Pyromania and the Fires of Inflation

 by Thomas E. Brewton  

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The Fed attempts to stamp out the forest fires it keeps starting.

Panic in world financial markets has dominated the business news of the past month.  The Dow Jones Industrials dipped down almost 400 points below their July high.  Mortgage bankers and hedge funds have lost heavily or been forced out of business.  Lenders have sharply increased credit standards, delaying or canceling some corporate takeovers and IPOs.

Earlier this month, to restore market confidence and to ease the overall credit squeeze, the Federal Reserve purchased an extra $40 billion or so of Treasury securities in the open market to provide liquidity to financial institutions.

Ironically, the Fed itself created the conditions that produced the financial meltdown.  Over the past decade it has all but drowned the world in excess creation of dollars to fund ever-growing Federal deficit spending and to satisfy consumers' demands for instant gratification without the bother of working and saving money. 

1970s stagflation, the quintessential application of Keynesian economics to Federal Reserve policy, seems to have been forgotten.  Only once in 25 years – under Chairman Paul Volcker in the early 1980s – has the Fed dealt appropriately with inflation by restricting the money supply.  Since then, the Fed has reverted to Keynesian economic orthodoxy that preaches Federal deficit spending as the cure for all ills.

The Fed's creation of money faster than needed for legitimate business encouraged banks and institutional investors to lower credit standards in order to find places to invest the torrent of money.  The volume of credit card debt, home equity loans, subprime mortgages, and exotic derivative securities has ballooned in the past decade.

The resulting credit market panic has taken our attention away from the other shoe, which has yet to fall: significant further dollar devaluation.

Robert P. Murphy's recent article, "A Falling Dollar, After All," on the Mises.org website, notes that the classic relationship between currency exchange rates and export-import trade has been disrupted by excessive money supply expansion.

Historically, when the current account deficit (excess of imports over exports) gets too high, the dollar exchange rate declines, because we are sending more dollars abroad to pay for the imports.  But the declining dollar exchange rate makes our exports cheaper in importing countries' currencies.  This levers up our exports, cuts the current account deficit, and begins to strengthen the dollar against other currencies, as importing countries buy more dollars to pay for their imports from us.

Mr. Murphy writes:

. . . since 2002 there has been an unprecedented divergence . . . The dollar has fallen to historically low levels, and yet the current account deficit has continued to climb to historically high levels. It seems very unlikely to me that our present trade deficits should be attributed to the wonders of the US economy. Instead, it seems more likely that the artificially cheap credit of the early 2000s fueled various wealth bubbles, leading Americans to consume their capital without realizing it.

The US economy is far more flexible now than it was during the dark days of the Carter years. Tax rates are much lower, the Fed isn't as insane, and financial markets are far more sophisticated at handling risk. Even so, it is hard to avoid the conclusion that the dollar could be ready for another beating.

For background on why further devaluation is not good, read "Exporting Inflation to China."

Concerning the Fed's hubristic presumption that it can control inflation and the dollar exchange rate by indirectly tinkering with interest rates without reining in the money supply, read the following:

"Ben Bernanke and the "Barbarous Relic""

"Fascist Fed: Who Cares?"

"Need We Fear Inflation?"

"The Fed Facade"

"Storm Ahead?"

"Stoking the Fires of Inflation"

"Chickens Coming Home to Roost?"

"Democrats, the Fed, and Milton Friedman"

"Echoes of 1929?"

"How FDR Destroyed the Dollar"

Econ. & Public Policy, Science, Technology, Energy

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