The Fed Plays Lady Macbeth

William Krehm

here are secrets simply too big to stay hidden. Shakespeare’s Lady Macbeth was a classic instance. The Wall Street Journal (6/11, "Unsettling Scenario – Inside the Fed Deflation Draws a Closer Look" by Greg Ip) sets the banquet scene afresh with the US Fed in the principal role.

"Alan Greenspan and his colleagues at the Federal Reserves have spent their professional lives fighting inflation. But in the fall of 1999, central bank officials gathered at a country inn in Woodstock, Vt., to talk about the opposite: What would they do if faced with deflation, or widespread falling prices, [when] they had already cut interest rates [their ‘one blunt tool’] to zero?"

"Deflation is dangerous because it makes it hard to boost the economy by cutting interest rates, and because it makes debt, now at a postwar high in the US, harder to pay.

"At Woodstock, the researchers brainstormed about possible ways the Fed could spur spending, such as adding a magnetic strip to dollar bills that would cause their value to drop the longer they stayed in one’s wallet." Yet astonishingly there was no mention of the policy that finally lifted the world out of the Great Deflation of the Thirties: government investment to provide the demand that the business world, sunk in a deep funk, was no longer able to. Had it been provided in a more timely way for constructive ends, there would probably have been no World War II.

"At the time (1999) the chance of deflation in the US seemed remote. The Fed had lifted short-term interest rates above 5%. Today deflation no longer seems so remote. Prices of consumer goods, as opposed to services, are falling for the first time since 1960. By the Fed’s preferred measure, overall inflation, was just 1.8% in the year throughout August. Fed policy makers have cut short-term interest rates to a 41-year low of 1.75%, and investors expect them to cut rates again to as low as 1.25%. [That actually happened the next day.]

"The US economy is struggling with the collapse of a gigantic stock mania. Sinking prices for telcom services, to name just one conspicuous example, are making it harder for some businesses to support their heavy debts.

"Overseas, Japan is in its fourth year of declining prices even with interest rates near zero, the result of a decade of economic stagnation that followed the bursting of its real-estate and stock bubbles. China has experienced intermittent deflation since 1999, and many economists think Germany may be close. Fed officials and most private economists still think deflation is highly unlikely" The word "think," however, is stretching the point. They are frightened frozen of the responsibilities they have incurred in interring the lessons bought with blood and tears in the 1930s. The real peril for mankind is that a high-tech military adventure will be grabbed as the alternative to rethinking the failed economic orthodoxies.

"During the Great Depression prices tumbled 24% between 1929 and 1933, bankruptcies mounted, thousands of banks failed and the unemployment rate hit 25%.

"William McDonough, the 68-year-old president of the Federal Reserve Bank of New York, recalls his father taking him in the late 1930s to see breadlines and ‘people in jail for stealing food for their families.’

"‘When a deflation occurs...without any great volumes of debt, the resulting evils are much less,’ Yale economist Irving Fisher wrote in 1933, ‘It is the combination of both which works the greatest havoc.’

"A company borrows on the assumption that rising sales volumes and prices will enable it to repay the debt. As prices fall, that becomes more difficult. The same applies to households that suffer falling income and have to cut spending to service debt. If too many businesses and households do this, depressed demand fuels further deflation.

"More troublesome is that deflation makes it impossible for a central bank seeking to jump-start the economy to get inflation-adjusted interest rates below zero. (When inflation is at 3% and the Fed cuts rates to 2%, the inflation-adjusted rate is minus 1%). For that reason, modern central bankers consider a low inflation rate – typically between 1% and 3% – ideal. The US is now in the lower part of that range."

That brings us to an even greater problem: the entire increase in the price level cannot be ascribed to "inflation," i.e., an increase of market demand over supply. Part of that increase must be ascribed to the inevitable growth of non-marketed public services within the economy that is paid for by taxation which must show up as a deepening layer in price. I have termed this the "structural price rise" in contrast with market inflation which does reflect an excess of demand over supply. Contrariwise the amount of real deflation may be understated if we ignore the structural price change factor.1

If economists had not resisted all enquiry into such structural factors in price rise they would long since have made a sensational discovery: "the low inflation rate that modern central bankers – typically between 1% and 3% – consider as ideal" is in fact not inflation at all, but structural price rise. But for that official market theory has no sensors. Little more than a decade ago on instructions from the Bank for International Settlements, "modern central bankers" proclaimed "zero inflation" an imperative to be enforced with interest rates high enough "to do the job." The consequences of that were devastating.

"A study by 13 Fed economists this summer concluded that ‘when inflation and interest rates have fallen close to zero and the risk of deflation is higher,’ policymakers should respond more aggressively than economic forecasts suggest. If the Fed lowers interest rates too little, deflation could result, rendering the Fed less potent. If the Fed overdoes it, it can always raise rates later to suppress the unwanted inflation,’ the study says."

In short the Fed has reached the end of its rope. "Fed officials argue that they applied these lessons last year, cutting rates 11 times, and say the lessons are less relevant now, with the economy growing, albeit slowly. But Martin Barnes, editor of the Bank Credit Analyst, a Montreal-based forecasting journal, warns that prices received by most businesses are already declining. A near-term rate cut by the Fed might help, he says, ‘but it is not going to prevent deflationary pressure from intensifying over the next few months." Since then, on 6/11 the Fed cut short-term rates by a full 1/2% rather than by the 1/4% applied in the past, but the economy took that and the Republican electoral victory in its stride – with no great response. If Keynes and his legacy had not been buried in potter’s field, the Fed authorities would recognize this as the classic example of his ‘liquidity trap’ when lenders are too scared to lend and borrowers to scared to borrow.

So what have the Fed folks left in their rusty medicine cabinet? "Other proposals, some possibly not legal, were for the Fed to lend to private companies to buy things such as stocks, real estate or even goods and services, such as used cars."

Most amazing, and a measure of the brainless state that four decades of thought-suppression have produced, is this proposal for the Fed to buy up used cars. Surely this is the ultimate apotheosis of free market thinking. There is no mention of the government using its own central bank to address the huge backlog of neglected infrastructural needs – putting our health and educational systems in order, providing essential housing after years of neglect, cleaning up the environment, and much else.

All that remains, then, is Bush’s beautiful little war against Iraq, which could well turn out just the next in a chain. It does wonders for elections, and seems to be the sole acceptable way of using the nation’s credit to provide stimulus to the economy.

Is it not time for inquiries into the why and wherefore of the blind alley into which our central banks have worked themselves?

William Krehm

1. Krehm, William (2002). Towards a Post-Autistic Economy – A Place for Society at the Table, COMER Publications, pp16 to 19. There I employ the technique of reductio ad absurdum twice for a rigorous mathematical proof of this. Step One. Assume it is possible for essential unpriced government services to increase within the GDP without affecting the price level, but for some reason prices have nonetheless risen. Increase taxation on the private sector and use the proceeds to subsidize producers to return prices to their previous levels. Since by the assumption this is possible, there is no good reason for stopping there. Repeat the procedure until the price level reaches zero. QED. You have proved that when essential government unpriced services increase within the economy, the price index must go up.

Second step. Instead of raising taxes with the proceeds going to subsidize the producers to bring their prices back to where they had been, impose higher interest rates on all producers and consumers and the government. Clearly that is an a fortiori version of what has just been proved. Hence it is impossible to have a growing public sector within the economy without structural price increase. And that increase is not market inflation.

But that principle should be evident even without reductio ad absurdum. At the beginning of the 20th century, only some 10% of the world’s population lived in cities of several million population, and the rest in the countryside and small towns. Now those proportions have pretty well been reversed. When anybody moves from the countryside to New York City, he expects his living costs to jump. How then could prices stay flat when humanity makes just such a move?

— from Economic Reform, December 2002


Conference on the General Agreement on Trade in Services (GATS)
22 February 2003, 1030 - 1600
Friends Meeting House, Euston Road, London

The GATS negotiations are reaching a crucial stage this coming spring, with the deadline for WTO members to list the services they are prepared to liberalise under GATS rules being the end of March 2003.

This conference will be a crucial event in the fight against GATS in the UK, and will aim to expose GATS to the light of public awareness and to mobilise people for a demonstration in Brussels in March.

Speakers will iinclude Caroline Lucas MEP, Ronnie Hall of Friends of the Earth International, and John Edmonds of the GMB union.  We are also hoping to get a speaker from the developing world.