As we close in on congressional votes to increase the federal debt limit, negotiators are coming up with all kinds of ideas to hike taxes. (Suspiciously, they haven’t revealed very many spending cut ideas so far).

One idea being discussed is to raise revenue by reducing the indexing of parameters in the income tax code. Currently, tax brackets and other features of the tax code are indexed to the Consumer Price Index (CPI). It is widely recognized that the CPI overestimates inflation for various reasons, as discussed here.

The Bureau of Labor Statistics has developed a more accurate (and lower) measure of inflation, called chained CPI. If the tax code was indexed to chained CPI instead of CPI, the government would receive an automatic tax increase relative to current law every year until the end of time.

Switching to chained CPI is a very bad idea for two reasons:

• It would create a large tax increase over the long run. And it would be an invisible annual tax increase on families and voters because there would be no obvious changes in their tax forms.
• It would be an anti-growth tax increase because it would push families into higher tax brackets more quickly over time, subjecting them to higher marginal tax rates. The chained CPI proposal is essentially a proposal to increase marginal tax rates slowly and steadily over time.

Some economists may argue that the chained CPI proposal is a good idea because the tax code would more accurately reflect inflation, and it would. However, the tax code already contains a bias that pushes families into higher tax brackets over time, which is called “real bracket creep.” Real growth in the economy steadily moves taxpayers into higher rate brackets since the tax code is indexed for inflation but not real growth. The discussion in the Congressional Budget Office’s new long-range budget outlook implies that this will be an important force in raising federal revenues as a share of GDP in coming decades.

So I’ve got a better idea than indexing the tax code to chained CPI: indexing the tax code to nominal GDP growth. That would adjust for the effects of both inflation and real economic growth on tax code parameters, and it would prevent stealth tax rate increases under our graduated income tax system.

Chained CPI: A Stealth Tax Increase is a post from Cato @ Liberty - Cato Institute Blog

Who knows more about inflation, Richard Galanti or Ben Bernanke? I maintain that, when it comes to the facts, Mr. Galanti knows more than the Fed chairman. Galanti is the CFO of Costco Wholesale Corp.

The Wall Street Journal reported last Thursday (May 26th) on a conference call with Mr. Galanti. He said “we saw quite a bit of inflationary pricing” in the 3rd quarter.

Price increases occurred in a broad range of products” dry dog food (3.5%). Detergents (10%+), plastic products (8-9%). Costco will “hold prices as long as we can.” When it can no longer, the consumer will face rising prices.

Costco is a good leading indicator of inflation at the retail level. It turns over inventory quickly, and is leading other retailers in restocking at higher prices. Costco offers a forward-looking view of consumer price inflation.

Meanwhile the Fed and its chairman, Ben Bernanke, rely on backward looking measures of inflation, like the CPI. That index, and the “core” component that excludes food and energy prices, overweight the depressed housing sector. And they are yesterday’s news.

For years, American consumers have benefitted from cheap imports from China and India. When those countries liberalized and opened up to global commerce, Americans got the benefit of the hard work and low wages of 2 ½ billion workers. The era of cheap labor is coming to an end, and with it the flood of imports that held down prices in the U.S. Especially in China, wage rates are rising rapidly.

Heretofore, the flood of dollars has chiefly affected asset prices and inflation in other countries. The flow through to U.S. consumer prices will now be quicker. You’ll experience it when you go to Costco to restock.

Inflation Expert is a post from Cato @ Liberty - Cato Institute Blog

Today the Bureau of Labor Statistics released the consumer price index (CPI) numbers for April, which generally gives us the best picture of inflation.  The headline number is that between April 2010 and April 2011, consumer prices increased 3.2 percent, as measured by the CPI.  Obviously this is well above 2 percent, the number Ben Bernanke defines as “price stability.”  Setting aside the reasonableness of that definition, there is definitely some mild inflation in the economy.

Also of interest in the April numbers is that if you subtract housing, which makes up over 40% of the weight of the CPI, then prices increased 4.2 percent — twice Bernanke’s measure of stability.  What has always been problematic of the housing component is that its largest piece is an estimate of what owners would pay themselves if they rented their own residence.  This estimate makes up about a fourth of the CPI.  As the chart below demonstrates, for much of 2010, the direction in this number was actually negative, which held down CPI over the last year.  The current annualized figure for owner’s rent is 0.9 from April 2010 to April 2011.  Oddly enough, this is below the actual increase in rents, which was 1.3.  For most homeowners, the real cost of housing — their mortgage payment — has likely been flat, not decreasing.  So whatever benefit there has been to declining housing costs, most consumers are unlikely to feel any benefit from those declines, if they are actually real.

While the primary driver of CPI has been energy costs, food prices have also garnered considerable attention.  Excluding food from the CPI does not change the headline number, although this is due to the fact that the cost of eating out has been rising considerably slower than the cost of eating at home.  So as along as you’ve been eating out every night, you’ve apparently been fine.  This touches upon what is one of the less recognized features of current inflation trends:  the regressive nature of these prices increases.  If you rent, then you’ve seen costs increase more than if you own.  If you mostly eat at home, then you’ve seen prices increase more than if you dine out a lot.  If you have a lot of leisure time, the you’ve gained by the decrease in reaction prices.  While I don’t think one’s position on inflation should be driven purely by distributional concerns, the fact that working middle-income households have been hit harder by recent inflation trends than higher-income households should cut against the claims that inflation is somehow good for the poor or working class.

Is Housing Holding Back Inflation? is a post from Cato @ Liberty - Cato Institute Blog

The Wall Street Journal has pointed out that in his recent press conference Federal Reserve Chair Ben Bernanke used the words “inflation expectations” (or some variation) 21 times. His argument is that we need not worry about inflation because we will see it coming, and then the Fed will do something about it. Such an argument relies heavily on the ability of inflation expectations to predict inflation. Which of course raises the question, just how predictive are inflation expectations?

The graph below compares inflation, as measured by CPI, and inflation expectations, as measured by the University of Michigan consumer survey, the longest times series we have on inflation expectations.

Clearly the two move together. For instance, the correlation between current inflation and expectations is almost 1 (its 0.93), while the correlation between inflation and actual inflation a year later is slightly less at 0.81. The relationship declines as we move further into the future. So yes, consumer expectations appear a reasonable predictor of the direction of inflation. However, they don’t appear to be a great predictor of the magnitude or the frequency of changes. For instance, the standard deviation of actual inflation is about twice that of expected inflation. As one can easily see from the chart, expectations are quite sticky and rarely pick up the extremes. During the late 1970s and early 1980s, expectations did move up, but then never reached the heights actually experienced, nor did consumers ever actually expect deflation during the recent financial crisis (if we are going to base policy on expectations, we should at least be consistent about it).

For about the last decade we also have market based measures of inflation, based upon inflation-indexed bonds. The TIPS measure tends to be less correlated with actual inflation, but does a better job of capturing the extremes. Although interesting enough, TIPS was already predicting that deflation would be short-lived before we even experienced any deflation.

The point is that while expectations are useful for qualitatively purposes, they do not have a strong record of recording the extremes. Given that most of us expect some positive level of inflation, the real debate is over how much. In this regard, either survey or market-based expectations are likely to be both a lagging indicator and an under-estimate of actual inflation.

Can We Rely on Inflation Expectations? is a post from Cato @ Liberty - Cato Institute Blog

To put it mildly, the Federal Reserve has a dismal track record. It bears significant responsibility for almost every major economic upheaval of the past 100 years, including the Great Depression, the 1970s stagflation, and the recent financial crisis. Perhaps the most damning statistic is that the dollar has lost 95 percent of its value since the central bank was created.

Notwithstanding its poor performance, the Federal Reserve seems to get more power over time. But rather than rewarding the central bank for debasing the currency and causing instability, perhaps it’s time to contemplate alternatives. This new video from the Center for Freedom and Prosperity dives into that issue, exposing the Fed’s poor track record, explaining how central banking evolved, and mentioning possible alternatives.

This video is the first installment of a multi-part series on monetary policy. Subsequent videos will examine possible alternatives to monopoly central banks, including a gold standard, free banking, and monetary rules to limit the Fed’s discretion.

As they say, stay tuned.

End the Fed: More than Just a Bumper Sticker Slogan? is a post from Cato @ Liberty - Cato Institute Blog

NPR reports on rising food prices across the world. They may have played some role in the revolts in Tunisia and Egypt, and if so, those wouldn’t be the first revolutions sparked by inflation. NPR reporter Marilyn Geewax mentioned several reasons that food prices are rising — droughts, floods, oil prices, financial speculation – but not the obvious one: the continuing creation of unbacked money by central banks around the world. As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” And as Jerry O’Driscoll wrote just two weeks ago, about rising food prices, “Inflation is here.” But that point isn’t yet universally understood, at least not at our government radio network.

Anyway, I turned off the radio and turned on the television, where TCM was just broadcasting the 1942 MGM propaganda film “Inflation” (made at the request of the Office of War Information but then never released because it was too anti-capitalist even for wartime propaganda). Edward Arnold plays the Devil, in league with Hitler and posing as a businessman who who encourages people to buy more, evade price controls, stockpile goods, and use the black market. (The film was made by Cy Endfield, who had been a member of the Young Communist League at Yale and went on to make such films as Zulu and Universal Soldier.) The film features what appears to be President Franklin D. Roosevelt’s April 28, 1942, radio speech, “Total War and Total Effort.” As the young couple in the film go to buy a new radio, the shopkeeper turns on the radio and they hear FDR say:

You do not have to be a professor of mathematics or economics to see that if people with plenty of cash start bidding against each other for scarce goods, the price of those goods (them) goes up.

Yesterday I submitted to the Congress of the United states a seven-point program, a program of general principles which taken together could be called the national economic policy for attaining the great objective of keeping the cost of living down. I repeat them now to you in substance:

First. we must, through heavier taxes, keep personal and corporate profits at a low reasonable rate.
Second. We must fix ceilings on prices and rents.
Third. We must stabilize wages.
Fourth. We must stabilize farm prices.
Fifth. We must put more billions into War Bonds.
Sixth. We must ration all essential commodities which are scarce.
Seventh. We must discourage installment buying, and encourage paying off debts and mortgages.

As it happens, I have a 1942 OWI poster with that same message hanging in my kitchen:

In fact, of course, price inflation was the natural result of a substantial increase in the money supply before and during the war. All of FDR’s policies — cartels, destruction of crops, wage and price controls, rationing — were misguided attempts to deal with the consequences of monetary manipulation and other bad policies.

By the way, FDR famously said, “The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.” Which might explain another propaganda film produced by MGM, this one in 1933, that extolled the virtues of FDR’s policy of inflation, utilizing the argument that is variously called “stimulus” or “the broken window fallacy.” The film cited the successful results of Civil War inflation. “What inflation has done before it will do again! . . . What a man! And what a leader! Yowzer! Happy days are here again!” Yeah, that went well. And by 1942 MGM was back on board, making a government propaganda film opposing inflation.

For background on inflation, read Cato adjunct scholar Lawrence H. White at the Concise Encylopedia of Economics.

Misunderstanding Inflation through the Years is a post from Cato @ Liberty - Cato Institute Blog

Chinese President Hu Jintao’s visit to Washington brought renewed focus on China’s currency.  It was likely the largest point of discussion between President Obama and President Hu.  I suspect a less public, but related, issue was China looking for some certainty that America would make good on its obligations; after all, China is our largest lender.

What is often missed is the connection between these two issues:  currency and debt.  When China receives dollars for the many goods it sells us, instead of recycling those dollars into the purchase of US goods, it uses that money mostly to buy US Treasuries and Agencies (Fannie/Freddie securities).  These large Treasury/Agency purchases (foreign holdings of GSE debt are over $1 trillion) have the effect of increasing the demand for dollars and depressing that for yuan, resulting in an appreciation of the dollar relative to the yuan.  This connection exposes the hypocrisy of President Obama’s complaints about China currency manipulation – without massive US budget deficits, China would not be able to manipulate its currency to the extent it does.  If the US wants to end that manipulation, it can do so by simply reducing the outstanding supply of Treasuries and Agency debt.

Another solution, which would also do much to end the “implicit guarantees” of Fannie Mae and Freddie Mac, is to take Fannie and Freddie into a receivership, stop the US taxpayer from having to cover their losses, and shift those losses to junior creditors, which include the Chinese Central Bank.  Were the Chinese to actually suffer credit losses on their GSE debt, they would quickly start to reduce their holdings of such.  They might also cut back on Treasury holdings.  These actions would force the yuan to appreciate relative to the dollar.  And best of all, it would end the bottomless pit that Fannie and Freddie have become.  It is worth remembering that even today, under statute, the Federal government does not back the debt of Fannie and Freddie.  It is about time we also teach the Chinese a lesson about the rule of law, by actually following it ourselves. 

Of course this would increase the borrowing costs for Agencies (and maybe Treasuries), but then if China were to free float its currency, that would also reduce the demand for Treasuries/Agencies with a resulting increase in borrowing costs.  We cannot have it both ways.

Fannie & China: 2 Birds, 1 Stone is a post from Cato @ Liberty - Cato Institute Blog

China’s President Hu Jintau arrives in Washington today for a state visit, turning the spotlight once again on U.S.-China trade and China’s allegedly undervalued currency, the yuan. Not one to let such an opportunity go to waste, Sen. Charles Schumer (D-N.Y.) is introducing legislation that would threaten to impose duties on imports from China if the yuan does not appreciate quickly.

Count me skeptical that a more expensive yuan relative to the U.S. dollar would make much of a dent in our bilateral trade deficit with China, or that it would have any positive effect on U.S. economic growth and employment. But even if those assumptions were true, the big story is how much the yuan as already appreciated against the dollar.

It has been a mantra of Sen. Schumer and other critics of U.S.-China trade that the yuan is undervalued by 15 to 40 percent. They were saying that before the 2005 appreciation, and they’re saying that now, as though nothing has changed.

Yet a lot has changed. In nominal terms, the yuan appreciated by more than 20 percent between 2005 and 2008. That’s when China relaxed its hard peg with the dollar and allowed its currency to gradually appreciate. After holding the peg steady again during the recent financial turmoil, China has again allowed it to rise another 3 percent since last June.

The nominal rate is just part of the story, however. Price levels in the United States and China determine the real exchange rate–the actual amount of goods that can be bought with each currency. A big story in China recently is its rising inflation rate, which makes Chinese goods relatively more expensive at any given exchange rate. In this way, a relatively higher inflation rate in China compared to the United States acts in the same was as a nominal increase in the exchange rate of the yuan.

When you combine the effect of rising prices in China with the higher nominal value of the yuan, you get a double boost to the real exchange rate. According to a chart on the front page of this morning’s Wall Street Journal, the real value of the yuan has appreciated by 50 percent since the beginning of 2005. In early 2005, 100 Chinese yuan could be exchanged for about $12; today it can be exchanged for $18 (in real, inflation adjusted dollars).

Rather than complain, Sen. Schumer and his allies should congratulate themselves on achieving their goal of a much stronger yuan and a much weaker dollar, even if we are still waiting for the tonic effect they predicted it would have on jobs and growth.

Appreciating China’s Currency is a post from Cato @ Liberty - Cato Institute Blog

“Faced with rising international food prices,” Steven Mufson writes in the Washington Post, “governments around the world are cooking up measures to protect domestic supplies and keep a lid on prices at home.” Instead of export bans, subsidies, and price controls, governments might better consider the role of their central banks in creating money out of thin air and causing price inflation. Cato senior fellow Gerald P. O’Driscoll, Jr., made that point at the blog ThinkMarkets:

“Prices Soar on Crop Woes” reads the headline in today’s Wall Street Journal.

Global output of key crops such as corn, soybeans and wheat is down, and their prices are up, respectively, 94%, 51% and 80% from June lows. Today’s PPI report has wholesale prices up 1.1% in December after rising 0.8% in November. The Journal reminds us that in 2008 high food prices sparked riots around the world.

Meanwhile Fed officials tell us they don’t expect inflation.  It is not an issue of expecting inflation, but of observing it here and now.  The Fed prefers, of course, to look at “core” inflation rates, which are much lower. A former Fed colleague explained to me the central bank does so on the theory that people do not need to drive to work and can stop eating.

In our global economy, easy US monetary policy has thus far mainly affected commodity prices (including now food), real-estate in Asia and now broader price measures in Asia. It is implausible that the US would remain unaffected. Food, energy and clothing prices are all rising. I don’t think many households are presently gripped with a fear of deflation.

In the Mises/Hayek theory of economic fluctuations, the transmission of monetary shocks works through producer prices and incomes, and only later consumer prices. No measure of consumer prices, and certainly not a subset of consumer prices, is an adequate gauge of inflation.

(For another take on rising food prices, you can read the views of Paul Krugman and Lester Brown, who say that at last — at last! — we really are running into those “binding resource constraints” that Brown has been predicting for his entire life and that will finally require us to start living at Chinese levels.)

Inflation Is Here is a post from Cato @ Liberty - Cato Institute Blog

After proponents of the Federal Reserve’s second round of quantitative easing (QE2) abandoned the argument that QE2 would spur growth by bringing down interest rates (only after rates increased), the new defense became “we intended for rates to go up all along, as a result of increased inflation expectations.”  Since few would argue for increased inflation, or expectations of such, as an end in itself, the claim was that increases in inflation expectations would drive households to consume more, which would in turn causes businesses to hire more, bringing down the unemployment rate.  But does this chain of reasoning withstand empirical scrutiny?

It turns out looking at the historical data on inflation expectations, as collected at the University of Michigan, that inflation expectations and household savings rates (the inverse of consumption rates) are positively correlated.  Now of course correlation doesn’t mean causality,but what the data suggest is that instead of consuming more when inflation expectations increase, households have actually saved more.  This positive correlation also holds for the second half of the data series, so it’s not simply the result of a downward trend in either inflation or savings.

To review, the latest argument for QE2:  increase inflation expectations, which is assumed to increase consumption, which is hoped to increase employment.  The problem I’ve had all along with this position is that the only thing we know for certain is the first part, QE2 would increase inflation expectations.  The hope that it would increase consumption and hence employment was just that:  hope.  Given the disconnect we’ve seen between consumption and unemployment over the past 18 months, the third link in that chain is also a weak one.   So what do we have at the end of the day:  certain costs with fairly speculative and uncertain benefits.  And here I was thinking that reckless speculation was the sole province of the private sector.

Do Inflation Expectations Drive Consumption? is a post from Cato @ Liberty - Cato Institute Blog

While listening to NPR this morning, I was subjected to yet another economist claiming that we cannot have inflation in an environment of such high economic slack.  Setting aside the fact that perhaps this economist missed the 1970s, this is a vital question to examine, because it is the foundation of so much of Bernanke and the Federal Reserve’s current thinking.  That is, the notion that inflation is always and everywhere the result of an over-heating, or excess demand, economy.

One of the measures commonly followed by the Fed, and others of the slack-restrains-inflation school, is the measure of capacity utilization rate.  Setting aside some of the problems with this measure, are increases in capacity utilization associated with increasing inflation, as would be suggested by the slack-restraint school?  It turns out not.  Since 1967, when the data series begins, the correlation between capacity utilization and inflation, as measured by the consumer price index (CPI), has been negative.  That is, as more and more industrial and economic resources have been brought into use, inflation has actually fallen, rather than risen (as would be predicted).  A negative correlation also implies that low or falling capacity utilization does not mean low inflation.

Now what is positively correlated with inflation is the growth in the money supply.   The chart below shows annual changes in both CPI and M2.  Even just eye-balling the chart, one can see the positive correlation, which also shows up under statistical analysis. 

Another question one often hears in today’s economic discussions is what would Milton Friedman say?  I won’t claim to be able to channel Milton (or anyone else), but I do think the empirical evidence continues to support the conclusion that inflation is always and everywhere a monetary phenomenon.

Economic Slack and Inflation is a post from Cato @ Liberty - Cato Institute Blog

A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet.  Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk.  In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.

Recall that the yield, or interest rate, on a long term asset is inversely related to its price.  So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par.  The same holds for Treasury securities.  I think  it is a safe assumption that rates will be higher at some point in the future.  When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.

Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity.  But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet.  It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets.  But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).

Now the Fed claims to have other avenues by which to tighten, besides open-market operations.  For instance, it can raise the interest rate on excess reserves.  But then this would further erode the value of assets on its balance sheet.  Not to mention that they have to find the money somewhere to pay these higher rates on reserves.

Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary.  The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet.  One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.

Is the Federal Reserve Heading Towards Insolvency? is a post from Cato @ Liberty - Cato Institute Blog

Journalists talk endlessly these days about the need for more consumer spending to revive the economy, and for government programs to juice consumer spending. Economist Steven Horwitz takes on the assumption that spending is the key to economic activity:

One of the most pernicious and widespread economic fallacies is the belief that consumption is the key to a healthy economy.  We hear this idea all the time in the popular press and casual conversation, particularly during economic downturns.  People say things like, “Well, if folks would just start buying things again, the economy would pick up” or “If we could only get more money in the hands of consumers, we’d get out of this recession.”  This belief in the power of consumption is also what has guided much of economic policy in the last couple of years, with its endless stream of stimulus packages.

This belief is an inheritance of misguided Keynesian thinking. Production, not consumption, is the source of wealth.  If we want a healthy economy, we need to create the conditions under which producers can get on with the process of creating wealth for others to consume, and under which households and firms can engage in thesaving necessary to finance that production….

Putting more resources in the hands of consumers through a government stimulus package fails precisely because the wealth so transferred ultimately has to come from producers.  This is obvious when the spending is financed by taxation, but it’s equally true for deficit spending and inflation.  With deficit spending the wealth comes from producers’ purchases of government bonds.  With inflation it comes proportionately from holders of dollars (obtained through acts of production) whose purchasing power is weakened by the excess supply of money.  In neither case does government create wealth. Nor does consumption.  The new ability to consume still originates in prior acts of production.  If we want real stimulus, we need to free up producers by creating a more hospitable environment for production and not penalize the saving that finances them.

The ‘Consumer Spending’ Myth is a post from Cato @ Liberty - Cato Institute Blog

Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.”   But does this trade-off actually exist? 

While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).

It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship.  In fact, since 1960, the correlation between changes in CPI and unemployment has been positive.  We have generally seen rising unemployment along with rising inflation.  Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment.  While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.

The Richmond Fed also has a great history of the Phillips curve that is well worth the read.  Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.

Is There an Inflation-Unemployment Trade-off? is a post from Cato @ Liberty - Cato Institute Blog

Early in the Obama Administration, there was an amusing/embarrassing incident when Chinese students laughed at Treasury Secretary Geithner when he claimed the United States had a strong-dollar policy.

I suspect that even Geithner would be smart enough to avoid such a claim today, not after the Fed’s announcement (with the full support of the White House and Treasury) that it would flood the economy with $600 billion of hot money. Here’s what my colleague Alan Reynolds wrote in the Wall Street Journal about Bernanke’s policy.

Mr. Bernanke…believes (contrary to our past experience with stagflation) that inflation is no danger thanks to economic slack (high unemployment). He reasons that if people can nonetheless be persuaded to expect higher inflation, regardless of the slack, that means interest rates will appear even lower in real terms. If that worked as planned, lower real interest rates would supposedly fix our hangover from the last Fed-financed borrowing binge by encouraging more borrowing. This whole scheme raises nagging questions. Why would domestic investors accept a lower yield on bonds if they expect higher inflation? And why would foreign investors accept a lower yield on U.S. bonds if they expect exchange rate losses on dollar-denominated securities? Why wouldn’t intelligent people shift their investments toward commodities or related stocks (such as mining and related machinery) and either shun, or sell short, long-term Treasurys? And if they did that, how could it possibly help the economy?

The rest of the world seems to share these concerns. The Germans are not big fans of America’s binge of borrowing and easy money. Here’s what Finance Minister Wolfgang Schäuble had to say in a recent interview.

The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. …I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don’t recognize the economic argument behind this measure. …The Fed’s decisions bring more uncertainty to the global economy. …It’s inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.

The comment about borrowed money has a bit of hypocrisy since German government debt is not much lower than it is in the United States, but the Finance Minister surely is correct about monetary policy. And speaking of China, we now have the odd situation of a Chinese rating agency downgrading U.S. government debt.

The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy. Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the US by one level to A+ from previous AA with “negative” outlook.

This development shold be taken with a giant grain of salt, as explained by a Wall Street Journal blogger. Nonetheless, the fact that the China-based agency thought this was a smart tactic must say something about how the rest of the world is beginning to perceive America.

Simply stated, Obama is following Jimmy Carter-style economic policy, so nobody should be surprised if the result is 1970s-style stagflation.

Will the Federal Reserve’s Easy-Money Policy Turn the United States into a Global Laughingstock? is a post from Cato @ Liberty - Cato Institute Blog

The Fed’s planned purchases of $600 billion of long-term Treasury bonds were targeted for domestic problems, but are having international consequences. The expansion of the Fed’s balance sheet drives down the foreign-exchange value of the U.S. dollar, and (same thing) forces other currencies to appreciate in value.

Emerging markets with high short-term interest rates will attract “hot money” flows. These flows are not stable sources of funding, and disrupt the small capital markets in these countries. Long-term, the appreciation of their currencies harms their competitiveness in global goods’ markets.

Brazil has already imposed capital controls and other emerging markets may follow. The Chinese in particular have reacted sharply.  According to a Reuters dispatch, Xia Bin, adviser to China’s central bank, said another financial crisis is “inevitable.” He added that China will act in its own interests.

In short, the Fed’s actions have undone whatever good came out of the G20 meetings. Any hope for cooperation on currency values and financial stability is out the window. There are potential spillovers in other areas of global cooperation.

Currency wars, like other wars, have unintended consequences and collateral damage.  Some countries will predictably react by imposing capital controls.  Moves to curb imports can follow. Monetary protectionism leads to trade protectionism.

However it might like matters to be, the Fed cannot simply act domestically.  It has reached the useful limits of further easing.

Currency Wars Also Have Unintended Consequences and Collateral Damage is a post from Cato @ Liberty - Cato Institute Blog

If you ever want to see how federal student aid is used for political gain, look no further than the report on the American Opportunity Tax Credit released today by the U.S. Treasury Department.  The accolade-begging for the President begins right on the cover page:

The President created the American Opportunity Tax Credit (AOTC) as part of the American Recovery and Reinvestment Act, which he signed into law in February 2009. For tax years 2009 and 2010, the new law allows families with tuition expenses to receive a tax credit of up to $2,500 per student, and up to $1,000 per year of this amount is refundable. If the AOTC is made permanent, as proposed in the President’s FY 2011 Budget, a student could receive a credit up to $10,000 over four years. 

The President, of course, doesn’t create these things, the legislative branch does. But the Prez, apparently, wants the credit for the credits. A White House event  scheduled for today suggests why: It appears that the President will be using the report, as well as his proposal to extend the AOTC, to curry favor with college students, a potentially large voting bloc. 

The content of the report, unfortunately, is just as bad as its PR use, going on and on about how much free money the credit offers for college, and breaking down the benefits so every type of filer can see how he or she might benefit. Meanwhile, there’s hardly amention of the AOTC’s cost — something in which you’d think the Treasury Department would be at least a little interested.  But, to be fair, I’m not just talking about the obvious cost to taxpayers who will sooner or later have to foot the bill for this Santa Claus program. Arguably the even bigger cost is that expanding federal aid like this ultimately just enables colleges to raise their prices and capture the money, making it a major, self-defeating source of fuel for rampant tuition inflation.

So the AOTC will do little or nothing to make college more affordable in the long-run. It will, though, make colleges and their employeesbetter off, and create the powerful illusion that Washington politicians — especially, in this case, the President — are doing their best to make college affordable for all.  And that, as pure-PR reports like this one strongly suggest, is likely the primary goal.

Merry Christmas, Ivory Tower! is a post from Cato @ Liberty - Cato Institute Blog

Allan H. Meltzer, a frequent participant in Cato’s annual monetary conferences, warns in the Wall Street Journal that the Federal Reserve may be about to lay the groundwork for another Great Inflation like we saw in the 1970s:

The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.

Then the press reported rumors about plans to raise the inflation target to 4% or higher, from 2%. This is a major change from the Fed’s quick rejection of a higher target when the International Monetary Fund suggested it a few months ago.

Anyone can make a mistake, but wise people don’t repeat the same one. Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman’s analysis is now a standard teaching of economics. Surely Fed economists understand this….

Yes, a sustained deflation would be a big problem, but it is unlikely in today’s circumstances. Countries with a depreciating exchange rate, an unsustainable budget deficit, and more than $1 trillion of excess monetary reserves are more likely to inflate. That’s our problem today, and it’s another reason the Fed should give up this nonsense about more stimulus and offer a credible long-term program to prevent the next inflation.

Register for Cato’s upcoming monetary conference here. More on inflation risks here and here.

Meltzer on Looming Inflation is a post from Cato @ Liberty - Cato Institute Blog

Thanks to the Obamacare legislation, we already know there will be a new 3.9 percent payroll tax on all investment income earned by so-called rich taxpayers beginning in 2013. And the capital gains tax rate will jump to 20 percent next year if the President gets his way. This sounds bad (and it is), but the news is even worse than you think. Here’s a new video from the Center for Freedom and Prosperity that exposes the atrociously unfair practice of imposing this levy on inflationary gains.

The mini-documentary uses a simple but powerful example of what happens to an investor who bought an asset 10 years ago for $5,000 and sold it this year for $6,000. The IRS will want 15 percent of the $1,000 gain (Obama wants the tax burden on capital gains to climb to 23.9 percent, but that’s a separate issue). Some people may think that a 15 percent tax is reasonable, but how many of those people understand that inflation during the past 10 years was more than 27 percent, and $6,000 today is actually worth only about $4,700 after adjusting for the falling value of the dollar? I’m not a math genius, but if the government imposes a $150 tax (15 percent of $1,000) on an investor who lost nearly $300 ($5,000 became $4,700), that translates into an infinite tax rate. And if Obama pushed the tax rate to almost 24 percent, that infinite tax rate gets…um…even more infinite.

The right capital gains tax, of course, is zero.

Obama’s Wants a 23.9% Capital Gains Tax, but the Rate Actually Will Be Much Higher Because of Inflation is a post from Cato @ Liberty - Cato Institute Blog

…since 1970, after adjusting for inflation. What have we got to show for it? Bob Ewing of the Institute for Justice tackles that question with a little help from a gory chart I put together a couple of months back, but he’s got another nugget of information that a lot of folks may find more compelling.

Cost of a K-12 Edjercation Has Quadrupled… is a post from Cato @ Liberty - Cato Institute Blog