Monday, May 4, 2009

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.


hapa said...

china isn't buying our physical trash for recycling, either

Robert D Feinman said...

One thing is to look at how people act, not what they say. I see a trend which has extended over at least a decade away from long-term bonds (private and government) and more towards short-term alternatives.

As a parallel there is the rise in money market funds, the ultimate in short-term investing. The Treasury gave up 30 year bonds under Bush and has only recently revived them in a small way.

The reluctance of investors to commit for the long-term seems to me an indication that inflation fears are just below the surface, despite what business leaders say in public.

I look at the situation under LBJ as a parallel to the current day. He fought (lost) a war and refused to raise taxes to pay for it, instead promoting "guns and butter". It was left to those who came after to deal with the inevitable inflation. Volcker may be seen as a hero by some, but I think he was a disaster for those at the bottom of the ladder.

We are now engaged (and losing) two wars and also failing to pay for them. Why should things turn out any differently in a few years?

The problem is that once you have punched a big hole in the bottom of the boat the need to keep bailing before you can make repairs overrides long-term fixes. Just when a new tax policy was overdue to correct for Reaganism, we get hit with a popped bubble, thus making the range of solutions even more limited.

We are faced with the a choice of least worst options, not good ones.

Anonymous said...

«Volcker may be seen as a hero by some, but I think he was a disaster for those at the bottom of the ladder.»

Inflation was pretty bad for them too, and anyhow he used the right policy -- it is not his fault that the victims of the right policy had a very bad safety net. The fault was with the political consensus that those who become are unemployed are losers and no winners wants to waste money supporting them.

«We are now engaged (and losing) two wars and also failing to pay for them. »

What, haven't they been fully paid for with tax cuts? :-)

Or rather subsidized by selling what are in effect war bonds to China, Japan and Saudi Arabia at fantastically high prices?

Robert D Feinman said...

I remember the Volcker era differently. There was a higher degree of unionization and many other firms followed their settlements.

Unions trailed (slightly) behind the cost of living increases, but workers didn't lose out to much as a consequence. On the other hand retirees, those with savings set aside for retirement (this was before 401K's, so savings tended to be bonds or bank accounts) suffered. Poor people had little savings to be inflated away, but they didn't have the bargaining abilities of the better paid workers.

So their wages lagged and their expenses went up. Indexing SS was one of the things that came out of the period.

There is never an excuse for 15-20% inflation, it shows a poorly run government and one that allowed itself to get into a such a bad situation in the first place.

I see that some (like George Soros) are now promoting a return to inflation, but only for a short term to eliminate the possibility of deflation. This would be followed by a rapid rise in interests to choke it off before it went too far. I think he doesn't understand political dynamics well enough. Controlled wildfires have a way of jumping over the fire breaks...

Sandwichman said...

There is no reason to believe this debt is not sustainable.

Presumably Peter means 'sustainable' in a narrow economic context, not a broader ecological and social justice one. I would argue that even from the narrow economic perspective that sustainability is uncertain because one is not just dealing with abstract debt to GDP ratios. There is the matter of the qualitative make-up of that GDP.

If fiscal stimulus policies have a tendency to debase or water down the socially necessary content of GDP relative to superfluous elements, then the ratio of debt to GDP is misleading.

So there are at least four reasons to believe debt may not be sustainable:

climate change;

the end of cheap energy;

world population growth;

unreliability of GDP as a measure of economically sustainable activity.

Sandwichman said...

Let me be more specific. As long as work-time regulation is not a key part of the stimulus policy mix, debt-fueled economic expansion will tend to be increasingly ineffectual in achieving full employment.

SteffenH said...

Regarding to energy efficiency investment there is a difference between overcoming market failure and paying subsidies for arbitrary projects. Keep in mind that the so called "landlord-tenant"-problem often is not the cause but the effect of other government failure. Econospeakers should think of Bastiats Brooken-Window-Fallacy: Do you heard of opportunity costs?

Peter Dorman said...


It's odd you would mention Bastiat, since you could interpret my column on Krugman a few days ago as an invocation of exactly that argument. Would you agree? In this case, however, we are not talking about broken windows but thin, unsealed, leaky windows that waste heating energy. With IRR's well into the double digits, weatherization programs are efficiency-enhancing, whether undertaken voluntarily by owners or financed out of stimulus funds. I agree, of course, that arbitrary projects whose only purpose is to spend money will not raise efficiency. In his famous quote about burying bottles of money, Keynes began by recommending productive investments instead.

TheTrucker said...

To SteffenH:

Opportunity isn't a cost. Once you fall into that pit you are doomed to tail chasing forever in the land of "only private gamblers can make a difference". People who are productive do not concern themselves with opportunities they might have had. They take the productive option that maximizes utility for them and they do it. A foregone opportunity has no cost. There is only opportunity value and no such thing as opportunity costs until you become a neoclassical liar. Labor Theory of Cost.

See Also: Economics Explained. Pay particular attention to the Snickers Bars.

Sujan Patricia said...

I must admit I’m loving the little catfight between Meltzer and Krugman. Inflation vs. deflation debate between Allan Meltzer and Paul Krugman is a rather interesting and insightful. Allan Meltzer says inflation is our greatest threat and I'm agree with him. Meltzer’s warning remains relevant.