07/12/2009 05:12 am ET Updated Dec 06, 2017

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.