Tuesday, September 1, 2009

Refuting "Economic Suicide"

Inflation is always and everywhere a monetary phenomenon. These are the words of Milton Friedman in A Monetary History of the United States. The meaning of those words is that no matter what, inflation is a function of the amount of money available. Inflation occurs when more money is introduced into the supply. When this happens, the real value of the money goes down. This is the reality. The face value perception is that things begin to "cost more." Physical things actually still hold their same value, it is the money, due to inflation, that has lost its value, meaning that it takes more of that money to buy the same thing. Nowhere was the phenomenon of inflation, and indeed hyperinflation, more evident than in the Weimar Republic, where we find the famous historical incident of it costing a wheelbarrow full of money to buy a loaf of bread.

I bring up a brief discussion on the nature of inflation in response to possibly one of the most foolish articles I have seen lately. At Seeking Alpha, Henry Bee writes that Auditing the Fed is Economic Suicide. In an incredible feat of intellectual gymnastics, Bee lays down the accusation that somehow the public knowing what is happening with the money supply will be the end of the free market:

The free market understands that auditing the fed is a very dangerous line to cross. If crossed, U.S. inflation will likely skyrocket over the next decade to unseen levels. U.S. economy tanks. Bond investors lose money as interest rates rise. Stock investors earn negative real return as equity risk premium rises and aggregate PE ratio tank. The US Dollar erodes due to higher domestic inflation relative to foreign inflation. Gold and commodity prices rise.
Perhaps we can forgive Mr. Bee for being Canadian, and therefore not understanding the history of the Federal Reserve and monetary policy in the United States. Or perhaps we can direct him to the aforementioned Milton Friedman, or maybe Murray Rothbard, or F.A. Hayek, for some simple education on monetary policy. Remember, "gold and commodity prices rise" only in terms of the value of the money itself. They are physical, tangible things. They always retain the same value, and it is the value of the money itself that changes due to inflation. After beginning with the Vault, Bee continues and moves on to the Balance Beam:

How Does Auditing the Fed Cause Inflation?

Inflation is caused by a central bank that loses control of its money supply. There are two ways that a politically compromised central bank can lose control of its money supply.

I'll interrupt Mr. Bee while he's still doing some of his simple posing, and before he really gets going with the tumbling. Inflation is caused by a central bank that loses control of its money supply? I think not. Remember, inflation is always and everywhere a monetary phenomenon. Inflation is caused by the introduction of more money into the supply. Who introduces more money into the supply? The central bank. The Federal Reserve is our central bank. Incidentally, Mr. Bee might be interested to know that since its inception, the Federal Reserve has practiced nothing but inflationary monetary policy and, in about 100 years, has managed thereby to devalue the dollar by approximately 97%. It would seem then, that the Federal Reserve itself has been the cause of inflation all along. But I will allow Mr. Bee to continue:

Road to Inflation #1: Repeating the Political Cycle

When the central bank is not independent, politicians have historically pumped up the money supply (for temporary economic boost) shortly before an election to buy votes with a lower unemployment rate. After the election, the effects wear off, returning the economy to its natural rate of unemployment but at a higher inflation rate than before. Because it is hard to fight off inflation quickly, by the time the next election rolls around the economy has not been squeezed back to its original inflation rate. Politicians pump up the money supply again, this time from a higher base inflation. As this cycle repeats itself, the central bank loses control of the money supply.

Bee makes a good point here in defending the separation of church bank and state. However, akin to a balance beam backflip, Bee here asserts that an audit of Federal Reserve will allow politicians direct control of the money supply. Since the discussion surrounding HR 1207 has been one of simply getting a look at the books, Bee's arguments, while valid conceptually, are unfounded in reality. Indeed, both Barney Frank and Ron Paul have agreed with Bee's own argument, and intend to be disciplined in making the audit one that trails real time by enough that exactly what Bee purports to be the danger will not happen.

That said, I would like to ask Mr. Bee a simple question. What makes you suppose, Mr. Bee, that the Federal Reserve is not already unduly influenced by politicians? As I have explained in the past, the Fed is largely a conglomeration of private banking institutions, overseen by a Board of Governors, headed by the Chairman of the Federal Reserve, currently Ben Bernanke. The Board of Governors is a seven-member panel appointed by the President of the United States. This means, Mr. Bee, that seven people who, through their appointment, answer to the President, and the President alone, control all that is our monetary policy, all that is our money supply, and therefore all that is our inflation. If Ben Bernanke and six others answer only to the President, how exactly is the Federal Reserve not influenced by politics in the manner you suggest already?

Bee goes on to discuss a second road to inflation:

Road to Inflation #2: Financing Government Spending

A central bank that lacks independence from politicians makes it tempting for the government to finance an inappropriately large portion of its spending through printing money. A central bank that promises to finance too much government spending also loses control of the money supply.

Now honestly, there is only just so much we can forgive of Mr. Bee for his being Canadian. This really represents a complete lack of attention to current events. Inside of a four month period, the Federal Reserve just financed a $700 billion bailout of the US Financial industry through TARP, an effort, mind you, that resulted in all that money going to the noble purpose of, well, nobody really knows, followed by the $800 billion stimulus package. Based on Barney Frank's admission in the video found in this post, Ben Bernanke indicated to him when the bailouts began with AIG, that he had $800 billion to play with. Well that covered TARP. The only logical inference then is that the Fed printed the rest to finance the stimulus. Our central bank is already following this road, Mr. Bee. The only question is, how much have they inflated the money supply?

Well the answer from the Fed has been, to this point, simple. Silence.

When seven men who answer to one man control the entire money supply, and hold no accountability, they can do as they please. Adding a check to this highly centralized power by making their actions transparent to the public cannot be a bad thing.

13 comments:

  1. Good eye Paul.

    The points you brought up are all valid. I had decided to leave them out intentionally from the article. The post was simply getting too long and getting into the issues you raised would diverge from the main topic.

    The Fed was indeed printing money in the last 12 months through direct purchase of government bonds. This is done to create inflation to counteract the deflationary forces brought about by the severe recession. As the recession turns into a recovery and then a boom, the Fed would need to decreases the money supply to rein in inflation.

    And certainly the Fed could very well be already under political influence. In fact, I remember that Congress last year was sending strong messages to the Fed to "use all tools available" to fight the recession. That is very much political influence.

    The type of inflationary consequences possible is double digit inflation (or more). This has not occurred since the Volcker Fed. Nevertheless, the RISK of it happening goes way up with the passing of this bill compared to not passing it.

    In any case, you made the first rational, logical response to my article. Apart from that, it's just a sea of angry comments, reflecting anger and strong support of the HR 1207 bill. I enjoyed reading your refute.

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  2. Henry, I would check your facts about the Volcker Fed. This is hearsay on my part through some recent Peter Schiff interviews, but it is my understanding that he presided over the last DEFLATIONARY Fed, and did so as a means to tackle the double digit inflation brought about by the collapse of Bretton Woods.

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  3. Yep! What I meant by "Volcker Fed" is the fed that squashed inflation in its tracks! Since then, inflation has never reached double digits.

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  4. Not that we are able to monitor anyway, since all we have to go on is the Fed's word as to what the money supply is, which is akin to putting your child in charge of the cookie jar and trusting him when he tells you it's full. Just as you would not be surprised to open the jar one day to find it empty, I find it extremely difficult to believe we don't already have double-digit inflation bearing down upon us after the Fed just doubled its balance sheet.

    The fact is, since Volcker, Greenspan and Bernanke have done little else but manage the Fed via inflation and low interest rates, first revelling in the Dot-Com bubble and its burst, and essentially curing it, as Paul Krugman once suggested Greenspan do, with the subsequent housing bubble.

    We have been inflating the entire time, whether that rate has been low or not, and now we have just cranked the helium valve wide open on an economy that is ALL bubble, and with a big hole in it at that. There is no more inflating to be done other than on a grand, double-digit scale.

    It's time we take our medicine.

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  5. You see Paul, this is why I wrote the article. At the core of auditing the Fed lies the ugly truth. Those of you who subscribe to the Austrian economics school want a completely free market without ANY government. This is why I didn't want to get into any of those issues to begin with. It isn't about Auditing the fed. It's about abolishing the Fed and changing the system.

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  6. I am all for changing the system, to be sure. It would seem to me your bias is to keep the system as-is, since succeeding within its framework appears to be what you do, and apparently quite well.

    My bias is toward Freedom and Liberty, which both rightly require a common sense, yes Austrian, economics.

    You are wrong to posit that I, or any other person of an Austrian leaning, save for perhaps the anarchists, want a free market with zero government involvement. We want the government to be what it is supposed to be: the referee. In any sport, the referee cannot also be a participant, let alone be one that stands to profit, a-la Tim Donaghy, from the result. The Fed is a participating pseudo-referee that stands to profit from the results. Its existence is therefore not only against the interests of true Free Market Capitalism (as opposed to the Corporatist system we have, do not be confused on that point), but also grossly amoral at the core of the idea.

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  7. Following up, even if you are not for a complete change of the system, and you do not view the existence of the Federal Reserve to be wrong, I fail to see how you can be against Congress having a look at the books in the trailing manner that has been suggested. The idea fits the American idea of checks and balances perfectly, even if nothing else were ever to happen.

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  8. Auditing in a trailing manner is not just going to about looking at the books. If it was merely "looking at it", i'm okay with it. After the congress looks at it, if they do not agree with the Fed's actions, they will actively influence monetary policy. I do not want to see congress having any influence on monetary policy whatsoever.

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  9. I have left this one sit for a while, Henry, as I've been writing about other things and busy with work otherwise.

    However, to your point about not wanting Congress to influence monetary policy, I can only ask you why not?

    Monetary policy is one of the responsibilities delegated to the Congress by the Constitution. Somehow it has been delegated to the Federal Reserve under a program that places the Fed under the "supervision" of the President. We all know, however, that the Fed simply does what it pleases, answering to no one.

    Even if it were to obey the hierarchy, however, why do you assume it is better that the Fed answers to one man, rather than to the 535 in Congress?

    Your claim is that transparency would be inflationary. I dispute that based purely on logic.

    Monetary policy is much more likely to become wildly inflationary when fewer people are involved in the decision making process. If it is the Fed and the President, you are far more likely to get a quick decision without much deliberation. And wouldn't you know it, that's how we wound up with hundreds of billions of dollars bailing out companies that didn't deserve it, seemingly to the great benefit of Goldman Sachs, who has come out of everything like King Solomon, particularly in terms of the AIG bailout.

    If that kind of decision is put before Congress, instead of the President, I think a much better decision, one that perhaps even has some semblance of benefit to normal Americans, ends up being made.

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  10. Paul, There is overwhelming academic literature available studying the relationship between inflation and central bank independence (CBI). While there are a few skeptics, the overwhelming evidence is that CBI is negatively correlated with inflation.

    Two representative papers:
    http://www.imf.org/external/pubs/ft/wp/2005/wp0575.pdf

    http://ssrn.com/abstract=258970

    And here's a skeptical view: http://ssrn.com/abstract=1112026

    You can also type the keyword "central bank independence" into the search box at SSRN for a complete list of studies: http://papers.ssrn.com/sol3/displayabstractsearch.cfm

    I understand that perfect independence can never be achieved in practice. But any political steps taken to swing the pendulum away from independence would not help control inflation, which would not be in any nation's best economic interest.

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  11. I'm not arguing against independence, Henry. I asked you how you can think that providing Congress with more information about what the Fed does would make the Fed LESS independent. My argument is that the Fed is as independent as possible, but is influenced in any case by the President, and directly at that. Being influenced in any respect by one person automatically makes ANYTHING less independent than it would be if influenced by a large body of people who need a long time to make any decision. The moral hazard is simply much greater.

    Now, this is not to say that I am for either the President or Congress or anybody having any influence over the Fed. As long as we have a central bank attempting to replicate the effects of a gold standard through imperfect policy, we need to have them as independent as possible.

    However, we also must recognize when the Fed is acting irresponsibly, as they have been, and take steps to reign them in.

    Accountability to the people of this country is a must, if they are to be making decisions that affect the value of our money.

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  12. Yes, the president may have general influence over the fed, but not on the specific open market operation conducted by the FOMC.

    Passing the Fed Transparency Act is like "opening up a port" on a firewall, making it vulnerable to outside "attacks". It allows the political body to see into the activities of FOMC, and influence its specific operations. So here we have a large body who have specific influence vs. a single person who has general influence.

    Your view is that single-person-influence is greater than large-body-influence, which I concur. However, I believe influence on specific operations outweighs the effect of single-person-influence. This is where we differ. Hope that makes some sense.

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  13. Which is where perhaps we come full circle. I'm not sure that I've seen, in HR 1207, anything that says the Congress would have authority to do anything other than observe monetary policy decisions in a trailing manner.

    Or perhaps you are afraid it's a foot in the door to Congress eventually proposing new legislation down the line to interfere in policy?

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