Mankiw Dissects the Belly of the Inflation Beast (but wants to feed it)

Harvard economist Greg Mankiw has an NYT column out, Bernanke and the Beast. The column is fascinating in what it gets right and what it gets wrong. The first part of the column should be engraved in stone. He writes:

Is galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.

Let’s start with first principles. One basic lesson of economics is that prices rise when
the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.

A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.

Those two lessons go a long way toward explaining history’s hyperinflations, like those experienced by Germany in the 1920s or by Zimbabwe recently. Is the United States about to go down this route?

To be sure, we have large budget deficits and ample money growth. The federal
government’s budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago.

The Federal Reserve has also been rapidly creating money. The monetary base — meaning currency plus bank reserves— is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years.

Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t
terribly worried about inflation. What gives?

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.

So far pretty good. Technically, I wouldn't call expansion of the monetary base, expansion of the money supply, it confuses things, since the reserves that are part of the monetary base are not necessarily in the system impacting the economy, but this is just a minor technical problem on use of words.

Second, I note that Mankiw uses a two year period in looking at M2 growth and coming out with 6% annualized rate. This is a curious choice of time period since it masks the more erratic money manipulation of the Fed with its double digit annualized money growth between September 2008 and February 2009, and its switch to a near zero growth from March 2009 to date. That 9-08 to 2-09 money growth is most likely an important factor in fueling the current stock market spike, and the slowdown in money growth is likely to end the climb. So he misses all the key changes in the money supply and how it is likely to impact the stock market and economy, by using the two year growth rate.

From here Mankiw misses another important factor and then turns inflationist Keynesian:

As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.

For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.

What Mankiw completely misses is that the Fed has announced clearly that they are about to wind down their special credit facilities. This means the banks will have to pay down the loans they have outstanding, and it is my contention they will use the excess reserves they are holding to pay down the debt. Thus, the monetary base is going to shrink big time. That's why Mankiw is way off base when he says that, "As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation." The excess reserves aren't going to be there. And he has to be kidding if he thinks the Fed can sell off the junk mortgage backed securities anywhere near what the Fed paid for them.

From here Mankiw goes from bad to worse and simply turns into a Keynesian inflationist:

...a little bit of inflation might not be so bad. Mr. Bernanke and company could decide that letting prices rise and thereby reducing the real cost of borrowing might help stimulate a moribund economy. The trick is getting enough inflation to help the economy recover without losing control of the process. Fine-tuning is hard to do.

This call for inflation probably has something to do with the supposed stickiness of wages, a factor that supposedly keeps them from dropping and clearing the marke.

But if you have unemployment insurance and extensions on unemployment insurance, that has a lot to do with the stickiness. If people are being paid to not work, they will take their sweet time finding another job, viola stickiness. Eliminate the unemployment insurance cushion and they drop their high wage demands pretty fast.

Mankiw may also be calling for inflation to spur the credit markets, but this is simply distorting the economy from its natural direction. Once the Fed stops its "little" inflation, the economy tends to reverse the distortions, sending the economy into recession again. And, the Fed will have to eventually reverse because you can't stay at a "little" inflation. You have to regularly increase the rate to support the manipulated structure, which ultimately brings on the hyperinflation risk.

But that's what Keynesianism is all about, bronco riding money manipulation, and Mankiw clearly wants to go on the ride.

Amazingly, after calling for this "little" inflation, Mankiw then soft pedals the dangers of holding long term bonds:

Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right.

But this being Mankiw, he twists once more to say the exact opposite, to cover himself regardless of what happens

:...because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.

Bottom line, Mankiw may write as though he is concerned about the inflation beast, but he wants to feed the beast for no damn good reason and it will mean that all of us will eventually have to battle inflation again. It is a little ways off, but with mainstream economists in lockstep with the thinking of Mankiw, the inflation beast will be back.