Monetary


Daniel J. Mitchell performs a fisking on an article in The Economist magazine:

Writing about the stagnation that is infecting western nations, the magazine beclowns itself by regurgitating stale 1960s-style Keynesianism. The article is worthy of a fisking (i.e., a “point-by-point debunking of lies and/or idiocies”), starting with the assertion that central banks saved the world at the end of last decade.

The point I want to make is about the Phillips Curve, which Dan refers:

According to adherents, all-wise central bankers can push inflation up if they want lower unemployment and push inflation down if they want to cool the economy.

This idea has been debunked by real world events because inflation and unemployment simultaneously rose during the 1970s (supposedly impossible according the Keynesians) and simultaneously fell during the 1980s (also a theoretical impossibility according to advocates of the Phillips Curve).

The common understanding of the Phillips Curve is not based on what Mr. Phillips actually studied. This is from John P. Hussman.

The Phillips curve, named after economist A.W. Phillips, is widely understood as a “tradeoff” between inflation and unemployment. The idea is so engrained in the minds of economists and financial analysts that it is taken as obvious, incontrovertible fact.

John agrees with Dan about the common definition and its acceptance but there is another problem with the Phillips Curve.

See, the Phillips Curve takes its name from a 1958 Economica paper by A.W. Phillips, which studied the relationship between unemployment and wage inflation in Britain, using a century of historical data through the 1950’s. What Phillips found was this: when unemployment was low, wage inflation tended to be above-average, and when unemployment was high, wage inflation tended to be subdued. . . .

The answer is simple. During most of the period that Phillips studied, Britain was on the gold standard. As a result, the general price level was actually very stable, with very little general price inflation at all. . . .

The true Phillips Curve, then, is a relationship between unemployment and real wages.

Note, when analysts use the word “real” like this it means adjusted for inflation.

John delves into detail if you wish further explanation.

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Stanford-trained economist John Hussman on the economy’s persistent weakness:

Instead, the true wealth of a nation is embodied in its capacity to produce, as measured by the stock of real investment (productive capital, stored resources, infrastructure, knowledge) it has accumulated as a result of prior saving.

. . .

One of the hallmarks of the bubble period since the late-1990’s is that the growth rate of real U.S. gross domestic investment has slowed to less than one-quarter of the rate it enjoyed in the preceding half-century.

. . .

Over the past 16 years, U.S. real gross domestic investment has crawled at a growth rate of just 1.0% annually, compared with a growth rate of 4.6% annually over the preceding half-century. There’s your trouble.

 

. . . The path forward:

Simply put, the only thing QE really does is to distort the financial side of the economy, enabling and encouraging yield-seeking speculation and massive sectoral imbalances that we observe as wealth disparities and bizarrely distorted securities markets. The proper course of economic policy is to expand productive investment at every level of the economy through the action of Congress (including infrastructure investment, corporate investment tax incentives, workforce development credits, and other measures ideally tied to the creation of new jobs). The Federal Reserve is not a source of prosperity. It is the single most dangerous and unregulated risk factor in the U.S. economy. We should have learned that during the yield-seeking mortgage bubble and the collapse that followed. We have not, so we now face the equivalent prospect again.

Here.

My introductory statements are followed by Hussman’s comments in double-quotes.

The source of wealth:

“Understand that securities are not net economic wealth. They are a claim of one party in the economy – by virtue of past saving – on the future output produced by others. Fundamentally, it’s the act of value-added production that ‘injects’ purchasing power into the economy (as well as the objects available to be purchased), because by that action the economy has goods and services that did not exist previously with the same value. True wealth is embodied in the capacity to produce (productive capital, stored resources, infrastructure, knowledge), and net income is created when that capacity is expressed in productive activity that adds value that didn’t exist before.

Future returns and the destructive effect of the Fed on the economy:

“Bubbles do not create wealth. They simply raise the current price of a security, lower the future expected long-term return, and, at best, leave long-term cash flows unchanged.

“I say “at best” because there’s no evidence that yield-seeking speculation, encouraged by central banks, has any positive effect on long-term cash flows at all. Indeed, I don’t think there’s any real doubt that the crisis and disruption following the collapse of prior yield-seeking bubbles is precisely what has crippled the accumulation of productive capital at every level (real investment, work experience, infrastructure) in the real economy. Given that the accumulated stock of productive capital is the basis for the net worth of our nation (as detailed above), it follows that yield-seeking speculation, intentionally encouraged by the Federal Reserve, is perhaps the single most destructive force in the U.S. economy, and in the lives of the American people.

On the Fed’s mandate updated in the 1970’s (Humphrey-Hawkins):

“For me, probably the saddest part of this whole spectacle was watching an earnest, well-meaning congressman asking Janet Yellen, during her Humphrey-Hawkins testimony two weeks ago, why the Fed was not doing “more” on behalf of unemployed people of color. The problem here is that the underlying assumption is false. If one actually examines data across history, there is no reliable or economically meaningful relationship between activist monetary policy and subsequent changes in output or employment. This congressman was essentially begging the Fed to deliver poison to his community.

On the correlation of monetary policy and desired outcomes on the economy:

“Virtually nobody cares to look at the utterly weak and insignificant correlation between monetary policy and desired outcomes, apparently preferring a dogmatic insistence on some little graph or model they learned in Economics 101. While Janet Yellen showed enough conceit to give the Fed credit for millions of new jobs since 2009, the path of the economy since the crisis has been nearly identical to what one would have anticipated in the absence of all of this monetary insanity (a result that one can demonstrate using vector autoregression).

What “saved” the economy:

“The crisis itself was not “fixed” by monetary policy, but ended the same week that the Financial Accounting Standards Board announced it would waive the requirement for financial institutions to mark their assets to market value, allowing them “significant judgment” in how they valued those assets, and eliminating the specter of widespread insolvency with the stroke of a pen.

On the correlation between interest rates and equity prices:

“Still, the relationship between equity valuations and bond yields is far weaker than investors seem to recognize (the “Fed Model” is an artifact of the 1980-1997 disinflation), and low interest rates have never durably removed equity market volatility, downside risk, or the tendency for compressed equity risk premiums to be restored over the completion of the market cycle.”

Whole thing.

Here. Good.  The Fed’s “boost”, “jolt”, and whatever joingo has had the reverse effect then intended. They’re killing us with kindness. A cheaper dollar pushed oil prices higher. Mortgage rates were higher during QE2.

Those who are now looking backwards at how poorly the U.S. economy performed under QE2 in order to “forecast” the future appear to be neglecting the potentially beneficial effects of a firmer dollar in deflating the bubble in U.S. commodity costs. In the end, quantitative easing turned out to be an anti-stimulus which stimulated nothing but the cost of living and the cost of production. Good riddance.

Here. The reaction to QE2 was the opposite of what was expected. Interest rates rose, not fall. The price of commodities such as oil, gold, and other materials rose. The US dollar fell against the Euro. The cost of exported US goods rose.

Here. Only Rep. Paul (R-TX) has the ideas that will do something positive about the government’s financial problems. The others are just a variation on the same bankrupt theme of devalue the currency by keeping interest rates low and having the Fed monetize the debt by buying Treasury bonds. The Fed’s actions show it is not an independent agency from the rest of the Federal Government.

In response to Sen. Richard Shelby’s (R-AL) comment about President Obama’s nomination of Peter Diamond for the Federal Reserve, Felix Salmon says:

This makes no sense at all, from an economics point of view. The budget is set by Treasury and Congress, not by the Fed.

Shelby said:

It would be my hope that the President will not seek to pack the Fed with those who will use the institution to finance his profligate spending and agenda.”

Salmon is referring to the executive and legislative branches controlling fiscal policy while the Federal Reserve controls monetary policy. But the Fed can fund fiscal policy by buying Treasury bonds that finance the spending, a process known as monetizing the debt. So Salmon is wrong. Here.

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