Ride me down easy, Lord

Ride me on down

Leave word in the dust where I lay   

 Billy Joe Shaver

People ask me, "How is he doing?"  How is Ben Bernanke doing as Fed Chairman?  Is he making it up as he goes, making monetary policy by the seat of his pants?

My answers are that he is doing quite well, thank you, after a slow start in the summer. But, from that first cut in the discount  rate through yesterday (Sunday), he has been right on, innovating (seat of the pants innovation) to make up for the fact that the traditional tools of monetary policy aren't well suited for the current crisis in financial markets.

This crisis is unique — literally.  It's a crisis of fear that you won't be repaid for loans you make and fear that your counterparties in large transactions may go belly up, or otherwise stiff you.  There is a massive shift from the absence of meaningful risk premiums to overly large premiums not only on risk but on instruments that hardly seem risky (like Fannie and Freddie-backed securities, for example).

Chairman Bernanke's creation of auctions for money to take away the perceived stigma of using the discount window was right on, as was the decision to liberalize borrowing and collateral terms and requirements.  The quick intervention over this past week-end to assure an orderly resolution of Bear Stearns was handled with excellence.

One issue I've heard no-one mention during this slow-moving train wreck is what the proper relationship between the Fed funds rate and the discount rate is.  During my tenure on the FOMC, the discount rate was at a discount much of the time, which was contrary to conventional wisdom dating back to Walter Bagehot's Lombard Street, which could have been titled as a guide to central banking in times of crisis.

Chairman Greenspan and the Committee looked forward to opportunities to restore the premium to the discount rate.  At the conclusion of that long process the discount rate was essentially pegged one percentage point above the target Fed funds rate.  After about three years of this passive status, the discount rate was largely forgotten by financial talking heads.

The Bernanke Fed was correct to focus first on the discount window and dropping the discount rate by 50 basis points.  Subsequent target reductions in Federal funds included equal reductions in the discount rate, thereby keeping the differential constant at 50 basis points. Sunday's move, in cutting the discount rate another 25 basis points puts the premium at only one quarter of one percent.

I assume that the choice of 25 basis points on Sunday was designed to dovetail with what Chairman Bernanke had in the back of his mind to recommend to the FOMC on Tuesday.  My experience tells me there was no open discussion of what Tuesday's decision should or would be, but the tone of the discussion probably gave all the members a clue as to what the Chairman is likely to recommend.

Not long ago, I thought the FOMC should either do nothing tomorrow or next to nothing.  That is no longer possible, and I now expect another large move.

Originally appeared March 8th in:

When I was president of the Dallas Fed, Alan Greenspan wouldn't let me, or other members of the Federal Open Market Committee (including himself), talk about the dollar. The dollar was so sacred, or so fragile, that only Treasury secretaries were allowed to discuss it — but convention silenced them too.

Treasury secretaries always retreated into ritualistic claims of having a strong dollar policy to maintain a strong economy, although economic theory doesn't necessarily support that causation. Reporters, presumably for sport and amusement, occasionally lured one of them into the dollar-talk trap, so they could then write about his naïveté for going there.

Now I'd like to say something provocative about the dollar. Here goes: While our currency, the dollar, may be sacred to you and me as an institution — it's ours out there competing with theirs on the world playing field — we shouldn't treat any particular dollar exchange rate as sacred.

A strong dollar usually serves us well, but occasionally, and temporarily, a weaker dollar serves us better. Dollar depreciation boosts our exports relative to imports and, right now, is our best hope for avoiding or cushioning a recession.

I prefer a strong dollar for eternity, but right now I feel about the dollar what St. Augustine felt about chastity. To paraphrase his notorious prayer, "Lord, make our dollar strong, but not just yet."

Currency strength is a more arbitrary concept than most people realize. For example, the Canadian dollar recently reached parity with the U.S. dollar. Parity means they trade one for one, dollar for dollar; yet the Canadian dollar is considered strong and ours weak.

Contrary to most talking heads and Treasury secretaries, strong currencies don't guarantee strong economies, or vice versa. Other things equal, a strong domestic economy stimulates import demand and weakens the home currency, as we have to sell more dollars to buy foreign goods.

The prospect of good investment opportunities at home and future currency appreciation, on the other hand, strengthens the currency by attracting foreign capital, which requires dollar purchases by the foreign investors, even if trade remains in deficit. This has been the U.S. pattern in recent years — a combination of large trade deficits and capital inflows.

The Japanese yen, which had been trading above 110 to the dollar, recently strengthened to below 110. That's relative strength, but when I joined the Fed in 1968, the rate was 360 yen to the dollar. Now that's real yen strength for you — from 360 to 110 — and real dollar weakness. But I wonder if the Japanese benefited from their strong yen and we were harmed by our weak dollar. I'm not so sure.

Current focus is on the strong euro relative to the dollar, but who really believes the strong euro is good for Europe under today's circumstances? The euro zone's unemployment rate has declined to a recent low of 7.2% while the U.S. unemployment rate is 4.8%. While inflexible labor markets are mostly to blame, I wonder what role an overly strong euro and overly tight ECB may have played. The strong euro's cheerleaders may soon feel like the dog that caught the car, if they don't already.

While the dollar may be sacred, no single dollar exchange rate should be. Exchange rates are a compromise among legitimate competing interests.

Consumers benefit from the greater purchasing power of a stronger dollar, and we're all consumers. But our interests as producers and workers are more concentrated. Exporters prefer a weak dollar (i.e., they benefit when foreigners can purchase more of our goods with their strong currency) while importers like it strong. We wisely leave it to the market to achieve the necessary compromise, but a compromise it remains.

Any exchange rate will hurt many market participants through no fault of their own, and give an unearned windfall to others. A good, efficient and productive business that has adjusted well to the prevailing exchange rate may suddenly go belly-up thanks to an adverse exchange-rate movement caused by a completely unrelated development on the other side of the planet. More ethanol production in Iowa may increase hunger in Africa.

The price of one currency in terms of another is a different animal from other market prices. The price of bread adjusts until the quantity of bread demanded equals the quantity supplied at that price. The price may turn against the consumer for various reasons, but mostly having to do with the supply and demand for bread. A market-determined exchange rate also adjusts to clear the market for foreign exchange — but that balance is likely to be a balance of imbalances.

Nevertheless, if a cleanly floating rate remains fairly stable for a while, we label it the appropriate or equilibrium rate and make it the baseline from which future movements are judged to represent strength or weakness.

An ideal equilibrium exchange rate might involve balanced trade in goods and services with the rest of the world. But, with independently motivated capital flows in addition to financing capital flows, there is no economic mechanism to produce that result. Equilibrium can just as easily involve large persistent trade deficits matched by large capital inflows (our situation) or large trade surpluses matched by capital outflows.

A trade balance with the rest of the world would still include huge bilateral imbalances with countries (China) or strategic goods (oil) — but the overall balance would halt the rapid accumulation of dollar assets by surplus countries and keep us from falling deeper into debtor-nation status. To reverse the process would require, not a trade balance, but a surplus. And a stronger dollar any time soon would delay or prevent these needed adjustments.

The late economist, Herb Stein, is famous for saying that, if something is inevitable, it will happen. I assume he meant sooner or later, because the large and growing current account deficit has made dollar depreciation inevitable for years now.

Yet that only recently began to happen because strong capital inflows, especially from Europe, supported the dollar and prevented the depreciation needed to increase exports and bring the trade deficit into balance. We weren't fully paying for our imports with exports of goods and services; so we made up the difference by selling bonds and other assets to strong-currency countries like China.

The accumulation of massive dollar reserves in China led to worry that they would diversify those holdings at some point, a diversification that would involve moving the dollar into other currencies, especially the euro — with such a sell-off depressing the dollar and leading to higher U.S. interest rates. Instead, the diversification so far has been from Treasury securities into private-sector dollar assets. To continue the current account deficit is to continue the fire sale of U.S. assets to foreigners.

My preference would be for dollar depreciation to reduce the current account deficit and slow the accumulation of dollar assets abroad. That process has recently begun. Exports of goods and services in December were up $2.2 billion from November while imports were down by the same amount, more than accounting for the annual December to December improvement in the deficit of only $1.5 billion. Hopefully, that reduction in the trade deficit will continue, but chances are the recent appreciation in the dollar from its lows will slow or halt that improvement.

The level of the dollar is important for trade. But for foreign investors, the level of the dollar is not as important as its expected future movement.

They want to get into U.S. assets when the dollar is cheap and get out when the dollar is dear. The more the dollar depreciates, the sooner it will be expected to reverse, and the sooner foreign investors will resume their participation in the most dynamic, creative economy in the world.

A premature strengthening of the dollar would slow needed trade adjustment and neutralize foreign trade as a source of domestic demand as we try to avoid a severe recession. Once again, Lord make our dollar strong, but not just yet.

 

The "Again" in the title above has two meanings.  First, the question is whether we may repeat the stagflation experience of the 1970s.  Will it happen again?  Second, my last blog posting was on stagflation, and, upon reflection, I need to try again.  I think it was correct (economically); but I got carried away by some issues of my student days.  Reminiscing took over, and I abandoned the KISS principle and became pedantic.  My apologies.  Let me do it again here in a more user-friendly manner.  But the serious reader might still do well to read the previous one first and treat this one as a summary review.

My main point is there are major differences between the 1970s and the current decade that make stagflation less likely now:

*The seeds of 1970s inflation were sown in the 1960s with the guns and butter (Vietnam and Great Society) approach of the Johnson Administration.  Inflation growth led to an ill-advised and counter-productive decision by President Nixon in 1971 to impose wage and price controls, which distorted prices and ultimately made matters worse.

*The decision to break the link between the dollar and gold in 1971, may or may not have been a beneficial move for the long run, but it probably did take a lid off suppressed inflation at the time. 

*The Arab oil embargo in 1973 was a supply restriction on a necessary commodity that both "pushed" some prices up, contributing to inflation, and weakened the economy generally because of reduced purchasing power for other goods and services.  This action alone contributed directly to both sides of stagflation, at a time when the U.S. economy was energy inefficient and vulnerable.

*In contrast, today's high oil prices are primarily demand driven, which, while it raises some prices and reduces purchasing power elsewhere, it also generates a different dynamic in the economy.  Think of supply and demand curves.  Given supply, higher demand increases both prices and output.  Lower supply increases prices but restricts output.  Hence, lines at the pumps.

*Another significant difference is in productivity growth, or growth in output per hour worked, which was much lower (by about half) in the 1970s than in the years since the mid-1990s.  Recent higher productivity growth has multiple benefits:  It allows higher wages without higher unit costs.  That means companies can pay higher wages without a profit squeeze, and the Fed has more leeway to "give growth a chance," i.e. allow faster output-income growth without triggering higher inflation.  Productivity growth raises the growth potential of the economy and increases the Fed's "speed limit."

[Footnote to the point above. Chairman Greenspan always emphasized that it wasn't higher productivity that benefited monetary policy, but an increase in the rate of productivity growth.  It had to be accelerating.  His emphasis here and elsewhere on the rate of change tempted me to nickname him "Mr.Second Derivative Man."]

*The Fed contributed its part to higher inflation in the 1970s because of faulty operating procedures.  FOMC members understood that "money is always and everywhere a monetary phenomenon" but they were trying to hit their money targets indirectly by hitting the Fed Funds target consistent with the desired money growth based on the econometric models.  The Fed Funds targets chosen weren't sufficient to slow money growth sufficiently to hold inflation down, as became evident when they changed to direct control of money growth in October 1979.  Another way to look at the error is that they thought the rising interest rates were a sign of monetary restraint when they were as much a sign of very strong underlying demand in the economy.  Presumably the FOMC is better now at distinguishing between the causes of a change in rates — supply or demand.

*With the strong demand and growing inflationary pressures from various sources in the late 1970s, monetary and fiscal restraint tended to raise unemployment more than curb inflation — at least that trade-off was less favorable then than it has been lately.  The major villain in the 1970s was insufficient downward price and wage flexibility, which makes rising unemployment too close a substitute for lower inflation. 

*As I just said, downward price and wage flexibility were relatively lacking in the 1970s:  Major industries had not yet been deregulated, including banking and finance, transportation, etc.  That was before the seminal event of President Reagan's firing of the air-traffic controllers, which shifted the balance of power between labor and management.  Wage increases greater than productivity growth, because of the monopoly power of unions and the government (minimum wage) are similar to an oil supply restriction in that the higher wages add to inflation while attempts to offset them with policy adds to unemployment.  So they got both.

This is my list.  It isn't complete, and I haven't proven all my assertions, but I think it gives some reassurance that stagflation is not necessarily in our near future because of huge differences in the economic environment.  But, then again, I could be wrong.

The Role of Cost-Push Inflation

When I studied economics in the early 1960s, cost-push vs demand-pull inflation were hot topics that became relevant later in helping to explain the 1970' experience with stagflation.  Cost-push inflation is worth reviewing as background to the current questions as to whether stagflation may be returning.  Inflation has risen lately as the economy has weakened; so are we likely to slip back into stagflation?  Based on my understanding of the analysis of cost-push inflation in the 1960s and the unique circumstances of the 1970s, I don't think stagflation is in our future.  

The wage/cost-push question in the 1960s was whether monopoly power exercised by strong unions in pushing wages up beyond productivity growth or by the government doing the same in raising the minimum wage would cause inflation to rise.  Another way the question was put by one of my professors was whether labor unions could raise real wages in the long run.  That professor hired me as his test grader, and he always had a cost-push question on his final exam. 

In coaching me on how to grade answers to that question, he emphasized that a good answer had to contain at least two important elements.  The first was that, for wage-push to be inflationary, wages had to be pushed up by more than the increase in labor productivity.   Otherwise, the higher wages wouldn't raise unit labor cost; rising demand for labor would keep up with the artificial wage.  If out-sized wage increases — say, 10 percent — did push up unit labor costs, the second element of a correct answer had to do with the stance of monetary policy at the time. If monetary policy remained restrictive, the higher unit labor cost would cause employers to cut back on workers and rising unemployment would be the primary result.  Monetary policy had to ease enough to increase the derived demand for labor so that the supply and demand curves for labor would intersect at the higher mandated wage.  If that happened, monetary expansion would validate the higher wages, and, ultimately result in higher prices, or inflation. 

My professor summed all this up in a little poem that I still remember:  

Economists, all or most of us consent

If wage rates rise by 10 percent

It puts the choice before the nation

Of unemployment or inflation.  

Fed Policy in the 1970s  

During the 1960s and 1970s, Milton Friedman convinced most right-thinking economists that inflation was caused by too much money chasing too few goods and that inflation was always and everywhere a monetary phenomenon. Cost-push eventually came to be regarded as a secondary issue since its impact depended on monetary policy. Just keep the money supply growing at a rate comparable to the potential growth rate of the economy, and inflation should not rise.  The Fed could slip up if it took its eye off money growth and started targeting interest rates, or if it took its eye off inflation and started targeting growth or unemployment. It did.

Interest-rate targeting runs the risk of having the Fed inadvertently subordinate monetary policy to fiscal policy, when, for example, a growing budget deficit puts upward pressure on interest rates and triggers Fed ease to keep interest rates from rising.  Similarly, if some monopoly power pushes wages up, the resulting incipient unemployment could cause the Fed to inflate in its effort to maintain full employment.  So, the rule was to focus on money growth rather than interest rates and inflation rather than unemployment.

At about the same time, Milton Friedman convinced most economists that the Philips-curve trade-off between inflation and unemployment was bogus, at least in the long run.  That rationale meant that focusing on inflation and ignoring the adverse impact of inflation-fighting on unemployment was not a cruel policy.  Less inflation didn't necessarily mean more unemployment, at least not for long.

While monetarism grew in theory and in support by monetary economists, it didn't become a formal policy of the Fed until October 1979, when Chairman Volcker called a Saturday meeting of the FOMC and announced that henceforth the FOMC would focus exclusively on money growth and ignore its impact on interest rates.  Prior to that, during the 1970s, the FOMC had recognized the importance of money growth, but their operating procedures involved estimating what short-term interest rates would be consistent with the correct rates of money growth and they would try to hit their money-growth target indirectly by hitting their Fed funds target.  It turned out however that they consistently underestimated the level of interest rates that would be necessary to slow money growth to noninflationary rates. The degree of their underestimate became obvious when rates were turned loose and rose far above expected levels, with some rates over 20 percent for a time.

The shift in procedure to direct money targeting caused Fed watchers to focus as closely on the money supply statistics as they now do on the target Fed Funds rates.  The new monetarist approach to monetary policy gradually faded away in the 1980s as financial innovation and deregulation made difficult the question of the appropriate definition of money and loosened the link between the money supply, however defined, and economic activity.  The more sophisticated economists — especially those from universities that didn't have good football teams — described the problem as the demand for money becoming unpredictable and unstable. Being from a jock school, I described it more simply as an unpredictable or unstable velocity of money. 

In any case, the Fed went back to Fed-funds targeting while glancing only occasionally at the money supply.  It seemed ironic when I served on the FOMC that most members still believed that money matters most and that inflation was ultimately a monetary phenomenon but paid less and less attention to money and rarely talked about it in public or privately for that matter.  Nevertheless, Fed-funds targeting worked out pretty well as inflation declined to the point of causing some concern about possible deflation.  The FOMC hasn't made the same mistake in operating procedures that it made in the 1970s, at least, not yet. 

Special Circumstances in the 1970s

I have focused at length on the issue of cost-push or wage-push inflation and the Fed's faulty operating procedures because I believe both to be important contributors to the stagflation of the 1970s.  The Fed inadvertently contributed to inflation through rapid monetary expansion while sticky wages and costs kept unemployment from falling as inflation later receded.  I believe the relative absence of downward wage flexibility to be a primary cause of stagflation of the 1970s and their greater flexibility today to be the primary reason we will dodge that bullet in coming years.  A huge turning point in that regard was President Reagan's firing of the air traffic controllers in 1981, which accelerated the decline in union monopoly power, i.e. the power to push wages up without increases in productivity.

Another significant difference between now and the 1970s is the difference in productivity growth.  Productivity growth in the 1970s was anemic compared to its growth since the mid 1990s.  In rough, round numbers, it was less that 1.5 percent in the 1970s and close to 3 percent since the mid-1990s. As the new economy period demonstrated, faster productivity growth means that wages can rise faster without exceeding productivity growth, leaving unit labor cost and inflation relatively flat. Rapid productivity growth continued into the 2000s, but has fallen off some in the last couple of years, the surge in the third quarter of 2007 notwithstanding. 

Productivity growth, in addition to depressing unit labor cost despite rising wages, gives the Federal Reserve more leeway to allow high growth rates in the economy without so much concern about inflation.  Some call that higher potential growth rate of the economy a higher speed limit for the Fed to enforce. The FOMC's recent projections out to 2010 implies that they are pessimistic regarding an acceleration of productivity growth.

Another difference in the two decades is all the deregulation that makes our economy more flexible and resilient since the mid-1990s didn't start until the late 1970s. The deregulation of many industries, but particularly banking and finance, has added to flexibility and has made the economy much more resilient.

In contrast to today's resilience, consider the impact of the Arab oil embargo, in October 1973 and its impact on the economy.  Pushing up oil prices by restricting supply has both an inflationary effect on the total economy (depending on monetary policy) and a depressive effect on the non-energy sectors of the economy.  The first oil embargo had a large impact because earlier cheap oil and energy had left the U.S. economy energy inefficient, in contrast to much greater energy efficiency today, which has allowed us to tolerate (so far) current record energy prices.  Another big difference is that today's high energy prices result from booming demand rather than supply restrictions.  You don't get stagflation from demand pull as you might from cost push.

Another major difference (I hope) is that we are unlikely to repeat the mistake President Nixon made in imposing wage and price controls in August 1971, which distorted the price mechanism for a couple of years and caused a misallocation of resources.

Conclusion

To summarize, in 2008 we have greater wage- and price-flexibility than in the 1970s, fewer cost- and wage-push forces, more deregulation, a wizened Fed, more energy efficiency, and, not mentioned earlier, more globalization imposing price and wage discipline.

While inflation has crept up to uncomfortable levels and the real economy slowed in the 4th quarter, I doubt that stagflation in any serious way is in the cards.  Given the differences I've cited above, that's more than just a hope and a hunch.  But it's that too.

Bob spoke with Bloomberg's Tom Keene about the Fed's decision to lower its benchmark interest rate by half a percentage point to 3 percent, the risk of a U.S. recession and the outlook for the credit default swaps market. To listen to the interview, click here.

Today is the 49th anniversary of the day the music died, when a plane crashed in a snow storm killing Buddy Holly, Richie Valens, the Big Bopper, and the pilot. As band member Sonny Curtis later put it, "That'll be the day" came way too soon." Waylon Jennings wasn't on the plane because he "lost" a coin toss, reminding us all that we never really know when news is good or bad. I was a high school junior in 1959, and, of course, I liked Buddy, but those were the days of Elvis, Chuck Berry, Jerry Lee Lewis, and so forth. Elvis was king.

Many years later my appreciation of Buddy grew when I was in London and went to the play, Buddy, which had been running for years.  I wouldn't have thought a play in London could capture the austerity of a small radio station in Lubbock, Texas, but it did.  But, more than that, when the play ended, the reserved British were dancing in the aisles of the theater.  Buddy ballooned in my estimation that night.

Some time later I was going to Lubbock to make a speech, and I asked someone to drive me by the cemetery that contained Buddy's grave.  I had my picture made there, leaving guitar picks as was the custom, and later included that picture in my President's Letter in the Dallas Fed's annual report, alongside a picture of me at Adam Smith's grave in Edinburgh, Scotland.  I thought those two heroes gave me balance.

Gary Bussey played Buddy wonderfully in a pretty good movie.  My favorite scene was when Buddy and the Crickets went to New York to sign a recording contract.  The host offered champagne for the occasion when Buddy said, "Make mine a coke," and one of the others said, "Make mine a Dr. Pepper."  They were Texans all right.  While I liked the movie a lot, it apparently contained some flaws that mattered to some people, like mountains in the background of Lubbock.  To set the record straight, Paul McCartney produced and hosted The Real Buddy Holly Story, a documentary that included great footage and much reminiscing by Buddy's former band members, music producers and others.

You probably already know that the Beatles took their name from the Crickets, but there were more connections than that.  Buddy had the first solid guitar they had seen with a gear shift on the side. He was one of the first performers to write and perform his songs; up until then you had your song writers and your singers.  This inspired the Beatles to write songs as well as perform, according to McCartney.  Buddy was also one of the first performers to wear his glasses while performing — black horn rims, no less.  His example is reported to have given John Lennon the courage to do the same.  There was more, but you get the point.

(Don't worry, I'll get to Greenspan later.)

National Public Radio thought it odd that a Reserve Bank President would put his picture at Buddy Holly's grave in his annual report letter. So, near the end of an interview about the economy, the host brought up the subject and asked if it was true that I had made a pilgrimage to Buddy Holly's grave.  I told him it was true.  He then asked me what Buddy Holly had contributed to the economy.  I told him that Buddy's Rave On would have made a great  anthem for the booming New Economy. That was a taping rather than a live interview.  It ran two days later when, using the marvelous ability NPR has with sound and sound effects, as the interview drew to a close, Rave On, started up softly then reached full crescendo as the program ended.  That was, without doubt, my finest hour.  I had brought Buddy Holly back to radio.

As you might imagine, Alan Greenspan showed some curiosity about the Buddy Holly thing and, in particular, the annual report picture at Buddy's and Adam Smith's grave. So, taking the offensive, I proposed that the Chairman and I co-author an essay about Buddy Holly and Adam Smith, the father of Rock and Roll and the father of Economics. The Chairman graciously declined my offer on the grounds that his taste in music was more like Adam Smith's taste than mine, i.e. J.S. Bach. I wrote back and told him I'd heard of old J.S., but I thought Buddy had more hits.

Rave On!

(But Let's Drop the Fiscal Package)

For the second time in just over a week, I have proposed bold action for the FOMC, not really expecting them to take my advice.  And for the second time in just over a week, they were even bolder than I recommended.  That gave us what I thought we needed, but more than I dared ask for. What's going on here?

My first recommendation for a 50 basis points reduction in the target Fed Funds rate got us 75.  Then, I hoped for another 50, predicted only 25, and we got the 50. I have been conditioned to expect excessive caution.  I guess I need to be reconditioned, or, like the sexy woman in my GPS says when I don't take her advice, "I'm recalculating."

My probability for a recession keeps going from just under 50 percent to just over 50 percent.  I had been encouraged by four consecutive declines in new claims for unemployment insurance, down to 301,000. Then yesterdays new orders for durable goods came in strong. But yesterday's advance estimate for fourth quarter GDP was a disappointing 0.6 percent, although that included significant inventory run down, which will be reversed.

Then jobless claims reported this morning jumped up by 69,000 and last week was revised down slightly. I guess the slowdown has finally softened the labor market.  Still, I don't expect unemployment to go much over 5 percent in January, and a slight reduction wouldn't surprise me.

The large reductions in the target Fed Funds rate finally gave some needed upward slope to the yield curve which is very helpful to banks and other financial intermediaries that borrow short and lend long.  Rate reductions in 1993 gave the yield curve a steep positive slope and finally ended the credit crunch that threatened to linger forever. 

So, what about the fiscal package that just passed the House and is likely to go from bad to worse in the senate? Will it help prevent recession, or hurt?

There may be a very narrow sense in which it will help marginally by adding modestly to total spending. But, when you look at it more broadly and consider longer run consequences, the modest help comes at a high price in terms of increasing the budget deficit, implying higher tax rates down the road. 

The rebates will be borrowed from one group of citizens and given to another group, with no incentive value at all.  The net impact of that, we learned in Money and Banking class, depends primarily on what's happening with monetary policy at the same time.  If monetary policy doesn't ease sufficiently, the borrowing will be from existing money and more spending by the recipients will be offset, or partially offset by reduced spending by others.  You get a bit more expansion, but very little, if you finance with newly created money, but no newly created bank reserves.  To get the maximum bang for the buck, the extra spending should be accompanied by an expansion of both money and bank reserves-a very easy monetary policy.

But, as I said in the previous posting (The San Diego Op Ed), if monetary policy is ideal, the fiscal policy will be redundant.  Why not just go with monetary policy and keep the deficit lower?

Timing is another issue.  We just had a dramatic example of how fast monetary policymakers can act once the make up their mind to.  Fiscal policy takes much longer to put in place and may just add to inflation when it kicks in after recovery has started.

Some of the business portion of the fiscal package contain some incentive to invest and may do some good.  However the good is not so good as to offset the bad of rebates.  Those business incentives should be considered separately and should become a permanent feature of the tax code than a temporary feature.  If we aren't careful we may hurt investment by promising incentives sometime in the near future.

We may or may not avoid a recession, but either way the economy is likely to be sluggish for a while.  Not as sluggish, however, as it would have been without the aggressive monetary action.  We need to monitor monetary policy carefully however, because of the exclusive focus on interest rates.  The fundamental impact of monetary policy, especially on inflation, and on the monetary assistance given to fiscal ease, depend on the growth of the money supply.  Narrow measures of money have been pretty flat lately. Broader measures of money have been growing, but not very fast.

Mr. Bernanke, don't take your eye off money.  Here, as elsewhere, it pays to follow the money.

Bob discusses the Fed's decision to cut rates and the impact it has on the stock market in a radio interview with Small Business Advocate Jim Blasingame. To listen to the interview click here.

 Originally appeared January 20th in:

(ri sesh' en): n. Econ. a period of general economic decline; specifically, a decline in GDP for two or more consecutive quarters

New incentives, not fiscal stimulus, are the best way to bolster a slowing economy

The recession watch has begun. With the second and third quarter real GDP - our most comprehensive measure of economic activity - coming in at at a robust 3.8 and 4.9 percent, respectively, we wouldn't normally be expecting a recession, but these aren't normal times. The steep housing slump is unlikely to reverse any time soon, and the head-spinning financial market turmoil triggered by subprime slime is bound to take its toll. Paper wealth is melting away. The unemployment rate, which had remained remarkably low and was the chief source of hope, surged in December. That light at the end of the tunnel now seems like a fast train to Georgia. Those good mid-year GDP numbers now remind me of the guy who jumped off a tall building and about half-way down said "so far, so good."

Monetary policy was late to the rescue, but it has been catching up with both traditional and new, creative measures to inject liquidity into the financial system. The Fed has cut its target federal funds rate, the rate at which banks borrow from each other. It has also cut its discount rate, the rate at which it lends to banks. It has liberalized loan terms and collateral requirements for those loans. And, finally, the Fed has literally been auctioning money to banks. It has eased policy substantially, but more ease is needed, sooner rather than later. Once the Federal Open Market Committee, the policy-making arm of the Fed, decides that a substantial move is warranted, I see little reason to wait for the next scheduled meeting at the end of January. Ben, use your speed dial.

One problem is that the Fed's policy tools aren't very well suited to the current crisis in financial markets. If the problem was a shortage of liquidity, it would be solved by now. The bigger problem is that lenders are afraid they won't be repaid, and the interest rate they won't be repaid at makes little difference to them. They worry about what land mines - read that subprime mortgages in mortgage-backed securities - are hidden in counterparties' balance sheets. This crisis is unique, but Fed actions, past and future, should help limit the collateral damage to the overall economy and ease the severity of the impending slowdown, whether it reaches recession proportions or not. Monetary policy is powerful medicine, and a little like sipping vodka: you don't feel it, then you are on the floor. But with monetary policy, as with vodka, memories are short.

With monetary policy not getting the job done, many are calling for fiscal stimulus - more government spending or lower taxes. But while fiscal measures to stimulate the economy are tempting, it's a temptation that should be resisted for several reasons.

First, is timing. By the time it is formulated, passed by Congress, and implemented, the fiscal measure may be the opposite of what is then needed. Second, fiscal policy doesn't work without the appropriate accompanying monetary policy, but if monetary policy is appropriate - meaning more aggressive - then it is probably sufficient without a fiscal component. Fiscal ease, or an increased budget deficit, without appropriate monetary expansion puts upward pressure on interest rates and crowds out private-sector borrowing and spending. We'd just end up substituting government spending for private-sector spending, not a good recipe for growth and prosperity.

Politicians say we should put money in the hands of middle-and low-income people because they are more likely to spend it that those with higher incomes. More redistribution may or may not be desirable for social reasons, but the idea rich folks don't spend their money is ridiculous. Their saving goes into a financial intermediary or financial instruments that provide funds for investment. Taking it to the bank rather than the store is just the first step. The rich generally don't put their money in mattresses.

Old-fashioned stimulus through more net government spending is a poor substitute for supply-side fiscal measures that increase incentives to work and produce. The most important and most effective fiscal measures for now and for the future would be to remove the threat of higher marginal tax rates on both labor and capital that would result from the expiration of the Bush tax-rate cuts. Those reductions should be made permanent as soon as possible, and even augmented, especially the taxes on capital gains and dividends.

Lower tax rates on capital is about as close to a free lunch as it gets. The lower rates, by stimulating more activity, almost always generate more tax revenue. Close behind making the Bush tax cuts permanent in importance would be to reduce significantly the corporate income tax, which is currently internationally noncompetitive, and eliminate the death tax, which dilutes and distorts incentives of small businesses to maximize output and employment. Tax credits for new investment, or the expensing of investment rather than depreciating it, should also be considered. For the longer run, of course, fundamental tax reform is needed - either a low flat income tax or a tax on consumption rather than income.

Professors at universities that don't have good football teams dismiss supply-side tax-rate cuts as ineffective voodoo. That myth stems partly from the fact that the Reagan tax cuts were overhyped and overpromised. Tax revenue didn't rise enough to overcome higher defense spending, but not working as hyped is different from not working. There are levels of tax rates on the Laffer Curve, which depicts tax rates and corresponding tax revenue, where lower tax rates would completely pay for themselves with more revenue, levels where they would lower revenue and levels where they would substantially but not completely pay for themselves.

We are probably in that third category where lower marginal tax rates would substantially, but not completely, pay for themselves. That's good enough for me. It may not be the proverbial free lunch, but it would be an awfully cheap lunch. If supply side marginal tax-rate cuts were good enough for John Kennedy and Ronald Reagan, I don't see why Congress can't get it together.

A new element has complicated the quest for policies to stave off recession - the weakening of an already weak dollar in terms of other major currencies.

The dollar is an important factor in the results of any policy action, and a strong dollar over time is a major positive for the U.S. economy. But, while I favor a strong dollar generally, this is not the time to give up the stimulative effects of the weak dollar. To paraphrase a famous prayer, "Lord give us a strong dollar - but not just yet!" The stimulus to exports and restraint on imports caused by the currently weak dollar is needed to offset housing and other weak sectors of the economy. The current level of the dollar should help our international trade balance for some time to come. For international capital flows, the expected direction of the dollar is more important than its current level; so, soon, if not already, expectations will turn and the dollar will climb back to its rightful place in the sun. We want that. But not just yet!

The bottom line on fiscal stimulus to stave off or ameliorate a recession is this: None is needed for that purpose that wouldn't be good policy under more normal circumstances. Low marginal tax rates on income, capital gains and dividends are always good policy and largely pay for themselves by stimulating economic activity. They need to be lower, but the first urgent priority is to avoid making them higher by letting the Bush tax cuts expire and to make that clear as soon as possible to end the uncertainty.

Corporate tax rates should be lowered at least to the level of those of our trading partners and lower still if we can get our minds around the fact that corporations don't pay taxes, people do. Death taxes are the final insult, coming at an awkward time and on top of all the taxes already paid over the years as income was earned and assets were accumulated. How many more family businesses must be sold or broken up to pay the tax?

Eastern European countries are way ahead of us in fundamental tax reform as they implement flat, low income taxes. Do we have to sink to their previous levels before we have the courage to implement fundamental reform? When will we learn that what is taxed is destroyed; so taxes on consumption that exempt saving is key to continued dynamic income expansion. We don't need election-inspired makeshift rebate goodies from Washington under the guise of economic stimulus. We need to get real with fundamental reform worthy of this great nation.

In honor of Martin Luther King and in observance Martin Luther King Day, I'm reprinting below a speech I gave on MLK two years ago when I was Chancellor of the Texas A&M University System. It and other old speeches and articles may found on my personal web site http://www.bobmcteer.com/.

                                                                                  Bob McTeer

Martin Luther King

January 16, 2006
Sulphur Springs, Texas

It's an honor to be invited to talk about Martin Luther King on Martin Luther King Day. But, frankly, I don't know why you invited me, of all people. But I accepted your invitation because it is an honor. And it just seemed like the right thing to do.

I greatly admired Martin Luther King, especially in the early years of the civil rights movement, but I've never mentioned that publicly. My invitation must be based on the fact that Dr. McFarland was a previous speaker and did a good job. So, if the president of A&M-Commerce did a good job, then maybe the chancellor would too.

Maybe, but that logic is suspect since university presidents are probably more scholarly than chancellors. That's certainly true in this case. You may not know what a chancellor's job is. I didn't until Mark Yudof, the chancellor of the University of Texas System, explained it to me. He said being chancellor is like managing a cemetery: There are lots of people under you, but most of them aren't listening.

I admired Dr. King, both the man and his work. But I never marched with him, or against him. I was on his side: for desegregation, for an end to discrimination based on race, and for equal rights. I was against separate public bathrooms, separate water fountains, and separate and unequal schools-the most visible signs of discrimination at the time.

I was a supporter, but I watched the civil rights movement on television, as a spectator.

There were no marches or sit-ins in my little town in the foothills of north Georgia. This part of the state had never been plantation country, so we didn't have rich whites and poor blacks. In my little town of Ranger, we only had poor whites. And no blacks at all.

I attended grade school-it was called grammar school back then-in a three-room schoolhouse in Ranger, Georgia, population about 100, maybe a few more. As I said, there were no black families in Ranger. I went to high school five miles south in Fairmount, which, I believe, had three black families. I remember that because my school bus passed their houses on the way to school. I don't know if they had school-aged kids, but, if they did, they went to the black school in the county seat of Calhoun, 18 miles to the west. Both my grade school and my high school got consolidated away, so now everyone travels 20 miles to Calhoun's consolidated and integrated Calhoun schools.  

I just used the term "blacks" and "black families." I trust that's not offensive to anyone. Back then the proper term-and the term Dr. King used-was "negroes." Today it's "African American." Since this is an historical account, I'm using the term that emerged during the civil rights movement.

Martin Luther King Jr. was born in Atlanta, about 75 miles south of Ranger, on this day in 1929-77 years ago. He attended Morehouse College in Atlanta and studied theology at Boston University. Like his father and grandfather before him, he became a Baptist preacher.

On December 1, 1955, Rosa Parks-who died last October at age 92-refused to give up her seat on a Montgomery, Alabama, bus to whites. (For perspective, this was just over a year after Brown vs. the Board of Education.) 26-year-old Martin Luther King, a local pastor and member of the Montgomery Improvement Association, was drawn into the ensuing bus boycott and, as they say, the rest is history. I was barely 13 at the time, and had been baptized as a Baptist four months earlier in a muddy creek behind Liberty Church outside Ranger. A deep-water Baptist!

I mention my Baptist credentials so I can tell a Baptist joke, hopefully, without getting into trouble:

They say being Baptist doesn't keep you from sinning; it just keeps you from enjoying it. That's why you can probably classify me now as a backsliding Baptist.

On occasion, one might have classified MLK the same way, but that doesn't take away from the greatness of the man, in my opinion. If we set the bar for our role models and heroes too high, I'm afraid we won't have any. You don't have to be perfect to be great.

In an interview years later, they asked Rosa Parks if she kept her seat on the bus because she was tired. She said no, she was just tired of giving in.

MLK emerged from the successful Montgomery bus boycott, which lasted over a year, as a civil rights leader.

He became the founding president of the Southern Christian Leadership Conference (SCLC) in 1957.

His belief in nonviolent tactics was based in part on Gandhi's teaching, and a trip to India in 1959 strengthened that commitment.

He didn't initiate or lead the sit-in movement (at lunch counters and the like), but he got drawn into it by activists in SNCC, the Student Nonviolent Coordinating Committee.

He was arrested in October 1960, during an Atlanta sit-in, just before the presidential election. John Kennedy called King's wife, Coretta, to express his concern. This attention reportedly helped get King released, and probably helped Kennedy get elected president.

By then, I was a freshman at the University of Georgia and voted for Kennedy in that, my first election-partly because he seemed stronger on civil rights and partly because my Dad had always voted for the Democrat, whoever he was, because, in his words, "Democrats are for the little man." My Dad dropped out of school in the seventh grade to work in the sawmill. He always considered himself a little man. He was a very smart man who was borderline illiterate, and I'm here today because of him.

(But I still don't think it was smart for him to allow his vote to become automatic-to be taken for granted. Especially if it's based on the slogan of a past era.)

That January-on January 9, 1961-the University of Georgia was integrated by two black students: Hamilton Holmes and Charlayne Hunter. He later became a doctor in Atlanta, and she made it big in journalism as Charlayne Hunter-Gault on The NewsHour with Jim Lehrer.

Hamilton Holmes registered for the psychology class I was taking. As I recall, he sat apart from the other students, and they (that is, we) pretty much ignored him. I wish I could report to you that I went out of my way to make him welcome, but honestly, I felt like I was just barely hanging on myself as a freshman from a tiny rural town in a big university. I didn't do anything ugly. I just didn't do anything, and I was typical. If I was feeling overwhelmed, think how he must have felt.

Looking ahead two years, I sat next to Harold Black in an international trade class. Harold told me he had been the third black student at UGA, and we became classroom friends of sorts.

I stayed at Georgia and got a Ph.D. in economics. He left and got his Ph.D. in economics from Ohio State. He'd told me he'd been subjected to some minor harassment early in his freshman year-people banging on his dorm room door and so on-but it was not too bad. What I admire most about Harold is that he says he has fond memories of his Georgia days and he doesn't hold a grudge. I believe he sent his daughter to Georgia.

[As a footnote, so did Hamilton Holmes, who graduated Phi Beta Kappa, went on to Medical School at Emory in Atlanta, and latter became an ardent UGA supporter. He died in 1995 at age 54. Georgia named a professorship after him in 1999 and named the academic building after him and Charlayne Hunter in 2001, on the 40th anniversary of their arrival.]

Back to Harold Black. At one point, I thought I'd probably lost his friendship when he asked me to sign a petition to bar the ROTC from campus. I declined to do so, but he didn't take it personally. Following several important positions in government, Harold has been in recent years a professor of finance at the University of Tennessee, another one of those schools that wear those awful orange-colored football jerseys. In preparing these remarks, I googled Harold and his picture indicated that he has lost more of his hair than I have.

Harold's asking me to sign the ROTC petition created quite a moral dilemma for me. I wanted to support him as a friend, and, frankly, as a black student in a white school. But I didn't see the connection with ROTC, one way or another. Later on, of course, Martin Luther King presented the country with the same dilemma by bringing Vietnam into the Civil Rights Movement. More about that later.

Charlayne Hunter had a rougher start at the University of Georgia. One night during her first or second week, Georgia lost a basketball game, and as the upset fans piled out of the arena, someone yelled out, "Let's go to Center Myers"-which was her dormitory. A crowd of students and locals gathered there, threw some rocks, broke some windows and made news acting like the redneck idiots they were. My roommate and I were in our room, listening to it on my portable radio. He wanted to go over there and watch-just watch, he promised. I wouldn't go. So he called me a bad name that you can imagine.

After the first couple of weeks, I don't recall much fuss about race or desegregation on the Georgia campus. I graduated in 1963-the year James Meredith entered the University of Mississippi with the help of 5000 federal troops-and won a fellowship to stay at Georgia for graduate school.

When my fellowship ran out in 1966, I became a full-time instructor for two years and didn't leave Georgia until August 1968, about four months after King's assassination at age 39. So his remarkable civil rights career began when I was roughly 13 and ended just before I was 26. Where I was and what I was doing are, of course, not important, but it helps me keep track.

As a civil rights leader, Dr. King had his failures as well as his successes. Through it all, he adhered to a nonviolent approach, despite the urgings of more militant leaders like Malcolm X and Stokely Carmichael. He achieved a great victory in Birmingham in 1963 when his organization, the SCLC, orchestrated a series of clashes with the police. Remember Bull Connor? The use of police dogs and fire hoses on peaceful protestors attracted much media attention and national sympathy and prompted President Kennedy to introduce major civil rights legislation in June 1963. Kennedy was assassinated that November, and it was left to Lyndon Johnson to get the legislation through Congress the following year.

King's most famous and most-quoted writing was his letter from the Birmingham jail in 1963, in which he defended the use of civil disobedience to unjust laws.

His most famous speech also came in 1963-his "I Have a Dream" speech, following the march on Washington.  

Time magazine, fittingly, named him "Man of the Year" for 1963.

1964 wasn't a bad year either: He became the youngest person to win the Nobel Peace Prize, at age 35.

Voting rights protests and the march from Selma to Montgomery, Alabama, came in 1965. That August, President Johnson signed the Voting Rights Act.

King took a major turn in 1966, moving into a Chicago ghetto and launching a campaign against poverty.

He also became increasingly vocal against U.S. involvement in Vietnam and delivered a strong antiwar speech at Riverside Church in New York on April 4, 1967.

His antiwar stance attracted more attention from J. Edgar Hoover's FBI, which used bugs and wiretaps to find something damaging.

Dr. King became involved in a Memphis sanitation workers' strike in April 1968. On the evening of April 3, he made the following familiar comments regarding his optimism for the future despite the obstacles that lay ahead.

He said . . .

". . . it really doesn't matter with me now, because I've been to the mountaintop . . . and I've seen the Promised Land. . . .

I may not get there with you. But I want you to know tonight, that we, as a people, will get to the Promised Land."

He was murdered the next day, on April 4, 1968, as he stood on the second-floor balcony of his room at the Lorraine Motel in Memphis, Tennessee.

He was only 39 years old.

Martin Luther King Day was first celebrated in 1986.

So far I've been summarizing facts that many of you remember, at least vaguely.

It goes without saying that I was, and still am, a great admirer of Martin Luther King.

He was a great man, a great leader, a great orator-right up there with Winston Churchill.

When I taught a weekend mini-course on public speaking at Johns Hopkins University in the 1980s, I assigned his speeches because I considered them some of the most eloquent ever written.

Earlier I said I admired Martin Luther King, especially in the early years of the civil rights movement.

What I meant by that qualification was that in the early years, he was trying to right clear wrongs, to end racial discrimination and demeaning treatment, and promote equal opportunity and respect for all.

His philosophy was to turn the other cheek, despite attacks by thugs with badges and their dogs.

He avoided returning violence that would likely have caused many more casualties and polarized the nation rather than won its support, as he did.

His message was accepted not only because it was right, but also because it was pure and unencumbered by extraneous issues. He fought clear and plain evil in those early years.

I personally thought it was a mistake for him to mix his messages in his later years and put our Vietnam efforts and fighting poverty on the same plane with ending racial discrimination.

Many others and I believed at the time that our cause was noble in Vietnam-that what we were trying to do was right, even if we weren't doing it very well. I think King's position on Vietnam muddied his message on civil rights.

Public opinion on Vietnam after all these years has moved in King's direction. History will probably declare him right on the war, but I still think our cause was noble and that millions of people would have been better off had we won. But in the context of tonight, I just want to offer the opinion that Vietnam diluted King's main message, which was a purer and more righteous message.

Similarly, I also thought it was a mistake for him to take on some of the economic issues that he made part of his movement.

Make no mistake about it: We are all against poverty and unemployment, which were especially severe among his people, and still are to a lesser extent. His goals were and are shared by all people of goodwill.

The problem comes not with the goals of ending poverty and unemployment but with the means of doing so-with the economics.

Good people disagree on that-especially economists, even good economists.

You've all heard the economist jokes.

One is that if you laid all the economists end to end they would never reach a conclusion

My point here is that those who care the most don't necessarily have the best answers. Some well-intentioned remedies end up doing more harm than good.

I would even define economics as the study of unintended consequences.

President Kennedy's assassination left it to President Johnson to get most of the civil rights program through Congress.

Having been Senate majority leader, Johnson was good at that, perhaps too good.

The Civil Rights Act was needed. The Voting Rights Act was needed.

My Dad, in his Truck Stop, needed the Civil Rights Act as an excuse to do the right thing.

But laws have their limits.

You can't eliminate poverty by making it illegal, and you can't achieve prosperity by voting for it.  

Attempts to do so generally run afoul of the law of unintended consequences.

Economists generally agree, for example, that legislating higher minimum wages can raise wages for a few while contributing to the unemployment of many.

Getting the incentives right can create a needed safety net for the poor. But getting the incentives wrong can lead to welfare dependency for generations of the poor.

I don't mean to turn this into a polemic on economics.

My point is simply that the drive for freedom and the end to discrimination is probably more successful if it doesn't become part of a larger ideology with unrelated features that weaken the total message.

I don't know what Martin Luther King would say about some of the major issues of today.

But because he was a very intelligent man, I believe his thinking would have evolved with the times, with changing facts and circumstances, and with our better understanding of economic issues.

If he were here today, I think he would say the job is not finished, that more needs to be done.

But I think he would also recognize the enormous progress that has been made.

I think he would caution his people against thinking of themselves as victims-even though they have been victims-and urge them to take responsibility for their progress and prosperity.

It takes time. Usually generations.

I'm relatively prosperous. I have a good job.

But I can't take much of credit for that. Most of the credit goes to my Dad, the seventh grade dropout who quit school to work at the sawmill.

From the time I can remember, he told me I had to go to college so I wouldn't have to work as hard as he did.

I assumed I had no choice in the matter.

He saved enough money to start a gas station and saved enough there to build a truck stop, which is where I grew up-raised by my folks and long-haired waitresses.

The truck stop was successful enough to send me to college before Interstate 95 bypassed it and drained off its business.

We are all poor until someone steps up and, with sheer will, decides to break the cycle of poverty.

Government safety nets are needed to catch us if we fall, but we can't depend on them to help us soar.

That depends on us, with the help of our family and friends.

Martin Luther King was a great man. A great leader.

He gave his people freedom and dignity and a more level playing field.

He gave his people a beginning toward the good life.

I'm not sure what a 77-year-old Martin Luther King would say if he were here tonight.

But with more eloquence than I could ever muster, I think he would say something like the following to his people:

Don't forget the past, but don't dwell on it.

Continue to seek justice, but look inward and to God for the strength to move onward and upward.

Don't use the past as an excuse for failure in the future.

Use the past as an incentive to break the cycle of poverty through education, dedication and hard work.

Take responsibility for your own progress and success.

What I will leave you with tonight is that I hope we in the Texas A&M University System can help in the noble quest.

We have nine universities-not as many flavors as Baskin- Robbins, but enough to meet diverse needs.

The closest is Texas A&M Commerce, but they are all in Texas.

We have Texas covered.

We are proud that a high percentage of our students are first-generation college students, just as I was.

We want to help.

I can't think of a better way to celebrate Martin Luther King's birthday than to be here with you tonight.