Is Monetary Policy Helping Economic Recovery?

Published January 18, 2011

Recovery from a recession can be a tricky thing. However, it need not be. The simple approach is to identify the cause, fashion the policies that deal with the cause, and then let the market adjust without obstacles from the government. The adjustment will take time if the recession is deep.

What does not help is trying to continue the cause of the recession. When you are in a hole, “shovel-ready” digging does not help. 
The Cause
It is not an exaggeration to say most economists believe that artificial incentives for “affordable housing” led to mortgages for those not qualified and that, in turn, led to packaging of substandard mortgages and later securitization allowing the trading of the mortgage packages in derivative markets.

The Federal Reserve contributed to the problem by holding down interest rates to historically low levels. Risk hedging was handled by credit default swaps, which are also derivatives. The reason was that housing insurance is regulated by states, mainly for fire and wind damage, and the mortgage derivatives were not organized along state lines.

In short, a housing asset bubble was created. As Gerald P. O’Driscoll Jr. of the Cato Institute pointed out in the Wall Street Journal on July 7, 2010, the crisis is a Hayekian asset bubble, not a Keynesian lack of effective demand.
The Solution
The solution to the housing asset bubble is to allow the market to disinvest in housing and divert new investment into other, more productive activities. These tend to be unknown and risky, especially if subject to political scrutiny and regulation.

What is not helpful for recovery are most of the government programs that have been tried under both the Bush administration and the Obama administration.
The Government Stimuli
Government attempts to mitigate the downturn started with the first Troubled Asset Relief Program under Hank Paulson, Treasury Secretary to President George W. Bush and a former CEO of Goldman Sachs. The $700 billion plan started as a way to clean up the balance sheets of banks with nonperforming loans. The objective was to foster more lending by banks, a policy endorsed by the Hoover Institution’s John Taylor in his book, Getting Off Track (2009).

But the task proved so difficult, according to Paulson in his book On the Brink (2010), that it was soon transformed into a bailout of the large investment banks on Wall Street. The rationale at the time was that the bailout was necessary in order to prevent a cascading failure of the financial markets. That ran contrary to the prevailing view in the derivative markets that trades are to be protected, not traders. See, for example, Chicago Mercantile Exchange Chairman Emeritus Leo Melamed, For Crying Out Loud (2009), pages 251-254.
When the Obama administration took office another stimulus program was enacted. It was expected to cost $787 billion and was directed mainly toward “shovel ready” construction projects. Also adopted was a bailout of General Motors and Chrysler and their unionized workers.

The stated purpose of these programs was to create jobs and reduce unemployment. Thus far the April 2008 stimulus has not been successful. Going into 2011 the unemployment rate is stubbornly stuck at almost 10 percent. This underscores O’Driscoll’s point that the crisis is not a Keynesian lack of effective demand.
Many other programs have been proposed and enacted to stimulate demand, increase unemployment benefits, support state government employment, and reduce taxes on the middle class. Most recently the Congress, with the support of the Obama administration, enacted a new tax law. The 10 year score for the bill is $858 billion in cuts. The score for the two-year postponement of the tax increases for all income classes is on the order of $700 billion. Only a fraction of that amount is associated with incomes over $250,000.
This was a highly controversial provision in the bill. It reflects the two views of the crisis and the implied solutions. The Keynesian view emphasizes avoiding tax increases on lower incomes in order to stimulate effective demand. For the Hayekian view, the emphasis is on postponing tax increases on the higher income classes that are the sources of capital investment, to facilitate the transition of investment from the housing bubble to other sectors of the economy. The tax bill is a mix of both of these options.
Quantitative Easing 2
The latest initiative is from the Federal Reserve, called quantitative easing. It involves the Fed’s buying $600 billion in government bonds from the Treasury over eight months starting in November 2010. The intent of the Federal Reserve is to avoid deflation and create just 2 percent inflation as measured by the Consumer Price Index. Chairman Ben Bernanke has promised that if inflation shows signs of exceeding 2 percent the Fed will take countervailing action. The personal consumption expenditure index of inflation is now below 1 percent and could be zero percent within a year, according to Marc Sumerlin, former deputy director of the National Economic Council under President George W. Bush.
A point to be appreciated is that the Consumer Price Index is a historic measure, not a market outcome. Market measures indicate a greater rate of future inflation. For example, long-term interest rates, which reflect anticipated inflation, are rising. Commodity prices are rising. Gold, silver, copper, and oil prices are near record highs and have been rising sharply in the last year. The yield curve for gold futures on the Comex also indicates future rates of inflation in excess of the Fed’s 2 percent goal.
The Fed has been encouraging foreign currencies, especially the Chinese yuan, to appreciate while the U.S. dollar declines. This is designed to reduce imports to the United States and increase exports. This has upset many countries and raises the prospect of a competitive series of currency devaluations. This is reminiscent of the 1930s when the Smoot-Hawley tariff in the United States spread the Great Depression throughout the world.
Another international activity that has a similar effect is the agreement among the Group of 20 developed countries. The pact calls for an increase of bank reserves from 2 percent to 7 percent on what is deemed “risky assets.” This will make lending more difficult in a recession period, when virtually all projects are risky.

The move is similar to the Fed’s doubling of the bank reserve requirement in 1936 which, according to Milton Friedman and Anna Schwartz, was largely responsible for the sharp downturn of 1937-38. It is interesting to note that this policy is inconsistent with both the Hayekian and Keynesian prescriptions, since the higher reserve requirement makes bank credit less available to businesses.
In an interview on the December 5 broadcast of the CBS program 60 Minutes, Bernanke claimed that there has been no increase in currency, the basic component of the money supply. An examination of the Fed’s currency data, however, shows that the annualized rate of increase for the three months ending October 2010 was a substantial 9.5 percent. Later, four-month data that includes a projection for November shows an annualized rate of 9.6 percent. These data indicate that the currency component of the money supply is increasing at an increasing rate. These rapid rates cannot be ascribed to an increase in demand for money. The growth rate in GDP is just half of the increase in currency and just one-quarter of the rate for the larger M1 money supply.
Pre-Election Economic Bump
Thus we have inflation measures higher for the future than in the present. This reflects the fact that there is a lag between an injection of money by the Fed and the subsequent appearance of inflation.In his book Monetary Mischief (1994), Milton Friedman concludes from his lifelong study of monetary policy that there is a pattern in the lags. Six to nine months after an injection to the money supply, there is a short-term increase in economic activity. After 24 months, inflation appears and is persistent until money growth is slowed, another recession occurs, and  24 months  pass before the inflation is abated. 
If these lags are superimposed on the nation’s political calendar, there is a disturbing conclusion. A short-term increase in economic activity will occur before the 2012 presidential election and a virulent inflation will occur after the votes are in.
Paul to Oversee Fed
The Republican takeover of the U.S. House of Representatives in January 2011  brings Rep. Ron Paul (R-TX) to the Chair of the Subcommittee that oversees the Federal Reserve. Fed Chairman Bernanke has warned that if the Congress increases its oversight of the central bank, the Fed’s independence from political influence will be impaired.

But the political influence appears to be already present, either by accident or intention. Although Paul’s oversight may not reverse the political influence, it could reduce it. That would be a good outcome, not a dangerous one.
Jim Johnston is an economic advisor to The Heartland Institute.