Is it possible that monetary policy can’t fix all of our economic problems? That was one of my main discussion points with our accounts in Boston last week. In recent years, the major central banks have been taken over by macroeconomists who believe that they have the power to tame the business cycle. Since the financial crisis of 2008, they’ve led us to believe that they can revive self-sustaining economic growth and stabilize inflation around 2%. That’s because they strongly believe in their powers--even though they’ve been providing abnormally easy monetary policy since the crisis yet economic growth remains subpar with inflation below 2%.
I believe that the macroeconomists at the central banks (a.k.a. central monetary planners) have failed to achieve their goals because they are blindly fighting very powerful economic forces that are microeconomic in origin. They are also fighting the forces of technology and demography. Technological innovation, one of the primary drivers of “creative destruction,” disrupts and displaces the old ways of doing things with better goods and services at lower prices (BGSALP). Demographic trends are disruptive too, as people are living longer while baby creation is tanking, as evidenced by plunging fertility rates around the world, with deflationary consequences.
By ignoring these forces, the macroeconomists are unknowingly disrupting the microeconomic adjustment mechanisms that automatically eliminate economic and financial excesses on a regular basis. In other words, their obsession with moderating the business cycle is actually contributing to the problems they are trying to fix, because they won’t let Mother Nature--who is a microeconomist--manage the business cycle. Consider the following:
(1) Tolstoy. Last Thursday, we learned that real GDP rose just 1.5% (saar) during Q3. That was widely reported. Not as widely reported was that the GDP deflator rose just 0.9% y/y. Excluding food and energy, it was up just 1.1% y/y, the lowest since Q1-2010. The deflator for personal consumption expenditures excluding food and energy rose only 1.3% y/y, with the comparable market-based core inflation rate at just 1.1%.
Why has the Fed’s ultra-easy monetary policy failed to boost inflation? The answer may be in Leo Tolstoy’s War and Peace. A chart of the US CPI since 1800 shows very clearly that inflationary periods have been associated with wartime conditions during the War of 1812, the Civil War, World War I, and World War II through the Cold War. The restoration of peace is associated with outright deflation, i.e., falling prices after each one of these wars with only one exception. There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7% y/y during November 1989, when the Berlin Wall was toppled, to zero today.
During wartime, government takes command of the economy since all resources must be mobilized to win the war. Global trade is disrupted since there can be no trade among combatants, and it can be hard to trade with allies. In other words, wars are trade barriers. During peacetime, globalization occurs. There is more free trade even among former adversaries, and markets become freer from government controls and also more competitive.
The end of the Cold War in 1989 was the end of biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001. So far, it has been different this time because there has been no deflation. That’s because so far the central banks have succeeded in averting it with ultra-easy monetary policy. But that doesn’t mean that there won’t be adverse consequences.
Macroeconomists don’t spend much time thinking about markets, especially competitive ones. These markets tend to be very deflationary because having fewer barriers to entry during peacetime means that established, profitable producers are constantly under attack from startups hoping to take some if not all of their profits by providing BGSALP. It’s one of Mother Nature’s great wonders because it greatly benefits the one and only economic class that should matter--that is, the Consuming Class!
Competition exists in nature for only one reason, which is to improve the standard of living of consumers. It is not designed to enrich companies, shareholders, trade unions, or workers. The protagonist in this natural narrative is the entrepreneurial capitalist. (Along the way, those who succeed among them have a tendency to turn into crony capitalists, but that’s a subject for a book that I will write someday.)
(2) Turing. These days, the hero of entrepreneurial capitalists is Alan Turing, the British mathematician who is widely credited with having invented the computer. As a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with BGSALP. Steve Jobs, who was a big fan of Turing, was the entrepreneurial capitalist who started the personal computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads. All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.
In the GDP accounts, the price deflator for IT capital equipment spending has declined 79% since 1977 when Apple introduced the Apple II, a color computer with expansion slots and floppy drive support. Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, up from just 23% during 1977.
(3) Bismarck. The welfare state originated in Germany during 19th century with the policies implemented by German Chancellor Otto von Bismarck. The welfare system in the United States began in the 1930s, during the Great Depression. After the Great Society legislation of the 1960s, for the first time a person who was not elderly or disabled could receive need-based aid from the federal government. The notion that government has an obligation to provide a social welfare safety net is now widely accepted in all developed nations.
The good news is that people are living longer and more comfortably in their old age. The problem is that government deficits have swelled to finance entitlement spending rather than public investments in infrastructure. It’s conceivable that the plunge in fertility rates might be partly attributable to the perception that raising children is expensive and not a good investment if the government will support us in our old age, obviating the need for adult children to do that.
The result is that the number of social welfare beneficiaries are increasing faster than workers who can support them. In the US, the ratio of 65-year-olds who are not in the labor force rose to a record 24% of the civilian labor force during September, up from 20% only 10 years ago.
In any event, these demographic trends are likely to be deflationary, since older people tend to consume less than younger people with children. This might explain the strong secular correlation between the inflation rate in the US and the Age Wave, which is the percent of the labor force that is 16 to 34 years old. The Age Wave has dropped from a record 51.2% during January 1981 to only 35.4% currently. Over that same period, the CPI inflation rate has plunged from over 10% to under 2%.
Last week, the Chinese government abandoned its one-child policy, which over the past 35 years has led to a myriad of social and economic ills in China. All Chinese couples will be allowed to have two children. The move is most likely too little too late, as China already faces a declining, graying population without the workers it needs for its vast economy.
(4) Bernanke. The macroeconomists who are running the major central banks seem oblivious to these secular forces of deflation. Nonetheless, they can be credited with successfully countering the natural forces of deflation, so far, with ultra-easy monetary policy. Perhaps they eventually will be proven right in their belief that if they persist, then self-sustaining growth will make a comeback and inflation will stabilize around 2%.
More likely, in my view, is that easy money has lost its effectiveness and won’t boost demand as still widely expected by the demand-side macroeconomists who steer the central banks. Meanwhile, on the supply side, easy money has disrupted the economic laws of nature by propping up ““zombie” producers, who would have been buried for good, and for the good of the economy, in a competitive market. The living-dead companies exacerbate deflation with their excess capacity and weaken profits for healthy companies, thus depressing the overall economy.
As I’ve often noted, no one has been as committed to moderating the business cycle with monetary policy as former Fed Chairman Ben Bernanke. He reiterated this view in a 10/4 WSJ op-ed titled “How the Fed Saved the Economy,” timed to coincide with the release of his new book, The Courage to Act: A Memoir of a Crisis and Its Aftermath:
“What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.”
In his memoir, Bernanke does acknowledge that the “experience of the Great Moderation had led both banks and regulators to underestimate the probabilities of a large economic or financial shock.” In my opinion, attempts by the central banks to moderate the business cycle make the economy more vulnerable to financial instability and deeper recessions. Consider this: After so many years of attempting to revive economic growth and stabilize the financial system, Fed officials have hesitated to hike the federal funds rate by a measly 25bps, fearing the consequences. By the way, I looked in the index of Bernanke’s book for the word “capitalism.” It isn’t there.
I believe that the macroeconomists at the central banks (a.k.a. central monetary planners) have failed to achieve their goals because they are blindly fighting very powerful economic forces that are microeconomic in origin. They are also fighting the forces of technology and demography. Technological innovation, one of the primary drivers of “creative destruction,” disrupts and displaces the old ways of doing things with better goods and services at lower prices (BGSALP). Demographic trends are disruptive too, as people are living longer while baby creation is tanking, as evidenced by plunging fertility rates around the world, with deflationary consequences.
By ignoring these forces, the macroeconomists are unknowingly disrupting the microeconomic adjustment mechanisms that automatically eliminate economic and financial excesses on a regular basis. In other words, their obsession with moderating the business cycle is actually contributing to the problems they are trying to fix, because they won’t let Mother Nature--who is a microeconomist--manage the business cycle. Consider the following:
(1) Tolstoy. Last Thursday, we learned that real GDP rose just 1.5% (saar) during Q3. That was widely reported. Not as widely reported was that the GDP deflator rose just 0.9% y/y. Excluding food and energy, it was up just 1.1% y/y, the lowest since Q1-2010. The deflator for personal consumption expenditures excluding food and energy rose only 1.3% y/y, with the comparable market-based core inflation rate at just 1.1%.
Why has the Fed’s ultra-easy monetary policy failed to boost inflation? The answer may be in Leo Tolstoy’s War and Peace. A chart of the US CPI since 1800 shows very clearly that inflationary periods have been associated with wartime conditions during the War of 1812, the Civil War, World War I, and World War II through the Cold War. The restoration of peace is associated with outright deflation, i.e., falling prices after each one of these wars with only one exception. There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7% y/y during November 1989, when the Berlin Wall was toppled, to zero today.
During wartime, government takes command of the economy since all resources must be mobilized to win the war. Global trade is disrupted since there can be no trade among combatants, and it can be hard to trade with allies. In other words, wars are trade barriers. During peacetime, globalization occurs. There is more free trade even among former adversaries, and markets become freer from government controls and also more competitive.
The end of the Cold War in 1989 was the end of biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001. So far, it has been different this time because there has been no deflation. That’s because so far the central banks have succeeded in averting it with ultra-easy monetary policy. But that doesn’t mean that there won’t be adverse consequences.
Macroeconomists don’t spend much time thinking about markets, especially competitive ones. These markets tend to be very deflationary because having fewer barriers to entry during peacetime means that established, profitable producers are constantly under attack from startups hoping to take some if not all of their profits by providing BGSALP. It’s one of Mother Nature’s great wonders because it greatly benefits the one and only economic class that should matter--that is, the Consuming Class!
Competition exists in nature for only one reason, which is to improve the standard of living of consumers. It is not designed to enrich companies, shareholders, trade unions, or workers. The protagonist in this natural narrative is the entrepreneurial capitalist. (Along the way, those who succeed among them have a tendency to turn into crony capitalists, but that’s a subject for a book that I will write someday.)
(2) Turing. These days, the hero of entrepreneurial capitalists is Alan Turing, the British mathematician who is widely credited with having invented the computer. As a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with BGSALP. Steve Jobs, who was a big fan of Turing, was the entrepreneurial capitalist who started the personal computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads. All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.
In the GDP accounts, the price deflator for IT capital equipment spending has declined 79% since 1977 when Apple introduced the Apple II, a color computer with expansion slots and floppy drive support. Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, up from just 23% during 1977.
(3) Bismarck. The welfare state originated in Germany during 19th century with the policies implemented by German Chancellor Otto von Bismarck. The welfare system in the United States began in the 1930s, during the Great Depression. After the Great Society legislation of the 1960s, for the first time a person who was not elderly or disabled could receive need-based aid from the federal government. The notion that government has an obligation to provide a social welfare safety net is now widely accepted in all developed nations.
The good news is that people are living longer and more comfortably in their old age. The problem is that government deficits have swelled to finance entitlement spending rather than public investments in infrastructure. It’s conceivable that the plunge in fertility rates might be partly attributable to the perception that raising children is expensive and not a good investment if the government will support us in our old age, obviating the need for adult children to do that.
The result is that the number of social welfare beneficiaries are increasing faster than workers who can support them. In the US, the ratio of 65-year-olds who are not in the labor force rose to a record 24% of the civilian labor force during September, up from 20% only 10 years ago.
In any event, these demographic trends are likely to be deflationary, since older people tend to consume less than younger people with children. This might explain the strong secular correlation between the inflation rate in the US and the Age Wave, which is the percent of the labor force that is 16 to 34 years old. The Age Wave has dropped from a record 51.2% during January 1981 to only 35.4% currently. Over that same period, the CPI inflation rate has plunged from over 10% to under 2%.
Last week, the Chinese government abandoned its one-child policy, which over the past 35 years has led to a myriad of social and economic ills in China. All Chinese couples will be allowed to have two children. The move is most likely too little too late, as China already faces a declining, graying population without the workers it needs for its vast economy.
(4) Bernanke. The macroeconomists who are running the major central banks seem oblivious to these secular forces of deflation. Nonetheless, they can be credited with successfully countering the natural forces of deflation, so far, with ultra-easy monetary policy. Perhaps they eventually will be proven right in their belief that if they persist, then self-sustaining growth will make a comeback and inflation will stabilize around 2%.
More likely, in my view, is that easy money has lost its effectiveness and won’t boost demand as still widely expected by the demand-side macroeconomists who steer the central banks. Meanwhile, on the supply side, easy money has disrupted the economic laws of nature by propping up ““zombie” producers, who would have been buried for good, and for the good of the economy, in a competitive market. The living-dead companies exacerbate deflation with their excess capacity and weaken profits for healthy companies, thus depressing the overall economy.
As I’ve often noted, no one has been as committed to moderating the business cycle with monetary policy as former Fed Chairman Ben Bernanke. He reiterated this view in a 10/4 WSJ op-ed titled “How the Fed Saved the Economy,” timed to coincide with the release of his new book, The Courage to Act: A Memoir of a Crisis and Its Aftermath:
“What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.”
In his memoir, Bernanke does acknowledge that the “experience of the Great Moderation had led both banks and regulators to underestimate the probabilities of a large economic or financial shock.” In my opinion, attempts by the central banks to moderate the business cycle make the economy more vulnerable to financial instability and deeper recessions. Consider this: After so many years of attempting to revive economic growth and stabilize the financial system, Fed officials have hesitated to hike the federal funds rate by a measly 25bps, fearing the consequences. By the way, I looked in the index of Bernanke’s book for the word “capitalism.” It isn’t there.
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