Who to blame for the Gov’t shutdown? I blame the Fed and bad economic theory!

Posted on October 4, 2013 by


You say “Really?  Are you just an anti-Fed nut case?”  Well, I’m certainly anti-Fed, and my wife won’t confirm or deny #2.    But let me make my case.  As economist Russ Roberts likes to say, economists often tell “stories” that we think reflect reality.  These stories are backed by a particular theory and often have an array of evidence that supports.  The problem is that these stories have opposing stories that also have theories and counter evidence.  As my macroeconomic students know, I criticize macroeconomics precisely because of its claims to understand a complex system, as if the economy were a machine that could have levers pulled to direct.  Most of our stories relate to macroeconomic theories.  Sure there are stories with micro, such as a few economists continued attempt to suggest the law of demand isn’t universally true and therefore minimum wage increases won’t result in additional unemployment.  But stories like this get little traction with economists because of the overwhelming micro economic foundation and evidence in support of the opposite position.  With macro, its harder to get any consensus.  But that doesn’t mean that any individual economist’s story is wrong, its just a lot harder to build consensus.  In any case, here is my “story” on the why I can blame the Fed and bad theory for the gov’t shutdown.

  1. Bad economic theory suggests that deflation is always bad.  Deflation is the bogey man of all economists, ever since the Great Depression.  This is bad theory because there are two ways to get deflation.  One is good, and one is bad.  To call the good deflation bad, and take action to correct, causes REALLY bad things.  More below.  Good deflation occurs when we have a positive shift in aggregate supply, such as we saw with the productivity gains in the last two decades due to technology gains and opening of markets and increased division of labor (e.g., China, Eastern Europe opening).  Bad deflation occurs when the monetary authority allows the money supply to collapse, as in the Great Depression.  We should cheer the first deflation, and prevent the second.
  2. The Fed’s irrational fear of deflation (both Mr. Greenspan and especially Mr. “Helicopter” Ben Bernanke) led the Fed to have negative real interest rates from 2002-2005, which created a massive bubble in housing.  They deceived themselves that they weren’t inflating because there was no consumer price inflation, ignoring the massive asset inflation underway.  Yes, the government support of Fannie/Freddie housing policies were the key reason the inflation manifested itself in the housing sector, yet the bubble could not have occurred without the Fed supplying the fuel.
  3. With every bubble, eventually consumer prices start to rise, and the monetary authority is forced to choose to prick the bubble or risk accelerating inflation.  Does anyone now remember $150/barrel oil and $5 gas?  Yes, the Fed started increasing rates in mid-2004, but they were behind the curve, and only raised interest rates by 1/4 point at time.  They finally pricked the bubble in 2007, and we saw the result unfold in the financial crisis.  With the financial crisis, the Fed correctly fears that a monetary demand collapse could occur, and they cut interest rates ultimately to effectively zero.  Ironically, their fear of the good deflation in early 2000s leads them to create policies which could cause the bad deflation.  Perhaps this is reflective of Proverbs 10:24, “What the wicked dreads will come upon him”?
  4. As the financial panic grew and spread in early 2008, there was no way for Republicans not to get blamed politically; an unknown Mr. Obama and the Democrats swept into power.  Not for their agenda, but rather they weren’t Republicans.  Democrats saw this an opportunity leave the liberal legacy they’d always dreamed of, and thus we got Obamacare and massive spending.
  5. This led to the American people waking up and saying, in effect, we need some check on unbridled liberalism, and 2010 saw the Republicans gain the house, giving us a divided government.
  6. The merry band at the Fed is determined to save the day, by creating more bubbles.  The economy never seems to get “green shoots” that the Administration and the Fed promise, but one thing we do get:  zero interest rates which make the cost of increasing debt virtually zero.  Further, the Fed directly monetizes the U.S. government debt, helping the politicians conceal the costs of the debt.  So since the costs are being deferred, most Americans attention is diverted, and tea party fever cools.
  7. Mr. Obama is reelected, taking that as a sign his agenda is validated.  Republicans are also reelected in the House, giving them a sign that their agenda is validated
  8. We have dysfunction…..

I’ve said enough, we can let the political science experts comment and expand on 4-8, yet I’m pretty confident that steps 1-3 led to Mr. Obama’s presidency–that’s at least half of the problem of our current stalemate.

The lesson?  Everyone should take my macroeconomic class!  Including Mr. Bernanke and Mrs. Yellen; I would try to disabuse them of the notion that all deflation is bad!  Or better yet, they should take a class from Professor Selgin, who has made this abundantly clear: