Economics, Growth & Inflation On My Mind

Brian Wesbury's excellent piece in yesterday's Wall Street Journal, "Inflation Is a Clear and Present Danger," moved me to write a piece on recent developments in the US economy.

But, to start this post, I'd like to refer to an economics editorial in the Journal on July 25th by David Ranson, head of research at H.C. Wainwright Economics. Among several excellent points he made, this one stood out in my mind,

"There's an old saying that if your neighbors are losing their jobs it's a recession; if yu are losing yours it's a depression. It's therefore unfortunate that such a large fraction of prominent forecasters hails from the financial community. Their views are colored by the turmoil suffered in their industry. In an earlier generation, many of the best-known forecasters ran economics departments in nonfinancial companies. Today these are a dying breed, thanks to the past decades of corporate cost-cutting.

We are not a nation of whiners, but we do have a lot of alarmists. It is becoming politically incorrect to suggest that the economy is basically sound.

We shouldn't expect forecasters to shrug off the depressing effects of what's happening in their own back yards. This is human nature. We just need to keep things in perspective when we listen to them. A more objective diagnosis is especially needed during an election year, in which many unfounded fears are broadcast and amplified by the media."

Ranson wrote quite a bit to chew over in those three paragraphs- all of it true. He hit the nail on the head when he noted that economists in the financial sector, being employed by managements that have screwed up their industry big time this past year, see the rest of the US economy in similarly dire straits.

And they do shout about their misperceptions to anyone who will listen.

Ranson made another interesting point in his editorial. He also wrote,

"A natural system has built-in redundancy. It manages and heals itself. The economic system is no exception. On this page about 10 years ago, Penny Russell and I argued against the idea that the economy is a "house of cards," susceptible to collapse as soon as a few cards are dislodged. We suggested that it's more like a beehive. The future of the hive does not depend on the full employment for all the worker bees. In fact, an accident can put many bees out of action without compromising the hive as a whole.....Yet despite the human tragedies at the local level, the system as a whole muddies through.

Failure to recognize this endangers the mental health of our society. We create a far bigger tragedy when we lose heart, change the rules of the game, or act recklessly with quick fixes."

I really love that analogy. It's so apt for a market economy such as that of the US. Yes, technically, we have a mixed economy, with such a large government sector. But the driving force of value creation is the private sector. And that sector does heal itself. Thanks to individual initiative, resources and creative energy flow naturally to the areas with the best opportunity for economic success.

The system prospers and thrives, although, at any one time, individual 'worker bees' may be displaced. It has always been this way in the American economy from the time the colonies of Jamestown and Plymouth were founded.

However, even if growth in the US economy has not vanished, and a recession is not necessarily underway, or even on the horizon, inflation does seem to now be a renewed threat to our prosperity, as Brian Wesbury warned in his editorial. He began by writing,

"The most painful and frustrating economic policy blunder of the past 50 years was the Great Inflation of the 1970s. Painful, because it was the catalyst for three damaging recessions (1973-75, 1980, 1981-82), all the while eroding living standards and seriously undermining confidence in America.

It was also deeply frustrating. Despite the teaching of Milton Friedman -- which clearly explained that inflation was caused by too much money chasing too few goods -- a combination of bad economic models, denial and political expediency allowed it to happen.

President Reagan meets with Paul Volcker, chairman of the Federal Reserve Board, 1981.
One would think that the odds of a repeat were low, and for 20 years, after Ronald Reagan and his Fed Chairman Paul Volcker had the courage to get inflation under control with tight money and tax cuts, this was true. Unfortunately, the lessons seem to be fading. Today, the U.S. (and through it the world) faces its greatest threat from inflation in 30 years. And as in the past, this threat is being met with denial and political expediency."

Strong words, but true. I respect Wesbury as being a very talented, blunt-speaking and insightful economist. One of those who, per Ranson's piece, probably would have worked in a large US corporation twenty years ago. Now, he's with a money management firm.

Wesbury continues,

"As is so often the case, after the Fed has acted, but before the typical lag in monetary policy has fully played out, conventional wisdom argues that the Fed has become impotent. Back in 2002 and 2003, the logic was that the Fed was powerless over globalization, and low-cost labor would continue to feed deflation. In addition, because long-term rates were rising as the Fed cut short-term rates, many thought that markets were undermining Fed intentions.

But, as always, when the Fed injects excess liquidity into the system, inflation begins to rise. As early as 2002, soaring commodity prices and a falling dollar became the canaries in the coal mine of excessively loose monetary policy.

But oil and food are absorbing a large part of excess Fed liquidity. When consumers spend more on energy, they have less to spend in other arenas. This reduces demand for other goods, keeping prices lower than they would be otherwise. This helps explain the divergence between overall and core measures of inflation.

This divergence is now coming to an end. If the recent decline in energy and food prices continues, that money will be released and other prices will start to rise more quickly. The July jump of 0.3% in "core" CPI inflation is likely one of the first signs.

Some argue that the recent drop in commodity prices indicates lessening inflationary pressures. But nothing could be further from the truth. Commodity prices had reached levels that were not justified by current monetary policy. As a result, their pullback is just a correction, not the beginning of a new trend. If this pullback had occurred as the Fed was lifting the federal-funds rate, like back in 1999, it would be a different story. Excluding food and energy from the CPI is sometimes justified because their price movements are often volatile and short-lived. But the five-year average annual growth rate of the CPI, which should smooth out any short run issues, is now 3.6% -- its highest level since 1994. Moreover, the Cleveland Fed's trimmed mean CPI, which excludes the 8% of prices growing the fastest and the 8% growing the slowest, is also up 3.6% in the past year -- its fastest growth since 1991."

Wesbury clearly identifies empirical measures which show inflation on the rise. To address the cause- an overly-rapid expansion of the US monetary base- he writes,

"With the real (or inflation-adjusted) federal-funds rate now negative, the signals are clear. The Fed is still adding more money to the system than is demanded, and this suggests that the general increase in inflationary pressures will continue. The only question is whether policy makers will get the courage to fight inflation before it gets out of control.

And this is the rub. Much like the 1970s, there is a widespread denial that inflation is a problem today. Some argue that Fed policy is not easy, either because the money supply is not growing, or that banks are deleveraging, which counteracts any attempt by the Fed to inject money.

The first argument hits at the root of Friedman's monetary theory. If money is not growing, then how can inflation be a problem? But money is growing. No measure of money is declining, despite bank deleveraging, and Reserve Bank Credit (the Fed's balance sheet) has expanded at a 14.4% annual rate in the past three months.

Another sign of easy money is that every country that pegs to the dollar, including China and the United Arab Emirates, is experiencing a rapid acceleration in its inflation rates as it imports inflationary U.S. monetary policy.

The second argument is belied by history. Between 1983 and 1994, exactly 2,747 U.S. banks and S&L's failed, representing total assets of $894 billion. During that period of deleveraging, real GDP in the U.S. expanded at an annual average of 3.5%. The Great Depression is the only period of sharp economic contraction in the U.S. correlated with bank failures. But that was clearly related to a deflationary mistake in Fed policy. Real interest rates were outrageously high in the late 1920s, and much of the '30s, which is not true today."

It's typical of Wesbury's genius that he finds and presents exactly the evidence that contradicts most of the hand-wringing worriers who despair at the self-induced casualties in the financial services sector. Failures or consolidations of large investment and commercial banks, due to their own bad risk management, needn't cripple the rest of the US economy, nor cause a recession.

Finally, Wesbury notes,

"One of the reasons that monetary policy is so loose today is that our economy is addicted once again to easy money and low interest rates. We hear over and over that the Fed cannot tighten because the housing market and the economy are vulnerable. This was the same argument made in the pre-Volcker 1970s, when the U.S. bounced from one economic crisis to the next.

But a look back at the past 40 years clearly shows that the economy was much healthier in the 1980s and '90s, when real interest rates were high, rather than low as they were in the 1960s and '70s."

He's right again. Reagan, together with Volcker, engineered lower taxes (fiscal policy) and higher interest rates (monetary policy) which laid the foundation for over 20 years of healthy US economic growth.

Wesbury closes by reminding us of the damage the late Senator (D-MN) Hubert Humphrey did with his idiotic "Humphrey-Hawkins" dual Fed mandate law. By forcing the Fed to take employment into account, rather than simply focus on a stable growth in the monetary base, Humphrey bequeathed a legacy of economic risk to his nation upon his death.

As Wesbury comically puts it,

"The Fed's "dual mandate" -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time."

Wesbury ends his editorial with a call for a return to the courageous actions of Reagan and Volcker by today's government leaders.

Ranson demonstrates that our economy is neither fragile, nor in danger from lack of growth. Wesbury reminds us of the medicines which, taken over 20 years ago, led to our economy's remarkable performance since then.

Let's hope leaders in US government and industry listen to both of these economists. Soon.