Monetary Mischief and the Debt Trap.

• Author: Heller, Robert

"Monetary mischief" is a situation in which the current stance of monetary policy does not serve the long-term objectives of the nation. In this article, I argue that the Federal Reserve is causing monetary mischief in two ways.

First, the Federal Reserve is mistaken in declaring that 2 percent inflation constitutes price stability. In fact, the cumulative effect of such an inflation rate over time will be very significant and eventually result in a massive erosion of the value of the dollar.

Second, the Fed's long-lasting low interest rate policy, which was implemented through massive purchases of federal debt and mortgage-backed securities, has led the United States toward a "debt trap," in which the debt-to-GDP ratio rises above 100 percent and the interest rate on debt service is greater than the growth rate of GDP. In such a situation, debt service obligations grow more rapidly than the economy; eventually, the accumulated debt can no longer be serviced properly. In other words, the dynamics of the situation become unsustainable and a death spiral ensues.

I short, I believe that the Federal Reserve's policies on inflation and quantitative easing have resulted in severe financial dislocations that will cause future financial and economic instability.

The Fed's Congressional Mandate

It is appropriate to begin any discussion of central bank monetary policy with the mission statement given to the Fed by Congress. According to Section 2A of the Federal Reserve Act, "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

While it is somewhat incongruous that the three congressional mandates of maximum employment, stable prices, and moderate long-term interest rates are usually referred to as the "dual mandate," most observers agree that moderate long-term interest rates generally go hand-in-hand with stable prices. Hence, if the goal of price stability is achieved, it is likely that moderate long-term interest rates will also prevail. Consequently, instead of three separate goals, there are really only two independent ones.

But what about the other two objectives: maximum employment and stable prices? Former Fed chairs Paul Volcker and Alan Greenspan often argued that price stability is a precondition for the attainment of maximum growth and employment. Ben Bernanke (2006) also stated that he agreed with "the modern consensus that price stability, besides being desirable in itself, tends also to increase economic growth and stability." In economists' terms, then, price stability is a necessary condition for full employment and maximum economic growth. Price stability should therefore be the overarching goal of the Federal Reserve in its conduct of monetary policy (see Heller 2016: 266-67).

Does 2 Percent Inflation Constitute Price Stability?

During Alan Greenspan's tenure as chairman, the FOMC had a formal deliberation on the appropriate long-term inflation goal. This discussion took place on July 2, 1996; the inflation rate at that time was about 3 percent, as measured by the year-on-year increase in the consumer price index. Then-Governor Janet Yellen led off the debate by suggesting that the FOMC adopt a 2 percent inflation target (Board of Governors 1996: 45).

During that discussion, Chairman Greenspan defined price stability as "that state in which expected changes in the general price level do not effectively alter business or economic decisions." When pressed by Yellen to put a number on that, he replied: "I would say that number is zero, if inflation is properly measured" (ibid.: 51).

The discussion of the FOMC was wide-ranging, and not all participants clearly specified their preference. But if I read the transcript correctly, one-third of the speakers favored a zero percent inflation target--that is, actual price stability--just like Chairman Greenspan. Another third of the FOMC members favored moving as soon as practicable to a 2 percent inflation target. The remaining third wanted to "cap" inflation at the current level of 3 percent but move to a lower inflation rate over time.

Trying to form a consensus, Chairman Greenspan summarized that "we have all now agreed on 2 percent," leaving open the question of what inflation measure to use: the consumer price index, the personal consumption deflator, the GDP deflator, or possibly some other measure of inflation (ibid.: 63).

After concluding the discussion of the 2 percent inflation target, Greenspan cautioned that

The question really is whether we as an institution can make the unilateral decision to do that ... I think this is a very fundamental question for this society. We can go up to the Hill and testify in favor of it; we can make speeches and proselytize as much as we want. I think the type of choice is so fundamental to a society that in a democratic society we as unelected officials do not have the right to make that decision [ibid.: 67]. By this, Greenspan questioned whether the Federal Reserve actually had the right to take such an action, and wondered what the possible consequences might be.

The following morning, Greenspan praised the FOMC: "The discussion we had yesterday was exceptionally interesting and important" (ibid.:72). But he also admonished the Committee members: "I will tell you if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate" (ibid.). Thus, he expressed his grave concern that even an informal inflation target of 2 percent might raise a few Congressional eyebrows, as it might be seen as not being in full compliance with the mandate for "price stability" as enunciated in the Federal Reserve Act.

Fifteen years later, under Chairman Bernanke, the FOMC announced a formal inflation target of 2 percent. Since then, the FOMC has consistently argued that this 2 percent inflation target conforms with the congressional mandate for price stability.

However, a 2 percent inflation rate means that the price level will double approximately every 35 years. This means that, over a normal lifespan of 70 years, the purchasing power of a dollar will decline to a mere 25 cents. It is highly questionable whether Congress had this in mind when it tasked the Fed with achieving "price stability." Defining 2 percent inflation as price stability may well constitute "monetary mischief" in the eyes of many impartial and fair-minded observers.

Moreover, there is little or no evidence that a 2 percent...