American Missive

ATLANTA— Barack Obama announced on his radio address today that without action, the U.S. economy could lose hundreds of thousands more jobs- pushing unemployment above 10%. 

He is building the case for his economic polices, which include a plan to spend up to $1 trillion over the next two years on infrastructure and other items.   Separately, Ben Bernanke announced in December the Federal Reserve’s movements toward  a monetary policy of quantitative easing (which, put simply, is a technical term for printing money).   I wonder – just how will Ben Bernanke’s interventionist Fed and Barack Obama’s forthcoming stimulus spending initiatives be viewed long-term?  One of the biggest unspoken risks in my opinion remains runaway inflation in the next year or two, as the economy potentially moves out of its recessionary rut.

Historic Precedant for Federal Reserve and Obama Policies

Mr. Obama’s and Mr. Bernanke’s policies involve the government continuing to increase public debt to historic levels.  In general terms, both policies have been tried before- most recently by Japan during the late 1990’s and the early part of this decade.  For Japan, similar policies were largely viewed as failures.  Japan’s economy is still stagnant and they are now buried by the largest per capita public debt for any country in human history. 

In addition to a recession, the United States is facing an economy wide “disinflation,” which means the inflationary spike in prices caused by high commodity prices early in the year are receding with the dramatic decrease in commodity prices that began occurring later in the year.  This risks pushing us into a period of deflation, which is a more general decline in consumer prices caused by a slow-down in economic activity.

Deflation can be self-reinforcing- and devastating.  As the economy slows, sellers of goods drop prices to attract buyers.  But as prices continue to drop, buyers are encouraged to delay purchases- to see if prices may drop even further.  The cycle of drops and delays can continue to very detrimental effects.  As you can imagine, economic activity can grind to a very slow crawl.  Deflationary pressures plagued the Japanese economy after their real estate collapse in the early 1990’s and have brought their economy to a virtual standstill for extended periods at various points over the last 15 or more years.  It is in response to these problems that Japan implemented policies similar to Mr. Obama’s and Mr. Bernanke’s.  As stated, the policies did not work effectively.

Purpose Behind the Policies

As the Federal Reserve draws interest rates to near zero and as economic activity remains stagnant, Ben Bernanke is employing an aggressive monetary policy to fight deflation.  The monetary policy has its roots in John Meynard Keyne’s economic theories and it was popularized by libertarian Milton Friedman, in his famous ”helicopter drop” essay.  The theory is that through expanding the money supply, deflationary forces are counteracted- resulting in a healthy, near-term inflation to bolster prices and wages.

Because the Federal Reserve can no longer influence the money supply through interest rates (as they are now near zero), the Federal Reserve instead has begun massively expanding the monetary base through other means- including covert capital infusions into banks and financial institutions (via acquiring certain of those institutions assets) and through  quantitative easing (which involves buying public debt).   As you can see in the above chart, the Federal Reserve has launched into uncharted territory in expanding the monetary base.   The above data is from 1920 up through November of 2008.  There is no precedent for what the Federal Reserve has done.

Similarly, Mr. Obama is trying to increase “aggregate demand” by incurring substantial government debt to finance “public works projects,” the purpose of which is to get America working again.  The theory is that economic demand from most sectors of the economy have declined, driving us into a recession.  The thinking is that the government should increase its demand to fill in the gaps- to keep the engine of the economy running.  Similar policies in the United States in the past have not been overly successful- nor were similar policies in Japan.  Expanding public debt could lead to higher U.S. interest rates, which stymies growth and could result in currency inflation.

Conclusion

I am increasingly afraid of what may occur, should the United States recovery occur more rapidly than Mr. Bernanke and Mr. Obama anticipate.  Should such a thing occur, and should monetary policy not be tightened quickly enough, there is a legitimate chance of an inflationary exit to the current recession.  Inflationary exits generally look and feel good at first- prices rise, profits grow, and wages increase.  But they quickly are self-defeating- inflation overtakes and erases all gains.  The risk of inflation and the massive deficits could actually push long-term interest rates up quickly, conflicting with the Federal Reserve’s planned quantitative easing of those rates and choking off future economic growth. I continue to believe this is one of the biggest risks to the Obama and Bernanke plans.

I am becoming increasingly convinced of the Austrian school of economics, advocated by Ron Paul and others.  I have not read enough to fully articulate the view points of that theory, but the general idea is that economic collapses should be allowed to run their course, with minimal government involvement.  Also, the government should maintain a strong money policy so as not to risk inflation on the back end of the recession and not to overburden the public with debt.  The view holds that government involvement only elongates and exacerbates economic crises.  If allowed to fully function, the free markets generally find a more efficient, less costly approach to overcoming near-term economic difficulties.  Such a viewpoint may lead to a more severe recession short-term, but may also lead to a quicker recovery.

Appendix:  Economic Liquidity Trap

For the sake of discussion, here is an interesting and informative description of an economic liquidity trap, as provided by Wikipedia.  As you can see from this summary, this is precisely what the United States has entered.   Also, it is interesting to note the discussion of Japan included here as well as the brief Austrian critique of the monetary policies currently being employed by the Federal Reserve.

A liquidity trap is a situation in monetary economics in which a country’s nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation.

 

In normal times, the monetary authority (usually a central bank or finance ministry) can stimulate the economy by lowering interest rate targets or increasing the monetary base. These actions are meant to increase borrowing and lending, consumption, and fixed investment. When the relevant interest rate is already at or near zero, lowering it to a level which would stimulate the economy may not be possible. The monetary authority can increase the overall quantity of money available to the economy, but traditional monetary policy tools do not inject new money directly into the economy. Rather, the new liquidity created must be injected into the real economy by way of financial intermediaries such as banks. In a liquidity trap, banks are unwilling to lend, so the central bank’s newly-created liquidity is trapped behind unwilling lenders.

 

The liquidity trap theory applies to monetary policy in non-inflationary depressions.

 

Economists’ perspectives

In the 1989 film Batman, the Joker drops millions of dollars upon the citizens of Gotham City, passing by the Gotham Central Bank as he does so, in a literal illustration of Friedman’s perspective.Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away. During the Great Depression in the United States, the Federal Reserve offered to buy any gold at a price well above current market prices. This was essentially a money gift to gold holders. In Japan in the 1980s, the Bank of Japan began buying newly-issued common stock and bonds as a hidden money gift to firms.

 

John Maynard Keynes is usually seen as the inventor of the liquidity-trap theory. In his view, financial actors fear the possibility of suffering capital losses on non-money assets and thus hold money (liquid assets) instead. For example, the fear of default on loans can inhibit lenders from lending except to extremely credit-worthy customers. These fears are most likely after a financial crisis such as that associated with the Stock Market Crash of 1929. Further, if nominal interest rates are extremely low, there is no place for them to go but up. That implies that bond prices will likely fall in the near future, causing capital losses.

 

Neoclassical schools of economics which hold that economic agents make decisions based on real rather than nominal values contend that monetary efforts to lower nominal risk-free rates have no significant impact on the nominal interest rates charged by banks. A bank will not lend unless it can charge a (nominal) interest rate which is at least equal to the rate of inflation during the loan period. In an environment where banks are prohibited or discouraged by law from charging high rates of interest on loans, banks will be more reluctant to lend, since doing so would result in receiving a low (and possibly negative) real rate of return on investment. Unlike Keynesian theory, which claims that “liquidity traps” arise from fear or a hoarding mentality among banks, neoclassical theories argue that liquidity traps of this form do not exist and that monetary efforts to lower rates will have little, if any, effect on the quantity of real goods produced.

 

Note that even if the expected inflation rate is zero, nominal interest rates charged for loans will never fall below zero. Negative interest rates would imply banks paying borrowers to take loans. Furthermore, the liquidity advantages of holding money in an uncertain environment will set a non-zero, positive lower bound on the rate at which any agent will be willing to lend.

 

Japan’s liquidity trap

It has been suggested that the Japanese economy in the 1990s suffered from a “liquidity trap” scenario. This diagnosis prompted increased government spending and large budget deficits as a remedy. The failure of these measures to help the economy recover, combined with an explosion in the Japanese public debt, suggest that such a fiscal policy may not have been adequate.

 

Some economists believe that much of Japan’s government spending followed a stop/go pattern and involved spending on unneeded infrastructure. Nobel-Prize-winning American economist Paul Krugman suggests that what was needed was a central bank commitment to steady positive monetary growth, which would encourage inflationary expectations and lower expected real interest rates, which in turn would stimulate spending.

 

Austrian Critique

Economists of the Austrian school challenge the idea that Japan experienced a liquidity trap, contending instead that it suffered from the bust portion of a business cycle brought on by monetary inflation, which could only be cured by allowing the bust to liquidate the malinvestments made during the boom. Austrians contend that busts are necessary corrections to booms and that artificial credit expansion or other government interference will only make the bust longer or delay an even bigger bust. Thus, they blame Japan’s rigorous government interference in the market for causing the bust to last throughout the decade.