Author: Warren Coats

I specialize in advising central banks on monetary policy and the development of the capacity to formulate and implement monetary policy.  I joined the International Monetary Fund in 1975 from which I retired in 2003 as Assistant Director of the Monetary and Financial Systems Department. While at the IMF I led or participated in missions to the central banks of over twenty countries (including Afghanistan, Bosnia, Croatia, Egypt, Iraq, Israel, Kazakhstan, Kenya, Kosovo, Kyrgystan, Moldova, Serbia, Turkey, West Bank and Gaza Strip, and Zimbabwe) and was seconded as a visiting economist to the Board of Governors of the Federal Reserve System (1979-80), and to the World Bank's World Development Report team in 1989.  After retirement from the IMF I was a member of the Board of the Cayman Islands Monetary Authority from 2003-10 and of the editorial board of the Cayman Financial Review from 2010-2017.  Prior to joining the IMF I was Assistant Prof of Economics at UVa from 1970-75.  I am currently a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  In March 2019 Central Banking Journal awarded me for my “Outstanding Contribution for Capacity Building.”  My recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. I have a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. My dissertation committee was chaired by Milton Friedman and included Robert J. Gordon. I live in National Landing Va 22202

Las Vegas

For the second year in a row I participated in Mark Skousen’s FreedomFest here in Las Vegas. This year I spoke on “Inflation, Hyperinflation, and Will We Have One” and I debated “Fed up with the Fed: Should We Abolish it?” (John Fund and I vs Gene Epstein and Tom Woods) televised on C-SPAN.

Las Vegas itself deserves some comment. Its airport (the second busiest destination airport in the U.S.) has 16 baggage carousels (Dulles has 8) and can load 21 cabs at a time. The so called Strip (on the edge of town and seen in the picture) has 5 of the worlds 7 largest hotels. They are enormous. People still smoke inside here. Outside it gets to 110 plus degrees every day during the summer but the air is dry and you can see forever. We took a day trip to Hoover Dam about an hour away.

IMG00010-20090709-1539

The image of Vegas as a dessert oasis of bright lights and ever clanging slot machines is well deserved. You have to walk through the gigantic, cavernous, gaming rooms to go anywhere and the bells and whistles and whirling never stop. But Vegas is also THE CITY of SHOWS. It puts Broadway, with its cramped West End London like theaters, to absolute shame. The performance spaces are stunning and the productions spectacular. On this trip I took my daughter and two grand kids to see “LOVE,” the Cirque du Soleils’ tribute to the Beatles as only it could do it. It was just breath taking. Cirque du Soleil has at least five different shows permanently housed along the Strip. The Strip is lined with spectacular shows (not just the usual Jerry Seinfeld, Bette Midler, and magic shows that you would expect). Every Paris and Broadway shop of note is here as well (not that I would care). You can walk for blocks down the streets of Paris, Venice, the Village, etc without going outside (which is usually a good thing).

Now on to Bakersfield to help move my parents into an assisted living unit in their retirement complex (another painful downsizing).

Government corruption of our economy

I have noted on several occasions (most recently “State Ownership of Businesses) the growing threats to America’s economic productivity of ever greater government involvement in the economy. This productivity is the basis of our high standard of living and of our influence in the world. It is almost impossible for the government to get involved, especially as a shareholder without replacing commercial judgment and considerations with political considerations. Rather than better goods and services at lower prices we get more expensive goods that provide employment or profits for the benefit of a congresswoman’s constituents at tax payer expense. Today’s Washington Post has an article that so clearly illustrates this corrosive danger that I must pass it on: "Time to Click and Drag Car Sales into the 21 Century". The government’s involvement in the economy reduces its productivity but of equal if not greater importance it erodes the integrity of government.

On Friday in Las Vegas I debate whether we should get rid of the Federal Reserve as part of FreedomFest. If interested, you can see it on C-SPAN.

Best wishes,

Warren

Nairobi, Kenya

My latest two weeks in Nairobi are over. I am quite happy with the progress being made by the Central Bank of Kenya in developing its capacity to formulate and implement monetary policy. My advice in these areas has enjoyed the full and enthusiastic support of the Governor.

The sights and sounds of Africa included many memorable moments. Early on my first Sunday morning (about 6:00am), fifty or sixty singers passed on foot on the street below my window lead by a chanter. He would sing a phrase and the choir would respond. It was a lovely way to start the day.

My second Sunday, after two other members of the IMF team arrived, we drove to the home of Karen Blixen, authoress of Out of Africa. Much of the Meryl Streep and Robert Redford movie was filmed there. We also visited the orphan zoo on the edge of the Nairobi National Park. The zoo is unique and has a very different feel than any other zoo I have been to because all of its animals there have been rescued from certain death when they had been separated from their mothers (usually by her death) in the nearby jungles or bush. There I feed a giraffe from my hand and pet a cheetah. When I scratched the cheetah’s ears it purred loudly (reassuringly). You can see pictures on www.facebook.com/wcoats

Actually the highlights of my visit were the dinner discussions with fellow mission members Phil Bartholomew and Tom Lutton. Phil lead our IMF mission but earlier was Chief Economist of the Office of the Controller of the Currency ( the primary regulator of national banks) and staff economist of the former House Banking Committee (the Financial Services Committee now chaired by Barney Frank). Tom is now Principle Economist of Federal Housing Finance Agency, which regulates the bankrupt and now effectively nationalized Fannie Mae and Freddie Mac (the huge government sponsored mortgage financiers about which I have written much earlier). In 2003 Tom wrote a report on Fannie and Freddie for OFHEO as it was then called in which he concluded that they were not financially sound and should be broken up. He was asked to change the conclusion and refused. The report was not issued– an example of the corrupt relationship between industry, labor, and the government. Phil and Tom elaborated on why they consider the financial crisis of the last two years a major regulatory failure (not a failure to have enough regulations, but a failure to enforce existing ones) and why the government’s bailout response is a source of serious (moral hazard) problems for the future, and their disgust at the corrupting influence of Wall Street on American politics and government policy. I looked forward each day to another dinner discussion and wish I could share more of it with you but you have heard bits of it in my earlier notes on the crisis.

Our friend Denny Drabelle’s latest book is being published this month. He is also a traveler and has wonderful stories to tell. Information and reviews are attached.

There was sad news during my stay in Nairobi. Michael Jackson’s surprise death was announced. I received emails about it from all over the world. The next day the local newspaper delivered to my hotel room devoted its first full eight pages to Jackson.

The bodies of two of the Kroll PSDs (personal security details) assigned to my BearingPoint colleague Peter Moore, kidnapped in Baghdad two and half years ago, were turned over to the police. One of them, Jason Creswell, had an existing medical condition that may have caused his death, and we had been told a long time ago that the other Jason had committed suicide. Peter is the one that the kidnappers put on the Internet last year and may still be alive along with the other two Kroll PSDs kidnapped with him.

The two Jasons had actually been dead for some months. Their bodies were turned over to the police and then to the Ministry of Foreign Affairs. The bodies were released because one of the prisoners that were supposed to be exchanged for the hostages was released.  This was a "good faith" gesture on the part of the kidnappers. Such exchanges or payment of ransom keep kidnapping and piracy profitable, and guess what…

On the “lighter side” the joke (but all too true) of the week:

"Big Oil’s Answer to Carbon Law May be Fuel Imports"

By Joe Carroll and Edward Klump

June 26 (Bloomberg) — America’s biggest oil companies will probably cope with U.S. carbon legislation by closing fuel plants, cutting capital spending and increasing imports.

State Ownership of Businesses

Whatever you think about the necessity of the various government bailouts of banks, insurance companies, investment banks and now auto makers, we should all clearly recognize the inevitable consequences of state ownership and thus ultimately control of enterprises. When governments own enterprises, they have an obligation to the tax payers to ensure that their oversight of the companies they finance serves the public interest. History is full of examples of how this has worked out in practice around the world—bloated work forces (how can a caring public official say no to unemployed relatives); thus high cost, uncompetitive outputs; misdirected investments (how can a caring public official say no to constituents in his home town); thus low productivity and losses; thus lower growth and per capital income—but our Congress has wasted no time in demonstrating how it works.

 

This morning’s Washington Post reports that "Lawmakers Chide Automakers Over Dealership Cuts". Surely no one imagines that Congressmen have better judgment about the contribution to the profits and thus the financial viability of GM of its dealer franchise arrangements than GM does itself. Congressmen are responding to the complaints and pressures from GM dealers in their congressional districts. Why would these dealers go to their congressmen to try to pressure bankrupt GM to give them a better deal with tax payers’ money? Well, of course, because the U.S. government and thus Congress now own a significant share of GM and thus have a say in its business decisions. You might hope that your congressman puts the national interest first (the restoration of a viable profitably GM), but you will generally be disappointed (unless you are a GM car dealer). It is our representative’s local congressional district voters who put and keep him/her in office and whose interests must come first. This is the nature of and the way government works and is one of the many reasons it should not own enterprises.

In yesterday’s Post Steven Pearlstein gave one of many specific examples of this behavior: “For sheer hypocrisy, however, you can’t beat Republican Sen. Bob Corker of Tennessee. Last November, Corker took to the Senate floor to denounce the Bush administration’s proposal for bailing out domestic auto manufacturers, saying it didn’t force the companies to do enough to restructure their costs and their operations. Among his big concerns: oversize dealer networks that prevented even the strongest dealerships from making a decent profit.

“Fast forward to today, as Chrysler and GM are finally undergoing the radical downsizing and restructuring that Corker had long demanded. And what does Corker have to say about that? He’s outraged at the way the discontinued dealers have been treated and is pushing legislation to ensure that they get at least six months to wind down their operations and receive full refunds from the automakers for any unsold cars or parts.”[1]

From across the isle Rep John P. Murtha (D-Pa) says it all (in connection with his investigation for favors to and from the “military industrial complex?): "If I’m corrupt, it’s because I take care of my district."[2]

When President Bush first proposed bailing out GM and Chrysler, I argued that if they could not raise the money they needed in the market they should seek the protection of bankruptcy, which provides a well defined and orderly process for restructuring (if warranted) under Chapter XI. A year later both have declared bankruptcy, but the new Obama administration has managed to make mush of the legal bankruptcy process (e.g. treating junior creditors better than senior credits[3]) further politicizing our economy and eroding the rule of clearly defined property rights, which provide the basis on which investors act. I still have confidence that most policy makers of both parties understand the risks of moral hazard and the importance of incentives in guiding behavior, but if they ever get out of hole they dug in crisis mode to start rebuilding a sounder long run, they will have many steps to climb to get out of the policy mess we are in. But for the sake of the country we need to reclarify what should be rendered unto Caesar and what is ours.

[1] Steven Pearlstein,  "Crisis Managers vs. Naysayers" The Washington Post, Friday June 12, 2009

[2] The Washington Post,   "Eye-Opening Earmarks" June 14, 2009 Page A16.     

[3] George F Will, "More Judicial Activism, Please", The Washington Post, June 14, 2009, A15.

Hyperinflation in Zimbabwe

Hi from Harare, the capital of Zimbabwe,
I am here as part of an IMF technical assistance team to the Finance Ministry and central bank specifically authorized by the IMF’s Executive Board to begin the IMF’s re engagement with Zimbabwe. Zimbabwe is a resource rich country and Harare is a beautiful city. (Top picture: Skyline with Reserve Bank of Zimbabwe prominently in the center. Second picture:  Me, Finance Minister Biti, and Ken Sullivan at a “casual Sunday” morning meeting)  I am impressed with the intelligence and skills of its professional class. What has happened in this country in recent years is a huge and shocking tragedy.

Our first day here The Harald’s front page headline in big letters read: “IMF technical team expected today.” Our second day the front page of the business section carried an article titled: “IMF team to assess payment system,” while the front page of the paper carried the headline “Man fights off crocodile in 6-hour battle.” On our third day the newspaper didn’t mention us at all, thank God. Our team of five (from the Netherlands, Denmark, Canada, New Zealand and myself) is here at the request of the Minister of Finance to advise the government on the governance of the central bank (the Reserve Bank of Zimbabwe), the efficiency of interbank and retail payment systems, the safety and soundness of the banking system following the collapse of Zimbabwe’s currency after the world’s second worst hyperinflation in history and to begin discussions of a future monetary regime. Most of our work was in the Reserve Bank, whose Governor (a close alley of President Mugabe) the Finance Minister would like to replace. We wished to be as inconspicuous as possible.

These missions, as the IMF calls them, draw upon and test every bit of knowledge and skills we have accumulated over our lifetimes. To appreciate the enormity and difficulty of our task, you need to understand a bit of Zimbabwe’s recent history. Please bear in mind in reading what follows that I hope to return to Harare and nothing is private anymore.

Zimbabwe, formerly known as Rhodesia, became independent of British rule in 1980, much later than most other African colonies. President Robert Mugabe has headed the government one way or another since then.[1] Mugabe became a national hero leading the guerrilla fighters in the Bush War (1964–1979) that overthrew the white-minority government ruling Rhodesia leading to its independence. He is/was revered throughout Africa.

Guided by the Lancaster House Agreement that provided for the transition from white to black rule of Zimbabwe, to which Mugabe was a signatory, Zimbabwe prospered. Over the past ten years, however, Mugabe became impatient with the pace of his people empowerment programs (“reallocating” property from white Zimbabweans to black ones). His “Fast Track Land Reform”, which abandoned the land reform agreement among Zimbabwean stakeholders at Lancaster House, confiscated farm land from white corporate farmers and redistributed it to “poor’ blacks. In reality the redistribution largely enriched Mugabe’s political supporters. Every employee of the Reserve Bank, for example, was given land taken from its owners. Agricultural output plummeted.[2] Mugabe’s “social” policies have bankrupted this beautiful and once prosperous country. The IMF reports “an estimated 14 percent fall in real GDP in 2008, on top of a 40 percent cumulative decline during the period of 2000–07.”[3]

The greed and corruption of Zimbabwe’s ruling classes diverted the government’s resources. The Reserve Bank was increasingly called upon to lend to various government projects (i.e. print money) to cover the difference. Inflation (annual percent change in the CPI) averaged around 20 percent in the 1990 and gradually rose to 239 percent in 2005, over 1,000 percent in 2006, and 10,000 percent in 2007. In 2008 it exploded and “is estimated to have peaked in September 2008 at about 500 billion percent. This incomprehensible rate of inflation means that in September prices were doubling every 11½ days. Are you surprised that a 100 percent increase in 11½ days if continued at that rate for one year will result in a 500 billion percent increase? This is the magic of compounding.

When the Zimbabwe Stock Exchange stopped trading the ZIM dollar in Nov 2008, the exchange rate of the ZIM dollar to the U.S. dollar was estimated by the UN to be 35 quadrillion (35 x 1015). This the rate generally used for 2008 year end financial statements. This is after 9 zeros had already been dropped from the currency last summer and three had been dropped earlier. The largest note issued before its collapse (and after the removal of the 12 zeros) was for 100 trillion ZIM dollars (100,000,000,000,000). The largest note I was able to get was for 20 trillion. The old notes are hard to find because Zimbabweans threw them away in disgust. As the currency collapsed, angry Zimbabweans came to the Reserve Bank to throw their notes at the building (this was the explanation given to me for why the sidewalk in front of the Bank was still roped off.

It is difficult to comprehend such rates and the impact on Zimbabwean economic life was devastating. The economy spontaneously dollarized, which was formally recognized by the new “inclusive” government in February.[4] Thus for the time being inflation is over (prices—now in U.S. dollars—have actually declined since the first of the year.)

Under the conditions of last year economic calculation becomes impossible. Over a year before the collapse of the currency many firms had already established financial accounts in U.S. dollars for internal management purposes. In real terms the banking sector today is little more than a quarter of its size in 2004. Banks are well capitalized today because they invested all they could in real estate and the stock market rather than lending in order to protect the real value of their assets. As a result, however, they now have very little lendable resources.

Two of my team members were here in December 2006. At that time, the shelves in the shops were empty and there were long lines for gasoline. The Reserve Bank couldn’t print new currency notes fast enough to keep up with the demand as people spent ZIM dollars faster and faster before prices went up even more. This is what happens in hyperinflations. The velocity of circulation of money accelerates reflecting raising expectations for further inflation with the result that the real value of the money supply shrinks. The total amount of ZIM dollars currency in circulation at the end of 2008 was 22,400,000,000,000,000. Its value in U.S. dollars is 64 cents, yes 64 cents. The Zimbabwean people and economy have been brutally raped. The governor of the Reserve Bank drives a Lamborghini.

Because the Reserve Bank could not keep up with the demand for currency, it imposed a limit on the amount of cash depositors could take out of their bank accounts at one time. At one point this amount was not enough to pay for a gas tank fill up, thus multiple trips to the bank were required. Zimbabwean’s can write checks on their bank accounts, but paying for gasoline with a check would entail a much higher price reflecting the inflation expected over the several days it would take the gas station to collect the money via check.

To help their customers pay for gasoline, wholesalers issued coupons denominated in litters of gasoline. These were purchased months before the holder intended to use them to pay for gasoline and locked in the real gasoline value of the later actual purchase of gasoline. Some firms bought large quantities and used these coupons to pay their employees. The coupons circulated as currency. The early sale of coupons for cash and its immediate use to pay for imported gasoline protected the wholesaler just as well as holding the inventory of gasoline for subsequent sale at a higher ZIM dollar price.

Restaurants put prices of menu items on a sheet at the back that could be replace every day with new prices and some stated prices in “units” where the ZIM dollar value of a unit was updated ever day. These few examples barely scratch the surface of the brutal attack on Zimbabweans by their government. I have not mentioned the murders and arrests of political opposition party members and many other forms of voter intimidation.

While the shops are full again and you can order almost everything on the menu, the practice of listing menu prices on a separate sheet perseveres still. With dollarization (the USD or the South African Rand), thus no more ZIM dollar, and stripping the powers of the Reserve Bank to the minimum needed to perform its remaining core functions of banking and payment system supervision (as we have proposed), hyperinflation is no longer possible.

This is made possible by ending government borrowing thus limiting its disbursements to cash on hands as tax revenues are received. However, for some time this means that many obligations cannot be honored. Government employees cannot be paid their salaries (all receive month stipends of $100 for the time being). The Reserve Bank cannot repay all depositors, etc. The economy can only earn USD by exporting and many of its industries are operating at one third capacity because they do not have the money to pay for electricity and other imported inputs needed to operate. Private banks cannot lend to them because significant amounts of their money is deposited with the Reserve Bank which cannot repay it at the moment. This policy is not sustainable without a recovery of the economy and the tax revenue that will accompany it and/or foreign assistance.

The private sector here is amazing and is rebuilding its positions quickly. But if the Reserve Bank is not bailed out by the government (which has no money with which to do so without international support), it will not be able to repay money owed to the private banks, which is owed ultimately to private firms and house holds. These failures could and very likely would bring down the new inclusive government. Aid in the past has helped keep corrupt governments in power (I will avoid names while I am still here in Harare). But at times it is critical. I met with the economic advisor in the U.S. Embassy here yesterday and she said that they are debating this dilemma and the right balance every day. The official U.S. position (but it is up to Congress) is that sanctions will not be lifted until at least the Governor goes. In the mean time Bob’s (Mugabe’s) friends have levied what are almost certainly trumped up charges against 4 of the MDC’s (Tsvangirai’s party) members of Parliament. Convictions would return control of Parliament to Mugabe’s friends (Bob is now largely a puppet under the control of his military leaders). This is but one instance of a very dirty game.Everyone has very tough choices.

Our parting gift was this mornings headline, “Cabinet gives nod to amend RBZ Act…,which will see the central bank revert to its core functions. Finance Minister Tendai Biti said…, This will ensure the central bank becomes a clean and legitimate institution.”  We will see.

[1] The early days of independence were marked by infighting between Maoist leaning Mugabe, whose support came largely from his Shona-speaking homeland in the north, and pro Soviet Joshua Nkomo, whose support came largely from the Ndebele-speaking south.

[2] Eddie Cross, “The Cost of Zimbabwe’s Continuing Farm Invasions”, Cato Foundation, Economic Development Bulletin no. 12, May 18, 2009

[3] Zimbabwe—Staff Report for the 2009 Article IV Consultation, International Monetary Fund, April 20, 2009.

[4] In general elections held March 29, 2008 Mugabe’s party, the ZANU-PF, lost its majority in the Parliament, and informal returns indicated that Mugabe had lost the Presidency to Morgan Tsvangirai of the MDC, whose party in coalition with a relatively small party (MDC-M) now has a majority of Parliament. Mugabe refused to concede and won an uncontested run off in the midst of considerable violence as Tsvangirai refused to participate in the run off to protect his party members from violence. A coalition government was finally formed in February 2009 with Mugabe as President and Tsvangirai as Prime Minister and the Ministries divided up.

Econ lesson: Getting Our Money’s Worth

Our defense budget, like any other budget, is finite. Our resources are limited. To get the maximum value from limited reserves, their deployment must be carefully directed and prioritized.

Defense Secretary Gates, along with the Secretary and the Chief of Staff of the Air Force, want to end production of the F22 in order to shift limited resources to other more pressing needs. "The Air Force’s top two leaders explained … that … they couldn’t justify spending billions more on stealth fighters when other higher service priorities exist and money is tight. The $13 billion for the 60 additional fighters could be better used to repair the service’s nuclear enterprise, ramp up its unmanned aircraft fleet and better fight irregular wars.”[1]

I cheered when I read this and said to myself, we will now see how deeply the military industrial complex President Eisenhower warned us about is entrenched in defense policy making, just as Wall Street is currently demonstrating its power to influence the government’s financial policy (and what a mess that is). Lockheed Martin and Boeing have scattered their F-22 plants widely around the country, but “strangely” concentrated them in the states of the congressional members of the defense appropriations committees. This has nothing to do with economic efficiency and everything to do with political support for keeping the money coming.

“Lockheed Martin Corp. is lobbying the Obama administration to purchase additional F-22 fighter jets by arguing that continued production of the plane would preserve nearly 100,000 jobs across the country, including 19,500 in California…. The F-22 program is directly responsible for 25,000 jobs at Lockheed and its major suppliers. But Lockheed officials say when jobs from sub-suppliers are added in, the F-22 program maintains 95,000 jobs in 44 states.”[2]

Shame on Lockheed. If jobs were the reason for keeping up the production of the world’s best jet fighter (designed to out maneuver Soviet Migs), we would do better (and for less) to hire several million people to sweep streets with brooms. But it should be obvious that the nation’s output available to be shared around and consumed one way or another, not to mention the nation’s defense capability, would be much less in that case. So “jobs” is not the right criteria for choosing the government’s expenditure priorities. In the case of the military budget, the goal should be to produce the maximum defense possible from a given level of expenditures (determined by defense needs relative to the needs for other government services and the fact that the more government takes from us in order to provide these services the smaller and weaker our economy, which builds these things, will be). Budgets are about priorities, and trade offs, and hopefully efficiency.

The private market produces efficiency by forcing low priority and/or inefficient producers from the market, thus freeing up the resources (including workers) they used for better things. Fortunately, the government is demanding increased efficiency from GM and Chrysler as a condition for the injection of additional taxpayer money. This means fewer jobs at GM and Chrysler as the price of the prospect to survive (eventually) on their own. It was a mistake (by the Bush administration) for the government to interfere in the first place rather than to allow the existing tools of bankruptcy to clean up and restructure these firms if need be, but at least Obama has drawn a line in the sand on the use of additional tax payer bailout money (at least with regard to GM and Chrysler).

We are a wealthy nation, able to support the strongest military in history AND to enjoy a very high standard of living for the average person, because each person is able to produce a lot. This results from the very careful allocation of our resources (people, capital, and technology) to their most productive uses (minimizing the number of people needed for each activity so that they may engage in other activities thus increasing our overall output). With changing tastes and technologies this needs to be a very dynamic process. If the jobs to produce no longer wanted products are artificially preserved, the value of our output will decline.

The profit incentive of the private sector rewards good resource allocation decisions and punishes poor (or unlucky) ones. Government is needed to establish and enforce reliable and predictable rules of the game for private interaction, but government over reach can undermine the virtuous workings of the profit incentive in competitive markets. Competition and consumer sovereignty in the private help direct man’s natural greed (i.e. self interest) toward the social good and help keep it in check. Government has a more difficult time of it. It is difficult for an individual congressman to uphold the national interest against the interest of his constituency to preserve their jobs. But our national defense and general well being demand it. Good luck Mr. Gates.

[1] Robert O’Harrow Jr., "An Era Begins Closing On F-22", The Washington Post, April 13, 2009.

[2] Julian E. Barns, "Lockheed Lobbies For F-22 Production on Job Grounds", Los Angeles Times, February 11, 2009.

Comments on : “Is there Inflation Ahead?”

Dear Friends,

As always, some of you made interesting comments on my Inflation note.

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May I infer that what you expect is significantly higher interest rates AND inflation significantly above 2 per cent? If so, other than writing a letter to our Congresswoman (who can’t vote) and perhaps buttonholing Barney Frank at your next Christmas eve party, what else? Could you write a second piece looking at investment strategies—what investments one might make to neutralize, or even benefit from, higher interest rates 2-3 years from now, raging inflation and a devalued dollar? All of your friends would be DEEPLY INDEBTED to you for this kind of advice. I’m refinancing my apartment, capturing 4.65 interest rates for 30 years. But what else?

Best,

Charles [Krause, Washington DC]

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So the answer is "maybe"?
Russ [Schrader, San Francisco, CA]

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Warren,

Nice to hear from you. I hope to visit that region of the world again at some point. Relaxing by the Dead Sea is no doubt nice, but so is dancing with the Dead! I’ve recently attended a few concerts by the remaining members of the original Grateful Dead who are on tour this spring.

The Dead began doing shows around 1966. For more than 40 years, presidents have come and gone while they just keep playin’ in the band, sharing their music with whomever happens their way.

They met briefly with President Obama during there stop-over in Washington. Probably moreso for Obama to pay homage to them, then vice versa. Someone associated with the band was quoted in the Post saying "there were no ties, and no tie-dyes." Ah, the Jeffersonian spirit lives. An extended hand of friendship with all, at least initially, and alliances with none.

There’s something about the scent of patchouli, the glow of fire in glass as the lights go out, the haze that engulfs a roaring crowd as the band takes to the stage, and the music of the ages that pours forth like a favorite wine.

How does any of that relate to the economy and inflation? The best things in life do not come from government, they are not expensive (although they are precious), and they are readily available to all who have ears and wish to hear, and all who have eyes who wish to see, in a manner of speaking.

Nero may have fiddled while Rome burned, but Rome had no business in Israel, and they never should have killed Jesus.

"I spent a little time on the mountain,

spent a little time on the hill.

saw some things gettin’ out of hand,

and I guess they always will…"

(from New Speedway Boogie, 1969)

David Garland [Richmond VA]

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Warren:

  Right on target!

Jim [Dorn, Cato Institute, Washington DC]

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Warren

Thanks for this.  Feldstein had a piece in the WSJ or FT yesterday giving a more pessimistic scenario about in inflation, and Volcker and Don Kohn got into a public verbal argument about it.

RWR [Richard Rahn, Great Falls VA]

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Dear Warren’

Many thanks for the insight. It was very helpful to me. I hope you are doing well….

Cheers

Tolga [Sobaci, Istanbul, Turkey]

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Hi Warren,

Very interesting article.

I hope I’m clever enough to buy long bonds when rates are way up, as they probably will  be at some point over the next 10 years…   if  we had bought 30-yr. bonds in Sept. or Oct. 1981, we’d still today be earning 15% per annum, that’d be wonderful!

Writing one’s congressman may not be enough, there may simply be too many powerful constituencies in favor (maybe without openly expressing it) of a sharp burst of debt-reducing inflation, or in favor of sustained not-extreme but not-so-moderate inflation (+5% per annum).

I do – sort of – remember the late 70s & early 80s, I was 10-15 yrs. old during that period. I remember going to Europe in 6th grade, my dad took me over for about three weeks, that must have been around 1979, and the dollar had recently reached a postwar low, I  remember how grumpy my dad was when I’d ask for walking-around money in London, hahaha and with 2,000 Ital. lira equaling a dollar, even at that tender (but no longer virginal) age, I somehow instinctively understood that this "goofy" exchange rate reflected past inflation, that the Italians hadn’t started out with a currency worth a tenth or a twentieth of a penny.   

Anyway, welcome back from Jordan.

Wolfie [Ernest McCall, Istanbul/Washington DC]

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Thanks Warren – a fantastic note! This is exactly what we are currently studying in my International Economics course (whether Fiscal policy has an effect on Monetary policy).

Hope all is well!

Best,

Alex

Alex Seleznyov

Georgetown University

McDonough School of Business class of 2010

[Almaty, Kazakhstan]

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Dear Warren,

Speaking of future inflation, have you read Greg Mankiw’s crazy article in Sunday’s New York Times ("Maybe the Fed Should Go Negative", NYTimes, April 19, 2009:  http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1). 

After reading it, I was reminded of Lord Acton’s statement, "There is no error so monstrous that it fails to find defenders among the ablest men."

Basically Mankiw advocates a partial (10%) repudiation of Federal Reserve Notes in a desperate effort to get the public to buy Treasuries that pay negative interest rates.  He believes this extreme measure is necessary to jump start the economy and reignite inflation, his ultimate goal.  Each year he would have the Treasury choose a random 10% of all banknotes and repudiate their legal tender status as a way to encourage people to buy T-bills that pay less at maturity.  

That’s got to be one of the most dangerous policy ideas since Keynes endorsed Silvio Gesell’s "stamped" money idea and "zero money rate of interest" …Keynes himself labeled Gesell a "crank" (General Theory, pp. 353-57).  If enacted, Mankiw’s dollar repudiation idea would surely panic the public into withdrawing billions from bank accounts and into gold. 

With hair-brained schemes like this one, I can see why the country is losing faith in its government and economics profession.  And this is coming from the #1 econ textbook writer! 

It’s highly doubtful the Treasury would adopt Mankiw’s crazy idea, but it won’t enhance Mankiw’s reputation as a sound thinker. 

I’ve known Greg for many years and have told him that he’s making a serious blunder that will come back to haunt him. 

BTW, in the same New York Times yesterday, they had a sample AP exam in econ.  Amazingly, I got a "5" point scale ("extremely well qualified").  You can take the quiz online by going to:  http://www.nytimes.com/interactive/2009/04/19/education/edlife/20090419EdlifeQuiz.html?scp=1&sq=economics%202009%20ap&st=cse

Best wishes, AEIOU,

Mark [Skousen, NY]

Is There Inflation Ahead?

In reaction to the financial and credit crisis that seized American and international financial markets last September, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank (the Federal Reserve) printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the U.S. and the dollar to serious inflation in the next few years. This note reviews the historical relationship between the growth in the money supply and prices (inflation) and the recent behavior of the money supply, and presents my assessment of the prospects for inflation over the next few years.

 

The simplest analytical framework for understanding inflation is the quantity theory of money. This framework may be presented in two different ways. As economists prefer to think of price determination in terms of supply and demand, our preferred formulation of the theory says that the value (purchasing power) of money (“the price level” P) results from its supply (M) relative to its demand and that (as the simplest assumption) its demand is proportional (k) to real output (real GDP–q) or M = kqP. An increase in the supply of money (M) will cause prices to raise (P) until the demand for money (kqP) matches the increase in its supply. Both theory and evidence says that the money supply has no long run effect on real output (q), thus ultimately the entire effect of money growth is on the price level (CPI).

 

Thus inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply or ΔM = Δq + ΔP (where k is constant, q is independently determined by growth in labor, capital and productivity, and Δ is the change from one period to the next in whatever it refers to). Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply:

ΔP = ΔM – Δq.[1] If the economy is growing at 3% per year and the money supply is growing at 5% per year, inflation will be approximately 2% per year. However, historical evidence reveals a lag of one to two years between changes in money growth rates and inflation. If money growth increases to say 10%, the impact on inflation would not materialize for another one to two years.

 

Instead of the demand for money formulation described above, the quantity theory of money is sometime presented in term of money’s velocity of circulation (V): MV = Pq. The two versions are equivalent (V = 1/k). The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.

 

These are long run relationships. In the short run other factors can dominate the behavior of inflation. In the long run a reduction in the economy’s growth rate (Δq) increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls (with no change in its long run potential growth rate) it has the opposite effect on inflation. Economists refer to this as the output gap (between real output and potential or full employment output). When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply (the demand for money—k—increases temporarily).

 

Our central bank–the system of Federal Reserve Banks–indirectly controls the money supply (currency held by the public and the public’s deposits with banks) and its rate of growth. There is a link between the money created by the Fed (called base money) and the broader money supply (M). The two are related by the so called the “money multiplier.” Usually the money supply grows at about the same rate as base money.

 

With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities and mortgage backed securities from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on April 11, 2008 to 2.15 trillion on April 15, this year. Almost all of that increase occurred since September. As a result, base money almost doubled over the same period, rising from 874 billion Sept 10, 2008 to 1,726 billion March 25th of this year.

 

The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve Credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM), the money supply rose from 8.6 trillion on April 7 2008 to 9.4 trillion on April 6, 2009. Stated in terms of growth rates, which can be directly related to inflation rates, the growth in MZM over the past year (year on year) was 9.7%. This is already significantly reduced from the year on year increase of 14.5% on January 19th of this year and only modestly above the 8.7% average annual rate of growth over the decade ending December 2008 during which inflation averaged 3.0% (the demand for money, k, grew about 2% per year on average over this period).

 

Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public “moved to safety” in the holding of its assets (currency and insured bank deposits). An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing “output gap” further reduces inflation (temporarily).

 

Finally, the Fed intends to withdraw the extra liquidity it has injected (and thus reduce base money) as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2%. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have confidence that it will be able to do so more or less (but not exactly) at the right time and pace.

 

The real risk of inflation, however, is political. The Federal budget has unfunded liabilities (the difference between the cost of the benefits promised and the revenue now legislated to pay for them) that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments’ is six time (yes six times) that. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry. In addition, the rest of the world will not continue to finance as much of our annual deficits (and thus to own as much of the outstanding debt) as they have in the past, i.e. the market will force our external trade deficits to contract.

 

All of this adds up to higher, potentially significantly higher, interest rates in the years ahead (once we have recovered from the current recession) to enable the government to raise the money needed (sell its bonds) to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world lets us have.

 

“Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.”[2] The short run effect of monetary growth is the opposition of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets build into new borrowing and lending interest rates pushing rates up eventually.

 

Current monetary policy does not need to result in higher inflation down the road. But the higher interest rates we are in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to the pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation nominal interest rates will end up being even higher still. Try to remember the inflation and high interest rates of the 1970s through 1981 and tell your congressman to resist the inflation solution.

[1] This is a simplification of the following ΔP/P = ΔM/M – Δk/k – Δq/q, more correctly reflects the percentage rate of change of each variable.

 

[2] Richard W. Fisher (President of the Federal Reserve Bank of Dallas), "Storms on the Horizon",  Remarks before the Commonwealth Club of California, San Francisco, California,  May 28, 2008.

What are SDRs?

The very large increase in world trade (globalization) over the last four decades has enormously reduced poverty and raised living standards for very large numbers of people. Government policies in the U.S., China and elsewhere have produced large, unsustainable trade imbalances (mismatch of imports and exports). Free trade on its own would not produces such imbalances.  New Global Studies has just published my article “Time for a New Global Currency?” http://www.bepress.com/ngs/vol3/iss1/art5. The article explains what the IMF’s Special Drawing Rights (SDRs) are following the G 20s recommendation that the IMF allocate an additional 250 billion dollars worth of them, and how they might facilitate achieving and maintaining better global balance.

Living with Bias

One of the many factors that have contributed to America’s success is its ability to accommodate people with different religious beliefs and cultural practices. This has been an important factor in attracting the world’s best and brightest to our shores, thus keeping us ahead in an increasingly globalized and competitive world economy. To be sure, while accommodating diversity, we also require a broad consensus on the need to respect the rights of others and the separation between the private and public spheres. But within that broad consensus, people worship as they chose, celebrate the holidays and festivals of their choice, and abide by the behavioral norms of their choice. Debates have occurred throughout our history about where the boundary between the public and private spheres should be, but our success resides, in part, in our agreement to leave many very important issues to the private sphere. I have commented on this issue a number of times but there are several recent examples that bring to the fore again the debate over the proper dividing line between public and private spheres.

Our religious and cultural preferences are biases. They are beliefs we hold for whatever reason or choices that we make about values we chose to adopt because we believe them to be superior or at least the most appropriate for guiding our own actions. Muslims, Jews, and Catholics, chose to cluster together with their own kind on Fridays, Saturdays and Sundays respectively without the rest of us being much bothered. It would be foolish for Catholics to extend this clubiness to which restaurants and shops they patronize, but if that is their choice, what is the harm compared with the harm of restricting their freedom to choose? For better or worse a preference (bias) for “our own kind” is part of our human nature. The social costs of forcing a Catholic to shop in a Jewish or Muslim owned shop would be enormous and would strike American’s as ridiculous. Fortunately, the free market itself discourages such biased and economically irrational behavior because the indulgence in such biases comes with a cost. Limiting your shopping and dinning (or employment) to your own kind, limits choice (be definition) and competition and thus almost always increases the cost you must pay to indulge your biases.

Social acceptance of the right of people to indulge their personal biases in broad areas of our lives, allows people with different beliefs can live peaceably together. It is when we try to force our own beliefs and rules on others beyond the truly essential values needed to live together that series strains and social turmoil can result. Here are some recent examples.

Afghanistan just passed a law that moved the boundary between public and private spheres far too far in favor of public religion. “The law, which was approved by parliament and signed by President Hamid Karzai [in March], codifies proper behavior for Shiite couples and families in the most intimate detail. It requires women to seek their husband’s permission to leave home, except for "culturally legitimate" purposes such as work or weddings, and to submit to their sexual demands unless ill or menstruating.

“Initially seen as a political gesture to the country’s Shiites, who make up 20 percent of the population and have long sought legal recognition of their religious beliefs, the law has become a political nightmare for a government struggling to balance conflicting pressures from traditional and modernizing forces at home and abroad…. I could not keep silent any longer," said Foreign Minister Rangin Dadfar Spanta…. The Shiite law, he said, had a ‘totalitarian orientation that does not accept the difference between what is private and public. It identifies some Afghan citizens not as human beings but as slaves.’

“‘The law… was supposed to be an achievement: to recognize Shias’ legal rights so Hanafi [Sunni] laws would not be imposed on them,’ said Sima Samar, a Shiite woman who chairs the Afghan Independent Human Rights Commission. ‘But it was also used by a few leaders who want to put chains around half the population. It is good to have rules for marriage and divorce, but if I want my wife to wear pink lipstick and she wants to wear red, why should that be a matter of law?’”[1]

Islamic states or Islamic dominated states differ dramatically over the issue of whether to separate church and state. In Turkey and Indonesia they are separate and in Iran they are not. The Islamic Republics (Afghanistan, Iran, Mauritania, and Pakistan) may offer a purer choice for Muslims but are bound to pay the price of bias discussed above. Contrast Afghanistan’s approach to that taken by British Archbishop of Canterbury, Dr Rowan Williams, in which he argued that British law should accommodate Islamic practice for those wanting to adhere to it (rather than incorporating it into the law as was done in Afghanistan). His comment precipitated a laud public debate and illustrates how difficult it is to reconcile some of these issues.

As I mentioned in an earlier note American Muslims who could afford it are able to effectively achieve by contract the rights and obligations of second, third and fourth wives as permitted by Islam while observing the American limit to one wife (at a time). The observance of the practice in some Islamic countries of subordination of wives to the practices just adopted into law in Afghanistan would require the voluntary agreement of the wife in the U.S. Some conflicts in values and practices are simply not resolvable within America’s legal system, but the number of conflicts can and generally are minimized by leaving many things to custom and contract. Oxford University Islamic scholar Professor Tariq Ramadan stated that: “I really think we, as Muslims, need to come up with something that we abide by the common law and within these latitudes there are possibilities for us to be faithful to Islamic principles.”[2]

Our founding fathers did not come here to establish a religious state (at least the wiser of them did not). They came here to escape religious states that did not allow them to worship according to their own beliefs. They came here to be free to worship as they wished and that required that they allow others to worship as others wished. Thus they wrote the separation of church as state into our constitution leaving religion to the private sphere. Those who wish to brake down that barrier are doing a dangerous thing.

There are also some alarming recent examples in which private citizens are being forced by law to comply with preferences of others. Laws that command actions are generally more invasive and repulsive than those that prohibit them. A month ago it was reported that: “President Barack Obama will rescind a Bush Administration rule that granted protection to doctors, nurses, pharmacists, and other health care workers who refuse to perform or assist in abortions, sterilizations, and other contraceptive procedures on moral grounds. The rule was issued by the Department of Health and Human Services late in Bush’s term, and applied to any hospital or clinic receiving federal funds.”[3] This would be a bad move. "’I will do nothing against my conscience in the practice of medicine ever regardless of what any law is at any time,’ Sen. Tom Coburn told FOX News” and rightly so.[4]

The Washington Post recently reported a number of court cases in which the rights of individuals were violated for one or another “social interest:”

“– A Christian photographer was forced by the New Mexico Civil Rights Commission to pay $6,637 in attorney’s costs after she refused to photograph a gay couple’s commitment ceremony.

— A psychologist in Georgia was fired after she declined for religious reasons to counsel a lesbian about her relationship.

— Christian fertility doctors in California who refused to artificially inseminate a lesbian patient were barred by the state Supreme Court from invoking their religious beliefs in refusing treatment.

— A Christian student group was not recognized at a University of California law school because it denies membership to anyone practicing sex outside of traditional marriage.”[5]

These are dangerous (to public harmony) trends. Gay and Lesbian Americans deserve to have every right enjoyed by any other American (marriage, adoption, inheritance, etc.). But I don’t think I should have the right to demand that you work for me in whatever capacity whether you want to or not. Why in the world would a lesbian want to hire a psychologist to council her on her relationship whose unloving and misguided religion thought lesbians were evil? I can’t imagine that a reluctant shrink would be worth the money.

Let’s keep the public private boundary more in favor of the private sector. Let’s prohibit only that behavior that truly harms us (stealing our property, harming our person, etc) and not force others to do what we want them to do. Address “bad” behavior with education and the market cost of bias. There will always be difficult boundary issues but the less the state interferes in matters that can and should be left to individual briefs and customs the richer, healthier, and more peaceful we will all be.

[1] Pamela Constable, "Afghan Law Ignites Debate on Religion, Sex" , The Washington Post, April 11, 2009, Page A01.

[2] "Sharia law row: Archbishop is in Shock…" September 2, 2008, London Evening Standard.

[3] Mark Impomeni, "Obama Scraps Protections for Abortion Objectors" Political Machine, Feb 28th 2009.

[4] "Obama to Repeal Bush Abortion Regulation" Fox News.com, March 3, 2009

[5] Jacqueline L. Salmon, "Faith Groups Increasingly Loss Gay Rights Fights" The Washington Post, April 10, 2009, Page A04.