Sunday, May 11, 2014

Monetary Policy and Theory

Fifty years ago monetary policy seemed such a simple matter.  All one needed to do was track "M2" carefully.  Growth in M2 typically preceeded growth in GDP and, in time, produced inflation.  The simple predictability of this relationship was a triumph for Milton Friedman and the Chicago monetarists.  Alas, this simple story is no longer true.

No one really knows how to define the money supply anymore, even conceptually.  If a Martian landed on earth tomorrow and asked what one meant by the word "money," it is by no means obvious what response to make to the Martian.  Who uses coin and currency, or even checks, to make purchases anymore?  Overdraft facilities are becoming ubiquitious, so a negative money balance for a growing number of people simply means paying a modest interest rate on overdrawn balances.  Do you really need to hold money in the old fashioned way?  Purchases on the internet and the adventures of bitcoin make all of this talk of money supply talk seem old fashioned.

So, what are Bernanke and Yellen up to.  Bernanke always claimed Friedman as his mentor (in spirit, if not in fact).  So Bernanke dramatically expanded member bank reserves by the various QEs that the Fed embarked upon after 2008. The idea was that M2, or some monetary aggregate, would grow because loans would grow.  But, loan growth remained dormant as the slowest economic recovery in American history gradually unfolded.

Why didn't the usual money multiplier work? Why didn't loans expand and the monetary aggregates expand with them?  Interestingly, both supply and demand increases failed to materialize.  Excessive regulation and demonizing of financial institutions put a brake on bank's willingness to make loans, except to folks who didn't want them or need them.  So, what happened.  Tepid loan growth and a sluggish economy. 

Now in the sixth year of the economic recovery, not much has changed.  The war on financial institutions continues unabated.  Attorney General Holder looks on the financial system as a piggy bank for him to plunder as he sees fit.  Banks are hunkered down, hoping desperately for a change in the political and regulatory environment.

So, what is Yellen up to.  Not much.  She enters the picture in time to survey the landscape of a failed monetary policy and a failed fiscal policy.  As an advocate of much that has happened in the past five years, Yellen is, no doubt, somewhat surprised by the weakness of the American economy, as well as that of Europe.  Yellen is a partisan of the majority group of economists who no longer believe that incentives make any difference.

Raising the minimum wage, for example, is a policy that Yellen supports.  Usually, the Yellen types argue that small increases in the minimum wage have small effects.  That's like saying that smoking only five cigarettes a day is not as harmful as a pack a day.  It's still addictive and it can still kill you.  And how do you kick the habit?

Similarly, Yellen gives no credence to the idea that making employees much more expensive by expanding worker rights and protections and employer mandates (think health care) reduces the demand for labor.  Somehow to Yellen-like economists, the employee costs (non wage costs, especially) to an employer are largely irrelevant to the decision to hire.  Somehow, employers are expected to maximize profits without taking into consideration the costs of employees.  Is this what Yellen teachers her students?

Non-wage costs have exploded in America.  This means that employees, especially at the lowest wage levels, cost multiples of the wage they receive.  The employee often gets almost nothing, while the costs to the employer are staggering. This is the obvious result of government-imposed mandates on employers.  Who gets hurt?  Employees at the bottom of the skill and wage ladder. The rich and prosperous are largely unaffected by all of this.

So, Yellen muses outloud about what to do.  Well, really nothing is available to people that believe government is the answer.  Yellen and Bernanke decided long ago that free markets are largely irrelevant to economic prosperity and that monetary tricks can make GDP grow.  They are wrong and the data show it.  The last five years are a painful testament to the failure of the kind of macroeconomics and monetary policy that are routinely taught throughout the American university system.

The problem with the American economy is a microeconomics problem.  It is irrational for most employers to add employees.   It makes a lot more business sense to keep employment levels low, outsource where you can, and keep your head down.  That is the rational and predictable response of intelligent business folks to the Yellen-Bernanke-Geither-Obama policies.  No real surprises here -- just a lot of misery for middle and lower income Americans.

Real economic growth will never return to the US and western Europe until free markets are permitted to work.  Excessive government intrusion has always stifled economic growth.  What we are witnessing now will continue until the governments relax their assault on free markets.

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