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Today on the podcast, an extended Idiot of the Week with a Fed historian who is celebrating with the tea party today Allan Meltzer. Also the excerpt from Robert Pollin on the error of austerity we promised. But first
This election will mark a significant downturn in the economy. It did not matter who won. This is the way it was planned. The stimulus was enacted in 2009 with a timeline for payouts that precisely matched the electoral cycle. It was thought to be enough to carry the economy through election day. That it was too small was the responsibility, in all likelihood, of Larry Summers, now returned to Harvard.
The political business cycle has been part of politics since it was introduced by Richard Nixon. Only Jimmy Carter failed to implement a pro-electoral cycle economic policy. We are seeing a major miscalculation when we see the stimulus was not enough to do the job. Many say the stimulus did not work. The next two years, absent a lame duck stimulus, will tell the tale. If the economy recovers during gridlock, our explanation will have to be revised. If it falters and stagnates, the arguments of the market fundamentalists will have to be quietly put back in the drawer and new red herrings invented.
The point is that fiscal policy will soon become a significant net drag, as states and localities hit their budget walls while the federal government's major program payouts drop. Corporations are already downsized. Investment capital is fleeing the country. More money from the Fed is not going to alter any of this. QE II is DOA.
To set up our next segment, some commentary on inflation and deflation.
The Great Financial Crisis and the current what I will call depression is evidence enough that money is not created the way it has long been supposed. That is, in spite of the massive production of money via Fed purchases of this and that, no inflation has occurred. Therefore, either the tenet of Milton Friedman that inflation is always and everywhere a monetary phenomenon is wrong, or the tradition that the Fed controls the money supply is wrong. Or both.
It is both. Inflation is not driven by the supply of money, the supply of money is driven by expansion. In some conditions, expansion is accompanied by inflation. So except in the narrow condition that you need money to make transactions, inflaiton is not a monetary phenomenon. And if we've learned nothing else in the current crisis, we should have learned that just because the Fed produces money, it doesn't mean the banking system turns it into credit.
This latter mistake is one that was made across the economics spectrum. Stiglitz, Feldstein, Krugman, and most economists hooted down the first version of TARP in favor of a straightforward recapitalization of the banks. The Troubled Asset Relief Program was seen as a way to move bad assets from the banks into the Treasury. Better capitalize the banks directly, since the value of the assets to be sold had to be lower than the price the Treasury would get them at. Besides, the banks would multiply their new reserves by lending and the economic impact would be a multiple. Well, the new TARP didn't work. Yes, the government got paid back in large measure, but the lending did not occur. The banks stabilized by getting too bigger to fail and by milking the spread between zero rate borrowing at the Fed and the very low, but greater than zero, rates they can get from the Treasury.
In any event, the hoped-for credit creation never occurred. Which should teach us all that the Fed can print money. It can inflate financial assets. But it is not the Fed's printing of money that drives real economy inflation.
Which we will review in our idiot of the week in just a moment. But we need to add some relevant details. With excess productive capacity in recession territory, there could be a lot of purchasing power added to the economy without bidding up prices. And with cheap positions now moving into commodities, it is far more likely that inflation will derive from a weak dollar and booming commodity prices than from any demand spur. Yet it is only demand-pull inflation that the Fed can see. Or rather, any inflation is assumed to be demand-pull and thus to require higher interest rates to dampen.
Allan Meltzer, noted historian of the Fed and professor of political economy at Carnegie Mellon University. We're going to allow that Mr. Meltzer has some principles, and we're going to spend a good deal of time with him today. These interviews span the past two and one-half years. We want to enlist the flow of history in contradicting this Market First, watch out for inflation, nonsense. First, from an interview on Bloomberg on March 17, 2008.
OOOPS. Stability of the economy is not the second leg of the dual mandate. It is full employment. The Fed is tasked with price stability and full employment. It is not tasked with making banks profitable. It is well established that Mr. Bernanke's academic career is based on work that hypothesizes that had the Fed saved the banks in the Great Depression, there would have been no Great Depression. But that was a monetarist hypothesis, which he is in the process of disproving. It WAS work that earned him the trust of the banks and no doubt got him the job as head of the Fed, but it is not work that is reliable or useful to price stability or full employment, only to bank profitability.
So Mr. Meltzer slipped on that one. Setting aside the support of Hank Paulson and the health of the U.S. economy, at that point three months into the recession.
Here I would agree with Mr. Meltzer. The Fed went to one percent interest under Alan Greenspan and generated a housing bubble. Now it is at zero interest, and the fact that there is no problem is not that there is no problem, but that it is not occurring in the United States. Of course, here the public was burned on stocks in the 1990s and real estate in the 2000s and there is no other asset as widely held. But emerging markets. Yeah. That's the ticket. Brazil and China can boom like you've never seen before, we'll take our cheap Fed money and carry it to emerging markets. Presto. A bubble. Not one that helps us. It may set other economies on fire, but .... You get the point. Cheap Fed rates are a substitute for effective policy. It is not going to do anything but eventual harm.
And see the preceding discussion and the subsequent two years of history to demonstrate that inflation was and is not the bogeyman Mr. Meltzer sees at the window.
Hallelujah. This is so very true. Here we have to congratulate Mr. Meltzer on adhering to principle. He may have given back his credibility when he fudges the comparison. It is not six percent today, since over 25 percent of a tremendously larger housing market is in question now versus the era of the Great Depression, which was before 30-year fixed mortgages. So he fudged on his comparison. But more interestingly, Will the population revolt?
Now we move to another Bloomberg interview. This one is in August of 2008, at the time of the financial sector meltdown. He begins on the same note as he ended his March interview. Then, well, here ....
I'm not sure what to make of this. It is not a recession because it is worse, is what I here him saying. But I think he may be trying to say ... something on the order of the lenders and creditors need to take a hit, not just the households. That would create the conditions for a steeper growth path in recovery. Are we poorer? What has been transferred to the foreigners? In many cases the foreigners are the capitalists. I believe this is a weak cousin of Richard Koo's balance sheet recession. If so, good.
Well, you've heard us make the same point, that commodity prices increasing is not the same as inflation, nor should it be treated like inflation. Here, Meltzer's one-time increase in energy and food was soon reversed, so it is entirely possible to have another commodity bubble, but what is really not clear is how the Fed is supposed to keep the price of oil out of other activities. I assume he wants to use the Volcker prescription, or a modern version, of incrasing the price of money to counteract an increase in the price of energy. Demand Side is one place you will not find congratulations for Paul Volcker, as we see the severe recession of 1981-83 as coming out of this experiment and the unemployment of millions as the way inflation was brought down, not any sterile Freidmanesque painless deflation of the money.