The View From 1776

Why The Fed Will Not Be Able To Prevent Higher Inflation

As former Fed chairman Alan Greenspan admitted in post-meltdown testimony to Congress, no group of bureaucrats, no matter how intelligent or how well informed, can accurately predict the timing of economic turns or determine the correct theoretical equilibrium rate of interest.

With an economy as huge as ours, one with tremendous internal momentum, the Fed is in the position of a one-man row boat attempting to dock an ocean liner being pushed by heavy winds and strong tide.  Even if the Fed honestly seeks to forestall inflation, its loose money policies have already built up well nigh irresistible inflationary momentum.

In Bond Investment Guru Predicts Dollar to Lose International Reserve Status I wrote:

Interest rates have begun to rise, and there is little the Fed can do about it without triggering further rapid decline in the exchange value of the dollar.

Declining purchasing power of the dollar (a declining exchange rate vs. other currencies) , at home and abroad, is the manifestation of inflation.  The Fed has flooded the economy with far too much money over the last decade, and is now pumping trillions of dollars more into the economy to fund the stimulus plan and prospectively yet more trillions to fund the President’s budget imposing massive socialization of the economy. 

The odds are slim to none that it will be able to suck enough phony money out of the economy in a timely way to forestall inflation without throwing us into another severe recession.  History is altogether against Fed Chairman Bernanke’s confidence that he can pull it off. 

The only time since the creation of the Federal Reserve system in 1913 that the Fed has acted to drain the economy of excess liquidity and shut off inflation was in the Reagan administration under Paul Volcker in 1980.  Hammering inflation out of the economy was a very painful process that entailed about three years of recessionary conditions.

In that vein, read Fed Cannot Withdraw the Money, by Robert Blumen on the website.

Governments, since the golden age of Athens and other Greek city states, as well as later in the Roman Empire, have repeatedly attempted to deal with excessive public debt by inflating their currencies.  This is precisely what President Franklin Roosevelt, for the first time since ratification of the Constitution, set out deliberately to do in 1933 (see How FDR Destroyed the Dollar).

Why did Roosevelt encourage inflation, particularly on the heels of Germany’s 1920s hyperinflation that wrecked its economy, wiped out the middle class, and set the stage for the political triumph of Hitler’s National Socialist German Workers Party (the Nazis)?

The short answer is that Roosevelt, and now Obama, wanted to expand Federal spending far beyond prior levels and far beyond the scope of potential tax revenues.  Inflationary expansion of the money supply was a fast, though illusionary way to do so.  Inflation amounts to a hidden tax on people who work and save, because, in effect, it transfers the future purchasing power of workers’ savings to the Federal government.

President Roosevelt was, as President Obama appears to be, a relative ignoramus regarding economics.  Both presidents were enthralled with ivory tower theories about magic solutions to political and economic problems.  In FDR’s case, he followed the policies propounded by his crew of Harvard and Columbia University socialist economists, chief among them Rex Tugwell.  In President Obama’s case, he follows the historically discredited doctrine of John Maynard Keynes, which has been since the mid-1930s the economic orthodoxy of the Democrat/Socialist Party.

Turning both Roosevelt and Obama to expansion of the money supply while disregarding its destructive inflationary impetus, is the belief that more Federal spending always guarantees higher employment.  To spend more - in Obama’s case, a great deal more - in the middle of a recession, with tax revenues sharply reduced, requires that the Fed manufacture money, a great deal more money, out of thin air, via bookkeeping entries.

Unfortunately, stimulus spending artificially channels money into employment in government-selected economic and geographic segments.  In those areas, employment increases only so long as the government keeps spending its stimulus money.  When that spending stops, the economy drops back into much the same status of misaligned investment and employment that produced the recession in the first place.  Note, for example, that government stimulus spending supports the very economic sectors which wildly over-expanded on cheap money (Fannie Mae and Freddie Mac, along with mortgages to sustain the over expansion of the housing bubble).  This amounts to increased dependence on debt as a supposed counter to excessive reliance on debt that caused our recession.

If that inflationary process continues, the exchange rate of the dollar will be further devalued and foreign suppliers and foreign holders of dollar-denominated investments will demand progressively higher prices for their merchandise and higher interest rates for their dollar-based investments.  The largest of these investors today are the central banks of major exporting nations, such as China, Japan, and Germany.  In addition to subverting our economy, placing such economic power in the hands of those nations will severely hamper our foreign policy efforts in the Middle East with jihadists and with a nuclear Iran, as well as in the Far East with North Korea.

Thus, at the very time the Fed seeks to keep interest rates low to facilitate domestic business activity and consumer purchasing, the force of rising inflation will push interest rates higher and choke nascent business revival.  This will leave the Fed two choices: continue inflationary flooding of the market with fiat money to fund Federal welfare spending, or squeeze the money supply.  Both policies will push interest rates skyward and torpedo the Fed’s prior efforts to resuscitate the economy.

The better choice when a recession hits is to allow the free market place to clean out excess inventory and reduce employment in industries that have expanded too much with the artificial impetus of the Fed’s loose-money and low-interest-rate policies. 

The free-market process is painful, but it is much quicker and much fairer than the muddle produced by government intervention and favoritism to special interest groups such as labor unions.  Moreover, it returns the economy to a more balanced state in which real, new jobs can be created.