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Re-Thinking The Fed's Exit Strategy
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About a year ago I wrote an article entitled "Re-Thinking The Inflation Scenario". You can find it in the archives of Kitco.com under my name. In that article I suggested that although the Fed had increased the money supply by over a trillion dollars, it may not ever become an inflationary problem:
"The trillion dollars supplied by the Fed attempts to replace the money lost to the banks and financial companies. It is an attempt to prevent deflation and an implosion of the entire banking system. If prices rise, will the Fed attempt to withdraw the money it injected into the economy in order to return the inflation rate to a lower level as many hard money advocates want? Bernanke has said as much in testimony. This, I believe could be a huge mistake. There is an example of this in history that provides a valuable lesson.
During the first World War, England was on the Gold Standard. It suspended gold convertibility and pursued inflationary monetary policies to finance the war. After the war it tried to return to the Gold Standard by reducing the money supply and return to the price level of pre-war days. It tried to fix the Pound in terms of gold at the previous price. The experiment failed miserably. The Gold Standard got the blame as the nation was thrown into depression. This mistake was responsible for England abandoning the Gold Standard which it had adhered to, more or less, since the 14th century. In many things monetary, you can not go back. I believe this is the case now."
A year ago, the consensus was that the Fed would need to reduce the money it had injected into the banking system. The Fed had developed a plan to exit from its quantitative easing policy. Today is a different day.
Economics is contextual. What works in one situation may be exactly the wrong thing to do in another. For example, when Ronald Reagan opted to increase the deficit and lower tax rates in the eighties, it was the correct policy mix. And it worked. Today it is exactly the wrong thing to do. The context has changed as the economic landscape has changed. In the 80's the problem was too much taxation, regulation, and money supply growth. It was stagflation that we were fighting. Today it is too much debt, deficits, leverage, and uncertainty. It is deflation, de-leveraging, and re-regulation that we are fighting. This is why you can not hold on to absolutes in economics. Economics is more times than not, contextual!
I believe we are in a situation today where inflation and economic artificial growth are behind us as drivers of monetary policy. Today deflationary forces due to debt defaults and austerity measures are pushing us toward lower growth. You do not contract the money supply in this kind of economic environment. You do not raise interest rates in this kind of environment. And you do not slash government spending in this kind of environment. You stabilize. You allow markets, individuals, and businesses to adjust.
As it is, the money supply - as measured by M1 - is virtually unchanged over the last year. And M3, the broadest measurement of money which, by the way, governments lost control of years ago - is contracting at an accelerated rate. M3 fell by amounts not seen since the Great Depression. Meanwhile, short term interest rates are at recent lows and long term rates are falling into new low territory. All signals point to the economy returning to a deflationary/recessionary bias.
Under a gold standard the production of gold equals money growth. Historically that ranged between 2 and 3% a year. Milton Friedman advocated setting the money supply at 3 to 5% to compensate for a 3 to 5% GDP growth. Both were intended to bring about non-inflationary growth. It worries me that the fed is completely ignoring the money supply.
The Fed should be increasing the money supply by a steady amount of 3-5%. It should allow interest rates to reflect market rates and not try to micro-manage them. And fiscally speaking, we should be living within the revenues we have. If we legislate bills that spend more than we have we will have to increase taxes, inflate, (same thing -- different method) or borrow. All paths lead to less prosperity. The least of the bad choices before us is to live within our means. It's true that not running a deficit, or running a very low deficit, means having to cut government spending. But, that is what we as individuals must do when we live beyond our means. Why not expect it from our government? A ten percent cut or so in a government budget which is at all time highs is not a recipe for catastrophe. It's called fiscal discipline.
These changes will give predictability to the system, at least to a certain degree. Low inflation and low interest rates will be with us for the foreseeable future. This is what markets are telling us. As the 10 year long bond interest rate is breaking below 3% into the 2% area, which is almost unprecedented, we should not be talking about the Feds "exit strategy". We should not be talking about contracting the money supply. The next move by the fed should be quantitative easing.
The fact that Bernanke and the fed have not been giving much thought to this course of action and is instead still focusing on contracting the money supply is worrisome, to say the least.
Anyone wishing to be added to my weekly commentary, just contact me at Paulnathan2000@aol.com
Paul Nathan
July, 2010
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Paul Nathan has specialized in gold and gold stocks and has written extensively on monetary and economic matters since 1968.
© 2010 Paul Nathan All Rights Reserved
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