Only if we’re lucky.
I sometimes joke that the old dispute between the Monetarists and the Keynesians was resolved when the Keynesians conceded all the substantive points and the Monetarists agreed to be called Keynesians. Like most jokes, it’s not quite true. The one thing the Keynesians never conceded was the raison d’etre of the Monetarists, the Quantity Theory of Money – the idea that nominal national incomes, and ultimately prices, are determined (in some reasonably simple and predictable way) by the quantity of money. By the mid-1980’s, financial innovation had made the quantity of money in the US very hard to measure, and so the theory – whether right or wrong – became largely irrelevant. And in August 2008, it still seemed largely irrelevant.
But that has all changed in the past three months. While it is still quite difficult to measure the “true” quantity of money, it is easy to measure the quantity of base money –the money created directly by the Fed. When the quantity of base money shoots up in a way that dwarfs all prior experience, it’s fair to say that the “true” quantity of money – whatever that may mean empirically – is also rising more quickly than usual. And some monetarists, clinging to empirical relevance over the period since the 1980s, would argue that the quantity of base money is the true quantity of money.
If this latter group is right – both about the validity of the Quantity Theory and about using base money as the true measure – then we are in for one hell of an inflation. Fortunately (or, alas, perhaps unfortunately) they’re wrong. At least I’m convinced they’re wrong. But let’s examine what has happened. On September 1, the monetary base was $846 billion. On December 1, it was $1.483 trillion. As an annualized rate of increase, that would come to more than 800%. It’s an increase of $637 billion, enough to finance the whole federal deficit for fiscal year 2008, cut every household in America a $1000 check, and have plenty left over for everyone in Washington to spend on whores and liquor – and I’m talking Glenfiddich and Ashley Dupré here.
OK, I apologize to Miss Dupré (who I imagine doesn’t even like being called a “former sex worker,” let alone a “whore”), and for that matter, to everyone in Washington (many of whom are scrupulously monogamous teetotalers, and many of whom, indeed, are in categories to which the escort business doesn’t even market itself). I was using a conventional figure of speech to make a point: the Fed has created a huge, huge, huge amount of money in the past few months. And with T-bill rates already at zero and no danger of their going lower, it’s easy to imagine that the Fed will be able to finance the entire 2009 federal deficit, gargantuan though it is projected to be, and perhaps 2010 as well, without having much immediate effect on anything.
But in the long run, will it cause inflation? This is where I declare (in case you had any doubt) with the Keynesians. I’m not even sure that two years of fully monetized deficits would be enough to stop deflation, if it should happen, let alone cause inflation. In the textbook Keynesian model – the one in today’s textbooks, not the one Keynes would have put in if he had written a textbook – the case is pretty clear: there is a non-accelerating inflation rate of unemployment (NAIRU) – an idea, by the way, derived from the Natural Rate Theory associated with Milton Friedman, the leader of the Monetarist school. When the unemployment rate goes below the NAIRU, the inflation rate rises, and it keeps rising until unemployment goes back up. When the unemployment rate goes above the NAIRU, the inflation rate falls, and it keeps falling until unemployment comes back down.
One of the problems with the NAIRU is that nobody ever knows exactly what it is. But recent estimates have tended around 5 percent, and just about any economist will agree that it can’t be much higher than 6 percent. The unemployment rate for November was 6.7 percent, comfortably above anyone’s estimate of the NAIRU. A nearly universal consensus holds that it will rise from here, and some very reputable economists are talking casually about double digits. Moreover, the experience of recent business cycles suggests that, once it rises to its peak, it will come down only very slowly. So if you’re even just a little tiny bit Keynesian, you won’t be expecting much inflation for quite a while. If you take the textbook model as gospel and have confidence in recent empirical estimates of the NAIRU, you probably expect deflation, and you may be worried that the deflation could become quite severe.
I don’t take the textbook model as gospel, but I think it’s a pretty good way of looking at things, and I’m confident that the NAIRU – to the extent that the concept is valid – is not too far from 5 percent. Moreover, the 65 percent drop in the price of oil, which would have been considered wonderfully good news during most of the last 40 years, is not encouraging under today’s circumstances. Things could get quite ugly, and the ugliness will not resemble that of the 1970’s.
Now you might say, “So much for the short run, but in the long run, monetization today will cause inflation in the future.” When I start to see double-digit inflation in Japan, maybe I’ll believe you, but that long run is starting to look very, very long. Even if the US recovery comes fairly quickly (like the middle of 2009, rather than the end of 2010 or the beginning of 2015), the Fed will have plenty of opportunity to demonetize the federal debt before the unemployment rate starts to fall to a normal level.
But I’m skeptical as to whether much if any demonetization will even be necessary. Back in the old days, the four decades after World War II, we used to have sharp recessions – mostly the manufacturing sector would contract quickly, then turn around and expand quickly. That doesn’t happen any more. Today’s service economy doesn’t expand and contract quickly. Recessions begin more slowly, and recoveries are painfully slow. Even in a best-case scenario, the unemployment rate is likely to be above the NAIRU for quite some time. It strains my crystal ball to try looking ahead to the time when any demonetization at all will be necessary.
No, we won’t have to give back the $637 billion (or even the trillions that may follow). It was a Christmas present from the Weak Economy. The biggest Christmas present the US has ever gotten. Unfortunately, it’s not the one that was at the top of my wish list.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
Rogoff on The Money Illusion
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