Free Markets, Free People

Sometimes A Picture …

Is definitely worth a thousand words.

Or a chart.

Arthur Laffer is not amused:

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

And what have those “panic-driven monetary policies” brought us? Well, first the picture:ed-aj638a_laffe_ns_20090609175213

The chart is certainly no laffer.

Remember, we’re being told by “experts” (*cough* Krugman *cough*) that we’ll be able to handle this with no problem, really, if we just manage it properly. A tweak here, a tweak there and bingo – no inflation.

Hmmm … let’s get a little context here, shall we?

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base.

So that means that what? Well Laffer goes into a good explanation of bank reserves and how they function, etc. etc. – bottom line, banks are going to be loaning a bunch of money, thereby injecting liquidity into the marketplace.


With the present size of the monetary base, and …

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.

And what does that mean could happen? Well again, we’re in uncharted territory, but the last time we had anything even similar, eh, not so good:

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

Yeah. I remember it well. And here we are again – on steriods. So now what?

Per Laffer, the Fed must contract the money supply back to where it was plus a little increase for economic expansion. And if it can’t do that, it should increase the reserve requirement on banks to soak up the excess.

But Laffer doubts that can or will be done:

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

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


Yes friends – we’re in the best of hands. I’m just wondering how the present administration is going to attempt the blame shifting when the inevitable happens.


14 Responses to Sometimes A Picture …

  • I kind of laughed when I saw the chart. It’s obviously a serious problem, but sometimes you can’t help but laugh at the absurdity of what our lovely government is getting us into. Sometimes I think we’d be better off being “led” by trained seals.

  • Looks like it’s time to move the entire 401k into TIPS.

  • Bruce,

    Sometimes a picture is worth a thousand…basis points!


  • I recall that Art Laffer was one of the many analysts who clashed with Peter Schiff during the 2004-2006 time frame, when Schiff was warning us that the real estate bubble was near to collapse.  Schiff was claiming that this collapse would take the economy along with it, while Laffer and others insisted that the economy was strong and getting stronger.  It seems that the last two years have been like a dash of cold water in Art’s face, and he’s sounding a lot like Schiff now.  But as long as other “experts” continue to tell us that we’re coming out of the recession and that things will be getting better as soon as next year, there will be no impetus to demand that government ease its foot off of the accelerator.  Guys, that’s a cliff up ahead…

  • One minor but depressing thing I’ve learned from this economic crisis is that economics is about as far from a science – or even an art – as psychology.  Give me ten economists, even top-flight ones, and it seems that I’ll get ten different opinions about what this or that economic data means.


    • It’s been a joke for years that if you ask something of ten economists, you’ll get eleven answers.

      Similar is, “Economists have successfully predicted 15 of the last three recessions.”

      • How are Economists different from Meteorologists?

        The Meteorologists can all agree what the weather was like yesterday.

  • I don’t get Laffer’s Catch-22.  How in heavens would higher interest rates exacerbate inflationary pressures?  Higher interest rates is precisely what Volcker used in the early 1980s to break the back of inflationary pressures.

  • I’m just wondering how the present administration is going to attempt the blame shifting when the inevitable happens.

    Obie and his lackeys will find a way.

  • I think it probably is better to deal with inflation than deflation, but it will not be fun.

    Double Dip recession if Obama is responsible or stagflation if he is not.

  • This isn’t about the Laffer curve. This is about the laws of supply and demand applying to money. That’s Friedman and monetarism, and, frankly, accepted economics. Laffer is just pointing it out.