The US stands more than a year into a grave economic crisis, with a projected budget deficit of 13% of gross domestic product. The unfunded liabilities of US federal programmes have crossed the $100 trillion mark. Such a debt all but guarantees higher interest rates, massive tax increases and partial default on government promises.
But as bad as the fiscal picture is, panic-driven monetary policies portend 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.
About eight months ago, starting early September, Ben Bernanke’s Federal Reserve did an abrupt about-face and radically increased the monetary base—comprising currency in circulation, member bank reserves held at the Fed and vault cash—by a little less than $1 trillion. The Fed controls the monetary base 100%, and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signalled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.
The percentage increase in the US monetary base is the largest in the past 50 years by a factor of 10. It is so far outside the realm of the US’ prior experiential base that historical comparisons are rendered difficult, if not meaningless. The currency in circulation component of the monetary base—which prior to the expansion had comprised 95% of the monetary base—has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now, the currency in circulation component of the monetary base is a smidgen less than 50% of the monetary base.
Banks are required to hold a certain fraction of their liabilities—demand deposits and other checkable deposits—in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren’t able to inject liquidity into the economy. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.
What’s important for the overall economy is how fast these loans are made and how rapidly the quantity of money increases. For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travellers cheques (called M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency and increases in commodity prices such as oil and gold.
At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (that is, 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.
With an increase in trust in the overall banking system, the panic demand for money has begun to, and should continue to, recede. The dramatic drop in output and employment in the US economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a sure-fire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.
It’s difficult to estimate the magnitude of the inflationary and interest rate consequences of the Fed’s actions because, frankly, the US hasn’t ever seen anything like this. To date, what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits.
Now, the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared towards economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves.
Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with the US treasury’s planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.
In addition, a rapid contraction of the monetary base, as I propose, would cause a contraction in bank lending, or at best limit expansion. This is exactly what happened in 2000-01, when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed chairman Bernanke, it’s a Hobson’s choice. For me, the issue is how to protect assets for my grandchildren.
THE WALL STREET JOURNAL
Edited excerpts. Arthur B. Laffer is chairman of Laffer Associates, and co-author of The End of Prosperity (Threshold, 2008) . Comment at email@example.com