Fighting Inflation While Maintaining Economic Growth
In the second full week of June, the inflation rate hit 8.6 percent, the highest it has been in 40 years; the Federal Reserve announced its biggest interest rate increase in nearly 30 years; and the stock market plunged amid fears that we are headed for an economic recession.
To understand what is going on, one must understand the function of money in the economy and how the Federal Reserve System operates.
When the founding fathers were writing the constitution in 1787, they considered setting up a central bank with the authority to print paper money. But France, which had been our staunchest ally during the Revolutionary War, was going through a monetary crisis in which the government printed paper money until it became worthless. So, they decided to authorize our federal government to mint only coins.
During the Civil War, both the North and the South resorted to printing promissory notes to pay for war materials. These were known as “Greenback” dollars because they were not backed by either silver or gold, just the green ink of the paper upon which they were printed. Many merchants refused to accept the greenbacks, and those who did traded them at a significant discount.
Following the war, Congress decided we needed a national paper currency, so it established a system of national banks with the authority to print paper money redeemable for either silver or gold at the exchange ratio of 15:1. But after the Comstock Lode was discovered in Nevada, the price of silver fell, and people began to buy dollars with silver, then turn around and redeem them for gold, draining all the gold from the U.S. Treasury and nearly bankrupting the government.
Money was a major political issue in the last half of the 19th century as farmers in the western states wanted the currency to be backed by cheap silver, and big businesses in the east wanted it to be backed by gold, which was the international standard. One result was William Jennings Bryant’s famous “Cross of Gold” speech. (Google it.)
In 1913, Congress decided to establish the Federal Reserve System to serve as the nation’s central bank with the authority to print paper money. “The Fed,” as it is known, is an independent government agency. It is not funded by Congress. And while the members of its board of directors must be nominated and approved by Congress, they cannot be removed by Congress or the president. And the government has no oversight of Fed policy making.
Many monetary economists, such as Milton Friedman have been critical of the Fed, and blame it for extending the Great Depression by contracting the money supply. This resulted in deflation, with prices falling as money became scarcer and more valuable.
The result was that people stopped spending money because they believed prices would be lower in the future. Many who lived through the Depression were notorious money hoarders, stuffing it in their mattress, sticking it in holes in their wall, or burying it in their backyard. Consequently, much economic activity ground to a halt.
Following World War II, the U.S. was on the international gold standard, with the dollar redeemable for gold at the rate of $35 per ounce. But we borrowed heavily to finance the Vietnam War, and by 1971 it was clear that the dollar was over-valued. (Today, it costs $1,800 to buy an ounce of gold.) Then in August of 1971, France sent a warship to New York harbor with instructions to bring back all its gold from the New York Federal Reserve Bank. The Fed complied, but the move forced President Nixon to take the U.S. off the gold standard.
The Fed was required by congress to have assets to back up the money it printed, and now the only “safe” asset it could buy was federal bonds. In other words, our currency is now backed by the federal debt.
During the 1970s, the Fed was busy buying off the federal debt and paying for it with new dollars. All these new dollars caused prices to rise, and people began spending their money at a faster rate before prices went up even more. By 1979, the inflation rate reached 13.29 percent, the prime lending rate was 21 percent, and homebuyers were lined up around the block to finance their home at 15 percent. We were on the brink of hyper-inflation when people start looking for an alternative currency.
That changed in 1979 when Paul Volker became chairman of the Fed and made it policy to limit money expansion to 3 percent per year. This caused a brief recession, but it ended inflation and restored economic growth in the long run.
As the Graph A on the opposing page shows, the Fed lowered the interest rate on federal funds to close to zero to combat the 2008 economic recession. This was called “quantitative easing” and was supposed to be temporary. But the Fed continued to keep the rate low because low interest rates were politically popular.
Graph B shows how the Fed continued to pump more money into the economy even after the recession was over because inflation appeared to be under control. Graph C shows a profound decrease in the velocity of money, which how quickly people spend their money.
Recetly, the economy was awash in new stimulus dollars, but people were putting it into the stock market, into crypto-currencies or just leaving in the savings accounts. They weren’t buying goods and services with it. This may have been due to uncertainty caused by the pandemic, disruptions in the global supply chains, or the technological revolution underway in our economy … but they are starting to spend it on goods and services now.
The dilemma the Fed now faces is how to rein in inflation without stifling economic growth. Given all the political turmoil in our nation, it is going to be difficult to keep politics out of the Fed board room.
Comments are closed.