Here’s a good interview with Chicago’s John Cochrane, who offers incisive contrarian views on money, inflation, “stimulus,” Greece, the euro, economic growth, and Milton Friedman’s “Inflation is always and everywhere a monetary phenomenon” meme. I wrote about these topics here.
Can economic growth stop the coming fiscal inflation?
See my new Forbes column on the puzzling economic outlook and a new way to think about monetary policy . . . .
The Federal Reserve plan to buy an additional $600 billion in longer term securities — known as QE2 — is taking flak domestically and from around the world. And rightly so, in my view. Check out e21’s understated but highly critical open letter to Ben Bernanke from a group of economists, investors, and thinkers.
But in some ways, QE2 is nothing new. Yes, it is a departure from the traditional Fed purchases of only very short-term securities. And yes, it could lead to all the problems of which its new critics warn. But this is just the latest round in a long series of mistakes. The new worries are possible currency debasement, inflation, asset bubbles, international turmoil, and avoidance of the real burdens on the U.S. economy — namely fiscal and regulatory policy. These worries are real. But this would be a replay of what already happened in the lead up to the 2008 Panic. Or the 1998 Asian Flu. Or the 2000 U.S. crash.
Here was my warning to the Fed in The Wall Street Journal in 2006:
It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.
That was two years before a Very Big Disruption. (I followed up with another monetary critique in the WSJ here.)
But over the last few decades, there was no common critique of monetary policy among conservatives, Republicans, libertarians, supply-siders, nor among Democrats, liberals, or Keynesians, etc. (Take your pick of labels: the point is there was no effective coalition with any hope of altering the American monetary status quo. There were, for example, just as many Republican backers of Greenspan/Bernanke, and of America’s weak-dollar policy, as there were detractors.) A silver lining today is that QE2 appears to have united and galvanized a broad and thoughtful opposition to the existing monetary regime. Hopefully these events can spur deeper thinking about a new American — and international — monetary policy that can build a firmer foundation for global financial stability and economic growth.
Columbia’s Charles Calomiris discusses his opposition to the Fed’s QE2
Fed chairman Ben Bernanke over the weekend gave a big speech at the American Economic Association annual meeting in Atlanta. He defended his and and Alan Greenspan’s unprecedented easy money through the 2000’s and acknowledged no connection between monetary policy and the financial crash.
Economist David Malpass, however, had the whole thing nailed back in 2002. Here’s Malpass in a note today:
Today’s New York Times front page has a David Leonhardt article on the Fed entitled “If Fed Missed Bubble, How Will It See New One?” It criticizes Chairman Bernanke’s Atlanta speech: “This lack of self-criticism is feeding Congressional hostility toward the Fed.”
I’ve attached my 2002 WSJ article on the same topic (The Fed’s Moment of Weakness). It argued that Chairman Greenspan was “letting himself off the hook” in 2002 by saying that the Fed couldn’t anticipate asset bubbles. The 2002 article concludes that: “If the value of the dollar is allowed to fluctuate as wildly in the future, then momentum will dominate the global economy as it did in the 1990s, creating constant boom/bust cycles.”
We expect Chairman Bernanke to be reappointed and the Fed’s lagging monetary policy to continue for at least one more cycle. For now, this feels good to financial markets (everything is up today except the dollar — gold, oil, the euro, U.S. equities and especially foreign equities in dollar terms.) However, this gradually channels capital away from the U.S. and especially from the many small businesses (and yet-to-be-created businesses) left out of Washington’s aggressive credit rationing process. This undercuts U.S. growth and leaves unemployment much higher than it should be.
We often say hindsight is 20/20. Monetary policy is in a sorry state when the hindsight of the insiders lags the foresight of the outsiders. By eight years and counting.
Treasury Secretary Hank Paulson is back at it. Having presided over the debasement of the U.S. dollar, he is once again cajoling the Chinese over the value of its currency, the renminbi (or yuan). Paulson earns a few points for his semiannual Special Economic Dialogue that has facilitated U.S.-Chinese cooperation on some fronts and helped defuse some of the worst protectionist policy on both sides. But the Greenspan-Snow-Bernanke-Paulson weak dollar policy — which was in itself deeply protectionist, and ultimately highly self-destructive — utterly swamped any of Paulson’s good intentions vis-à-vis China.
Digging through some old files, I found a May 13, 2006, e-mail I wrote to a senior White House economic official, warning of the certain harmful effects of its weak-dollar policy. (I had, six months prior, met with the official in the West Wing to discuss the matter.) The morning of my e-mail, The Wall Street Journal, citing top Administration officials making clear their weak-dollar preference, had published a major story: “U.S. Goes Along With Dollar’s Fall to Ease Trade Gap,” with the subhed, “Quiet Acquiescence Holds Possible Risks for Economy; Surge in Exports in March.”
The previous week economist John Taylor, just off his post as Treasury Undersecretary, had, in another Wall Street Journal article, dismissed the views of Nobel laureate Robert Mundell and Stanford economist Ronald McKinnon. Mundell and McKinnon had been arguing against dollar weakness and urging dollar-yuan stability. Taylor’s offensive, moreover, had been previewed by yet another two articles, one from Martin Feldstein and another from Lawrence Lindsey, arguing for a “more competitive” dollar. That’s a euphemism for weak, as in competitive devaluation. (See, not supposed to happen in America).
Written in the heat of battle, I think my e-mail memo holds up pretty well:
From: Bret Swanson <bret.swanson@********.com>
Date: Sat, May 13, 2006 at 1:38 PM
Subject: stunning protectionist mercantilism
To: [senior White House official]*** Warning: Blunt Statements to Follow ***
[senior White House official],Even considering Treasury’s misguided currency stance these past few years, today’s news in the Journal that the White House approves of the further weakening of an already too-weak dollar is stunning and alarming.
Using monetary policy to target the trade deficit instead of using monetary policy for its only legitimate purpose of price stability and currency stability, is massively irresponsible. The trade deficit is a mostly meaningless accounting number that if anything demonstrates the strength of the American economy, not its weakness. “Competitive devaluation” is what Third World nations did for decades. It’s what helped keep them poor. It’s what we did in the 1970s, a lost decade of malaise. In an era of globalization, currency devaluation is more damaging than ever when there is more cross-border trade and investment and a larger proportion of inputs into our final products and services come from abroad.An already inflationary dollar will become more inflationary. Oil prices will rise further. Recession in 2007 now becomes a real possibility because the Fed will likely now overshoot on interest rates to combat inflation that they and Treasury created but which they never see until it’s too late. Why are we risking ruin of a robust economy?
The best economists I know are alarmed at the Fed’s lack of vigilance and the deepening of Treasury’s weak-dollar policy. Having now lost faith in the Fed and Treasury, these economists have changed their outlooks for the U.S. economy from positive to negative.Lindsey and Feldstein are 180-degrees wrong on monetary/currency/trade policy. Clearly their recent Journal articles were a set-up for this potentially disastrous currency move. John Taylor’s statements last week pooh-poohing Mundell and McKinnon — who are absolutely right on China — were equally discouraging. Not since Richard Nixon have Republicans stood for debasing the currency. It’s painful to agree with those who say this may be the most protectionist Administration since Herbert Hoover.
The U.S. Auto Companies and manufacturers want a weaker dollar — manufacturers always do — but the dominance of the Japanese auto makers is not a currency issue. Japan has just come out of a decade of deflation — the yen was way too strong, not artificially weak — exactly the opposite of what the auto makers say. Manufacturers in general face a huge challenge from China, but not because of the yuan, which is exactly in line with the dollar. The China challenge is real, not monetary. The U.S. must become more competitive via lower tax rates and less regulation. Currency is nothing but a scapegoat, and focusing on it reduces the chances we can solve our real competitive disadvantages on taxes and regulations. Because changing the unit of account cannot change the terms of trade, debasing the dollar does not make us more competitive; it makes us less competitive because it fosters inflation and possibly recession.Furthermore, autos and manufacturing are a shrinking portion of our economy, and this misguided protectionist policy at their behest is highly damaging to the real, growing, leading edge sources of American wealth and power: our prowess in technology, finance, and entrepreneurship.
Please forgive my blunt statements. I make them with respect and concern for the success of this White House. I know you can’t comment on currency matters, but if I am overreacting or wrong on my interpretation of what appears to be happening, please let me know.
I then sent the following warning to a number of friends at the U.S. Chamber of Commerce, who had been seeking my views:
From: Bret Swanson <bret.swanson@*******.com>
Date: Sat, May 13, 2006 at 2:26 PM
Subject: ALERT: stunning protectionist mercantilism
To: [U.S. Chamber officials]ALERT
I believe the outlook for the U.S. economy could be shifting. An article in this morning’s Wall Street Journal makes clear that instead of reversing the dollar’s decline and inflationary pressures, the White House and the Fed are actually encouraging a further fall of the dollar. Amazing. This means more inflation, a potential Fed overshoot on interest rates, and a slow-down and possible recession in 2007. None of this was necessary. We’ve had a very robust economy since mid-2003, and it could have easily continued. Debasing the dollar in a misguided protectionist attempt to reduce the trade deficit is hugely counterproductive. I warned of this possibility in my February memo but held out hope that the Fed and Treasury would reverse its inflationary/weak-dollar course in time to blunt these effects. No such luck.What this means: The Chamber should prepare for a slow-down/recession in 2007-08. We should prepare for an inflationary environment. This policy means gas prices will probably stay high or go HIGHER. Some auto and manufacturing companies could benefit in the very short term, but overall this is bad for the larger economy, especially for technology and financial firms and for entrepreneurs. When the Fed figures out what’s going on, it will have to raise interest rates more than if it had gotten ahead of the curve in 2004-05. Commodity based businesses will continue to do well for a while, with intellectual property based businesses being hit the hardest. Eventually a recession would hurt everyone.
Currency volatility will also discourage international trade and investment, which could lead to slower global growth.
I’ll continue to think about what this means and how the Chamber should prepare.
Most of this scenario came to pass. Oil and commodity prices rocketed. Subprime loans, fueled by easy weak-dollar credit, kept flowing through 2006 and 2007. And the U.S., we now know, hit recession in “2007-08.”
Only the mechanism was a bit off. With elevated inflation, real interest rates never got very high — certainly not to the point that normally causes recessions. But the bursting of the adjustable-rate housing bubble, enabled by weak-dollar easy money, and the ensuing credit crisis had the same effect as a high real Fed Funds rate.
Many of the easy money mistakes had already been made by the Fed in 2003-2005. But this crucial period in 2006, when the U.S. government doubled down on a misguided weak-dollar strategy, told foreign capital to stay away, directly devalued all dollar assets, accelerated the financial collapse, and destabilized the globe.
Please, Mr. Paulson, enough with the currency lectures.
Really? That seems like an odd thing to advise at a time like this. But read David Dreman’s argument:
One last investment that should work out well over time: Buy property, if you live in a place with a forest of for-sale signs. The housing crisis is terrible, but it won’t last forever. If you can get a mortgage, and if I’m right about inflation, you will eventually be paying it back with 50- or 60-cent dollars. Pay 20% down on a house that rises 40% in five years and you’ll triple your investment, assuming you can cover the interest and maintenance with rental income. If prices rise above the rate of inflation, a reasonable possibility given how depressed they are now, your return will be still higher, possibly significantly so.
William Baldwin of Forbes comments:
Shrewd advice from an accomplished money man. But, at the same time, it’s dispiriting that he’s right. The way to make money is not by financing progress but by speculating against the ability of the Federal Reserve to do its job.
Gambling by investors is a good thing, if by that we mean gambling on the next Orville Wright or Steve Jobs. But the gamble against the dollar is something different. It’s one in which your windfall profit is matched by a windfall loss for the fellow on the other side of the table–the unfortunate saver who lent you the money for the house.
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
— F.A. von Hayek
To Hayek’s observation, I would only add the corresponding phenomenon of “deflation.” Both inflation and deflation can be grouped into a singular category. Robert Mundell once called both inflation and deflation a decline in the monetary standard.
Steve Pearlstein of the Washington Post is on Charlie Rose right now saying the U.S. trade deficit was a chief cause of the present financial crisis. He’s got it just backwards. It was our overreaction to the innocuous trade deficit — namely, inflationary weak-dollar easy credit, designed in part to close the trade gap — that brought us here. The weak-dollar Fed juiced oil and home prices. High oil prices boosted the trade deficit — just the opposite of the weak-dollar advocates‘ intent. Skyrocketing home prices required, and were fueled by, hyper-aggressive and unsustainable mortgage lending.
Pearlstein then said we needed an international regulator to stop this from happening. This entity should have stopped the U.S. from buying so much from China. Wrong again. We needed the Fed and Treasury to maintain a stable dollar. A stable currency is the ultimate financial regulator and disciplinarian. If we had ignored the trade deficit and focused on stable money, there would be no financial crisis.
Economist Mike Darda:
There’s nothing like a credit crisis to stop inflation in its tracks.
Headline inflation will fall markedly over the coming year as energy and food prices fall from the previous spike. But inflation could later resume when the panic-induced plunge in velocity picks up. The Fed more than doubled its balance sheet to more than $2 trillion in the last two months, and it will have to be vigilant to pare liquidity as panic hoarding goes away. An inflationary weak-dollar Fed caused most of the credit crisis in the first place as it juiced the oil, housing, credit, and foreign reserve markets. Today’s crisis, which happens to be temporarily disinflationary, is not an especially pleasant trade-off to bring down the price index. Better just to keep the dollar sound in the first place.