We Sure Do Need to Talk about Inflation

Published in National Review:

Writing for AIER, Alex Pollock has a superb review of a recent book by Stephen King: We Need to Talk about Inflation. Since that topic is very much on people’s minds these days and with true  believers in omnipotent government like Kamala Harris blaming it on greed and proposing price controls, the book is most welcome.

Pollock writes:

Reflecting on the enduring temptation of governments to inflate and depreciate their currencies, King rightly observes:

• “Inflation is very much a political process.”

• “Left to their own devices, governments cannot help but be tempted by inflation.”

• “Governments can and will resort to inflation.”

• “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” (Here he is quoting J.M. Keynes.)

Absolutely right. Rulers (whether monarchs, elected politicians, military despots, or any other kind) can be counted on to extract wealth from the citizenry to pay for the things they want to do, but prefer to extract it in a hidden fashion by cheapening the currency. And of course, they will try to pin the blame elsewhere.

This new book is must reading.

The Permanent Temptation of All Governments

Published in the American Institute for Economic Research:

In We Need to Talk About Inflation, his thoughtful, accessible tour of the history, theories, politics and future of inflation, Stephen King warns us that: 

          “Inflation is never dead.”  

He is right about that, and that blunt reminder alone justifies the book. 

The book begins, “In 2021, inflation emerged from a multi-decade hibernation.” Well, inflation had not really been in hibernation, but rather was continuing at a rate which had become considered acceptable. It was worry about inflation that had been hibernating. People found themselves caught up in the runaway inflation of 2021-2023, a wake-up call. As the book explores at length, that explosive inflation had been unexpected by the central banks, including the Federal Reserve, making their forecasts and assurances look particularly bad and proving once again that their knowledge of the future is as poor as everybody else’s. 

Now, in the third quarter of 2024, after historically fast hikes in interest rates, the current rate of inflation is less. But average prices continue going up, so the dollar’s purchasing power, lost to that runaway inflation, is gone forever. Inflation continues and has continued to exceed the Fed’s 2-percent “target” rate. And the Fed’s target itself is odd: it promises to create inflation forever. The math of 2-percent compound shrinkage demonstrates that the Fed wants to depreciate the dollar’s purchasing power by 80 percent in each average lifetime. Somehow the Fed never mentions this. 

King shows us that such long-term disappearance of purchasing power has happened historically. Chapter 2, “A History of Inflation, Money and Ideas,” has a good discussion, starting with the debate between John Locke and Isaac Newton, of the history, variations and continuing relevance of the quantity theory of money. It also contains an instructive table of the value of the British pound by century from 1300 to 2000. The champion century for depreciation of the pound was the twentieth. The pound began as the dominant global currency and ended it as an also-ran, while one pound of 1900 had shriveled in value to two pence by 2000. The century included the Great Inflation of the 1970s, during which British Prime Minister Harold Wilson announced, the book relates, that “he hoped to bring inflation down to 10 percent by the end of 1975 and under 10 percent by the end of 1976.” His hopes were disappointed, as King sardonically reports: “The actual numbers turned out to be, respectively, 24.9 percent and 15.1 percent.”

These inflationary times need to be remembered, as should numerous hyperinflations. Best known is the German hyperinflation of 1921-23, the memory of which gave rise to the famous anti-inflationist regime of the old Bundesbank. (It was once wittily said that “Not all Germans believe in God, but they all believe in the Bundesbank” — however, this does not apply to its successor, the European Central Bank.) King also recounts that the effects of the First World War gave rise to three other big 1920s hyperinflations — in Austria, Hungary and Poland, and that “inflation in the fledging Soviet Union appears to have been stratospheric.” He discusses the 1940s hyperinflation in China, and how in the 1980s “Brazil and other Latin American economies…succumbed to hyperinflation, currency collapse and, eventually, default.” We must add the inflationary disasters of Argentina and Zimbabwe.  

All these destructive events resulted from the actions of governments and their central banks. The book considers the theory of how to put a stop to this problem that Nobel Prize-winning economist Thomas Sargent made in 1982. First and foremost, as described by King, it is “the creation of an independent central bank ‘legally committed to refuse the government’s demand for additional unsecured credit’ — in other words, there was to be no deficit financing via the printing of money.” Good idea, but how likely is this suggested scene in real life? The central bank says to the government, “Sorry about your request, but we’re not buying a penny of your debt with money we create. Of course, we could do it, but we won’t, so cut your expenses. Good luck!” Probably not a winning career move for a politically appointed central banker, and not a very likely response, we’ll all agree. 

Moreover, in time of war or other national emergency, the likelihood of this response is zero. War is the greatest source of money printing and inflation. War and central banking go way back together: the Bank of England was created in 1694 to finance King William’s wars, was a key prop of Great Britain’s subsequent imperial career, and in 1914, fraudulently supported the first bond issue of the war by His Majesty’s Treasury.i The Federal Reserve was the willing servant of the U.S. Treasury in both world wars and would be again, whenever needed. In the massive war-like government deficit financing of the 2020-2021 Covid crisis, the Fed cooperatively bought trillions in Treasury debt to finance the costs of governments’ closing down large segments of the economy. 

Reflecting on the enduring temptation of governments to inflate and depreciate their currencies, King rightly observes: 

• “Inflation is very much a political process.”  

• “Left to their own devices, governments cannot help but be tempted by inflation.” 

• “Governments can and will resort to inflation.” 

• “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” (Here he is quoting J.M. Keynes.) 

Just as economics is always political economics and finance is always political finance, central banking cannot avoid being political central banking. The book considers at length the inevitable interaction between government spending and debt, on one hand, and money creation and inflation, on the other—in economics lingo, between fiscal policy and monetary policy. In theory, there can be a firm barrier between them, the spending and taxing done in the legislative and executive branches; and the money printing, or not, in the control of the central bank. In practice, the two keep meeting and being intertwined. King calls this the “Burton-Taylor” problem. Here is his metaphor: 

“History offers countless examples in which fiscal expediency trumps monetary stability. The two big macroeconomic levers are the economic equivalent of Elizabeth Taylor and Richard Burton, the Hollywood stars who were married twice [and divorced twice] and who were, perhaps still in love when Burton died: occasionally separated but always destined to reconnect.”  

Indeed, governments’ desire for deficit spending and the ready tool of money printing and inflation are always destined to reconnect.  

This reflects the fundamental dilemma of all politicians: they naturally want to spend more money than they’ve got to carry out their schemes, including wars. As the book observes, “Wartime provides the ultimate proof of inflation’s useful role as a hidden tax.” Politicians want to keep their perhaps lavish promises to their constituencies, to reward their friends, to enhance their power, to get re-elected; they like much less making people unhappy by taxing them. The simple answer in every short term, is to borrow to finance the deficit and run up the government’s debt. When borrowing grows expensive or becomes unavailable, the idea of just printing up the money inevitably arises, the central bank is called upon, and yet another Burton-Taylor marriage occurs.  

Just printing up the desired money is a very old idea. As the book discusses, this frequently practiced, often disastrous old idea has been promoted anew—now under the silly name of “Modern” Monetary Theory. 

King writes: 

“The printing press is a temptation [I would say an inevitable temptation] precisely because it is an alternative to tax increases or spending cuts, a stealthy way in the short run of robbing people of their savings…. Ultimately, there is no escaping ‘Burton-Taylor.’” 

When governments and central banks yield to this temptation, can the central banks correctly anticipate the inflationary outcomes? Do they have the required superior knowledge? Clearly the answer is no. 

Chapter 6 of the book, “Four Inflationary Tests,” provides an instructive example of failed Bank of England inflation forecasts, to which I have added the actual outcomes, with the following results[ii]:

To apply an American metaphor to these British results, that is four strikeouts in a row. The inflation forecasting record of the Federal Reserve presents similar failures. 

Central banks try hard, including their large political and public relations efforts, to build up their credibility. They want to preside over a monetary system in which everybody believes in them. 

But suppose that everybody, including the members of Congress, instead of believing, developed a realistic understanding of central banks’ essential and unavoidable limitations. Suppose everybody simply assumed it is impossible for central banks to know the future or the future results of their own actions. Suppose, as King puts it, the whole society had “a new rule of thumb… ‘these central bankers don’t know what they’re doing.’” Rational expectations would then reflect this assumption. 

In that case, central banks would certainly be less prestigious. Would our overall monetary system be improved? I believe it would be. We Need to Talk About Inflation, among many other interesting ideas, encourages us to imagine such a scenario. 

From Inflation to Power Shifts: Alex J. Pollock’s Eye-Opening Dive into Political Finance

Published in Million Dollar Book Agency:

Today’s episode was an absolute game-changer. We had the privilege of diving deep into the world of finance with none other than the incredible Alex J. Pollock. This man has been in the banking game since 1969, and trust me, he’s got some eye-opening insights to share. Buckle up, folks, because we’re about to uncover the hidden truths behind the Federal Reserve, perpetual debt, and the secrets of our monetary system.

SUMMARY

Ever felt like there’s an invisible tax on your hard-earned money? Alex dropped a truth bomb on us – continuous inflation is exactly that. It’s a sneaky tax on anyone holding money, including those with savings accounts. How does this work? When the interest rates on savings are suppressed, wealth is transferred from money holders to the government. The fiat system allows the government to finance deficits indefinitely, making it a subtle yet effective way of expropriating purchasing power.

Hold on tight because this revelation might just blow your mind. Alex simplified the concept of perpetual debt with a powerful analogy. Imagine a banking system that lends you $100 but demands $110 in return. Where does that extra $10 come from? The Federal Reserve. This perpetuates a cycle of constant debt, creating what can only be described as a modern-day slavery system. The Federal Reserve creates a debt-ridden society by injecting money into the system.

Alex emphasized a crucial point – there’s no such thing as pure finance; there’s only political finance. The shift from the gold standard in 1971 marked a pivotal moment in our monetary history. With the introduction of a fiat system, there are no limits on how big a government deficit can be. This translates to an increase in government power. As you monetize and free up money, the government gains the financial resources to expand its reach and control.

Mike Fallat and Alex J. Pollock talk about the book Finance and Philosophy: Why We’re Always Surprised.

Let’s talk about inflation, the silent wealth eroder. While some may cheer at a seemingly low 3% inflation rate, Alex breaks down the reality. Over a lifetime, a 3% inflation rate results in prices going up 10 times! Imagine the impact of a 4% inflation rate – prices skyrocketing 23 times. It’s not just a tax without legislation; it’s a constant expansion of government power through the central bank, all cleverly disguised.

Alex shared two must-reads for anyone looking to unravel the mysteries of finance. First up, Frank Knight’s book is a treasure trove of insights. But that’s not all; he also recommended “The Fourth Branch” by Bernard Shull. This gem provides a historical perspective on the Federal Reserve’s unlikely rise to power. Both books promise to be eye-openers for those eager to understand the intricacies of our financial system.

As we wrapped up the episode, Alex left us with a powerful notion – there’s no such thing as pure economy, only political economy. The fiat currency system, though clever, is also insidious. It not only inflates the currency but also empowers the government at the cost of the people. This conversation with Alex J. Pollock was nothing short of mind-blowing. We’ve scratched the surface today, but there’s more wisdom to uncover.

Applying Volcker's Lessons

Published in Law & Liberty:

The year 2022 has certainly been a tough one for the Federal Reserve. The Fed missed the emergence of the runaway inflation it helped create and continued for far too long to pump up the housing bubble and other asset price inflation. It manipulated short- and long-term interest rates, keeping them too low for too long. Now, confronted with obviously unacceptable inflation, it is belatedly correcting its mistake, a necessity that is already imposing a lot of financial pain. 

Sharing the pain of millions of investors who bought assets at the bloated prices of the Everything Bubble, the Fed now has a giant mark-to-market loss on its own investments—this fair value loss is currently about $1 trillion, by my estimation. It is also facing imminent operating losses in its own profit and loss statement, as it is forced to finance fixed-rate investments with more and more expensive floating rate liabilities, just like the 1980s savings and loans of Paul Volcker’s days as Fed Chairman.

In short, the Fed, along with other members of the international central banking club, sowed the wind and is now reaping the whirlwind. Comparing the current situation with the travails of the Volcker years grows ever more essential.

Samuel Gregg, Alexander Salter, and Andrew Stuttaford have provided highly informed observations about the past and present, and offer provocative recommendations for the future of the “incredibly powerful” (as Gregg says) Federal Reserve—the purveyor of paper money not only to the United States, but also to the dollar-dominated world financial system. 

Stuttaford considers the issue of “Restoring the Fed’s Credibility?” with a highly appropriate question mark included. He points out that Volcker did achieve such a restoration of credibility and ended up bestriding “the [wide] world like a colossus,” although, we must remember, not without a lot of conflict, doubt, and personal attacks on him along the way.

But is it good for the Fed to have too much credibility? Is it good for people to believe that the Fed always knows what it is doing, when in fact it doesn’t—when it manifestly does not and cannot know how to “manage the economy” or what longer-run effects its actions will have and when? Is it good for financial actors to believe in the “Greenspan Put,” having faith that the Fed will always take over the risk and bail out big financial market mistakes? It strikes me that it would be better for people not to believe such things—for the Fed not to have at least that kind of “credibility.”

Stuttaford elegantly and correctly, as it seems to me, suggests that “the price of a fiat currency is—or more accurately, ought to be—eternal vigilance against inflation.” Such eternal vigilance requires that we should never simply trust in the Fed and poses the central question of who is to exercise the eternal vigilance.

It is often argued, especially by economists and central bankers, that central banks should be “independent,” thus presumably practicing by themselves the vigilance against inflation, making them something like economic philosopher-kings. Indeed, inside most macro-economists and central bankers there is a philosopher-king trying to get out. But the theory of philosopher-kings does not fit well with the theory of the American constitutional republic.

Those who support central bank independence always argue that elected politicians are permanently eager for cheap loans and printing up money to give to their constituents, so can be depended on to induce high inflation and cannot be trusted with monetary power. But if the central bank also cannot be trusted, what then? Suppose the central bank purely on its own commits itself to perpetual inflation—as the Fed has! Should that be binding on the country? I would say No. The U.S. Constitution clearly assigns to the Congress, to the elected representatives, to the politicians, the power “to coin money [and] regulate the value thereof.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Salter suggests we should follow this constitutional logic. “The Fed should have a single mandate,” he recommends, that of price stability, and “Congress should pick a concrete inflation target.” The Fed wouldn’t get to set its own target: “Since the Fed can’t make credible commitments with a self-adopted rule, the target’s content and enforcement must be the prerogative of the legislature, not the central bank.” In sum, “As long as we’re stuck with a central bank, we should give it an unambiguous mandate and watch it like a hawk. Monetary policymakers answer to the people’s representatives, in Congress assembled.” 

Along similar lines, I have previously recommended that Congress should form a Joint Committee on the Federal Reserve to become highly knowledgeable about and to oversee the Fed in a way the present Banking committees are not and cannot. I argued:

“The money question,” as fiery historical debates called it, profoundly affects everything else and can put everything else at risk. It is far too critical to be left to a governmental fiefdom of alleged philosopher-kings. Let us hope Congress can achieve a truly accountable Fed.

This still seems right to me. As I picture it, however, neither the Federal Reserve nor the Congress by itself would set an inflation target. Rather, on the original “inflation target” model as invented in New Zealand, the target would be a formal agreement between the central bank and the elected representatives. New Zealand’s original target was a range of zero to 2% inflation—a much better target than the Fed’s 2% forever. Since an enterprising, innovative economy naturally produces falling prices through productivity, we should provide for the possibility of such “good deflation.” Hence my suggested inflation target is a range of -1% to 1%, on average about the same target Alan Greenspan suggested when he was the Fed Chairman, of “Zero, properly measured.”

In his insightful history of the Fed, Bernard Shull considered how the Fed is functionally a “fourth branch” of the U.S. government. The idea is to put this additional branch and the Congress into an effective checks-and-balances relationship.

Among other things, this might improve the admission of mistakes and failures by the Fed, and thus improve learning. As Gregg observes, “Admitting mistakes is never something that policymakers are especially interested in doing, not least because it raises questions about who should be held accountable for errors.” And “central bankers do not believe that now is the time for engaging in retrospectives about where they made errors.” Of course they don’t.  But are you more or less credible if you never admit to making the mistakes you so obviously made?

Gregg is skeptical of the ability to control central banks by defined mandates, since we are always faced with “the ability of very smart people to find creative ways around the strictest laws (especially during crises).” The politicians, he points out, often want the central banks to use creative rationales for stretching and expanding their limits, and this is especially true during crises. As a striking example, “the European Central Bank has engaged in several bailouts of insolvent states and operated as a de facto transfer union.” But “governments…say as little as possible about such ECB interventions (and never question their legality),” and this “has everything to do with European governments wanting the ECB to engage in such activities.”

We are left wondering, as always, who will guard the guardians. There has been no easy answer to that question since Juvenal posed it to the ancient Romans.

Another Roman, Velleius Paterculus, expressed another fundamental central banking problem: “The most common beginning of disaster was a sense of security.” It is most dangerous when the public and the central bankers become convinced of the permanent success of the latest central banking fashion, especially, as Volcker pointed out in his autobiography, if that involves accommodating ever-increasing inflation.

We can conclude our review by stressing that the price of having fiat money is indeed eternal vigilance against inflation. But we don’t know very well how to carry out that vigilance and we can’t count on a new Volcker appearing in time to prevent the problems, or belatedly to address them, or appearing at all.

Freedom Adventure Podcast 471: Volker and the Great Inflation

Published by Freedom Adventure. Click here to listen.

Alex J. Pollock discusses Paul Volker and the great inflation and the similarities to today. Volker raised interest rates to an all time high and defeated run away inflation. His predecessor Arthur Burns anguished over inflation and central bankers are facing a similar anguish today.  We discuss the knowledge problem and how central planners are a menace to society.

article discussed

Alex’s website

Finance and Philosophy

Boom and Bust

Volcker and the Great Inflation: Reflections for 2022

Published in Law & Liberty and also in RealClear Markets.

The celebrated Paul Volcker (1927-2019) became Chairman of the Federal Reserve Board 43 years ago on August 6, 1979. The 20th-century Great Inflation, stoked by the Federal Reserve and the other central banks of the day, was in full gallop in the U.S and around the world. In the month he started as Chairman, U.S. inflation continued its double-digit run—that August suffered a year-over-year inflation rate of 11.8%. On August 15, the Federal Reserve raised its fed funds mid-target range to 11%, but that was less than the inflation rate, so a nominal 11% was still a negative real interest rate. How bad could it get? For the year 1979, the December year-over-year inflation was an even more awful 13.3%. At that compound rate, the cost of living would double in about five years.

Everybody knew they had an inflationary disaster on their hands, but what could be done? They had already tried “WIN” (“Whip Inflation Now”) buttons, but inflation was whipping them instead. In this setting, “The best professional judgment among leading economists was that Americans should view the problem of inflation as being…intractable,” wrote Volcker’s biographer, William Silber. Leading Wall Street forecaster Henry Kaufman, for example, was pessimistic in 1980, opining “that he had ‘considerable doubt’ that the Fed could accomplish its ultimate objective, which is to tame inflation. He added for good measure that the Fed no longer had ‘credibility in the real world.”

Those days are now most relevant. Although Silber could write in 2012, “Inflation is ancient history to most Americans,” today it is upon us once again. What can we re-learn?

From Burns to Volcker

In September 1979, Arthur Burns, who had been Fed Chairman from 1970 to 1978, gave a remarkable speech entitled “The Anguish of Central Banking.” Discussing “the reacceleration of inflation in the United States and in much of the rest of the word,” “the chronic inflation of our times,” and “the world wide disease of inflation,” he asked, “Why, in particular, have central bankers, whose main business one might suppose is to fight inflation, been so ineffective?”

We may observe to the contrary that they had been very effective—but in producing inflation instead of controlling it, just as their 21st-century successors were effective in producing first the asset price inflation of the Everything Bubble, which is now deflating, and then destructive goods and services inflation, much to their own surprise. In both centuries, inflation was not an outside force attacking them, as politicians and central bankers both then and now like to portray it, but an endogenous effect of government and central bank behavior.

In what one might imagine as a tragic dramatic soliloquy, Burns uttered this cri de coeur: “And yet, despite their antipathy to inflation and the powerful weapons they could wield against it, central bankers have failed so utterly in this mission in recent years. In this paradox lies the anguish of central banking.”

I suspect the central bankers of 2022 in their hearts are feeling a similar anguish. Their supporting cast of government economists should be, too. “Economists at both the Federal Reserve and the White House were blindsided,” as Greg Ip wrote. “Having failed to anticipate the steepest inflation in 40 years,” he mused, “you would think the economics profession would be knee-deep in postmortems”—or some confessions of responsibility. But no such agonizing reappraisals as Burns’ speech seem forthcoming.

Reflecting that “Economic life is subject to all sorts of surprises [which] could readily overwhelm and topple a gradualist timetable,” in 1979 Burns announced that “I have reluctantly come to believe that fairly drastic therapy will be needed to turn the inflationary psychology around.” This was correct except for the modifier “fairly.” But, Burns confessed, “I am not at all sure that many of the central bankers of the world…would be willing to risk the painful economic adjustments that I fear are ultimately unavoidable.”

In our imagined drama of the time, enter Volcker, who was willing. He proceeds with firm steps to center stage. Burns fades out.

“If Congress had doubts about Volcker’s intentions,” says Allan Meltzer’s A History of the Federal Reserve, “they should have been dispelled by his testimony of September 5 [1979]”—one month after he took office. “Unlike the Keynesians, he considered the costs [of inflation] higher than the costs of reducing inflation.” Said Volcker to Congress, “Our current economic difficulties…will not be resolved unless we deal convincingly with inflation.”

In a television interview later that month, he was equally clear: “I don’t think we can stop fighting inflation. That is the basic, continuing problem that we face in this economy, and I think until we straighten out the inflation problem, we’re going to have problems of economic instability. So it’s not a choice….”

But what would it take to put into reverse the effects of years of undisciplined money printing, which accompanied oil supply and price shocks and other bad luck? Under the cover of restricting the growth in the money supply, Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%.

It is not clear whether Volcker ever took seriously the monetarist doctrine of focusing on the money supply, which he later abandoned, or simply used it as a pragmatic way to do what he wanted, which was to stop the runaway inflation. It is clear that he firmly rejected the Keynesian Phillips Curve approach of trying to buy employment with inflation. That had led central banks into inflationary adventures and resulted in simultaneous high inflation and high unemployment—the “stagflation” of the late 1970s, to which many think we risk returning in 2022.

The Double Dip Recessions

The Volcker program triggered a sharp recession from January 1980, five months after he arrived, to July 1980, and then a very deep and painful recession from July 1981 to November 1982—“double dip recessions.” Both hit manufacturing, goods production, and housing particularly hard, and generated the hard times of the “rust belt.” In 1982, unemployment rose to 10.8%, worse than the “Great Recession” peak unemployment of 10.0% in 2009.

“The 1981-82 recession was the worst economic downturn in the United States since the Great Depression,” says the Federal Reserve History. “The nearly 11% unemployment reached in late 1982 remains the apex of the post-World War II era [until surpassed in the Covid crisis of 2020]…manufacturing, construction and the auto industries were particularly affected.”

There were thousands of business bankruptcies. “The business failure rate has accelerated rapidly,” wrote the New York Times in September 1982, “coming ever closer to levels not seen since the Great Depression.” The total of over 69,000 business bankruptcies in 1982 was again worse than in the “Great Recession” year of 2009, which had 61,000.

The extreme interest rates wiped out savings and loan institutions, formerly the backbone of American mortgage finance, by the hundreds. The savings and loan industry as a whole was insolvent on a mark-to-market basis. So, in 1981, was the government’s big mortgage lender, Fannie Mae. A friend of mine who had a senior position with the old Federal Home Loan Bank Board recalls a meeting with Volcker at the time: “He was telling us he was going to crush the savings and loans.” There were securities firm and bank failures and then the massive defaults on the sovereign debt of “less developed countries” (“LDCs” in the jargon of the time), starting in August 1982. These defaults put the solvency of the entire American banking system in question.

This was a really dark and serious downer, but Volcker was firm about what he was convinced was the long-run best interest of the country. Was it debatable? Certainly.

There was plenty of criticism. Volcker wrote: “There were, of course, many complaints. Farmers once surrounded the Fed’s Washington building with tractors. Home builders, forced to shut down, sent sawed-off two-by-fours with messages…. Economists predictably squabbled.… Community groups protested at our headquarters….My speeches were occasionally interrupted by screaming protestors, once by rats let loose in the audience….” And “the Fed insisted I agree to personal security escort protection.”

In the government, Congressman Henry Reuss “reminded Volcker that the Constitution gave the monetary power to Congress”—as it does. “Congressman Jack Kemp called for Volcker’s resignation.” At the U.S. Treasury, “Secretary Donald Regan, a frequent critic, considered legislation restoring the Treasury Secretary to the [Federal Reserve] Board.” “Senator [Robert] Byrd introduced his bill to restrict Federal Reserve independence by requiring it to lower interest rates.” Inside the Federal Reserve Board, Governor Nancy Teeters, citing failures, the economy, high long-term interest rates, and high unemployment, objected in May 1982, “We are in the process of pushing the economy not just into recession, but into depression…I think we’ve undertaken an experiment and we have succeeded in our attempt to bring down prices…But as far as I’m concerned, I’ve had it.”

The minutes of the Federal Open Market Committee consistently display the intense uncertainty which marked the entire disinflationary project. “Volcker expressed his uncertainty frequently,” Meltzer observes, as he told the FOMC, for example: “I don’t know what is going to happen in the weeks or months down the road, either to the economy or to the aggregates or these other things,” or as he told Congress, “How limited our ability is to project future developments.” To his perseverance, add honesty. The same deep uncertainty will mark the Fed’s debates and actions in 2022 and always.

The 1982 recession finally ended in November. Inflation in December 1982 was 3.8% year-over-year. The fed funds rate was 8.8%. The year 1982 also saw the start of the two-decade bull market in stocks, and the 40-year bull market in bonds.

Meltzer speculated that the recession was more costly and “probably lasted longer than necessary.” Could a less severe recession have achieved the same disinflation? About such counterfactuals we can never know, but the current Fed must certainly hope so.

In 1983, President Ronald Reagan reappointed Volcker as Fed Chairman. In 1984, Reagan was re-elected in a landslide, the economy was booming, and inflation was 3.9%.

When Volcker left office in August 1987, inflation was still running at 4%, far from zero, but far below the 13% of 1979 when he had arrived as Fed Chairman. Real GDP growth was strong; fed funds were 6.6%. “The Great Inflation was over, and markets recognized that it was over.” Endemic inflation, however, was not over.

Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent.

Volcker’s Legacy

On top of the pervasive uncertainty, the Federal Reserve worried constantly during the Volcker years, as it must now, about its own credibility. Meltzer believed Volcker’s lasting influence was to “restore [the Federal Reserve] System credibility for controlling inflation.” But a generation after Volcker, the Fed committed itself to perpetual inflation at the rate of 2% forever. At the 2% target rate, prices would quintuple in an average lifetime. That is obviously not the “stable prices” called for in the Federal Reserve Act, but the Fed kept assuring everybody it was “price stability.” Volcker made clear his disagreement with this 2% target, writing of it in 2018, “I know of no theoretical justification. … The real danger comes from encouraging or inadvertently tolerating rising inflation.”

The classic monetary theorist Irving Fisher had warned, as have many others, that “Irredeemable paper money has almost invariably proved a curse to the country employing it.” Silber reflects that “The 1970s nearly confirmed Irving Fisher’s worst fears.” I would delete the word “nearly” from that last sentence.

The inflationary problems of Volcker’s days and ours are fundamentally linked to the demise of the Bretton Woods system in 1971, when the United States reneged on its international commitment to redeem dollars in gold. This put the whole world on pure fiat money instead, with fateful results. According to Brendan Brown, “Volcker considered the suspension of gold convertibility…’the single most important event of his career.’”  Indeed, it created the situation which put him on the road to future greatness. Ironically, Volcker began as a strong supporter of the Bretton Woods system, but then helped dismantle it. Of course, he was always an ardent anti-inflationist. “Nothing is more urgent than the United States getting its inflation under control,” he had already written in a formal Treasury presentation in 1969.

“Inflation undermines trust in government,” Volcker said. That it does, and such loss of trust is justified, then and now. Putting the thought another way, Volcker deeply believed that “Trust in our currency is fundamental to good government.” Throughout his life, he did his best to make the U.S. dollar trustworthy.

In retrospect, Volcker became “an American financial icon.” He elicits comments such as this one: “I knew Paul Volcker (who slew the Great Inflation). Volcker stopped inflation in the 1980s….” Or: “Volcker was the Federal Reserve knight who killed inflation.” Or: “Volcker and his FOMC…did what they thought was necessary, generating enormous pain but finally stamping out inflation. I hope Jerome Powell will find his inner Volcker.” As we have seen, Volcker didn’t actually stop or kill or stamp out inflation, but he brought it down from runaway to endemic.

His successor as Fed Chairman, Alan Greenspan, said “We owe a tremendous debt of gratitude to Chairman Volcker and the Federal Open Market Committee for…restoring the public’s faith in our nation’s currency.”

In 1990, Volcker spoke in the same Per Jacobsson Lecture series which had been the site of Arthur Burn’s anguish eleven years before. A similar audience of central bankers and finance ministers this time was treated to “The Triumph of Central Banking?” This included “my impression that central banks are in exceptionally good repute these days.”

However, he pointed out the question mark. “I might dream of a day of final triumph of central banking, when central banks are so successful in achieving and maintaining price and financial stability that currencies will be freely interchangeable at stable exchange rates” (shades of his earlier commitment to Bretton-Woods). “But that is not for my lifetime—nor for any of yours.” About that he was right, and also right about a more important point: “I think we are forced to conclude that even the partial victory over inflation is not secure.” There he was wiser than his many eulogists, as is obvious in 2022.

In discussions of the current inflation, including similarities to the 1970s, references to Volcker are frequent and laudatory. For example, “Federal Reserve Chairman Jerome Powell has taken of late to praising legendary Paul Volcker, as a signal of his new inflation-fighting determination.” Or “Powell tried to engage in some plain speaking, by telling the American people that inflation was creating ‘significant hardship’ and that rates would need to rise ‘expeditiously’ to crush this. He also declared ‘tremendous admiration’ for his predecessor Paul Volcker, who hiked rates to tackle inflation five decades ago, even at the cost of a recession.”

No Permanent Victories

With the model of Volcker in mind, will we now experience parallels to the 1981-82 recession, as well? This is the debate about whether a “soft landing” is possible from where the central banks have gotten us now. If we repeat the pattern of the 1980s, it will not be a soft landing and the cost of suppressing inflation will again be high, but worth it in the longer run. It should rightly be thought of as the cost of the previous central bank and government actions that brought the present inflation upon us.

Silber concluded that in the 1980s, “Volcker rescued the experiment in fiat currency from failure.” But experimentation with fiat currency possibilities has continued, including the creation of a giant portfolio of mortgage securities on the Fed’s own balance sheet, for example. When politicians and central bankers are hearing the siren song of “just print up some more money”—a very old idea recently called modern in “modern” monetary theory— in whatever guise it may take, who will provide the needed discipline, as Volcker did? Under various versions of the gold standard, it might be a matter of “what” provides monetary discipline, but in the fiat currency world of Volcker’s time and now, it is always and only a question of “who.”

Volcker wrote that “Bill Martin [William McChesney Martin, Fed Chairman 1951-70]… is famous for his remark that the job of the central bank is to take away the punch bowl just when the party gets going.” Unfortunately, Volcker continued, “the hard fact of life is that few hosts want to end the party prematurely. They wait too long and when the risks are evident, the real damage is done”—then it is already too late and the problem has become a lot harder. Like now.

As has been truly said, “In Washington, there are no permanent victories.” Volcker’s victory over runaway inflation was not permanent, because the temptation to governments and their central banks of excessive printing, monetization of government deficits, and levying inflation taxes is permanent. In 2021-22, we are back to disastrously high inflation, recognize the need to address it, and feel the costs of doing so. And Chairman Powell is citing Chairman Volcker.

But are there factors, four decades later, making the parallels less close? For example, international investor Felix Zulauf “thinks the Powell Fed is quite different from the Volcker Fed, and not just because of the personalities. It’s in a different situation and a different financial zeitgeist [and different political zeitgeist]. He doesn’t think the Fed, or any other central bank can get away with imposing the kind of pain Volcker did and will stop as soon as this year.” (italics added)

Suppose that is right—what then? Then the pain will come from continued inflation instead. There is now no avoiding pain, which will come in one way or the other.

A similar, though more strident, argument from June 2022 is this: “It will be politically impossible to raise rates enough to stop inflation. … Volcker raised rates to 19%. There is no way the Fed is going anywhere near that.…You may recall the Fed not long ago said they…were just talking about raising rates.” And echoing Henry Kaufman in 1980, “None of them has any credibility anymore.”

We must admit that the current fed funds rate of 1.75% with an inflation of 8.5%, for a real fed funds rate of negative 6.75%, is hardly Volckeresque. Indeed, there is nothing Volkeresque yet. Interest rates in 1980-81 went far higher than most people imagined possible—perhaps they will again go higher than now thought possible and maybe we will even see positive real interest rates again.

Chairman Powell was a Fed Governor and Chairman while the wind of the present inflation was being sown, and he is there to reap the whirlwind. Will the Fed under his leadership tame it and at what cost, as all the maladjustments and the financial dependence of both the government and private actors on negative real rates and cheap leverage during the last decade must now be corrected?

We might imagine a hypothetical case in which Paul Volcker was 40 years younger, and with his unyielding commitment to trustworthy money and his insistence that achieving it is worth the cost, had become the new Fed Chairman in 2022. We can speculate about what he would be and could be doing now.

But in the real case, just as Volcker did beginning in 1979, Chairman Powell has now stepped to center stage in the current drama. We cannot yet say whether his future valedictory lecture will be about the Anguish or the Triumph of central banking.

William Isaac Announcements: February 15, 2022

February 15, 2022

My long-time friend and brilliant scholar, Alex Pollock, has written an essay on the probable impact of inflation currently gathering steam due to fiscal policies being pursued by Congress and the Administration and monetary policies being pursued by the Federal Reserve. I'm sure the article will resonate and bring back troubling memories of the 1970s and 1980s:

• 'Biden Inflation' made simple: Borrow from the Fed, take away from the rest of us by Alex J. Pollock published by The Hill.

The full article can be found at williamisaac.com. Be safe and be well.

All the best,

Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion

Published by the Mises Institute,

With inflation running at over 6 percent and interest rates on savings near zero, the Federal Reserve is delivering a negative 6 percent real (inflation-adjusted) return on trillions of dollars in savings. This is effectively expropriating American savers’ nest eggs at the rate of 6 percent a year. It is not only a problem in 2021, however, but an ongoing monetary policy problem of long standing. The Fed has been delivering negative real returns on savings for more than a decade. It should be discussing with the legislature what it thinks about this outcome and its impacts on savers.

The effects of central bank monetary actions pervade society and transfer wealth among various groups of people—a political action. Monetary policies can cause consumer price inflations, like we now have, and asset price inflations, like those we have in equities, bonds, houses, and cryptocurrencies. They can feed bubbles, which turn into busts. They can by negative real yields push savers into equities, junk bonds, houses, and cryptocurrencies, temporarily inflating prices further while substantially increasing risk. They can take money away from conservative savers to subsidize leveraged speculators, thus encouraging speculation. They can transfer wealth from the people to the government by the inflation tax. They can punish thrift, prudence, and self-reliance.

Savings are essential to long-term economic progress and to personal and family financial well-being and responsibility. However, the Federal Reserve’s policies, and those of the government in general, have subsidized and emphasized the expansion of debt, and unfortunately appear to have forgotten savings. The original theorists of the savings and loan movement, to their credit, were clear that first you had “savings,” to make possible the “loans.” Our current unbalanced policy could be described, instead of “savings and loans,” as “loans and loans.”

As one immediate step, Congress should require the Federal Reserve to provide a formal savers impact analysis as a regular part of its Humphrey-Hawkins reports on monetary policy and targets. This savers impact analysis should quantify, discuss, and project for the future the effects of the Fed’s policies on savings and savers, so that these effects can be explicitly and fairly considered along with the other relevant factors. The critical questions include: What impact is Fed monetary policy having on savers? Who is affected? How will the Fed’s plans for monetary policy affect savings and savers going forward?

Consumer price inflation year over year as of October 2021 is running, as we are painfully aware, at 6.2 percent. For the ten months of 2021 year-to-date, the pace is even worse than that—an annualized inflation rate of 7.5 percent.

Facing that inflation, what yields are savers of all kinds, but notably including retired people and savers of modest means, getting on their savings? Basically nothing. According to the Federal Deposit Insurance Corporation’s October 18, 2021, national interest rate report, the national average interest rate on savings account was a trivial 0.06 percent. On money market deposit accounts, it was 0.08 percent; on three-month certificates of deposit, 0.06 percent; on six-month CDs, 0.09 percent; on six-month Treasury bills, 0.05 percent; and if you committed your money out to five years, a majestic CD rate of 0.27 percent. 

I estimate, as shown in the table below, that monetary policy since 2008 has cost American savers about $4 trillion. The table assumes savers can invest in six-month Treasury bills, then subtracts from their average interest rate the matching inflation rate, giving the real interest rate to the savers. This is on average quite negative for these years. I calculate the amount of savings effectively expropriated by negative real rates. Then I compare the actual real interest rates to an estimate of the normal real interest rate for each year, based on the fifty-year average of real rates from 1958 to 2007. This gives us the gap the Federal Reserve has created between the actual real rates over the years since 2008 and what would have been historically normal rates. This gap is multiplied by household savings, which shows us by arithmetic the total gap in dollars.

To repeat the answer: a $4 trillion hit to savers.

The Federal Reserve through a regular savers impact analysis should be having substantive discussions with Congress about how its monetary policy is affecting savings, what the resulting real returns to savers are, who the resulting winners and losers are, what the alternatives are, and how its plans will impact savers going forward.

After thirteen years with on average negative real returns to conservative savings, it is time to require the Federal Reserve to address its impact on savers.

The Price of Inflation, Now and in the Future

Published in The Wall Street Journal.

Your excellent editorial “Biden Has an Inflation Problem” (Aug. 12) points out that average real wages have fallen for seven months in a row. In other words, the Biden inflation has reduced the real wages of workers in every month that he has been in office. This confirms yet again that high inflation is a way of cutting wages by sneaky central-bank means.

This inflation has come as a surprise to the Federal Reserve, as it busily monetizes government debt, but it is no surprise at all. It reflects the most fundamental principle in economics: Nothing is free. You pay for monetizing government debt by taking money from the wage earners and robbing the savers.

Alex J. Pollock

R Street Institute

‘Biden Inflation’ made simple: Borrow from the Fed, take away from the rest of us

Published in The Hill and MSN.

“What is the difference between banking and politics?” a pointed old witticism goes. “Banking is borrowing money from the public and lending it to your friends. Politics is taking money from the public and giving it to your friends.”

The current American government has a new twist on this, however: Politics is borrowing money from the Federal Reserve and giving it to your friends. Clever, eh? The Fed can print up all the money it wants and the government can borrow it and pass it out. Except that, eventually, you find out that this depreciates the nation’s currency and brings high inflation.

So now we have the ‘Biden Inflation’, which I calculated as running at an annualized rate of more than 7 percent from the end of 2020 through June.

Let us state the obvious facts which everybody knows about a 7 percent rate of inflation. It means that if you are a worker who got a pay raise of 3 percent, the government has made your actual pay go down by 4 percent — that is, plus 3 percent minus 7 percent = minus 4 percent.  If you got a raise of 2 percent, the government cut your real pay by 5 percent.

If you are a saver earning, thanks to the Federal Reserve’s policies, the average interest rate on savings accounts of 0.1 percent, then with a 7 percent rate of inflation, the government has taken away 6.9 percent of your savings account.

If you are a pensioner on a fixed pension or annuity, the government has cut your pension by 7 percent.

In a sound money regime, in order to spend a lot, the politicians have to tax a lot. They then have to worry about whether workers, savers and pensioners will vote for those who escalated their taxes.

With the borrowing from the Federal Reserve ploy, the politicians avoid the pain of having to vote for increased taxes but they still savor the pleasure of voting for their favorite spending. Nonetheless, all the money for the politicians to give their friends has, in fact, been taken from the workers, the savers and the pensioners. It has just been taken in a tricky way by using the Fed.

In a previous generation, when the Federal Reserve was led by William McChesney Martin, for example, the public discourse was clear about this. Martin, who was Fed chairman from 1951 to 1970, called inflation “a thief in the night.” He also said, “We can never recapture the purchasing power of the dollar that has been lost.”  This was long before the Fed newspeak of today, which pretends that inflation at 2 percent forever is “price stability.”

But not even today’s Fed can languidly face a 7 percent rate of inflation. So while still planning to create perpetual inflation, it keeps repeating, and hoping against hope, that the very high inflation is “transitory.”

However transitory the current high inflation may be, the money of the workers, the savers and the pensioners has still been taken and won’t be given back. If the rate of inflation falls, their money will still be being taken, just at a lower rate. If inflation speeds up further, as it may, their money will be taken faster.

Inflation pain allegedly caused by Biden’s spending demands transparency, Republican says

Published in Fox Business.

But Alex Pollock, a distinguished senior fellow for finance, insurance and trade at the libertarian R Street Institute, told FOX Business that despite the other factors, he “certainly” thinks the president’s policies are playing a large role in the current inflation.

Pollock said the biggest contributor is massive government spending that’s financed by monetizing the debt. And the inflation, Pollock emphasized, is reducing Americans’ “real wages” and cutting the value of their savings.

Read the rest here.

Video: Is inflation back?

Hosted by the American Enterprise Institute.

The recent increase in US inflation numbers has shocked the stock market and begun a debate about whether an inflationary period is starting. This surge comes while the Joe Biden administration engages in the country’s largest peacetime fiscal stimulus, monetary policy remains highly accommodative, and demand has been pent-up due to social distancing and COVID-19 restrictions.

Join AEI and a distinguished panel of economists for an event evaluating whether there is an immediate inflationary risk to the US economy, the longer-run inflation outlook in light of anticipated demographic changes in China and elsewhere, and what the implications might be for future monetary and fiscal policy.

Letter to the editor: Fed’s Inflation Genie May Deliver More Than Wanted

Published in The Wall Street Journal.

For the first four months of this year, the seasonally-adjusted consumer-price index is rising at an annualized rate of 6.2%. Without the seasonal adjustments, it is rising at 7.8%.

“The consumer-price index rose at a remarkable 4.2%,” says your editorial, “Powell Gets His Inflation Wish” (May 13). Remarkable, yes, but our current inflation problem is far worse than that 4.2%, which is bad enough. The real issue is what is happening in 2021. We need to realize that for the first four months of this year, the seasonally-adjusted consumer-price index is rising at an annual rate of 6.2%. Without the seasonal adjustments, it is rising at 7.8%. Meanwhile, house prices are inflating at 12%.

We are paying the inevitable price for the Federal Reserve’s monetization of government debt and mortgages. As for whether this is “transitory,” we may paraphrase J.M. Keynes: In the long run, everything is transitory. But now it is high time for the Fed to begin reducing its debt purchases, and to stop buying mortgages.

The New Monetary Regime – Debt and The Inflation Crisis: A Special Panel Presented by The Liberty Fund and The RealClear Foundation

Hosted by Real Clear Politics.

The roundtable is moderated by Alex J. Pollock of the R Street Institute, and the panelists included Law & Liberty senior writer David P. Goldman of the Claremont Institute, Veronique de Rugy of the Mercatus Center, and Christopher DeMuth of the Hudson Institute.

A New Inflationary Era

Published in Law & Liberty.

In this provocative but calmly argued book, The Great Demographic Reversal, Charles Goodhart and Manoj Pradhan predict a new era of widespread and lasting inflation. Goodhart, who has been a respected expert in financial, monetary, and central banking issues for decades, and Pradhan, a macroeconomist who studies global financial markets, express as their “highest conviction view” that “the world will increasingly shift from a deflationary bias to one in which there is a major inflationary bias.”

This conviction reflects their “main thesis” that “demographic and globalization factors were largely responsible for the deflationary pressures of the last three decades, but that such forces are now reversing, so the world’s main economies will, once again, face inflationary pressures over the next three or so, decades.”

The demographic factors include the end of the “positive supply shock” to the global supply of labor provided by China over the previous decades. That is because “China’s working age population has been shrinking, a reflection of its rapidly aging population,” and “the surplus rural labor supply no longer provides a net economic benefit through [internal] migration.” Thus, “China will no longer be a global disinflationary force” and it “no longer stands in the way of global inflation.”

A second key factor is that birth rates around the world continue to decline and longevity to increase, furthering the aging of society and increasing dependency ratios. In this context, the authors point out that the average fertility rate in advanced economies has fallen to well below replacement. This includes the U.S. For the foreseeable future, there will be an ever-lower ratio of active workers to the dependent elderly, with the huge expense of support and health care for the elderly stressing government budgets. They add this striking thought: “Our societies today are still relatively young compared to what is to come.”

These are longer-term, not short-term movements. The implication is that we may envision a slow, great cycling over decades of inflationary and disinflationary or deflationary periods. The 2020s swing to inflation would mark a great cycle reversal, with perhaps a book like The Death of Inflation of 1996 symbolizing the previous reversal.

In a different estimate of the duration of the coming inflationary era, Goodhart and Pradhan make it somewhat shorter: “The coronavirus pandemic… will mark the dividing line between the deflationary forces of the last 30-40 years, and the resurgent inflation of the next two decades.” But whether it’s two or three decades, the authors expect two or three decades, not two or three years, of significantly higher inflation.

The effects of such an inflation would be, they write, “pervasive across finance, health care, pension systems and both monetary and fiscal policies,” and they surely would be. For example, they suggest, “It will no longer be possible to protect the real value of pensions from the ravages of inflation.” Nominal interest rates will be higher, but “Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate,” so “negative real interest rates… will happen.” Here they should have written, “will continue,” since we already have negative real interest rates, the yield on the 10-year U.S. Treasury note now falling short of the year-over-year inflation rate.

Further, “The excessive debt amongst non-financial corporates and governments will get inflated away.” In other words, governments will implicitly default on their bloated debt through inflation, a classic strategy. Of the three alternatives the book cites for reducing excess debt, “inflation, renegotiation and default,” inflation is the easiest for a government with debt in its own currency.

As the authors say, “neither financial markets nor policymakers are prepared” for such an inflationary future world.

In a final chapter written in 2020, Goodhart and Pradhan conclude that the government deficits and debt created in response to the coronavirus pandemic have reinforced and accelerated the coming inflationary era. Government-mandated quarantines and lock-downs were “a self-imposed [negative] supply shock of immense magnitude.” To finance it, “the authorities quite rightly opened the floodgates of direct fiscal expenditures,” in turn financed by escalating debt and monetization.

“But,” they logically ask, “what then will happen as the lock-down gets lifted and recovery ensues”—as is now well under way—“following a period of massive fiscal and monetary expansion?” To this question, “The answer, as in the aftermaths of many wars, will be a surge in inflation.”

Directionally, I think this is a very good forecast. We are already seeing it play out in the first months of 2021.

How much inflation might there be? They suggest the inflation numbers will be high: “quite likely more than 5%, or even on the order of 10% in 2021.”

Is 5% inflation possible? Well, the U.S. Consumer Price Index rose from December 2020 to April 2021 at the annualized rate of 6.2% when seasonally adjusted, and 7.8% when not seasonally adjusted. Signs of increasing inflation are widespread.

It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

How about that 10%? Could we really go to a 10% inflation? It has happened before. The U.S. has been at 10% inflation or more in 1917-20, 1947, 1974, and 1979-81. Most of these followed inflationary financing of wars, but the fiscal deficits and money printing of late are as great as during a war.

The authors proceed to the question of “What will the response of the authorities then be?” and offer this prediction—made in 2020: “First and foremost, they will claim that this a temporary and one-for-all blip.” We already know that this prediction was correct.

Overall, is this theory of a new inflationary era plausible? It seems to me that it does fit naturally with the world’s current system of pure fiat currencies, and the burning urge of many politicians to spend and borrow, especially when they are supplied with expansive central bankers. That the official forecasts and public relations statements of those central bankers are so much to the contrary of the theory makes me more inclined to believe it.

Speaking of the central bankers, Goodhart and Pradhan observe something important: “In recent decades Central Banks have been the best friends of Ministers of Finance [and Secretaries of the Treasury], lowering interest rates to ease fiscal pressures and to stabilize debt service ratios.” But what will happen “when inflationary pressures resume, as we expect”? Will the relationship become more tense or even hostile? To put it another way, might the disputes of 1951 between the U.S. Treasury and the Federal Reserve be re-played and the celebrated “Accord” between them come out in the opposite way: with the central banks more subservient? “Inevitably,” the authors rightly say, “central banks have to be politically agile.”

The book interestingly comments on an implied cycle in the standing of macroeconomics and macroeconomists. How credible are their pronouncements and forecasts? “From the Korean War until about 1973 was a transient golden age for macroeconomics.” The 1960s featured the misplaced confidence of macroeconomists that they could “fine tune the economy,” and control inflation and employment using the “Phillips Curve” they believed in. Sic transit gloria: “It all then went horribly wrong in the 1970s,” when they got runaway inflation and high unemployment combined. And “the second golden period for macroeconomics (1992-2008) [also] went horribly wrong.” That time the announcements of the “Great Moderation,” which central bankers gave themselves credit for, turned into a Great Bubble and collapse. The golden macroeconomic ideas of one era may seem follies to the next.

If the new inflationary era predicted by Goodhart and Pradhan becomes reality, the follies of the present will seem blatant. Should we adopt their “highest conviction” that this inflationary era is on the way? In my view, the economic and financial future is always wrapped in fog, but their argument is well worth pondering and entering into our considerations of the biggest economic risks ahead.

Inflation Is Here

Published by Barron’s.

Randall W. Forsyth (“Flood of Liquidity Is Sweetening Retirement for Stock Owners and Home Sellers,” Up & Down Wall Street, April 30) points out the rapid first-quarter growth in gross domestic product, final sales, and personal income, but oddly fails to mention that the consumer price index increased from December to March at an annualized rate of 6.8%. Inflation isn’t coming; it’s here.

It is intensely here in house prices, as he says, up in double digits (about 12%). Forsyth writes forthrightly: “The Fed keeps inflating that bubble by buying $40 billion of agency mortgage-backed securities…every month.” Yup. But why is the Federal Reserve still buying? Why is the Fed still monetizing mortgages when house prices are in runaway inflation? The answer is simple: It needs to stop.

Video: The New Monetary Regime: An Expert Panel Discusses Government Debt and Inflation

Hosted by Law & Liberty.

For decades, the U.S. Government has been charging a credit card with no limit, running up previously unimaginable trillions of dollars on the balance sheet at the Federal Reserve, leaving future generations as the guarantor—and the bill may be coming due sooner rather than later. What will be the effects of this Fed/Treasury alliance on our economy and our society?

Law & Liberty and the Real Clear Foundation hosted a distinguished panel of experts who discussed the growing crisis of inflation and debt in our government.

The discussion was moderated by Alex J. Pollock of the R Street Institute, and the panelists included Law & Liberty Senior Writer David P. Goldman of the Claremont Institute, Veronique de Rugy of the Mercatus Center, and Christopher DeMuth of the Hudson Institute.

Inflation Comes for the Profligate

Published in Law & Liberty.

Printing money to finance wars with resulting inflation is the most time-honored monetary policy. It can also be used for other crises thought of as analogies to wars, like to finance the massive expense of bridging the Covid 19-triggered bust of 2020.

In these situations, the central bank necessarily becomes the Treasury’s partner and servant, stuffing its balance sheet with government debt and correspondingly inflating the supply of money. This captures an essential mandate of every central bank, though it is not one you will find in the Federal Reserve’s public relations materials, namely lending money to the government of which it is a part.

Now, as the economic recovery from the Covid bust strengthens, soaring government debt is still being heavily monetized in the Federal Reserve’s balance sheet, which has now expanded to a previously unimagined $7.6 trillion, in a classic Treasury-Fed cooperation. The printing (literal and metaphorical) continues and the new administration wants to expand it even more. Isn’t accelerating inflation on the way?

The distinguished former Secretary of the Treasury, economist Larry Summers, recently suggested that it may be. “There is a chance,” he wrote, that government actions “on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.” I believe this is correct.

If we agree that there is such “a chance,” how big a chance is it? With political delicacy, Summers’ essay does not address this question. Instead, he carefully points out the “enormous uncertainties” involved. While the fog of uncertainty always obscures the economic future, it looks to me like the answer is that the chance is substantial. It would not be at all surprising to see inflation move significantly higher.

“There is the risk,” Summers writes, “of inflation expectations rising sharply.” Well, inflation expectations are already rising among bond investors and analysts, giving rise to such commentaries as these:

“According to the Bank of America’s January fund manager survey, some 92% of respondents expect rising inflation.” (Almost Daily Grant’s Newsletter, February 10, 2021)

“Bonds Send Message that Inflation is Coming” (Barron’s, February 5, 2021)

“For those of us not inclined to believe in free lunches, the funding of large deficits with printed money is another source of inflation and financial stability concerns” (Barron’s, February 12, 2021)

“A new worry now is whether the tremendous spending plans…can really be done without prompting a historic inflation.” (Don Shackelford, Proceedings newsletter)

“With growth in unit labor costs surging and a range of survey indicators also pointing to rising price pressures, we think inflation will be much stronger over the rest of this year.” (Andrew Hunter in Capital Economics)

“Inflation Worries Drive Platinum Up” (Wall Street Journal)

“The rat the Treasury market is smelling is consumer price inflation.” (Wolf Street, February 13, 2021).

Reflecting these concerns, the yield on the 10-year Treasury note, while still low, has risen meaningfully of late, to about 1.4 percent from 0.7 percent six months ago. This move has imposed serious losses on anybody who bought long-term Treasuries last summer and held them. The price of the iShares Treasury Bond ETF, for example, is down about 18 percent since the beginning of August.

In contrast to the views just quoted, Summers observes “administration officials’ dismissal of even the possibility of inflation.” Who is right, the investors or the politicians? Whose assessments of inflation risk do you believe? Politicians may be expected to deny an economic result that would get in the way of their intense desire to spend newly printed money.

As has frequently been discussed, a notable inflation has already been running for some time—the inflation in asset prices. Monetary expansion, needing to go somewhere, has gone into the prices of equities, bonds, houses, gold, and Bitcoin. The “Everything Bubble” stoked by the Federal Reserve and the other principal central banks has taken asset prices to historically extreme, and in the case of Bitcoin, amazing, valuations. Financial history presents an essential recurring question: How much can the price of an asset change? It also provides the answer: More than you think.

U.S. house prices have been and are inflating rapidly. They are substantially over their Housing Bubble peak of 2006. According to December’s Case-Shiller index, they are rising at an annualized rate of 10 percent, and AEI’s December Home Price Appreciation Index shows a year-over-year increase of 11 percent. This is abetted by the Fed’s monetization of long-term mortgages, of which it owns, including unamortized premiums, a striking $2.3 trillion—a sum 2.6 times its total assets in 2007—and which it continues to buy in size. This huge monetization of mortgages by the institution they created would greatly surprise the founders of the Federal Reserve, could they see it, and displease them. Instead of taking away the punch bowl as the party warms up, the Fed is now pouring monetary vodka into the housing finance punch. Reflecting on this inversion of the famous metaphor, Ed Pinto of the American Enterprise Institute has reasonably asked if they couldn’t at least stop buying mortgages. But it appears this will not happen anytime soon.

Of course, as a base line, we have endemic inflation of goods and services prices. The Federal Reserve has moreover formally committed itself to perpetual inflation. The Covid bust notwithstanding, the Consumer Price Index increased 1.4 percent year-over-year in January, 2021, and over the two months of December-January at an annualized rate of 3.1 percent. We are told frequently by the Fed about its “2% target” and hear it endlessly repeated by a sycophantic chorus of journalists. Since the Constitution unambiguously gives the power of regulating the value of money to the Congress, I believe the Federal Reserve acted unconstitutionally in announcing on its own, and carrying out without the approval of the Congress, a commitment to perpetual depreciation of the purchasing power of the U.S. currency.

Last year it formally added a new willingness to let inflation go higher than 2 percent for a while. How much higher and for how long nobody knows, including the Fed itself, but this willingness is consistent with a greater chance of accelerating inflation.

How much inflation is a sustained 2 percent? At that rate, average prices quintuple in a lifetime. The global movement among central banks, including the Fed, to trying for 2 percent inflation is a notable example of the changing intellectual fashions of central bankers. When serving as Federal Reserve Chairman, Alan Greenspan suggested the right inflation target was zero, correctly measured, and an inflation rate of zero was the long-term goal of the Humphrey-Hawkins Act of 1978. The distinguished economist, Arthur Burns wrote in 1957 that “our economy is faced with a threat of gradual or creeping inflation over the coming years.” He was right about that, except that gradual unexpectedly became galloping in the 1970s (ironically, when he was Fed Chairman).

“It is highly important that we try to…stop the upward drift of the price level,” Burns argued. Over time, “even a price trend that rises no more than 1 percent a year will cut the purchasing power of the dollar”—so much the more would 2 percent, he added. How ideas have changed. . Since the 1970s, we never are told about “creeping inflation” anymore. While Burns in the 1950s attacked 1 or 2 percent inflation, our current monetary mandarins strive for 2 percent forever and more than 2 percent for now. This increases the risk, consistent with Summers’ observations, that they will get more than they are bargaining for.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

At 3 percent inflation, prices would multiply by 11 times in the course of a lifetime. We are always a little surprised at the result over time of relatively small changes in a compound growth rate like the average rate of inflation.

One of the key Keynesian arguments for inflation was that wages are sticky downwards, so that if real wages economically need to fall, you can make then go down by inflation instead. Over the decade prior to the Covid crisis, average U.S. hourly earnings for all employees were rising first at about 2 percent and later 3 or 3.5% percent a year. So a 2 or 3 percent inflation would sharply cut or wipe out real wage gains, at the same time as it imposes negative real returns on savers. Other items you will never see in the Federal Reserve’s public relations materials are its potent abilities to reduce real wages and punish savers.

“Throughout history, there’s absolutely no currency in the world that has maintained its value,” international fund manager Mark Mobius pronounced. The U.S. dollar certainly has not, losing 96 percent of its purchasing power since the creation of the Federal Reserve and losing 98 percent of its value in terms of gold since 1971. (That was when the U.S reneged on its Bretton Woods commitments and led the world into a pure fiat currency regime.) Increasing inflation going forward from here would be consistent with history.

Economics is so little a science that economists can always be found on both sides of any question. This is certainly true of the debate about escalating debt, monetization, and the risk of accelerating inflation.

With the opinion farthest from mine, we have the cheerleaders for monetizing a lot more debt and practicing “What, me worry?”—these are the proponents of “MMT” or Modern Monetary Theory. Of course, it should be written “M”MT, or “Modern” Monetary Theory, since solving your problems by printing up money and forcing the people to accept the depreciating currency is a very old financial idea. The City of Venice used it in 1630, for example, to spend with inflationary result during an attack of bubonic plague. Alternately, we could consider calling it “WMT” or “ZMT” for Weimar Monetary Theory or Zimbabwe Monetary Theory. Even better would be “JLMT” for John Law Monetary Theory.

John Law was the creative, persuasive theorist of risk and paper money, “secretary to the King of France and controller general of His Majesty’s finances,” who presided over first the inflation and then the panicked collapse of the Mississippi Bubble of 1720. A main theme, then as now, was how to produce paper assets to cover the government’s debts, but his history also provides a precedent for our house price discussion: “Thanks to Law’s money-printing, land and houses were expensive.”

Like the close ties of John Law to the French monarchy, the question of debt monetization and its inflationary risks is closely tied to the question of what kind of government we want. Should the federal government’s power be limited or expansive and dominant? What the proponents of “M”MT really long for is a vastly expanded and more powerful government, with themselves in charge. If debt can be indefinitely expanded by bloating the central bank, then you don’t have to tax much in order to spend forever. Thus one of the most important limits on the power of Leviathan to dominate the society can be removed. We see that much more is involved than a monetary theory.

Are those desiring to wield the expanded power willing to cause much higher inflation to get it? This is the political meaning of the monetary question.

Inflation and the Fed

Published in Barron’s.

Forsyth suggests that a “‘complete financial externality’…would aptly describe the Great Financial Crisis of 2007-09.” I don’t think so. That crisis, like many others, was “endogenous,” as my old friend, Hy Minsky, used to say—reflecting the internal dynamics of interacting leverage, inflated asset prices, moral hazard, and risk in the financial system. Central banks are part of the system, and its internal interactions are not above the system in some celestial role. If you are prone to believe in “the control asserted by central banks over economies,” recall the hapless announcement by central banks that they had created the “Great Moderation,” which proved instead to be the Great Bubble. Widespread belief that central banks are in control may be another endogenous risk factor.

Over a century, which years were inflation-control champions and which booby-prize winners?

Published by the R Street Institute.

How much can the rate of inflation move around? A lot.

The Consumer Price Index (CPI) began in 1913, the same year the Federal Reserve was created. The CPI’s path over the 106 years since then displays notable variations in inflation — or alternately stated, in the rate of depreciation of the purchasing power of the U.S. dollar. In this post, I consider the average inflation rates during successive 10-year and five-year periods, starting in 1913. (The very last period, 2013-2018, includes six years.) I also note the context of historical events. Wars, especially, induce accelerated government money-printing, but the history displays constant inflation since 1933, sometimes slower, sometimes much faster.

Which decades and half-decades are the inflation-control champions, meaning the lowest average inflation rate without descending into serious deflation?  The decade champion is that of Presidents Eisenhower and Kennedy, 1953-1962. Its average inflation rate was 1.31 percent.

The booby prize goes to 1973-1982, when inflation averaged the awful rate of 8.67 percent per year. No wonder Arthur Burns, who was chairman of the Federal Reserve from 1970 to 1978, afterward gave a speech entitled “The Anguish of Central Banking.” In second place for the booby prize is 1913-1922, with an average inflation rate of 5.60 percent. That was the result of the first World War. The decade included, first, double-digit inflation then a short, very sharp depression in 1921-1922, but high inflation overall.

The inflation-control champion among half-decades is 1923-27, during the boom of the “Coolidge Prosperity,” when inflation averaged only 0.47 percent. In second place is 1953-57 at 1.24 percent. At that time, William McChesney Martin, who considered inflation “a thief in the night,” was chairman of the Fed.

Table 1 shows the record by 10-year periods in chronological order. It also shows what $1 at the beginning of each period was worth in purchasing power at the end of each 10 years. The last column shows what $1 in 1913 was worth in purchasing power, as it depreciated over the entire 106 years.

Table 2 shows the five-years periods, this time in order of lowest average inflation to highest, with historical notes on the context. It contrasts the lowest third of the observations with the highest third.

The average annual inflation over the 106 years was 3.11 percent. That reduced the $1 of 1913 to about 4 cents by the end of 2018, as shown in Graph 1. Note that, because of the scale of the graph, the change looks smaller in recent decades, but it isn’t. For example, the drop in purchasing power from 1983 to 2013 is the same as that from 1943 to 1973—about 60 percent in 30 years in each case.

Many central banks, including the Federal Reserve, now believe in perpetual inflation of 2 percent. Had that inflation rate been maintained since 1913, instead of the actual 3.11 percent, the dollar’s purchasing power from then to now would have followed the dashed line on the graph and fallen to 12 cents, instead of 4 cents.

We know from history that big wars will always be financed, in part, by depreciation of the currency of the winners, while the losers’ currencies will often be wiped out. There were several wars in addition to the two world wars in the 106 years under consideration, but was the constant inflation since 1933 necessary? Perhaps there was no other way for the government to deal with the debt automatically produced when taxes are forever less than government expenditures, war or no war, and the Federal Reserve is always there to help the Treasury out by monetizing its debt.

Thanks to Daniel Semelsberger for research assistance.