Optimal Policies Under Expectations Of Stagflation

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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(I submitted this article to The Wall Street Journal on October 29, 2009. I have re-published this article today on my blog with a minor language edit to reflect the change of power in the United Kingdom).

“We now have the worst of both worlds —not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of [‘]stagflation[’] situation and history in modern terms is indeed being made.”
Iain Macleod
November 17, 1965
Member, House of Commons, United Kingdom

The future Chancellor of the Exchequer of Great Britain, Iain Macleod, former British Prime Minister Gordon Brown’s predecessor by nearly three decades, who is credited with bequeathing Margaret Thatcher her policies of economic liberalization, coined a word that would come to haunt the United States and the rest of the G7 until Paul Volcker began administering the medicine of severe monetary contraction about 15 years later. The man knew what he was talking about.

Currently, inflation is hovering around 2% in the United States and the economy is trying to still recover from the recession. History, in postmodern terms, could be repeated. Today, the word “stagflation”, at one time an inductive premonition of a prescient man, has entered the lexicon of “rational” expectations in economic theory.

There is temptation, the lure of the Great Moderation, to recycle past economic policies to keep inflation low. If only oil prices are low even as the country works its way toward energy independence by mid-century and if only Americans can keep on consuming cheap goods imported from abroad, there is the temptation to think that the G7 can avert another bout of stagflation at the expense of the rest of the world that can wait to grow to develop. It is perhaps a rational expectation for economic policy makers who see the G7 as the indispensable hub of the global economic wheel, but an irrational one for policy makers. The dichotomy between economics and politics has never been greater.

Before the wishful thinking of the economists from the ‘90s can be dismissed, especially given that they outnumber all others in the Obama administration, still fighting a battle to prove their economic policy “supremacy”, never mind the crises, it could be useful to apply the method of proof by contradiction to disprove them. It could be useful to begin the analysis by accepting that they are correct, to prove by deduction that they are wrong. To do so, homo economicus has to be placed in the context of homo sapiens.

After the Cold War had ended in the period between 1989 and 1992, the tumult of ideological transformation had given the benefit of doubt to the last man standing in the century long skirmish over ideology. Capitalism had won the battle. The world on the other side of the iron curtain was free to aspire to the world it could not until then see. The wall of separation that was built brick by brick by a totalitarian government, just before Kennedy had spoken on June 26, 1963 standing next to it, was taken down brick by brick nearly 30 years later by the people who did not want it. They had to rebuild their role in a new world, again, without walls.

Both myths and quantum physics talk of the same world where material objects pass through walls. Capitalism can be weird. Rational expectations can be irrational. What those people behind the iron curtain did not have for nearly a century, they had wanted it in a decade, except those behind the Great Wall of China. The freer side of the felled Berlin Wall was not rational either. It had wanted to change the world in that same decade. Time was compressed by economic expectations on a scale of 1 to 10 in a 20th century world where communications were sped up to light speed for them all to put their faith and wealth in the United States and the “West” and we saw ourselves as impregnable.

Those behind the Chinese wall though, kept the wall and let the money in but did not let it out. Still, they saved, but kept their savings in the West. It was their savings, not lost wealth as was the case in the east of Europe. The Chinese consumed less to feed the appetites of those who were beginning to think that they had become the new masters. These are the economic policy makers from the ‘90s. So, oil prices were low because the Chinese had made things for others but not for themselves. If the demand for a finite growth resource such as oil could be mitigated in favor of those who want to consume more to grow, prices would be low. Thus came the Great Moderation of prices in the United States and Western Europe. The savings of others and their labor had stoked the illusion of wealth in the West which collapsed in 2007 like a house of cards.

In 2009, twenty years after 1989, much has changed. Those who were behind the walls, both who were unrestrained and naïve in their aspiration and those who were restrained and more cautious, realize that they cannot keep putting their faith and wealth in a deck of cards which, think they that they have been led to believe, is a house of brick and mortar. They have learned to trust themselves first, quite wisely as all normal human beings should. They want to make things for themselves. So, they want to keep more of their savings and labor for themselves. This is the definition of capitalism since Adam Smith wrote the Wealth of Nations. They have learned to be capitalist. America has achieved its economic purpose. The hope is that through capitalism they will also learn to be free peoples, and eventually one people. Then we will have won the war. It is a conjecture that is yet unproven by reality. It is therefore unwise to expect another Great Moderation unless we can do it ourselves because they will not be forced into it. If they are, there could be another 100 year war that could consume both this century and (our) humanity with it, miring us in self-doubt and them in resurrecting the ghosts of totalitarianism with a capitalist twist.

Then how do we achieve another Great Moderation by ourselves when we are not entitled to it? The wealthy may have to bite the bullet of higher inflation to pay their way through change with their own money. The United States will have to do several things, in earnest, to minimize the inflation we cannot but tolerate because we were not prepared. Honesty is the first step toward rehabilitation, whether that is for addictions such as oil and imported goods or for morality. The country is on its third boomer president since the end of Cold War, all the three having publicly confessed to some form of prior addiction from which they have rehabilitated themselves. Therefore, it is time to rehabilitate the country from its.

First, the Federal Reserve must stop paying interest on the excess reserves for the banks to start thinking about using the money more gainfully. Second, it must continue to buy back American debt at a steady and transparent pace before the others would want to sell it themselves, to continue to put dollars out into the global financial markets, even if it means a lower valued dollar and Fed financing of U.S debt, in the short run. Third, the Fed must take the bull by the horns and redirect the expanding liquidity to restructure the balance sheets of its member banks while recapitalizing them to align bank profitability with real growth, to rehabilitate Wall Street from its addiction to paper wealth. Fourth, to support the Fed, the rest of the government must simultaneously and expediently reform financial regulations, pass comprehensive energy, transportation and infrastructure bills with targeted corporate tax cuts and reform health care more sensibly, to rehabilitate itself from its addiction to political gridlock. Fifth, the country must reform the social safety net for the post-boomer generations. Then, inflation will first rise and then fall as we pay our way through change with our own money over the course of the next decade.

This is a tall order for quotidian politics. However, it must be accomplished if our diurnal rhythms are not to change to keep our cherished way of life, to bequeath it to future generations of Americans and to communicate to the peoples of the rest of the world that keeping faith in America means keeping faith in themselves, for America thrives on the enterprise of all the free peoples of the world.

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About Chandrashekar (Chandra) Tamirisa

http://www.thecommonera.com/Common_Era/Me.html
This entry was posted in Economics, Foreign Policy, Monetary Policy, National Security and Defense, Politics, Transformations LLC and tagged , , . Bookmark the permalink.

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