Low Inflation Is No “Mystery”
By Brian S. Wesbury, chief economist, and Robert Stein, deputy chief economist, First Trust
Last week, at her press conference,
Federal Reserve Chair Janet Yellen said continued low inflation was a “mystery.”
She’s referring to Quantitative
Easing (QE) and the lack of the economic evidence that it worked. The Fed
bought $3.5 trillion of bonds with money it created out of thin air in an
extraordinary “experiment” to avoid repeating the mistakes of the deflationary
Great Depression. Milton Friedman was the leading scholar in this arena,
proving the damage done by a shrinking money supply during the 1930s.
The money supply is a “demand-side”
economic tool. A lack of money inhibits demand, while a surplus of money (more
than the economy needs to grow) can cause inflation.
The idea of QE (which has
been tried unfruitfully for more than a decade in Japan) was to boost
“demand-side” growth. And, yet, inflation and economic growth have both been
weak. In other words, demand did not accelerate.
So forgive us for asking, but after
unprecedented expansion of banking reserves and the Fed balance sheet, with
little inflation, is it really a “mystery?” Or, is it proof of what we believed
all along: QE didn’t work?
We get it. Just the fact that the
US economic recovery started in 2009 and stock prices went higher is all some
need to convince themselves that QE worked. But no one knows what would have
happened without QE.
Back in 2008, even Janet Yellen
knew there were problems with QE. During a December 2008 Fed meeting, she said
there were “no discernible economic effects” from Japanese QE. Back then she
was a Fed Governor and this was said during internal debates about whether to
do QE. Today she leads the Fed and bureaucracies can never admit failure.
So,
the lack of inflation becomes a “mystery.”
Conventional Wisdom is so convinced
that QE worked, it can’t see anything as a failure.
QE supposedly pushed up
stock prices and drove down interest rates, while at the same time boosting
jobs.
As for the lack of demand-side
growth, the explanations are confusing. Yellen says low inflation is a mystery,
others say it’s because of new technologies, global trade, and rising
productivity. Slow real GDP growth is blamed on global trade, a Great
Stagnation in productivity and the lack of investment by private companies. QE
gets credit for the things that went up, but things that didn’t are explained
away, denied, or determined to be mysteries.
We have promoted an alternative
narrative that agrees with the 2008 Janet Yellen – QE didn’t work. It flooded
the banking system with cash. But instead of boosting Milton Friedman’s key
money number (M2), the excess monetary base growth went into “excess reserves”
– money the banks hold as deposits, but don’t lend out. Money in the warehouse
(or in this case, credits on a computer) doesn’t boost demand! This is why real
GDP and inflation (nominal GDP) never accelerated in line with monetary base
growth.
The Fed boosted bank reserves, but
the banks never lent out and multiplied it like they had in previous decades.
In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008,
which is the same rate it grew in the second half of the 1990s.
So, why did stock prices rise and
unemployment fall? Our answer: Once changes to mark-to-market accounting
brought the Panic of 2008 to an end, which was five months after QE started,
entrepreneurial activity accelerated. New technology (fracking, the cloud,
Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and
productivity in the private sector. In fact, if we look back we are astounded
by the new technologies that have come of age in just the past decade. These
new technologies boosted corporate profits and stock prices and, yes, the economy
grew too.
The one thing that did change from
the 1990s was the size of the government. Tax rates, regulation and
redistribution all went up significantly. This weighed on the economy and real
GDP growth never got back to 3.5% to 4%.
Occam’s Razor – a theory about
problem solving – says, when there are competing hypothesis, the one with the
“fewest assumptions” is most likely the correct one.
The Fed narrative assumes QE worked
and then uses questionable economics to explain away anything that does not fit
that theory. It blames “mysterious” forces, both strong and weak productivity
and claims business under-invested. We’ve never understood the weak investment
argument; why would business leave opportunities on the table by not investing?
Our narrative is far simpler. It
looks at M2 growth, gives credit to entrepreneurs, and blames big government.
After all, the US economy grew rapidly before 1913 when there was no Fed, and
during the 1980s and 90s, when Volcker and Greenspan were not doing QE. And
history shows that inventions boost growth, while big government and
redistribution harm it. Because it has the fewest assumptions, Occam’s Razor
suggests this is the more likely hypothesis.
The Fed has never fracked a well or
written an app. We understand that government bureaucracies want to take credit
for everything. But, in spite of record-setting money printing, inflation did
not rise. Prices are measured in dollars, so if those dollars had actually
entered the economy, prices in dollar terms would have gone up. They didn’t,
which clearly says that money didn’t enter the economy and QE didn’t work as
advertised.
Some say that’s because the money
went into financial assets, but if that was the case the P-E ratio for the
S&P 500 would be through the roof. But because earnings have risen so
sharply, the P-E ratio is well within historical averages based on trailing
12-month earnings and relative to bond yields.
We also understand that
entrepreneurship is a “mystery” to some people because they can’t do it. Most people
can’t change the world the way entrepreneurs can, but that doesn’t mean that by
rearranging the assets of an economy in a different way, entrepreneurs don’t
create new wealth.
By claiming that low inflation is a
“mystery” the Fed is admitting it doesn’t understand the mechanics of QE. Yet,
it is perfectly willing to allow people to think QE is what saved the economy.
This is teaching an entire generation of young people, who in many cases don’t
study economic history, that growth requires government intervention. The only
“mystery” is why they would allow this to happen.
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