Martin Feldstein's Sadistic Monetary Mysticism

X
Story Stream
recent articles

In his op-ed in the March 31 issue of The Wall Street Journal entitled "The Fed Needs to Step Up Its Pace of Rate Increases," eminent conservative economist Martin Feldstein buys into a host of Keynesian economic superstitions, while advocating that the Federal Reserve pursue a sadistic policy goal via unworkable means.

The subhead of Professor Feldstein's article provides a good idea of the economic train wreck bearing down on the reader:

"Unemployment is now 5.5%, historically the lowest rate that can be sustained without starting an inflation spiral."

Ah, yes; by all means. Let's start with the Phillips Curve; the economic fantasy that more people working causes inflation. Here are a few points that Professor Feldstein seems to have missed:

• His assertion about the historical relationship between unemployment and inflation is simply not true. Over the five years starting with January 1951, unemployment averaged 3.85% and CPI inflation averaged 1.47%. For the entire Bretton Woods gold standard period (January 1948 through August 1971), the nation averaged 4.72% unemployment and 2.31% inflation.

• Even if low unemployment could cause inflation (which it cannot), we don't have low unemployment right now. Professor Feldstein's 5.5% unemployment number is an artifact of people fleeing the labor force. Adjusted to the labor force participation (LFP) rate of December 2008, February's unemployment rate was 9.8%

• America is still 13.8 million FTE* jobs away from full employment. Contributing to this yawning employment gap is the fact that 2.4 million more people are working "part time for economic reasons" than were doing so 8 years ago.

Having gotten off to a roaring start, Professor Feldstein segues into "sado-monetarism," the notion that the jobs of millions of aspiring wage earners must be sacrificed to appease the inflation gods. He dismisses the hopes and dreams of "...part-time workers, (and) those too discouraged even to look for work..." with a casual, "...it is wrong to think that this group can be helped by monetary policy without triggering an inflationary spiral."

Professor Feldstein then criticizes the Fed's (purported) desire to see inflation rise toward its 2% target. Instead, he recommends that the Fed raise interest rates, and content itself with below-target inflation. Here is where both Feldstein and the Fed itself seem to be dangerously out of touch.

Since June 2014, the dollar has increased in value by 45.5% against the CRB Index**, and by 12.2% versus gold. This is dangerous. The economy needs a stable dollar, and monetary deflation can be even worse than the inflation that Professor Feldstein seems to fear so much.

As the dollar has risen in value, the growth rate of nominal GDP (NGDP) has slowed. After rising at a 6.67% annualized rate in 2Q2014, NGDP growth slowed to 6.27% in 3Q2014, and to a mere 2.36% in 4Q2014. Meanwhile, the latest reading from the Fed's "GDPNow" model suggests that NGDP growth in 1Q2015 might have been as low as 0.36% (assuming the same 0.16% GDP inflation that was observed during 4Q2014).

It makes sense that an unanticipated rise in the real value of the dollar would depress NGDP growth. After all, NGDP is composed of billions of transactions where money is exchanged for "stuff." If the value of the dollar goes up dramatically, while the general price level remains the same, people will buy less "stuff," at least until the price level adjusts to the new value of the dollar.

The point here is that Professor Feldstein is urging the Fed to raise interest rates to fight inflation, when our monetary issue right now is deflation. Meanwhile, no one seems to have noticed that the Fed Funds rate has been both extremely stable and completely irrelevant for the past six years.

During the six years ending on March 31, 2015, daily Fed Funds rate was essentially constant. It ranged between 0.04% and 0.25%, with an average of 0.13%. Meanwhile, during the same period, interest rates on 10-year Treasuries moved in the 1.43% to 4.01% range, gold prices fluctuated between $888.20/oz and $1,813.50/oz, and the CRB Index saw a high of 370.56 and a low of 211.86.

During the latest 23 calendar quarters for which we have data, the Fed Funds rate was virtually a flat line, while NGDP growth ranged from -0.80% to 6.09%, and GDP inflation reached a high of 2.93% and a low of -0.09%

For at least the past six years, the Fed Funds rate hasn't seemed to drive, or even to correlate with, anything. Accordingly, it is strange that both the Fed and Professor Feldstein are so fixated on it.

Central banks have been manipulating short-term interest rates for so long that they have come to believe that this is their job. It's not. Keeping the value of money constant in real terms is their job, and this should be done directly. For example, if the Fed were to use its various monetary tools to keep the CRB Index within a narrow range, we would have stable money. Under that regime, all interest rates would be set by the market.

Professor Feldstein's final point, that the Fed must raise interest rates now in order to preserve financial market stability, is so confused that it must be disassembled like an unexploded bomb.

First, Professor Feldstein seems to buy into the commonly held belief that the Fed is "keeping interest rates low." They are not-at least not in the way that most people think, by "printing money." There have been long periods during the past six years (including the past 10 months) during which the monetary base actually declined, and yet interest rates remained low.

The only thing that can keep interest rates low across the yield curve for any length of time is a sluggish, slow-growth economy. So, while the Fed's flailing monetary improvisation has contributed to low interest rates, so has Obamacare, so have Obama's tax increases, and so has the EPA's regulatory jihad against the energy industry.

Despite what Professor Feldstein seems to believe, the Fed cannot raise interest rates (at least not the interest rates that matter to the economy) by fiat. In fact, with $2.4 trillion in excess reserves sloshing around in the banking system, the only way that the Fed could increase the effective Fed Funds rate right now would be to raise the interest rate that it pays on reserves, thus bidding higher for Fed Funds itself.

The only thing that can produce higher interest rates is faster economic growth, which would increase both the demand for, and the return on, capital. The biggest contribution that the Fed could make to higher economic growth would be to stop concerning itself with interest rates, and to just stabilize the CRB Index at an appropriate level, which is probably in the range of 300.00.

A CRB Index target of 300.00 would be much higher than that of March 31 (211.86). However, it would be slightly lower than the level of June 2014 (308.22), while slightly higher than the average of the past six years (289.74).

What causes the systemic financial crises that Professor Feldstein fears is the bursting of asset bubbles. And, what causes asset bubbles to inflate and then to burst is unstable money, which first encourages malinvestment, and then later exposes it as malinvestment (which must then be liquidated at an economic loss).

There were no financial crises under the Bretton Woods gold standard, and very few bank failures. If the Fed were to start supplying a stable dollar, asset prices would normalize to their "real" values (based upon economic fundamentals), and we would have the financial stability that Professor Feldstein correctly prizes.

No amount of regulation (and no amount of interest rate manipulation by the Fed) will yield stable financial markets without a stable dollar. Conversely, with a stable dollar, there would be no need for heavy-handed financial system regulation. Professor Feldstein seems to miss these fundamental facts completely.

Professor Feldstein ends his article with another warning about rising inflation, thus circling back to the Phillips Curve superstition.

Here is the conceptual flaw of the Phillips Curve. Low unemployment can't cause inflation (a reduction in the value of the dollar) any more than it can cause the length of the foot to shrink. The dollar is a unit of measure (it is our unit of market value), and the magnitudes of units of measure do not depend upon how much they are used, by whom, or for what. They depend only upon the determination of the governing body to maintain the standard.

What Professor Feldstein says in his article may actually be valid for an economy with a fiat currency issued by a central bank that is mesmerized by the Phillips Curve. However, he misses the big point, which is that our 43-year experiment with a floating, fiat dollar has been a complete failure. It's time for the Fed to stop trying to control interest rates, and to stabilize the dollar against something real.


*FTE (full-time-equivalent) jobs = full-time jobs + 0.5 times part-time jobs

**The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.

 

 

Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, and a RealClearMarkets contributor.  

 

Comment
Show commentsHide Comments

Related Articles