Defunct Economic Theory and Doomed Policies

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 pressures.

To which I ask: “What do you mean, ‘neutral 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.

However, 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 declining.

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.

Nonetheless 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 ½ 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.

Although 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 it.


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.

Nonetheless, 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 1.

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.

Accordingly, 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 politicians.

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 this:

Similarly, 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.

Politicians will demand the hard stuff. They always do.

They always get it.

November9, 2006

Gary 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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