Confronting Monetary Ignorance At The Wall Street Journal

Once in a while, an op-ed will be so offensive in its obtuseness that it raises my hackles. In this case, the offending column was not written by Thomas Friedman, despite his tireless efforts to make sentient readers pop a gasket. 

Today’s column was written by the esteemed George Melloan, the Wall Street Journal’s patriarch of solid conservative thinking, and of the sound dollar, the bedrock of American prosperity. 

Below is what this confused man wrote, and my parenthetic commentary in italics. Note the nature of his lapidary prose: he speaks in unanswerable platitudes, as if there could be no possible disagreement. Melloan is a theologian, not an economist. He exemplifies the Journal’s inexplicable embrace of austerity, deflation and depression.

Deficits, Debt and the Fate of the Dollar

By George Melloan

January 9, 2013

The year-end "fiscal cliff" tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April.

So...bond yields rose because of the cliff deal, and not because of the publication of the FOMC minutes which suggested that QE3 could be ended prematurely? Both events happened simultaneously.

There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation's No. 1 economic problem, massive federal deficits.

Is the #1 problem overspending, or inadequate nominal growth?

The bond-market decline came despite the Federal Reserve's renewed program to gobble up yet more government debt.

So far, the Fed has bought nothing for the past 20 months. The monetary base hasn’t budged since June of 2011.

Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed's manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar.

So far the Fed’s balance sheet has been flat, and the dollar has been rising since mid-2011.

The concerns expressed in the FOMC minutes didn't cheer the bond market either.

So which was it: the cliff deal or the minutes?

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy. Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble.

Right now, the world is happy with exceptionally low interest rates on dollar securities, so we are not in any kind of trouble. We were in trouble back in 1981  when rates were very high, but that was thirty-two years ago.

The only force standing in the way of that now is the Fed's support of bond prices.

The Fed hasn’t started buying bonds. When it does, hopefully bond prices will fall as inflation expectations rise.

But regional Fed presidents are prudently asking how long that can be sustained.

Which is ironic since the Fed’s balance sheet hasn’t grown since June, 2011. There is nothing to sustain.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the "cliff" talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

Wouldn’t faster nominal growth caused by higher inflation also shrink the deficit, and in a less painful fashion? Or is austerity good for its own sake?

The Fed's worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates.

The purpose of QE, if it ever starts, is to raise inflation expectations and, by extension, long-term interest rates. So far the Fed hasn’t been able to do this because its expansionary efforts have lacked scale and credibility. It doesn’t yet have control of interest rates because it hasn’t inflated enough.

That's why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

If bond prices fall, it will signal that the Fed’s reflationary efforts are gaining credibility. This should spur investment and economic activity.


First of all, government borrowing costs will rise, making it even more difficult to control the deficit.

Lower bond prices will affect bondholders, not the Treasury. However, higher inflation will increase government revenue while shrinking the real value of the national debt. Wouldn’t that be a good thing?

Second, the value of the Fed's gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won't take much of a portfolio loss to wipe out the Fed's capital base.

The Fed does not mark to market, so there would be no portfolio loss, just as there has been no portfolio windfall as rates have fallen from 15% to 1.5% over the past thirty years.

Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Central bank solvency is meaningless in a fiat currency economy, since money is a Fed liability which can be costlessly created. If you were to book the Fed’s money monopoly as an intangible, its value would be infinite. The Fed has plenty of independence and has no responsibility for the dollar’s foreign exchange value, only its purchasing power. You may want the Fed to support the dollar, but it has no such mandate.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Which is the whole point of the exercise, except that the Fed isn’t buying enough to move the needle on inflation. Were it to ever start buying up “hundreds of billions of Treasury paper”, you might see the needle start to move.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.

Are asset prices an element of the price level? If so, we experienced pretty horrible deflation during the crash.

Brendan Brown, London-based economist for Mitsubishi UFJ Securities, reminds us that asset inflation is usually followed by asset deflation, and that's no fun, as the events of 2007 and 2008 testified. More seriously, a rise in the price of assets often presages a general rise in the prices of goods and services.

Which is what Bernanke is praying for, so far to no avail.

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Right now, the market is demanding the lowest dollar interest rates since WW2, right across the yield curve.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed's abdication to irresponsible government.

The Fed is trying (unsuccessfully) to create higher inflation so as to increase nominal growth, grow government revenue, reduce the deficit, and shrink the real size of the national debt. Is that an abdication to irresponsible government? Would you prefer zero nominal growth, such as the BoJ and the ECB have been delivering? Would zero growth help balance the budget?

If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on "price gouging" by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

So far the Fed’s policy for the past 20 months has been to talk a lot and do nothing. If it ever takes up QE3 in earnest and starts growing its balance sheet, we will be lucky to see higher inflation and higher nominal growth.

The Fed's dilemma is in fact everyone's dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don't understand one simple fact: In the end, the bond market rules.

We have no stake in the value of the dollar in foreign currency, other than making sure that it doesn’t get so high as to price us out of global markets (which it has). What we do have a stake in, is more rapid growth and higher government revenue. Cutting spending in order to cope with weak growth is a strategy for depression. Take a look at Europe.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism", Simon & Schuster, 2009.