Fed Chairman Yglesias says:
I’m going to have the Federal Reserve purchase lots of stuff, with the quantities of the stuff, the nature of the stuff purchased, and the timing of the purchases done at my discretion. And I’m going to keep doing it until unemployment is down to 6.5 percent or so unless core inflation gets over 5 percent. If core inflation goes over five percent, then I’ll conclude that my estimate [of what constitutes full employment] was off and we need to reconsider. But as long as inflation is below 5 percent and unemployment is above 6.5 percent, my conclusion will be that the Fed needs to buy more stuff and buying more stuff is exactly what we’ll be doing.
Then what happens? It’s like FDR and the gold standard redux. A minority of rich businessmen will think to themselves that this is a great idea, and revise upwards the quantity of potential customers for their products or services in the medium term and start investing to hire workers and equipment while idle resources are still cheap and plentiful. The majority of rich businessmen will think to themselves that this guy is an insane socialist who’s going to produce runaway inflation, and will start ditching cash and low-yield dollar-denominated financial instruments in favor of some mix of foreign currencies, commodities, and concrete assets like bigger houses and fancier yachts. Both the majority who think I’m an idiot and the minority who think I’m a genius will be taking steps that boost real output.
I want to poke some holes in the notion that the actions of the majority in this hypothetical will assist in the recovery.
Let’s take an extreme scenario: the majority takes all their money out of circulation and puts it into gold. Gold’s the classic inflation hedge. Why shouldn’t they buy gold if they think the dollar is going to be debased? Obviously, gold isn’t going to absorb 100% of the cash currently in low-yielding financial instruments – but what if it did? What would be the economic consequences?
Well, that money would now be out of circulation. The Federal Reserve would have added a certain amount of money to the economy, by buying a variety of debt instruments. The sellers of those instruments, instead of putting the proceeds of their sales to work generating employment and income, stuffed it in a shiny yellow mattress. The Fed has expanded its balance sheet without boosting the economy in any way – but the market is aware of this expanded balance sheet, and aware that, eventually, it has to be unwound. And thus the net effect is contractionary.
As I say, this won’t actually happen. So what if some of the money goes into other assets that are likely to perform well in an inflationary climate – oil, say. Will that boost economic activity? Quite the contrary. Because of America’s dependence on oil as an economic input, a speculation-driven spike in oil prices would be an immediate negative shock to the economy. Now, if the rise in prices was driven by higher end-user demand, it might boost more investment in things like refining capacity. But if it’s driven by inflation concerns, not so much. You might still get an increase in extraction efforts, and some increase in employment as a consequence. But mostly not; oil prices are high enough already that there’s a lot of investment going on in this area. Incremental increases in the price of oil would probably just be a tax on productive activity that uses oil as an input, distributed into the coffers of entities who already own or lease oil properties. Again, the net effect is contractionary.
What about land? Surely increases in the price of land would be a good thing; after all, the collapse in the housing market is what got us into this mess in the first place. Well, don’t be so quick. Yes, an increase in land prices would help alleviate the problem of so many underwater mortgages. But expensive housing is, all else being equal, a drag on economic activity, a barrier to establishing a household. Yglesias himself has pointed out that the insane housing boom of the 2000s was mostly a boom in land prices; the boom in housing construction was well within historic norms (albeit building went quite nuts in specific regions like California’s Inland Empire and south Florida). In current conditions, reflating the housing bubble will alleviate the debt overhang, but it’ll leave us with a new problem: housing prices that are out of line with reasonable expectation for future wages, which would either imply another crash in the future (which would precipitate another recession) or a long-term economic drag. Because the bottom line is: land as such doesn’t generate much economic activity. As they say: we aren’t making more of it. So rises in land prices, unlike rises in the price of, say, automobiles, don’t create an incentive to produce more land more cheaply.
So how can speculative bubbles be expansionary? Why did we see strong NGDP growth in the middle of the 2000s, when this was substantially underwritten by the housing bubble? Well, because higher prices made it possible for incumbents to spend their increase in paper wealth through debt, and the combination of low interest rates, poor credit standards and exotic products made it possible to increase debt at little or no increase in the cost of debt service, at least for the short term (many of these exotic products raised the service cost substantially down the road). This produces a short-term increase in demand, but it’s borrowed from the future. Now, that’s fine – if you’re borrowing to increase your earnings capacity in the future. Then you come out ahead. But that’s not what we were doing in the 2000s.
The crash and subsequent recession are a consequence of the false growth of the 2000s. To the extent that monetary expansion fails to create real economic activity, but instead fuels speculation, it’s creating new economic problems. Those problems might be immediate – if they amount to alternative forms of money stuffed in mattresses – or they might take a while to manifest – if we dig our way out of our problem by reflating the housing bubble, for example, then we’ll have the bubble to deal with.
Chairman Yglesias, in other words, could, by pursuing an inflationary strategy, actually push the NAIRU up even as he pushes unemployment down. Instead of 4% inflation and 6.5% unemployment, he could wind up with 5% inflation and 8% unemployment. And then he has a problem.
I don’t know how much of the monetary stimulus will “leak” into this kind of unproductive speculative activity, and neither does he. Some of it will. If very little does, then the Yglesias strategy will work. If lots of it does, it’ll backfire – badly. But I do think it’s a mistake to be sanguine that whatever the holders of cash do in response to rising inflation expectations will assist in the economic recovery.
And that’s why I keep coming back to the need to tackle the structural problems in the economy. Among other things, tackling these will make monetary stimulus more effective – because they will provide a rationale for diverting money into productive activity rather than into speculation.