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Allan Meltzer: Bernanke's Anti-Inflation Exit Strategy Will Fail - WSJ.comBy ALLAN H. MELTZER
Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.
I don't believe this will work, and no one else should.
The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.
The efforts to reduce inflation during the 1970s failed because they ended prematurely. And they ended prematurely when business, unions, Congress and the administration objected loudly to the rising unemployment accompanying higher interest rates. Today's high current and prospective unemployment rates pose a similar dilemma.
No economist doubts that the Fed can induce banks to hold some more reserves by paying interest. But how much?
Normally, banks' principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves. Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.
When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.
With the exception of the early years after Paul Volcker became Fed chairman in 1979, the Fed has paid no attention to money growth. There have always been some Fed bank presidents concerned about too much or too little money growth, but they have not affected decisions. That problem remains.
The Federal Reserve has a well-known dual mandate to prevent both inflation and unemployment. It chooses to act on only one part of its mandate at a time. That cannot be the best way to achieve both targets, and it has failed repeatedly to bring low inflation and low unemployment. For example, the policy implied by the famous Phillips Curve—which says you can trade off higher inflation for lower unemployment—failed in the 1970s. We got rising inflation and higher unemployment.
Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.
Christina Romer, chairman of the Council of Economic Advisers, reminds us regularly about the Fed and the Treasury's tig ht-money mistakes in 1937 which aborted the recovery, and she warns against repeating these mistakes. The principle drivers behind the recovery in 1934-36 were the veterans' bonus in 1936 and a gold inflow following the 1934 devaluation of the dollar—accomplished by unilaterally raising the gold price. The bonus ended, and the Treasury began to sterilize gold inflows in 1937 by selling securities, while the Fed doubled reserve requirements. Monetary policy shifted from excessive ease to excessive restraint.
Nothing of the kind is called for today. Instead, the Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.
Policies without prices hide the serious problem posed by excessive debt and reserves, and are not credible. Policy makers should develop and announce credible plans now.
Mr. Meltzer is a professor at the Tepper School of Business, Carnegie Mellon University, and the author of "A History of the Federal Reserve" (Chicago, 2003 and 2010
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BBC News - Social unrest 'on the rise' in ChinaSocial unrest 'on the rise' in China
By Shirong Chen
BBC News China analyst
Burned out bus in Urumqi, China 6/7/09
Large-scale violence, like Urumqi's riots, have spread in 2009
Social unrest is on the rise in China, according to an analysis by a Chinese think-tank.
The country is grappling with more acute social problems than ever before, according to a report from the Chinese Academy of Social Sciences.
Crime is also up, despite a nationwide campaign to shore up social stability.
Although continued economic growth has provided a greater number of jobs, China has seen more social conflict in 2009 than before.
The report on China's social trends sounds a stark warning to policy makers.
The authors believe deep resentment has been accumulating over the past few decades against unfairness and power abuses by government officials at various levels.
They quote six large-scale popular protests - from taxi strikes to unrest in central China in June - involving tens of thousands of people.
This does not include the rioting in the north-western region of Xinjiang, where nearly 200 people were killed in early July.
Urban-rural gap
There has been more crime too - official figures for January to October 2009 show more than four million recorded criminal cases, an increase of about 15% above last year.
The report admits some of China's policies have prevented more people from sharing the benefits of the economic development.
The urban-rural income gap, for example, has become even bigger and the country's phenomenal GDP growth has been achieved at the expense of the rural population, the environment and overall social cohesion.
The report is a damning indictment on the authorities' slogan of building a harmonious society.
But there is one ray of hope in the report - while the Chinese authorities are taking tighter control over the media, people are turning more and more to the internet to expose official failings and abuses.
In the past 12 months, nearly a third of the top stories originated from the internet, pushing the boundaries of press freedo
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FT.com / Columnists / Martin Wolf - Britain’s dismal choice: sharing the lossesBritain’s dismal choice: sharing the losses
By Martin Wolf
Published: December 15 2009 22:11 | Last updated: December 15 2009 22:11
The UK is poorer than it thought it was. This is the most important fact about the crisis. The struggle over the distribution of the losses is going to be brutal. It will be made more so by the second most important fact about the crisis: it has had a huge effect on the public finances. The deficits are unmatched in peacetime.
Happily, the general election would appear to offer a golden opportunity for a debate. Is that not the discussion the country ought to have? Yes. Is it the discussion it is going to have? No. What the government would do if re-elected remains, even after the pre-Budget report, “a riddle, wrapped in a mystery, inside an enigma”, as Churchill said of Stalin’s Russia.
On the Treasury’s current forecasts, the economy will regain 2008 levels of economic activity in 2012. Four years of expected growth would have vanished. In last week’s pre-Budget report, the Treasury forecast growth of 1.25 per cent next year, 3.5 per cent in 2011 and 2012, then 3.25 per cent in 2013 and 2014. Suppose that growth were to continue at 3.25 per cent a year thereafter. It would still take until 2031 before the economy was as big as it would have been if the 1998-2007 trend had continued. The cumulative loss of output would be 160 per cent of 2007 gross domestic product. If growth after 2014 were at the pre-2008 trend rate, lost GDP would be almost three times 2007 GDP by 2030 (see chart). It is easy to imagine worse possibilities.
These losses in output have had a severe impact on the public finances. Indeed, the fiscal deterioration in the UK has been far bigger than in any other member of the Group of Seven leading high-income countries.
The proximate explanation has been the collapse in government revenues. Between the 2008 Budget and the 2009 pre-Budget report, the forecast of total spending for this financial year has risen by just 4.4 per cent. The forecast of nominal GDP has indeed fallen by 9.1 per cent. But the forecast of revenue has collapsed by 18.1 per cent.
Yet the UK’s recession has not been more severe than that of other high-income countries. As Alistair Darling, the chancellor of the exchequer, noted in his speech on the pre-Budget report, the cumulative contraction in this recession, up to the third quarter of 2009, has been 3.2 per cent in the US, 5.6 per cent in Germany, 5.9 per cent in Italy, 7.7 per cent in Japan and only 4.75 per cent in the UK. The reason this not particularly dramatic decline in output, by the standards of this “Great Recession”, has had an exceptionally big impact on revenues is that, in the UK, the financial sector played a huge role in supporting consumer expenditure, property transactions and corporate profits. No less than a quarter of corporate taxation came from the financial sector alone. Receipts from corporate taxes fell by 26 per cent between the 12 months to October 2008 and the 12 months to October 2009. Receipts from value added tax fell by 17 per cent over the same period. Over and above the general effect of the recession, this is, to a significant extent, a result of the vulnerability of the UK economy to the disruption in credit and collapse in profits of financial businesses.
What does this imply for the UK’s future? A good way of thinking about this question is that the UK has not only had a financial crisis, with the usual severe impact on output and the public finances, but that the UK has also been a “monocrop” economy, with finance itself acting as the “crop”.
Countries that depend heavily on output and exports of commodities whose markets are volatile are all too familiar with the cycles these can create. In booms, export revenues and government revenues are buoyant, the real exchange rate appreciates and marginal producers of tradeable goods and services are squeezed out – a fate sometimes known as the “Dutch disease” after the impact of discoveries of natural gas on the economy of the Netherlands. Often, both government and the private sector borrow heavily in these good times. Then comes the crash: exports and government revenues collapse, fiscal deficits explode, the exchange rate falls and, quite often, inflation surges and the government defaults.
The biggest mistake one can make in macroeconomics is to confuse the cycle with the trend. In monocrop economies, the danger is particularly big, because cycles can be so large. This, in retrospect, is the mistake the UK made. Thus, the Treasury has decided that the UK’s potential output suddenly fell by 5 per cent during this crisis. This is nonsense, as Robert Chote, director of the Institute for Fiscal Studies, has suggested. What the Treasury used to consider sustainable output was, instead, the product of the bubble in the UK’s monocrop financial sector, spread, directly and indirectly, to the economy and the public finances.
If this view is right, it has three painful implications: first, properly measured fiscal policy was far looser than was thought during much of Gordon Brown’s period as chancellor; second, it is likely that the UK will suffer not only from a permanent loss of output, but also a permanent decline in the trend rate of economic growth; and, third, a huge fiscal tightening cannot be avoided.
At present, the government envisages a structural fiscal tightening of 5.4 per cent of GDP over two parliamentary terms, much of it unspecified (see chart). It now expects that a third of this will be achieved through higher taxes and two-thirds through cuts in spending. To make this credible, it envisages a fiscal consolidation plan that would, in some incomprehensible manner, be legally binding. Would a defaulting chancellor be taken to the Tower of London? But the problem with the plans is not only that they are barely credible, but also that the envisaged tightening is probably too little and the final level of public sector net debt, at around 60 per cent of GDP, too high for comfort, given the likelihood of further adverse shocks. Even so, cuts in spending are larger than in similar episodes in the postwar period.
While the chancellor has presented overall numbers, he has shied away from exploring the full implications and, still more, the nature of the choices the country faces. This is the debate the UK must have. It must start from a realisation: the country is poorer than was thought. So how should these losses be shared in ways that minimise both the harm done to vulnerable people now and to the country’s economic prospects for the longer term? Those are the big questions in UK politics. Serious politicians must not duck them.
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Paper Probes Fed Nightmare — Inflating Away U.S. Debt - Real Time Economics - WSJPaper Probes Fed Nightmare — Inflating Away U.S. Debt
By Michael S. Derby
While it may be the stuff of nightmares for central bankers and dollar defenders, a new paper describes how the U.S. could use inflation to reduce the burden of record-high and rising government debt.
The research, published by the National Bureau of Economic Research, is based on a historical look at the interplay between rising prices and government debt burdens. It’s an issue sure to strike a few nerves, as the U.S. government’s debt moves to 50% of the nation’s gross domestic product, amid fears it could rise to 100% within the next decade.
What may lie ahead evokes the experience of the years right after World War II, when the U.S. debt burden did breach 100% of GDP. Much of that weight was taken off the nation by way of inflation. If back then, the U.S. could ride rising price pressures to make its problem go away, then why not now?
To be sure, the paper, which was written by economists Joshua Aizenman and Nancy Marion, isn’t advocating that the U.S. pursue a particular policy path. Federal Reserve officials, for their part, have been worrying in public about what they see as an unsustainable path of long-term government deficits. They believe those deficits could end a multi-year stretch of decidedly low inflation levels.
Others worry for different reasons. Some fear that inflating the nation’s debt away is the path of least resistance for political leaders who can’t make the hard choices on taxation and spending. The paper notes that “inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade” as a sign of the temptation the strategy represents. In any case, there is widespread agreement that the current fiscal outlook is a grim one, even as short-term economic realities make increased government spending logical and welcome.
For those who detest inflation–and that’s most economists and policy makers–the bad news comes first. The paper says a review of the U.S. experience since World War II shows “eroding the debt through inflation is not farfetched.” If the U.S. now had inflation levels of 6%, it could grind the U.S. debt-to-GDP burden down by a meaty 20% in a mere four years. The paper notes that this level of inflation isn’t that far off the average level of price pressures seen since 1945.
It’s even possible that a stillborn recovery could do some of the work. “When economic growth is stalled, the U.S. debt overhang may trigger an increase in inflation of about 5% for several years,” and that “would significantly reduce the debt ratio,” the paper says.
There are notable differences between now and the immediate post-war period. Whereas the average maturity of U.S. debt is now shorter and much more of it is held overseas, in the wake of the war the debt maturity was longer and nearly all was in domestic hands, the paper notes. That said, the two periods both feature “a large debt overhang and low inflation” and that together increases “the temptation to erode the debt burden through inflation.”
But there are also reasons why trying to inflate the debt away might not be viable now. The research says the balance between who holds the debt and its maturity is important. Whereas the fact that more foreigners hold government debt can make it more attractive to inflate your way to a lower debt burden, the shorter maturity of the debt makes it a more expensive proposition over the longer run to do it.
Ultimately, it’s a risky strategy, the paper warns. It notes that there is a decent chance that “modest” inflation can give way to the double-digit percentage inflation that is painful to contain. In the current environment, the U.S. would also run the chance of making foreign creditors angry, and it could also exacerbate the move away from the dollar as the world’s chief reserve currency.
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Elizabeth Warren: America Without a Middle ClassCan you imagine an America without a strong middle class? If you can, would it still be America as we know it?
Today, one in five Americans is unemployed, underemployed or just plain out of work. One in nine families can't make the minimum payment on their credit cards. One in eight mortgages is in default or foreclosure. One in eight Americans is on food stamps. More than 120,000 families are filing for bankruptcy every month. The economic crisis has wiped more than $5 trillion from pensions and savings, has left family balance sheets upside down, and threatens to put ten million homeowners out on the street.
Families have survived the ups and downs of economic booms and busts for a long time, but the fall-behind during the busts has gotten worse while the surge-ahead during the booms has stalled out. In the boom of the 1960s, for example, median family income jumped by 33% (adjusted for inflation). But the boom of the 2000s resulted in an almost-imperceptible 1.6% increase for the typical family. While Wall Street executives and others who owned lots of stock celebrated how good the recovery was for them, middle class families were left empty-handed.
The crisis facing the middle class started more than a generation ago. Even as productivity rose, the wages of the average fully-employed male have been flat since the 1970s.
2009-12-03-warren12.jpg
But core expenses kept going up. By the early 2000s, families were spending twice as much (adjusted for inflation) on mortgages than they did a generation ago -- for a house that was, on average, only ten percent bigger and 25 years older. They also had to pay twice as much to hang on to their health insurance.
To cope, millions of families put a second parent into the workforce. But higher housing and medical costs combined with new expenses for child care, the costs of a second car to get to work and higher taxes combined to squeeze families even harder. Even with two incomes, they tightened their belts. Families today spend less than they did a generation ago on food, clothing, furniture, appliances, and other flexible purchases -- but it hasn't been enough to save them. Today's families have spent all their income, have spent all their savings, and have gone into debt to pay for college, to cover serious medical problems, and just to stay afloat a little while longer.
2009-12-03-warren34.jpg
Through it all, families never asked for a handout from anyone, especially Washington. They were left to go on their own, working harder, squeezing nickels, and taking care of themselves. But their economic boats have been taking on water for years, and now the crisis has swamped millions of middle class families.
The contrast with the big banks could not be sharper. While the middle class has been caught in an economic vise, the financial industry that was supposed to serve them has prospered at their expense. Consumer banking -- selling debt to middle class families -- has been a gold mine. Boring banking has given way to creative banking, and the industry has generated tens of billions of dollars annually in fees made possible by deceptive and dangerous terms buried in the fine print of opaque, incomprehensible, and largely unregulated contracts.
And when various forms of this creative banking triggered economic crisis, the banks went to Washington for a handout. All the while, top executives kept their jobs and retained their bonuses. Even though the tax dollars that supported the bailout came largely from middle class families -- from people already working hard to make ends meet -- the beneficiaries of those tax dollars are now lobbying Congress to preserve the rules that had let those huge banks feast off the middle class.
Pundits talk about "populist rage" as a way to trivialize the anger and fear coursing through the middle class. But they have it wrong. Families understand with crystalline clarity that the rules they have played by are not the same rules that govern Wall Street. They understand that no American family is "too big to fail." They recognize that business models have shifted and that big banks are pulling out all the stops to squeeze families and boost revenues. They understand that their economic security is under assault and that leaving consumer debt effectively unregulated does not work.
Families are ready for change. According to polls, large majorities of Americans have welcomed the Obama Administration's proposal for a new Consumer Financial Protection Agency (CFPA). The CFPA would be answerable to consumers -- not to banks and not to Wall Street. The agency would have the power to end tricks-and-traps pricing and to start leveling the playing field so that consumers have the tools they need to compare prices and manage their money. The response of the big banks has been to swing into action against the Agency, fighting with all their lobbying might to keep business-as-usual. They are pulling out all the stops to kill the agency before it is born. And if those practices crush millions more families, who cares -- so long as the profits stay high and the bonuses keep coming.
America today has plenty of rich and super-rich. But it has far more families who did all the right things, but who still have no real security. Going to college and finding a good job no longer guarantee economic safety. Paying for a child's education and setting aside enough for a decent retirement have become distant dreams. Tens of millions of once-secure middle class families now live paycheck to paycheck, watching as their debts pile up and worrying about whether a pink slip or a bad diagnosis will send them hurtling over an economic cliff.
America without a strong middle class? Unthinkable, but the once-solid foundation is shaking.
Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard and is currently the Chair of the Congressional Oversight Panel.
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FT.com / Comment / Opinion - We must get ready for a weak-dollar worldWe must get ready for a weak-dollar world
By Jeffrey Garten
Published: November 29 2009 20:02 | Last updated: November 29 2009 20:02
The two most significant structural consequences of the recent financial debacle are the massive deficits and debts of the US and the shift of economic power from west to east. There is only one effective way for governments to address the combined impact of both: press for a sea change in currency relationships, especially a permanently and greatly weakened dollar.
The roots of this situation are well known. The American budget deficit of this past fiscal year reached 10 per cent of gross domestic product, the largest since the aftermath of the second world war. Meanwhile, the net external debt of the US nearly tripled last year to $3,500bn and it is projected to increase by nearly $1,000bn every year for the next decade. All this underestimates the problems of a country where unfunded liabilities for baby boomer entitlements are in the stratosphere, infrastructure deterioration is scandalous and many large states are out of money. To close the gaps, taxes would have to be raised to sky-high levels and spending brutally slashed. It would take a miracle if America’s political system – one rife with vicious partisanship and riddled with well-financed special interests – could do either, let alone both.
Washington will therefore have little choice but to take the time-honoured course for big-time debtors: print more dollars, devalue the currency and service debt in ever cheaper greenbacks. In other words, the US will have to camouflage a slow-motion default because politically it is the easiest way out.
There is another factor pushing America towards a weaker dollar: lacking the domestic consumer demand that came with the unrestrained credit of the past 15 years, the US is desperate to find buyers abroad, especially in emerging markets where the middle class is growing and infrastructure requirements are soaring. A cheaper dollar could make US products and services more competitive.
Meanwhile, in the coming decade, the big emerging markets of Asia will be growing twice as fast as the US and three times faster than the European Union. By 2020, China, India, Indonesia, Korea and Vietnam together could generate more wealth than the the US, Japan and the EU combined. China, India, and South Korea have all been amassing dollar reserves and will be looking to reduce them. While imports into leading industrial countries have slowed, intra-Asian trade is booming and need not be financed only in dollars. The bottom line: Asian currencies are likely to strengthen against the dollar.
A much cheaper dollar is a sad development for the US, even though it is inevitable. It will make the US poorer, since Americans will pay higher prices for everything they buy from abroad – clothes, computers, cars, toys, food, you name it. It will make the US military presence abroad more expensive, since the cost of contractors and local suppliers will escalate in dollar terms. It will slow imports, removing competition that is essential to hold down the general price level in America, thereby making inflation more likely. It will send the wrong price signals for a country that prides itself on creating sophisticated, highly valuable products, for a low dollar will encourage producers to compete on price more than quality. It will diminish the political influence and prestige that the US has had while the dollar has been king.
Moreover, the US dollar has been at the heart of the global economy for well over half a century. Its demise, if not smooth and gradual – hardly certain – could lead to an era of competitive devaluations and other mercantilist trade policies.
An alternative to a global monetary system that has been centred on the dollar is now imperative. That means a multi-currency framework including the euro, the yen, the renminbi and significant issuance of an IMF-backed currency called “special drawing rights”. This regime will take time to devise, but it should start now.
That is why Tim Geithner, US Treasury secretary, should invite his colleagues in the UK, eurozone, Japan and China to meet secretly, perhaps between Christmas and New Year, to start discussions out of the public spotlight (to avoid spooking markets). The big question: what kind of monetary system will best serve the world given deep-seated changes in the balance of economic power, and what process can be followed to develop it?
Since the late 1980s I have believed that a strong dollar was in the US and world interest. Now, however, the context has fundamentally changed. The issue is no longer whether the dollar is in long-term decline but which of two options will be taken. Should Washington and other capitals calmly and deliberately manage the transition to a new era, or, by default, should they let the market do it, with the risk of massive financial disturbances. Today, governments have a choice. Soon they may not.
The writer is the Juan Trippe professor of international trade and finance at theYale School of Management
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