Defunct Economic Theory and Doomed Policies

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Price inflation
is slowing. This is because Federal Reserve monetary policy has
moved to stable money. You
can see this here

A recent speech
by a Federal Reserve Board member revealed that the FED is committed
— this week, anyway — to its present policy.

It is too bad
that she did not raise the question of a looming recession. Recessions
are always the result of a prior bank monetary inflation. This fact,
of course, no central banker ever admits in public, because the
central bank establishes the monetary base on which the commercial
banks expand their fiat money loans.

This speech
was relevant for what it revealed about the economic theory adopted
by a key decision-maker: cost-push price theory. This theory of
pricing was refuted in the 1870s. Menger, Walras, and Jevons independently
came to the same conclusion: Consumers establish prices by their
buying and saving decisions. Inflation is always demand-pull, and
specifically monetary demand-pull.

Prices rise
in an economy for the same reason that they rise in an auction where
counterfeiters have showed up to make bids.

Show me a cost-push
economist, and I’ll show you a mid-nineteenth-century thinker —
a promoter of defunct economic theory.

I will soon
show you such a thinker. Your economic future is dependent on her
and her colleagues. If they guess wrong, you had better guess right
about their bad guesses. If you don’t, you’re going to be in big
trouble. But first. . . .


The Federal
Reserve System, like any central bank, officially pursues the following
policies: stable prices (ha!), economic growth (to keep tax revenues
flowing), and high employment (to keep incumbents in office).

The assumption
is that without central bank bureaucrats to manage the money supply
in order to manage the economy, we would get deflation, recessions,
and permanent unemployment. The free market is distrusted when it
comes to money. We need experts to do our planning for us — monopolists
whose decisions are none of our business.

What America
has experienced under central banking is universal price inflation,
economic booms and busts, and — since 1973 — very slow improvements
in the average worker’s real income. As a result of Nixon’s unilateral
suspension of gold convertibility in 1971, the promised goals of
the Federal Reserve System have been even less attainable than they
were from 1914 to 1971.


On November
2, Board
Governor Susan S. Bies delivered a lecture at Drake University

in Iowa. It was the usual put-‘em-to-sleep speech by a bureaucrat
who has been trained not to communicate. She began:

In my remarks
today, I will discuss the near-term outlook for the U.S. economy
and some of the longer-run issues that economic policy makers
should consider. I want to emphasize that these views are my own
and not necessarily those of my colleagues on the Federal Open
Market Committee (FOMC).

The fact is,
no government-salaried bureaucrat ever gives a speech that is very
far out of touch with the views of his/her colleagues, as reporters
know all too well.

She noted that
economic activity slowed, mid-2006: to 2.6%, down from 3.6%. (It
is worse than this if you consider the most recent quarter and extend
it for a year: 1.6%.)
But she put on a happy face. "Despite the recent slowing in
output, however, resource utilization remains relatively high by
historical standards and thus continues to be a potential source
of upward pressure on inflation."

Fact: "Resource
utilization" does not create price inflation. The Federal Reserve
policies of monetary expansion create price inflation. She admitted
as much.

In the aftermath
of the 2001 recession, the FOMC eased monetary policy substantially.
However, the degree of easing in place in 2003 and 2004 was clearly
unsustainable and risked overheating the economy.

In other words,
Greenspan’s policies would have led to mass inflation and the collapse
of the dollar. But she was not about to put it this way.

Since mid-2004,
the FOMC has gradually moved monetary policy from an accommodative
stance to a more neutral position. As a consequence, the elements
now appear to be in place for some easing of resource utilization
rates over the next year or so and a reduction in inflationary

To which I
ask: "What do you mean, u2018neutral position’? What is neutral?"
There is no neutral. There is only policy set by salaried bureaucrats
in a monopolistic agency that controls monetary policy.

If neutral
is good, then why did Greenspan’s FED get so unneutral? And what
will the price be of returning to really, truly neutral?

The problem,
as always, is that central bank monetary inflation, when it ends,
produces an economic recession. Capital was misallocated during
the boom phase. It is re-allocated in the post-boom phase. The question
is: How much reallocation? In short, how bad will the slowdown be?
She spoke like a true economist. She professed ignorance.

substantial uncertainty surrounds the near-term outlook. In determining
the future path of interest rates, the FOMC will be guided by
the incoming data on both output and prices, so let’s begin by
reviewing recent developments.

In short, nobody
knows — surely not the salaried bureaucrats on the FOMC, who determine
the size of the monetary base, which in turn creates the basis of
money creation by the fractional reserve banking system.

They improvise
as they go along.


Like a matador
who is trying to focus the bull’s attention elsewhere than on the
sword, she told her listeners to look at the housing market, not
the FED’s reversal of policy.

The slowdown
in the growth of real GDP since the spring largely reflects a
cooling of the housing market: The number of single-family and
multifamily housing starts has fallen nearly 25 percent since
the beginning of the year; sales of both new and existing homes
have dropped sharply since their peak of last summer, and the
inventory of unsold homes has soared. At the same time, homes
are appreciating more slowly and in some markets prices are even

Is the housing
slump over? Will houses once again become the reliable ATM machines
of middle-class spenders? Maybe not, she said.

While much
of the downshift in the housing market appears to have occurred
already, some further softening may yet lie ahead.

But not to
worry! It’s not as bad as it looks to those gloomy-Gus types who
worry about a collapse of a bubble in housing.

a variety of factors should help limit any remaining contraction
in housing demand. For example, despite the 4-1/4 percentage point
increase in short-term interest rates over the past two years,
the interest rate on a thirty-year fixed-rate mortgage has increased
only about percentage point, and borrowing costs continue to
be relatively low. The ongoing growth in real incomes and the
recent increase in the stock market wealth of households should
also support the demand for housing.

I’ll say the
30-year rate is low. We
now have an inverted yield curve.
This means we have the traditional
prelude to a recession.

Pardon me,
Dr. Bies, but how does a recession keep housing prices high?

In short, blah,
blah, blah. No problem! The business cycle really isn’t about to
go into recession. The stock market is there to make people feel
rich. Problem: 69% of Americans own their mortgaged homes. The number
of people who own stocks outside their pension funds is around 20%.

Consumers are
still confident, she said. Sort of. Possibly.
We hope. Let’s cross our fingers.

In addition,
consumer confidence currently stands a bit above its long-run
average and consumption is still being fueled by past house-price
gains, which raised household wealth. This contrasts with previous
slowdowns in the housing market, which have typically coincided
with widespread economic weakness.

the slowdown in the housing market has so far done little to reduce
consumer outlays, other factors do appear to have had a damping
effect. In particular, consumption likely was restrained earlier
this year by the rise in energy prices, which took a large bite
out of household budgets.

She implies
that rising home prices are good. They make us feel rich. But rising
energy prices are bad. They make us feel poor.


What she refuses
to say is this: The supreme issue is productivity. This takes capital.
Capital requires saving. American households do not save. They borrow,
net, from foreign investors.

Oil prices
rise, so oil-exporting governments benefit. The wealth of Americans
flows abroad. This apparently is bad.

Problem: The
outflow of Americans’ future wealth is the long-run implication
of a household savings rate below zero. But she did not mention
this. Instead, she focused on business capital spending. That is
fine, but when a country is running a payments deficit of $800 billion
a year, the question is this: Who is buying up ownership claims
on future American productivity? The answer is plain: foreigners.

Current financial
conditions also are supportive of business spending. Corporate
balance sheets are strong and flush with cash, and broad stock
price indexes are up more than 10 percent so far this year. At
the same time, yield spreads on corporate bonds across the ratings
spectrum have been low, supported by the strong balance sheets
and robust profit growth.

Great. But
who owns legal claims on the future of corporations? That is, who
owns their bonds? Something in the range of 20% of U.S. corporate
bonds are owned by foreigners. Who owns the T-bills that serve as
claims on future taxes? This is in the range of 40%. As for stocks,
this figure is about 10%. These percentages will rise relentlessly
because of the $800 annual account deficit.

Americans are
selling their economic futures. Why won’t Federal Reserve Board
members warn about this? Because there is nothing that the FED can
do about it.

Better to ignore


Core inflation
— excluding food and energy — is up 2.4%, year to year, she said.
Why exclude food and energy? Officially, because they fluctuate
too much. "Temporary shocks to food and energy prices typically
don’t translate into changes in inflationary pressure." Core
inflation had risen only 2% the year before that.

Where is core
inflation headed? Down. Why? She refuses to say. There is a reason:
The FOMC has stabilized the monetary base ever since February. It
has stopped inflating. It has adopted a new policy. If it persists,
we are going to get a whopper of a recession. That’s why the FOMC
will reverse course, as it always does. But when?

She refused
to mention any of this. She went on and on about cost-push price
inflation, which was proven incorrect in the 1870s, but which central
bank advocates refuse to acknowledge.

the scene appears to be set for a deceleration in prices over
time. One contributing factor is likely to be the slowing in activity
I already discussed, which should ease the overall pressure on
resources. Another important factor affecting the inflation outlook
is household and business expectations for inflation. As best
we can judge, inflation expectations appear to be well contained.
. . .

Then she said
that the labor market might push up prices.

One upside
risk to the inflation outlook comes from the labor market. The
unemployment rate declined steadily between the second half of
2003 and the beginning of 2006 and has stood at a relatively low
4.7 percent for the past six months. With labor markets comparatively
tight by historical standards, unit labor costs have begun to
accelerate, especially since the end of last year, and firms may
pass on some of these higher costs to consumers.

See? She appeals
to cost-push inflation. The economic reality is different. If people
don’t have new wads of fiat money to bid up prices, money-registered
(nominal) consumer prices will fall because they have been bid up
too high by false expectations and consumer debt. This is Austrian
and Monetarist Economics 1. But this woman doesn’t understand Economics

In considering
the appropriate setting for monetary policy, the level of the
economy’s underlying productive capacity — its potential output
— is the benchmark against which we assess actual output.

We? Who is
we? Salaried bureaucrats who don’t understand Economics 1.

whether the recent slowdown in economic activity eases resource
constraints enough to reduce inflationary pressure depends importantly
on how fast potential output is growing.

On the contrary,
it depends entirely on whether she and her colleagues start pumping
up the monetary base again. If they don’t, the capital markets will
fall. Investors have bet on more fiat money from the FED. Their
bet has been wrong in 2006.

Then she then
went into a mind-numbing and utterly irrelevant discussion of the
labor markets. I will spare you the agony.

What is crucial
today, as always, is the capital markets. Stable money, if extended,
is good policy. But this policy will collapse the capital markets
during the capital-reallocation phase.

That will be
great news for Democrat politicians in 2008 and bad for Republican

She went on
and on about fewer participants in the labor force as oldsters retire.
She avoided mentioning the obvious: These people will sell their
stocks and bonds to get their hands on ready income. The
stock market boom will turn into a bust.

This woman
has adopted the familiar rhetorical strategy of all bureaucrats:
Direct the listeners’ attention from what is crucial and focus it
on what is irrelevant. Then put the audience to sleep. She
is a master at this.

She ended with

it is important now to try to understand the new forces determining
potential output growth so that monetary policy can respond accordingly.

You mean they
don’t yet understand the "new forces"?

I guess so.

And then, like
a true bureaucrat, she ended in the passive voice: "so that
monetary policy can respond accordingly." Monetary policy does
not respond. Faceless salaried bureaucrats who create money out
of nothing respond.

What do they
respond to? Screaming incumbents in Congress, who are in turn responding
to screaming unemployed constituents and screaming investors who
have just lost 40% of their wealth in a stock market crash.


The thought
that this verbally dull, uninformative, cost-push economist is in
charge of establishing monetary policy for 300 million Americans
is unnerving.

Let us hope
that she really doesn’t speak for her colleagues. If she does, then
they are equally uninformed regarding economic theory.

She got one
thing right, but only one: Price inflation is slowing. It is slowing,
not because of theoretically defunct cost-push factors, but because
of falling demand. Buyers are not getting their hands on as much
fiat money as they were used to under Greenspan.

They will soon
be like drug addicts whose connection has retired. They will go
into withdrawal.

Bernanke will
attempt to supply methadone.

will demand the hard stuff. They always do.

They always
get it.

9, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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