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Critique of Fed President Charlie Evans' Speech
A couple of days ago Chicago Fed President, Charlie Evans, gave a speech at the Bank of Ann Arbor detailing risks he perceived to the U.S. and global economies, along with a number of opinions on what actions governments and central banks could take to curtail those risks. When juxtaposed with Austrian economic theory, the speech by Mr. Evans was so riddled with fallacies, I could not help myself but document the offences. Excerpts from Mr. Evans' speech are italicized below, followed by my responses.
I have vigorously supported strongly accommodative monetary policy measures as the appropriate response to the unacceptable state of the U.S. labor market.
Monetary policy does not create productive labor, but rather the opposite. History does show that accommodative policy stimulates activity, but this activity usually circumvents natural market forces which direct resources to their most productive uses. The ultimate result is an exacerbation of economic woes when the next cyclical downturn arrives.
A recent example can be found in the Fed's response to the bursting of the tech bubble. Artificially low interest rates in combination with well-intentioned, but faulty government policy, lead to a speculative bubble in housing. I do not believe any economist can credibly deny that resources... both labor and natural... were wasted building millions of homes for which no one had an immediate, practical use. This misallocation of resources eventually manifested in enormous economic loss as revealed by the 2008 financial crisis.
The context for our recent actions is an economy that has been growing, but not at a pace fast enough to restore it to its productive potential in anything close to a reasonable amount of time.
We all may have opinions about what is a reasonable recovery time, but no one person or group is smart enough to know this answer. Such statements are simply excuses for central planning, and once again, history is has not been kind to centrally-planned economies.
More monetary accommodation and greater confidence in the future mean a stronger U.S. economy.
Monetary accommodation distorts the price discovery mechanism for the most important price in any economy: the price of money. Without a free market for interest rates, business operators cannot make judgments that use resources most effectively because more ventures appear viable, thereby putting a greater strain on available labor and raw materials. By allowing the market to set a higher price for money, only those operators who could run a business profitably with higher cost... in other words, those who know how to use resources most efficiently... would have access to those resources. The prevailing interest rate used to be called a "hurdle rate" for a reason: the price of money would reveal whether or not a venture was economically viable. In the absence of an appropriate hurdle rate, many more ventures appear viable than would otherwise be. While this outcome appears to be the objective of accommodative policy, the result is a waste of resources and lower long-term wealth for the nation.
In the absence of further monetary stimulus or fiscal repair, the outlook would be for more of the same: moderate growth that is not strong enough to generate substantial improvement in the labor market.
In the absence of further monetary stimulus, the economy would undoubtedly suffer a sharp downturn. However, the process would be reparative. Inefficient businesses would fail. Bad debts would clear. Deflation would also set in, bringing down labor costs in conjunction with the prices of resources and consumer goods. Those with heavier debt loads would suffer the burden of repaying debts with a stronger currency than they borrowed. These effects would be fleeting, however, as the process of pushing resources toward more productive use produces greater national wealth in the long run.
A great deal of state-of-the-art analysis -- done both inside and outside of the Fed -- indicates that the severe downturn in 2008-09 was mainly the result of a large drop in aggregate demand which left the economy operating below its potential.
The drop in aggregate demand seen during the 2008-09 financial crisis was a side effect, not a cause, of the downturn. Excessively high debt levels and mispriced assets... both the result of accommodative policy... were the cause of the crisis. In fact, every major financial crisis in history can find its roots in the abuse of an effectively fiat currency. Even U.S. crises of the 19th century... when we were purportedly on a gold standard... came in the aftermath of speculative bubbles fuelled by banks which issued paper in excess of specie they held in reserve.
Research also shows that better and more accommodative policies have the power to reverse these setbacks and raise employment, output and incomes.
Such research only considers benefits in nominal terms, but when a currency is constantly devalued by accommodative policies, the benefits in real terms turn into losses. Furthermore, the effects of accommodative policy, even nominally, lessens in proportion to outstanding debt within a society, and increased debt is a side effect of such policies, explaining why each crisis requires a larger stimulus. Furthermore, debt is the most insidious threat to the potential for economic recovery, meaning that in the long run, accommodative policy is a very destructive force.
Furthermore, appropriate policy can deliver these better outcomes without generating inflation that is significantly higher than the Fed's long-run goal of 2 percent.
The fudging of inflation numbers is an open secret. No one who buys gas or groceries believes that inflation is truly running near 2%. Independent economists such as John Williams calculate inflation closer to 6%, and this elevated inflation rate is occurring during recession. More rapid price increases have not yet materialized due to rather tame money velocity. Ironically, if the Fed achieves its goal of spurring nominal economic activity, the reins of inflation will be lost.
There are many who believe otherwise. In their view, our current low output and high unemployment are the hallmarks of an economy that has lost its competitiveness.
Not at all. Our current economic stagnation comes from a combination of inefficient resource use... a problem that the marketplace could solve in the absence of central planning... and an uncertain political landscape. The threat of a further consolidation of central control and confusing signals from national leaders regarding attitudes toward business, among other issues, have paralyzed innovation and productive risk-taking.
Carmen Reinhart and Kenneth Rogoff and others find that, given the monetary and fiscal policies that are typically pursued, a prolonged period of slow growth following a financial crisis is the unfortunate norm.
Mr. Reinhart and Mr. Rogoff need to study conditions rather than make generalizations. The panic of 1819, which like the current crisis followed a period of national speculation in real estate, saw economic expansion return in less than 18 months because the market was left to clear itself. Prolonged periods of slow growth, most notably during the Great Depression, did not become the norm until politicians decided they knew better than the market how to fix the economy.
Whenever the economy operates below its potential, the key mechanism that returns the economy back to potential is a fall in real interest rates.
A fall in real rates does lower the hurdle rate which thereby plays a role in creating economic activity. However, a more powerful stimulative effect comes from lower resource prices as demand falters. Unfortunately, accommodative policy is designed to fight deflation, thereby negating one of the key mechanisms for clearing malinvestment and transferring resources to those who can use them more productively.
Over the past couple of decades, world economic growth has depended heavily on U.S. consumers. Our consumer spending was a critical driver of growth in auto sales, electronics, housing and technology -- all of which not only benefited the U.S. economy, but also supported growth beyond our borders. Given the forces holding back U.S. consumers, the world economy can no longer count on U.S. households to drive growth. Other countries need to take steps to stimulate their own domestic demand.
This obsession with consumption by mainstream economists is terribly misguided as the focus is once again directed toward a side effect, not a cause. Consumption is the privilege granted as a result of production. Production creates wealth. Consumption consumes it. Why should policy be directed toward the consumption of wealth? If government must interfere in some way in the economy, our politicians should at least be advised to find ways to stimulate innovation and investment. However, the best long-term policy is to minimize the size of government so as to leave resources available to private enterprise where natural human spirit and innovation will put assets to their highest and best use.
For a country with its own currency, a quick channel for achieving improved competitiveness is currency depreciation.
Competitiveness gained through currency devaluation is superficial because you are not operating more efficiently but rather simply exchanging your assets for less of a foreign currency. (A wiser move would be to strengthen a foreign currency after you have acquired it.) Furthermore, advocates of a weaker domestic currency neglect the other side of the equation: purchasing resources from overseas becomes much more costly. So not only does a weak currency allow a country to trade their goods for less of a foreign currency, the country also has the privilege of spending more of their own currency for imported goods. This trade-off hardly seems like a path to prosperity.
In addition, under current law, in the absence of a budget deal, there will be automatic sequestration of spending amounting to $1 trillion over a 10-year period... And unfortunately, a political stalemate that triggers slated spending cuts -- an extreme outcome -- cannot be ruled out.
Cutting $1 trillion over 10 years... only $100 billion per year... is hardly an extreme outcome with the deficit running at over $1 trillion annually and total spending of $3.6 trillion. We need much larger spending cuts before the U.S. debt becomes too large to manage without a massive monetization, a process that would be far more mendacious to prosperity than a temporary depression.
Specifically, I believe we should adopt an explicit state-contingent policy rule that commits the Fed to providing accommodation at least as long as the unemployment rate remains above 7 percent and the outlook for inflation over the medium term is under 3 percent... Note the importance of the inflation trigger -- it is a safeguard against unacceptable outcomes with regard to price stability.
Unfortunately, many other central bankers who have advocated counterfeiting operations... the expansion of the Fed's balance sheet creates money out of thin air... have had the audacity to believe they can tap the brakes on inflation at just the right time, but none of them have succeeded. Once money velocity picks up, inflation will accelerate too quickly to be controlled. Accelerated economic activity also brings higher interest rates. Since higher rates imply lower bond prices, the Fed cannot possibly withdraw the money that was injected through bond purchases since the sale of those bonds will bring less money.
Furthermore, any rate of inflation is corrosive to wealth. Even if the stated 3% rate were accomplished, our currency would lose 25% of its purchasing power in a decade. If the inflation rate runs closer to the 6% calculated by independent economists, our currency will lose half of its purchasing power in a decade. Savers, and especially retirees, are therefore forced to either spend or speculate with what they thought was a store of wealth. Such inducements hardly seem prudent.
And stating that we expect to keep a highly accommodative stance for policy for a considerable time after the recovery strengthens is an important reassurance to households and businesses that Fed policy will not tighten prematurely.
Maintaining accommodative policy after the velocity of money picks up guarantees a higher rate of inflation. Mr. Evans' policies are obviously contradictory. We were quite fortunate as a nation that after Alan Greenspan set the precedent for such nonsensical policies in the late 1980s, the Soviet Union fell. The fall of the iron curtain resulted in flood of natural resources, helping tame inflationary pressures. We have no such crutch at this juncture... just the opposite. With burgeoning demand from China and India, resources prices are already under pressure to rise. Devaluation of our currency will only make the effects more dramatic.
If we continue to take only modest, cautious, safe policy actions, we risk suffering a lost decade similar to that which Japan experienced in the 1990s.
Japan has lost two decades, not one, and the culprit is excessive intervention. Cultural issues compelled the Japanese to preserve revered institutions rather than let them fail, thereby preventing resources from finding more efficient use. The result of Japan's "cautious" escapades is an debt to GDP ratio over 200% and interest payments in excess of 20% of government revenue... both dwarfing any other industrialized nation, including Greece. So rather than preserve their nation's wealth, Japanese policy has instead spent it, with little to show in return. Mr. Evans now proposes the U.S. adopt a similar policy, but an order of magnitude larger in order to avoid the "error" of caution. The policies he advocates are reckless, and history shows them to be destructive to wealth and prosperity.
Our leaders must stop confusing symptoms with causes. We must return the power of setting the price of money to the marketplace. Uncertainty over business policies must be removed in order to raise the confidence of entrepreneurs. And most importantly, Congress must quickly adopt policies to control national debt, and protect the basic quality of money as a store of wealth.