Where is Milton Friedman when we need him? It is too bad he died nine months before we once again really need his insight.
The Federal Open Market Committee, the Federal Reserve’s policy-making body that meets Tuesday, knows what Friedman would say. The media and the general public don’t, so the national discussions about economic policy are full of misunderstandings.
Friedman argued that if you increase the money supply faster than the economy grows, inflation eventually results. Moreover, inflation is a tax, just as surely as the personal income tax is. But it is hidden. Most people don’t even realize they are paying it. They know only that the cost of living has gone up. They don’t understand why.
Reportedly, we face a financial crisis right now. The immediate cause is home mortgages that cannot be repaid. Mortgage defaults may bankrupt originators like Countrywide Financial or various investment funds that bought packages of these mortgages. Fear of making bad investments threatens capital markets. Businesses and households suddenly find it hard to borrow. The stock market may drop. The economy may slow. Unemployment may rise.
If you watch TV or read newspapers, you soon learn all these problems can be solved if the Fed just increases the money supply. Nobody phrases it that way. Instead, we are told the Fed should lower interest rates. But it is the same thing.
The Fed can lower interest rates only by increasing the money supply faster than it otherwise would.
Here, Milton Friedman would warn that increasing the money supply too fast foments inflation.
Inflation does not seem high. A little bit more inflation can’t be all that serious, if it means keeping companies from going broke, the stock market from dropping and people from getting laid off. At least that is what people seem to assume.
Inflation risk is not benign. Gross domestic product, the value of all goods and service produced in a year, is nearly $14 trillion. Direct consumption of goods, as opposed to government spending or business investment, makes up $9.6 trillion.
If we have 3 percent inflation rather than 2.5 percent because the Fed boosts the money supply to ease a credit crunch, the effective tax increase will be $48 billion. Nobody will write out a check to the IRS, but the effect will be the same.
If a presidential candidate of any party proposed increasing taxes by $48 billion to clean up mortgage market problems, the other candidates would hoot him or her out of the running.
Yet, these same candidates piously support the Fed doing something that may have exactly the same effect. If only we could channel Dr. Friedman back from the grave to educate them.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.