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Inflation, stagflation and money supply

By Jonathan J. Ariel - posted Friday, 20 June 2008


The media crowed that Steiger single-handedly unleashed the boom in venture capital investment that jump started Apple and Sun Microsystems. But the prosaic truth was that the surge in venture capital investment had its roots five years earlier, in 1973, when a law was passed requiring companies to park some money to fund its staff superannuation liabilities.

Super funds’ assets quickly ballooned to more than $1 trillion, and fund managers clamoured for more flexibility in the strict super fund investment rules. When the rules were eased in 1979, it was mainly super funds that were the source of most of the new venture capital. Morris argues that it’s bogus in the extreme to argue that a cut in capital gains tax spurred venture capital investment, as these super funds were immune from the ramifications of a capital gains tax cut, given were tax exempt.

Steiger’s tax cut sowed the seeds of mythology among the free market faithful, Morris asserts.

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President Jimmy Carter’s appointment of Paul Volcker as Chairman of the Federal Reserve in 1979 came at a very troubling time for Wall Street in particular and the global economy in general. The job description of the financial economist, who divided his career between the Treasury and the Chase Manhattan Bank, was to slay the inflation dragon and restore financial order.

Inflation had traumatised long term investors, siphoning money away from bonds and stocks that financed businesses and fuelling hard asset bubbles in gold, art and real estate. Prior to his appointment, on spot markets, the dollar price of oil rose by 6 per cent a month and gold rocketed 28 per cent in a single month.

People were scared. Both business leaders and trade unionists feared stagflation (a recession accompanied by galloping inflation).

Paul Volker moved into the chairman’s office just as Milton Friedman’s sermon was claiming a large congregation in Washington, DC. Friedman held that monetarism would cap government meddling in the economy and that inflation could be controlled by solely controlling the stock of money. The stock being the sum of all bank deposits and circulating cash. If the Fed ensures that the stock of money mirrors the growth of economic activity, then everything would remain just sweet.

While Morris admits that Volcker applied certain monetarist rules to snap the back of inflation, he is resolute in his chant that monetarism didn’t break inflation. Volcker did. Friedman acolytes, Morris explains, hadn’t guessed that as the Fed cracked down on the supply of conventional money stock, sharp Wall Street suits would create new financial instruments to get around these restrictions. Which they did, with high yielding bonds, interest bearing cheque accounts and other innovations.

Morris argues that Volcker broke inflation by simply clamping down very hard and very consistently using three key weapons in his arsenal: interest rates, money supply and jawboning.

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Within two years (by the end of 1982), the Fed funds rate fell to 8.7 per cent and the economy started to inch forwards. In response, the US Dollar soared. When in 1984 the economy needed some tightening of monetary policy, Volcker was backed (once again) by the free marketeer himself, President Reagan. Volcker managed to keep real GCP at a respectable 4.1 per cent while the inflation menace was tamed to 1.9 per cent. A 20-year low.

Wall Street was finally convinced. The world now fathomed what pain the White House will endure to protect the greenback. The stewardship of the United States economy was revered by the rest of the world.

Morris’ trepidation with the current state of the financial markets rests to a great extent with his naked hostility to Volcker’s replacement, Mr Alan Greenspan, while ignoring Greenspan’s replacement, Mr Ben Bernanke.

Greenspan, Morris alleges, was actively not involved as financial markets regulator for most of his time as Chairman of the Fed. During the leveraged buy out (LBO) boom - where Greenspan chose not to curtail bank lending for highly leveraged transactions until it was far too late as well as in the late 1990s when he refused to tighten stock margin rules - only served to show his preference for a hands off approach. This was more than enough to raise the ire of Morris.

Morris expects the financial disaster in 2008 to cost about $1.1 trillion. This being the total of residential, commercial, corporate and consumer loans which are expected not to perform. Given it’s too late to avert the coming catastrophe, he passionately pleads for active financial oversight to ensure the unwinding is orderly, but isn’t holding his breath.

Charles R. Morris has written a book revealing that the failings of some can have devastating repercussions on the many. To those who care about the state of global finance, this book is timely, well argued and best of all, a joy to read.

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The Trillion Dollar Meltdown - Easy Money, High Rollers and the Great Credit Crash by Charles R. Morris. Public Affairs (March, 2008), New York City, $46.



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About the Author

Jonathan J. Ariel is an economist and financial analyst. He holds a MBA from the Australian Graduate School of Management. He can be contacted at jonathan@chinamail.com.

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