Meltzer: Fire Keynes, Replace Him with Friedman

Readers of today’s New York Times Op-Ed page can enjoy the spectacle of two economists side-by-side, one warning of deflation, the other of inflation. The Cassandra of inflation is Allan Meltzer, a monetarist of the fundamentalist variety and founding father of the Shadow Open Market Committee, a Fed watchdog group that barks at the first glimmer of monetary loosening. On the face of it, railing against inflation in the midst of incipient debt deflation is madness, but I happen to think that Meltzer has a point, just not for the reasons given.

Meltzer goes on a long detour about the rise and fall of US inflation during the 1970s that ignores the actual economic record (growth was pretty good) and dismisses the disastrous consequences of the ensuing disinflation (especially the developing country debt debacle) in a few flippant words:

And the anti-inflation policy continued until the unemployment rate rose above 10 percent, many savings and loan institutions faced bankruptcy, and most Latin American countries defaulted on their debt. These were the unavoidable side effects of the public’s gradual adjustment to the new economic environment.

But let’s get to the point: are we setting the stage today for a massive resurgence of inflation down the road? Meltzer says yes, for three reasons: too much money creation, too much deficit spending, too little investment in productivity. None of these is actually documented; it is all anecdote and assertion, but let’s give him the benefit of the doubt.

Money creation? Well, it depends on what definition of the money supply you want to use. M1, the monetary base beloved of paleo-Friedmanites, is through the roof, but this is because of the massive buildup of excess reserves held by member banks at the Fed. A more meaningful measure is M2, which includes checkable deposits, and here the growth is in the high single-digits. Is that a lot? Apparently the velocity of money (how rapidly it turns over), which is cyclically volatile, is depressed, since nominal GDP (the value of output at current prices) is falling—which it seldom does. The Fed is leaning against this monetary friction by pushing a bit harder on the supply side. As long as its policy is reversible, it is not inflationary.

Deficit spending? The US is on track to boost its public debt to about 80% of GDP by the outer years of the (first) Obama presidency. This is in the middle of the peleton as far as industrialized countries are concerned, and well below the level reached in 1945 after fifteen years of depression and war. There is no reason to believe this debt is not sustainable. Nearly all economists agree that the US has the fiscal space to run the deficits it is programming, a luxury available to relatively few other nations.

Productivity? To begin with, it is odd for an arch conservative like Meltzer to look to the government for investments in productivity growth, but let’s follow his line of argument: is the stimulus being spent in ways that will boost future productivity? Not surprisingly, the answer is yes and no, but more yes than Meltzer is willing to acknowledge. He makes a couple of major errors:

Better health care adds to the public’s sense of well-being, but it adds only a little to productivity. Subsidizing cleaner energy projects can produce jobs, but it doesn’t add much to national productivity.

Aside from the throw-away tone of the opening phrase, his dismissal of the productivity effects of health care investments is contradicted by a mountain of research. At both the individual and social levels, health is a significant determinant of productivity; add to this the fact that the US has a notoriously inefficient health care sector whose cost trajectory is unsustainable, and you have a clear case for productivity-enhancing investment. Meanwhile, Meltzer’s comments about energy demonstrate he is unaware of the energy efficiency gap, whose closing would be a big contribution in both economic and ecological terms.

In the end, however, I think an inflationary surge is entirely possible, for reasons that Meltzer doesn’t address. The first is the potential for a future run on the dollar once the private demand for Treasuries eases up. The low inflation environment of the last two decades was founded on an over-strong dollar; a rapid depreciation would turn this around. The second risk has to do with the unprecedented role of unconventional assets in the Fed’s balance sheet. Traditionally, the Fed conducted open market operations by buying and selling Treasury obligations—the “bonds” in your macro textbook. It could expand the money supply by buying bonds and, if it wanted to disinflate, reverse course by selling them. Under the banner of bailing out the financial system, the Fed is now injecting money by buying toxic assets, but what happens if the Fed wants to soak up money instead? It has unloaded all its stash of public debt, and the assets it holds are not marketable. This asymmetry in Fed policy should be a real source of worry for the Meltzers of this world, and even irresponsible economic populists like myself.

In a nutshell, the fiscal and monetary initiatives undertaken to support the bailout present significant inflationary risks. True, resisting deflation is the immediate task, but there are better and worse ways to do this. Using the US central bank to trade cash for trash is a dangerous path.