NCPA - National Center for Policy Analysis


June 10, 2009

The economic crisis, the ill-conceived government reactions, the ensuing economic downturn and the massive liabilities of government programs like Social Security and Medicare and Medicaid, all but guarantees higher interest rates, massive tax increases, and partial default on government promises, says Arthur B. 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" (Threshold, 2008).  

As bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences.  We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s, says Laffer.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base -- which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash -- by a little less than $1 trillion.  The Fed controls the monetary base 100 percent and does so by purchasing and selling assets in the open market.  By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position, says Laffer:

  • The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10; it is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless.
  • The currency-in-circulation component of the monetary base -- which prior to the expansion had comprised 95 percent of the monetary base -- has risen by a little less than 10 percent, while bank reserves have increased almost 20-fold.
  • Now the currency-in-circulation component of the monetary base is a smidgen less than 50 percent of the monetary base.

It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because we haven't ever seen anything like this in the United States, says Laffer:

  • 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 percent 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.

Source: Arthur B. Laffer, "Get Ready for Inflation and Higher Interest Rates," Wall Street Journal, June 10, 2009.

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