Forget the Fiscal Cliff – Focus on the Moneychangers

We’ve been addressing the negative effects of Fed policy for some time. The longer this goes on, the greater will be the cost when it ends. The Fed is distorting all prices across the economy, especially financial assets, which is how we compare prices between the present and the future. These distortions hamper the efficient allocation of capital and other resources, reducing our growth potential. US (and world) economic growth is anemic, this is why. Feldstein is right: The Federal Reserve is heading in the wrong direction.

The Fed’s Dangerous Direction

By keeping long-term interest low, the Fed has removed pressure on the president and Congress to deal with deficits.


The Federal Reserve is heading in the wrong direction. What the central bank describes as “unconventional monetary policy” is creating dangerous bubbles in asset markets that will lead to higher future inflation and is supporting the explosive growth of the national debt. Its new “communications strategy” will, moreover, only further confuse markets.

The Fed’s recently announced plan to buy $85 billion a month of government bonds and mortgage-backed securities will keep long-term interest rates at historic lows, with a 1.6% yield on 10-year Treasuries and a negative yield on 10-year TIPS (Treasury Inflation-Protected Securities). The Fed sees its strategy as a way of boosting the prices of equities, real estate and other assets. It has indeed boosted asset prices, although the increase in individual balance sheets has had very little positive impact on real economic activity. [Note: Yes, you see, the Fed is funding the gambling casino on Wall St., not the factories off Main St.]

Once the Fed stops buying securities, however, interest rates will rise and asset prices, including stock prices, will fall. This will have serious adverse effects on investors, particularly highly leveraged institutions and pension funds.

Long-term interest rates are also likely to rise in the future because of the higher inflation induced by the Fed’s current policy. Because of the Fed’s purchases of bonds and mortgage-backed securities, commercial banks have $1.4 trillion more in reserves than is legally required by the size of their balance sheets. The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation.

For now, the banks are content to leave their excess reserves at the Fed in exchange for a low rate of interest. But the day will come when aggregate demand is increasing, companies want to borrow, and the banks are willing to lend aggressively. When the increase in money starts to cause a rapid increase in prices, the Fed will need to limit the banks’ credit creation by raising the interest rate it pays for banks to keep their reserves at the central bank.

That is the “exit strategy” that Fed Chairman Ben Bernanke and others are counting on to prevent future inflation. Unfortunately, no one knows how high rates will have to go to restrain the commercial banks.

Moreover, because of the large number of very long-term unemployed, unemployment may remain high even as prices climb. And so, just when the Fed should act to tighten the money supply, there will be strong voices in the Federal Open Market Committee emphasizing the Fed’s dual mandate to achieve “maximum employment” as well as price stability. Congressional leaders are also likely to warn that raising interest rates while unemployment is still high could cause Congress to punish the Fed with new restrictions. These pressures may cause the FOMC to delay in raising rates, allowing inflation to get out of hand. [Of course. Politics is short-term and Fed policy will be subordinated to the next election cycle, at the cost of long-term economic health.]

Although Mr. Bernanke and others at the central bank declare their commitment to price stability, the Fed’s new “communications strategy” runs the risk of undermining public confidence in the Fed’s approach to policy. After its December meeting, the FOMC announced that it would keep the federal-funds rate at its current near-zero level until the unemployment rate is less than 6.5%—as long as the predicted inflation rate between one and two years ahead is no more than 2.5%.

The rationale for this radical announcement was discussed last month in a brilliant lecture by Janet Yellen, vice chair of the Fed, at the University of California, Berkeley. She explained that it approximates the optimal path for a dual-mandate monetary policy that is implied by simulations with the Fed’s macroeconometric model of the U.S. economy.

This communications strategy may be persuasive to a small group of academic specialists and others versed in modern monetary theory. But the Fed’s statement and the actions it implies will confuse the general public and undermine confidence in the bank’s commitment to price stability.

In the first place, the Fed’s new approach appears to raise the inflation threshold above 2%. Moreover, at his news conference after the December FOMC meeting, Mr. Bernanke made it clear that there is both flexibility and ambiguity in how the central bank will apply this new approach. It won’t judge labor-market conditions by the unemployment rate alone, and its expectation of inflation will reflect a variety of indicators.

It will be difficult for the public to understand what the Fed is trying to do, and even technical monetary experts will be unable to anticipate when and by how much the Fed will change the federal-funds rate. The outlook for monetary policy is further confused by the Fed’s comment that the new unemployment and inflation guideposts apply only to the fed-funds rate and not to the Fed’s purchases of Treasury bonds and mortgage-backed securities.

The final problem with the Fed’s unconventional policy is perhaps the most obvious. By keeping long-term interest rates low, it removes pressure on Congress and the Obama administration to deal with budget deficits.

The deficit has increased to 7% of gross domestic product this year from 1.5% in 2007. The ratio of debt to GDP has doubled in that time to 73%. Even if the president’s original proposed budget was enacted and accomplished all the deficit reduction that the administration claims, the debt-to-GDP ratio would still be above 70% in 2022 and would be expected to rise after that. The Fed, in short, has killed the bond vigilantes before they could have forced Congress to act.

The Fed would do well to gradually end its program of buying long-term securities and shift its communications to a simple statement that it will do whatever it takes to achieve long-term price stability.

Crony Capitalist Blowout

Don’t say this blogger didn’t warn you. (It shouts out in the title of this blogsite.) The Wash DC crowd will reward corporatism and punish entrepreneurs because it’s a lot easier to cut deals with corporate CEOs and their firms than with millions of smaller risk-takers trying to create new wealth. And these corporations can then reward the pols with campaign funds. But the power of US economic growth and the bulwark of freedom resides with these small risk-takers being trampled under foot. Time for a true populist revolt.

From the WSJ:

A tax increase for everyone but the favored wealthy few.

In praising Congress’s huge new tax increase, President Obama said Tuesday that “millionaires and billionaires” will finally “pay their fair share.” That is, unless you are a Nascar track owner, a wind-energy company or the owners of StarKist Tuna, among many others who managed to get their taxes reduced in Congress’s New Year celebration.

There’s plenty to lament about the capital and income tax hikes, but the bill’s seedier underside is the $40 billion or so in tax payoffs to every crony capitalist and special pleader with a lobbyist worth his million-dollar salary. Congress and the White House want everyone to ignore this corporate-welfare blowout, so allow us to shine a light on the merriment.

Senate Finance Chairman Max Baucus got the party started this summer when he said he would subject 75 special-interest tax breaks to a “tax reform” review. That was pretty funny. Nearly every attempt by Tom Coburn (R., Okla.) and others to pare back the list was defeated in a bipartisan rout.

The Senators even voted down, 14-10, an amendment to list the corporate interests that receive tax perks on a government website. This “tax extenders” bill passed Mr. Baucus’s committee, 19-5 (see the table nearby), and then sat waiting until Harry Reid and the White House stuffed it wholesale into the “fiscal cliff” bill.

Thus Michigan Democrat Debbie Stabenow was able to retain an accelerated tax write-off for owners of Nascar tracks (cost: $78 million) to benefit the paupers who control the Michigan International Speedway. New Mexico’s Jeff Bingaman saved a tax credit for companies operating in American Samoa ($62 million), including a StarKist factory.


Distillers are able to drink to a $222 million rum tax rebate. Perhaps this will help to finance more of those fabulous Bacardi TV ads with all those beautiful rich people. Businesses located on Indian reservations will receive $222 million in accelerated depreciation. And there are breaks for railroads, “New York Liberty Zone” bonds and so much more.

But a special award goes to Chris Dodd, the former Senator who now roams Gucci Gulch lobbying for Hollywood’s movie studios. The Senate summary of his tax victory is worth quoting in full: “The bill extends for two years, through 2013, the provision that allows film and television producers to expense the first $15 million of production costs incurred in the United States ($20 million if the costs are incurred in economically depressed areas in the United States).”

You gotta love that “depressed areas” bit. The impoverished impresarios of Brentwood get an extra writeoff if they take their film crews into, say, deepest Flatbush. Is that because they have to pay extra to the caterers from Dean & DeLuca to make the trip? It sure can’t be because they hire the jobless locals for the production crew. Those are union jobs, mate, and don’t you forget it.

The Joint Tax Committee says this Hollywood special will cost the Treasury a mere $248 million over 10 years, but over fiscal years 2013 and 2014 the cost is really $430 million because it is supposed to expire at the end of this year. In reality Mr. Dodd will wrangle another extension next year, and the year after that, and . . . . Investing a couple million in Mr. Dodd in return for $430 million in tax breaks sure beats trying to make better movies.

Then there are the green-energy giveaways that are also quickly becoming entitlements. The wind production tax credit got another one-year reprieve, thanks to Mr. Obama and GOP Senators John Thune (South Dakota) and Chuck Grassley (Iowa). This freebie for the likes of the neediest at General Electric and Siemens —which benefit indirectly by making wind turbine gear—is now 20 years old. Cost to taxpayers: $12 billion.

Cellulosic biofuels—the great white whale of renewable energy—also had their tax credit continued, and the definition of what qualifies was expanded to include producers of “algae-based fuel” ($59 million.) Speaking of sludge, biodiesel and “renewable diesel” will continue receiving their $1 per gallon tax credit ($2.2 billion). The U.S. is experiencing a natural gas and oil drilling boom, but Congress still thinks algae and wind will power the future.

Meanwhile, consumers will get tax credits for buying plug-in motorcycles ($7 million), while the manufacturers of energy-efficient appliances ($650 million) and builders of energy-efficient homes ($154 million) also retain tax credits. Manufacturers like Whirlpool love these subsidies, and they are one reason that company paid no net taxes in recent years.

The great joke here is that Washington pretends to want to pass “comprehensive tax reform,” even as each year it adds more tax giveaways that distort the tax code and keep tax rates higher than they have to be. Even as he praised the bill full of this stuff, Mr. Obama called Tuesday night for “further reforms to our tax code so that the wealthiest corporations and individuals can’t take advantage of loopholes and deductions that aren’t available to most Americans.”

One of Mr. Obama’s political gifts is that he can sound so plausible describing the opposite of his real intentions.

The costs of all this are far greater than the estimates conjured by the Joint Tax Committee. They include slower economic growth from misallocated capital, lower revenues for the Treasury and thus more pressure to raise rates on everyone, and greater public cynicism that government mainly serves the powerful.

Republicans who are looking for a new populist message have one waiting here, and they could start by repudiating the corporate welfare in this New Year disgrace.