Arthur Laffer: “Get Ready for Inflation and Higher Interest Rates”
June 11, 2009
Writing in the Wall Street Journal, Arthur Laffer, chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen”, has written what I think is a very perceptive essay on Get Ready for Inflation and Higher Interest Rates. As one who remembers the 1970′s quite well, I think he is “on target” in this assessment:
It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.If it could be worse than the economic situation we had during the Carter administration, I would say we certainly do not need to be taking the course we are now taking with the economy!
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Art Laffer is a professor of Economic’s at USC. He was an economic advisor to President Reagan and along with Jack Kemp was a leading advocate of “Supply Side” economics and was a favorite of Larry Kudlow who is fellow “ Supply Sider”. Professor Laffer was the creator of the “ Laffer Curve” which demonstrated conclusively as rates of marginal taxation on capital are reduced total aggregate tax paid to the government rises.
Points to consider:
1. Laffer actually understates the inflationary impact of the expansion of the monetary base. The fractionalized banking system allows for 9 dollars of loans for each dollar of capital. In addition he fails to mention the multiplier effect on the loans made, this is not surprising as he is a non Keyensian and the multiplier was a key innovation developed by Keyens in his General Theory. Laffer also fails to mention in such an inflationary atmosphere the Velocity of money or Turnover greatly increase.
2. When the amount of expansion of the monetary base is considered the expansion of the money supply (M1) at 15% is not as dramatic as it should be. It could be surmised that this is due to a dearth of quality loan opportunities exists now. Households are contracting their finances so there are not qualified opportunities to lend. The banks therefore leave large amounts of capital on deposit at the Fed where they are now paid interest which generates a positive yield spread helping to strengthen Balance Sheets. This is a situation that eventually will change! As the banks begin lending this ocean of money must go someplace. It will be inflationary.
3. The final point to consider is that what Laffer describes in the U.S. with the Fed is going on all over the world. Central banks everywhere are rapidly creating new money supply as is the I.M.F. on a global basis – This indicates devaluation of all currencies, some faster relative to others such as the Dollar V.S. the Yuan as example. In esscence you have a race for the bottom.
In your last paragraph you mention “a race to the bottom” in devaluation of *all* currencies. I know that in the Weimar Republic with their hyperinflation it was localized there, and the same thing would be true in Zaire now. Would you happen to know: has there ever been anything close to a world hyperinflation? Did the existence of the gold standard prevent such a thing from happening?
Your understanding is correct. I believe that Laffer understates possible inflationary impacts in his article.
In answer to your question about world wide hyperinflation: Upon reflection I cannot think of a incidence in modern times. Most “Weimar” type of inflations have taken place on a national basis – Nationalist China, Russia (a couple of times), Indonesia, Malaysia, Mexico, Argentina ( again more than once). I would say a regionalized type of inflation has existed on a hyper basis several times with a group of South American Banana Republics at the same time. On a more historical basis Europe during the Napoleonic Wars had hyperinflation to finance their war. The Roman controlled world (The Roman Empire) experienced inflation when Rome debased their coinage.
Thinking about these cases of hyperinflation caused me to realize something common to all in modern times. The hyperinflation was a prelude politically the rise of “ Strongman” rule in almost all cases. Hilter in Germany, Sukarno in Indonesia, Peron in Argentina – Military Juanta’s in Chile and Latin America, Chang and Mao in China, and variours strong man dictators in Africa. (Zimbabwe, Zaire and numerous others) This may have ominous implications for the future.
One final thing to remember when we and Laffer discuss inflation rates, we are talking about official government rates based on official rates of exchange. Many parts of the developing world have an active “Black Market Economy” where most of the common people do their daily transactions. So it would be quite possible for official rates to be far below “ Black Market” rates that could be hyperinflationary.
One of the more troubling aspects of this for me is that unlike the 1930′s when we were more rural than we are now (and hence had better access to food locally), now as a society it seems that we are far more interdependent on outside sources of food. This will not be a good thing if the global economy has much of a breakdown at all.