The Fed made a valiant effort two weeks ago to propel the economy past the subprime whirlpool. The reaction of the financial markets suggests that the effort was vain, if not counterproductive. The stock market is sharply down; the dollar is at record lows against other major currencies; the most-watched commodity prices – oil and gold – are surging. Those could be harbingers of a stagnant economy and rising prices, a return to the good old malaise of Jimmy Carter’s administration.
Some observers, ranging ecumenically from the Wall Street Journal’s editorial page to Islamofascist cheerleader George Soros, blame Ben Bernanke and his crew for irresponsibly expanding the money supply. In their view, inflation will sink the real economy, as it did in the 1970’s. They urge monetary restraint to dampen inflationary expectations at any early, controllable stage.
As the Journal summarized the case yesterday, under the headline “Adam Smith Growls” [link for subscribers only]:
“The U.S. dollar is the linchpin of not only the American economy but also the world monetary system.” Those words were the lead of an editorial in this newspaper on August 21, 1978, amid the inflation of the 1970s and the world's last great dollar crisis. Are we watching another such period today? It’s not inevitable, but this week we all got a reminder of what such a thing looks like, and it isn’t pretty. . . .
The supply of dollars in the world is ultimately controlled by a single source, the Federal Reserve. With its aggressive easing in September, and again in late October, the Fed has signaled to the world that it cares more about creating dollars in the hope of limiting U.S. credit problems than it does about the dollar’s value. Investors can see this, and so they are dumping dollars and looking for other assets to hold. This includes commodities such as gold, which is now at $835 an ounce. The nearby chart from economist Michael Darda gives a sense of how far the dollar has fallen this year. . . .
Our current financial woes are in large part the result of previous monetary excess, which fueled a debt and asset boom that has become a banking bust. The way to emerge from the mess is to slowly but honestly work off the bad debt and write down the losses. The one sure way to make things worse is with more monetary excess. That could trigger a run on the dollar and the necessity for far higher interest rates to stem it.
This case is troubling but not irrefragible. There are a number of facts au contraire.
Judged by hard numbers, the Fed’s “aggressive easing” has so far done what it was supposed to do: Yields on Treasury bonds at all maturities are lower than a year ago. (And whatever happened to fear of the inverted yield curve and its forecast of an imminent recession?) Mortgage interest rates, despite the turmoil in that market, are at just about the same level. Nowhere in these data does one see much evidence that lenders anticipate accelerated inflation.
But what about the falling dollar? As the chart cited by the Journal (reproduced infra) shows, the greenback’s value is at an historic low against other currencies. Looking at the historical rises and falls, however, they conspicuously fail to correlate with the fortunes of the American economy. Note that the current deterioration began five years ago and has coincided with a period of strong economic growth. On the other hand, the dollar went up and then down during Ronald Reagan’s expansion, down and up during Bill Clinton’s.
The lack of an easy-to-understand correspondences between the state of America’s economy and the value of our money shouldn’t be a surprise. The factors that influence the relative supply of and demand for different currencies are multifarious. Maybe the world expects, as the Journal’s editorialists assume, that dollars will buy less in the future and is swapping them now for goods or alternative stores of value. If so, dollar lenders and dollar holders apparently hold divergent views, which would be surprising indeed.
An alternative explanation of the declining propensity to hold dollars is anticipation that U.S. equities, investment in which is a major use of dollars, will offer lower after-tax returns. That wouldn’t be an irrational forecast. U.S. tax revenues are scheduled to rise sharply over the next several years, both in real terms and as a proportion of the GDP, owing to the much publicized glitches in the alternative minimum tax and the sunset of the Bush tax cuts after 2010. The Democratic majority in Congress regards those increases as sacrosanct. Under its “pay-go” rule, the targets of the increased taxation can be changed but not the overall revenue stream. Hence, the tax bill just passed by the House “fixes” AMT for one year by imposing new, permanent taxes on investment. Rep. Rangel’s “mother of all tax reforms” does the same sort of reshuffling on a grander scale.
Can it really be the case that what the U.S. economy needs right now is higher taxes? That is the implicit rationale behind the Democrats’ current tax policy and the explicit contention of all of the Democratic Presidential candidates.
The Feds’ liberalization of monetary policy isn’t merely a short-term expedient to smooth over the meltdown in subprime mortgage lending. It is also an attempt to stave off recession. Unfortunately, while Captain Bernanke strains to move the boat forward, he holds only one oar, monetary policy. The other is fiscal policy, which Congress is pulling in the opposite direction. A rational policy mix would be somewhat more caution on the monetary front, since the risk of tipping into an inflationary spiral can’t be ignored, and a pro-growth fiscal package that would, at the very least, keep the federal government’s share of the GDP at no higher than the present level. Better still would be an actual reduction. Maintaining the status quo can be accomplished by repealing the AMT and making the EGTRRA tax regime permanent. For reductions, one might look to cuts in marginal tax rates and diverting the current FICA surpluses into individual accounts.
The Left’s response will be, of course, that the feds need every dollar of projected revenue and more in order to stave off the unthinkable evil of budget deficits. Even on its own terms, that argument is faulty. Nothing saps government revenue faster than a recession. Consider, for instance, that the Joint Tax Committee estimated in 2001 that the Bush tax cuts would absorb only one-third of the projected ten-year budget surplus. The projections didn’t take into account the recession that had begun late in the Clinton Administration, which more than wiped out the surpluses. Something similar would put a real damper on a second President Clinton’s spending ambitions.
EGTRRA mitigated, to some extent fortuitously, the impact of the slowdown that President Bush inherited. Now would be an excellent time to apply the lessons of 2001, before the next recession comes to pass.
