When Inflation Doves Cry

Allan H. Meltzer

13 August 2013

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PITTSBURGHThe Wall Street Journal recently ran a front-page article reporting that the monetary-policydoves,” who had forecast low inflation in the United States, have gotten the better of the “hawks,” who argued that the Fed’s monthly purchases of long-term securities, or so-called quantitative easing (QE), would unleash faster price growth. The report was correct but misleading, for it failed to mention why there is so little inflation in the US today. Were the doves right, or just lucky?
The US Federal Reserve Board has pumped out trillions of dollars of reserves, but never have so many reserves produced so little monetary growth. Neither the hawks nor the doves (nor anyone else) expected that.
Monetarists insist that economies experience inflation when money-supply growth persistently exceeds output growth. That has not happened yet, so inflation has been postponed.
Instead of rejecting monetary theory and history, the army of Wall Street soothsayers should look beyond the Fed’s press releases and ask themselves: Does it make sense to throw out centuries of experience? Are we really so confident that the Fed has found a new way?
The Fed has printed new bank reserves with reckless abandon. But almost all of the reserves sit idle on commercial banks’ balance sheets. For the 12 months ending in July, the St. Louis Fed reports that bank reserves rose 31%.

During the same period, a commonly used measure of monetary growth, M2, increased by only 6.8%. No sound monetarist thinks those numbers predict current inflation.
Indeed, almost all the reserves added in the second and third rounds of QE, more than 95%, are sitting in excess reserves, neither lent nor borrowed and never used to increase money in circulation. The Fed pays the banks 0.25% to keep them idle.
With $2 trillion in excess reserves, and the prospect of as much as $85 billion added each month, banks receive $5 billion a year, and rising, without taking any risk. For the bankers, that’s a bonanza, paid from monies that the Fed would normally pay to the US Treasury. And, adding insult to injury, about half the payment goes to branches of foreign banks.
In normal times, there are valid reasons for paying interest on excess reserves. Currently, however, it is downright counter-productive. Bank loans have started to increase, but small borrowers, new borrowers, and start-up companies are regularly refused.
Current low interest rates do not cover the risk that banks would take. To be sure, they could raise the rate for new and small borrowers; but, in the current political climate, they would stand accused of stifling economic recovery if they did.
The new Consumer Financial Protection Board is also a deterrent, as banks consider it safer to lend to the government, large corporations, and giant real-estate speculators. The banks can report record profits without much risk, rebuild capital, and pay dividends and bonuses. And the Fed can congratulate itself on the mostly unobserved way that the large banks have used taxpayers’ money.
Instead of continuing along this futile path, the Fed should end its open-ended QE3 now. It should stop paying interest on excess reserves until the US economy returns to a more normal footing. Most important, it should announce a strategy for eliminating the massive volume of such reserves.
I am puzzled, and frankly appalled, by the Fed’s failure to explain how it will restore its balance sheet to a non-inflationary level. The announcements to date simply increase uncertainty without telling the public anything useful. Selling $2 trillion of reserves will take years. It must do more than repeat that the Fed can raise interest rates paid on reserves to encourage banks to hold them. It will take a clearly stated, widely understood strategy – the kind that Paul Volcker introduced in 1979-1982 – to complete the job.
Should the end of QE come in September, December, or later? Does it matter? Historically, the Fed has typically been slow to respond to inflation. Waiting until inflation is here, as some propose, is the usual way. But that merely fuels inflation expectations and makes the task more painful.
And how high will the Fed push up interest rates? Once rates get to 5% or 6%, assuming inflation remains dormant, the Fed can expect a backlash from Congress, the administration, unions, homebuilders, and others.
When contemplating the consequences of this, remember that 40% of US government debt comes due within two years. Rolling it over at higher rates of 4% or 5% would add more tan $100 billion to the budget deficit. And that is just the first two years.

The budget cost increases every year, as more of the debt rolls over – and that does not include agency debt and the large increase in the current-account deficit to pay China, Japan, and other foreign holders of US debt.
Those who believe that inflation will remain low should look more thoroughly and think more clearly. There are plenty of good textbooks that explain what too many policymakers and financial-market participants would rather forget.
Allan H. Meltzer, University Professor of Public Policy at Carnegie Mellon University and Distinguished Visiting Fellow at the Hoover Institution, is the author of Why Capitalism? and A History of the Federal Reserve.


August 15, 2013, 10:34 p.m. ET

How Mexico Ended Political Gridlock

Stream of Deals Revives Confidence in Country's Economy



MEXICO CITYAt a time when politicians in Washington struggle to agree on anything, their Mexican counterparts—who spent the past dozen years locked in bruising battlessit down almost daily to talk about thorny issues.

Sometimes they tip a glass. Sometimes they share a pizza. And, increasingly, they reach agreements.
Associated Press
Mexican President Enrique Peña Nieto, center left, shown embracing PRD President Jesús Zambrano, with whom he is working to enact reforms.
In the past eight months, Mexico's Congress has passed a constitutional change to curb the powerful public teachers union; a legal reform to strip public officials of immunity from criminal prosecution; and a telecommunications bill that sharply limits the quasi-monopolistic powers of the country's biggest telephone company, controlled by billionaire Carlos Slim.

In interviews with The Wall Street Journal, top officials from Mexico’s three major political parties discussed the impact of a wide-reaching agreement that has paved the way for key reforms.

This week, President Enrique Peña Nieto delivered a proposal to crack open Mexico's historically closed state-owned energy market to private companies. All three parties also began discussing the creation of a national election agency that oversees all federal, state and local elections—a key demand of the opposition.

The steady stream of deal-making, after years of partisan gridlock, is causing ordinary Mexicans to take notice and reviving international confidence in the country's economy even as interest in other big emerging markets flags. During the past 12 months, Mexico's stock index rose 5% and the peso strengthened 3.5% against the dollar, even while Brazil's leading stock market index fell 13% and its currency sank 14%.
José Murat
Political leaders met last November to negotiate a pact to pave the way for major reforms. Attendees included representatives of Enrique Peña Nieto and top officials from the PAN and PRD parties.

In the coming months, Mr. Peña Nieto and the three parties plan to tackle a tax reform to boost revenues and reduce heavy reliance on income from oil exports, and end the constitution's ban on lawmakers serving consecutive terms. "I spend around 60% of my time with members of the opposition, discussing bills," says Aurelio Nuño, chief of staff to Mr. Peña Nieto. "We've all gotten to know each other very well. You come to see each other as people, not just politicians."

As he talks, the phone rings. It is the president, asking how the day's meetings with the opposition went. "He calls after every meeting," Mr. Nuño says.

Behind the change is a wide-ranging political agreement called the Pacto por México, or Pact for Mexico. Unveiled with little fanfare the day after Mr. Peña Nieto took office in December, the deal was signed by the all three major political parties, the ruling Institutional Revolutionary Party (PRI), the leftist Party of the Democratic Revolution (PRD) and the conservative National Action Party (PAN). 

The pact outlines 95 goals ranging from the tax overhaul to barring junk food in schools. The hope is to get all done before the politics of midterm elections in 2015 make deal-making more difficult.

"What we're seeing so far is a kind of legislative coalition, something remarkable in Mexico," said political analyst José Antonio Crespo at Mexico City's CIDE graduate school and research institute.

Many investors view the future of Mexico's economy as linked to the success of the pact. "Investors care a lot about the pact. You can't imagine how many questions I get about it," said Gray Newman, chief economist for Latin America at Morgan Stanley.

Obstructionist politics were the norm here over a bitter 15-year stretch beginning in 1997, when the country became a full democracy and the PRI, which had governed since 1929, lost control of Congress for the first time. Few major initiatives passed both houses, which were divided between the three big political parties, none holding a majority.

The bickering got so bad that the losing candidate in the 2006 presidential election, nationalist leader Andrés Manuel López Obrador, refused to acknowledge then President Felipe Calderón as president. Mr. López Obrador led months of street protests and declared himself the "legitimate president."

Bickering is bound to resurface. The pact's most crucial test comes as the parties sit down to discuss opening the oil industry, whose protected status has long been a point of national pride.

The chances of getting the initiative approved appear high. The opposition PAN party says it will back the proposal, giving the ruling PRI the two-thirds majority needed to change the constitution.

The wild card is the leftist PRD. The party will almost certainly vote against the reform—even possibly take to the streets to protest it, party leaders say. But they say they won't blow up the pact if they don't get their way on a single issue.

"We're not going to abandon the negotiating table," said Guadalupe Acosta Naranjo, a high-ranking PRD official who helps represent the party in pact negotiations. "We can protest in the streets against the energy reform, and at the same time talk with the government over tax reform."

While the political stalemate in Washington has become most pronounced in recent years, Mexico's politics were stuck long enough for the country to drift dangerously. Indeed, a big reason why the pact happened is that all three parties grew alarmed about how weak the Mexican state had grown.

For centuries, this land was ruled with an iron fist—from Aztec emperors to Spanish colonial viceroys to a succession of powerful presidents. That ended with the rise of democracy in the 1990s. The president was forced to cede power to institutions like Congress and the courts that had atrophied under centralized rule.

The result: a power vacuum filled by other forces, including drug gangs that killed an estimated 70,000 people in the past seven years and seized control of parts of the country. Some state governors, left unchecked, ruled their states like feudal lords, building up vast fortunes. Union leaders became enormously powerful.

Big business operated unfettered. Government attempts to regulate the country's monopolies and introduce competition in sectors from telecommunications to beer went nowhere.

"While politicians quarreled during these last 15 years, the space that the state's democratic authority left empty was occupied by private interest groups, be they monopolist firms, drug traffickers or the unions," said Jesús Zambrano, the president of the PRD.

While the parties have very different ideologies, they found common ground. All three parties, for instance, found that they shared a frustration that Mr. Slim's telephone companies charged ordinary Mexicans far higher rates than in comparable countries, and got around regulation by tying up rulings in the country's Byzantine courts. So the political parties agreed to create a new telecom regulator with powers to break up monopolies and whose decisions cannot be suspended in court until the appeals process ends.

Another factor behind the deal-making was the departure from the PRD of Mr. López Obrador, who left to form his own party last September. That gave the party a unique chance to rebrand itself as a moderate, open-minded left-wing group.

PRD moderates broached the idea for the pact, inspired by a landmark deal in Spain in 1977 that helped transform the country after the decadeslong Franco dictatorship.

It all began a year ago, around a month after the July presidential election, when PRD president Mr. Zambrano and his right-hand man, Jesús Ortega, held a secret meeting at the Mexico City house of José Murat, a senior PRI politician with friends across party lines. At the meeting was Mr. Peña Nieto's top adviser, Luis Videgaray, the current finance minister. He took the idea of a broad-ranging pact to the president-elect.

"Why not? What do we lose?" Mr. Peña Nieto responded, according to two people who talked to him on those days. For the president, the pact could broaden his popularity beyond his 38% vote share and get Mexico's economy moving again.

At the same time, the president-elect's team began holding private meetings with leaders of the PAN, which governed Mexico from 2000 to 2012.

"We didn't want revenge," said Gustavo Madero, the president of the PAN. When in power, the PAN felt constantly thwarted by the PRI.

By mid-September, a group of nine people from all three parties secretly started working on a draft at the house of Mr. Murat, the PRI politician.

The group laid some early ground rules. "First, we agreed negotiations must always remain private. Second, nothing is agreed until all is agreed. And third, negotiations shouldn't be affected by current events," said Santiago Creel, a former PAN interior minister who participated in the talks.

The group of nine politicians would agree on broad principles, and then a group of only three membersone from each side—would break off to hammer out the specific language of the pact.

An atmosphere of mistrust at the outset gave way to familiarity and even friendship. Some nights ended with leaders sharing improvised dinners of tacos or pizza.

"The key was to give the benefit of doubt to the adversary," said Mr. Ortega. "Not to be dogmatic and avoid as much as possible an ideological approach."

By late November, a 34-page draft was nearly ready. On a feverish last night of negotiations following the president's inauguration on Dec. 1, parties finally agreed on the wording of the proposed energy reform. At 2 a.m., Mr. Murat broke open a bottle of Johnnie Walker Blue Label and poured everyone a glass.

They raised their glasses and offered each other a toast: "To Mexico."

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

Undercover Economist

August 15, 2013 6:43 pm
How the wealthy keep themselves on top
The more unequal a society, the greater the incentive for the rich to pull up the ladder behind them

When the world’s richest countries were booming, few people worried overmuch that the top 1 per cent were enjoying an ever-growing share of that prosperity. In the wake of a depression in the US, a fiscal chasm in the UK and an existential crisis in the eurozone – and the shaming of the world’s bankersworrying about inequality is no longer the preserve of the far left.
There should be no doubt about the facts: the income share of the top 1 per cent has roughly doubled in the US since the early 1970s, and is now about 20 per cent. Much the same trend can be seen in Australia, Canada and the UK – although in each case the income share of the top 1 per cent is smaller. In France, Germany and Japan there seems to be no such trend. (The source is the World Top Incomes Database, summarised in the opening paper of a superb symposium in this summer’s Journal of Economic Perspectives.)
But should we care? There are two reasons we might: process and outcome. We might worry that the gains of the rich are ill-gotten: the result of the old-boy network, or fraud, or exploiting the largesse of the taxpayer. Or we might worry that the results are noxious: misery and envy, or ill-health, or dysfunctional democracy, or slow growth as the rich sit on their cash, or excessive debt and thus financial instability.

Following the crisis, it might be unfashionable to suggest that the rich actually earned their money. But knee-jerk banker-bashers should take a look at research by Steven Kaplan and Joshua Rauh, again in the JEP symposium. They simply compare the fate of the top earners across different lines of business. Worried that chief executives are filling their boots thanks to the weak governance of publicly listed companies? So am I, but partners in law firms are also doing very nicely, as are the bosses of privately owned companies, as are the managers of hedge funds, as are top sports stars. Governance arrangements in each case are different.
Perhaps, then, some broad social norm has shifted, allowing higher pay across the board? If so, we would expect publicly scrutinised salaries to be catching up with those who have more privacy – for instance, managers of privately held corporations. The reverse is the case.

The uncomfortable truth is that market forces – that is, the result of freely agreed contracts – are probably behind much of the rise in inequality. Globalisation and technological change favour the highly skilled. In the middle of the income distribution, a strong pair of arms, a willingness to work hard and a bit of common sense used to provide a comfortable income. No longer. 

Meanwhile at the very top, winner-take-all markets are emerging, where the best or luckiest entrepreneurs, fund managers, authors or athletes hoover up most of the gains. The idea that the fat cats simply stole everyone else’s cream is emotionally powerful; it is not entirely convincing.

In a well-functioning market, people only earn high incomes if they create enough economic value to justify those incomes. But even if we could be convinced that this was true, we do not have to let the matter drop.

This is partly because the sums involved are immense. Between 1993 and 2011, in the US, average incomes grew a modest 13.1 per cent in total. But the average income of the poorest 99 per centthat is everyone up to families making about $370,000 a yeargrew just 5.8 per cent. That gap is a measure of just how much the top 1 per cent are making. The stakes are high.

I set out two reasons why we might care about inequality: an unfair process or a harmful outcome. But what really should concern us is that the two reasons are not actually distinct after all. The harmful outcome and the unfair process feed each other. The more unequal a society becomes, the greater the incentive for the rich to pull up the ladder behind them.

At the very top of the scale, plutocrats can shape the conversation by buying up newspapers and television channels or funding political campaigns. The merely prosperous scramble desperately to get their children into the right neighbourhood, nursery, school, university and internship – we know how big the gap has grown between winners and also-rans.
Miles Corak, another contributor to the JEP debate, is an expert on intergenerational income mobility, the question of whether rich parents have rich children. The painful truth is that in the most unequal developed nations – the UK and the US – the intergenerational transmission of income is stronger. In more equal societies such as Denmark, the tendency of privilege to breed privilege is much lower.

This is what sticks in the throat about the rise in inequality: the knowledge that the more unequal our societies become, the more we all become prisoners of that inequality. The well-off feel that they must strain to prevent their children from slipping down the income ladder. The poor see the best schools, colleges, even art clubs and ballet classes, disappearing behind a wall of fees or unaffordable housing.

The idea of a free, market-based society is that everyone can reach his or her potential. Somewhere, we lost our way.

‘The Undercover Economist Strikes Back’ by Tim Harford is published this month in the UK and in January in the US

Copyright The Financial Times Limited 2013.