The Big T

How to prevent inflation when the Fed prints a trillion dollars.

• NPR reports that "...in the U.K., the ... latest attempt to goose the economy ... calls for the Bank of England to create 75 billion pounds" in new money. And NPR quotes the BBC: "These actions are unprecedented in the Bank's 315-year history but are now considered necessary...." [From NPR's "Planet Money" blog, 11 March 2009]
• Under the headline "Fed Prints a Trillion," on 20 March 2009 Chris Martenson reported: "In a shocking development that I frankly hoped we'd never actually see, the Federal Reserve dropped a bombshell yesterday and announced that it is going to create an extra $1 trillion dollars out of thin air...."
• The Seattle Times reports that the Fed's trillion-dollar decision was unanimous. [Seattle Times, 20 March 2009]

Well, it's happening. And the Internet response to these printing press releases is largely what you'd expect: Inflation, inflation, inflation. I have a different take. 

Yes, the central banks have boxed themselves into a corner. But to get out, to avoid the inflation, they can use the door that I open in the NAE PDF.

Central banks are dumping money into the economy like crazy because they think they have to. I don't know if your typical central banker is a whole lot smarter than your typical internet user. But I know that the banker's job is to know about money and the economy. I've got more confidence in the bankers' actions than the internet's reactions. Anyway, I think they have to, too.

Arthurian theory says if they'd printed that money gradually over the past 30 years, we could have avoided the credit-crisis mess. Internet theory says printing money causes inflation without regard to how or when. But the Internet Theory of Inflation is incomplete because it ignores the use of credit.

I did have to laugh, though, at the Fed's statement in the Seattle Times:

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability."

Note that price stability is second in the statement of the Fed's priorities.

The phrase "preserve price stability" seems to mean the Fed will fight inflation. But it really means the Fed will fight deflation. In the January 8, 2009 issue of FedViews, Glenn D. Rudebusch of the Federal Reserve Bank of San Francisco discusses "unconventional strategies available to the Fed." Rudebusch writes: "A transparent commitment to a positive inflation objective may help prevent inflationary expectations from falling too low, which could help forestall any excessive decline in inflation directly."

Exactly what is the meaning of this statement? One could argue that Rudebusch says having a positive objective (a clear and definite plan) is a good idea. I'm sure it is a good idea, but that's not what Rudebusch is saying. He is talking about positive inflation as an objective: a commitment to keep prices going up. As opposed to negative inflation, or deflation, or a depression-style free-fall of prices. Note that Rudebusch wants to "forestall any excessive decline in inflation," and hopes to "prevent inflationary expectations from falling too low." Price stability is a distant second on the Fed's list of priorities.

The view that favors inflation is rooted, I think, in the idea that inflation and growth go together. It is rooted in the desperate hope that if we have inflation then we must be getting some growth out of this tired old economy. It is a false hope. And I am not first to say such a thing. In the New York Times of 31 December 1933, John Maynard Keynes called the idea a technical fallacy. Keynes wrote:

"When more purchasing power is spent, one expects rising output at rising prices.... [But] too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension of the part prices can play in the technique of recovery."

The Fed's willingness to set aside its concern with inflation shows that the Fed sees the current recession as a very grave threat, a more serious threat than inflation. Anyway, they can print all the money they want and it won't cause inflation until people start spending. (It's a velocity thing.) But when the economy finally does start growing again, look out! When people decide they're ready to spend, that's when all that new money will start pushing prices up.

Until that happens though, the Fed is doing a dirty job that has to be done. Yeah, it would be better to add a trillion (or two) gradually. And yeah, maybe "gradually" means not "in a year" but "over two or three decades." But it is too late for that now. When the economy went into its excessive-credit phase, speculative profits became irresistible. Deals that sounded to good to be true (such as those offered by Bernie Madoff) became irresistible. Everybody wanted a piece of it. Everybody was making money off it. Nobody wanted to stop it. Yeah, it would be better if we stopped it then. But nobody wanted to stop it, then. Eventually, it stopped itself.

Anyway, here we are now, and central banks are printing money like crazy. It's happening, like it or not, justified or not. So how are we going to minimize the inflation when the time comes? How are we going to protect the value of the dollar and the standing of the United States in the world economy? Remember, it is not the printing that causes inflation, but the spending.

How do we prevent the inflation? We have a few options. The Reserve Requirement (RR) should be higher, so that banks have to keep more money in reserve where it can't cause an increase in spending, and also so they always remain liquid, so that they are not vulnerable to credit crises. The RR is very low now, far lower than it should be. It must be raised only gradually. But it must be raised.

Banks don't like the Reserve Requirement because it costs them money. But the Fed also has the power to pay interest on bank reserves, and the banks do seem to like that. Control over the rate of interest paid on reserves significantly increases the Fed's control over the level of bank reserves. Together, the reserve requirements and interest on bank reserves give the Fed a powerful way to control velocity, the growth of spending, and the level of prices. The decision to pay interest on reserves was a stroke of pure genius.

And the Federal Reserve can sell some of its holdings of Treasury Bills, which would take some of that newly printed money out of circulation. (By the way, if the Fed is buying T-Bills, it should buy them directly from the Federal Government. This way the newly printed money would go directly into the Treasury where it could be used to pay for the stimulus package. As the Federal Reserve is more concerned about economic recovery than price stability, they surely believe the stimulus is needed. The Fed should put its money where its mouth is.)

And there is something else that can be done to help prevent the inflation. This is new. Spending is a combination of cash and credit use. The spending that led to the credit crisis was a combination heavy on credit and light on cash. Now central banks are printing unprecedented quantities of new cash. My idea is this: We need only adjust the mix of cash and credit-in-use to make room for the newly printed money by cutting back on the use of credit.

This should make everybody happy who thinks we have too much debt, and everybody who wants to minimize inflation. And that's just about everybody, I should think.

There is a certain level of spending that is "just right" for the economy, based to the size of the economy. We can achieve that level of spending with a little cash and lots of credit. Or we can achieve it with more cash and less use of credit. Most people would probably prefer the latter. So, let's take advantage of current events and use the opportunity to reduce the use of credit in this economy.

Our fate is in the hands of our lawmakers. Will Congress pass tax law to accelerate the repayment of debt? Will they eliminate the business tax deduction for interest expenses? Will they revise the law that put an excessively low upper-limit on the Reserve Requirement? Will they stop doing everything they can think of, to increase our use of credit?

From page 10 of the NAE.pdf:

We cannot wait to see how far the economy falls. Every inch it falls will take yards and yards of government spending to gain it back. And that is a problem: For where will the money come from?

The money can come—the money should come—from the pool of funds the Federal Reserve has been withholding for half a century and more. The Fed can double the quantity of money-in-circulation on a whim. Of course, accepted theory says you can’t do that because it will cause inflation. But then, accepted theory ignores monetary imbalance. If we gradually double the quantity of money-money relative to output—and at the same time cut in half the quantity of credit-money that is created from money-money—then we have done nothing inflationary to the money supply. But we’ve reduced the growth of debt. We’ve reduced our reliance on credit. And we’ve reversed the trend of monetary imbalance.

And from page 11 of the NAE.pdf:

The Federal Reserve can provide the funds for the massive spending needed to prevent a second Great Depression. But if it does, it is absolutely essential to restrict the growth of credit use, so that total-currency-in-circulation grows at a non-inflationary rate.

Arthur Shipman, 22 March 2009