Laffer Is Not Laughing at the Inflation Threat

Arthur Laffer hits some good points in his op-ed today at WSJ.

However, for my taste, he focuses too much on the monetary base and M1 money supply versus M2 money supply. It's M2 that drives the economy.

The monetary base is only important to the degree it results in growth in M2. M2 has been growing, at times since September of '08 in excess of 15% annualized, which is severe. But, Laffer has a chart showing the more than 100% increase in monetary base, which if it resulted in similar M2 growth would be phenomenal, but it has not. Laffer says:

The expansion of money, given an increase in the monetary base, is inevitable..

As I have explained to my private clients, the monetary base is like a bunch of unfertiled eggs. Counting the number of unfertilized eggs in the world is not going to tell me how many mouths I have to feed. Tell me how many eggs have been fertilized and I will tell you how many new mouths will have to be fed in 9 months.

It's the same thing with money watching. Don't tell me what the monetary base is, tell me how much the increase in monetary base has resulted in growth in M2, and I will tell you in a general way how severe the price inflation will be down the road.

A further point, Laffer discusses the need for the Fed to increase debt to drain funds from the monetary base:

I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds.

The Fed has indicated that they intend to control money growth by controlling interest rates on reserves, rather than by raising funds and draining reserves. Thus that trillion dollar over hang no longer exists.