Art Laffer Is Wrong on Inflation
Yesterday the right wing world was ablaze with an Art Laffer editorial in the WSJ. Hyper inflation is on the way -- at least according Art Laffer and echoed by Ed Morrissey at Hot Air, and Scott Johnson at Powerline. The problem is Laffer's argument is half the story -- and once you know the other half you realize how wrong Laffer is.
Here's the chart that Laffer bases his entire argument on:
Notice he calls this "Our exploding money supply." Only it's not our money supply, it's our monetary base. According to Laffer:
About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base -- which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash -- by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.
The key here is "member bank reserves held at the Fed" -- this is what banks make loans on. Here's how it works. The Federal Reserve buys securities from a member bank, giving the member bank cash. The member bank then uses this cash as reserves for more loans. In a fractional reserve system (like the banking system we have) a bank only needs to keep a percentage of cash on hand. So an increase in reserves can lead to a really big increase in money supply. But it requires increasing loan demand -- which means consumers have to take out more loans -- and banks have to be willing to lend.
But that's assuming a few things that just aren't happening right now. First, households are decreasing their overall loan holdings. According to the latest Flow of Funds report total household debt outstanding decreased in the fourth quarter of last year and the first quarter of this year. And that trend is likely to continue:
U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007. That dramatic rise in debt was accompanied by a steady decline in the personal saving rate. The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period.
In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes. For many U.S. households, current debt levels appear too high, as evidenced by the sharp rise in delinquencies and foreclosures in recent years. To achieve a sustainable level of debt relative to income, households may need to undergo a prolonged period of deleveraging, whereby debt is reduced and saving is increased. This Economic Letter discusses how a deleveraging of the U.S. household sector might affect the growth rate of consumption going forward.History provides examples of significant deleveraging episodes, both in the household and business sectors, which offer a basis for gauging how debt reduction may affect spending. From 1929 to 1933, in the midst of the Great Depression, nominal debt held by U.S. households declined by one-third (see James and Sylla 2006). In a contemporary account, Persons (1930, pp. 118-119) wrote, "[I]t is highly probable that a considerable volume of sales recently made were based on credit ratings only justifiable on the theory that flush times were to continue indefinitely....When the process of expanding credit ceases and we return to a normal basis of spending each year,...there must ensue a painful period of readjustment."
And in case you missed it, the entire financial system is really tightening lending standards right now. Here are some relevant points from the latest Senior Loan Survey from the Federal Reserve:
On net, about 40 percent of domestic respondents, compared with around 65 percent in the January survey, reported having tightened their credit standards on commercial and industrial (C&I) loans to firms of all sizes over the previous three months. On balance, domestic banks have reported tightening their credit standards on C&I loans to large and middle-market firms for eight consecutive surveys and to small firms for ten consecutive surveys. Although 40 percent is still very elevated, the April survey marks the first time since January 2008 that the proportion of banks reporting such tightening fell below 50 percent. Similarly, the net percentages of domestic respondents that reported tightening various terms on C&I loans over the previous three months remained elevated but were slightly lower than those reported in the January survey. Specifically, about 80 percent of domestic banks, on balance, indicated that they had increased spreads of loan rates over their cost of funds for C&I loans to large and middle-market firms, compared with around 95 percent in January. About 75 percent of domestic respondents, compared with about 90 percent in January, indicated that they had increased such spreads for C&I loans to small firms. A significant majority of banks reported having charged higher premiums on riskier loans and having increased the costs of credit lines over the survey period.
And then there is the story of residential real estate lending:
In the April survey, somewhat larger fractions of domestic respondents than in the January survey reported having tightened their lending standards on prime and nontraditional residential mortgages. About 50 percent of domestic respondents indicated that they had tightened their lending standards on prime mortgages over the previous three months, and about 65 percent of the 25 banks that originated nontraditional residential mortgage loans over the survey period reported having tightened their lending standards on such loans. About 35 percent of domestic respondents saw stronger demand, on net, for prime residential mortgage loans over the previous three months, a substantial change from the roughly 10 percent that reported weaker demand in the January survey. About 10 percent of respondents reported having experienced weaker demand for nontraditional mortgage loans over the previous three months-a substantially lower proportion than in the January survey. Only two banks reported making subprime mortgage loans over the same period.
But perhaps the most damning chart comes from David Altig -- senior vice president and research director, at the Atlanta Fed -- who posted the following chart on his blog:
In Altig's own words: "OK, but in my opinion it is a bit of a stretch -- so far, at least -- to correlate monetary base growth with bank loan growth ... Let's call that more than a bit of a stretch."
In short, Laffer's contention is not based in any current fact. Instead, it's based in his desire to get Republicans elected.
Thanks to Invictus over at Blah3 for being a great economic sounding board on this matter.
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These comments are a riot. Laffer wrote a piece predicting certain (dire) consequences of the current admin's policies combined with the Fed's policies. It was a thoughtful piece, and Obama supporters are certainly justified in arguing a different view. But keep in mind that this is a debate that is quite a bit different than, say, a debate over the war in Iraq. Whether or not the war in Iraq was justified or successful are questions that may never be answered, at least not in most of our lifetimes. It makes sense, then, to get a bit vitriolic over that one. But over this? Whether Laffer or you guys is correct is something we will know within a couple of years. Name-calling, under those conditions especially, seems stupid. It's like all the passionate debating over the validity of polls prior to election day. Or maybe we can start a thread where people can debate over the winner of a ball game. We could get start the debate during the first inning, and everyone could argue about why Team A will win, or why Team B. How ridiculous is that? Some debates call for passion, others not so much. This one, not so much. We'll find out soon enough. If Laffer is right, sayonara Democrats. If you guys are right, well, the outcome is not so clear. No matter what, though, we are going to be saddled with lots of debt. And didn't Obama promise fiscal responsibility? Just wondering.
OK, we got another Laffer curve pitched at us. It was 8 feet from the plate, as usual. Doesn't that get scored as a wild pitch?
Besides the growth in the money supply, I wonder what the lack of growth in real incomes is doing to our purchasing power? During the Bush terms, real incomes declined for most. Eventually with a lack of purchasing power, consumption which is 70% of the economy, will decline. Given this reason, I think conservative demands for a low wage structure of society, seen in their anti-union, often anti-labor stance, is self-defeating. If people do not have the purchasing power, free from excesssive medical bills and other concerns, the economy will suffer. It is a downward spiral.
Maybe Laffer is wrong but as another story on HP has pointed out, the price of oil has doubled in the past 3-4 months. In Chicago, the price of gas has risen from a low of $1.64 in Jan 2009 to #3.00 per gallon. The price of copper has risen fron abut $1.20 per pound in January to about $2.36 today. The price of US treasury bonds has been falling and the yields are rising in spite of the Feds efforts to keep rates low. Prices of raw materials and especially energy doubling in 6 months sounds like inflation to me. Perhaps this qualify a hyperinflation, but it is still a shock to pay an extra $20 per month for a fill up
Art Laffer has been spreading horse kaka for years...............why ANYONE who thinks and understands HUMAN NATURE would give this guy one second is more than puzzling.
Those deeply worried about inflation should visit
http://www.bep.treas.gov/section.cfm/2/431
It's fun.
Is Laffer politically motivated? What is the politics? Bernanke just said the same thing - to beware of inflation. Who benefits from these pronouncements?
Seeing Laffer warn us about the dangers of inflation helps clear my head. -- Deflation must be the big problem -- His track record for public pronouncements is not so good - very Bush-Reagan - and his predictions have been wrong.
1. Back in "07, debating pessimist Peter Schiff, Laffer stated that the bubble would not deflate. Not that Schiff is so great, but by then the real estate part of the bubble looked untenable.
2. The Laffer curve looks like think-tank PR for Reaganomics. It is a formal restatement of the prejudices of every county-seat Boss Hogg in the Deep South. "There is no point in paying poor people more. They would just waste it." . The South gradually took over the GOP, starting about '70.
The Laffer curve is a restatement of an old idea - that cutting taxes results in greater revenue for the gov because the rich invest their extra money and we have more business. generating more taxes.
But regarding the wealthy today, we are still far on the left side of the curve, not near the top, so raising taxes on them does generate more tax revenue .
Wrong. CA just implemented a massive tax increase and the result was less revenue coming in. Just like in the early 90s when they made the same mistake. Raising taxes during a recession is a guaranteed recipe for less tax revenues. I'm not for lowering taxes any further but any tax increases should be postponed until the economy recovers.
The economy went into the toilet because of the economic crisis, not because of any tax hike. Don't you get that? You must be living in bizzaro-world.
http://www.salon.com/comics/tomo/2009/05/26/tomo/index.html
Oh and this one is good too... http://www.dilbert.com/2009-06-11/
Then how come the economy did better when taxes were higher pre-voodoo?
And any investment that did occur was done overseas - not domestiocally, or they simply took their extra money and squirreled it away in some tax haven
Tax cuts use to be provide stimuli effectively. That changed when we shipped our MFG offshore and the repugs cant adjust to that change... thats why we now have jobless recoveries.
Today when people take their tax cut money and go shopping, they buy mostly imported goods and stimulate some what elexes economy much more than ours..
Company's took their tax savings and built new plants in China while ours rusted, and 5 million of our MFG jobs flowed to China.
A dollar of MFG produces 5 times as much economic activity as 1 dollar spent on imports. Go through the steps in both cases....
Our one trillion trade deficit is a 5 trillion hit to our economy or a 30% reduction in the std of living of every american.
Its really worse because much of our exports are 3rd world exports... agriculture and raw materials/scrap, low value added products.
Regards
Laffer was questioned about his tickle down theory and how it caused massive deficits and he shrugged. Why does anyone take this man seriously?
You do realize that Reagan massively increased federal spending, don't you?
As always, Bonddad, you're missing the point. I'd love for you to explain how quantitative easing didn't cause hyperinflation in Zimbabwe and Weimar Germany. Comparing price changes now versus in the 30's some interesting things can be seen. While there was long lasting deflation in the 1930's as the asset bubbles popped, for all intents and purposes deflation is over for the current crisis. This is explained by inflationary pressure caused by the increase in the money supply, which is being spent by the US government rather than being loaned by the banks. I don't know how else you'd characterize a $254 billion monthly budget deficit.
So tell me, what reparations running at 25% of GDP are we paying to France/Italy/England/Russia right now? Oh, we aren't?
Well then, your entire Weimar Germany comparison is crap then. The situations are not even REMOTELY similar.
As a percentage of the GDP, our current debt it worrisome, but nothing like either of the countries you compare it to.
In order to repay its debt, Germany debased the mark and massively increased the money supply.
In order to "stimulate the economy" we're running a 64% budget deficit ($2.7 trillion deficit with $4.2 trillion spending), compared to our normal 10-30% deficit. US treasuries are moving higher as we "borrow" (read: create) money.
To dismiss the situations as "not even REMOTELY similar" proves your blissful lack of knowledge of monetary and fiscal policy. Massive inflation is coming for the United States.
To be honest Hale, how can you say he is wrong?
What we are doing right now to our money supply has never been tried in this country before.
It hasn't been tried here, but it has been tried in Zimbabwe and Germany, and many other times in history, and it always destroys currencies and countries.
Its been tried in the Weimar Republic. Didn't turn out too well for those folks, if I remember correctly.
The Weimarer Republic was PRINTING money with denomitations of million, billion and trillion. Let me know when you see a million dollar bill on the street. So far the largest I have ever seen was $100.
And if you really want to know how much money gets printed... it's on the web:
http://www.bep.treas.gov/section.cfm/2/431
I did a quick spreadsheet and it seems they made
$12,288,000,000 in May 2008 in regular notes in the Washington DC facility and
some $16,454,400,000 a year later in May 2009. Since you would have to subtract the number of notes that got destroyed at the same time, the net amount of new paper currency is considerably less than that. I left out the minor note production in Forth Worth, TX. You can do that on your own and for every month of the year, if you are interested.
He's never been right before. I guess he COULD be right. But then, so could I, and I don't want Obama (or this nation) to fail.
It's troublesome that the amount of debt is so high. But panicking will surely get us killed.
Why did this country allow Bush to "Stay the Course" toward the cliff for 8 long years when it will not even give Obama a year to turn the nation and the world around?
"Why did this country allow Bush to "Stay the Course" toward the cliff for 8 long years when it will not even give Obama a year to turn the nation and the world around?"
That is the question, isn't it? I am afraid the answer is because "We are stupid... and no what.".
Ya mean this guy is still around, thought his theories were disproved long ago. Oh I forgot it was in the WSJ, Rupert's rag, that explains.
Mr. Supply Side Economics. Anyone remember where that got us? Was that the Laffer Curve or the Laugher Curve???
Bondad - Please discern between price inflation and monetary inflation - it is confusing the crowd here who can't google the difference.
Price inflation
When your dollar goes in the toilet - price inflation will kick in because 90% of goods that you buy are made in China and you dollar won't buy what it did before.
Monetary Inflation - the increase in money supply
I do agree partially with you bondad, no one seems to get the velocity of money concept. If banks won't lend and people are too afraid to take out credit - no amount of govt or fed money supply expansion will matter. This happened in the depression - people were so devastated by credit int he 20's that it was considered taboo to borrow money, we are finally going back to that era and concept.
Imagine people, actually saving you money to buy something - what a concept!
Typical of left wingers - no idea about finance - but boy you love to spend.
When you have the ill-thought-out notion to post "Typical of left wingers..." you immediately lose all credibility on preaching to ANYONE about spending, as you identify yourself as to the RIGHT, and we have all seen just how well the "fiscally conservative" Right has done on spending in recent years.
Blatant hypocrisy does not a credible critic make.
Wait, so all these people we see losing their homes are left-wingers? And all these businesses and banks who are failing now were run by left-wingers? And the national debt was created by...well we know that one is wrong. That old leftie Bill Clinton left a surplus, and dear ol' right as rain Bush turned it into a massive deficit with his right-wing war of choice.
I was actually interested in your explanation of price inflation vs. monetary inflation. But if your economics is as astute as your politics, I'm not so sure.
Been busy google-ing.
I don't want to get into anything on different roads to inflation, but since both Laffer's editorial and Hale's article used the exploding monetary-base graph, even we ignorant lefties can get the picture that this is PRIMARILY money-supply inflation.
What I failed to see in either commentary was the fact that, in recognition of UNPRECEDENTED excess bank reserves caused by the Bernanke-Summers-Rubin school of financial salvation, there will be a dire need quite soon to continually increase the minimum reserve requirements of these banks going forward, in order to ensure that we do NOT increase the other M- measures.
I sense a hint of libertarian economic thought here and I ask why not bring up another part of the solution to ensuring that more savings are available to support the economy - these would be the abolition of the Fed's money-creation powers(and let's argue about the alternative) and the establishment of a full-reserve banking system.
The problem with not having an exit strategy from fractional-reserve banking to SOME other method is this: In a fractional-reserve, debt-money system, ALL MONEY IS CREATED AS A DEBT.
And if YOU google Atlanta FED credit manager Robert Hemphill's quote on the economic ramifications of our debt-money system, you will see why we cannot readily transition to there from here.
We need an exit strategy.
Who's working on that?
respectfully.
Joe,
Here is a link to the f.6 the history money supply by fed. You can navigate around this data site all the way back to the 60s.
http://www.federalreserve.gov/releases/h6/
The issue with fractional reserves is that it permits expansion (of the economy for example) When a bank makes a loan to create deposits, the request comes from the public, the entrepreneur. If the bank approves, then this finances economic activity. With a full reserve system (instead of fractional) there'd be no growth. The abuse has taken place at the margin. How many people would be in houses if they had to pay cash? It's the American dream. Think about this. You're right there is no exit strategy. The growth of the economy depends on growth of the financing of that very growth. You should not have to google this. It's a matter of common sense.
Personally, our 401k's are pathetic and we're in debt up to our eye balls on a credit card due to having two mortgages and being forced to drive 172 miles round trip just to go to work each day. It'll be a while before we can work off that debt. When you add together the number of people like us plus the people who have lost their homes, it's a very large segment of the population. I don't think demand is going to come surging back anytime soon, recovery or not. Also, I think Obama's team is going to be more quick to make adjustments, when/if things do start to pick up. I don't think they will hestitate to "remove the punch bowl". The Republicans are judging this administration based on their administration and you just cannot do that because it's comparing apples to bananas. Historically, the economy always does better under a Democratic administration.
It's just more of the same old intellectual dishonesty that we always see from the right. They've evidently looked at the polls that show that the American people are about 50/50 on how they feel Obama is doing on the economy and figured that they could exploit that uneasiness by stoking fears, same game plan that they've always used. We will have inflation, but it will be because of Wall Street's actions as more and more traders decide to speculate on commodities, especially oil. Yes, oil will continue to see inflation, which will cause inflation in other prices, just as we saw when gasoline went up to $4.00 a gallon. There are off-setting factors, however, and this is where Laffer is being intellectually dishonest. High unemployment and debt, not to mention how much wealth has been lost by the middle class due to their losses of their 401k funds and other investments.
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