classical economics
for analysis,  forecasting
and policy design

Kick Funds Rate Habit

By Wayne Jett
© December 27, 2007

    Inflation hawks deride the Federal Open Market Committee’s actions in the last four months of 2007 reducing the funds rate from 5.25% to 4.25% as precipitous and abrupt reversal of policy. Yet Fed chairman Ben Bernanke has seemed more like a new captain turning the Queen Mary. He continued raising the funds rate in three consecutive meetings after succeeding Alan Greenspan in February, 2006, then maintained that maximum funds rate 15 months before reducing it by 50 bps September 18. Considering the severe strains observed in credit markets in August and recurrently since, any more deliberate conduct of Fed policy might well have run the central bank’s ship aground. As it is, the Fed missed the shoals, but faces greater dangers ahead unless it turns more sharply away from past policies.
    Mainstream debate of Fed actions features an array of Keynesians (including Martin Feldstein and Bill Gross) calling for sharply lower funds rate targets, while self-proclaimed supply-side economists (including David Malpass, Brian Wesbury, Donald Luskin, Michael Darda and Jerry Bowyer) support steady or higher funds rates. Those lines of argument are surprising. Keynesians theorize that a high funds rate target is requisite for central bank “credibility” in fighting inflation by inducing higher unemployment. By the same token, supply-siders often contend that higher economic growth permitted by lower funds rates will strengthen the currency. Sad to say, both sides err by accepting, if not supporting, abuse of U. S. and global economies by Fed manipulation of domestic interest rates.
Preserving the Positive-Sum World
    Eminent European economist Martin Wolf eloquently chronicles the historic importance of the world’s turn from “zero-sum” to “positive-sum” macro-economic thinking about two centuries ago. Since 1820, average real income per capita world-wide has risen 10-fold; 23-fold in the U. S. Central to the turn was the idea that everyone can progress by his own industry without diminishing prospects of others. This overcame, and should have ended, ancient dogma that a nation prospers only by gaining positive trade balance against trading adversaries. Tragically, this discredited concept is resurgent, even dominant, in U. S. economic policy today.
    Zero-sum thinking is obvious in Keynesian insistence that the U. S. current account deficit is so ominous that it must be eliminated by devaluing the dollar. The U. S. dollar’s sharp decline since 2003, particularly since mid-2005, is praised by these economists as engineered successfully to diminish the current account deficit. Astonishingly, these economists advise even deeper dollar devaluation for the same purpose, even while acknowledging as “inevitable” the collapse of U. S. asset prices as a consequence. Convinced that the current account deficit has negative implications, they advise destruction of the dollar and the economy to eradicate the risk.
    As Wolf observes, we ought to be more intelligent than to allow zero-sum thinking to dominate us again. Wolf says it leads to political “… repression at home and plunder abroad …, a world of savage repression and brutal predation.” Yet, the Fed continues to ply manipulation of domestic interest rates with its funds rate “tool,” devaluing the currency for no purpose other than fighting trade wars to achieve positive current account balance. Currency devaluation is tariff protection by another name, enriching exporters and barring competition from domestic markets, all at the expense of the general populace. This is the essence of ancient mercantilism that classical economic theory and free trade policy overcame two centuries ago.
Mercantilist “Zero-Sum” Resurgence
    Resurgence of mercantilist influence is neither coincidental nor recent. Eighty years ago, mercantilists stuck their noses back into the Republican political tent and imposed the Smoot-Hawley Tariff Act on the U. S. and the world. Franklin Roosevelt then delivered the Democratic Party to them, turning previously free-trading farmers into government-subsidized champions of trade barriers. Mercantilists won control of the Federal Reserve in 1971 after years of Keynesian whittling at the Bretton Woods pledge to keep the dollar’s value stable relative to gold.
    Keynesian/mercantilist control of the Fed since 1971 has given the world the Great Inflation of the 1970’s: soaring oil prices, wage-price controls, gas lines, unaffordable housing, stagflation, double-digit interest rates and a “misery index” to measure the depth of “malaise.” The “cure” was the First Great Deflation of 1981-1982, collapsing oil prices, bankruptcies in oil producing infrastructure and near-collapse of financial institutions due to falling product prices. Temporarily chastised, the Fed stabilized the dollar relative to gold during 1988-1996, but inexplicably sharply deflated by withholding liquidity in 1996-2001, causing collapse of equity prices, first in Asia, then in the U. S. in 2000-2002.
Engineered Dollar Devaluation
    The Fed added to its inane policy repertoire during 2004-2006 by raising the funds rate while injecting liquidity. This is a certain recipe for a devalued dollar - slowing economic growth while adding liquidity - and the proof is in the pudding. From $350/oz gold in 2003, the dollar’s value has dropped to $825/oz in late December, 2007. Supply-side economists should have detected earlier that raising the funds rate really does not “tighten” or otherwise drain liquidity. Yet many continue to support higher interest rate manipulation that penalizes domestic production while causing (yes, intentionally engineering) the devalued dollar and price escalations.
    With no sign the Fed has learned that its policy mix of blundering and deception is causing great harm, including incipient trade wars, the European Central Bank cried “uncle” to the falling dollar. With European industry losing competitiveness even in their own markets, the ECB December 18 announced temporary injection of $500 billion in euros into its economy. As the World Trade Organization does not permit trade wars using tariffs, the ECB accepts the U. S.’s weapon of choice: devalued currency. Europe has no alternative but to join the Fed’s engineered devaluation. Of course, this enables Fed supporters to brag that the dollar is “showing signs of strength” against the euro.
New Year’s Resolution for FOMC
    Here is a worthy New Year’s resolution for every FOMC member: Heed Martin Wolf’s call to preserve positive-sum thinking which has so prospered the world. Stop the zero-sum manipulation of domestic interest rates. Float the funds rate and stabilize the dollar relative to gold by managing your portfolio of Treasury securities. Market processes will clear away the gathering storm clouds of credit strains in the early months of 2008, and the world’s future will brighten. ~