Last week Janet Yellen  testified before Congress, and said basically much of the same things she has  said before. The one new thing she said that I stood up and took note of was  her passionate defense of the importance of fighting  progressive inflation such as we experienced during the 70's. All The  members of the Fed she said, have a complete understanding of the dangers  of allowing the inflation genie out of the bottle; and that the heroic efforts  of Paul Volker to contain runaway inflation in the 1980’s was an exercise that  none of them ever want to have to confront again.

I believe her. As a  matter a fact I also believed Alan Greenspan and Ben Bernanke when they said  the same thing. And since Volker, inflation has fallen from 14% to .07 last  year, the lowest rate since WWII. Of course prices have still gone up because  inflation has gone up every year, so it's just a matter of degree of price  increases. I am on the record as of the first of the year with my “Looking  Forward” article predicting that would change this year and that inflation  would turn up again with gold leading the way.

We are not yet in  the position, as much as many would like us to, to intentionally foster or allow years of deflation as a matter of  monetary policy. The Fed can not take a "hands off" stance. Japan did that. It didn't work out well for them. A monetary  policy that intentionally allows prices to deflate in the middle of a process  of de-leveraging is like adding gasoline to a burning fire. The Fed’s actions  during the Great Depression is testimony to that. Yellen’s statement indicates  that the Fed will neither make the mistake of deflating as they did during the  deflationary depression of the 30’s, or inflate as they did during the  inflationary years of the 60’s and 70’s.

The best the Fed can do  under present circumstances is to foster a little inflation, but not  progressive inflation. They pursued a progressively inflationary policy in the  70's, and increased the money supply and credit allowing the inflation rate  to rise yearly from 2% to 14%. This nearly destroyed the economy of the  United States. It took a contraction of the rate of increase in the money supply,  and 21% interest rates which led to a severe two year recession to save the  dollar and stabilize the situation. But that was then and this now and  there is no comparison between the two eras.

It irritates me to no  end when Libertarians and Conservatives draw on the theories of Ludwig von  Mises and Milton Friedman, two great economists, to denounce the Fed  from Greenspan to Yellen for inflating even as inflation has fallen  for over three decades. Let me say that there is nothing wrong with the  monetary theories of von Misses and Friedman; what's wrong is how many free  market advocates interpret those theories in today's world.  Before you  click off this article in total disagreement, read this from Milton Friedman:

Over the course of a long friendship, Alan Greenspan and I have  generally found ourselves in accord on monetary theory and policy, with one  major exception. I have long favored the use of strict rules to control the  amount of money created. Alan says I am wrong and that discretion is  preferable, indeed essential. Now that his 18-year stint as chairman of the Fed  is finished, I must confess that his performance has persuaded me that he is right—in  his own case. His performance has indeed been remarkable…There is no other  period of comparable length in which the Federal Reserve System has performed  so well…

Inflation averaged 3.7% per year from the end of World War II to the  Volker era, but only 2.4% per year during the Greenspan era. Even more  important, inflation was much less variable. ... Greater price stability had  far-reaching effects. By greatly reducing the uncertainties, enterprises could  use their resources more efficiently and steadily. Price stability fostered  innovation and supported a high level of productivity. ...

…It has long been an open question whether central banks have the  technical ability to maintain stable prices. Their repeated failures to do so  suggested that they did not -- whence, in part, my preference for rigid rules.  Alan Greenspan's great achievement is to have demonstrated that it is possible  to maintain stable prices. He has set a standard. Other central banks around  the world, whether independently or by following his example, are following  suit. The timeworn excuses for central bank failure to stem inflation will no  longer do. They will have to put up or shut up. -Milton Friedman WSJ essay  Jan 31, 2006

Let me add that since  that article was written, inflation continued to fall to nearly zero. Yet  throughout the years it is the Fed that has been the main target and alleged  villain of the Right.

Von Misses lived in the  days of a gold standard, in one form or another, and his theories endeavored to  improve that particular monetary system and deter us from imposing a total fiat  standard. Friedman lived in the days of a fiat standard and advocated a  monetary theory that was designed to control an out of control Fed. He  advocated a controlled, rule-based fiat standard under free market  capitalism. Both economists were right in their particular time and context but  I am sure, after being a life-long student of both, that neither economist  would apply their theories, valid as they were, to today's economic landscape. Today’s  problems are distinctly different than those of the past.

Today deflation is the  major threat. We have most Americans reducing debt, consuming less, and rarely  using credit. There is no artificial or excessive credit expansion such as the  20’s or the 70’s. Money supply is dormant. The velocity of money is  non-existent. You can't get a loan on a home unless you are very well off and  your credit is perfect; and while the Fed has pumped trillions into the banking  system and mortgage markets the money lays dormant neither being used for  business expansion nor for consumer consumption. We have a broken credit  system. We certainly do not have easy money except what the government doles  out and the Federal Reserve is not in control of the Federal or the States  budgets.

Think about it, as the  Federal government runs fiscally out of control, running up the highest  deficits, national debt, and unfunded liabilities in history, hurdling us  toward bankruptcy, the Fed gets the blame as inflation falls to almost zero  last year.

The daily bashing of the  Fed alleges we are inflating and distorting the economy and that mal-investment  is being caused by the Fed which is feeding the banking system, causing bubbles  everywhere. They blame the Fed for the high stock market, the low interest  rates, and an inflation that will ravish this country, yet never comes. They  are wrong. Today it is the absence of  credit expansion and investment that is the problem. Those insisting that because  of the Fed, we will endure terrible consequences in the future are propagating  theories tied to nothing.

The classical theories  of money and economics are still as true today as they ever were, but few  understand the application of such theories in today's unique context. It makes  no sense to predict runaway inflation in an economy that is seeing money supply  stagnant, credit expansion tepid, and velocity of money flat on its back. The  failure to think outside of the box, has led to very smart people being  continuously wrong in their evaluations year after year. The shame is that they  refuse to adjust their thinking regardless of the facts all around them. This  is not the 1920’s or the 1970’s.

The increase in excess reserves is not equivalent  to an increase in money supply. 

Money supply is lower  today in terms of percentage increase than before the excess reserves were  created. M2 fell from over 10% increases at the beginning of QE to under 5%  last year and stands at this writing at 6.45%. There is no statistical evidence  that the trillions of dollars supplied by the Fed have progressively increased  the nation’s money supply. And I might add that at the push of button, that  money held as excess reserves, can be withdrawn instantly from the banking  system, if the Fed chose to do so. There is no imminent inflationary threat.

The allegation that the  Fed is dramatically affecting interest rates is also overstated. It flies in  the face of the low interest rates in the euro-zone which has not yet even embarked  on QE. If the Fed’s QE is responsible for our low interest rates, why are  interest rates in Germany lower than US rates? Germany who has a tight monetary policy and a money supply  that has been contracting lately has  interest rates across the board that is substantially lower than ours.

The two nation’s  interest rates have one thing in common – a low inflation rate. (Do you think  maybe they’re connected?) The rate of inflation is the major component of interest rates. Yet, most  free market advocates insist that the Fed is artificially holding down interest  rates and distorting the economy. There is no empirical evidence to support  this; only theory that is contradicted by the facts. It should not be surprising that as inflation fell over the last couple of years, so have interest rates.

If the Fed allowed  interest rates to float, something I advocate, it is very possible that rates would stay low, just as they are in Germany and for the same reasons. Look what happened to the Yuan  which went down as soon as the  Chinese government let its grip on its currency loosen, instead of up as so many free-market economists  predicted. What was their reaction to this contradiction in their expectations  and theories? Blank-out.

Economics and monetary  theory is not religion. You don't apply blind faith to theory or the economy. You  apply logic. You have to think your way through what is happening based on  evidence and analytical reasoning. This is not being done today by many of our  best and brightest, and it is an embarrassment to free market economics and  great economists like Ludwig von Mises and Milton Friedman.

We are teeter-tottering  between the forces of deflation and recession on the one hand, and growth and  inflation on the other and have been for over 6 years now. Instead of bashing  the Fed on a daily basis I suggest that those for free markets and monetary  stability work to eliminate the Fed’s mandate to work towards full  employment, something they can’t do, and concentrate on monetary stability, something they’ve proven they can do.

It’s time to end the war against the Fed.

Paul Nathan