Sunday, June 21, 2009

Inflation Smackdown: Laffer vs. Blinder

Arthur Laffer in the WSJ on June 11, "Get Ready for Inflation and Higher Interest Rates":

As bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10. It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless.

Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans. At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.

Alan Blinder counters in today's NY Times article "Why Inflation Isn’t the Danger:"

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. But their concerns are misplaced. To understand why, start with the basic economics of banking, money and inflation. In normal times, banks don’t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation.

In abnormal times like these, however, providing frightened banks with the reserves they demand will fuel neither money nor credit growth — and is therefore not inflationary.

MP: The chart above shows the significant growth in both the monetary base and excess reserves over the last year. According to Laffer, banks are lending out the excess reserves, which will be inflationary, and according to Blinder, banks are holding onto the excess reserves, which will not fuel inflation.

Who's correct? The graph below of the Total Loans and Leases of all commercial banks suggests that Blinder is more correct, at least for now. Total bank loans peaked in late 2008 and have actually been gradually declining since last October, falling by almost $200 billion from the peak. And the graph above shows that excess reserves at banks have increased lately, which is consistent with the recent decline in bank loans. As the Fed has expanded the monetary base and bank reserves, banks have been holding a majority of those increased reserves as excess reserves, and they are NOT lending them out.

Blinder also argues that the bond market does not seem too worried about future inflation:

The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6% and the 10-year expected rate was about 1.9%. Notice that the latter matches the Fed’s inflation target rate of just under 2%. I don’t think that’s a coincidence.

MP: The chart below shows the recent history of 10-year Treasury yields from both regular and inflation-indexed notes and illustrates Blinder's point of inflationary expectations of about 2%, based on the difference in yields between regular 10-year Treasuries of 4% and 10-year inflation-indexed Treasuries of about 2%.

Bottom Line: Both the bond market data showing contained expectations of inflation at around 2%, and the commercial banking data showing declining loan volume, seem to support Blinder's position more than Laffer's. I'm leaning toward Blinder's position for now. Inflation is not any kind of "clear and present danger," at least not yet.


At 6/21/2009 6:19 PM, Blogger fboness said...

There is a lot of fuel out there for inflation but, we won't see inflation until there is something to ignite it. That something would be an increase in the velocity of money. For now, much of the money "printed" by the Fed is sitting in bank reserves.

At 6/21/2009 6:34 PM, Blogger PeakTrader said...

I've written before:

It's not important whether the Fed Funds Rate is 10% or 0%, the money supply is high or low, or how many booms and busts take place in asset markets. What's important is maintaining sustainable growth, which is optimal growth.

In the equation MV = PT, if M and P are constant, then V = T, i.e. V, the velocity of money, or the number of times money is exchanged, equals T, the number of transactions, or the quantity of goods exchanged. T can be represented by real GDP. The goal of monetary policy should be to keep actual GDP close to potential GDP, which smooths-out the business cycle creating optimal growth (since there's neither strain nor slack in the economy). The fact that there are monetary tightening and easing cycles, to close output gaps, are attempts to smooth-out T in the short-run. V and T fluctuate in the short-run, which require adjustments in M to stabilize P and smooth-out T. For example, if people decide to hoard money, then V and T will fall (in the short run). So, M needs to rise (higher than a constant growth rate).

At 6/21/2009 6:44 PM, Anonymous Anonymous said...

PeakTrader-I remember MV=PT from Econ 101 or something like that.
Anyway, we need inflation now, a good, long moderate swig of it.
Neither of our political parties has the slightest will to reduce the federal deficit, and I am scared to think about the trade deficit.
We are the only nation on Earth that can pay off our debt in dollars. China backed down immediately from their veiled threat to switch to another currency.
I hope Bernanke is up late at night, making sure the night crew is running the presses hot, hot, hot.
When I can wallpaper my house in George Washingtons, then we are there. (BTW, this is not as bad as you think--you should see the kind of wallpaper my wife wants. GW's might be cheaper. Then, when you sell the house, you can tear them down and spend 'em)
We simply will never pay off the national debt unless we invalidate about one-half of it through inflation. Many homeowners and commercial property owners will be helped too.
Given the political realities, when does anybody reading this blog expect either the R-Party or the D-Party to balance the federal budget? Really, really? Bush Reagan Bush? Give me a break. Obama, Pelosi, Reid? Har, har. (That's old comic-book speak for ha-ha).
A cheaper dollar might help our balance of trade, and if it gets cheap enough, maybe foreigners will invest here more, enticed by our cheapness.
Remember Bernanke; The night shift: Make those lazy government employees hop to!


At 6/21/2009 6:50 PM, Blogger PeakTrader said...

Fiscal policy is the big threat. It's good the American people are focusing on budget deficits. To achieve a balanced budget, either the economy needs to expand, taxes has to rise, spending needs to fall, or the government has to sell assets.

At 6/21/2009 6:55 PM, Blogger PeakTrader said...

Benjamin, there are too few dollars chasing too many assets and goods in the U.S., in part, because foreigners have been absorbing dollars. The world is flooded with dollars; yet, there are too few dollars in the U.S.

Some inflation, e.g. 3% real growth and 3% inflation, or 6% nominal growth, will raise "animal spirits."

At 6/21/2009 7:23 PM, Blogger Unknown said...

alan blinder is wrong, this time the banks have reserves because the fed for the first time in my memory is paying interest on those reserves

At 6/21/2009 7:34 PM, Blogger PeakTrader said...

Fiscal policy is also a threat to the dollar as the world's reserve currency, except other major economies remain more constrained than the U.S.


What You Should Know About the World's Reserve Currency

"A country whose currency is the predominant reserve currency benefits tremendously. In the case of the dollar, the U.S. benefits from the increased demand for the dollar that the reserve currency status creates. Other countries give the U.S. valuable goods in exchange for dollars issued by the Federal Reserve. They also lend the dollars they've accumulated back to the U.S. at low interest rates. Most significantly, the U.S. benefits from importing these goods and exporting its inflation to other countries in the form of depreciating dollars."

At 6/21/2009 7:39 PM, Blogger juandos said...

Well personally I think Alan Blinder is at best questionable...

Here Alan Blinder writing in the WSJ whines rather petulantly about AIG bonus compensation: Crazy Compensation and the Crisis

Meanwhile Conor Clarke writing in the Atlantic Business blog about same said AIG: I count $454,771,905 distributed to 51,493 employees. Unless I'm making some terrible math error, that's an average bonus of about $8,832. For comparison, the average bonus on Wall Street in 2004 was $100,600...

Why didn't Blinder think this important?

At 6/21/2009 7:51 PM, Anonymous gettingrational said...

The only way to defeat high deficits that pay for massive new transfer programs is inflation. A tilliion dollars needs to be not an outrageous amount anymore. If in ten years the dollar is worth only fifty cents then the concern has been sanitized and only the investor has been hurt -- not the people at the night club blowing their transfer payments.

Where will the investor go to defeat inflation? This administration is hell bent on growing the transfer payee class. Thus investible capital seeps out of the country to possibly never return.

This adminstration needs inflation to carry out its programs and yes they will be successful.

At 6/21/2009 7:55 PM, Anonymous geoih said...

No inflationary risk "for now"? What a cop out.

How long does "for now" last? The only way all of this extra money won't cause inflation is if 100% reserve banking is required or if the Fed sells off a massive amount of assets and then burns the money that was used to pay for them.

When since 1913 hasn't there been an inflation risk. That's what central banks and fractional reserve banking does. They inflate. It is inevitable.

At 6/21/2009 9:04 PM, Blogger Alan said...

I think McTeer does a better job of explaining the difference between the monetary base and the money supply in this article:

McTeer on Fed Balance Sheet and Excess Reserves

FWIW, I am with McTeer on this one and think Laffer is wrong. That said, this money will have to be wrung out sometime in the future, but I am more concerned that we have had no net money growth in 6 months (despite the rise of the monetary base). As McTeer describes it, there is a difference between "money on the wing" and "money sitting".

At 6/21/2009 10:03 PM, Anonymous Anonymous said...

Whoever argues for high inflation is extremely foolish. You want inflation to wipe out the relative strength of the debt? It will have exactly the same effect on REGULAR PEOPLE'S LIFE SAVINGS. A dollar that is weaker is easier to pay back, but a weaker dollar has less value if you have been saving it all this time. Thank you for advocating value-theft of the middle class's money.

"Certainly no nation ever before abandoned to the avarice and jugglings of private individuals to regulate according to their own interests, the quantum of circulating medium for the nation — to inflate, by deluges of paper, the nominal prices of property, and then to buy up that property at 1s. in the pound, having first withdrawn the floating medium which might endanger a competition in purchase. Yet this is what has been done, and will be done, unless stayed by the protecting hand of the legislature. The evil has been produced by the error of their sanction of this ruinous machinery of banks; and justice, wisdom, duty, all require that they should interpose and arrest it before the schemes of plunder and spoliation desolate the country."
- Thomas Jefferson

At 6/21/2009 11:14 PM, Blogger Hot Sam said...

So what Blinder is saying is that the reason we're not getting inflation is because banks are hoarding excess reserves rather than lending. If they're not lending, then we're not getting car loans, mortgages, consumer credit, and small business loans.

So he's saying we're screwed one way if they lend and another way if they do.

Oh, but even if banks do start lending again we'll get some low level economic growth but a sloooooow return of jobs, i.e. Stagflation.

Thanks for clearing that up Alan. That's what I was guessing all along.

At 6/22/2009 9:40 AM, Anonymous Anonymous said...

The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation

- Vladimir Lenin

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

... As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

- John Maynard Keynes

At 6/22/2009 10:16 AM, Blogger said...

Amusing to see how pervasive is the either/or framing. What I have found is that those who always feel compelled to "choose" within this false construct never really get very far.

At 6/22/2009 12:46 PM, Anonymous Anonymous said...

Why is it that the guy who's saying inflation isn't a problem because banks aren't lending is the same guy who supports the stimulus, whose purpose is TO GET THE BANKS LENDING AGAIN. Hello?

At 6/23/2009 3:56 PM, Blogger Unknown said...

When was the last time Laffer did good economics? Economists I know think Laffer is kind of a running joke. A friend I know who had worked in his group found his methodology simplistic.

Herbert, the Fed isn't paying for reserves when the fed funds rate is sitting at 0-.25%. The policy to pay reserves puts them at a set spread below the federal funds target, so the huge amount of excess reserves aren't receiving interest.


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