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Making things more complicated than they need to be

With Quantitative Easing having poured massive amounts of cash into the economy, basic monetary theory would have inflation launch to the moon. But prices have held steady if not come down. Is monetarism wrong? No, just the picture is more complicated than the basics.

One great lever that is influencing inflation is ironically the government intervention itself. The current neo-Keynesian thinking that prevails seeks to replace private sector consumption with government consumption to keep the general economy flowing where growth is limited when consumption decreases in a recession. The QE pumped into the banks and other financial institutions is not being funneled through to consumer or business lending, and is supporting institutional balance sheets rather than eventually increasing consumption. A reflection of this is the stagnation in the securtization markets, only recently beginning to recover; this is where loans would be packaged and sold off to investors and remove the original loans from originators’ balance sheets. The lack of such risk-hedging action shows not only that the market for riskier investment vehicles is still comparatively low due to general economic conditions and regulatory uncertainty, but also the underlying loans feeding the process are not being generated in sufficient quantity to support the rebirth of that industry. QE has taken the place of private consumption that otherwise would occur in a recovering economy. Given the recent data regarding housing and employment (both home sales and hiring remain constant if not slightly negative adjusting for government stimulus) the economy is not recovering. The neo-Keynesian policy of borrow to spend drained the reservoir to aid the populace so that the tax increases recently enacted cannot be offset with more deficit spending.

Keynesian theory holds that general consumption can be sustained with government spending replacing what is lost in private consumption that results from economic contraction. That government spending comes from government borrowing, but also should come from surplus funds the government collected during boon times. When in a period of vigorous growth the government is to impose more taxes not only to reign in irrational exuberance but also to have reserves in time of depression. Keynes, however, runs into the fact that the government does not generate income. It cannot contribute to growth. Keynes increased consumption through direct spending, hire unemployed workers to do anything, including the proverbial hiring of one worker to fill in the ditch just dug by another government hire. The neo-Keynesian stimulus does not improve consumption but attempts to nudge consumer behavior through incentives and transfers to labor unions. The neo-Keynesian program imposes new taxes to support the borrowing and additional spending exactly at the time when Keynes would want to encourage consumption by putting more money in private hands. The neo-Keynes in this regards hits the Laffer Curve. The Laffer Curve is the relationship of tax rates and revenue to the government where at some point increasing tax rates produce less revenue. On the lower end of the curve, increasing taxes does increase revenue, however, after the optimum point further increases generate less government income. Less income means either less government spending, or more likely, more deficit spending to make up for the lost revenue. In theory, the decrease in revenue results from the depression of economic activity brought about by the increased taxes. The economy is not recovering at nearly the pace needed to produce growth tangible on main street. The administration must start looking at the fundamentals if it ever hopes to be able to maintain spending and service the unprecedented debt levels. Obama reviewing the answer he gave to Charley Gibbs in a democratic primary debate question of raises in capital gains taxes reduce revenue to the government stated that it was not a matter of money to the government but one of “fairness”. One of his 300 economic advisors can slip a copy of the Laffer Curve to the President with a footnote that at some point it is about the money, especially given the irrationally exuberant spending indulged by the democratic majority. (As a corollary, they can reference the Hauser Law, where the tax rates cannot collect more that about 20% of GDP due to the affect of tax rates on the economy.)

The second great lever influencing inflation is employment. In monetary theory the massive amounts of cash pushed into the economy drives inflation rates up. Inflation is constant for the moment. The economic force holding inflation constant in the deluge of cash is unemployment. The Phillips Curve maps the inverse relationship between inflation and employment. Low unemployment correlates with higher inflation. The increased income and subsequent consumption from full employment drives prices higher. The conundrum is that real wages fall thanks to inflation. Even though you earn more the higher prices translate into being able to buy less.

The current economy does not have this problem since unemployment is hovering around 10% and surveys indicate those who are working do not expect any increase to income. This is how the Administration is presenting the rosy picture of the economy. The government is spending hand over fist while the Federal Reserve monetizes the debt (the Treasury issues more government debt, which is immediately bought by the Fed thus instantly converting debt to cash with the government owing itself interest.) Economic advisors tried to hint that higher unemployment will be the new norm, but in reality, it is a return to normal. The 1990’s under Clinton saw unemployment under 6% (economists and pundits at the time went hysterical that inflation would explode) and inflation was nominal. That was the aberration while today is the economic norm. Clinton era saw the rise of securitization of debt. Banks were forced to lend to people who otherwise would not qualify for loans (meaning the loans could never have been repaid but had to be issued for political purposes). Banks developed securities to take the “bad” loans off their balance sheets to reduce risk of default and still comply with government regulation. When the security instrument market reached a tipping point such that they not only hedged risk but also generated profit the market eventually exploded into the crisis of 2008. That artificiality produced the aberration of the recent past. It looks like Phillips is back with a vengeance.

The Obama administration gets a lot of criticism for its spending. It is also catching from both sides of the political aisle for the handing of the oil spill. It deserves all of it. For too long the administration has wanted its cake and eat it too. There cannot be substantial economic growth with high taxes and low unemployment. Obama likewise cannot take a hands off approach to the oil spill and also feign personal outrage and command. Obama in order to restore the messianic mantle placed upon him by the media needs to find some core philosophy and stick to it. Will it emulate Bill Clinton and feel the pain (accepting the criticism of being too touchy-feely and not commanding enough results) or remain the stoic professor in charge (accepting the barbs of not understanding, which can be mitigated by actually producing positive results). To date Obama has done neither. His outrage comes across as contrived and his command of facts and options woefully lacking. The President needs to pick a path and stick with it. Likewise with the economy, either need to prop up economic growth bubbles with wild spending (trying to replicate the 90’s) or start to educate the American citizenry to the fact that the massive federal government will limit private economic growth and unemployment returns to predictable levels.

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