An alternative to popular faith
Next year, the Fed may be faced with stagflation, the simultaneous occurrence of economic stagnation and inflation. Sadly, the Fed cannot cure stagflation.
You’ll find a more complete discussion of this phenomenon at http://rodgermitchell.com/inflation.html, but here is a quick overview:
Money is the lifeblood of an economy. During a recession, an economy suffers from “anemia,” a shortage of money. The treatment for anemia is to increase the blood supply. But typically, the Fed tries to cure recession by cutting interest rates and tries to cure inflation by doing the opposite, i.e. increasing interest rates. Since recession is not the opposite of inflation, doing the opposite doesn’t work, and changing interest rates does not fix the money shortage.
To cure inflation it is necessary to raise interest rates. To cure stagnation it is necessary to treat the anemia, i.e to deficit spend. The former is the task of the Fed. The later is the task of Congress. That’s why the Fed alone cannot cure stagflation.
Unfortunately, the Fed wrongly believes high interest rates slow the economy, so when stagflation appears, the Fed will urge a reduction in deficit spending (bleeding the anemic), which they consider “fiscally prudent,” while only reluctantly and incrementally raising interest rates.
This will continue the Greenspan and Bernanke policies, which will extend or worsen the recession.
Rodger Malcolm Mitchell
#Monetary Sovereignty - Mitchell 
Is this different under monetary sovereignty than under, say, a gold standard? Or for a country that is a currency user rather than a currency owner? Obviously, growth rates vary across the EU countries, but does inflation also vary among them, according to their budgetary actions, or other things?
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Yes, different. A Monetarily Sovereign government can cure stagflation by spending and raising interest rates. For a monetarily non-sovereign government, spending is limited.
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Yes, I knew that. It seems I asked the question wrong.
Obviously most of Europe is in the same sort of slow growth / recession scenario as the US. But what about their inflation rates? Does the inflation rate vary from country to country? Could some of them have stagflation while others have deflation and recession, and still others growth and inflation? Or do they all have a common inflation rate, due to the common currency?
And if the inflation rates are different, why? Because of different fiscal policies? Or because of different trade situations and / or cultural attitudes toward saving?
How much control does each country have over interest rates? Can Germany impose higher rates and prevent Germans from borrowing at low rates in France? Or does the ECB control a single rate throughout, as the Fed does here?
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The euro is nothing more than a quasi-gold standard. Ask the same questions about a group of nations that all are on a gold standard.
Rodger Malcolm Mitchell
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Let me see if I understand. On a gold standard, as the US was before 1971, a country still has complete control, just like with fiat money, as long as there is enough gold in the vaults to satisfy redemption requests. We had deficits as high as we wanted to have, and our central bank controlled our own interest rates. There was still inflation and deflation, all without changing the fixed gold price.
But individual EU countries have no central bank of their own. Their interest rates are set in the bond market, not by their governments. How do they control inflation? Or can they control it? I would think not, not like the Fed could control rates on the gold standard. Or does the ECB control rates for each country, by open market operations in the various sovereign debt issues? Who decides on the target rate for each, or must it be the same for all?
Europe is interesting, but I guess my main question is about how things are different for the US now, as compared to the gold standard. Do I have it right, that the constraint on a gold standard country is the amount of gold in their vaults, and otherwise they are as free to do policy as a fiat country is?
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RMM,
I’m confused about how raising interest rates cures inflation…
If by raising interest rates this increases the value of owning/holding (saving) money, instead of spending it, how is this not just another way of saying spending is causing the inflation?
If in the case of stagflation: it seems your recommendation is to flood the economy with money and at the same time encourage people to save?
Can you try explaining this again? Specifically, how does encouraging people to save cure inflation, if inflation is not caused by spending (too many dollars chasing too few goods)?
thanks!
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Inflation is the loss in value of money compared with the value of goods and services. Value is based on supply vs. demand.
Raising interest rates increases the value of money by increasing the demand for money.
Rodger Malcolm Mitchell
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“Unfortunately, the Fed wrongly believes high interest rates slow the economy…”
This is likely because of Paul Volcker’s rate increases and their correlation with the recession of the early 1980s.
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