barrels of oil, a move that replaces a total of 2.75 days of monthly consumption in the U.S. The SPR is supposed to be drawn upon only in the case of emergencies like natural disasters, so this draw-down is as irresponsible as it is impotent. In fact, OPEC is prepared to offset the SPR release with a production cut. Biden has resorted to begging OPEC to increase production, which is pathetic because the U.S. was a net exporter of oil not long ago … until Biden took charge.

Conclusion

Properly stated, the challenge mounted against markets as an institution is not that they fall short of “perfection”. It is that some other system would lead to superior results in terms of efficiency and/or equity. Central planning, including the kind exercised by the Biden Administration in it’s hurried and foolish effort to tear down and remake the energy economy, is not even a serious candidate on either count.

Granted, there is a long history of subsidies to the oil and gas sector. I cannot defend those, but the development of the technology (even fracking) largely preceded the fruits of the industry’s rent seeking. At this point, green fuels receive far more subsidies (despite some claims to the contrary). Furthermore, the primacy of fossil fuels was not achieved by tearing down competing technologies and infrastructure. In contrast, the current round of central planning requires destruction of entire sectors of the economy that could otherwise produce efficiently for the foreseeable future, if left unmolested.

The Biden Administration has adopted the radical green agenda. Their playbook calls for a severe tilting of price incentives in favor uneconomic, renewable energy sources, despite the economy’s heretofore sensible reliance on plentiful fossil fuels. It’s no surprise that Biden’s policy is unpopular across the economic spectrum. His natural inclination is to blame a competitive industry victimized by his policy. It’s a futile attempt to avoid accountability, as if he thinks doubling down on the fascism will help convince the electorate that oil and gas producers dreamt up this new, nefarious strategy of overcharging customers. People aren’t that dumb, but it’s typical for the elitist Left presume otherwise.

Inflation Doomsayers and Downplayers

25 Friday Jun 2021

Posted by in Inflation, Monetary Policy

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There’s a big disconnect between recent news about escalating inflation and market expectations of inflation. In fact, there’s a big disconnect between market expectations and what we’re hearing from some conservative economists. The latter are predicting more inflation based on the recent spurt in prices and the expansionary policy of the Federal Reserve. Can these disparate views be reconciled?

Market Predictions

Market interest rates are considered pretty good predictors of inflation, at least relative to surveys and macroeconomic models. That’s because a fixed interest return is eroded by inflation, and fixed income investors will bid up interest rates to incorporate a premium to compensate for perceptions of increased inflation risk. This is known as the Fisher Effect, after the economist Irving Fisher. In fact, investors should bid rates up more than one-for-one with expected inflation, because the inflation premium will be taxed. A higher return must compensate for both higher expected inflation and taxes on the increased inflation premium.

After rising by about 1.2% from last summer through mid-March, interest rates on Treasury notes have declined slightly. The earlier run-up anticipated a strengthening economy, but if the increase was due to higher expected inflation, we could say it represented an added premium of about 1%, and that’s roughly in-line with changes in some other market-based gauges of expected inflation (ignoring pandemic lows).

Recent Inflation News

Meanwhile, measured inflation certainly has increased in 2021. I say “measured” because 1) “true” price changes are measured imperfectly, and 2) there is a difference between real inflation, which is a continuing process, and month-to-month changes in prices. Here, we’re really talking about the latter and hoping it doesn’t turn into a bad case of the former!

The green line in the chart below is the percent change in the consumer price index (CPI) from a year earlier. After declining during the pandemic, it rebounded sharply this year to almost 5% in May. The purple line is the increase in the CPI excluding food and energy prices, otherwise known as the “core” CPI. The jumps shown in the chart are well in excess of the market’s assessment of inflation trends.  

Both versions of the CPI have jumped in the past few months, but it turns out that durable goods like washing machines, TVs, and (probably) Pelotons have jumped the most sharply. Most of the weakness in prices during the pandemic was in non-durable goods, which stands to reason because so many activities away from home were curtailed. Also noteworthy about these price movements: when measured over a span of two years, prices excluding food and energy have risen at an annualized rate of only 2.6%. 

There are two other lines in the chart above that demonstrate much less alarming changes in prices: the orange line is so-called “median” inflation, which is the price change in the median component of the CPI. That is, half of all price components included in the CPI rose faster and half rose slower than the median. It has barely accelerated this year and stood at only about 2.1% higher in May than a year earlier. The blue line is the so-called “trimmed” CPI, or the average price change of the middle 84% of all CPI components. While it has accelerated in 2021, the year-over-year increase was only 2.6% in May. 

Thus, the breadth of the jump in prices was limited. The Federal Reserve and a lot of market participants insist that the uptick is narrow and temporary — a transitional phenomenon related to the sluggish recovery of supplies in the post-pandemic environment.

But again, the accuracy of price measures is always in question. For example, the housing cost component of the CPI was up only 2.2% in May from a year ago, but it is calibrated to actual survey data only twice a year, the survey is a weak data source, and we know home prices and rents have risen aggressively. Quality and quantity adjustments are always in question as well. An old approach for businesses dealing with rising costs is to reduce package size, which has been called “shrinkflation”. It seems to be back in vogue.

Inflation Drivers

It’s not yet clear how much wage pressure is occurring now. The economy-wide average hourly earnings data has been distorted over the past 15 months by the changing mix of employment, first shifting toward greater concentration in high-wage (work-at-home) occupations and now shifting back toward lower-wage jobs as the economy reopens. But we know many employers are facing a labor shortage, due in large part to extended unemployment benefits and other pandemic-related aid, so this puts upward pressure on wages. In 2021, minimum wage rates are undergoing substantial increases in 17 states, and a number of large employers such as Amazon have increased their minimum pay rates. That creates competitive pressure for smaller employers to boost pay as well.

The fundamental cause of an “honest-to-goodness” inflation is “too much money chasing too few goods”. The Federal Reserve has certainly given us enough to worry about in that regard. The basic money stock (M1) increased by four-fold in the late winter and early spring of 2020, just as the pandemic was spreading. Today, it is almost five times greater than in early 2020, so growth in the money stock remains quite fast even as the recovery proceeds. No wonder: the U.S. Treasury is issuing about $1 trillion of new debt every four-to-six weeks, and the Fed is essentially monetizing these deficits by purchasing a huge chunk of that debt.

That’s a lot of “helicopter” money… new money! But are there too few goods for it to chase? Or is it really chasing anything? Is it just sitting idle? First, GDP is likely to exceed its pre-pandemic level in the second quarter, despite the fact that private payrolls are still down by about 7 million employees. Of course, that doesn’t eliminate the ostensible imbalance between money and goods, and one might expect a veritable explosion in price inflation under these circumstances.

So far that seems unlikely. The so-called velocity of money (its rate of turnover) has plunged since the start of the pandemic, with no discernible rebound through the first quarter of 2021. That means a lot of the cash is not being used in transactions for real goods, but financial transaction volume has been quite strong in 2020-21. Daily stock trading volume was up by more than 50% in 2020 from 2019, and in the first quarter of 2021 it stood another 34% higher than the 2020 average (though volume tapered in April). This is to say nothing of the increased frenzy in cryptocurrency trading. So, while some money is turning over, the expansion of the money stock remains daunting and pressure might well spill-over into goods prices.

Caution Is a Virtue

So long as the Fed keeps printing money, and assuring investors that it will keep printing money, the equity markets are likely to remain strong. There are mixed signals coming from Fed officials, but the over-riding message is that the recent uptick in prices is largely temporary and limited in scope. That is, they assert that certain prices are being squeezed temporarily by rebounding demand for goods while suppliers play catch-up. 

Market expectations of inflation seem to agree with that view, but I have strong trepidations. There are cash reserves held in the private sector to support more aggressive spending. Large companies, consumers, and banks are still holding significant amounts of cash. The Biden Administration is doing its best to spend hand-over-fist. This administration’s energy policy is causing fuel bills to escalate. Home prices and rents are strong. The dollar is down somewhat from pre-pandemic levels, which increases import prices. Finally, the Fed is reluctant to reverse the huge increase in the money supply it engineered during the pandemic. If the recent surge in prices continues, and if higher inflation embeds itself into expectations, it will be all the more difficult for the Fed to correct. 

The market and the Fed might be correct in predicting that the spike in measured inflation is temporary. The recent data show that these worrisome price trends have not been broad. Just the same, I don’t want to hold fixed income investments right now: if higher expectations of inflation cause market interest rates to rise, the value of those assets will fall. Stock values should generally keep pace with inflation barring stronger signals of tightening by the Fed. Unfortunately, however, many would suffer in an inflationary environment as wages, fixed assets, and benefits are devalued by rising prices.

The Federal Reserve and Coronatative Easing

09 Monday Mar 2020

Posted by in Monetary Policy, Pandemic

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Laughs erupted all around when the Federal Reserve reduced its overnight lending rate by 50 basis points last week: LIKE THAT’LL CURE THE CORANAVIRUS! HAHAHA! It’s easy to see why it seemed funny to people, even those who think the threat posed by Covid-19 is overblown. But it should seem less silly with each passing day. That’s not to say I think we’re headed for disaster. My own views are aligned with this piece by Michael Fumento: it will run its course before too long, and “viruses hate warm weather“. Nevertheless, the virus is already having a variety of economic effects that made the Fed’s action prudent.

Of course, the Fed did not cut its rate to cure the virus. The rate move was intended to deal with some of the economic effects of a pandemic. The spread of the virus has been concentrated in a few countries thus far: China, Iran, Italy, and South Korea. Fairly rapid growth is expected in the number of cases in the U.S. and the rest of the world over the next few weeks, especially now with the long-awaited distribution of test kits. But already in the U.S., we see shortages of supplies hitting certain industries, as shipments from overseas have petered. And now efforts to control the spread of the virus will involve more telecommuting, cancellation of public events, less travel, less dining out, fewer shopping trips, missed work, hospitalizations, and possibly widespread quarantines.

The upshot is at least a temporary slowdown in economic activity and concomitant difficulties for many private businesses. We’ve been in the midst of a “flight to safety”, as investors incorporate these expectations into stock prices and interest rates. Firms in certain industries will need cash to pay bills during a period of moribund demand, and consumers will need cash during possible layoffs. All of this suggests a need for liquidity, but even worse, it raises the specter of a solvency crisis.

The Fed’s power can attempt to fill the shortfall in liquidity, but insolvency is a different story. That, unfortunately, might mean either business failures or bailouts. Large firms and some small ones might have solid business continuation plans to help get them through a crisis, at least one of short to moderate duration, but many businesses are at risk. President Trump is proposing certain fiscal and regulatory actions, such as a reduction in the payroll tax, wage payment assistance, and some form of mandatory paid leave for certain workers. Measures might be crafted so as to target particular industries hit hard by the virus.

I do not object to these pre-emptive measures, even as an ardent proponent of small government, because the virus is an externality abetted by multiplicative network effects, something that government has a legitimate role in addressing. There are probably other economic policy actions worth considering. Some have suggested a review of laws restricting access to retirement funds to supplement inadequate amounts of precautionary savings.

Last week’s Fed’s rate move can be viewed as pre-emptive in the sense that it was intended to assure adequate liquidity to the financial sector and payment system to facilitate adjustment to drastic changes in risk appetites. It might also provide some relief to goods suppliers who find themselves short of cash, but their ability to benefit depends on their relationships to lenders, and lenders will be extremely cautious about extending additional credit as long as conditions appear to be deteriorating.

In an even stronger sense, the Fed’s action last week was purely reactive. Scott Sumner first raised an important point about ten days before the rate cut: if the Fed fails to reduce its overnight lending target, it represents a de facto tightening of U.S. monetary policy, which would be a colossal mistake in a high-risk economic and social environment:

“When there’s a disruption to manufacturing supply chains, that tends to reduce business investment, puts downward pressure on demand for credit. That will tend to reduce equilibrium interest rates. In addition, with the coronavirus, there’s also a lot of uncertainty in the global economy. And when there’s uncertainty, there’s sort of a rush for safe assets, people buy treasury bonds, that puts downward pressure on interest rates. So you have this downward pressure on global interest rates. Now while this is occurring, if the Fed holds constant its policy rate, it targets the, say fed funds rate at a little over 1.5 percent. While the equilibrium rates are falling, then essentially the Fed will be making monetary policy tighter.

… what I’m saying is, if the Fed actually wants to maintain a stable monetary policy, they may have to move their policy interest rate up and down with market conditions to keep the effective stance of monetary policy stable. So again, it’s not trying to solve the supply side problem, it’s trying to prevent it from spilling over and also impacting aggregate demand.”

The Fed must react appropriately to market rates to maintain the tenor of its policy, as it does not have the ability to control market rates. Its powers are limited, but it does have a responsibility to provide liquidity and to avoid instability in conducting monetary policy. Fiscal actions, on the other hand, might prove crucial to restoring economic confidence, but ultimately controlling the spread of the virus must be addressed at local levels and within individual institutions. While I am strongly averse to intrusions on individual liberty and I desperately hope it won’t be necessary, extraordinary measures like whole-city quarantines might ultimately be required. In that context, this post on the effectiveness of “non-pharmaceutical interventions” such as school closures, bans on public gatherings, and quarantines during the flu pandemic of 1918-19 is fascinating.

 

 

 

 

 

Not Obama’s Economy

01 Sunday Mar 2020

Posted by in economic growth, Macroeconomics

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The “Trump economy” hasn’t been half bad, though one can’t attribute all of the results to the economic policies of his administration. In fact, the economy was growing when he took office, though it took several years after the Great Recession to recover under Barack Obama, and various sectors were showing strains before Trump took office. And yes, Obama inherited a very bad economy, but he went off the rails a few weeks ago in a pathetic attempt to take credit for ten-plus years of economic growth. Here is one of his tweets:

“Eleven years ago today, near the bottom of the worst recession in generations, I signed the Recovery Act, paving the way for more than a decade of economic growth and the longest streak of job creation in American history,”

The tweet was immediately ridiculed by Trump, as is his habit, but at best Obama received lukewarm support from his usually adoring media outlets. How interesting, however, that just a few days before Obama’s tweet, Chuck Jones, a regular Forbes contributor who really needn’t prove he’s an Obama hack, submitted a scorecard of economic performance covering President Trump’s first three years in office. It was an exercise in throwing shade at a series of good numbers. Then, a week later, Jones had the chutzpah to claim the Obama’s “shovel-ready” stimulus program of a decade ago, which proved anemic in its effects, was the proximate cause of healthy growth under Trump’s watch. Who gave him that idea?

Jones’ effort to diminish Trump’s economic accomplishments is music to the ears of leftists wistful for the days of Obama. They fancy Jones’ appearance in what they assume to be a right-leaning outlet as an enhancement to the credibility of his claims. Forbes, however, is certainly not the bastion of conservatism the Left would have you believe. Their model pays contributors who drive circulation, which has little to do with political alignment. To the extent that Jones is able to stroke the predilections of the Left, he probably can play well at that game.

The truth is it’s difficult to attribute variations in economic growth to different presidential administrations. This fairly well-balanced piece at NPR.org gives one very simple reason:

“Let’s stipulate that presidents of both parties often get more credit and blame for economic conditions than they deserve, given that much of what happens is outside their control.”

It is true that a new administration inherits economic conditions and policies from its predecessor. Trump inherited an economy that was growing, but there were plenty of strains, including sluggish wage growth, low labor force participation, weak business startups, and a languid housing sector, as this link makes clear. Moreover, economic expansions have lasted an average of only about five years in the post-WW2 era. The current expansion was about 90 months running at the time of Trump’s inauguration, a stage at which vulnerabilities might develop. But new policies often lead to new economic realities. In Trump’s case, that included tax cuts, and especially corporate tax cuts that spurred hiring and wage growth, and more liberalized regulation. Accommodative monetary policy by the Federal Reserve also provided an assist. As the chart at the top shows, Trump’s platform lifted small business enthusiasm considerably, which is a broad indicator of economic vibrancy. Of course, his trade initiatives have probably had negative effects thus far, but his way of negotiating new trade agreements might well end up making a positive contribution, on balance.

Now, the danger of a caronavirus pandemic is presenting major economic challenges. It’s unlikely to produce as many deaths as a bad flu season in the U.S., in part because the Trump Administration took quick action to limit domestic exposure. Nevertheless, the economic consequences of the virus and attempts to control its spread will be significant. At least the economy was strong when the shock occurred, so it is reasonable to expect a rebound if the outbreak runs its course over the next month or two.

The economic record since Trump took office has been impressive given the stage of the business cycle at which he took office. Not only that, but minority wage growth has surged, and minority unemployment has fallen substantially. Let’s face it: Obama and Joe Biden are eager to neutralize any plaudits a strong economy might earn Trump in an election year, but they shouldn’t embarrass themselves by trying to take credit for it, and Chuck Jones could do better than carrying their water.

 

 

Central Banks Stumble Into Negative Rates, Damn the Savers

01 Tuesday Mar 2016

Posted by in Central Planning, Monetary Policy

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Dollar Cartoon

Should government actively manipulate asset prices in an effort to “manage ” economic growth? The world’s central bankers, otherwise at their wit’s end, are attempting just that. Hopes have been pinned on so-called quantitative easing (QE), which simply means that central banks like the U.S. Federal Reserve (the Fed) buy assets (government and private bonds) from the public to inject newly “printed” money into the economy. The Fed purchased $4.5 trillion of assets between the last financial crisis and late 2014, when it ended its QE. Other central banks are actively engaged in QE, however, and there are still calls from some quarters for the Fed to resume QE, despite modest but positive economic growth. The goals of QE are to drive asset prices up and interest rates down, ultimately stimulating demand for goods and economic growth. Short-term rates have been near zero in many countries (and in the U.S. until December), and negative short-term interest rates are a reality in the European Union, Japan and Sweden.

Does anyone really have to pay money to lend money, as indicated by a negative interest rate? Yes, if a bank “lends” to the Bank of Japan, for example, by holding reserves there. The BOJ is currently charging banks for the privilege. But does anyone really “earn” negative returns on short-term government or private debt? Not unless you buy a short-term bill and hold it till maturity. Central banks are buying those bills at a premium, usually from member banks, in order to execute QE, and that offsets a negative rate. But the notion is that when these “captive” member banks are penalized for holding reserves, they will be more eager to lend to private borrowers. That may be, but only if there are willing, credit-worthy borrowers; unfortunately, those are scarce.

Thus far, QE and zero or negative rates do not seem to be working effectively, and there are several reasons. First, QE has taken place against a backdrop of increasingly binding regulatory constraints. A private economy simply cannot flourish under such strictures, with or without QE. Moreover, government makes a habit of manipulating investment decisions, partly through regulatory mandates, but also by subsidizing politically-favored activities such as ethanol, wind energy, post-secondary education, and owner-occupied housing. This necessarily comes at the sacrifice of opportunities for physical investment that are superior on economic merits.

The most self-defeating consequence of QE and rate manipulation, be that zero interest rate policy (ZIRP) or negative interest rate policy (NIRP), is the distortion of inter-temporal tradeoffs that guide decisions to save and invest in productive assets. How, and how much, should individuals save when returns on relatively safe assets are very low? Most analysts would conclude that very low rates prompt a strong substitution effect toward consuming more today and less in the future. However, the situation may well engender a strong “income effect”, meaning that more must be saved (and less consumed in the present) in order to provide sufficient resources in the future. The paradox shouldn’t be lost on central bankers, and it may undermine the stimulative effects of ZIRP or NIRP. It might also lead to confusion in the allocation of productive capital, as low rates could create a mirage of viability for unworthy projects. Central bank intervention of this sort is disruptive to the healthy transformation of resources across time.

Savers might hoard cash to avoid a negative return, which would further undermine the efficacy of QE in creating monetary stimulus. This is at the root of central bank efforts to discourage the holding of currency outside of the banking system: the “war on cash“. (Also see here.) This policy is extremely offensive to anyone with a concern for protecting the privacy of individuals from government prying.

Another possible response for savers is to “reach for yield”, allocating more of their funds to high-risk assets than they would ordinarily prefer (e.g., growth funds, junk bonds, various “alternative” investments). So the supply of saving available for adding to the productive base in various sectors is twisted by central bank manipulation of interest rates. The availability of capital may be constrained for relatively safe sectors but available at a relative discount to risky sectors. This leads to classic malinvestment and ultimately business failures, displaced workers, and harsh adjustment costs.

With any luck, the Fed will continue to move away from this misguided path. Zero or negative interest rates imposed by central banks penalize savers by making the saving decision excessively complex and fraught with risk. Business investment is distorted by confusing signals as to risk preference and inflated asset prices. Central economic planning via industrial policy, regulation, and price controls, such as the manipulation of interest rates, always ends badly. Unfortunately, most governments are well-practiced at bungling in all of those areas.

 

 

 

Fractured Fiscal Fairy Tales: Moot Multipliers

03 Wednesday Sep 2014

Posted by in Uncategorized

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crowding_out

Scott Grannis asserts that the multiplier associated with fiscal stimulus is roughly zero, and evidence over the past few years suggests that he may be right. He appeals to a form of the classic “crowding out” argument: that debt-financed increases in government spending absorb private saving, leaving less funding available for private capital investment. In the present case, federal deficits ($7.4 trillion since 2009) have soaked up more than 80% of the corporate profits generated over that time frame. Profits are a major source of funds for private capital projects, risky alternatives against which the U.S. Treasury competes.

There are other reasons to doubt the ability of fiscal policy to offset fluctuations in economic activity. Transfers, which have grown dramatically as a percentage of federal spending, can create negative work incentives, thereby diminishing the supply of labor and adding cost to new investment. The growth of the regulatory state adds risk to privately invested capital as well as hiring. Government projects also offer tremendous opportunities for graft and corruption, at the same time diverting resources into uses of questionable productivity (corn, solar and wind subsidies are good examples). Many federal programs in areas such as education fail basic tests of success. Federal bailouts tend to prop up unproductive enterprises, including the misbegotten cash-for-clunker initiative. Even government infrastructure projects, heralded as great enhancers of American productivity, are often subject to lengthy delays and cost overruns due to regulatory and environmental rules. Is there any such thing as a federal “shovel-ready” infrastructure project?

In recent years, research has found that spending multipliers are small and often negative in the long run, contrary to what statists and old-time adherents of Keynes would have you believe. Empirical multipliers tend to be smaller in more open economies and under more flexible exchange rate regimes. Of growing importance to many developed economies, however, is that spending multipliers tend to be zero or even negative in the long run when government debt is high relative to GDP. This is broadly consistent with the classic crowding-out explanation for low multipliers, whereby public debt burdens absorb private saving. U.S. government debt-to-GDP is now well above 60%, an empirical point of demarcation separating high and low-multiplier countries. Finally, some economists believe that fiscal stimulus is frequently offset by countervailing monetary tightening under an implicit policy of nominal GDP targeting. Scott Sumner describes this as the story of the past few years, as neither the fiscal expansion of the 2009 stimulus plan nor the contraction of the fiscal cliff and sequestration had much if any observable impact on economic growth.

Politicians, the mainstream press and eager Keynesian economists are seemingly always ready to pitch fiscal policy and higher federal spending as the solution to any macroeconomic problem. Sadly, that is unlikely to end any time soon, because the story they tell is so simple and tempting, and they are blind its insidious nature.