Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.

Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.

Like 2021, the post-election year of 1965 saw the inauguration of an ambitious unified Democratic government. That year, Congress enacted Medicare and Medicaid, began providing federal aid to local school districts, and greatly expanded federal housing programs. At the same time, the Johnson administration was expanding U.S. involvement in Vietnam, increasing the defense budget. The federal budget deficit expanded from $1.6 billion in the 1965 fiscal year (which ended on June 30 in those days) to $27.7 billion, or 3% of GDP, in fiscal 1968.

Although the Federal Reserve made some attempts to ward off inflation, it generally accommodated the government’s fiscal policy according to Allan Meltzer’s detailed history of this period published by the St. Louis Fed. Between calendar years 1965 and 1969, annual CPI growth surged from 1.6 percent to 5.5 percent, setting the stage for the Nixon administration’s closure of the U.S. Treasury’s gold window and imposition of wage and price controls. Inflation reached double digits in 1974 and again between 1979 and 1981. Notably, these were also recession years, refuting the fallacy of the Phillips Curve, which depicted a supposed policy trade-off between inflation and unemployment. By the early 1980s, we had ample evidence that ill-considered policies could give us a combination of high inflation and unemployment, known back then as “stagflation.”

This policy mix was also not great for equity investors. The Dow Jones Industrial Average moved sideways during the inflationary period, closing at the same level in December 1982 as it did in January 1966. One lesson from that period was that high interest rates can be bad for stocks.

That may be one reason the Fed remains reluctant to allow interest rates to rise today. Although messaging from the latest Federal Open Market Committee meeting showed greater willingness to normalize interest rates, action is not expected until 2023.

Rate hikes may bring other worries for the Fed in today’s environment. Given the large volume of variable rate mortgages and corporate loans outstanding in the U.S. today, a rise in interest rates could push highly indebted homeowners and companies into bankruptcy, potentially triggering a recession. The federal government would have to roll over its record stock of short-term debt at higher interest rates, ballooning its interest expense and potentially crowding out more popular spending priorities.

But if private capital is to continue participating in debt capital markets, such as those for corporate bonds and bank loans, interest rates will have to rise to compensate them for the loss of purchasing power on their principal.

Although annual growth in CPI fell sharply after 1982, it is not strictly correct to say that inflation was defeated. Except for a few years around the turn of the century, the federal government continued to run deficits, a portion of which were monetized. Notably, the government began running trillion dollar deficits, and the Fed drove interest rates down to near zero during the Great Recession, but CPI growth remained muted.

But CPI does not tell the whole story. Some sectors of the economy have experienced substantial inflation, but they are not fully incorporated in the consumer price index. Home prices, healthcare costs and college tuition all soared in recent decades. Meanwhile, apparel and consumer electronics remained affordable due to globalization and improved technology.

Back in the 1970s, most of the world was not part of the global economy. Eastern Europe was in the Soviet bloc, while China, Vietnam and India had yet to become major exporters. As more low-cost producers of goods and services came online during the 1980s and 1990s, prices were pushed downward (often and regrettably at the expense of American manufacturing jobs). The trend toward developing countries joining the international trading system and producing inexpensive consumer goods is now over. Indeed, the recent increase in protectionism is, if anything, rolling back the wave of international price competition.

On the other hand, technological improvements may continue to shield us from inflation in certain sectors. For example, the displacement of human cashiers by automated check stands might restrain price hikes at the big box retailers, supermarkets, fast food chains and other establishments that can afford to invest in them. Smaller businesses, facing higher wages, may have to try to pass them through to consumers in the form of higher prices. Already in some parts of the country, restaurants are trying to recoup costs without raising prices on their menus by adding various surcharges ostensibly tied to specific costs.

It is possible that inflation is now moving from assets and human-intensive services to consumer products, but we will need several months of additional data to know for sure. Meanwhile, policymakers should be cautious about adding more to the national debt and the money supply.

A version of this column originally appeared on TheHill.com.

The post Recent Inflation Figures Should Not Be Ignored by Policymakers appeared first on Reason Foundation.

A core precept of MMT is that sovereigns who control their currency cannot default because they can always create enough new money to service their debts. This is not entirely true. Bank of Canada’s sovereign default database includes several defaults on local currency bonds over the past half-century. These defaults occurred mostly in very poor countries, but a United States Treasury default is at least a theoretical possibility.

In the US, money creation is primarily the role of the Federal Reserve, whose chairman typically has some independence from the executive branch and the president. Although appointed by the president, the Federal Reserve chair’s term inevitably lasts into the next presidential administration. In a worst-case hypothetical scenario, if a Republican-appointed Fed chair refused to finance deficit spending by a newly elected president from the Democratic Party, the battle could potentially trigger a default. But this is obviously an extreme, and hypothetical, scenario.

In most cases, MMT’s assertion of the impossibility of a sovereign currency default is probably correct. If that’s true, MMT supporters argue the federal government only has to worry about deficits to the extent that the money printed to finance them causes unacceptable levels of inflation.

MMT goes on to argue that inflation should not be a threat unless there is full employment. Until then, the government can use freshly printed money to put unemployed capital and labor to work. Once all of the slack resources have been employed, further debt monetization would drive up prices and wages. Although MMT does not address an optimal inflation rate, I imagine that many MMT proponents would like to see a higher rate of inflation than most investors would. Inflation transfers wealth from creditors to debtors, a circumstance welcomed, for example, by Occupy Wall Street founder and MMT supporter David Graeber.

Regardless of the desired inflation rate, the MMT perspective on debt monetization, employment and price levels raises some major concerns. First, the 1970s saw periods of both high price inflation and high unemployment. These conditions overturned the then-prevailing Keynesian consensus and the infamous Phillips Curve, which depicted a trade-off between inflation and unemployment that, by 1980, had clearly broken down.

Also, full employment is a difficult term to define. At one time, full employment was thought to be associated with an unemployment rate of 5 percent —a minimum explained fully by individuals making job transitions. But we have now entered a period of much lower unemployment rates, mirroring the rock bottom jobless rates seen at the turn of the century. Today, however, we have much lower rates of labor force participation suggesting that more and better job opportunities could lure more people into, or back into, the workforce. In the absence of an economy in which every single able-bodied adult is working, it is very difficult to determine precisely what conditions would constitute full employment.

But these technical concerns are unlikely to deter MMT proponents because its narrative fits recent history so well. Fiscal Cassandras have been warning about large deficits since the early days of the Obama administration. But despite the ongoing failure to balance the federal budget—or even come anywhere close —we continue to see a thriving economy with low interest rates and minimal price inflation. While it may be possible that excessive debt monetization has contributed to an asset price bubble, we have yet to see meaningful adverse effects.

So, if the U.S. economy can run trillion-dollar deficits with nothing terrible happening, the theory goes, why not try two, three or four trillion-dollar deficits? MMT adds theoretical heft to the casually empirical observation, which has also been bolstered by the actions of both major political parties, that deficits don’t matter.

And in the short term, it may be that deficits do not pose immediate dangers.  That scary thing about MMT is that it could work for a while, indeed it could work for quite a long while, but it would stop working very suddenly when some random event causes the public to lose faith in its currency. By the time this happens, deficits would be so large that the printing press could not be turned off without a massive realignment of the economy and workers. If, for example, the federal government was running a $4 trillion deficit and needed to balance its budget to prevent runaway inflation the human consequences of, and the political pressure against, a course correction and fiscal consolidation would be severe. A sovereign default—that remote scenario I raised above—might make sense to policymakers under these conditions, but it would devastate the value of investment portfolios around the world.

Unfortunately, the case against massive new government spending has been poorly argued and often undermined by its putative supporters. While the Republican Party claimed deficits were an emergency under President Obama, they suddenly became defensible under President Trump. And, for some reason, deficit spending on programs like food stamps and Medicare attracts far more criticism from Republicans than deficit spending on the military.

Congress’ actions and budgets have been suggesting the federal government need not balance its budget or pay off its debt. But the risk posed by these budgetary actions — and by MMT’s ascendancy —is that once the US completely lets go of the balanced budget yardstick, we would lack an obvious standard of fiscal prudence. If a balanced budget isn’t needed and a $1 trillion deficit is okay why not a $2 trillion or $3 trillion deficit?

One approach to this issue that might be able to achieve some bipartisan support is that of stabilizing the debt-to-GDP ratio. While we don’t know what level of debt-to-GDP might trigger a crisis, perhaps we can agree that persistent increases in this ratio are ultimately unsustainable. Here we might make an analogy to climate change: we don’t know with any precision how much of an increase in greenhouse gas emissions over the long-term it would take to cause a calamity, but we can be confident that there is a maximum tolerable level and we would be wise not to test it.

Sen. Bernie Sanders, Rep. Alexandria Ocasio-Cortez and many progressives want the government to fund single-payer health care and a ‘Green New Deal.’ But they’re unlikely to find the massive amounts of money needed to pay for these programs. Taxing the rich won’t be enough to pay for them and nearly everyone in politics has a limited appetite for middle-class tax hikes. While cutting military spending might generate a decent chunk of money to spend elsewhere, it would not produce enough to fund their top policy priorities. Thus, MMT serves as sort of the intellectual framework that would let politicians have their cake and eat it too — spend money and don’t worry about debt or deficits.

True deficit hawks, not those who only argue against deficits when the other political party is in power, need to present realistic and consistent arguments about the long-term financial risks of growing debt and deficits if we hope to push back against the federal government’s budget-busting behavior and the potential onslaught of even greater spending.

The post The Rise of Modern Monetary Theory Could Trigger Fiscal Armageddon appeared first on Reason Foundation.

Pelosi’s estimate is attributed to the Tax Policy Center’s distributional analysis of the new law. But TPC reports that middle-income taxpayers (those in the third quintile of the income distribution) will receive an average tax cut of $930 per household in 2018 and $910 per household in 2025. Indeed, relatively few families stand to lose money over the next several years — and the tax increases TPC projects eight or 10 years out are unlikely to happen.

The real problem for Pelosi and her Democratic colleagues is that the rich will see bigger cuts in absolute dollar terms than those who are less affluent — an almost unavoidable feature of any across-the-board rate reduction. And this rubs equality-minded Democrats the wrong way.

Although income inequality is a traditionally Democratic issue, it has really gained traction in this decade due to Occupy Wall Street’s “We Are the 99 percent” slogan and Thomas Piketty’s influential book, Capital in the Twenty-First Century. Democrats’ emphasis on income inequality comes at a cost: It often prevents them from supporting pro-growth policies, like this tax bill.

In the past, economists often considered policies through the prism of Pareto efficiency, the idea that a change is socially positive if it helps at least some people while harming no one. The short-to-intermediate impact of the tax reform comes close to meeting the Pareto standard: Most taxpayers save money and only a small number (of mostly upper-middle income) families must pay more. Further, the plan can be expected to increase economic growth, albeit modestly, enlarging the total amount of wealth available for us to share.

The notion that a beneficial economic policy is bad because of its benefits are unequally distributed requires an appeal to envy and schadenfreude. Psychologically, many of us may feel worse when the wealthy get further ahead and better when they are punished. But these emotions are ultimately harmful. We’re each better off focusing on our own material and spiritual well-being rather wasting energy worrying about the other guy, or worse, using the tax system to bring him down.

It appears that Democrats are confusing the plan’s relative impact on the middle class with its absolute effect — which is generally beneficial until 2026, when most of the law’s individual income tax provisions are set to sunset. By 2027, TPC expects middle quintile taxpayers to see an average $20 tax increase.

A major reason that middle-income taxpayers would face a small tax increase 10 years from now is that the measure permanently changes the way tax brackets are adjusted for inflation. Rather than using the Consumer Price Index, the new law uses the Chain-Weighted CPI. This index provides a lower estimate of annual inflation because it assumes that families make substitutions, such as buying more chicken as beef prices rise.

But the sunset has virtually no chance of occurring. Instead, Congress will face enormous pressure to extend the individual income tax cuts — much as it did when the Bush tax cuts expired. When that happened, Congress temporarily extended all the cuts, and then permanently extended lower rates for taxpayers in all but the two highest brackets.

If that happens again, the budgetary impact of the GOP tax cuts will be much greater than the headline numbers indicate. Even when economic growth is considered, the Joint Committee on Taxation estimates that the tax measure will add over $1 trillion to the debt over the next 10 years. CBO’s static analysis shows personal income tax cuts adding about $140 billion to the deficit annually between 2023 and 2025. This falls to $83 billion in 2026 as the tax cuts phase out. By 2027, the law actually lowers the deficit by $22 billion, consistent with those small tax increases forecast by TPC. A renewal of the personal income tax changes would thus add about $175 billion to the debt in 2026 and 2027. Over a 30-year period, the impact would be trillions in additional red ink.

These new shortfalls will worsen an already bleak fiscal picture. After attaining a post-recession trough of $438 billion in 2015, the deficit increased in the last two fiscal years, reaching $666 billion in the year ending September 30, 2017. Fiscal 2018 was already looking dicey, with $198 billion in red ink being added in the first two months (or $15 billion more than the same period last year). And that’s before the tax cuts kicked in. It is also before Congress inevitably puts the bulk of disaster relief spending for recent hurricanes and forest fires on the national credit card and breaks budget caps to accommodate a surge in military and non-defense spending.

By 2025, trillion-dollar-plus annual deficits are likely to be the norm, so adding $150 billion annually by extending the 2017 personal tax cuts will seem to be no big deal. But at some point, the cumulative impact of all this deficit spending will trigger an economic crisis.

It is in this sense that the tax cuts are not nearly as Pareto efficient as they initially appear. The tax cuts benefit most of us now by harming our future selves, our children, and our grandchildren. Congress should not have passed them without equivalent spending cuts — a virtual impossibility in today’s political environment.

If Democrats were less worried about class warfare and more concerned about the nation’s future, they could make a case against the tax cuts that would resonate with a wider swath of voters. In the Clinton era, Democrats often preached fiscal responsibility, working with Republicans to balance the budget. Now that Republicans have tossed away the mantle of fiscal rectitude, perhaps it is time for Democrats to pick it up, becoming in the process a party of the future.

This column first appeared in The Fiscal Times.

The post The Tax Cuts Benefit Most of Us Now, But Harm Future Generations appeared first on Reason Foundation.

Members of the Los Angeles City Council plan to introduce a proposal to raise the minimum wage for non-unionized city hotel workers to $15.37 an hour. The exemption for unionized hotels has raised questions about whether the goal is higher wages or more unionized hotels, but Mayor Eric Garcetti vowed, “If it gets passed by the council, I would definitely sign it.”

At the same time, activist and entrepreneur Ron Unz is championing a proposal that would increase the state minimum wage to $10 an hour in 2015 and to $12 an hour in 2016. While Unz may agree with supporters of the L.A. hotel proposal who argue that raising the minimum wage will lift people out of poverty, he’s actually seeking to raise the minimum wage in hopes of deterring illegal immigration.

“The overwhelming majority of illegal immigrants come for jobs and they take the jobs that Americans won’t. But the reason Americans won’t take them is that the wages are too low, and the only people willing to work at poverty wages are often recent, desperate border-crossers,” Unz recently wrote in the Mercury News. “If the minimum wage were $12 per hour, many Americans and legal immigrants would apply for those positions, reducing the pressure on businesses to hire the undocumented.”

Regardless of the differing motivations for increasing the minimum wage, the bottom line is both plans would be bad for California’s low-income workers and businesses.

City and state-imposed minimum wages put businesses in those areas at a competitive disadvantage. Labor-intensive businesses in states with higher minimum wages struggle to compete with similar companies in lower minimum wage states. Escalating wage costs can drive these firms out of business altogether or force them to relocate to states like Texas, where the minimum wage is $7.25.

In December, the unemployment rate in Texas was 6 percent, below the national average of 6.7 percent. In California it was 8.7 percent. Texas also topped California in total job growth last year. New jobs are created by fast-growing businesses. Laws that increase labor costs hamper growth. In many cases, small businesses, which comprise 99 percent of California’s employers and employ 52 percent of the state’s workforce, are ill equipped to bear the costs of higher priced labor. For those small businesses, the cost difference between hiring a new employee at $7.25 per hour versus adding one at $10, $12 or $15 an hour is immense.

It’s also worth noting that if any new jobs were to be created as a result of further increases to California’s minimum wage, they’d likely be part-time positions. Two-thirds of today’s minimum wage jobs are part-time, and part-time labor is already outpacing full-time labor in terms of growth and the total percentage of the labor force. As the sluggish economic recovery continued in 2013, 77 percent of jobs created were part-time. Raising the minimum wage will only further that trend because when the price of labor goes up, hiring part-time workers is more cost-effective.

California’s economy has been improving, but businesses will suffer when the state’s minimum wage increases in July. The latest minimum wage proposals may be creatively aimed at nonunionized hotels and immigration, but the end result would still likely be fewer entry-level job opportunities, layoffs and reduced hiring that hurts the economic recovery.

Victor Nava is a policy analyst at the Reason Foundation.This article originally ran in the Orange County Register.

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NGDP targeting does have advantages over a regime that requires central banks to adjust policy in response to consumer price inflation-the model currently used by many central banks world over, including the Bank of England and the Bank of Canada. If inflation is high, banks tighten monetary policy and if low, they loosen it. But the consumer price indices that are used to measure inflation are easily swayed by factors beyond monetary policy like tax changes, exchange rates, or the availability of cheap imported goods. Moreover, they frequently blind central bankers to the formation of dangerous and destabilizing housing and asset bubbles-both of which were major players in the recent crisis. And just as inflation targets may obscure a coming crisis, they may not be a good guide to action once trouble arrives given that significant monetary disruptions can occur without immediate changes in the price level.

The idea behind the proposed alternative is relatively simple: central banks should use the tools at their disposal-interest rates, quantitative easing and the like-to deliver a stable NGDP growth rate, not simply target inflation. The most commonly cited target is 5 percent, equivalent to the sum of real growth (which is expected to run at 3 percent a year in normal times) and inflation (which is expected to run at 2 percent). It is a more inclusive target and a more forward-looking one: rather than reacting to the last measurable quarter’s inflation statistics, central banks should target expectations of future growth.

If NGDP growth falls or is expected to fall below 5 percent, the central bank would loosen monetary policy. If NGDP grows too fast, the central bank would tighten monetary policy. Notice that this implies a higher tolerance of price rises during a slump (when the real growth component of NGDP will be lower), coupled with a harder line on inflation during a boom (when the real growth component of NGDP will be higher). That suggests that NGDP targeting would produce a counter-cyclical monetary policy, making it a more effective economic stabilizer than inflation targeting. Or so its advocates suggest.

They also tend to propose level targeting, which requires central banks to make up for past NGDP under- or overshoots in subsequent years. That means that if NGDP growth is below 5 percent in Year 1, monetary policy should aim to bring it above 5 percent until the lost ground is made up, and vice-versa. Traditional targeting regimes are too content to let bygones be bygones, NGDP targeters say, and that allows significant slippage over time-another deficiency that shifting to a new monetary framework could rectify.

The irony of this is that some say the Bank of England-Mark Carney’s future home-is already pursuing an NGDP target. The Financial Times reported over a year ago that “[some Bank of England insiders] are open that the Bank is really targeting nominal gross domestic product growth of about 5 per cent a year.” Others have pointed out that the Bank of England’s policy decisions only make sense if you assume they’re doing something other than targeting 2 percent inflation-the primary objective legislation obliges them to pursue. After all, Britain’s rate of inflation has been consistently above that 2 percent target since December 2009. The Bank of England even announced £75 billion of additional quantitative easing when inflation stood at 5 percent-hardly the act of a central bank trying to rein in above-target inflation.

But just because the Bank of England opened the monetary spigots doesn’t mean it could make the money flow into the broader economy. Why? Because many banks seem to have used the money to recapitalize themselves, rather than offer more loans. Indeed, M4, the broad money aggregate, has remained sluggish even as the Bank of England has slashed interest rates and printed money.

Even if the Bank could overcome this problem, there’s no guarantee the added money would help rather than hurt the economy. The boom years have left Britain with a structural over-reliance on the financial industry, housing, and government spending-none of which are likely to be engines of growth any time soon. Thus a looser monetary policy might well prop up an unsustainable status quo in three credit-reliant sectors, preventing the rebalancing that is needed for robust growth. The big problem with NGDP targeting is that it assumes the central bank has power over something that it doesn’t.

Moreover, even if one accepts that a central bank is capable of hitting its growth target, that leaves open the question as to what target it should aim for. And it is not possible to know in advance what the “correct” rate of NGDP growth should be. The central bank can base its target on past growth, but even educated guesses can’t ultimately overcome this “knowledge problem.”

As London-based economist Anthony J. Evans has pointed out, if you consider 1997, the year that Bank of England began targeting inflation as your base year, and assume a 5 percent annual NGDP growth target, then you would believe that British monetary policy in the run up to the crash was more-or-less fine: NGDP growth stayed close to 5 percent throughout the “great moderation.” You would also believe that we are now significantly below the “correct” level of NGDP, and should fire up the printing presses to bring things up to scratch. If, on the other hand, you assume a 4.5 percent target since 1997, you would think that monetary policy was too expansionary in the run up to the crash, and that NGDP growth has already returned to trend-hence, time for monetary policy to “normalize”. The point here is not that 5 percent is the wrong target, or that 4.5 percent is the right one. The point is that even a small targeting error can have massive policy implications.

None of this is to deny that NGDP targeting could be an improvement over inflation targeting. But it is doubtful that it would work as effectively as its advocates suggest. Central banks lack both the power and the knowledge needed to deliver stable growth instead of distorting the economy. In fact, it’s not clear that any policy tool can overcome these problems.

Tom Clougherty is managing editor at Reason Foundation. This article originally appeared at RealClearMarkets, and was also published at reason.com.

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It won’t be a surprise to read conservatives lambasting this as unconventional monetary policy meant to help re-elect President Obama. And inflation hawks have already started screeching. But the loudest cry of “for shame” should be coming from the Occupy Wall Street movement.

Quantitative easing-a fancy term for the Federal Reserve buying securities from predefined financial institutions, such as their investments in federal debt or mortgages-is fundamentally a regressive redistribution program that has been boosting wealth for those already engaged in the financial sector or those who already own homes, but passing little along to the rest of the economy. It is a primary driver of income inequality formed by crony capitalism. And it is hurting prospects for economic growth down the road by promoting malinvestments in the economy.

How is the Federal Reserve contributing to regressive redistribution, income inequality, and manipulated markets? Let’s flesh this out a bit.

Last month, Bernanke said that quantitative easing had contributed to the rebound in stock prices over the past few years, and suggested this was a positive outcome. “This effect is potentially important, because stock values affect both consumption and investment decisions,” he argued, apparently under the belief that the Fed has a third mandate to support rising stock prices.

This is ironically a trickle down monetary policy theory, where rising stock prices mean more wealth and more consumption that trickles down the economic ladder. One problem with this idea is that there is a gigantic mountain of household debt-about $12 trillion worth-that is diverting away any trickle down. An even worse assumption is that the stock market really reflects what is going on in the real economy.

Where the Occupy movement should really be teed off is when you consider that most equity shares in America are owned by the wealthiest 10 percent. That is not inherently a problem-wealthier individuals with more disposable income will have more ability take ownership stakes in companies than those in lower income brackets. And it is not a call for class warfare. However, it does mean that when the Fed engages in quantitative easing it is providing a benefit to a very narrow segment of society at the expense of others (either through future inflation or through the cost of raising taxes to pay for increased federal debts). That is the definition of crony capitalism.

At the same time, all Americans have seen the prices of basic goods increase over the past few years in large part due to rising commodities prices. The whole idea of QE is to drive investors out of lower risk investments like mortgage backed securities and government debt and get them to put that money in “more productive” use-lend it, build skyscrapers, invest in technology, etc. Since there is little confidence about the future of the economy, many investors have crowded into the stock market with their money, and still others have invested in commodities.

The problem is that investing in commodities can push up prices on things like gas, meat (because of feed corn prices), bread (because of wheat prices), and even orange juice. There certainly have been other contributors to commodities prices going up, but if the Fed has boosted stocks, they’ve boosted commodities too. So not only are the cronies gaining from quantitative easing, there is a negative wealth effect too.

The cronyism doesn’t end there. In a Dallas Fed paper released in August, OPEC chief economist William White points out that easy monetary policy favors “senior management of banks in particular.” And even Bernanke himself suggested (as if it was a good thing) that quantitative easing purchases “have been found to be associated with significant declines in the yields on both corporate bonds and MBS.” Translation: the Federal Reserve has made it artificially cheaper for corporations to borrow money and has pushed up the prices of houses (benefiting homeowners but hurting homebuyers).

Correct me if I’m wrong, but I thought cheap loans allowing businesses to leverage up and juiced housing prices were key parts of what got us into this mess?

All of this might be acceptable to some if quantitative easing was helping the American economy recover. The reality is that quantitative easing has made it cheaper for the government to borrow, has artificially propped up the housing market (making it take longer to recover), and has dramatically manipulated the distribution of capital in financial markets. And the economy has not been in recovery.

The plans announced today will exacerbate pre-existing malinvestment and income inequality. What is this continuous round of purchases going to do? It won’t get banks lending any more than they already are. And even if it did, households and small business still have a lot of debt that will keep them in a deleveraging state for a while. It won’t help the housing market bottom out, clear away toxic debt, and end the wave of foreclosures that need to process. It is not going to push up incomes, create new jobs, or change the technological revolution that is altering the face of employment in America.

To put it simply: More quantitative easing is not going to move the dial much on the growth meter.

Taken together, the crony capitalism and negative wealth effects of quantitative easing should clearly give pause. The fact that QE promotes activities that led to the housing bubble should have stopped its progression as an idea a long time ago, especially since these problems are greater than any gain that would come from this now perpetual pace of money creation.

If there is a time to head down to Zuccotti Park and raise some cardboard in opposition to the continuation of such a devastatingly failed policy, it is now.

This commentary first appeared at Reason.com on September 13, 2012.

The post How Quantitative Easing Helps the Rich and Soaks the Rest of Us appeared first on Reason Foundation.

Depending on your perspective, the picture is either crooked or straight. And when a host of people is noisily debating whether the frame should be tilted left or right, the sound can become downright unhelpful. The same goes for monetary policy.

Yesterday, the Federal Open Market Committee (FOMC) released the minutes from its June meeting, giving financial industry analysts a peek inside what our illustrious leaders at the Federal Reserve are thinking. Unfortunately, there is little agreement as to what the meeting notes mean-there’s a near 50/50 split on whether the FOMC’s concerns about a deteriorating economy are proof positive that we’ll see QE3 or some other monetary stimulus program later this year.

QE-or quantitative easing-is a fancy way of saying create money out of thin air to put in a digital bank account and then spend on mortgage-backed securities or government debt in order to lower long-term interest rates. It’s kind of like that Libor interest rate scandal you might have read about, except the Fed fixing interest rates is, well, sold as more of a market driven process for setting rates at a non-market established rate.

Beyond disagreement in the perennial guessing game of “What Will Bernanke Do Next?”, there is plenty of debate over whether monetary policy can even influence interest rates any further. Since QE2 and Operation Twist have not moved long-term interest rates much, a third round (fifth round if you could the two “twists”) of monetary stimulus is unlikely to have any additional impact.

Still, even if QE3 could substantively impact the market, there remains the question of whether the weak economy merits more monetary stimulus. For example, unemployment remains high, but it matters whether the problems in the labor market are structural or still remnant of the financial crisis. If unemployment is due to economic immobility, education gaps, and changes in growth sectors of the economy (i.e., more IT workers needed for cloud computing and fewer manufacturing workers needed to operate machinery) then more QE is not the prescription for the economy. If the problem is just that the economy needs a better jumpstart for borrowing to lead to consumption and investments, then leading to hiring, then QE could be warranted (from a neo-Keynesian perspective).

But all of this misses the point in the monetary policy debate.

While the mainstream coverage of the Fed has focused guessing what tie Bernanke will wear when he nexts argues with Rep. Ron Paul (R-Texas) during congressional hearings, or whether there is more room for monetary stimulus to continue aiding the economy, we’ve failed to ask a simple question: Is the current monetary policy paradigm actually helping economic growth?

This sounds like a simple question, and for many commenters in the debate it is a given that monetary stimulus has been a good thing. However, there is a difference between whether monetary stimulus has impacted the markets (clearly it has) and whether this impact has been for the better.

Last month the Bank for International Settlements-based in Basel, Switzerland, and operating as something of a global financial mediator and commenter-released is annual global economic report, with two chapters focusing on warnings for how central banks around the world are actually doing more to destabilize our financial future than helping economic growth.

In what ways are Federal Reserve monetary stimulus policies causing more harm than good?

First, monetary policy is creating a future asset bubble crisis. Consider that cheap money does inspire borrowing, even if not at the levels monetary policymakers would have preferred. Since the start of quantitative easing in 2010, equity prices have steadily grown with investors able to borrow for virtually nothing and take advantage of arbitrage opportunities in a volatile stock market. Commodities like gold, cotton, wheat, heating oil, and coffee are all higher as well, as traders have used cheap money to flood the future markets.

The fears of bubbles are well founded. Consider that unemployment remains high, economic growth stagnant to non-existent, and household debt still sky high. So how is it that the stock market can be 10 percent to 15 percent higher than in 2005 and 2006 at the height of the housing bubble and be seen as in anyway sustainable? And when the Fed does eventually decide to tighten policy from today’s levels this could suck the life out of commodities trades funded not with capital raised in normal markets, but with cheap capital funded by a manipulative Fed.

So when these asset bubbles eventually unwind, it could be very painful. Supporting asset prices masks problems on bank balance sheets, and we could see another example of the subprime crisis as toxic assets are revealed when prices decline.

Essentially we will have responded to the deflation of one bubble (housing) with another. Unfortunately, that would make for a trend. The Fed responded to the dot-com bubble’s bursting with policy that created another bubble, and congressional and regulatory policies channeled this into the housing market. In effect, this is an intentional cycle of boom, bubble, bust. A present crisis is solved by creating a future crisis.

The Bank for International Settlements is not saying anything new by pointing out this fear, but it is telling the Fed that it is time to start paying more attention to this concern.

Second, monetary policy is contributing to global economic weakness. Many quality foreign firms have taken advantage of low interest rates, borrowed dollars, and then sold them in their home countries for local currency to fund expansion (essentially betting they will be able to pay back the dollar denominated loans easily and cheaply). The problem is that this increases the supply of dollars in foreign economies and drives up demand for local currencies. Foreign central banks, particularly in emerging market countries (EMCs) have not liked seeing the value of their currencies appreciate because that means fewer companies will be buying their exports (since the cost of goods in countries with stronger currencies is higher). In response, central banks in emerging market countries have been buying up dollars and inflating the value of their currencies to remain competitive in the export markets.

Essentially, the Fed’s inflationary policy has been transmitted to EMCs. The result has been the stifling of growing middle classes in those countries. Consider Turkey, one of the fastest growing EMCs, which has been favoring its export market by inflating its lira to the detriment of the Turkish middle class. GDP per capita in Turkey nearly doubled from 1999 to 2007 as the country experienced a dramatic economic revolution, but since then has leveled out. Inflation was just 6.3 percent in 2009 but has flirted with the 11 percent range this year.

This is not a class issue, but rather a matter of growing the global consumption base. The weakened purchasing power base of EMCs has contributed to a weakened global economy.

Third, the current monetary policy paradigm has threatened the future of American economic policy integrity as the line between monetary and fiscal policies has become completely blurred. As Atlantic Capital Management President Jeffrey Snider writes, there is nothing really “monetary” about today’s unconventional policies. Buying up bonds and securities to influence long-term interest rates is just borrowing money to create growth, like any other fiscal stimulus program.

The challenge with determining if these are ultimately harms (or evening happening) is that monetary policy is just that-policy making. It involves weighing trade-offs, doing cost/benefit analysis, and making a choice through a particular framework.

If the framework values short-term benefits then the asset bubble harm does not seem like that much of a problem. Much better to help out a few people today and worry about controlling the deflation of commodities and equities prices later. The slow down in emerging market countries is also of limited concern under this view, since low currency values can lead to increased exports as a quick way to boost economic growth. And monetary policy being blurred with fiscal policy is certainly not a concern in a short-term benefit framework since anything would go in order to achieve the objective of attempting to smooth out economic pain.

Contrast this with those taking a long-term benefit view as their framework for assessing the potential harms of today’s monetary policy paradigm. The risk of yet another bubble is terrifying and certainly worth serious consideration. Exports are certainly important for the growth of EMCs, but so is the ability of a local middle class to gain purchasing power and raise GDP-per-capital levels (not just overall economic growth); and that can’t happen with central banks forced to inflate away the value of local currencies. Furthermore, the long-term framework holds in higher esteem the integrity of the Federal Reserve as a monetary body while keeping fiscal policy choices with Congress, creating an inherent knee-jerk reaction against continued stimulus.

So if the FOMC is taking a short-term view (as any body integrated into the political system is wont to do) it is clear why monetary policy has maintained its stimulative levels. Tightening policy could cause credit to contract and possibly slow down an already weak economy. The fact that it could help prevent a steady build-up of misallocated capital is understood, but the benefits of stopping a potential bubble are less than the potential harms of breaking from today’s norms-at least according to today’s leading monetary theorists.

Seemingly lost on the Fed is the irony that this was Greenspan’s logic for ignoring the housing bubble. Back in 2004, economists from the Bank for International Settlements warned about problematic monetary policy creating cheap money that was flowing into U.S. asset markets (particularly housing) and creating a pattern of unsustainable growth. Eight years later we can look back and see how policymakers ignored these warnings and instead lashed out in frustration at that crooked picture on the wall. In 2020 will we look back again and lament Bernanke’s current refusal to heed the warnings?

Anthony Randazzo is director of economic research at Reason Foundation and is co-author of the policy study “The Hayek Rule: A New Monetary Policy Framework for the 21st Century.” This article first appeared at Reason.com on July 17, 2012.

The post The Fed’s Harmful Monetary Policy appeared first on Reason Foundation.

It turns out that the detergent is not just good for making your clothes brighter than the imitation brand. It’s also street currency for buying pot and cocaine. Briefcases full of cash are being cast aside in favor of blaze-orange containers of laundry soap. Yes, there’s liquid gold in dem dar bottles.

There is some debate over whether this is a new trend, and perhaps our more nefarious readers might enlighten us to the commonality of this practice. But reports suggest the Tide thefts are a nationwide phenomenon. And a former FBI agent explained to ABC why it might make a good commodity for barter: “Tide is highly recognizable,” said Brad Garrett. “It’s very difficult to trace and it’s easily resold.”

Tide, as the money gods would have it, carries nearly all the characteristics of sound money.

To start, it is widely used. Tide detergent is sold in every major city and most places in between. It can be found in the laundry room of both Upper East Side penthouses (the ones where residents don’t just throw away their dirty clothes to buy new ones) and “quaint” fixer-uppers of the South Bronx.

Next, it is readily recognizable. Even if the classic orange bottle is not something you frequently doodle, its iconic “Day-Glo” logo is difficult to confuse with another product. If you’re planning to use Tide to score an ounce, you’re dealing with an unambiguous product.

Critically, it is durable. Tide can be stored in a range of climates for a long period of time and still hold its value as a commodity. Bottles are going from $5 to $10 on the black market, which is about half the retail price. But you can wait a while before having to unload.

It is also difficult to counterfeit. A bottle could certainly be filled with water to dilute the product. So buyers would want to test the goods in the same way a bank teller might hold a $20 bill up to the light. But try and replicate that orange bottle on a large scale without heavy manufacturing equipment.

There is even a measure of scarcity in that there are only so many bottles of tide in any given city. Inflationary risks would certainly become a concern if Tide were really used to buy all your dish and hand soaps. Recall the woes of King Philip the II of Spain, after his realm was flooded with gold from the new world. Joy would only be temporary for the 21st century Tidequistadors raiding nearby towns, like Hernan Cortes, and flooding their own local stores with the new liquid gold.

The analogy is not without challenges. Tide does not covey a nominal value as readily as a $10 bill, but then again neither does a brick of gold. More problematically, it is difficult to transport. Large amounts can easily be moved by truck. But for smaller purchases, anything costing above two or three bottles is going to be difficult to purchase with any kind of stealth. Imagine inconspicuously slipping a 20-ounce blaze orange soap bottle into the palm of your local smack dealer behind a city park bench without drawing the attention of cops, or worse yet, the bums sitting beside you eager for your product and detergent cash.

The comparison ultimately breaks down on what is perhaps the most distinctive feature of sound money: it is not “honest” money. By this I don’t mean that the Tide was most likely pilfered and is used to purchase an illicit product. Rather, it is not a readily trustworthy currency. The skepticism some might have with the argument being made here is understandable because a manufactured product simply is not a reliable store of value.

This is one of the strongest arguments for a gold standard, since a dollar linked to gold has a reliable store of value where paper bills backed by nothing more than Fed Chairman Ben Bernanke’s good faith is unstable.

When you think about it, there actually isn’t much difference between Tide and dollar bills these days. Dollars are widely used, are readily recognizable, are fairly durable, and are difficult to counterfeit. But without anything backing the dollar, its scarcity is a relative concept. And the way the dollar is treated right now, rolling off paper reams faster than Charmin at a Chipotle, it is a blessing from the gods of finance that the Euro is in the midst of crisis. It also helps that Asian currencies are not widely accepted as usable alternatives either.

A few drug communities just may have found their solution to the weak dollar though. The Federal Reserve may not see inflation as an issue when referencing problematically manipulated consumer price index data, but it is apparent that those who experience real value changes of a dollar buying less and less dope by the day have become concerned. Just another example of how people are growing tired of Ben Bernanke’s dirty laundry.

Anthony Randazzo is director of economic research at the Reason Foundation.

The post Tidequistadors In Search of Sound Money appeared first on Reason Foundation.

There are few who would deny that the rates of return for stocks, real estate, and business equity depend primarily on the strength of the economy and how fast the economy is growing. Board members at the Federal Reserve, however, believe the converse: that the strength and pace of the economy is primarily dependent on the rates of stock, real estate, and business returns.

As such, their accommodative monetary policies target and inflate these very assets before the underlying economy justifies their returns. All Americans benefit from a healthy economy that provides higher wages, more purchasing power, and gains in productivity and innovation. Few benefit from higher asset prices when targeted and juiced by loose money.

Speaking about the effects of monetary policy on savers last Thursday, Fed Governor Sarah Bloom Raskin argued that “according to the Federal Reserve’s Survey of Consumer Finances, less than 7 percent of total household assets are directly held in transaction accounts, certificates of deposit, savings bonds, and bonds. Instead, the bulk of household wealth is held in stocks, retirement accounts, business equity, and real estate.” She concludes from this that the steady climb in stock indices over the past few years are generating wealth for everyone in America and helping the economy at large. For this reason, she claims “these returns should be supported, over time, by the accommodative monetary policy that we have in place.”

Ms. Raskin’s logic would be sound if that “bulk” of household wealth were distributed evenly. As it turns out though, the distribution is anything but even.

Eighty-three percent of all financial wealth in America is held by the top 10 percent, and nearly half is held by the top 1 percent according to NYU economist Edward Wolff’s analysis of the Fed survey cited by Governor Raskin. This echelon of individuals at least in the very near term welcomes and greatly benefits from the Federal Reserve’s money printing and zero-percent-interest-rate-policy as their stocks and business equity provide them growing wealth and growing income.

For the wealthiest 10 percent of American families, 47 percent of their income comes from interest and dividends, business profits, and capital gains compared to just 6 percent for the bottom 90 percent of U.S. families who depend on roughly 80 percent of their income from wages. And this data comes from the same report Fed Board Governor Raskin used to defend the Fed’s policy against savers. Only a negligible amount of total income for these individuals is derived from the “bulk” of household wealth that Raskin and the rest of the Fed board is so fixed on inflating.

The point here is not to demean the wealthiest Americans. There is nothing inherently problematic about a diverse distribution of wealth. There is something wrong, though, when wealth becomes deeply concentrated as the result of accommodative monetary policy. That is not the free market at work.

The Dow’s recent rise above 13,000 arguably owes much of its appreciation to the accommodative monetary policy of the Federal Reserve. This should not, however, be a reflection of an improving economy as Fed chairman Ben Bernanke is so quick to reference and take credit for. Much of the profits and investments of Dow Jones and S&P 500 companies take place and stay in other countries and do not benefit Americans who are themselves not invested.

And invested they are not. According to the same Fed report from Raskin’s speech, the average value of stocks held by the bottom 90 percent of American families is $16,785. This pales in comparison to the wealthiest 10 percent of American families whose average value of stock holdings is $683,500.

But so what? So the rich are getting richer as the bulk of household wealth is being targeted and inflated by the Fed’s free money. Doesn’t that ultimately benefit those at the bottom as well?

Under today’s fiscal and monetary policies, absolutely not.

A growing economy only benefits the economy as a whole, and thus those at the bottom, if growth comes in the form of operational innovation and gains in productive efficiencies. This means the ability to do more with less, to grow by leaps and bounds while driving down the cost of inputs. This was the case in the ’80s and ’90s, where for two decades technological and industrial innovation and efficiency gains allowed America to grow tremendously while having little to no effect at all on the price of commodities and the relative cost of labor. Real mean incomes grew nearly every year between 1981 and 2000 and 38 percent over the entire period according to the U.S. Census Bureau. Real wealth was created. The economy grew as a whole.

Then loose fiscal and monetary policies entered the story, and over the past decade the exact opposite has occurred. Commodity prices are skyrocketing, real mean incomes are at 1997 levels; having fallen nearly every year since 2000 according to the Census, and yet the relative cost of labor in America is still high. Real wealth is not being created.

Supporting stocks, business equity, and real estate through accommodative monetary policy merely accumulates wealth at the top and starves the remainder of the population from innovation and efficiency gains so needed for benefits to be felt by all members of the economy. That can only occur when capital is lured toward productive business investments and savings through higher interest rates, and discouraged from simply following the Fed’s quantitative easing into asset markets fueled by an artificial rise in financial wealth.

This article first appeared at RealClearMarkets on March 8, 2012

The post Americans Don’t Benefit From Fed Inflated Asset Prices appeared first on Reason Foundation.

The centrepiece of Krugman’s thesis is that “the creation of the euro fostered a false sense of security among private investors, unleashing huge, unsustainable inflows of capital into nations all around Europe’s periphery.” Krugman then notes that European nations had “roughly balanced trade in 1999,” but as manufacturing became uncompetitive, and costs and prices increased because of the capital inflows, those nations began running large trade deficits instead.

While the euro was certainly an ill-conceived project, the woes of Greece, Italy, Spain, Portugal and Ireland owe more to malfeasance on the part of their own governments than to the trade effects of monetary appreciation.

It is true that the creation of the euro led to capital inflows, though initially the euro fell against the dollar, sterling, and other currencies. When it began at the end of 1998, the euro traded for 0.85 dollars; the dollar then gained against the euro steadily for three years, reaching a peak of 1.17 euros/dollar in October 2000 and again in June 2001 before falling again slowly. By March 2003 the euro was again 0.85 dollars, eventually hitting a low of 0.63 euros to the dollar in June 2008.

But euro-induced capital inflows alone wouldn’t have caused a catastrophe. If that capital had been put to productive use, then the rise in prices of goods produced in the Eurozone could have been kept down.While this process may have occurred in some Eurozone countries, such as Germany, it did not occur in Greece, Italy, Spain, Portugal and Ireland. And the reason it did not occur in those countries is that perverse incentives existed for the capital to be diverted into bad investments.

Krugman won his Nobel for international trade theory. That no doubt colors his perspective on economic problems. But not all problems are related to international trade. In this case, the problems result from restrictions on domestic trade and other ineffective government policies – such as allowing teachers to retire at 50 (something that happens only in big-government places like Greece… and California). Blaming international trade and associated monetary phenomena clouds the real issues and results in solutions that are unsustainable, namely devaluation and inflation.

As financial economist Dr. Warren Coats explained clearly on his blog last week, devaluation and inflation do nothing to solve the underlying problems they merely provide a temporary respite that likely delays reforms and ultimately makes the problem worse.

The reason Greece (and some other countries, such as Italy) joined the euro in the first place was that their governments had a habit of either defaulting on debt or monetizing it through inflation. That’s why the yield on Greek bonds was around 35 percent in the mid-1990s. Before joining, they were supposed to get their public finances under control, but instead they worked out some clever fuzzy math, such as putting a substantial portion of their debts off their balance sheets and simply failing to include unfunded liabilities such as those pesky pensions. Many people knew that the numbers were nonsense but the EU let these countries in anyway.

This raises the fundamental problem with the euro, which is that it is a political project and not a monetary project. It was never really necessary as a monetary project since all European currencies were fully convertible with one another and several of those currencies were reasonably well managed – the Duetsche mark in particular. Moreover, as I pointed out in a study over a decade ago, prices were becoming increasingly transparent across Europe, largely as a result of Internet-based tools, ensuring that consumers could get the best deal on a product regardless of the currency in which it was sold.

If a European country really wanted to impose a set of strictures on itself that would have ensured monetary stability resulting in more rapid and sustainable growth, then all it needed to do was to tie its currency to a rare commodity such as gold. When a currency is truly backed by a rare commodity, it is impossible to use inflation to monetize debt, since that debt remains redeemable in that commodity. This induces more rational monetary and fiscal decisions.

Ironically, Krugman seems to think that the gold standard contributed to the Great Depression and that the euro is behaving like a gold standard. Both claims are nonsense. Peter Boettke observes that “The Great Depression was a consequence of (a) credit expansion to pay off war debts from WWI during the 1920s, (b) monetary contraction during the 1930s, (c) government microeconomic policies which completely curtailed the ability of market forces to adjust to the changing circumstances, and (d) government policies which eliminated the ability of individuals to realize gains from trade. None of this is about the gold-standard.” But more to the point: if the euro is behaving like a gold standard, then the ECB is Rumpelstitskin.

The euro was always intended as a stepping-stone on the road to a full fiscal and monetary union as part of a project to create a United States of Europe. The effort to create a joint European fund to bail out Greece (and perhaps Portugal, Italy, and Spain down the line) is consistent with this overall aim. There’s only one problem: previous attempts to force taxpayers in one country to shoulder the debts of other nations have not always turned out so well. I am of course referring to the requirement that German taxpayers be forced to pay reparations to the allies after WWI, which indirectly led to German hyperinflation and thence to WWII. It is just possible that in the attempt to create a European superstate, the Europhiles have sown the seeds not only of the destruction of the EU but also of peace in Europe.

Julian Morris is Vice President of Research at the Reason Foundation. This article was originally published by RealClearMarkets.

The post The Euro Isn’t the Problem, but Europe Is appeared first on Reason Foundation.

If you’re like a majority of Americans out there, you may be wondering why more than $2 trillion of printed Fed money and trillions more of government debt spending over the past three years has done little, if anything, to help you. You see that the S&P 500 more than doubled since the financial crisis bottomed, and that S&P companies posted their highest quarterly profits ever recorded last fall. Yet with all this seemingly good news, you’ve largely not benefitted. Why is that?

The reason is that if you’re not part of the wealthiest 10 percent in America, all this money being pumped into the system is not directed at you. As money is injected through Fed purchases and programs, it first reaches financial institutions and the balance sheets of large corporations boosting stock and bond prices and the individuals holding them. By design it’s meant to help out those at the top and slowly make its way to you as the economy grows. But even if the economy bounces back with all the new money, you’ll still be worse off than if that money had simply remained ink and paper.

The flawed logic goes that as money is provided to businesses and the wealthy, their investments will improve the economy as a whole and so benefit the poorer Americans.

Economists have disproved the theory repeatedly since long before the founding of our nation — even before the works of Adam Smith, the father of modern economics. Richard Cantillon, a French economist and banker, whose contributions influenced both Adam Smith and modern economics, theorized in the early years of the 18th century that as the supply of money increases, only those whose incomes rise early will benefit, while “workmen or fixed wage-earners who support their families on their wages” will not only not benefit but will actually be harmed as a result.

Bernanke’s current Fed policy is harming savers whose primary assets are their deposit accounts, homes and vehicles while benefitting those with substantial stock, bond and real estate holdings and business assets.

According to the most recent Federal Reserve Survey of Consumer Finances, 90 percent of all income earners held on average less than $10,000 in stocks and less than $25,000 in bonds. And they’re primarily dependent on their wages to support themselves and their families. The other 10 percent can augment their spending with income from sources other than wages like stocks, bonds and other productive assets. Those lacking a significant source of revenue apart from their job wages will not benefit from the Fed’s money printing and zero percent interest rates.

The reason is that as the economy returns to growth, prices of both goods and wages will rise but the former faster than the latter. And the stocks and productive assets of the top ten percent of income earners will have appreciated at such a pace that they control a larger percentage of wealth than prior to the Federal Reserve’s easy money policies. This is especially true and more pronounced under extremely low interest rates and high issuance of currency like at present and throughout the crisis.

So while the average American may be able to tuck away a sliver of wealth by keeping his or her job, following six years of money supply super expansion, the American elite will control a greater percentage of it.

Bernanke may not acknowledge the wealth disparity his policies are contributing to, but he clearly believes in this monetary trickle-down theory.

Following the latest Federal Open Market Committee (FOMC) decision last week, Greg Robb of MarketWatch asked Chairman Bernanke to comment about the affect his policies have on “individuals with fixed-incomes who have an inability to invest and make money with their funds.” He responded:

“The savers in our economy are dependent on a healthy economy in order to get adequate returns. …If our economy is in really bad shape then they’re not going to get good returns. …when the economy goes into a very weak situation, then low interest rates are needed to help restore the economy to something closer to full employment and to increase growth. That in turn will lead ultimately to higher returns for savers.”

Savers right now are losing both to a 3 percent erosion of their money and to a decreasing ability to grow and build wealth. Though many changes to Fed policy and the Federal Reserve System in general are in desperate need, the immediate first step should be to raise interest rates to at least 1 to 1.5 percent. The move would allow savers to protect their savings while not hindering business investment and allow the middle class to better participate with the wealthy by growing their wealth and actually benefitting with the improving economy. Without a change to policy soon, a majority of Americans will continue to suffer and lose ground as asset markets soar and companies continue to hoard cash.

The Dow Jones Industrial Average is currently at its highest level since May 2008 only 8 percent off its all-time high, and has nearly doubled since the financial crisis bottomed. Nonfinancial corporate businesses are awash in cash holding $2.21 trillion in cash and short-term securities, the highest levels ever recorded by the Fed’s Flow of Funds Account. So — how are you doing?

James Groth is a research associate at Reason Foundation, a nonprofit think tank advancing free minds and free markets.

The post What Has Ben Bernanke Done For You Lately? appeared first on Reason Foundation.

The lender of last resort (LLR) idea was first developed in the 19th century by two British economic writers, Walter Bagehot, who coined the phrase in his book Lombard Street, and Henry Thornton, considered to be the father of the modern central bank.

Essentially, a lender of last resort should be an institution that protects the monetary system from contractions in the face of bank runs and financial panics-i.e., it makes sure there is money to borrow if liquidity freezes without good cause. The supporting thesis is that if a company is healthy, with good collateral to put on the line for a loan, but can’t find a lender because of an abnormal lock-up of money, they shouldn’t be forced to fail. In this instance, a LLR can step in and prevent an unnecessary bankruptcy and “lend freely, but at a penalty rate,” as Bagehot wrote.

On this logic, many have defended the Federal Reserve’s recent lending not as a bailout, but as fulfilling its duties as lender of last resort. The problem with this logic is that the Fed’s emergency lending programs have deviated far from the classical model of the LLR. The Fed did not lend to creditworthy borrowers, it did not ensure good collateral for the loan, and it did not charge an interest rate above the going market rate (a “penalty rate” to avoid banks becoming dependent on the source of funds).

Let’s consider each of these accusations and the evidence.

First, the most important principle for LLRs is that they only lend to solvent companies that would otherwise be able to get a loan from the private sector. If a firm is unsound and failing it will naturally have trouble getting access to credit and go bankrupt. The LLR exists for the times when healthy companies can’t get credit for extraordinary reasons but are otherwise healthy institutions. To highlight how far away from this principle the Fed has ventured, consider the financial institutions that the Federal Reserve has recently lent to:

• American International Group-so full of toxic credit default swap contracts that it couldn’t get a loan at any price and was hours from running out of cash before the Fed stepped in with an initial $85 billion loan. It’s equity has since been diminished to near zero value.
• Bank of America-weighed down by losses from bad mortgage investments on its books so large that it required $94.1 billion in loans and has remained teetering on the edge of technical insolvency ever since.
• Citigroup-facing a $18.72 billion total loss for 2008, it borrowed $99 billion over a six day period in January 2009.
• Morgan Stanley-took $107 billion in Fed loans in September of 2008 and still posted a massive $2.3 billion loss in just the fourth quarter of 2008 alone (10 times the consensus estimate of bank analysts at the time).

The list could go on for pages because the Fed lent to nearly any financial institution it could find. And since no one could convincingly value all those toxic mortgage-backed securities during the height of the crisis (one of the reasons Treasury Secretary Henry Paulson decided to use TARP for equity injections instead of buying the toxic debt from the banks directly), it is hard to see how the Fed could justify determining that all the financial firms it lent to were creditworthy. The Fed knowingly violated the foremost tenet for a lender of last resort.

Bernanke’s letter to Congress says it is misleading for articles to “depict financial institutions receiving liquidity assistance as insolvent.” But since regulators like the Fed get to officially determine technical solvency or insolvency, Bernanke has the power to ignore the numbers and pass a letter of the law test in bailing out the entirety of the financial industry.

Second, while the Fed could have mitigated some of its risk in lending to unsound financial institutions by demanding good collateral, it didn’t. The Fed went ahead and also violated this tenet for lenders of last resort.

Former Richmond Federal Reserve Senior Economist Thomas Humphrey wrote in the summer of 2010 that the collateral the Fed had accepted through its special lending programs was “complex, risky, opaque, hard-to-value, and subject to default.”

He pointed out that banks could even offer the rights to be paid back for loans they’d issued to Fannie Mae and Freddie Mac as quality collateral. That meant that if the bank failed to return the Fed’s loan, the Fed could get those interest and principal payments from the GSEs-but in early 2008 the GSEs were considered by the government as near insolvent. In fact the Treasury Department decided in August 2008 that Fannie and Freddie were so unsound they had to be taken over by the government to avoid bankruptcy (and they’ve now cost taxpayers $182 billion in bailouts, and counting). How could the Fed consider GSE debt to be good collateral?

The reason why the Fed was able to accept risky and worthless collateral is because it set the terms for defining good collateral under its own lending programs. For instance, the framework governing the Term Auction Facility-just one of the many murky, awkwardly named programs the Fed launched as lender of last resort-notes that the local Federal Reserve branch for the institution getting the loan determines the value of any posted collateral. This allowed the Fed to price collateral however it wanted to ensure it could technically provide bailout loans to any firm.

Third, the Fed has charged a near zero penalty rate when conducting its extensive emergency lending operations. The final tenet of lending as last resort is designed to discourage banks from taking advantage of the LLR and to avoid political favoritism in determining the recipients of the loans.

Bernanke’s letter to Congress claimed that, “most of the Federal Reserve’s lending facilities were priced at a penalty over normal market rates so that borrowers had economic incentive to exit the facilities as market conditions normalized.” But consider the Term Auction Facility (TAF).

TAF was designed so that commercial banks could borrow from the Fed anonymously and avoid the negative stigma that came with publicly borrowing from the “discount window” (the Fed’s traditional source of credit for banks). This amounts to a tacit devaluing of truth in the marketplace, favoring asymmetric information that misdirects the use of capital (I’ll leave that discussion for a separate article). Over a 27-month period ending in March of 2010, the Fed lent out $3.8 trillion through TAF. This money was spread out over 4,000 different loans, with terms ranging from 13 days to 85 days, and with most institutions borrowing more than once from the program.

For 85 percent of program, the Fed lent at rates below the “discount window primary rate”-the market measure for what banks would normally borrow. If the Fed were charging a penalty, it would be charging at least the primary rate plus an additional amount.

Contrary to Bernanke’s statement that most were charged a penalty rate, most were actually underpriced loans. The ultimate result was the Federal Reserve lending to unsound institutions, against poor collateral, and with no penalty-i.e., giving money away for free to the Fed’s closest friends.

The Fed effectively put aside any concerns for moral hazard with its actions, and instead focused on short-term aims over long-term negative consequences. The result has been an outrageous carry trade, with some financial institutions taking in virtually free money, buying Treasuries that yield about 3 percent (lending it back to the government that just gave it to them), and banking the difference. Bloomberg estimates that banks have made about $13 billion from this, which those banks have then used to pay large compensation packages.

Lending to everyone, accepting whatever is available as collateral, subsidizing the entire operation, and ensuring that financial players suffer no consequences for their own foolish actions is not the free market at work. When the Occupy Wall Street crowd complains about illicit gains, this is the source of their anger. We have a crony capitalist system and the government is doing everything in its power to avoid changing it.

Anthony Randazzo is director of economic research at the Reason Foundation. This commentary first appeared at Reason.com on December 9, 2011.

The post Trillion Dollar Bailouts Equal Crony Capitalism appeared first on Reason Foundation.

It is assumed that improvements in the general economy benefit all the participants of that economy. A rising tide lifts all boats. While this phrase has historically been a truth for stock markets, under today’s conditions it is pure fallacy. The actual net effect of the stock markets’ return to growth shows that this rising tide lifts only a wealthy few.

It is no surprise that, after the Federal Reserve (Fed) ballooned its balance sheet from $900 billion in August 2008 to over $2.8 trillion today, stock prices have soared. This decade has already seen the effects of bubblicious Fed intervention following the then unprecedented 1 percent interest rate policy under Alan Greenspan. After its fuel artificially pumped housing prices and the short-run stock run-up from 2003 to 2007, they both came crashing down. The Fed is once again up to its old tricks-pushing the limits of the unprecedented. Ben Bernanke has trumped the “Greenspan Put” by dropping interest rates to zero and, for the first time in the Fed’s history, buying private assets with freshly printed money.

The result is the same: inflated asset prices. Stock prices have risen, but so too have the prices of commodities like gold, corn, sugar, orange juice, cotton, coffee and gasoline. And they have risen at a startling pace. From the beginning of the Fed’s first quantitative easing program through last week, the CRB CCI index, which measures the price of a diverse basket of commodities, is up more than 80 percent. Over the same period, large cap stocks as measured by the S&P 500 Index are up just over 50 percent. Prices for corn, sugar, cotton, and crude oil have all more than doubled.

This is not to say that Wall Street is enjoying the high life. Stocks are not trading much higher than levels seen 10 years ago. Financial institutions are bleeding staff and selling off businesses. And the temporary juice provided by quantitative easing is wearing off, revealing a less stable financial sector than many had hoped. In short, the Street is not exactly a fun place to be at the moment.

The reality is that the purchasing power of the dollar is falling as the Fed directs money artificially toward stocks, bonds, and commodities. Since 2002, when Greenspan first brought interest rates below 2 percent on their way to 1 percent, the dollar has lost 39 percent of its value against a weighted basket of currencies. Over this same period, gold has risen more than 500 percent, and continues to rise. The average American has not at all benefited during this time, as personal incomes have not only stagnated, but have declined. Employment has done nothing but fall.

Because most Americans are not heavily invested in the stock market, they do not benefit from rising stock prices that are artificially pumped up by government intervention and are not fundamentally reflective of real domestic economic conditions. In today’s centrally funded environment, higher cost pressures from the rising price of goods like food, clothing, and gasoline more than outstrip the benefits average Americans gain from higher stock prices. The Fed targeting asset prices expands the net worth of the top earners, while the combination of rising expenses, a depreciated dollar, and falling real wages consumes the savings and pinches the budgets of middle-class Americans. Unless one is in the top 20 percent of income earners in this country, current Fed policy is a detriment.

Those in that top 20 percent own more than 90 percent of all stock market wealth, and the Fed has targeted these assets to stave off deflation, a sort of progressive policy of trickle-down economics. But the result has been anything but mutually beneficial to all participants in the U.S. economy: the bottom 80 percent of Americans have seen higher costs offsetting any presumed gains from a rising stock market.

The median value of total stock holdings by median households (those with income between $39,400 and $63,900 per year) was $4,400 in 2009, according to Fed data. For those earning between $63,900 and $103,100, the median value of holdings was $10,000. Relative to rising commodities expenses, these stock portfolios are too small to keep pace. Any benefits individuals in these income brackets have seen via stock market gains over the past three years have been washed out due to rising costs from Fed intervention.

As the trend continues, middle-class Americans get squeezed out and pushed to the lower end – their standard of living all the while declining. The top 20 percent, on the other hand, absorb any rise in food, clothing, or gasoline, and more than welcome the outsized gains to their overall wealth.

Traditionally Wall Street and Main Street have been joined at the hip, but the recent trends are defying that notion. It’s true that when stock prices climb, all owners of stocks see gains respective to the amount of their ownership, but only when underlying economic fundamentals warrant the gain do all parties truly become better off. Rising stock prices that are reflective of real growth and innovation materializing in rising incomes, job growth, and increased purchasing power benefit all Americans regardless of the wealth ownership inequality in this country.

This mutual, cross-class benefit was most readily seen in the twenty-year bull market that began in 1980 (minus the last few years of the tech-bubble, of course). In the 80’s and 90’s, there were high net worth households that far exceeded many in the middle and lower classes. However, the rise in stock prices at that time was much different, and actually did benefit all participants of the economy since the entire period saw an overall deflationary trend in the price of commodities, and median incomes over this period rose by 21 percent.

The differences between then and now could not be more stark. Back then, it was hands-off for the Fed. Real growth, not dollar printing and asset purchases, produced actual wealth. In fact, the bull run began when then-Fed Chairman Paul Volker substantially raised interest rates in 1980. The decision to raise rates was initially followed by a recession, but then led to the greatest expansionary period in our nation’s history. From August 1979 through August 1999, the S&P 500 rose an incredible 1,108 percent, while over the same period the CRB CCI Index declined 24 percent.

Overall, that twenty year bull run was characterized by innovation, entrepreneurialism, and real economic growth. Technological improvements enabling more efficient production in manufacturing and of commodities freed up human capital and money that led to innovation in finance, communication, technology, and medicine. In sharp contrast, the past decade has seen almost the reverse trend, with commodity prices far outstripping investment gains – particularly since quantitative easing started up in early 2009. From August 2001 through August 2011, the CRB CCI Index is up 217 percent, while the S&P 500 Index is up only a minuscule 4 percent.

Why Bernanke believes more quantitative easing and long-term zero interest rates are the solution is beyond comprehension. What’s more is that, by telegraphing their every move, the Fed is directing banks and other potential lenders to speculate in commodities and stocks instead of issuing loans.

Through its programs, the Fed relies on a transmission mechanism (banks and, more notably, the Fed’s primary dealers such as JP Morgan, Goldman Sachs, and Morgan Stanley) to make loans that would spur economic growth and create jobs. Bernanke has stated that interest rates will remain at zero for at least two more years, and that the Fed will continue to purchase assets as its balance sheet matures. The Fed may even expand its balance sheet through another easing program. This is leading banks and institutions that deal with the Fed to allocate money for speculative purposes, thus exacerbating the situation.

From fiscal year 2009 to fiscal year 2010, Goldman Sachs added $9.42 Billion in commodities to its total financial assets. Over the same period, JP Morgan added $19.09 Billion. These are 253 percent and 52 percent rises in commodity exposure, respectively, while total financial assets for both firms grew by only a little over 5 percent. Conversely, small business loan portfolios at FDIC-insured institutions declined by 4.2 percent over this same 2009-2010 period, according to the FDIC. From their peak in June 2008, total holdings of small business loans have declined 14.3 percent through the first quarter of 2011, a decline of $101 billion.

This is not how economies grow, but don’t blame the banks for not lending. JP Morgan, Goldman Sachs, and others are doing exactly as they should, given the massive presence of the Fed in the marketplace. Look no further than to the sage economist David Hume for the explanation: “When any quantity of money is imported into a nation, it is not at first dispersed into many hands but is confined to the coffers of a few persons, who immediately seek to employ it to advantage.” Under the Fed’s current policies and direction, that advantage is in commodities and hot money assets – not slow growth vehicles like business loans and, God forbid, employment payrolls. And, those “few persons”, i.e., the banks, will continue on like this until the Fed changes course. There is no incentive to do otherwise.

Every indication expressed in the speeches from Bernanke suggests the Fed won’t change course anytime soon. In the latest government report, Q1 GDP for 2011 posted a paltry 0.4 percent gain, and Q2 is shaping up to be lackluster at best, with preliminary readings pointing to little more than 1 percent growth (a far cry from the projected growth rate of 3+percent). Employment numbers for this month show that the economy continues to falter with 9.1 percent unemployed. The market and pundits are now begging for another round of quantitative easing, and most likely, Bernanke will once again comply – after all, the only way quantitative easing can support markets is through continuous pumping of money into the system. Politicians will praise his genius, all while 80 percent of their constituents suffer under the Bernanke Fed’s actions.

This commentary first appeared at RealClearMarkets on August 24, 2011: http://www.realclearmarkets.com/articles/2011/08/24/the_feds_qe_makes_life_difficult_99210.html

The post The Fed’s QE Makes Life Difficult appeared first on Reason Foundation.

The United States is currently in a low-growth environment. The 2011 first quarter GDP has grown a weak 1.9 percent while the 2010 growth rate was only 2.9 percent. That may count as a decent performance in normal times, but it’s very low growth following the steep economic decline we recently experienced. Meanwhile, wages continue to remain flat and by some measures are in decline-not surprising given an unemployment rate of 9.2 percent. More than $2.1 trillion flowing from the Fed clearly has done nothing to mend the American job market. Asset markets on the other hand are booming.

Since the Fed began its campaign, the S&P has more than doubled, the Barclays aggregate is up 8 percent, and IPO pricings are signaling the next bubble. The latest major IPO to hit the street, LinkedIn, is trading at well-over 1,000 times its earnings. Plenty more companies will soon become public with price valuations that will make even that look cheap. Inflation is also beginning to creep higher and a commodity boom threatens to rapidly accelerate price hikes.

When solid underlying fundamentals of the economy contribute to inflation and to spiking asset prices, the Fed normally has a number of options at its disposal to curb the situation. But this situation is different. Now it’s the Fed itself, via its purchases, productivity gains, and abnormal speculation that has created this strange environment.

Typically commodity run-ups, inflation, and asset bubbles are associated with and partially offset by healthy economic growth, hiring, and innovation through entrepreneurism. That is not the case today. Without a strong economy corresponding with the coming confluence of inflation and bubbles, the Fed may find itself helpless to act given its current balance sheet and extended zero-interest-rate-policy (ZIRP).

Furthermore, the solution of either selling assets or raising interest rates would each run counter to the Fed’s mandate to promote full-employment. (Not that it’s a good mandate.)

As Chairman Bernanke has made clear, the Fed is comfortable maintaining the status quo for the time being, keeping asset prices propped up by reinvesting QE purchases as they run-off. In an effort to shirk the responsibility of acting preemptively, the Fed maintains that the slack job market is mitigating the threat of inflation and/or an asset bubble. The Fed also points to inflation expectations as keeping conditions anchored. These two factors are providing an excuse to justify further asset purchases and the continuance of ZIRP because the Fed believes asset bubbles and high inflation cannot occur in an environment with high unemployment and stagnant wages. The looming perfect storm is not even on the Fed’s radar.

For the Fed to take measures counter to its current policy something would have to change in the present environment, either a wage-price spiral or an unexpected (to the Fed) shift in inflation expectations. An asset bubble factoring into current Fed policy is not even conceivable at this point. And given its success at identifying the previous two, it most likely never will be.

The central (bank) irony here is that the Fed alone is keeping expectations low through its purchases. QE2’s $600 billion treasury purchases on top of the first round of quantitative easing clearly affected yields. Using them now as an indicator for future inflation is like using tech stock P/Es as an indicator for future growth in 1999. They are manipulated metrics. The Fed has artificially pushed down yields by bidding up prices, which not only skewed inflation expectations, but may also be contributing to a bond bubble. If nothing else, it has mispriced risk.

The very indicator the Fed is using to dictate a change in policy is being directly affected by its own policy. That paradox is also keeping the Fed from properly identifying pending problems in the economy.

So a perfect storm brews on the horizon while the Fed looks in the wrong direction. The crippling affects from inflationary stagnation and from the recessionary onset of a busting bubble would line-up some very difficult decisions for the Fed. If both occur simultaneously, the Fed will be helpless to defend against the two-front assault on the economy. Indeed, the Fed won’t even see it coming.

James Groth is a research associate at Reason Foundation. Anthony Randazzo is director of economic research at Reason Foundation. This column first appeared at Reason.com.

The post The Failure of Quantitative Easing appeared first on Reason Foundation.

So a simple question: what is going on with our struggling economy?

The answer can go on for pages and is hotly debated. However, I think we can get a sense of the problems facing the economy by taking a snapshot look at unemployment, housing, GDP, Wall Street, and the Federal Reserve.

Structural Unemployment

Right now it seems like the only place to find work is Texas. The overall unemployment rate ticked up to 9.2 percent in June, the highest point it has been all year. The median time individuals remain unemployed rose to 22.5 weeks while a total of 14 million Americans remain on the job hunt. Perhaps more damningly, initial unemployment claims were more than 400,000 last week for the thirteenth straight week in a row, a bad sign for the future.

The chart below explains one reason for the increasingly bad unemployment numbers. The private sector did add 57,000 jobs last month, however, this is only a 0.05 percent improvement from May, and the rate of growth has been on the decline for several months. Meanwhile, government employment has been trending downward, with 39,000 federal, state, and local workers getting laid off last month.

Despite the dismal employment picture, the Bureau of Labor Statistics reported in May that there were 3 million job openings the last time they checked. If you were to look at just the Fortune 500 companies alone-such as J.P. Morgan Chase, Best Buy, General Electric, or Microsoft-you’d find some 100,000 job listings.

The root of this misalignment in employment is structural. Fewer people are retiring because their savings were hit by slumping markets and depleted 401(k)s, leaving less openings for recent graduates to start working their way up the corporate ladder. In fact, those students who just completed degrees are facing a 17 percent unemployment rate for their age group.

Teens have it especially bad, 16 to 19 year olds have a 50 percent higher unemployment rate this summer compared to a decade ago-largely because of the minimum wage increase in 2009.

Further complicating issues in the job market are an unskilled labor force and housing woes. If Dell and IBM both want to hire a slew of software engineers, ideally they’d compete for the best workers and drive up wages. However, the math and technical skills required for these jobs are lacking among today’s unemployed. This is because a bulk of the unemployed have come from the manufacturing sector, making it difficult to fill employment needs. In a similar scenario, a company like Microsoft may want to hire 6,000 workers at its Redmond, Washington headquarters, but those whom are qualified to fill the positions are stuck in places like Nevada and Florida because they can’t sell their homes. These jobs thus remain open while the unemployed stay stranded in a jobless purgatory.

President Obama joked recently that his shovel ready job generating programs weren’t exactly shovel ready. Not a very funny joke for those 14 million-plus struggling Americans. Only the British appear to be laughing, as their unemployment is falling at a faster pace than any time in the past 10 years.

Housing Not On Solid Ground

New home sales fell 2.1 percent in May and existing home sales also continued to fall, sliding 3.8 percent. These housing sales numbers are some of the lowest reported figures since we began keeping records. The reason for continued troubles in the housing market can be boiled down to four basic elements.

First, housing prices are well-off their historical trend and need to fall further before we can begin to see any recovery. The administration’s policies and programs over the past few years have significantly propped up prices and contributed greatly to the bubble in 2006. Prices need to fall anywhere between 5 percent and 25 percent before a real recovery can begin, confirming the myth that housing makes for a good long-term investment. Price declines will mean more households facing negative equity.

Second, housing inventories need to be minimized. There is a massive supply glut of homes today (about 4 million) that needs to be sold before the residential construction industry can fully return. What is worse is that there are about two million homes in the shadow inventory-homes in the foreclosure process for one reason or another and not officially on the market to be sold. Whether because of a massive default volume or because of federal programs, it takes more than 18 months between the day a homeowner misses his first payment to the day the lender forecloses. In Florida, it takes 807 days, on average, and some homeowners have gone as long as five years without making a payment. There is a lot of deadbeat debt to get worked out.

Third, state attorneys general and federal banking regulators have been waging a war on mortgage servicers. Instead of simply levying a fine on these companies for mistakenly foreclosing with legal standing on some families, the state AGs have sought to force a new, universal set of servicing standards on the mortgage companies and are trying to extract a pound of flesh from the companies to create mortgage assistance programs. Putting the effectiveness or ineffectiveness of these programs aside, the process has gotten muddled and overextended. The longer this process takes, the more uncertainty there will be for mortgage investors considering jumping back into the market. Adding insult to injury in the housing market, the process has delayed foreclosures and added to the shadow inventory.

Finally, the fourth matter to address is the inexplicable continued existence of Fannie Mae and Freddie Mac. These gigantic subprime elephants still dominate the market, and Congress has barely moved any legislative reform past the subcommittee level in the House. Plenty of ideas are on the table for how to deal with them, but little action has been taken.

Double-Dip GDP Concerns

The economy expanded at a rate of 3.1 percent for the year 2010, inspiring many to write rosy outlooks for this year and the next. However, first quarter 2011 GDP numbers came in well below expectations at a dismal 1.9 percent. In the wake of the economy’s poor performance, most economists have since dropped their outlook for economic growth, including Federal Reserve Chairman Ben Bernanke, who lowered his GDP projections for 2011 to 2.7 percent, down from the 3.3 percent number he proclaimed earlier this year. To say this is worrisome is about as understated as calling Pete Townshend a mere guitarist.

Of course, GDP at its core is a relatively defective way of measuring economic growth. As Ludwig von Mises put it, “The attempts to determine in money the wealth of a nation or of the whole of mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimensions of the pyramid of Cheops.” But still, breaking down GDP into its components does tell us something about the health of the economy.

A majority of economic growth in the first three months of this year came from businesses buying up inventory, rather than businesses selling to consumers. The growth in final sales, as opposed to purchases between wholesalers and retailers, grew only 0.15 percent since the end of 2010. Martin Feldstein wrote in The Wall Street Journal last month that we are seeing “a collapse in payroll-employment gains; a higher unemployment rate; manufacturers’ reports of slower orders and production; weak chain-store sales; and a sharp drop in consumer confidence.” Plus, real exports slid from an 8.6 percent growth rate at the end of 2010, to a 7.6 percent expansion in the first quarter this year.

The economy is not going to grow on an inventory build-up alone and we won’t see a recovery without strong export growth. Bernanke has tried to argue that the negative trends are temporary, despite his outlook downgrade. His supporters point to the recent decline in oil prices and to the fact that supply chain routes are getting back up and running from the Japan earthquake. But the economy in the second half of 2011 will be facing a wind-down of the stimulus spending program, continued cuts in local government spending, more housing troubles, and an unpredictable European and Chinese demand for U.S. exports.

An economy with offsetting economic conditions that either leads to a slight rise in GDP or a slight decline may arguably be worse than a double-dip. Clearly robust economic growth is the ultimate goal, however, if the economy continues to draw-out on this stagnating path, a deeper, more prolonged recession may ensue. We need something more.

Wall Street Investor Schizophrenia

Beyond the bad economic news, there are regulatory constraints handcuffing economic activity. A number of foreign banks have sold their U.S. operations as new capital rules and business activity limits begin to take effect. Fee rates at commercial banks have jumped in order to compensate for lost revenue as a result of the new rules that limit the amount banks can charge on debit card transactions. People from small community bankers to the NAACP are even claiming that new definitions for qualified residential mortgages are racist and threaten to destroy the housing financial sector.

Compounding the negative effects of this oppressive regulatory environment, many corporations in the United States and Europe have been shedding debt as a result of a slow down in loan applications which has caused a sharp drop in traditional business for Wall Street’s top financial institutions. That has made life profoundly uncomfortable.

In response, the Office of the Comptroller of the Currency said last week that more than one third of banks are easing their standards for the last fiscal year. Specifically, consumer lending has seen standards relax for the first time in three years in response to improved credit market conditions and competition. However, as an indication of the still turbulent times, the OCC found that at least 30 percent of banks actually tightened standards further on credit cards, home equity loans, mortgages, and commercial construction lending.

One reason for this is that the continuous downturn in housing also means more losses for the banks-as much as $80 billion more than currently expected according to analysis from S&P. This means that the historically high amounts of reserves banks are holding onto won’t be coming down anytime soon.

The Fed Caught In Its Own Trap

What won’t be going up anytime soon are interest rates. The Federal Reserve continues to see its role as stimulator of the economy, despite Bernanke suggesting that a third round of quantitative easing would be unproductive. Under the zero-interest-rate-policy, the Federal Reserve has backed itself into a corner in at least two ways.

First, because the Fed has expanded its balance sheet largely with toxic mortgage debt purchases, it is susceptible to downward swings in the housing market. An increase in interest rates will mean more expensive mortgages, and in turn less demand for housing. The law of supply and demand suggests this will create downward pressure on housing prices and lower the value of the Fed’s mortgage related assets.

Second, if the Fed increased interest rates it would raise the U.S. government’s cost of borrowing. The average Treasury Department borrowing rate over the past 20 years is 5.7 percent, but the current rate is around 3 percent. If interest rates rose, normalizing the Treasury’s borrowing costs, it could add trillions to national spending expenditures. This would put political pressure on Congress to cut more spending and attack the national debt more ferociously-a good thing-but it would also make more spending in the future unlikely, and Bernanke is on record as believing Capitol Hill should be doing more to stimulate the economy.

What We Can Do About It

Run for the hills and convert to Zoroastrianism… Okay, I joke, but it might be easier than what we really must do to get out of this mess.

More stimulus and quantitative easing are not the answer. We cannot spend our way out of this recession, nor are there potential cuts in the federal budget that will alone unleash the private sector to spark a real recovery.

To address unemployment and GDP growth we should roll back America’s regulatory environment and loosen trade restrictions. The Index of Economic Freedom for 2011 was released this week and for the third year in a row, the U.S. has dropped. Now in 9th place behind Hong Kong, Singapore, and Denmark (and barely above Bahrain), America continued its decline due to reduced “Business Freedom” and “Trade Freedom.”

The nanny state culture where consumers and businesses are not being protected but rather parented could be dramatically cut back through the elimination of occupational licensing in many states and reducing red tape for construction and development permitting.

The more attractive it is for companies to produce here in America, and the less oppressive the permitting process, the more likely we’ll see manufacturing return to our shores and the more job openings will be created and filled. Repealing Dodd-Frank and putting in place a regulatory system that does not improperly restrict business activity, but instead effectively incentivizes Wall Street to manage risk, would be beneficial as well.

We also should be pursuing more free trade agreements. The pending pact with South Korea is expected to generate 50,000 to 100,000 new jobs as American companies gain better access to Korean markets. The recently negotiated free trade deal with Columbia would boost exports to the South American nation by 7 percent from Florida alone, and an FTA with Panama opens up a platform for U.S. businesses to increase their investment opportunities all across the Americas. Not only should these deals be pushed through, but America should also negotiate free trade agreements with Turkey, New Zealand, the European Union, and many others.

In addition to trade policy reforms, we could also open up our borders to more tourism through changes in visa policy. American companies can also become more productive by removing quotas on H-1B visas.

The housing recovery process can be moved forward simply by Washington ending its programs that aim to prop up prices. At present, they are only supporting artificially high prices and growing an already bloated shadow inventory. State and federal regulators need to finish their mortgage servicing settlement talks and Congress needs start the process of unwinding Fannie Mae and Freddie Mac.

Changes are needed in monetary policy as well. Not only would a natural, market induced increase in interest rates help get the housing sector to its bottom faster, allowing real recovery to start, but a consistent strong dollar policy could make America a more attractive place for foreign investment.

This is a laundry list of changes that are not likely to be easily embraced overnight. But the depth and complexity of what needs to be done, combined with the extensive range of problems in the economy, illustrate why it has been so challenging for the Obama administration (and I did not even mention the need for a tax code overhaul). Still, these ideas represent the pillars of a blueprint that would greatly benefit the American economy. Recovery would not be immediate, but it would be stable and sustainable. That is a goal and result we should all be able to live with.

The post A New Blueprint for Recovery appeared first on Reason Foundation.

A year later, the Fed is beginning to make that goal explicit. Over the past few weeks, Bernanke and other Fed bigwigs have been dropping conspicuous hints that they plan to boost inflation and pump another round of conjured-up cash into the economy. One proposal is to inject $100 billion per month. It’s being called Quantitative Easing 2 (QE2).

But why should the sequel be any more compelling than the original, which cost over $1 trillion and failed to move the unemployment rate or decisively revive the American economy?

This time, the Fed evidently believes that low interest rates and printed money no longer suffice, because-as the Chicago Fed president recently announced, and as John Maynard Keynes predicted would happen in an environment of zero interest rates-the U.S. is stuck in a liquidity trap. To get us out, the Fed is deploying its wonder-weapon: placebo inflation. Bernanke wants to start people thinking that prices will rise so that prices will rise. The Fed is planting a self-fulfilling prophecy in our heads. It’s kind of trippy.

Chicago Fed President Charles Evans, one of inflation’s loudest proponents, laid out the logic in an interview with the Wall Street Journal on Oct. 2:

If we could indicate to the public that we want inflation to increase toward that price stability goal [of 2 percent per year], that would serve to lower real interest rates given that short-term nominal interest rates [as set by the Fed] are close to zero.

More recently, Evans suggested temporarily coaxing inflation above 2 percent so that consumers and businesses splurge their money now, knowing that it will lose value if they hold onto it.

It’s not hard to spot Friedman’s posthumous hand in this business of inflationary QE2. Evans came right out with it in the Journal:

Milton Friedman looked at the U.S. economy in the 1930s and he saw low interest rates as inadequate accommodation, that there should have been more money creation at that time to support the economy…. I’ve come to the conclusion that conditions continue to be restrictive even though we have a lot of so called accommodation in place. An improvement would be a dramatic increase in bank lending. That would be associated with broader monetary aggregate increases. Then we would begin to see more growth and more inflationary pressures and then that would be a time to be responding.

Evans invoking Friedman is bizarre for several reasons-and not only because the theories of the late libertarian patron-saint are being trotted out to justify gigantic interventions in the world market.

• Friedman’s prescription was for a period, 1929-1933, of cataclysmic double-digit deflation. Today, the U.S. is experiencing glacial-paced disinflation, if that. The inflation rate now stands at 1.1 percent, and even Evans forecasts that inflation, if allowed to run its course, would only come down to 1 percent by 2012. There is no apparent risk of imminent catastrophic deflation, and still the Fed is considering emergency inflationary measures that Friedman only proposed for a period when the money supply had contracted by roughly a third.
• Friedman made his reputation as an inflation-fighter. His philosophy of monetarism conquered Keynesianism in the 1970s by promising an end to the chronic inflation of the time, and his first laboratory was authoritarian Chile, whose inflationary chaos he helped tame.
• Anna Schwartz-the only living progenitor of monetarism and the co-author of Friedman’s The Great Contraction: 1929-1933-told me last year that the Fed’s policies risk runaway or even hyperinflation. Indeed, she has become one of the most outspoken critics of her would-be monk, Ben Bernanke, the very man who provided the afterword to the latest edition of The Great Contraction, which Bernanke cited as the basis for today’s zero interest rates.

The Fed’s avowed monetarism should give pause to people like the Tea Partiers, who are convinced that the U.S. is caught in a neo-Fabian or Leninist transformation and that QE2 is another extension of socialist planning that could plunge America into civil war. That Fed Chairman Bernanke claims to be a disciple of Milton Friedman, and that Alan Greenspan was a follower of both Friedman and Ayn Rand, suggests that the Federal Reserve, the pre-eminent economic bureaucracy in the world, is a throne of libertarianism.

It is Friedman, not Marx or even Keynes, who has had the deciding influence on the world economy of the past and present century. Don’t take my word for it. Read this 2006 New York Times obituary of Friedman, entitled “The Great Liberator,” in which Lawrence Summers, chief economic advisor to President Obama, wrote:

Not so long ago, we were all Keynesians. (“I am a Keynesian,” Richard Nixon famously said in 1971.) Equally, any honest Democrat will admit that we are now all Friedmanites. Mr. Friedman, who died last week at 94, never held elected office but he has had more influence on economic policy as it is practiced around the world today than any other modern figure.

Friedman is dead. Long live Friedman.

Penn Bullock is a freelance writer for Village Voice Media. He lives in Florida. This column first appeared at Reason.com.

The post Are We All Friedmanites Now? appeared first on Reason Foundation.

New Zealand, Canada, and the postwar United States all managed to slash the state on a grand scale. Governments shed responsibility for forests, railways, radio spectrum, and more while relaxing labor markets, slimming the welfare state, and ending price controls. Far from damaging economies or increasing unemployment, these reductions in the size and scope of government boosted GDP, improved services, and created jobs.

Government cutters faced opposition along the way, from skeptical Keynesians to Kiwi bureaucrats. But they also found unlikely allies, with left-wing parties playing major roles in the Canadian and New Zealand examples. The stories below should encourage would-be cutters and reassure skeptics: It can be done.

Turning Guns to Butter
How postwar America brought the boys home without bringing the economy down
Arnold Kling

When World War II ended in 1945, President Harry Truman faced a problem. Public opinion called for a rapid demobilization that would bring the boys home as soon as possible. But the Keynesians who were gaining prominence in the economics profession warned that a rapid decline in government spending and the size of the public work force would produce, in the late economist Paul Samuelson’s words, “the greatest period of unemployment and dislocation which any economy has ever faced.”

Thankfully, Truman ignored the Keynesians. Government spending plummeted by nearly two-thirds between 1945 and 1947, from $93 billion to $36.3 billion in nominal terms. If we used the “multiplier” of 1.5 for government spending that is favored by Obama administration economists, that $63.7 billion plunge should have caused GDP to fall by $95 billion, a 40 percent economic decline. In reality, GDP increased almost 10 percent during that period, from $223 billion in 1945 to $244.1 billion in 1947. This is a rare precedent of a large drop in government spending, so its economic consequences are important to understand.

The end of World War II thrust more than 10 million demobilized servicemen back into the labor market, but without the catastrophic consequences Keynesians feared. Close to 1 million took advantage of the GI bill to attend college. In addition, some of the increase in the male work force was offset by a decline in female labor force participation from World War II levels. But if Rosie the Riveter became a housewife, many of her friends continued to work outside the home. Over all, from 1945 to 1947 the civilian labor force increased by 7 million, or 12 percent. The vast majority found work, as civilian employment rose by 5 million, an increase of 9 percent.

In addition to the demobilized servicemen, the federal government let go of more than a third of its civilian employees-over 1 million workers. Many of these civilians had been engaged in government attempts to manage the economy. As the economist Gary M. Anderson has pointed out in The Freeman, more than 150,000 people were employed by various wartime economic regulatory agencies, such as the War Production Board, the War Labor Board, the Office of Civilian Supply, and the Office of Price Administration.

With responsibilities that extended well beyond wartime production to include restrictions and controls on the civilian nonmilitary economy, those agencies and boards disbanded with great reluctance. The 1946 election, which gave Republicans a majority in the House of Representatives for the first time since 1930, prompted a change of heart, with Price Administrator Chester Bowles removing virtually all remaining price controls five days after the vote.

The conversion to a peacetime economy was a remarkable undertaking by the private sector. It did not merely involve converting wartime manufacturing to peacetime uses. For example, of the 2.8 million workers let go by the “other transportation equipment” sector between 1943 and 1948, when military vehicles were no longer needed, just half a million were absorbed by the civilian automobile industry. The big employment gains turned out not to be in manufacturing at all. The sectors that saw the most hiring were retail trade, services, contract construction, and wholesale trade, which together added nearly 4 million workers.

There are important differences between circumstances today and the circumstances in 1945, of course. Back then, federal spending was much larger as a share of GDP (40 percent, vs. less than 10 percent today), and government employment was a much larger share of the labor force than now (20 percent vs. 2 percent), so a more significant adjustment was required.

But there are other factors that make change more difficult today. During World War II, the personal savings rate climbed to more than 20 percent, so after the war households were able to offset the decline in government spending by consuming a larger share of their incomes. Today, with a savings rate of about 5 percent, households have much less room to expand. In addition, the skill requirements of today’s industries make it more difficult to match workers with jobs than was the case in the much simpler economy of the 1940s.

Any way you look at it, though, America’s experience from 1945 to 1947 demonstrates that the private sector is capable of overcoming a tremendous drop in government spending. As a percentage of GDP, the decrease in government purchases then was larger than would result from the total elimination of government today. While no one can be sure what would happen if the government were to shrink that quickly, the ’40s boom offers a hopeful example.

Arnold Kling (arnoldsk@us.net) is a member of the Financial Markets Working Group at the Mercatus Center at George Mason University. He blogs at econlog.econlib.org.

The New Zealand Miracle
When left and right worked together on far-reaching market reforms
Maurice McTigue

In the early 1980s, New Zealand was on the fast track to bankruptcy. By 1984, when the conservative National Party called a snap election, the deficit was approaching a massive 9 percent of GDP with no budget in place. The government’s share of GDP was 45 percent, unemployment was 9 percent (it would later peak at 11 percent), the top tax rate was 66 percent, and the rate of economic growth was a sluggish 2 percent.

A decade later, New Zealand had one of the most competitive economies in the developed world. The government’s share of GDP had fallen to 27 percent, unemployment was a healthy 3 percent, and the top tax rate was 30 percent. The government went from 23 years of deficits to 17 years of surpluses and repaid most of the nation’s debt.

This remarkable change was not only possible; it was fast and comparatively easy. The incoming Labour Party government paved the way in 1984 with its market-oriented approach to the economy; the National Party administration that took over in 1990 enthusiastically expanded the successful reforms. To solve deep economic problems, successive governments of New Zealand set out to eliminate the deficit, lower unemployment, and increase investment by shrinking the public sector, reforming or eliminating expensive programs, privatizing government enterprises, and reforming a burdensome regulatory process that was weakening our economy. Here’s how it happened.

Privatization: From 1986 through the mid-1990s, New Zealand sold off airlines, airports, maritime ports, shipping lines, irrigation projects, radio spectrum, printing offices, insurance companies, banks, securities, mortgages, railways, bus services, hotels, farms, forests, and more. The capital released by privatization paid down the debt and was reinvested in higher priorities. In each of the services sold, productivity increased and costs went down; the country’s competitiveness improved, and taxes poured into government coffers.

Rightsizing government agencies: After we eliminated those government functions, the bureaucracies that used to perform them were too large to perform their remaining tasks. So the civil service was reduced by 66 percent. Some agencies remained almost the same size, while others were reduced by 90 percent to 100 percent. After we privatized our forests, for example, only 17 of the Ministry of Forestry’s former 17,000 employees were deemed necessary.

Cutting taxes: At the same time, we reformed the revenue system by eliminating capital gains taxes, inheritance taxes, luxury taxes, and excise duties and by allowing income to be taxed only once. We halved tax rates, eliminated all deductions that were not a cost of earning income, and created a system where one-third of revenue came from consumption taxes and two-thirds came from income taxes. Under the simplified system, about 65 percent of the population no longer had to file tax returns-a major selling point for reform.

Reforming the appropriations process: Before 1987, a government appropriation was simply a grant to spend on a specific activity. If money was appropriated to employment programs, for example, there was no expectation that a certain number of unemployed people would become employed as a result. With the State Sector Act of 1987 and subsequent laws, funding was linked directly to results. Agency heads were now CEOs, chosen for capability. They received fixed-term contracts: five years with a possible three-year extension. The only grounds for removal was nonperformance, so a newly elected government couldn’t replace department heads with its own people. In the new appropriations process, these CEOs signed a purchase contract identifying exactly what was to be produced for the money allocated.

Consider this case from one of my own portfolios, the Ministry for Employment. Under the old system, a total of $60 million was appropriated in 1989 to 34 different programs, which found jobs for 40,000 clients. After 1990, under the new purchase agreements, the same amount was allocated to just four programs; the other 30 were terminated. The contract required the ministry to place 120,000 people in jobs, with 56 percent of that figure drawn from the long-term unemployed, 25 percent from the Maori, 14 percent from people with disabilities, and 7 percent from people with social and drug or alcohol dependence problems. The ministry successfully placed 135,000 people in jobs that year.

Welfare policy: We now aimed not just to shrink the state but to reduce the number of people dependent upon it. Welfare had evolved into an entitlement to state support for social circumstances such as solo parenting, unemployment, health problems, and other forms of dependency. Under the new approach, resources were devoted to resolving health problems, education problems, social problems, and poor work skills. This approach moved 300 percent more people from dependency to independent living. It was a carrot-and-stick approach, though: If work was available and a citizen was capable of doing the job, he or she had to take it or forgo benefits.

As the New Zealand example demonstrates, it is possible to meet a crisis with serious, substantial reforms. All it requires is a good plan and strong political leadership.

Maurice McTigue (mmctigue@gmu.edu) helped guide New Zealand’s reforms as a member of parliament, cabinet minister, and ambassador. He is currently the director of the Government Accountability Project at the Mercatus Center at George Mason University.

If Canada Can Do It…
Slashing the state in the Great White North
David R. Henderson

In 1994 government debt was 68 percent of Canada’s GDP. By 2008 that number was down to 29 percent. Finance Minister Paul Martin Jr. and Prime Minister Jean Chrétien, both of the Liberal Party, are the two unlikely stars in this heroic tale of fiscal discipline.

Paul Martin’s father was also known as “the father of Medicare,” Canada’s federally mandated single-payer health care plan, so revered by American liberals. Chrétien was the political heir of Pierre Trudeau, prime minister of Canada for all but nine months between 1968 and 1984, who bore a great deal of the responsibility for accumulating all that debt to begin with.

In the 1993 election, the Liberal Party promised to reduce the deficit. Almost unbelievably, its candidates actually kept this pledge after winning office. Chrétien and Martin accomplished the task with large budget cuts-not cuts in the growth of spending, but cuts in nominal dollars spent-and only small increases in taxes.

In assembling these cuts, Paul Martin didn’t follow the usual pattern of consulting interest groups one by one. Instead, he held four televised regional consultations in which various lobbyists, experts, and ordinary citizens contended with one another. Martin also spoke directly to the public about what was needed to turn Canada’s budget around. In October 1994, his Department of Finance published a report, A New Framework for Economic Policy, showing that in order to keep the ratio of debt to GDP from rising, government had to run a substantial surplus on its program budget-that is, have revenues significantly exceeding state expenditures.

Martin and Chrétien enforced discipline on other cabinet members with a zero-sum ground rule: If a cabinet member wanted a smaller cut in one program, he had to propose a bigger cut in another.

Martin’s 1995 budget remains a shining example of how to deliver on promises of aggressive fiscal discipline. Government spending didn’t just grow more slowly; it actually shrank. Spending on programs (as opposed to debt service) was lower in dollar terms, and therefore even lower when adjusted for inflation, than spending in 1993-94. Indeed, program spending was lower as a percentage of GDP than it had been at any time since 1951. The 1995 budget also privatized a number of government corporations, including a railway, a uranium company, and the air traffic control system; and it tightened Canada’s unemployment insurance program.

In this and later budgets, Martin used conservative assumptions to make sure he achieved his goals come “hell or high water,” an expression he used so often it became the title of his autobiography. Because his assumptions often turned out to be too pessimistic-a refreshing change from the usual budgetary wishful thinking-the ratio of debt to GDP fell even faster than projected. Martin also had a “no-deficit rule”: Once he had managed to get rid of the deficit, he pledged to avoid future deficits by keeping spending in check.

From 1992-93 to 2000-01, Canadian spending on federal programs fell from 17.5 percent of GDP to 11.3 percent. The Canadian economist Thomas Courchene notes that the latter figure was the lowest “in more than half a century.”

Not everything Martin did would meet with universal libertarian approval. Although there were six to seven dollars in budget cuts for every dollar of tax hikes, he did raise taxes. Virtually all of these increases were announced in the 1994 and 1995 budgets, and most were nickel-and-dime stuff: a reduction in the deductibility of meal and entertainment expenses, elimination of the $100,000 capital-gains tax exemption that a taxpayer could claim cumulatively over a lifetime, a 5.7-cent-per-gallon increase in the gasoline tax, a reduction of the upper limit on deductible contributions to Registered Retirement Savings Plans (Canada’s version of a deductible IRA), an increase in the corporate income tax rate from 39.14 percent to 39.52 percent, and a few others.

Martin did not raise individual income tax rates. He did, however, increase the degree of means testing for various federal benefits. Within some income ranges, benefits ended up falling for every additional dollar of income, so the implicit marginal tax was several percentage points higher than the explicit rate.

As a result of this fiscal discipline, in every year between 1997 and 2008 Canada’s federal government ran a budget surplus. In one fiscal year, 2000-01, its surplus was a whopping 1.8 percent of GDP. If the U.S. government had such a surplus today, it would amount to a cool $263 billion rather than the current deficit of more than $1.5 trillion.

Chrétien and Martin’s efforts were so successful that in 2000 they reduced the corporate tax rate by seven percentage points, cut income taxes, decreased the amount of capital gains subject to taxation, and increased the contribution limit for retirement accounts. Through most of this time period, Canada’s economy boomed, thus belying the Keynesian view that large budget cuts reduce economic growth. If the Canadians can do it, maybe, just maybe, we can too.

Contributing Editor David R. Henderson (davidrhenderson1950@gmail.com), a former Canadian, is an associate professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, California, and a research fellow with the Hoover Institution at Stanford University. This column first appeared at Reason.com.

The post It Can Happen Here appeared first on Reason Foundation.

Yet loud critics of big government-especially but not only Republican politicians-are often reduced to an awkward stammer when put on the spot by the all-important question, “So what would you cut?” Well, stammer no more.

Consider the following a Halloween-themed cheat sheet for explaining who, what, where, when, and why whole swaths of government need to be cut or euthanized outright, so that taxpayer money is spent more productively, the remaining government services perform better, and the United States can finally begin its long slow climb toward solvency.

We’ve asked analysts from the nation’s capital and around the world to offer tips and tricks for fighting off the cold, cold monster that is the state. The suggestions below are intended not as a last word but as a starting point: As in any good slasher movie, the savvy viewer will soon see potential victims everywhere.

Overhaul Medicaid

Imagine a government-run health care program that limits medical access for millions of patients, is racked by uncontrollably rising costs, and in many instances produces health outcomes demonstrably worse than having no insurance at all. The program exists, and it’s called Medicaid.

Created to provide aid to the country’s poorest and sickest individuals, the joint federal-state program was initially intended as a low-cost bulwark against further government intervention in the health care system. In 1965, its first year in operation, the program cost about $9 billion in inflation-adjusted dollars. But instead of heading off further government intervention, it became the vehicle for much of the government’s expansion into the health care sector. Between 1970 and 2000, the program grew from $29 billion to $250 billion in 2010 dollars.

This year the Department of Health and Human Services expects the total cost of Medicaid to top half a trillion dollars. And according to the National Association of State Budget Officers, it will account for more than 20 percent of total state spending. Medicaid outspends all other welfare programs combined, and, if not for the Medicare prescription drug benefit, it would already be more expensive than any other entitlement.

What do we get for all that money? Not much. Recent studies at the University of Virginia, the University of Pennsylvania, and Columbia University and Cornell indicate that in cases involving colon cancer, vascular disease, and several other maladies, Medicaid’s health outcomes are frequently worse or no better than the outcomes for individuals who lack health insurance entirely. Yet 46 million Americans are enrolled in the program-a figure that is projected to increase by 16 million over the next decade, thanks to ObamaCare.

Shuttering the program remains politically infeasible, and ObamaCare’s reliance on Medicaid to expand health coverage has dimmed the prospects for reform. But states could opt out of the technically voluntary program, and the rapidly deteriorating fiscal outlook of both Medicaid and the country means an overhaul may become necessary long before politicians build up the courage to tackle it.

The first step is to stop the matching grant funding process, in which states receive federal money for each Medicaid dollar they spend-creating an incentive for ever greater spending. Instead, the program should be funded by federal block grants indexed to the rising cost of health care. Better yet, scrap the program entirely in favor of a temporary assistance program that doesn’t create long-term dependency. That may sound radical, but the alternative is to perpetuate the ugly and unsustainable status quo, in which we devote ever more resources to a program that fails both taxpayers and patients.-Peter Suderman

Bring the Troops Home

You can’t make a serious dent in government spending without tackling the military budget. And the quickest way to reduce Pentagon spending is to end, as fast as physically possible, our ongoing occupations of Iraq and Afghanistan.

So far those two wars have cost well over $1 trillion-on par with this year’s federal budget deficit-almost all of it spent through off-budget, fiscally reckless “emergency” supplemental bills that smuggled in all sorts of nonemergency weapons pork and social programs. And if the wars had never been fought we could have saved something more precious than taxpayer money-tens of thousands of human lives.

We don’t know how long the wars will last if we don’t withdraw now, so we can’t say for sure how much a swift and total deoccupation would save. President Barack Obama has promised a wind-down in Iraq that would reduce troop levels to 50,000 by 2011 and zero by 2012, but there are already signs the timetable will be pushed back. If Obama lived up to his plans, Brookings Institution analyst Michael O’Hanlon reckons, they probably would save “$50 billion to $70 billion in fiscal 2011 and perhaps $80 billion to $100 billion a year in 2012 and beyond.”

According to the government’s back-of-the-envelope numbers, deploying one warrior for one year costs about $1 million. Congressional Budget Office projections for the 2012-2020 costs of both wars range from $274 billion to $588 billion-and both estimates assume we will be winding down troop numbers significantly, which may or may not happen.

Even if we stop the wars now, the expense won’t stop. As National Bureau of Economic Research economist Ryan Edwards noted in a July study, “Historically, the peaks in total benefits [paid to war veterans] have lagged the end of hostilities by 30 years or more, meaning the maximum effect on annual budgets…might not be felt until 2040.” It’s too late to do anything about that for our thousands of already wounded vets and their families. Given the dubious benefits and indisputable costs of these continuing occupations, we should immediately stop adding to their ranks. –Brian Doherty

Erase Federal Education Spending

In August the Obama administration gave the states a $10 billion bailout to save teachers’ jobs -even though the Bureau of Labor Statistics indicates that teachers aren’t losing them. After 30 months of recession, local education employment has suffered less than a 1 percent decline. In fact, education hires rose in 21 states between 2009 and 2010. By contrast, the private sector saw a 6.8 percent decline in employment.

In addition, the president has proposed a $78 billion education budget for 2011, a whopping $18.6 billion more than in 2010. Federal education spending has increased by close to 80 percent in real terms since 2001, but test scores in reading and math among 17-year-olds have been flat since 1971, according to the National Assessment of Education Progress.

Politicians have talked for a long time about eliminating the Department of Education. While this remains an excellent idea, there is plenty of low-hanging fruit that can be plucked immediately.

The feds’ largest education program, Title I, which costs $16 billion a year, has failed to come anywhere close to its goal of helping disadvantaged kids in high-poverty schools close the achievement gap. Head Start, at $8 billion annually, duplicates many other federal, state, and local early education programs without adding to their effectiveness; a January 2010 gold-standard study by the Department of Health and Human Services found that by first grade not one of more than 114 academic and behavioral tests indicated a reliable, statistically significant effect from participating in Head Start. The $1.2 billion in funding for 21st Century Community Learning Centers that provide after-school care should be eliminated too. There are many duplicative after-school programs, and these are not a high priority to improve educational achievement.

The $2 billion for various “adult education” programs should also be cut. Community colleges can serve adult education needs and are already funded through Pell grants and federal student loans.

These are just a few examples; the federal education budget is full of cuttable programs. If eliminating the entire Department of Education is politically impossible, then the programs with the most tenuous relationships to raising student achievement need to be the first to go.-Lisa Snell

Slash State Budgets

As usual, governments have been slower to adjust to harsh economic realities than the rest of us. The private sector shed nearly 8.5 million jobs during the recession, while governments at all levels actually added more than 100,000 employees, as of December 2009. This growth ensures that state governments will be struggling to balance budgets long after any private-sector recovery is under way. And it means that they will continue to come begging to the federal government-and their own taxpayers-to cover the shortfall.

In a July report, the National Conference of State Legislators determined that the states face a collective budget gap of $84 billion for fiscal year 2011, with 24 states reporting deficits of at least 10 percent of their general fund budgets. In a June report, the National Governors Association and the National Association of State Budget Officers estimated that the cumulative state budget deficits for fiscal years 2009 through 2012 would be $297 billion. Only $169 billion of that sum has been processed to date, leaving at least $128 billion in deficits that must be tackled over the next couple of years. Yet despite a decline in federal stimulus funds and continued lagging revenues, governors’ recommended budgets for fiscal year 2011 forecast a 3.6 percent increase in general fund expenditures.

States blame the recession for their fiscal problems, and the economy certainly did not help matters, either in tax revenues or in demand for services. But the correction merely revealed that lawmakers have been living way beyond their means for far too long.

One useful metric of good fiscal stewardship is the comparison of spending growth to the increase in population plus the increase in the cost of living, as measured by the Consumer Price Index. During the comparative good times of 2000 to 2008 (the most recent date for which the necessary numbers are available), the national population increased 8 percent and CPI inflation rose 25 percent, for a baseline spending-growth number of 33 percent. Yet actual combined state spending skyrocketed 60 percent. Bringing annual spending increases down to the rate of inflation plus population growth is a minimal first step, although that probably will be impossible without defusing the public pension bomb.-Adam B. Summers

End Defined-Benefit Pensions

The funding shortfall of public employee pensions at the state and local level exceeds $500 billion. Annual pension contribution costs have grown exponentially in the last decade from coast to coast. There is a simple way out of this government-manufactured mess: bankruptcy. As the city of Vallejo, California, discovered in 2009, bankruptcy protection can provide an avenue for governments to renege on their crushing pension commitments.

Unfortunately, the bankruptcy option is available only to cities and counties, not states or the federal government. And public employee unions in California and elsewhere are working time-and-a-half to change bankruptcy laws to stop future Vallejos from declaring insolvency, or at least to rig the settlement terms to labor’s benefit.

So what are the realistic solutions? California gubernatorial candidate Meg Whitman has a good idea: end defined-benefit contributions-in which taxpayers, rather than the employees, fund retirement plans-for all new government hires. Instead, public servants of the future should be put into 401(k) plans like the rest of us, with responsibility to contribute to and manage their own retirement nest eggs.

What about existing employees? The payouts contractually promised to employees at the time of hiring are devilishly hard to roll back. But there is wiggle room at the front end, with the option of requiring public workers to fund more of their own accounts. This doesn’t get governments to parity with the private sector, where defined-benefit plans are all but extinct. But it takes some of the immediate pressure off taxpayers. As the American people grow increasingly angry at gilded public-sector compensation, California Gov. Arnold Schwarzenegger succeeded in getting a handful of unions to accept increases in the percentage that employees contribute to their own plans, and similar proposals are gaining a foothold around the country.

Neither of these solutions will solve the looming shortfall, which ultimately will be filled in with taxpayer bucks. But they are steps toward bringing the era of defined-benefit pensions to an end.-Tim Cavanaugh

Declare Defeat in the Drug War

As Sting recently observed, channeling John Stuart Mill, the war on drugs by its very nature tramples on “the right to sovereignty over one’s own mind and body.” It also squanders taxpayer money while causing far more harm than it prevents.

To enforce drug prohibition, state and federal agencies spend more than $40 billion and make 1.7 million arrests every year. This effort wastes resources that could be used to fight predatory crime. But the direct taxpayer costs are only part of the story. While imprisoned (as half a million of them currently are), drug offenders cannot earn money or care for their families, which boosts child welfare costs. After they are released, they earn less than they otherwise could have-roughly $100,000 less over the course of their working lives, according to Harvard sociologist Bruce Western. These losses add billions more to the annual drug war tab.

The Office of National Drug Control Policy estimated that Americans spent $65 billion on illegal drugs in 2000, the equivalent of more than $80 billion today. Comparisons between legal and illegal drugs suggest that as much as 90 percent of that spending is attributable to prohibition’s impact on drug prices, meaning that legalization would make tens of billions of dollars available for other purposes each year. Some of those savings probably would be sucked up by drug taxes, which Harvard economist Jeffrey Miron estimates could generate nearly $50 billion a year in government revenue.

Lower prices also would dramatically reduce the incentive for heavy users to finance their habits through theft. In a 1991 survey, 10 percent of federal prisoners and 17 percent of state prisoners reported committing such crimes. Since stolen goods are sold at a steep discount, the value of the property taken to pay for drugs is several times higher than the artificially inflated cost of drugs.

Other problems associated with prohibition are harder to quantify in dollars, including official corruption, the erosion of Fourth Amendment rights and other civil liberties, interference with religious rituals and medical practice, terrorism subsidized by drug profits, deaths and injuries from tainted or unexpectedly strong drugs, and the prohibition-related violence that has claimed 28,000 lives in Mexico since 2006. The pervasive demands of the futile crusade against an arbitrarily selected set of intoxicants have made all of us, whatever our taste in psychoactive substances, less free, less wealthy, and less safe.-Jacob Sullum

Cancel the Federal Communications Commission

The Federal Communications Commission (FCC) oversees everything from TV and radio to wireless phones and Internet connections. But none of these tasks is a core government function. From regulating speech to subsidizing broadband, just about everything the FCC does is either onerous, constitutionally dubious, ineffective, or all three.

Take its role as broadcast censor: Under a policy that was recently overturned by a federal appeals court, the agency has spent decades enforcing an arbitrary, inscrutable code governing what speech and images are acceptable on the public airwaves. Are four-letter words forbidden or not? Which ones? And when? What about breasts or bottoms, or lower backs? Does it matter if the context is medical, accidental, or unattractive?

The FCC’s answer to all of those questions is yes, no, maybe, or all three, depending on whether the words and pictures in question meet its definition of “indecency.” But that test is performed using guidelines that are clear as mud: “An average person, applying contemporary community standards, must find that the material as a whole appeals to the prurient interest.” Naturally, judgments about who counts as an average person and what constitutes a “contemporary community standard” are left entirely to the commission’s whim.

Yet the FCC is bent on expanding its reach whenever and wherever possible. The agency’s recent actions include investigating the approval process Apple uses for its iPhone App Store, mulling whether and how phone companies might upgrade their networks, and passing regulatory judgment on various consumer devices of minimal importance. Many of its recent efforts have been focused on finding ways to regulate Internet traffic.

When the FCC was launched in 1934, backers argued that its existence was justified by airwave scarcity. In an age of information overload, with a wide array of media choices available to anyone with a mobile phone or broadband connection, no such argument can credibly be made. Yet rather than shrinking, the agency has ballooned, growing its budget by more than 60 percent between 1999 and 2009 in nominal terms. To what end? And at what cost to the private sector?

In addition to the agency’s $338 million budget, a 2005 study by economist Jerry Ellig estimated FCC regulations hit consumers with up to $105 billion a year in additional costs and missed services. Rather than facilitate communications technology, the agency has made America’s consumer electronics offerings substantially more expensive.

The best alternative is a world in which spectrum is freely tradable private property rather than a government-managed resource, interference is treated as a tort, and no one worries about whether their next on-air word will result in a seven-figure fine-in other words, a world with no FCC at all.-Peter Suderman

Uproot Agriculture Subsidies

Farm subsidies and price supports offer something for people of all political stripes to hate. They distort markets and spark trade wars. They make food staples artificially expensive, while making high-fructose corn syrup-the bogeyman of crunchy parents, foodies, and obesity activists everywhere-artificially cheap. They give farmers incentives to tamper with land that would otherwise be forest or grassland. They encourage inefficient alternative energy programs by artificially lowering the price of corn ethanol compared to solar, wind, and other biomass options. School lunches are jammed full of agricultural surplus goods, interfering with efforts to improve the nutritional value (and simple appeal) of the meals devoured by the nation’s chubby public schoolers.

Enacted in the 1930s as temporary emergency measures in a time of scarcity, subsidies of such staple crops as corn, wheat, and soy have managed to survive into the current era of abundance. Congress hands about $20 billion a year in direct farm support payments to a small group of powerful agricultural companies, while American consumers and firms double that amount in inflated prices at the supermarket, restaurant table, and even at the gas pump.

Challenge agricultural subsidies on Capitol Hill, and you’ll get a song and dance about America’s endangered family farmers. But farm welfare goes overwhelmingly to large corporations. (Those cuddly fruit and vegetable growers at the farmer’s market are virtually all ineligible for federal aid.) Congress reauthorizes the farm bill every five or six years, so in 2013 there will be another chance to set this wrong right. The only people harmed by phasing out farm subsidies would be a few big agribusiness firms and a bunch of congressmen who rely on their campaign donations. The beneficiaries would be farmers in less developed countries-and pretty much everyone else who eats.-Katherine Mangu-Ward

Unplug the Department of Energy

On April 18, 1977, four months into his new administration, President Jimmy Carter delivered a somber speech in which he declared the “moral equivalent of war” on the “energy crisis.” The centerpiece of Carter’s energy policy was
the creation of a new Department of Energy (DOE), which would implement sweeping proposals to transform the way Americans produced and used energy. Just four months later, the new department, centralizing some 50 scattered federal energy agencies, was approved by Congress.

One of the chief functions of the department was to administer price controls on oil and natural gas. The DOE would also dispense billions of dollars in research and development subsidies aimed at jump-starting alternative energy technologies such as coal gasification and solar power.

So what about the DOE today? In 2010 more than half of the department’s $26 billion budget ($16 billion) was devoted to managing the federal nuclear estate, which consists mostly of facilities that make and dispose of materials used for nuclear weapons. The next biggest chunk of DOE funding, $5 billion, is targeted at that old standby, energy R&D. But payoffs on government-supported research have not been impressive. Three previous programs costing a couple of billion dollars failed to produce automobiles that ran on electricity (1992), hydrogen (2003), or gas at three times the efficiency (1993).
And despite a total of $16 billion in subsidies over the years, solar electricity still costs between three and four times more than fossil fuel electricity.

Federal energy price controls were mercifully lifted in the 1980s. But the DOE continues to perform tasks better left to other players. Cleaning up after nuclear weapons is costly and will
be necessary for a long time. Why not let the Pentagon handle that problem? Private-sector energy R&D is moribund because energy production and distribution is the most heavily regulated segment of our economy, but federal R&D subsidies have utterly failed as a substitute for competition and the lure of profits. If Congress and the White House must pursue the development of alternative energy via social engineering, a far more effective alternative to allowing DOE bureaucrats to pick technology “winners” would be a tax on conventional energy. The boost in energy prices would at least encourage inventors and entrepreneurs to get to work.

In 1982 President Ronald Reagan called for abolishing the DOE. The Republican congressional “revolutionaries” in 1994 promised to end it as well. As late as 1999, bills were introduced in the House and Senate to eliminate it. And yet the beast lives on. Thirty-three wasteful years after Carter’s speech, we’re still wasting energy (and money) on the Department of Energy. Enough is enough.-Ronald Bailey

Dismantle Davis-Bacon

For nearly 80 years, contractors working on federally funded construction projects have been forced to pay their workers artificially inflated wages that rip off American taxpayers while lining the pockets of organized labor. The culprit is the Davis-Bacon Act of 1931, which requires all workers on federal projects costing more than $2,000 to be paid the “prevailing wage,” which typically means the hourly rate set by local unions.

Davis-Bacon was born as a racist reaction to the presence of Southern black construction workers on a Long Island, New York, veterans hospital project. This “cheap” and “bootleg” labor was denounced by Rep. Robert L. Bacon (R-N.Y), who introduced the legislation. American Federation of Labor President William Green eagerly testified in support of the law before the U.S. Senate, claiming that “colored labor is being brought in to demoralize wage rates.” The result was that black workers, who were largely unskilled and therefore counted on being able to compete by working for lower wages, were essentially excluded from the upcoming New Deal construction spree.

The legislation hasn’t come cheap for taxpayers. According to 2008 research by economists at Suffolk University, Davis-Bacon has raised the construction wages on federal projects 22 percent above the market rate. James Sherk of the conservative Heritage Foundation estimates that repealing Davis-Bacon would save taxpayers $11.4 billion in 2010 alone. Simply suspending Davis-Bacon would allow contractors to hire 160,000 new workers at no additional cost, something that should appeal to a jobs-obsessed Congress and White House.

Yet the Obama administration extended Davis-Bacon via the American Recovery and Reinvestment of Act of 2009, also known as the stimulus. Asked to clarify how the old rules applied to the new money, the Department of Labor declared that Davis-Bacon now applies to all “projects funded directly by or assisted in whole or in part by and through the Federal Government.”

In other words, even projects that are only partially funded by the stimulus must obey these costly requirements. With the economy floundering, the last thing taxpayers need is a rule that makes construction projects cost even more.-Damon Root

Repeal the Stimulus

Government inefficiencies sometimes pop up in surprising places. For instance, in spending money quickly. You’d think Washington bureaucrats, of all people, could figure out how to inject $794 billion in stimulus money into the economy, but as of early September, 18 months after the stimulus was passed, an estimated $301 billion remained unspent.

That money should be banked, not wasted. While more than half of those funds are already promised to specific programs, they could be rescinded because the projects haven’t begun yet.

If you believe the administration’s stimulus tracking website, Recovery.gov, stimulus projects had created 749,142 jobs as of June 30. In related news, unemployment has increased 1.3 percentage points since the stimulus was signed into law, from 7.7 percent then to 9.5 percent in July 2010. If you include underemployed workers, the overall rate of unemployment a year and a half after the stimulus was 16.5 percent, compared to 14 percent before. And a year and a half after approval of a stimulus that was supposed to create or save 3 million jobs, the labor force had contracted by nearly 850,000 people-individuals who aren’t counted in the unemployment numbers because they have given up hope of finding work anytime soon.

The president attributes much of the nation’s GDP growth to the stimulus spending. But there is no objective evidence to back up his claims. The only way you can tweak the numbers to show a significant stimulus contribution would be to assume, not demonstrate, a very high multiplier-the amount of economic activity generated by each government dollar. That’s what the administration does, but more honest economists do not.

Less partisan analysis shows that deficit spending has crowded out private investment. Harvard economist Robert Barro recently estimated that the $794 billion stimulus will shrink private investment in the economy by $900 billion. Whatever local benefits stimulus spending has created have been negated by a contraction of private-sector growth elsewhere.

Not only has the government largely replaced what the private sector could have done, but investors are cutting back on expenditures as they prepare for increased taxes. Given Obama’s declared intention to end the tax cuts of 2001 and 2003, plus various increases woven into health care reform, investors are justified in their
fears.

But all is not lost. A quick, merciful end to the dysfunctional stimulus program could save as much as $300 billion, taking a sizable chunk out of the projected $1.5 trillion deficit.-Anthony Randazzo

Spend Highway Funds on Highways

Congestion causes gridlock on urban expressways, costing an estimated $76 billion per year in wasted time and fuel. The 50-year-old Interstate highways are starting to wear out and will need reconstruction costing hundreds of billions of dollars. The funding shortfall just to maintain the Interstate Highway System at a decent level is $10 billion to $20 billion per year.

The federal Highway Trust Fund was created in 1956 with a promise that all proceeds from a new federal gasoline tax would be spent on building and maintaining the interstate highways. But Congress reneged on the deal. First it extended federal aid to all sorts of other roadways. Next it allocated 20 percent of those “highway user taxes” to urban transit. Today a quarter of the total is used for such nonhighway purposes, including sidewalks, bikeways, recreational trails, and transportation museums.

So the Highway Trust Fund is effectively broke, spending more than what comes in from gas tax revenues. To some, the remedy is a big increase in those taxes. But why not revive the original deal?

Libertarians typically reject any role for the federal government in highways, urging a complete devolution to the states and the private sector. But even if you agree that a seamless national superhighway network should be federal, lesser highways should all be the states’ problem. And sidewalks, transit, and bikeways, needless to say, are local issues.

Simply reviving the original users pay/users benefit principle of the Highway Trust Fund could save the money spent on central planners’ pet projects while still allowing the authorities to maintain the system’s infrastructure. Indeed, the current federal fuel tax would permit an additional $10 billion a year in interstate highway investment. Combined with the selective use of tolling and other forms of road pricing, this change could slash urban traffic congestion as well, unlocking billions of dollars in economic productivity.-Robert Poole

Privatize Public Lands

The U.S. Forest Service owns more than 156 million acres west of the Mississippi River-an area nearly the size of Texas-making it one of the largest landowners in the West. Letting the states manage this land instead would take up to $5 billion a year off the federal books. It would also devolve decisions about how to use the land to officials who are more accountable to local citizens, be they environmentalists or businessmen.

Deficit-riddled states are certainly in no position to purchase this land outright today, but a payback period of 25 to 30 years (as with a standard home mortgage) could make these deals feasible. Once in state hands, some land could be sold off or put to better uses, though there would still be political pressure to keep large portions of it undeveloped. And states could choose to partner with the private sector.

Private companies currently operate the commercial activities-lodges, shops, restaurants, and the like-in such treasured national parks as the Grand Canyon, Yosemite, and Yellowstone. Similarly, the Forest Service makes extensive use of concessionaires to operate and maintain complete parks and campgrounds more effectively and efficiently than government.

States could use this model to take on new park lands without absorbing them into their budget. One Forest Service contractor in Arizona recently offered to take over six state parks targeted for closure amid budget cuts. The concessionaire would collect the same visitor fees the state charges today while taking the operations and maintenance costs off the state’s books entirely. Further, the company would pay the state an annual “rent” based on a percentage of the fees collected, turning parks into a revenue generator instead of a money eater.

Devolving federal land to states could begin with pilot programs in select states to test the model and refine best practices. Once perfected, the process could be extended throughout the Forest Service and then replicated in the Bureau of Land Management, which owns roughly the same amount of Western land and costs taxpayers another $1.1 billion a year.-Leonard Gilroy

End (or at Least Audit) the Fed

At the height of his 2009 P.R. offensive against the audit-the-Fed bill sponsored by Rep. Ron Paul (R-Texas), Federal Reserve Bank Chairman Ben Bernanke warned that opening the Fed’s books would diminish the central bank’s political independence and “could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability.”

The audit-the-Fed and end-the-Fed movements have lost some steam since that time, and the Federal Reserve Transparency Act of 2009, which has 320 House co-sponsors, died a quick, quiet procedural death in the Senate. But the chairman’s words are worth remembering-because if there’s one thing that needs raising, it’s fear about future inflation.

The Fed more than doubled the monetary base in 2009. The depth of the deflationary spiral (primarily in real estate), a continuing “liquidity trap,” and a novel policy in which the central bank has begun paying private banks interest on their reserves have so far kept all that new money from causing significant price inflation. But the massive infusion of cash has also failed in its ostensible purpose of jump-starting economic activity. By keeping its foot on the gas, the Fed is already blazing a path toward a repeat of its disastrous behavior after 2001, when the central bank responded to the deflated tech bubble by creating an even more destructive housing bubble.

The Fed is the biggest bastion of central planning in the American economy, and eliminating it would both move us toward a freer market and remove history’s most powerful enabler of government waste. If that’s politically impossible, auditing the Fed would at least peel away the bank’s veneer of inscrutable wizardry to reveal the feckless dithering at the heart of U.S. monetary policy.-Tim Cavanaugh

Lisa Snell, Adam B. Summers, Anthony Randazzo, Robert Poole, and Leonard Gilroy work for the Reason Foundation, the nonprofit 501(c)3 that publishes this magazine. Versions of some of these pieces were originally published in The Washington Times. This column first appeared at Reason.com.

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In response to the financial crisis, the Federal Reserve has taken itself into unchartered water, more than doubling its balance sheet by buying up toxic debt and injecting huge amounts of liquidity into the banking system. As a result, banks are sitting on huge stockpiles of cash that, if released into the marketplace all at once, could cause some significant inflation problems, leading straight into a new crisis.

But Fed Chairman Ben Bernanke says he and his staff are “fully confident” they will be able to avert rampant inflation because they have “spent considerable effort” thinking about what they should do to avoid this from happening. Such a brazen statement could only come from someone who truly believes his c’est le coq du village lore.

The Fed faces a very difficult challenge: walking the tight rope of interest rate policy. Tightening too fast will cause the economy to contract and could set off a “w-shaped” recession. Fears of this result are particularly heightened given the lack of stability in the, government-supported recovery so far. Tightening too slow, however, could result in high inflation.

There is ample reason to question Bernanke’s confidence in himself and the Fed. In the years leading up to the financial crisis, Bernanke was equally confident that the Fed would be able to counter any crisis and that the U.S. financial system was on a sound footing. As he said in 2002, while a Fed Governor, “the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow.” He added:

“A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.” (Emphasis added.)

Former Fed Chairman Alan Greenspan, Bernanke’s predecessor, was similarly confident that the U.S. financial system was robust and resilient. During Greenspan’s tenure he was confident that the Fed had a good grip on the economy and that it would continue to do so. Shortly before he stepped down as Fed Chairman, he expressed confidence that “the central bank will meet the challenges that lie ahead.”

He also had “little doubt” that his successors at the helm of the Fed “will continue to sustain the leadership of the American financial system,” even though he expressed concerns that some difficulties lied ahead. At the very least, his prediction that Bernanke would continue his legacy turned out to be true.

Back in 2002, the “Maestro” was also quite confident that there was no such thing as a housing bubble in the making: “We’ve looked at the bubble question, and we’ve concluded that it is most unlikely.” And in 2005, when the booming housing market made it hard to deny that at least something was going on, he told that the Fed saw “a lot of local bubbles,” but he was quite sure there could be no such thing as a “national bubble.”

He wasn’t the only one who was confident, though. The National Association of Realtors and the National Association of Home Builders echoed the Chairman’s confidence in the U.S. housing market, saying in 2002, “there is no such thing as a current or impending house price bubble.” If anyone should have see the bubble coming, it should have been the ones building and selling the homes. Yet, the height of expertise failed here as well.

Another incurable optimist is Congressman Barney Frank. The chairman of the House Financial Services Committee was a driving force behind the efforts to expand “affordable homeownership” during the housing boom. As late as July 14, 2008, just weeks before his two coddled children Fannie Mae and Freddie Mac were about to collapse, Frank was pretty confident that “Freddie Mac and Fannie Mae are fundamentally sound. They’re not in danger of going under… I think they are in good shape going forward.”

As it turned out, they were in terrible shape, which is why the federal government took full control over the two entities and put them on life support. The shares of Fannie Mae and Freddie Mac, which peaked at $87.81 in December 2000 and $73.70 in December 2004, respectively, are now trading at around one dollar. So far the government has pumped over $145 billion into the two government-sponsored enterprises, and the expected future losses are estimated to be several times that amount.

Rep. Frank is still optimistic, this time about the prospects of a recovery, saying: “I have a lot of confidence in [Treasury Secretary] Geithner and [National Economic Council Chairman] Summers.” President Barack Obama, for his part, is not only confident-a word frequently heard in speeches-but also says that he is “very confident” in his economic team’s ability to fix what needs to be fixed. He is also “very confident” that the political leadership of this nation is “going to be in position to design the regulatory authorities that are necessary to prevent this kind of systemic crisis from happening again.”

America isn’t the only place where there is a lot of confidence. China’s economy is going through a massive boom in credit and asset prices, following in the wake of last year’s huge monetary stimulus to get the economy out of a downturn. Yet, in a recent speech, China’s Premier Wen Jinbao says he is “confident” that he can manage the boom in property prices. At the same time the Chinese government is boosting the supply of affordable housing and will use “economic and legal measures” to curb speculation.

Like Bernanke, Chinese officials assure us they have everything under control, and will be able to exit last year’s monetary stimulus through gradually deflating the bubble. They will do so by increasing reserve requirements for the banks, thereby trying to steer bank lending onto a firmer footing, and a host of fiscal policies including property tax reforms.

But this confidence is surely misplaced. As British journalist Andreas Whittam Smith said in January 2008, on the eve of Bear Stearns collapse and the worst stage of the financial crisis, “History records no case where the bubble gracefully deflated, accompanied by a slight hiss of escaping optimism. The speculative episode always ends with a loud explosion.” China would be wise to head these words.

Karl Marx once said that history repeats itself, first as tragedy, second as farce. Unfortunately, misplaced faith in the omniscient wisdom of government officials-or even private sector experts-isn’t anything new. And as our leaders express confidence in their abilities, history is repeating itself not for the second time, but for the umpteenth time. The reality is that, while government officials can sometimes manage crisis and anticipate the market, a broken clock is also right twice a day. Even the massive brain trust at the Federal Reserve must recognize that it cannot know everything in the market, and understand the constantly evolving cycle of demand and preferences that drive the economy.

Timing an exit as Bernanke and the Fed are trying to do is by far more art than science. Yet, ask Bernanke why we should now trust that he has the economy well under control, since he clearly didn’t the last time he said so, and he would likely say, “We’ve learned. This time is different.” Unfortunately, as Sir John Templeton says, those last four words are the most expensive in the English language.

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If the tax is a one-off “fine” for the whole banking sector, a bank levy similar to the one proposed in the U.S., this would be tantamount to punishing all banks, whether or not they actually engaged in imprudent investment activities. Also, since the worst performers have been bailed out by various governments, the net effect of the tax and bailouts would be a cross-subsidy, whereby prudent banks are forced to pay off imprudent banks, thereby creating yet another layer of perverse incentives for the banking sector.

If the tax is an involuntary payment into some kind of bank insurance scheme, something which the IMF is opposed to, this would create the impression that the government is committed to rescue any bank from its own financial follies, which would create even more moral hazard for the banking sector. Former implicit bailout guarantees of too-big-to-fail institutions would now effectively become explicit guarantees to all banks paying the tax, further removing incentives to act prudently. In the words of British economist John Kay: “More likely, by institutionalizing the concept of ‘too big to fail’, the scheme would aggravate the underlying problem of moral hazard. It would also transform state funding of the banking system from an exceptional response to a dire emergency into an expectation, even an entitlement.”

Furthermore, if this is a flat tax, banks would not get any of the benefits of traditional insurance, since prudent and imprudent banks would be taxed alike, thereby avoiding all risk premiums. This creates the perfect scheme for making banks place risky bets, as all profits are private, whereas any large-scale losses would be socialized.

So far the British government has been overly generous in its aid to the country’s troubled financial sector. According to estimates by the National Audit Office, the total value of subsidies, injections and guarantees extended to the UK financial services industry amount to the staggering sum of 1 trillion pounds or approximately 1.6 trillion U.S. dollars, which is more than double the size of the American TARP program passed by Congress in 2008 to help the ailing U.S. financial sector.

Even though no one yet knows the final price tag for the manifold bailout efforts in the industrial countries afflicted by the financial crisis, if we were to add up these costs we would surely find that the money needed to insure the global financial system against a similar incident would be immense. John Kay points out that a fund financed by the tax would not even come close to such figures, and in the event of another financial crisis, once more the burden will have to be shouldered by taxpayers. So the only effect of the scheme would be to encourage risky behavior, at the same time keeping taxpayers on the hook for the costs of future financial failures.

There are more troubling aspects to the “global bank tax.” Since the tax, if passed, would only cover the G20 countries, this would create strong incentives for banks to move their activities out of these countries and into less transparent jurisdictions, such as Switzerland. Already last year, when Gordon Brown was proposing a 50 percent top rate of income tax for high-earning bankers, some Swiss cantons launched a marketing campaign, targeting British financial firms, to get them to move their companies to Switzerland.

In other words, such a tax would mean that the British government puts its own financial firms at a disadvantage, compared to non G20 banks, encouraging them to move abroad. The financial services industry is of crucial significance to the British economy. The City of London ranks as the world’s most important international financial centre, and the services provided were the largest exporting item for the UK in the 2000s. Banking has been the single largest contributor to UK exports (net exports totaling £12.2 billion), followed by insurance ( 3.5 billion) and securities dealing (£3 billion), in 2006.

From 2001 to 2006 the sector’s share of GDP rose from 5.5 to 9.4 percent. The financial sector has been the major contributor to GDP and employment growth. Obviously, there is some need to scale down this sector, as the unsustainable financial boom preceding the crisis led to a bloated financial services industry, to a certain degree tying up resources that would be more productive elsewhere in the economy. However, by imposing this tax, the British government would only hurt its own economy, making a sustained economic recovery even harder.

The proposal also comes at a time when the U.K. government faces the urgent need to start cutting the budget deficit. This will be painful, as it will entail both spending cuts and tax increases. By proposing a bank tax, the British Prime Minister creates the impression that the financial sector could shoulder a large part of the needed tax increases. However, the most likely scenario would be for banks and other financial firms to find ways around this tax, such as moving abroad. If this happens, the British tax base would actually shrink, making the British fiscal position even weaker.

A new tax to punish the banking sector would create more uncertainty, not unlike the U.S. proposed “Volcker Rule.” This comes at a time when what is most urgently needed is a return to some kind of normalcy that will allow businesses to conduct long-term planning. Constant attacks on the banking sector by European leaders and the Obama administration is hardly conducive to stabilizing the financial services industry or contributing to sustained recovery for the rest of the economy.

Finally, if the G20 proposal turns out to be a Tobin tax, i.e. a tax on international currency movements, as was suggested by Gordon Brown last year, this would make international capital flows less efficient and to some degree discourage capital from floating into the countries that need it the most – the developing world. Such a tax would not do anything to stop money from flowing out if a crisis hit, though, because the potential losses to investors of keeping the money in the crisis-ridden country would be so much higher than the tax.

Using the proceeds of such a tax to combat climate change, as French President Nicolas Sarkozy and Gordon Brown have suggested, is simply preposterous, as the financial services industry in no sensible way contributes to global warming.

The prospects of a Tobin tax are slim, though, as the U.S., Canada and Russia rejected the idea when it was proposed at the last G20 meeting in November 2009. And the Director of the International Monetary Fund, Dominic Strauss-Kahn, himself usually sympathetic to the idea of government regulations and intervention, showed little enthusiasm, calling the proposal “a very old idea that is not really possible today.”

Even Gordon Brown himself has previously referred to the tax as “having very substantial drawbacks,” before changing his mind at the last G20 meeting. While Chancellor of the Exchequer, in 2002, he also made the quite obvious point that “it is very difficult to advocate a tax, that has been, in a sense, rejected by the person who put the proposal forward,” referring to how economist James Tobin himself came to the conclusion that such a tax would be a bad idea.

There is nothing to suggest that a Tobin tax would have prevented the current financial crisis. There is nothing to suggest that any of the other taxes outlined above would have hindered the global meltdown. And there is little reason to believe that such a tax would improve the performance of the banking industry or in any way would reduce systemic risk. Quite the contrary: If the tax is perceived as a payment into a global insurance scheme, systemic risk will most likely be amplified.

Like Obama’s verbal attacks on Wall Street and the recently proposed “Volcker Rule,” this latest attack on bankers by the British government comes at a time when the administration is politically exhausted and in desperate need of rattling up public support. The next British general election is due to take place in May, and Gordon Brown is looking at the almost certain prospect of a solid defeat. This is one reason why we should not expect a “global bank tax” to come to fruition, as the British Conservative Party, the Tories, are less likely to propose such a tax at the June G20 meeting, once they think through the consequences this would have for the British financial sector.

Another obvious reason why we should not expect a global “bank levy” anytime soon, is that it seems unlikely that all G20 countries would ever agree upon such a tax. Some countries would outright reject it, as happened to the Tobin tax proposal, and others would come to the realization that by imposing such a tax on their own financial sectors, many financial firms would simply move out of the G20.

Last year, Brown said that “global taxes will not be introduced unless all global financial centres are able to come behind them. But I believe there’s growing support for that. We’re trying to make a global supervisory system that makes sense for all the financial centres in the world.” Such grandiose schemes seem so far to be more rhetoric than reality, and getting “all financial centers” on board, will most likely turn out to be a difficult task.

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