AUGUST 24, 2010.
The Fed Can Create Money, Not Confidence
Inflation—or stagflation—remains the more serious danger than deflation
By GEORGE MELLOAN
A report by the Federal Reserve Bank of New York last week showed that consumers are having difficulty climbing out of the debt hole they dug for themselves before the credit bubble began to deflate in late 2007. The report gives support to the fears of those asset managers and economists who believe the U.S. is facing deflation.
Bill Gross, manager of the $239 billion Pimco bond fund, is one. His evidence is that the Consumer Price Index (CPI), annualized over the last two years, has fallen slightly.
Since deflation, in simple monetarist terms, means too little money chasing too many goods, with a consequent fall in prices, the remedy should be easy. Can't the Federal Reserve create as much money as it wants with just a few key strokes? Well, there are some things money can't buy. In political circumstances like today's, one of them is public confidence.
In fact, the Fed has been fighting deflation for nearly two years. It began pumping new money into the economy after the September 2008 stock market crash to restore liquidity in the financial system. It has kept the pumps running by maintaining a near-zero interest rate target. Its net purchases—with newly created dollars—of government and government-agency bonds have totaled some $1.4 trillion, expanding its balance sheet to $2.3 trillion. As the Fed pumped out new money, member bank reserves ballooned and now exceed $1 trillion. That means a vast amount of money is on deposit in Fed accounts, ready to be flooded into the economy if loan demand increases.
So what's the problem? Here it is best to depart from monetarist terminology, with its heavy emphasis on the magical powers of the central bank. Those magical powers are highly overrated, as almost anyone who has ever run a central bank will likely tell you. The Fed can flood the banks with liquidity in an effort to stimulate economic growth (if it is willing to run the very serious risk of inflation). But that will not necessarily stimulate a demand for this money.
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What's missing in these times is a strong desire among businesses and consumers to take on new debt, low rates notwithstanding. Corporations can't even decide what to do with all the surpluses their businesses are generating; they are sitting on vast amounts of cash even though it is earning them minimal investment returns. Because business's "animal spirits" are suppressed by caution, private-sector hiring is weak, which means the unemployment rate is likely to remain high. As the New York Fed report shows, householders on balance are struggling to pay off the debts piled up during the 2003-2007 credit binge and are building up savings. Consumer spending is relatively flat.
The key word here is "uncertainty." The Obama administration and Congress have dumped a huge load of highly dubious new legislation on Americans, much of it unread even by the legislators who voted for it. ObamaCare is an attempted federal takeover of a vast and complex industry. No one really knows how much chaos the financial sector "reform" act will generate. Hyperactive zealots in federal bureaucracies such as the Environmental Protection Agency have been unleashed to do silly things like attempt to reduce the planet's supply of carbon dioxide.
A massively expensive federal "stimulus" program failed to stimulate for the easily predictable reason that the money the government spends on its political projects robs the rest of the economy of resources. Opinion polls show that the soaring federal deficit is of major concern to voters, as it should be.
State and local governments are, on the whole, in terrible financial shape, which means that they will likely be shedding employees and adding to the ranks of the unemployed. The only remedy the Democrats have for cutting the deficit is higher taxes, which in a weak economy likely would be counterproductive.
As a rotating member of the Federal Open Market Committee, Dallas Fed President Richard W. Fisher helps guide national monetary policy. He addressed the uncertainty issue in a recent speech to the San Antonio Chamber of Commerce.
The prevailing sentiment among business leaders he surveys monthly, Mr. Fisher said, is that "the politicians and officials who craft and enforce the rules are doing so in a capricious manner that makes long-term planning difficult, if not impossible. They are increasingly distressed by the lack of consistent direction coming from Washington. . . . So they are calling time-outs and heading for the sidelines while they wait for the referees to settle the rules of the game."
He added that no amount of further monetary accommodation can offset the retarding effect of heightened uncertainty. Indeed, it would make matters even worse if the private sector concludes that the Fed has become "politically pliable and is prone to substitute such accommodation for fiscal discipline." Who would ever think that?
Getting back to Mr. Gross and his fears of deflation, it should be noted that he stacked the deck in referring to a two-year average, since that includes the brief period after the 2008 crash when the CPI fell. The index began climbing sharply at midyear 2009 and was showing nearly 3% inflation by the end of the year. A 0.3% rise in July still signals rising prices.
Since U.S. prices correlate inversely with the dollar's international purchasing power, and since the massive U.S. budget deficit puts downward pressure on the dollar in international markets, inflation surely remains a more serious danger than deflation.
But deflation and inflation predictions could both be right in a sense, if you aren't too fussy about strict definitions. In the late 1970s, the last time Americans suffered from manic interventionism from Washington, we had "stagflation," a combination of minimal economic growth and double-digit inflation. It wasn't pretty.
Stagflation was cured by a set of policies that reversed the Keynesian nostrums then in vogue and that are again the core basis for federal economic policy. In the early 1980s, the Fed tightened money, tax rates were cut, economic regulation was pared sharply and an effort was made to curb nondefense spending. It worked quite well, producing 25 years of economic growth. It will be much harder to repair today's damage, but the need to make another try is becoming urgent.
Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).
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