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