(c) 2013, Bloomberg News.
(c) 2013, Bloomberg News.
President Barack Obama has shown a determination to redistribute wealth by increasing government spending, despite unsustainable deficits. We shouldn't be surprised if Janet Yellen, the president's nominee to be Federal Reserve chairman, shares his objective.
After 30 years of Fed chairmen who pursued anti- inflationary policies, the central bank is now attempting to engineer an unexpected bout of inflation. One consequence of this policy is that it transfers wealth from lenders to borrowers. Yellen, whose nomination could be put to a Senate vote the week of Dec. 9, will probably redouble these efforts.
Advocates of inflationary monetary policy recommend increasing the money supply until the economy regains full employment. Christina Romer, the former chairman of the president's Council of Economic Advisers, for instance, once called on the Fed "to begin targeting the path of nominal gross domestic product" — to increase the money supply until it produced either growth or price inflation — because "desperate times call for bold measures."
Low interest rates can be an effective lever for spurring economic activity. When savings sit unused, as they often do during a recession, lower interest rates can discourage saving and, to a lesser extent, encourage investment. However, when nominal interest rates reach zero, as they have, real rates can fall no further without price inflation. If savings continue to remain unused at zero interest rates, price inflation can push real rates below zero. A zero nominal interest rate with 3 percent inflation costs savers 3 percent a year in purchasing power.
In an expansion, monetary policy can accelerate growth by easing credit constraints. During a recession or weak recovery, however, individuals and institutions often are reluctant to take the risks necessary to grow the economy even in the face of low interest rates. Cash — namely, bank deposits — sits on the sidelines, neither lent nor borrowed. In this situation, loosening credit constraints no longer produces growth or inflation. John Maynard Keynes called this "pushing on a string."
Under these conditions, it takes an enormous amount of monetary inflation to produce a small, if any, amount of price inflation. Current events bear this out. The Fed has printed more than $2 trillion of money since the financial crisis — a fourfold increase — with little, if any, effect on growth or inflation.
If a given amount of monetary inflation produced a proportionate amount of price inflation, the Fed could implement expansionary monetary policies with minimal risk to the economy. Under the current conditions, however, it would take an enormous and uncertain amount of monetary inflation to produce a trickle of growth or price inflation. That means the risks of unintended and not fully controllable consequences are great.
When the economy is already constrained by the unwillingness to take risks, adding a large amount of risk slows rather than accelerates growth. In the face of greater uncertainty, companies and individuals have remained reluctant to invest.
Some, including David Blanchflower of Dartmouth College, point to an increase in the purchases of items such as automobiles that rely on short-term financing as evidence that the Fed's monetary policy has stimulated growth. This argument ignores the fact that more spending in one sector can damp spending in another. Despite an increase in car sales, the current level of consumer spending on nondurable goods has been lower than during other recoveries. Overall, it is clear that the expansion of the money supply hasn't produced robust widespread growth.
Fed Chairman Ben Bernanke justified the central bank's bond purchases under quantitative easing by arguing that the resulting rise in asset values — the so-called wealth effect — would spur growth. Unlike cash savings, whose value decreases with inflation, asset values tend to rise. As a result, investors may temporarily value such assets more than alternatives when threatened with inflation. But unless investors and consumers are irrational, temporary distortions in asset values won't influence their behavior significantly. It is no surprise, then, that rising asset values haven't spurred increased business investment in the recovery.
Paul Krugman and others claim price inflation can lower wages, equilibrating supply and demand for labor in a recession, when labor sits idle. Wages, however, make up almost two-thirds of costs, so it is unlikely that prices would rise unless wages rose.
Joseph Stiglitz says income inequality has slowed the recovery. Like many liberal Keynesian economists, he sees increased consumer demand as the sole way to stimulate the economy, at least in the short run, because investors allegedly wait for demand to materialize and capacity to tighten before investing. An unexpected bout of price inflation would supposedly stimulate demand by transferring wealth from lenders, who save rather than consume, to borrowers, who can repay their debts with inflated dollars. Borrowers would presumably spend this windfall and therefore spur growth.
This is an outdated view of the economy. Today, investments in innovation drive growth. Innovation creates value regardless of economic conditions. And companies that face innovative competitors must similarly innovate to preserve their profits. The competitive evolution of smartphones hasn't slowed, for example, because of the slow recovery. Today, a transfer, or threatened transfer, of wealth from investors to consumers increases short-term consumption at the expense of investment, innovation and growth.
It is true that redistributing wealth from lenders to borrowers through unexpected price inflation is better than taxing successful equity investors directly. The latter predominantly bear the risks that grow the economy. Nevertheless, wealth, in all its forms, underwrites these risks. Redistributing and consuming wealth shrinks risk-taking and slows growth. Moreover, depositors and other debt holders tend to be consumers, often retirees, rather than wealthy business investors. To the extent wealth is transferred from one group of consumers to another, it does little to increase consumption overall.
But here is the rub. Obama has been willing to accept a slower recovery for the sake of increasing the redistribution of wealth and income. His administration has pushed for higher government spending despite unsustainable deficits and for higher taxes on wealthy investors despite marginal tax rates that are already higher than those under the Bill Clinton administration. Why wouldn't he nominate a Fed chairman who holds similar views?
Don't let 30 years without inflation fool you.
Edward Conard, a former managing director at Bain Capital, is a visiting scholar at the American Enterprise Institute. He is the author of "Unintended Consequences: Why Everything You've Been Told About the Economy Is Wrong."