Three Dangerous Myths about Monetary Policy

November 9, 2011

As growth has slowed in the United States and Europe and fears of a return to financial crisis and recession have intensified, policy actions -- especially those of the Federal Reserve -- have come under increasing scrutiny.  Although some of the criticism is justified, some assertions are simply wrong and, if taken seriously, could exacerbate the crisis the world economy and financial markets are now facing, says John H. Makin, a resident scholar at the American Enterprise Institute.

The first argument put forth by critics of the Fed is that by printing money, the Fed is enabling inflation in the near future.

  • However, the rate of inflation over time, beginning with rates before the Lehman collapse, suggests that the Fed's actions have had no such effect.
  • While headline inflation on a year-over-year basis was marked at 6 percent in September of 2008, this figure has fallen to 3.9 percent for the first three quarters of 2011.
  • Furthermore, this drop occurred despite higher food prices (caused by already-recovered developing nations) and higher rent (due to people renting after abandoning mortgages).

Critics of the Fed also assert that the United States should consider a return to the gold standard.  They point out that the market liquidity between American dollars and gold increased international demand for the dollar, thereby enhancing the United States' ability to borrow to finance its external imbalances.  However, it is also worth mentioning that this increased demand from foreign nations to hold dollars in reserve increased inflationary pressure, which directly contributed to the scheme's collapse.  Furthermore, the method of devaluation that has been used several times since the removal of the gold standard has been sufficient to check volatility in the demand for the dollar.

Finally, many blame the Fed's money printing for enabling the expansionary fiscal policy of the executive branch.  However, this would only be the case of if the Fed were producing unwanted money supply, the excess of which allows the government to pursue previously untenable spending levels.  Yet this is not the case, as the rise in M2 money supply has been met by increased demand from consumer households to obtain cash and save it in demand deposit accounts.

Source: John H. Makin, "Three Dangerous Myths about Monetary Policy," American Enterprise Institute, November 2011.

For text:

http://www.aei.org/outlook/101087

 

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