Fed now Fears Bubbles, Inflation

Henry Ford said, “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” The financial crisis of the last four years has focused more of the country’s attention on Wall Street and the banking system and while the revolution is not happening overnight as Ford suggested, it is happening slowly but surely. Some mainstream economists have changed their tone, possibly pointing to a change in policy to reflect the people’s understanding of banking.

Fed Official’s Attack on Ron Paul Retracted

David Andolfatto, VP of Research at the St. Louis Fed attacked Ron Paul in a blog article, primarily for his statements about the 95% erosion of the value of the dollar since the creation of the Fed. Andolfatto bases his stance on the principle of “money neutrality” which says that while prices have gone up over time, wages have also matched price growth. He says Ron Paul suffers from “money illusion”, mistaking money for its nominal value rather than its purchasing power (real value). After numerous negative comments on his post, Andolfatto retracted the post.

Contrary to David Andolfatto’s judgment of Ron Paul, the bailouts actually expose the government and Fed as suffering from “money illusion”. In order to stabilize the (nominal) price of real estate and Wall Street derivatives the government and Fed nearly doubled the money supply. Sure, the price of real estate in terms of dollars may stabilize, but in relation to other sectors of the economy it will be less valuable.

Austrian School Continues to Rise

The Austrian School of economics is the oldest yet smallest school of economic thought, but lately it is growing in leaps and bounds. The Harvard Political Review recently interviewed Austrian economist Mark Thornton. The article is a good introduction to the Austrian school’s principles. As this alternate school gets more and more attention, it will be interesting to see who wins the argument.

Bubbles and Inflation

Meanwhile, Federal Reserve economists are beginning to predict bubbles. Bubbles are overinvestments in particular sectors of the economy. They usually end by popping, causing crashes like the recent housing crisis.

Until now these events seemed to come as a surprise, despite existing research on the boom and bust cycle. Austrian economist Friedrich von Hayek won the Nobel Prize in Economics in 1974 for his research indicating bubbles result from mal-investment and loose credit but mainstream economists ignored him.

The Kansas City Fed is now predicting a bubble in Midwest farm land prices, as reported in my recent blog post. The bubble makes perfect sense in the framework of Austrian economics but not necessarily Keynesian. I take this as a good sign - Fed researchers may be opening up to Austrian economics.

More and more economists are talking about inflation now, too. Bailouts and quantitative easing, responses to the financial crisis, were meant to counteract an expectation of deflation. Meanwhile, the Austrian economists consistently warned about inflation.

Now even Alan Greenspan is concerned about inflation. Was it necessary for America to go through the financial crisis? Would policy changes (sound money) protect the economy from future financial or inflation shocks?

Sign of Encouragement

The change in tone of some mainstream economists is an encouraging sign. It is like we were driving straight toward a cliff but the driver just noticed his fatal trajectory. It may be too late to avoid the repercussions of bad monetary policy but at least the Fed might put the brakes on the debt binge. Of course, that doesn’t solve all the problems with the Fed or the economy, but it would be a good start.