The White House's latest attempt to scapegoat rising prices ignores everything that happened before the past three weeks.
Ten months ago, Jeremy Siegel issued a dire warning about the trajectory of prices.
“The money supply since the beginning of the pandemic, so a little over a year, has gone up almost 30 percent. Now, that money is not going to disappear. That money is going to find its way into spending and into higher prices,” Siegel, a professor of finance at the University of Pennsylvania’s Wharton School, told CNBC during an interview on May 14. “Over the next two, three years we could easily have 20 percent inflation with this increase in the money supply.”
He was hardly the only one sounding the alarm. A few months earlier, before Congress approved President Joe Biden’s $1.9 trillion American Rescue Plan, several prominent economists had warned that the stimulus bill—the third major one passed since the outbreak of COVID-19 just a year earlier—was too big and threatened to overheat the economy.
Among the critics were people like Lawrence Summers, who served as Treasury Secretary during the Obama administration. “There is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation,” Summers warned in a Washington Post op-ed in February 2021. “Administration officials’ dismissal of even the possibility of inflation, and the difficulties in mobilizing congressional support for tax increases or spending cuts, there is the risk of inflation expectations rising sharply.”
“I think we do not need to spend $1.9 trillion…and we should have a smaller program,” Olivier Blanchard, the former chairman of the International Monetary Fund, wrote on Twitter in response to Summers’ op-ed. Biden’s plan to shovel another $1.9 trillion into the economy was coming on top of unprecedented fiscal stimulus and high personal savings rates (due to the pandemic). Americans were already poised to spend a lot more money chasing the same amount of goods as the pandemic waned, and the increase in demand would require impossible levels of output to match. “Strong inflation” would be the natural result, he warned.
“This would not be overheating,” he wrote. “It would be starting a fire.”
By July, a few months after the American Rescue Plan passed, economists surveyed by The Wall Street Journal said Americans should be bracing for levels of inflation not seen in more than 20 years. That dire prediction was an underestimation.
This history matters because the White House’s latest attempt to explain away inflation rates that have hit their highest levels in 40 years is to blame Russian President Vladimir Putin, and the war he has started in Ukraine, for the whole mess. After the Labor Department released new data last week showing that inflation had jumped to 7.9 percent over the past year, the White House responded with a statement claiming that “today’s inflation report is a reminder that Americans’ budgets are being stretched by price increases and families are starting to feel the impacts of Putin’s price hike.”
The argument is that Russia’s invasion of Ukraine—and the global response to it, which has included cutting off purchases of Russian oil and gas—are pushing prices higher throughout the economy. “Make no mistake, the current spike in gas prices is largely the fault of Vladimir Putin and has nothing to do with the American Rescue Plan,” Biden said Friday.
It’s true that gas prices have spiked dramatically in the weeks since Russian troops invaded Ukraine. But Biden’s attempt to pin a year of steadily rising prices on the events of the past few weeks makes little sense.
For one thing, last week’s report from the Labor Department showing that inflation had hit 7.9 percent looked at prices from February 2021 through February 2022. Putin’s invasion of Ukraine began on February 24, so the White House is asking you to ignore 361 days of data in order to focus on what happened during the last four.
It’s certainly possible that the war in Ukraine—and the disruptions it has caused to global fuel and food supply chains—will put more upward pressure on prices. But that information won’t be visible in the government’s official data until the next consumer price index report is released in early April.
What about Biden’s more narrow claim: that rising gas prices are largely to blame for inflation. It’s true that higher gas prices will push other prices higher as a result—because higher fuel prices make it more expensive to ship anything from place to place. And the White House is correct that energy prices are rising faster than prices overall. Overall energy prices are up 25.6 percent since last year, and gasoline prices are up 38 percent, according to the Labor Department’s most recent data (which, again, captures prices through the end of February).
But if that’s all Putin’s fault, how do you explain the fact that energy prices—and gasoline prices, specifically—had been rising faster than just about anything else for much of the past year? In November, the Labor Department reported that energy prices were up 33 percent and gasoline prices up 58 percent over the previous year. In August, those numbers were 25 percent and 42 percent, respectively. What’s happening here seems to run a lot deeper than the events of the past few weeks.
“Yes, Putin’s invasion is making a huge difference. But demand for gasoline surged much earlier when consumers, with money in the bank and uninterested in flying because of COVID-19 concerns, put family cars on the road in the midst of the great COVID shutdown, making the number of miles traveled in spring 2021 rise to new heights,” wrote Bruce Yandle, former executive director of the Federal Trade Commission and economist at the Mercatus Center, last week in Reason.
Finally, this brings us back around to the economists who were warning last year that Biden’s stimulus bill would be a recipe for high inflation. It’s unlikely that Siegel, Summers, and the rest had a crystal ball that could predict Russia’s invasion of Ukraine.
What they were predicting—and, indeed, what we are now seeing—was persistently rising prices due to an excessive amount of money being dumped into the economy. Any attempt by the Biden administration to explain inflation that doesn’t include a hard look at its own policies is simply dishonest.
Since the global financial crisis, and particularly during the COVID-19 pandemic, fiscal and monetary policymakers have operated as if there are no tradeoffs to their expansionary policy programs. Now that economic conditions have changed, they may soon have to relearn old lessons the hard way.
Smart economic policymaking invariably requires trading off some pain today for greater future gains. But this is a difficult proposition politically, especially in democracies. It is always easier for elected leaders to indulge their constituents immediately, on the hope that the bill will not arrive while they are still in office. Moreover, those who bear the pain caused by a policy are not necessarily those who will gain from it.
That is why today’s more advanced economies created mechanisms that allow them to make hard choices when necessary. Chief among these are independent central banks and mandated limits on budget deficits. Importantly, political parties reached a consensus to establish and back these mechanisms irrespective of their own immediate political priorities. One reason why many emerging markets have swung from crisis to crisis is that they failed to achieve such consensus. But recent history shows that developed economies, too, are becoming less tolerant of pain, perhaps because their own political consensus has eroded.
Financial markets have become volatile once again, owing to fears that the US Federal Reserve will have to tighten its monetary policy significantly to control inflation. But many investors still hope that the Fed will go easy if asset prices start to fall substantially. If the Fed proves them right, it will become that much harder to normalize financial conditions in the future.
Investors’ hope that the Fed will prolong the party is not baseless. In late 1996, Fed Chair Alan Greenspan warned of financial markets’ “irrational exuberance.” But the markets shrugged off the warning and were proved correct. Perhaps chastened by the harsh political reaction to Greenspan’s speech, the Fed did nothing. And when the stock market eventually crashed in 2000, the Fed cut rates, ensuring that the recession was mild.
In a testimony to the congressional Joint Economic Committee the previous year, Greenspan argued that while the Fed could not prevent “the inevitable economic hangover” from an asset-price boom, it could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.” The Fed thus assured traders and bankers that if they collectively gambled on similar assets, it would not limit the upside, but it would limit the downside if their bets turned bad. Subsequent Fed interventions have entrenched such beliefs, making it even harder for the Fed to rein in financial markets with modest moves. And now that much more tightening and consequent pain may be needed, a consensus in favor of it might be harder to achieve.
Fiscal policy is also guilty of peddling supposedly painless economic measures. Most would agree that the pandemic created a need for targeted spending (through extended, generous unemployment benefits, for example) to shield the hardest-hit households. But, in the event, the spending was anything but targeted. The US Congress passed multi-trillion-dollar bills offering something for everyone.
The Paycheck Protection Program (PPP), for example, provided $800 billion in grants (effectively) for small businesses across the board. A new study from MIT’s David Autor and his colleagues estimates that the program helped preserve 2-3 million job-years of employment over 14 months, at a stupendous cost of $170,000-$257,000 per job-year. Worse, only 23-34% of this money went directly to workers who would otherwise have lost their jobs. The balance went to creditors, business owners, and shareholders. All told, an estimated three-quarters of PPP benefits went to the top one-fifth of earners.
Of course, the program may have saved some firms that otherwise would have collapsed. But at what cost? While capitalists anticipate profits, they also sign up for possible failure. Moreover, many small businesses are tiny operations without much organizational capital. If a small bakery had to close, the economic fallout would have been mitigated by the enhanced unemployment insurance. And if it had a loyal clientele, it could restart after the pandemic, perhaps with a little help from a bank.
The standard line is that the unconstrained spending was driven by a sense that unprecedented times called for unprecedented measures. In fact, it was the response to the 2008 global financial crisis that broke the previous consensus for more prudent policies. Lasting public resentment that Wall Street had been helped more than Main Street motivated politicians in both major parties to spend with abandon when the pandemic hit. But targeted unemployment benefits were associated with the Democrats, leaving Republicans seeking wins for their own constituencies. Who better to support than small businesses?
While political fractures were driving up untargeted spending, budget hawks were nowhere to be found: Their voices had been steadily drowned out by economists. In addition to the cranks who show up periodically to advocate ostensibly free lunches through money-financed spending, a growing chorus of mainstream economists had been arguing that prevailing low interest rates gave developed countries significantly more room to expand fiscal deficits. Politicians who were eager to justify their policies ignored these economists’ caveats – that spending had to be sensible, and that interest rates had to stay low. Only the headline message mattered, and anyone suggesting otherwise was dismissed as a hair-shirt fanatic.
Historically, it has been the Fed’s job to take away the monetary punch bowl before the party gets frenzied, and Congress’s job to be prudent about fiscal deficits and debt. But the Fed’s desire to spare the market from pain has driven more risk-taking, and reinforced expectations of further interventions. The Fed’s actions have also added to the pressure on Congress to do its bit for Main Street, which in turn has led to inflation and a belief that the Fed will back off from raising rates.Sign up for our weekly newsletter, PS on Sunday
All of this makes a return to the previous consensus more difficult. When the Fed does raise rates significantly, the government’s costs of servicing the debt from past spending will limit future spending, including on policies to reduce inequality (which has fueled political fragmentation), combat future emergencies, and tackle climate change.1
Every economy has a limited reservoir of policy credibility and resources, which are best used to mitigate genuine economic distress, not to shield those who can bear some pain. If everyone wants a free lunch, the bill eventually will be paid by those least able to afford it. Emerging-market economies have had to learn this the hard way. Developed countries may have to learn it again.
The inflation pot is boiling, and Secretary Yellen has poured gasoline on the fire.
Last week’s announcement that the Federal Reserve is gearing up for a round of tightening in response to runaway inflation raised the question: Where did this inflation mess come from? To some extent, we might stop to blame the word “modern.” That word used to be grand; you would be happy to have a kitchen filled with modern appliances, or to be a modern man. But today, the word has become a weapon wielded by cancel culture’s activists. In economics, the most infamous use of the word is in the creation of “modern monetary theory” (MMT), which suggests that the government can just print money to finance runaway expenditures. There is a strong case to be made that inflation is spinning out of control right now in large part because of MMT.
MMT is to blame for two reasons. First, Democrats embraced MMT at the beginning of the Biden administration and then passed astonishingly large spending increases when the economy was near full employment. This was true at the fringe, where Representative Alexandria Ocasio-Cortez and Senator Bernie Sanders explicitly referenced the theory, but also in the establishment, where Janet Yellen asserted that it was important to “go big” with spending because inflation was easy to control. Second, if markets began to believe that policy-makers truly embraced MMT, they would expect more inflationary policies in the future. This would remove the expectations anchor that has stabilized inflation for decades. (The link between fiscal policy and inflation has been extensively explored by our own John Cochrane here and here.)
As we look ahead to a year of Federal Reserve tightening, the effectiveness of the central bank’s policy will depend both on the interest-rate sensitivity of economic activity and on the Federal Reserve’s ability to restore markets’ faith in the commitment of policy-makers to policies that restore price stability. For that, they need the Biden administration’s help. In other words, if we want to whip inflation now, the Democratic threat of continuing to use MMT as an excuse for runaway spending must be addressed as well, lest expectations be completely unmoored.
Against this backdrop, one would have to classify Treasury Secretary Janet Yellen’s Davos speech as one of the most serious policy threats to the future of our economy launched by a treasury secretary. In it, she introduced the idea of “modern supply-side economics” MSSE — unfortunately for Yellen, this will forever be (appropriately) pronounced “messy.” Indeed, instead of rejecting the word modern to address the expectations crisis, the administration is recklessly spreading it like inflationary fertilizer.
What is “modern” supply-side economics? According to Secretary Yellen it begins with the rejection of traditional Reaganesque supply-side economics that advocates a policy focus on stimulating capital formation through low taxes and deregulation. “Significant tax cuts on capital have not achieved their promised gains,” the secretary said in the speech. “And deregulation has a similarly poor track record.” On this assertion, the treasury secretary is factually challenged. As documented extensively in the 2018 and 2019 Economic Reports of the President, the academic literature decisively supports traditional supply-side economics, as does the evidence after the Trump tax cuts. Secondly, the literature and evidence also strongly support the view that deregulation has large positive economic effects.
Continuing her journey away from the facts, Yellen adds that “this approach has deepened disparities in income and wealth by shifting the burden of taxation away from capital and towards labor,” ignoring the fact that income inequality declined sharply after the Trump tax cuts.
So what’s to replace this “failed” theory? President Biden’s Build Back Better plan, evidently. Yellen argues that the bill, which doubles down on the idea that government spending can “go big,” will deliver economic growth that isn’t “just focused on achieving a high top-line growth number that is unsustainable — we are instead aiming for growth that is inclusive and green.”
Yellen then cites four agenda items that exemplify the “modern” version of the theory. The first is the enormous expansion of child-care expenditures in the BBB plan. This, she argues, will increase the labor supply because parents can go back to work supported by almost free child care. The second is the commitment to large increases in federal spending on training and education — despite the remarkable dearth of evidence that either has a positive effect on productivity. The third is the continued interest in ever more infrastructure spending. This, at least, plausibly has supply-side effects — Arthur Laffer himself never argued against bridges, so this leg of the stool hardly deserves the moniker “modern.” Finally, she argues for a higher corporate-tax burden, ignoring the literature on the negative effects it has on supply and, accordingly, on inflation.
In other words, “modern supply-side economics” is just a “messy” corollary of modern monetary theory. If you want to deliver a strong economy, let the government finance enormous spending with the printing press and high taxes. These policies, of course, will not have the desired effect, but they will run the risk of dramatically increasing inflation expectations — even if they’re not enacted. After all, Democrats may well be able to enact this agenda in the future, and, in the meantime, they will choose the members of the Board of Governors of the Federal Reserve.
Since the days of Alexander Hamilton, it has been the role of the treasury secretary to defend the value of U.S. debt — including, as Secretary Robert Rubin did so effectively, reminding Congress of the risks of runaway spending.
No more. The inflation pot is boiling, and Secretary Yellen has poured gasoline on the fire.
It has long been an open secret that the Biden administration has adopted, hook line and sinker, the hard-line positions of the progressive wing of the Democratic Party. Nowhere is that more apparent than in two recent developments that threaten to make mischief at both the Securities and Exchange Commission and the Federal Reserve Bank—perhaps the two most powerful regulators of financial markets.
The two major initiatives are, first, to increase the control that the SEC exerts over nonpublic corporations, and second, to increase the authority of the Federal Reserve over activities affecting climate change. Thus Allison Lee, now an SEC commissioner, first appointed by President Trump as one of the Democrat commissioners and then reappointed by President Biden, is determined to bring to heel private corporations—those that are not listed on public exchanges like the New York Stock Exchange or NASDAQ. She wants to both require extensive disclosure of their financial operations and restrict their access to capital, reversing a Trump-era decision that went the other way. Next, Biden has nominated Sarah Bloom Raskin, a Duke Law School professor, to serve in a key position at the Federal Reserve as vice chairman for supervision. Raskin’s top goal appears to be strengthening the Fed’s role in promoting climate change regulation through its oversight function for banks.
Both moves are deeply problematic.
Turn first to the SEC’s effort to expand its control over private corporations. Commissioner Lee’s case starts with the simple proposition that private capital markets have raised huge pools of fresh capital without any public oversight whatsoever. By appealing only to wealthy investors, new firms are able to avoid the extensive costs and liabilities associated with going public, and subsequently being subjected to constant oversight by the SEC and the public exchanges. As a matter of first principle, there is no ideal way to determine the proper mix of public and private companies, because each has advantages over the other. One common pattern is for companies to start small and private and then grow into unicorns with $1 billion or more in assets. There are about four hundred of these businesses in the United States, and nearly nine hundred worldwide. Once these companies thrive, the original investors can either cash out or retain their shares when the company goes public, allowing the growing firm greater access to capital markets.
For many years this trend has been slowing down, creating the unfortunate situation in which individuals with the skills and wealth to run new ventures have found it more difficult to move out of relatively low-risk firms to free up capital to start the cycle anew with another set of private firms. Fortunately, the willingness in the post-COVID age to go public has increased substantially, but there were still far fewer public corporations in 2021(about 4,200) than there were in 1997 (about 7,200). Public oversight is in general far too onerous.
Hence the question arises: why does SEC Commissioner Lee want to regulate these private corporations by forcing them to reveal information on a biennial basis? Normally, the claim for additional regulation should follow on the heels of some well-identified market failure. But Lee points to no such failure in the private equity markets that continue to thrive. Instead, she makes this startling claim: “When they’re big firms, they can have a huge impact on thousands of people’s lives with absolutely no visibility for investors, employees and their unions, regulators, or the public.”
This charge makes no sense at all. Her use of the term “investor” contains a deliberate ambiguity. The investors in each of these firms are contractually entitled to receive relevant information. And there is no reason why the general investment community should be entitled to information about the internal operations of any firm in which they have no stake. The same ambiguity covers employees. Those who work for the firm will get information on wages and benefits. The employees of other firms should receive nothing at all. The current labor law, moreover, contains detailed rules that establish that “[an] employer has a statutory obligation to provide requested information that is potentially relevant and will be of use to a union in fulfilling its responsibilities as the employees’ exclusive bargaining representative, including its grievance-processing duties.” Private corporations are not exempt. These corporations are also subject to multiple disclosure regimes as part of their ordinary business obligations, such as making loans or issuing insurance policies. And it is downright dangerous to encourage widespread disclosures, as that information often contains trade secrets that are of great interest to competitors but of little relevance to the public at large, which has direct access to the price and quality of the goods and services offered for sale.
What makes this especially galling is that the SEC does not have an unmoored authority to regulate, as Lee claims, in the “public interest.” As Bernard Sharfman of George Mason University has written, “Whenever the term ‘in the public interest’ appears in the [security] Acts, the term ‘for the protection of investors’ is almost always sure to follow.” Without that connection the SEC can move with impunity to regulate the entire economy, including private corporations whose sophisticated investors are well able to protect themselves. No principle of deference should ever allow the SEC to unilaterally expand the scope of its jurisdiction.
The question of mission creep is equally apparent in the looming fight over the Raskin nomination. The Fed’s mission is “[c]onducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of maximum employment and stable prices.” The “in pursuit” language is a source of real uneasiness because is unclear how the Fed’s ability to deal with interest rates allows it to obtain “maximum employment.” On employment, direct regulation, or (better) deregulation, of labor markets is a far more efficient way to proceed, and it eliminates the need to resolve difficult question when the objectives of monetary policy and full employment clash. A single instrument—the control of the quantity of money—cannot be sensibly pressed into service to mediate between two conflicting ends.
The situation will not get any better if the Fed injects itself further into climate policy by seeking to shift the balance of returns from carbon-intensive investments to other forms of energy, which is why the confirmation battle over Raskin is so important. Nothing that she has ever said or written indicates any awareness of the complex trade-offs that are needed in dealing with energy issue. She is just gung-ho when she writes that regulators “need to ask themselves how their existing instruments can be used to incentivize a rapid, orderly, and just transition away from high-emission and biodiversity-destroying investments,” without once asking whether various improvements in the production and distribution of fossil fuels could be better than the blunderbuss approach that she apparently favors.
Yet the warning signs of energy breakdown are everywhere, given the evident difficulties of both wind and solar energy, which today can operate only because of massive subsidies in cash and in-kind — but only when the wind blows and the sun shines. Climate change is best addressed by some mix of private initiatives by corporations in the management of their own supply chains and regulators who deal with the emissions directly. Even without Raskin, Fed head Jerome Powell already takes it as his mission to starve the fossil-fuel companies of the capital that they need to survive, even as coal consumption worldwide continues to increase, especially in China, which today produces about nine times the amount of coal produced in the United States. The Fed, however, has no jurisdiction over China. Thus, its effort to rebalance the US energy portfolio will have little or no effect on the global output of coal or any resulting changes in global temperatures.
Yet its focused actions can wreak havoc not only in oil but also in natural gas. Just that grim transformation is evident in both Great Britain and Germany. Ironically, the inefficiency of solar and wind energy has forced Germany to increase its reliance on dirty coal—yet another application of the law of unintended consequences.
And matters are still worse from a geopolitical perspective, given that the constriction in fossil-fuel products from both the United States and the EU gives the whip to Vladimir Putin, from whom no public-spirited action has ever taken place, or ever will. Energy prices throughout the United States are already on the rise, and this country, already in the throes of an inflation spiral, could easily be next in line for major dislocations if Powell and Raskin have their way. It is a huge mistake to think that stopping the use of efficient fossil fuels, especially natural gas, is the path toward climate control.
So in both cases progressive policies make the common error. Mission creep is dangerous. The SEC should lay off private corporations; and the Fed, which already has too many things on its plate, should stay out of the energy and credit business. It is far superior to do one thing well than to do many things badly. The Senate should understand that a little humility is needed in the selection of powerful positions in the Fed, and turn down the Raskin nomination.
Policymakers should be cautious about adding more to the national debt and the money supply.
The sharp increase in consumer prices this spring may be a blip but may also be a sign that inflation is returning as a chronic problem. For those of us who can accurately recall the 1970s economy, it is a frightening prospect. Everyone else would benefit from reading contemporaneous news coverage.
Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.
Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.
Like 2021, the post-election year of 1965 saw the inauguration of an ambitious unified Democratic government. That year, Congress enacted Medicare and Medicaid, began providing federal aid to local school districts, and greatly expanded federal housing programs. At the same time, the Johnson administration was expanding U.S. involvement in Vietnam, increasing the defense budget. The federal budget deficit expanded from $1.6 billion in the 1965 fiscal year (which ended on June 30 in those days) to $27.7 billion, or 3% of GDP, in fiscal 1968.
Although the Federal Reserve made some attempts to ward off inflation, it generally accommodated the government’s fiscal policy according to Allan Meltzer’s detailed history of this period published by the St. Louis Fed. Between calendar years 1965 and 1969, annual CPI growth surged from 1.6 percent to 5.5 percent, setting the stage for the Nixon administration’s closure of the U.S. Treasury’s gold window and imposition of wage and price controls. Inflation reached double digits in 1974 and again between 1979 and 1981. Notably, these were also recession years, refuting the fallacy of the Phillips Curve, which depicted a supposed policy trade-off between inflation and unemployment. By the early 1980s, we had ample evidence that ill-considered policies could give us a combination of high inflation and unemployment, known back then as “stagflation.”
This policy mix was also not great for equity investors. The Dow Jones Industrial Average moved sideways during the inflationary period, closing at the same level in December 1982 as it did in January 1966. One lesson from that period was that high interest rates can be bad for stocks.
That may be one reason the Fed remains reluctant to allow interest rates to rise today. Although messaging from the latest Federal Open Market Committee meeting showed greater willingness to normalize interest rates, action is not expected until 2023.
Rate hikes may bring other worries for the Fed in today’s environment. Given the large volume of variable rate mortgages and corporate loans outstanding in the U.S. today, a rise in interest rates could push highly indebted homeowners and companies into bankruptcy, potentially triggering a recession. The federal government would have to roll over its record stock of short-term debt at higher interest rates, ballooning its interest expense and potentially crowding out more popular spending priorities.
But if private capital is to continue participating in debt capital markets, such as those for corporate bonds and bank loans, interest rates will have to rise to compensate them for the loss of purchasing power on their principal.
Although annual growth in CPI fell sharply after 1982, it is not strictly correct to say that inflation was defeated. Except for a few years around the turn of the century, the federal government continued to run deficits, a portion of which were monetized. Notably, the government began running trillion dollar deficits, and the Fed drove interest rates down to near zero during the Great Recession, but CPI growth remained muted.
But CPI does not tell the whole story. Some sectors of the economy have experienced substantial inflation, but they are not fully incorporated in the consumer price index. Home prices, healthcare costs and college tuition all soared in recent decades. Meanwhile, apparel and consumer electronics remained affordable due to globalization and improved technology.
Back in the 1970s, most of the world was not part of the global economy. Eastern Europe was in the Soviet bloc, while China, Vietnam and India had yet to become major exporters. As more low-cost producers of goods and services came online during the 1980s and 1990s, prices were pushed downward (often and regrettably at the expense of American manufacturing jobs). The trend toward developing countries joining the international trading system and producing inexpensive consumer goods is now over. Indeed, the recent increase in protectionism is, if anything, rolling back the wave of international price competition.
On the other hand, technological improvements may continue to shield us from inflation in certain sectors. For example, the displacement of human cashiers by automated check stands might restrain price hikes at the big box retailers, supermarkets, fast food chains and other establishments that can afford to invest in them. Smaller businesses, facing higher wages, may have to try to pass them through to consumers in the form of higher prices. Already in some parts of the country, restaurants are trying to recoup costs without raising prices on their menus by adding various surcharges ostensibly tied to specific costs.
It is possible that inflation is now moving from assets and human-intensive services to consumer products, but we will need several months of additional data to know for sure. Meanwhile, policymakers should be cautious about adding more to the national debt and the money supply.
The following is adapted from John H. Cochrane’s remarks at the European Central Bank’s Conference on Monetary Policy: Bridging Science and Practice. His full presentation about the challenges facing central banks is here.
Central banks are rushing headlong into climate policy. This is a mistake. It will destroy central banks’ independence, their ability to fulfill their main missions to control inflation and stem financial crises, and people’s faith in their impartiality and technical competence. And it won’t help the climate.
In making this argument, I do not claim that climate change is fake or unimportant. None of the following comments reflect any argument with scientific fact. (I favor a uniform carbon tax in return for essentially no regulation, but this essay is not about carbon policy.)
The question is whether the European Central Bank (ECB), other central banks, or international institutions such as the International Monetary Fund, the Bank for International Settlements, and the Organization for Economic Co-operation and Development should appoint themselves to take on climate policy—or other important social, environmental, or political causes—without a clear mandate to do so from politically accountable leaders.
The Western world faces a crisis of trust in our institutions, a crisis fed by a not-inaccurate perception that the elites who run such institutions don’t know what they are doing, are politicized, and are going beyond the authority granted by accountable representatives.
Trust and independence must be earned by evident competence and institutional restraint. Yet central banks, not obviously competent to target inflation with interest rates; floundering to stop financial crisis by means other than wanton bailouts; and still not addressing obvious risks lying ahead; now want to be trusted to determine and implement their own climate change policy? (And next, likely, taking on inequality and social justice?)
We don’t want the agency that delivers drinking water to make a list of socially and environmentally favored businesses and start turning off the water to disfavored companies. Nor should central banks. They should provide liquidity, period.
But a popular movement wants all institutions of society to jump into the social and political goals of the moment, regardless of boring legalities. Those constraints, of course, are essential for a functioning democratic society, for functioning independent technocratic institutions, and incidentally for making durable progress on those same important social and political goals.
It’s Not About Risk
The European Central Bank and other institutions are not just embarking on climate policy in general. They are embarking on the enforcement of one particular set of climate policies—policies to force banks and private companies to defund fossil fuel industries, even while alternatives are not available at scale, and to provide subsidized funding to an ill-defined set of “green” projects.
Let me quote from ECB executive board member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends that
[f]irst, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures. . . .
Let me point out the unclothed emperor: climate change does not pose any financial risk at the one-, five-, or even ten-year horizon at which one can conceivably assess the risk to bank assets. Repeating the contrary in speeches does not make it so.
Risk means variance, unforeseen events. We know exactly where the climate is going in the next five to ten years. Hurricanes and floods, though influenced by climate change, are well modeled for the next five to ten years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation.
That banks are risky because of exposure to carbon-emitting companies; that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture; that banks need to be regulated away from that exposure because of risk to the financial system—all this is nonsense. (And even if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financialproblem.)
Next, we contemplate a pervasive regime essentially of shame, boycott, divest, and sanction
[to] link the eligibility of securities . . . as collateral in our refinancing operations to the disclosure regime of the issuing firms.
We know where “disclosure” leads. Now all companies that issue debt will be pressured to cut off disparaged investments and make whatever “green” investments the ECB is blessing.
Last, the ECB is urged to print money directly to fund green projects:
We should also consider reassessing the benchmark allocation of our private asset purchase programs. In the presence of market failures . . . the market by itself is not achieving efficient outcomes.
Now you may say, “Climate is a crisis. Central banks must pitch in and help the cause. They should just tell banks to stop lending to the evil fossil fuel companies, and print money and hand it out to worthy green projects.”
But central banks are not allowed to do this, and for very good reasons. A central bank in a democracy is not an all-purpose do-good agency, with authority to subsidize what it decides to be worthy, defund what it dislikes, and force banks and companies to do the same. A central bank, whose leaders do not regularly face voters, lives by an iron contract: freedom and independence so long as it stays within its limited and mandated powers.
The ECB in particular lives by a particularly delineated and limited mandate. For very good reasons, the ECB was not set up to decide which industries or regions need subsidizing and which should be scaled back, to direct bank investment across Europe, to set the price of bonds, or to print money to subsidize direct lending. These are intensely political acts. In a democracy, only elected representatives can take or commission such intensely political activities. If I take out the words “green,” the EU member states, and EU voters, would properly react with shock and outrage at this proposal. If the ECB bought different countries’ bonds at different prices and in different quantities to reward those making greater progress on “green” policy implementation, there would likely be an outcry.
That’s why this movement goes through the convolutions of pretending that defunding fossil fuels and subsidizing green projects—however desirable—has something to do with systemic risk, which it patently does not.
That’s why one must pretend to diagnose “market failures” to justify buying bonds at too high prices. By what objective measure are green bonds “mispriced” and markets “failing”? Why only green bonds? The ECB does not scan all asset markets for “mispriced” securities to buy and sell after determining the “right” prices.
Here are two interpretations of the ECB’s proposal:
One: we looked evenhandedly at all the risks to the financial system, and the most important financialrisk we came up with just happens to be climate.
Two: we want to get involved with climate policy. How can we shoehorn that desire into our limited mandate to pay attention to financial stability?
Who Gets the Green Light?
How should we judge the proposal? I think it’s pretty obvious that the latter interpretation is true—or at least that the vast majority of people reading the proposal will interpret it as such. Feeding this perception is the central omission of this speech: any concrete description of just how carbon sins will be measured.
At face value, “carbon emitting” does not mean just fossil fuel companies but cement manufacturers, aluminum producers, construction, agriculture, transport, and everything else. Will the carbon risk and defunding project really extend that far, in any sort of honest quantitative way? Or is “carbon emitting” just code for hounding the politically unpopular fossil fuel companies?
In the disclosure and bond buying project, who will decide what is a green project? Already, cost-benefit analysis—euros spent per ton of carbon, per degrees of temperature reduced, per euros of GDP increased—is lacking. By what process will the ECB avoid past follies such as switchgrass biofuel, corn ethanol, and high-speed trains to nowhere? How will it allow politically unpopular projects such as nuclear power, carbon capture, natural gas via fracking, residential zoning reform, and geoengineering ventures—which all, undeniably, scientifically, lower carbon and global temperatures—as well as adaptation projects that undeniably, scientifically, lower the impact on GDP? Well, clearly it won’t. The ECB is embarking on one specific kind of green policy, popular at the cocktail parties at Davos, but having little to do with cost-benefit analysis or science of climate policy.
In sum, where is the analysis for this program? I challenge the ECB to calculate how many degrees this bond buying plan would lower global temperatures, and how much it would raise GDP by the year 2100, in any transparent, verifiable, and credible way. Never mind the costs for now: where are the benefits?
And how would the ECB resist political pressure to subsidize all sorts of boondoggles? If the central bank does not have and disclose neutral technical competence at making this sort of calculation, the project will be perceived as simply made-up numbers to advance a political cause. All of the central bank’s activities will then be tainted by association.
This will end badly. Not because these policies are wrong, but because they are intensely political, and they make a mockery of the central bank’s limited mandates. If this continues, the next ECB presidential appointment will be all about climate policy: who gets the subsidized green lending, who is defunded, what the next set of causes is to be, and not interest rates and financial stability. Board appointments will become champions for each country’s desired subsidies. Countries and industries that lose out will object. This is exactly the sort of institutional aggrandizement that prompted Brexit.
If the ECB crosses this second Rubicon—buying sovereign and corporate debt was the first—be ready for more. The IMF is already pushing redistribution. The US Federal Reserve, though it has so far stayed away from climate policy, is rushing into “inclusive” employment and racial justice. There are many problems in the world. Once you start trying to shape climate policy, and so obviously break all the rules to do it, how can you resist the clamor to defund, disclose, and subsidize the rest? How will you resist demands to take up regional development, prop up dying industries, subsidize politicians’ pet projects, and all the other sins that the ECB is explicitly enjoined from committing?
A central bank that so blatantly breaks its mandates must lose its independence, its authority, and people’s trust in its objectivity and technical competence to fight inflation and deflation, regulate banks, and stop financial crises.
A Narrow Role, and Essential
Working for a central bank is a bit boring. One may feel a longing to do something that feels more important, that helps the world in its big causes. One may feel longing for the approval of the Davos smart set. Why does Greta Thunberg get all the attention? But a central bank is not the Gates Foundation, which can spend its money any way it likes. This is taxpayers’ money, and regulations use force to transfer wealth between very unwilling people. A central bank is a government agency, and central bankers are public servants, just like the people who run the DMV.
Central banks must be competent, trusted, narrow, independent, and boring. A good strategy review will refocus central banks on their core narrow mission and let the other institutions of society address big political causes. Boring as that may be.
by Andrew Huszar
I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.
Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system’s free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs. Continue reading