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The unprecedented expansion of the money supply could make the ’70s look benign.
By Arthur B. Laffer
June 10th (WSJ)— Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be “wasted.” Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.
Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.
Art knows the difference between purchasing financial assets (usually done by the Fed) and purchasing goods and services (and indirectly through transfer payments) but here elects to ignore it.
With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.
He also recognizes the demand leakages including pension fund contributions, insurance reserves, USD financial accumulations of non residents, IRA’s, other corporate reserves, etc. tend to compound geometrically and are thereby strong contractionary biases.
But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.
He also knows causation runs from loans to deposits and reserves and not from reserves to anything at all.
I’ve had this discussion personally with him and I wrote ‘soft currency economics’ jointly with Mark McNary who worked at art’s firm with both involved.
About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.
Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.
He knows this is not the case. He knows that lending is in no case reserve constrained, and that it’s about price and not quantity.
Banks are required to hold a certain fraction of their liabilities — demand deposits and other checkable deposits — in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions.
There were no banks of any consequence constrained from lending by their reserve positions that I know of.
In fact, they all had excess collateral they could have taken to the discount window as needed.
There were some banks constrained by capital considerations but that’s an entirely different story.
That’s why adding the excess reserves didn’t change anything with regards to lending.
Art knows this as well.
They weren’t able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.
Yet a chart of lending shows no changes as functions of reserve positions.
The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company’s IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank’s sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed “stress tests” on banks are nothing more than checking how well a bank can weather differing levels of default risk.
Correct. And these loans are not reserve constrained.
And even if they were somehow constrained by reserves, innovations in sweep accounts have reduced reserve requirements to near 0.
What’s important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases.
Most important is the level of spending which may or may not be a function of the lending that creates the ‘quantity of money’ as defined by Art. And he knows that as well.
For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained.
He knows they are never reserve constrained.
The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.
In general the causation runs in the other direction, as he also knows.
At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.
He also knows a lot of this simply replaced commercial paper issuance and other forms of non bank lending, and that total credit is the more useful indicator of lending activity.
With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.
He also knows interest rates are voted on by the fed and that term rates reflect anticipated Fed moves.
It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S.
He knows there are no consequences. The Fed is like the kid in the car seat with a steering wheel who thinks he’s driving.
To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.
He knows that was caused by cost push from Saudi price setting that was broken by the deregulation of natural gas in 1978 that resulted in a 15 million barrel per day supply response as our utilities switched from oil to natural gas.
Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion.
All that would do is raise rates some due to the fed selling its securities.
Or the Fed could repo its position so the banks would hold overnight collateral rather than over night reserves. Functionally that changes nothing except for creating a lot more book keeping work.
Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves.
This is just plain silly.
Art knows there is no remaining ‘monetary purpose’ of reserves since we went off the gold standard, which he understands as well as anyone.
Canada and others dropped reserve requirements long ago with no consequences beyond a reduced accounting burden.
Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.
No penalty and no inflation consequences either.
Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury’s planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.
Yes, yields would go higher, though not as disorderly as he forecasts.
And, as previously discussed, there’s no reason to do that unless the fed wants higher rates.
In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession.
He knows the contraction of the base back then did not cause anything.
While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it’s a Hobson’s choice. For me the issue is how to protect assets for my grandchildren.
The best gift he could give his grand children is to tell the story right way around as he knows is the case.
Mr. Laffer is the chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen” (Threshold, 2008).