This past week we learned that the Chairman of the Federal Reserve, Ben Bernanke, is going to put his money printing presses into overdrive:
The Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment. “We’re looking for ongoing, sustained improvement in the labor market,” Chairman Ben S. Bernanke said in his press conference today in Washington following the conclusion of a two-day meeting of the Federal Open Market Committee. “There’s not a specific number we have in mind. What we’ve seen in the last six months isn’t it.” Stocks jumped, sending benchmark indexes to the highest levels since 2007, and gold climbed as the Fed said it will continue buying assets, undertake additional purchases and employ other policy tools as appropriate “if the outlook for the labor market does not improve substantially.”
I am not a fan of Austrian economics, and I have my concerns when it comes to monetarism. There is enough evidence out there to suggest that both theories have it wrong, at least generally, when it comes to the destructive consequences of printing money. However, when it comes to the new strategy by the Federal Reserve I am on the side of the monetarists.
My reason, though, is not primarily that I worry about inflation – for reasons I will explain in a moment, you can print a lot of money without causing inflation. My concern is instead that this happens at the same time as the European Central Bank (ECB) has decided to provide an infinite guarantee for the deficits of EU member states.
The Federal Reserve has two policy objects: to keep inflation down and to contribute to the growth of the U.S. economy. The ECB has only one policy object, namely to keep inflation down. Neither of the two central banks has a directive to bankroll a government deficit. That is, however, precisely what is happening: the Federal Reserve has been buying treasury bonds for a very long time, and the ECB has now gotten into the same business.
We could stop here and simply note that both these central banks are breaching their policy boundaries – and probably their charters as well – but that would not be of much consequence. The fact that something is wrong in principle has rarely stopped a politician or a government agency; what matters here is instead that both the Fed and the ECB are getting into policy territory that is very risky from an economic viewpoint.
When a central bank makes an open-ended promises to buy treasury bonds from the fiscal government of that country - which is precisely what the ECB has done for Spain and thus by implication for any other troubled welfare state in the euro zone – it effectively nullifies any effort by that same government to end a budget deficit. From the viewpoint of those who create the deficit, namely the legislators, the money printed by the central bank is the perfect solution: they don’t have to raise taxes to pay for their spending, nor do they have to schmooze foreign investors. As far as they can see, they can keep on spending ad infinitum.
For a while, they can. Short-term, there is no immediate penalty to expansive monetary policy. (There is later on; let’s get back to that in a moment.) On the contrary, the combination of sustained government spending and low interest rates is appealing to many mainstream policy makers. They can continue to run a deficit without having to support politically painful spending cuts or even more politically painful tax increases. Furthermore, they can make the case that private-sector activity is stimulated by low interest rates, from household spending on durable goods to businesses making investments at low cost.
Over time, though, two dark clouds rise on the horizon. The first is a downward macroeconomic spiral, driven by a relentless growth in government spending. Due to what legislators consider to be easy money, government will continue to spend on its entitlement programs, and do it essentially as if the deficit did not exist. Such government spending has negative effects on many fronts, one being that people reduce their workforce participation and live more on entitlements. This reduces the tax base and deprives the welfare state of some of the revenue it needs to pay for that same welfare state. It is this revenue gap that the central bank fills with freshly printed money.
By perpetuating this replacement funding the central bank thus perpetuates the spending that erodes the tax base and perpetuates people’s dependency on entitlements. It perpetuates the need for its own printing presses.
But this situation is not static. Over time, more and more people depend more and more on entitlements, and the increasing demand for taxes that comes with growing entitlement spending falls on fewer and fewer shoulders. Not only do people who are not working depend on government, but in a welfare state more and more working people get at least as much in entitlements from government as they pay in taxes.
When a central bank steps into this situation and makes an open-ended money-printing commitment, it only reinforces the destructive erosion of the tax base and of people’s ability to support themselves through work. A vicious circle becomes a vicious downward macroeconomic spiral. This is where Greece, Spain, Portugal and Italy find themselves today – and it is where America is heading.
The second dark cloud on the horizon is inflation. However, it does not kick in as early as Austrian and monetarist economists claim: the monetary printing presses in America have been running on overtime for years without causing the kind of inflation that those theories foresee. But that does not mean there is no connection whatsoever between an expanding money supply and the general price level in the economy.
The key is a set of so called “transmission mechanisms” between the monetary sector of the economy and the real sector (the one where production, consumption, investment and work take place). During the 1990s there was a lively debate in the academic economics literature about these transmission mechanisms, and one of the front figures in the related research was - you guessed it - Ben Bernanke. He was one of the economists involved who pointed out that there was insufficient research as to how these transmission mechanisms actually work.
This is important because prices are not monetary phenomena: they are real-sector value equivalents that happen to be denominated in a certain currency. When monetarists and others claim that prices rise as a direct consequence of expanding money supply, they assume – implicitly – that prices are monetary phenomena. They claim that a one-percent rise in the supply of money will cause a one-percent rise in prices, all other things equal. But all other things are neither equal nor irrelevant. A price does not rise just because there is more money in the economy.
Austrians and monetarists are missing a mechanism, namely that which makes the increased money supply change the real-sector value equivalents. Prices, for short.
What could possibly change real-sector value equivalents? Well, this is where government-provided entitlements enter the picture. In an economy without entitlements, all products produced are priced relative people’s workforce participation. You buy what you need and want by means of what you earn through work (current or accumulated in the form of investment dividends). When government provides entitlements it allows some people to pay for their goods without working, which increases demand for a given production. Since the entitlements also discourage workforce participation, there will be less labor available to produce in order to meet the extra demand. This has an inflationary effect on consumer prices.
So long as government pay for entitlements through taxes, it somewhat mitigates the imbalance by reducing demand among those who are net taxpayers. That way the inflationary effect on consumer prices is moderated or eliminated. However, when government decides to pay for some of its entitlements with newly printed money, it removes the inflation moderation that comes with taxes. When a sufficiently large share of consumer spending is driven by entitlements, and when a sufficiently large share of those entitlements are funded by money supply, consumer prices will start to rise. And when they do, there will be little in the way to stop them from rising further.
These mechanisms have been at work in many countries at different points in time. Weimar Germany is a classic example; some Latin American countries have a history of hyper inflation, driven by out-of-control entitlements. Zimbabwe has long suffered from a similar problem. Therefore, we know what this problem looks like and we have a good idea of what its causes are. However, what we do not know is just how far you can push a welfare state by funding its entitlements with freshly printed cash, without causing hyper inflation.
I would rather we don’t try to find out. But both the ECB and the Federal Reserve appear all too eager to test the limits of monetary sanity.
Let’s hope someone puts a foot down before these two central banks have caused consumer prices to spiral out of control in the world’s two largest economies.