Wednesday, September 23, 2009

Art Laffer's Recent WSJ Piece

Noted economist Art Laffer wrote a sobering piece in yesterday's Wall Street Journal. I would have gotten to his piece later yesterday, but a number of searches which brought people to my blog were about Laffer and the Journal, so I knew he must have written a new editorial.

There are quite a few economists who write on the pages of the WSJ from time to time. Brian Wesbury, one of my favorites, has been absent for some time. But those who still contribute include Robert Barro and Alan Reynolds, to name two more.

While not a degreed economist myself, I have studied the discipline with great interest since my freshman year in college. I've read a number of basic texts, including Keynes' work, and one of his contemporary critics, Michael Hutt.

I've come to feel comfortable reading and evaluating various economists' monographs. In this vein, Laffer's recent piece is very troubling.

Without going into details, Laffer addresses the 1930s as the milestone by which current fiscal and monetary powers that be are measuring themselves. Laffer begins by discussing the initially too-tight monetary policy of the Depression, and current Fed Chairman Bernanke's determination to avoid making that mistake again.

At this point, Laffer takes a turn into tax policy. Framing Smoot-Hawley as a tax, which it most assuredly was, he provides evidence of enormous increases in a myriad of tax rates. He observes,

"The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that the U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s."

Laffer then cites the current slated rise in state tax increases at 3.1% rate, the highest in almost twenty years. Further, he notes the 'cap-and-tax' legislation and health care levies as heading in this wrong direction.

He then turns to Milton Friedman and Anna Schwartz on the subject of gold.

Following the twists and turns of the period's gold policy, Laffer notes two rather obscure facts. First, FDR forcibly took gold from the US populace at $20.67/ounce, then, less than a year later, devalued the dollar to $35/ounce. He both seized assets, and unintentionally sparked inflation, with two gold-related actions.

And this was technically fiscal policy, because, as Laffer points out, it was FDR's doing, not the Fed's.

Laffer concludes with a rather astounding statement of facts. The consequence of FDR's actions, in concert with the Fed, by mid-decade, produced consumer price inflation of roughly 15% from 1933-37, during a period of double-digit unemployment.

He finishes his editorial with these words,

"The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon.

My hope is that the people who are running our economy do look to the Great Depression as an object lesson. My fear is that they will misinterpret the evidence and attribute high unemployment and the initial decline in prices to tight money, while increasing taxes to combat budget deficits."

There's no getting around what Laffer is saying. He bemoans the fact that fiscal tax policy can easily exist with lax monetary policy, ushering in a lethal economic brew of stagflation. That is, high unemployment, deficits, and high inflation. Because economic management is split between an administration and the Fed, this is a perennial risk.

As Laffer notes, Bernanke is already doing his part to over-inflate money supply. The current governments, state and federal, are repeating the mistakes of FDR's administration during the Depression, raising taxes to new heights.

This is the type of economic piece which causes me do dispute James Grant's recent cock-eyed optimism.

I had lunch earlier this week with my friend, B. He is a PhD with a focus on the history of monetary systems. He is currently concerned about inflation. As a member of a prominent think tank's board, he frequently participates in conferences and discussions of selected topics. Recently, he presented a paper concerning the sources and consequences of the recent financial debacle. B, and his colleagues, all fear hyper-inflation far more than a Depression.

And they are all pretty convinced we are headed in that direction. As Laffer notes, just because we have retarded economic activity today does not in any way mean we can't, or won't, also manage to ignite serious inflation.

The Fed had doubled the monetary base in the past year, as Laffer pointed out early in his editorial. The Fed is buying Treasuries, monetizing our own debt, too. The financial markets have responded by using the printed money and Fed cash to push up asset prices and keep interest rates low. Laffer remarked on this yesterday afternoon, on Neil Cavuto's Fox News program. With so much government liquidity flooding markets, he explained, of course equity prices are on a tear, as are commodities. But Laffer sees this sparking inflation within a few years.

Laffer quoted the esteemed late Milton Friedman,

"Inflation is, everywhere, a monetary phenomenon."

And monetary policy is probably the easiest in our Republic's history. Printing presses wide open and Congressionally-legislated deficits doubling through the next decade.

We have, as Laffer noted, a nearly-exact replay of the Great Depression's monetary and fiscal mechanics now in full swing. Monetary easing combined with fiscal irresponsibility that is resulting in higher tax burdens.

This is why I don't see an imminent, nor prolonged real economic recovery underway in the US at this time.

4 comments:

dex said...

Mr Sceptic,

Messrs Laffer and Grant don't really address the several major deflationary forces that oppose the fiscal and monetary stimulus of the Fed. If one wants to take a reasoned view on the prospect for inflation versus deflation, one must decide which will swamp which, or there'll be a muddle, or switch backs between the two.

Near term deflationary factors include the following: First, the earlier collapse in commodity prices is still working its way through the system. Second, producers, importers, wholesalers and retailers are still reducing inventories. Third, wages and benefits are being cut. Fourth, there's excess capacity outside the commodity sector. Fifth, there are close to $700 trillion gross notional derivatives outstanding, even cutting that by 70% for double counting, this is still a huge amount of leverage and much of it will be unwound because much of them were created for regulatory arbitrage benefits that regulators are likely to reduce or eliminate. If you look at the Fed's increases in money supply, so far, it looks as if the multiplier has been less than 1 to 1.

In the longer term, there are additional reasons. First, consumers in US (as well as Aus and UK and other countries) need to save more for retirement since boomers generally haven't saved much. Second, the financial sector will likely be forced to deleverage by regulators. Third, excess capacity in many commodity sectors likely will reduce consumption more by the exporters than it increases consumption by the importers since the difference is small per consumer but big per producer. Fourth, increased government regulation (securities, anti-trust, environmental, etc) likely will slow activity.

I've seen people try to model the net effect of the pro and con forces, with most predicing some where between -3% and +3% CPI for several years. And then you get inflationistas like Faber or Grant, and deflationistas like Prechter, who talk of really extreme outcomes. But I have yet to see an extremist who delivers a reasoned analysis of the net effect of the conflicting forces at work; they seem to just weigh the arguments to see which they think are stronger, and then look at the gross effect of those forces.

C Neul said...

dex-

Thanks for your extensive comment.

The Fed really can only affect monetary stimulus. The fiscal actions are by the Treasury and Congress.

If you believe Friedman, as I do, the fiscal activities can aggravate matters, but inflation can, does, and will result from Fed-only actions.

As I'll outline in an upcoming post, I believe the single term inflation is mistakenly bandied about for too many phenomena.

Prices of commodities are a different type of inflation than that of, say, home prices, or equity prices.

Then there's the price of borrowed money for the US, a/ka/ the interest rate on Treasuries.

The latter could soar, while commodities collapse under a dearth of demand.

Your reference to various models attempting to resolve these forces is interesting. I believe they fail because this isn't just one phenomenon.

You can have falling demand for energy, or commodities, or finance, and still have interest rates skyrockets.

In fact, it has a name- stagflation!

-CN

dex said...

Mr Sceptic,

Just to be clear, the work I've seen trying to predict CPI (positive or negative) uses the word "inflation" to refer to CPI, nothing more and nothing less.

And if households and banks increase savings by investing in treasuries enough to fund increased issuances of treasuries and reduced purchases for foreign central banks, interest rates won't necessarily rise. And banks might do this because credit worthy borrowers aren't willing to borrow, so the best available investment opportunity is investing in treasuries. And many boomers may be risk averse and invest in treasuries. As a percentage of investment holdings by consumers and banks, treasuries are pretty low from a historical perspective.

Again, I'm not saying an increase in private sector savings overall and investment in treasuries will necessarily prevent higher interest rates. But one needs to take that into account before asserting that interest rates will necessarily rise. There are a lot of factors in play.

And if one wants to look for increases in CPI based on further devaluation of the US dollar, one has to ask whether foreign countries are going to print more or less than the US. Jean Marie Eveillard and others think everyone is going to print.

C Neul said...

dex-

Your last point is relevant, to a degree.

However, since the US dollar is the world's current reserve currency, it's relative volume is much greater than other currencies. And the US is, I believe, now mostly a debtor nation, pumping out dollars for imports.

However, as my post noted, it's much simpler than all that. The Fed has increased the montary base 100% in the past year! When so much money is printed, inflation predictably follows.

-CN