Wednesday, June 10, 2009

Get ready for major inflation


Arthur Laffer is the economist who created the famous "Laffer Curve" showing that higher tax rates can result in lower tax revenues. In this article in the WSJ, he points out that:

"The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless."

As a result, "The 12-month growth rate of M1 [one of the main measures of money in circulation] is now in the 15% range, and close to its highest level in the past half century...

It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn't a pretty picture...

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds...

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren."

It's not widely known that the major cause of the 1930's depression was ill-advised manipulation of the money supply by the Federal Reserve. It looks like we are on track for a repeat of this devastating episode of economic history. Ben Bernanke has let the inflationary genie out of the bottle, and as Arthur Laffer has shown, it will cause tremendous economic pain to get it back in. Mr. Bernanke will almost undoubtedly go down in history as one of the worst Fed chairmen ever.

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