After the Taper: The Fed’s Non-Plan Is Unchanged
As an economist, it is getting more difficult to understand the logic underlying current monetary policy in the U.S. There are two main channels by which economists think monetary policy can influence growth and employment. The first is to lower interest rates to spur investment and consumption spending. The second is to induce inflation so real wages drop, spurring output and employment.
Since 2008, the central bank has reduced interest rates to almost zero with little to show for it. You can bring a horse to water in a trough, pond, or lake, but you cannot make him drink. Most of the added liquidity has found its way into excess reserves. Banks are not lending because they have few creditworthy customers who want to borrow. The household sector is still deleveraging and has less appetite for more debt, and the business sector is careful about making future investments in a financial and economic environment on unstable footing. Businesses are keenly aware of the malinvestments never cleaned up after the last bubble and of the price distortions of current monetary policy. Why would businesses stick their necks out if they suspect a painful adjustment is around the corner?
Since the first channel has failed, only the second channel remains. Economists are generally in agreement, however, that there is no long-run trade-off between inflation and unemployment. The Keynesians and monetarists believe that there may be a short-run trade-off. If people have adaptive expectations, (based on the recent past) then monetary policy that creates inflation will reduce unemployment by lowering a worker’s real wages. Of course, once a worker realizes he has been fooled, he will demand an increase in nominal wages to bring his real wages back up to previous levels. The gain in employment is only temporary. If, instead, people base their expectations rationally and are not fooled, the neo-classical position, there is no short- or long-run trade-offs between inflation and unemployment.
In a capitalist economy, relative prices play a crucial role in sending information to producers about what society wants. When one price goes up and another goes down, these are signals that tell producers to make more of the first good and less of the second. It is a complex system of signals with price changes reflecting the urgency of the needs within the reality of the law of scarcity. The most important aspect of a price system is the information it conveys to guide production.
Inflation causes an “information extraction” problem. When all prices are going up by different degrees, it is very difficult for an entrepreneur to distinguish between a relative and an absolute price change. Is a rising price a reflection of greater demand or inflationary pressure? That is, does it reflect a society’s changing needs or simply reflects a changed measuring stick (i.e., the value of money)? The same information extraction problem holds true with the prices of resources and labor. We have different labor markets with a wage gradient established along the production process. The printing of money interferes with this wage gradient and the information it conveys about the right proportion of capital and consumption goods to produce. Overall employment may initially improve but the gain is not worth the cost from the adjustment that must occur once the printing stops.
Looking at historical evidence, inflation leads to higher, not lower, unemployment. This should not be surprising. Inflation is like a wrench thrown into the workings of a capitalist system.
If economists agree that there is no long-term trade-off between inflation and unemployment, and the current Fed strategy to lower interest rates has failed miserably to boost growth, then we must ask, why is the Fed, even after this week’s taper, in effect printing $75 billion a month? It’s likely the goal is to induce inflation for a short-term gain in employment. Things are no better if the Fed’s strategy is to raise asset prices to induce an imaginary wealth effect. Yet multiple bubbles may pop before any wealth effect takes place. The Fed should not be playing the economy as a stake in a poker game.
Through multiple bubbles, Alan Greenspan’s monetary policy was responsible for massive human suffering worldwide. Yet Greenspan is living high on the hog with a comfy government pension, spending his spare time penning op-ed articles and dispensing his expert advice on the lecture circuit. He informs us that he was only human and that no one saw the bubble coming. This is less than ingenuous. If you play with fire, and you burn down the forest, it is criminal to say “I did not realize that playing with matches was dangerous.” The sad situation is that we recently replaced him with even bigger arsonists!
One can be certain that interest rates will shoot up once inflation picks up. Since most of the U.S. debt is short term, it is going to be very difficult to inflate prices to reduce the real value of the debt. How will the U.S. government react if it has to refinance at interest rates of 12 percent or more, like in 1981? Yellen is no Volker; will she be able to tame the inflation beast as Volcker did? The independent German central bank was powerless to stop the German government from using the printing presses during 1921-23.
Napoleon and Hitler, both responsible for millions of deaths, rode to power on a wave of discontent that followed periods of excessive monetary printing. Why are we taking such risks?