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No Cheerin’ for Yellen

Tags Booms and BustsThe FedBusiness CyclesInterventionism

12/19/2013John P. Cochran

While some Austrian influenced economists such as Peter Boettke are predicting “With Keynesian Yellen at the Helm, Expect More of the Same,” there are good reasons to believe monetary policy, from a sound money perspective, could get considerably worse than the Bernanke version of “Mondustrial Policy.” The prospects for an unwinding of the Fed’s bloated balance sheet without even more damage to the economy and a return to a more reasonable, but not optimal, rules-based monetary policy, are significantly diminished under a Yellen-led Fed.

Why? The recent nomination of Janet Yellen with her strong commitment to the Fed’s dual mandate to head the Federal Reserve system has revitalized the Keynesian more-inflation-as-cure-for-unemployment argument as promoted by Paul Krugman in 2012.1 These economists, such as Princeton’s Alan Blinder, who Dale Steinreich has labeled “kind of the Paul Krugman of the late 1980s,” look at the continuing slow recovery, and see, not a policy that has been totally ineffective and harmful, but a policy which has been less effective than intended because of the bad behavior of bankers. Bankers, who, following the crisis, “decided to store trillions of dollars safely at the Fed rather than lend them out,” according to Blinder, “as greed gave way to fear.” “High-powered money,” Blinder concluded, “became powerless money.” Banks which prior to 2008 held practically no excess reserves, “[t]oday ... hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points — for an annual total of about $6.25 billion.”2

The problem from Blinder’s perspective is, despite heroic efforts by the Bernanke-led Fed, too little actual money expansion and not enough inflation to effectively stimulate a sluggish economy. Blinder’s solution is similar to a recommendation for overcoming the fetish for liquidity highlighted by Keynes in The General Theory à la Silvo Gesell: a negative interest rate. Not a negative rate on all cash balances, mind you; only on excess reserves. Problem solved. Money and credit expansion resume even as the Fed’s balance sheet is allowed to shrink. All live happily ever after as the economy enters the Keynesian bliss of the perpetual boom. This with but little downside:

In the unlikely event, cutting IOER [interest of excess reserves] would neither provide stimulus nor enable the fed to shrink its balance sheet. However, the fed would start collecting about $6.25 billion per year in fees from banks instead of paying them about $6.25 billion in interest — a swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.

However, even non-Austrians have seen a two-fold risk from the Fed’s overly active discretionary policies. The first is the short-run and medium-run risk that the policy uncertainty causes slow growth and low employment. There exists strong empirical evidence supporting this claim. Austrians, however, go further. Policy uncertainty is just a portion of the regime uncertainty paralyzing the economy (see here and here). The second, longer-run risk, that if and when banks, as desired by Blinder, begin converting excess reserves into loans and an expanding money supply, is the risk of higher inflation. Austrians would add the risk of new bubbles, misdirected employment, failure to unwind previous malinvestments, new capital consuming malinvestments and overconsumption, and a return of the boom-bust cycle.3 Austrians have been joined by Kevin Warsh, former Federal Reserve governor, lecturer at Stanford's Graduate School of Business, and distinguished visiting fellow at the Hoover Institution, in this assessment of the risk of a continuing focus of monetary policy on reducing unemployment. In a recent Wall Street Journal editorial (“Finding Out Where Janet Yellen Stands”) Warsh became one of the few, if not the first, non-Austrian critic of Fed policy to use the m-word (malinvestment) in a mainstream publication when he argued:

The most pronounced risk of QE is not an outbreak of hyperinflation. Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment — which do not augur well for long-term growth or financial stability. (Emphasis added)

Thus, with Yellen’s appointment, the Wall Street Journal correctly points out the “Tobin Keynesians are back in charge at the Federal Reserve,” and with her comes a Keynesian-based commitment to the unemployment prong of the Fed’s dual mandate. The natural-rate revolution, which reduced Keynesian influence on policy and contributed to changes in central banks where policy became more focused on moderate inflation targets, and which used, either implicitly or explicitly, a rules-based approach to policy, will be further undermined. Despite Taylor’s optimism, a return to this approach, which on the surface appeared to help get the world economy out of the stagflation of the 1970s and contributed to the Great Moderation, will, as shown by Blinder’s proposal, become further unglued, not because the approach was not an improvement over Keynesian discretionary monetary policy which emphasized the dual mandate, but because the reformers failed to understand that credit creation in a growing economy still misdirects production and thus generates boom-bust cycles.4

Austrian influenced economists have consistently faulted central banks (here or here) for systematically destabilizing financial markets and the economy. As summarized by Richard Ebeling, the “100-year record of the Federal Reserve has been a roller coaster of inflations and recessions, including the disaster of the Great Depression of the 1930s, the ‘excessive exuberance’ of the late 1990s that resulted in the ‘Dot.Com’ bubble that burst in the early 2000s, and the recent boom-bust cycle of the last decade from which the U.S. economy is still slowly recovering.” For Ebeling it is thus time to end America’s century of central bank mismanagement. Greater economic stability and a return to sustainable growth require sound money (here or here) which is ultimately only possible by ending central banking. It is time, not to restore a rules-based policy, but to denationalize money.


Contact John P. Cochran

John P. Cochran (1949-2015) was emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He was also a senior fellow of the Mises Institute and served on the editorial board of the Quarterly Journal of Austrian Economics.