Friday, 31 August 2012

Harvard economist believes in magic

Yesterday, my friend Tim Coldwell sent me a copy of the Harvard economist Martin Feldstein's article at Project Syndicate, "Is Inflation Returning"?

Feldstein argues that the Fed's QE program will inevitably lead to inflationary pressures in the future, because when the new money finds its way into the real economy it will lead to a spending splurge. Frankly, at the moment a spending splurge would be a very good thing. The economic trend throughout the world is deflationary, everyone is cutting back spending, banks aren't lending and the velocity of money is dropping like a stone. The Bank of England (which Feldstein doesn't mention), which has done far more QE in relation to the size of the UK economy than the Fed in relation to the US, says that the primary purpose of QE is to maintain inflation near its 2% target and counteract DEFLATIONARY pressures. Many might dispute this, since the UK's CPI has been and remains well above target, but the BoE's quarterly inflation report shows a downwards trend and there is evidence of significant retail deflation which is not being picked up in the CPI measure because it is occurring through discounting from published prices, coupons, special offers and sales.

Many might also dispute the effectiveness of QE as a counter to deflation - by extension this also implies disputing its inflationary effect, although those who both complain about the ineffectiveness of QE and predict runaway inflation arising from it don't seem concerned by logical inconsistency. Stella and Singh argued that as QE is simply an asset swap, it has no effect on inflation. Others have noted that as most money in circulation is created through bank lending, and banks are currently restricting lending, all QE does is increase bank reserves without any great benefit to the wider economy. Conversely, the Bank of England (not surprisingly) argued recently that the UK would be in deeper recession without QE. My own view is that QE is at best a very weak stimulus and you would have to do an awful lot of it to achieve the same effect as a 50 bps cut in interest rates.

However, Feldstein is not describing an immediate inflation risk. He is looking ahead into the future when (we hope) the economy starts growing again. At that point the money created through QE would indeed be likely to create inflationary pressures in the economy, and it is the Fed's job to nip those in the bud through interest rate rises and other measures.

Feldstein believes the Fed will be unable to tighten monetary policy enough to counter the inflationary effect of QE. He notes that high unemployment rates persist throughout the Western world, and suggests that hysteresis will prevent unemployment falling to levels acceptable to politicians. Politicians will then apply pressure to prevent the Fed raising interest rates to the level needed to choke off inflation. This is really quite unfair to the Fed, which has maintained generally good control of retail price inflation for the last twenty years. The Fed does have two mandates - price stability and low unemployment - and the two might come into conflict, but that is certainly not a reason to suppose that the Fed would abandon any attempt to control inflation if unemployment remained high. Rising inflation is a disincentive to saving and investment, and in the longer run that destroys jobs. Controlling inflation is therefore an essential part of the Fed's low unemployment mandate.

There are calls for the Fed and other central banks to be brought under political control. Feldstein rightly in my view identifies this as a risk. Politicians by definition have a short-term view - their goal is always re-election - so they generally prefer policies that give short-term electoral gains at the expense of longer-term economic benefits. But in what way would preventing the Fed from controlling inflation improve their electoral chances? Well-off Americans are as terrified of inflation as the Germans, and the powerful "grey voters" have lived through a period of high inflation and remember its effects all too well. At present the political pressure is clearly in the opposite direction. The American right is arguing for tightening of both monetary and fiscal policy, ostensibly to choke off inflation that is not happening and will not happen any time soon, but I suspect actually to improve returns on capital and enable taxes to be cut for the well-off. And Feldstein is providing ammunition to their campaign. Political pressure doesn't always come from politicians.

The fact that the combination of tight monetary and fiscal policy prevents people spending and investing, and therefore inhibits growth, appears nowhere in Feldstein's analysis. Yet he clearly believes that growth would still happen if policy were tighter. I find it worrying that a Harvard professor of economics apparently believes in magic. 

And growth in the absence of adequate money supply is not the only Feldstein magical belief.  Feldstein argues that the recent rise in the gold price and rising price of agricultural land in Iowa and Illinois indicate flight to hard assets, and that this suggests that investors fear inflation. But if that is their fear, why are yields on non-indexed highly-rated government securities in negative territory? Why is there a global shortage of USTs? In short, why are investors still buying these securities if they believe the value of those investments is about to be catastrophically eroded by runaway inflation? And is there really a noticeable flight to hard assets anyway?

There is a fallacy of composition in Feldstein's assertion about agricultural land: since when has the price of land in Iowa and Illinois been a reliable indicator of the global price of agricultural land? Are there really no local effects?  And his argument about gold doesn't make too much sense either. The underlying trend in gold prices has been downwards from a peak of nearly 1900 in September 2011 (change the settings on the link to see the 1 year, 2 year and 30-day charts). Yes, in the last ten days there has been a bit of a positive spike. But a ten-day spike is not sufficient to indicate a change in the underlying trend. The gold price is traditionally volatile, and there are many possible reasons for that spike. Central banks have been buying gold for reasons that are not entirely clear: Izabella Kaminska argues that central banks are propping up the gold price, which would otherwise be falling off a cliff. Cullen Roche recently changed his investor advice for gold to "buy", because the long-term price and the risks to the economy had in his view changed sufficiently to make gold a reasonable investment choice within a diversified portfolio. Gold was recently reclassified as a zero-risk asset for the purposes of bank capital adequacy requirements, which would encourage banks to buy gold. And there might also be some investors buying physical gold as an inflation hedge, as Feldstein thinks - the inflation fear-mongers and goldbugs no doubt have some effect, and the FOMC's suggestion that more QE will be needed soon will have spooked some investors. But the effect doesn't exactly seem large, and it is really too soon to tell whether the gold price trend is reversing. Feldstein doesn't seem to have much evidence to support his claim that financial markets generally fear inflation.

Inflation is not the only risk to capital. Default is also a risk if your assets consist of someone else's debt, as most do. One thing I learned from my extensive debates with Freegolders recently is how frightened they are of counterparty risk - the risk that the borrower will simply walk off with your money, leaving you with nothing. The fact that investors are currently prepared to accept negative real returns on investments they regard as "safe" - USTs, German bunds, FDIC-insured deposit accounts - suggests that fear of counterparty default is not limited to the Freegold hyperinflationistas, but is widespread among investors. Better to suffer a small amount of capital destruction than risk losing everything for a positive return, it seems. The shadow of Lehman lies long over the American financial markets, and the Eurozone debt crisis looms large in the European markets.

On Twitter, the Berkeley economist Brad Delong asked me whether investors really fear inflation, since they don't seem to be hedging against it:
And in his own post on this matter, Delong notes that if investors really feared inflation they would be investing in index-linked securities, but there is no evidence of a flight to TIPS from other US government securities. Admittedly if the prevalent investor fear is hyperinflation, not inflation, then TIPS would not be regarded as adequate protection so would not be preferred over hard assets. But as I've already noted, there doesn't seem to be any evidence of a flight to hard assets from other "safe" investments, either.

Investors are indeed afraid - but not of inflation. In a debt-laden and deflationary economic environment, fear of default is quite sufficient to explain investor flight to "safe" assets - including, of course, gold and land, though the fact that at present there isn't a noticeable movement of funds from highly-rated government debt to hard assets suggests that investors in general still believe that their money is safe with government.

Feldstein's article is written entirely from an American perspective. So his mention of the ECB is somewhat strange. It is also very wrong. The Eurozone economy is dominated by Germany, which does not have high unemployment - but does have a paranoid fear of inflation. Unlike the Fed, the ECB has only one mandate, namely price stability (it has no mandate to control unemployment). Monetary policy in the Eurozone since 2008 has been tighter than anywhere else: it is the only major central bank that has not done QE, although its two LTROs amounted to much the same, and until recently it maintained interest rates well above the zero lower bound. And it has the Bundesbank breathing down its neck. Every time the ECB does anything slightly unconventional to loosen monetary policy, someone from the Bundesbank complains. And it is only a year since the ECB raised interest rates because of inflationary pressures in Germany, despite the mounting evidence of catastrophic deflation in the periphery. The ECB has also continually resisted attempts from the distressed peripheral countries (and France) to persuade it to finance sovereigns and recapitalise banks in contravention of its mandate: the little bond-buying and bank financing it has done has been only just sufficient to prevent deflationary collapse and protect the Euro. So Feldstein's suggestion either that the ECB would suddenly cave in to political pressure, when it has not done so throughout the debt crisis, or that Germany would suddenly choose low unemployment over inflation control, when it did not do so throughout German reunification, is yet more magical thinking on his part.

Inflation is not the main risk at the moment, and it is not what investors fear most. Feldstein is not only wrong, he is - because of his influence - dangerously wrong. The US has tightened monetary policy in a deflationary environment before. The result was the Depression.


  1. I agree with a lot of the discussion around QE, however I think this is pretty baseless;
    "The American right is arguing for tightening of both monetary and fiscal policy, ostensibly to choke off inflation that is not happening and will not happen any time soon, but I suspect actually to improve returns on capital and enable taxes to be cut for the well-off."

    One could similarly argue that Stiglitz and the left argue for reckless policy because they hope that destruction of savings and asset values will bring about a massive wealth redistribution.

    1. Tax cuts for the well-off are Republican policy. As far as I am aware, massive wealth redistribution is not Democrat policy.

    2. One could just as easily say that wanting to keep taxes low is an attempt to inspire business confidence and bolster investment. Not increases taxes is not a tax cut either.

      To ascribe the basest motives to those whose methodology we disagree with is disingenuous. One could easily argue that allowing high government spending to increase the debt load is a cynical Democrat attempt to create a massive wealth transfer from hard working savers to their constituents.

      I don't think either is the case.

      Bit of a shame because the rest of the article.

    3. BlackRaven

      I have not ascribed any "base motives" to the American right. I have simply noted that the ultimate aim of their well-publicised anti-inflation mantra is cutting taxes for the well-off - which, as I said, is Republican policy. You can interpret tax-cutting for the rich as a "good thing" (encourages investment, inspires business confidence) or a "bad thing" (deprives government of funding for social programs to help the poor) depending on your point of view. But that would be your judgement, not mine.

  2. (1/1)

    I pretty much agree with your assessment (apart from that bit about the Fed having done a bang-up job of controlling inflation for twenty years). The elephant in the room is definitely global deleveraging and the potential for widespread deflationary depression.

    Fortunately, the currencies of today are highly flexible, so at the first whiff of high demand for money (nominal consumer price disinflation) more liquidity can be (and will beis!) pumped in. Et voila - price stability (slowly rising general nominal consumer prices). Magic!

    #FOA: My friend, debt is the very essence of fiat. As debt defaults, fiat is destroyed. This is where all these deflationist get their direction. Not seeing that hyperinflation is the process of saving debt at all costs, even buying it outright for cash. Deflation is impossible in today's dollar terms because policy will allow the printing of cash, if necessary, to cover every last bit of debt and dumping it on your front lawn! (smile) Worthless dollars, of course, but no deflation in dollar terms! (bigger smile)

    Some hastily assembled exhibits for the jury to consider at leisure:

    Yellen on The Federal Reserve's Asset Purchase Program
    BoE Asset Purchase Facility

    (Clearly, I could go on… but, fortunately, I won't…)

    The deflation will be denominated in gold. There will be no dollar/euro/pound/yen/etc general consumer price deflation. As you (via Iza Kaminska) rightly point out, Central Banks are artificially pushing up the price of gold in their currencies. AKA targeted devaluation against gold, which through regression causes the markets to reassess the prices of other real commodities and goods. If and when their primary concern shifts to being significant and sustained inflation, they will once again consider selling gold - AKA targeted upvaluation against gold. Which is what happened from 1980's through to the end of the millenium, when the euro was finally ready to roll.

    They are pushing up demand for (therefore the price of) gold, in order to influence the market prices of all real goods. To stop them falling. And in the case of many Central Banks, who mark their reserves to market, higher priced gold also happens to help recapitalise their growing balance sheets. Result!


  3. (2/2)

    Getting back for a moment to that "the Fed having done a bang-up job of controlling inflation" thing…

    #Another: So, dollar hyper inflation never arrived and gold did not make it's run because world CBs bet your productive efforts on supporting the dollar reserve. In the process, the US standard of living was raised tremendously on the backs of most of the worlds working poor. But this is not about to last!

    For those twenty years, consumer prices didn't rise despite the actions of the Fed and the US Treasury. But it is not about to last! :-)

    Japan have run out of money to buy USTs with
    China don't have so many dollars to reinvest lately either
    Sometimes it seems like nobody's buying any more

    And why would they?

    China-Australia bilateral trade in yuan
    A similar China-Brazil deal
    Also China-Japan

    (Yes, I could indeed go on but, fortunately, I won't…)

    Long story short, the world is turning its back on the dollar and bilateral trade settled in one partner's own currency is the way things are going trade-wise. Reserve-asset-wise, gold is the new weapon of choice.

    The Kills - Last Day Of Magic (2008)

    1. Daren,

      The Fed's mandate is to control domestic price inflation within the US, not to control inflation around the world. Domestic price inflation has been moderated for the last twenty years in the US (except for 2008/9, obviously). You may not like the means by which that has been achieved, and you may believe that the Fed's involvement has been essentially passive. But you can't argue that domestic US price inflation hasn't been moderated. The evidence is totally against you.

    2. No, I am not arguing that domestic US price inflation hasn't been moderated. Only that it isn't as a result of the good stewardship of the Fed and US Treasury, rather in spite of their activity.

      For several decades, the Central Banks of the world have sent almost all of the copious vacationing trade deficit dollars straight back home to get back to work, in exchange for promises of them being restored to their rightful owner at some time in the future, along with a few extra friends in recognition for their patience in deferring their own consumption. Even as the promises came due, they were simply rolled over into further promises for even more recognition, for deferring their own consumption yet longer, thereby avoiding the need for the US to finally make good in delivering those many promised dollars.

      This is not about to last. So where will all the dollars come from now?

    3. Perhaps the US is going to suddenly start clearing their debts, not with copious amount of the promised freshly-minted dollars, but with large & sustained trade surpluses in goods & services?

    4. Deficits don't matter.

      Until they do.

    5. Daren,

      at present the world wants copious quantities not just of dollars but - especially - of US government debt. That's one of the points I make in the post. Until that changes the US government will not be able to cut its trade and fiscal deficits, let alone its debt.

    6. Wishing you a great weekend, Frances! ;-)

  4. This so called economist, Martin Feldstein, doesn’t understand the first thing about banking. He thinks banks lend out reserves. Hilarious. I suggest he Googles the phrase “banks do not lend reserves”. He’ll find plenty of articles to put him straight on that one.

    When the private bank system sees a series of profitable lending opportunities, it creates money out of thin air and lends it out. The Fed can pay 8%, 18% or 28% on reserves: it won’t have the slightest effect.

    And if Feldstein’s article is correct in suggesting that the Fed thinks it can constrain lending by bumping up interest on reserves, then the Fed is clueless as well. But then we already know that those in charge of the West’s economies are clueless: otherwise we wouldn’t have had a credit crunch. And having had one, we’d have escaped it long ago.

    1. I agree raising interest rates on excess reserves, as Feldman suggests, wouldn't have the desired effect. In my view negative rates on excess reserves would have more effect, since they are a tax so are by definition contractionary.

      However, raising interest rates on lender of last resort funding DOES work, because other rates such as the interbank funding rate generally track it. Banks create money when they lend, but they still have to fund deposit drawdown by borrowing from depositors, other banks or from the central bank, and if that borrowing becomes more expensive then banks are forced to raise rates to borrowers, which has a contractionary effect.

  5. I see you have veered far off course into the dreamy land of sure thought and objectivity, Francis! Next you will be saying something like the idea of an absolute truth is actually possible! Contemplate ideas spoken by Richard Rorty + his book together with the ideas of a younger analyst: "The Shape of 40 Years of Inflation"

    1. Please do me the courtesy of spelling my name correctly, and refrain from personal abuse. I will not publish any more of your comments unless you comply with this request. This comment runs very close to trolling.

  6. My apologies Frances! No rudeness was intended, I can assure you :-) I meant to highlight the fact that pursiing notions of absolute objectivity can lead otherwise exceptionally intelligent people such as yourself down blind alleys; I'm not saying you're a blind alley! If I thought as much I wouldn't have alerted you to the above links...

    Best wishes

  7. Looking at total domestic spending (private consumption, business investment, government consumption and investment)it turns out that inflation in the UK is pretty low, much lower than indicated by only the prices of consumer goods.

    Merijn Knibbe