41. The Price of Money

Aug 25

EXECUTIVE SUMMARY

1) To Show That Traditional Keynesian Fiscal and Monetary Stimulus Don’t work in high debt environments.

2) The Federal Reserves reliance on expanding debt to reflate recessions through discounted and negative FFR overtime has derogatory consequences for wealth and welfare.

3) Expanding Interventions that rely on debt creation or quantitative easing does not correct the private sector imbalance between consumption and production.

4) Negative FFR rates for prolonged periods influence longer rates and distort risk leading to bubbles.

5) Persistence of fiscal and monetary stimulus in high debt environments leads to destabilization and makes economy prone to depressions/inflations

INTRODUCTION

In an open economic system, the unfettered price of money will have a positive value and this value can be measured by the interest rate associated with it. The interest rate will be the sum of the existing inflation rate (I) plus some positive time value of money (pv). When risk ( r) of repayment exists the Price of Money = I + (pv) + r. The Price of Money is usually conceived of as opportunity cost in a near riskless loan. We use 2% annually as the time value of money for the almost riskless Federal Funds Rate, an overnight loan from the government to member banks. With regularity when central bankers wish to stimulate an economy, they will artificially lower interest rates they control or believe they can affect. The Federal Funds Rate referred to hereafter as “FFR” is the interest rate of choice. This process often artificially discounts the price of money. Prolonged periods of discounting the Price of Money may have derogatory effects societies’ wealth and welfare, not contemplated by the policy initiative. If the discount is so great that the interest rate falls below the inflation rate, the real interest rate becomes negative. A negative real interest rate means that the central bank is valuing loans to member banks below zero percent. A negative real interest rate means the Federal Reserve is paying banking institutions to borrow from the Fed. In that case, money no longer has a positive value.

How successful have traditional monetary tools been over the last 40 years of public reflations? Since 2002 the Federal Reserve’s Federal Funds Rate (FFR) has priced money at a negative value for its member banks 6 out of 8 years and counting. This looks like a repeat of a failed stimulus from 1974–1980 when the Fed ran negative real FFR for 7 out of 8 years. This led to inflation which directly resulted in the contraction in stimulus from 1981–1984 and the severe 1981–1982 recession [see Chart 1: Monetary Policy Intervention].

Most economists believe that as long as unemployment is “too” high or rising, the Federal Reserve is unlikely to raise rates largely because the economy is unable to generate inflationary pressures. This belief is rooted in the notion that labor cost price pressure is the largest contributory factor to general upward price movement. Most policy makers in Washington today subscribe to this view and therefore most policy prescriptions are geared toward influencing traditional Phillips Curve tradeoffs. The Phillips Curve describes an inverse relationship between money wage changes [inflation] and unemployment [Phillips 1958]. Public policy makers believe Phillips Curve exchanges or tradeoffs can be desirably influenced by stimulative monetary and fiscal interventions. But what if stimulation by both abnormally low interest rates and/or government deficit spending is no longer able to reduce unemployment? That is, the old tools no longer work as they did before. And additionally, what if high unemployment is no longer a guarantee of low inflation?

The job market is evolving in such a way that monetary and fiscal policy makers may have to change how they respond to the unemployment rate. We have had “jobless” recoveries following the 1992 recession and the 2001 recession. If we get a third jobless recovery now, then we shouldn’t expect 60’s, 70’s, or 80’s types of recoveries any longer. That changes how central bankers and incumbent policy makers should think about the role of public policy interventions. [Bullard, 2009]. From 1999 through 2009 employment only grew by 400,000 while the population grew by 30 million. Despite no improvement in employment negative real FFR, an extreme form of monetary stimulus, was sustained for 8 out of 10 years.

Since 1988, and particularly since 2000, the ability of partisan politicians in Washington to influence desired Phillips Curve tradeoffs through the use of traditional monetary and fiscal stimulus measures has substantially changed.

Examining the duration and magnitude of traditional fiscal and monetary interventions during five reflationary efforts in connection with five deflationary recessions since 1972, shows the declining effectiveness of interest rate easing and fiscal spending to stimulate loan demand and employment. Moreover, the declining monetary and fiscal stimulus appear to have been negatively correlated to increasing public debt. Since 1974, total federal public debt as a percent of GDP has almost tripled from 30.9% to 90%, and is expected to go above 100% within a year.

The evidence of the past forty years supports the proposition that increasing federal debt through government stimulus is less effective the greater the stimulus until it eventually is ineffective. Therefore debt dependant fiscal stimulus, quantitative easing and interest rate discounting to stimulate through monetary manipulations, will not achieve its policy objective of growth and increased employment in a high debt environment. If total public and private debt increase during periods of fiscal and monetary stimulus and the increased debt lowers the effectiveness of the interventions than increased interventions are required in each economic downturn to sustain the same result. The byproduct of increased interventions is increased debt requiring, more increased interventions yielding more increased debt.

Finally multiple interventions relying on traditional debt dependant fiscal and monetary tools eventually fail due to lack of funders for the debt. At that point the chooses become limited to monetizing the debt (”printing money”) or reneging to pay interest owed on the debt both paths lead to equivalent currency devaluations. Both lead to significant declines in the standard of living. Hence multiple new interventions that are similarly dependant on 1) private debt expansion, 2) lowering interest cost to bait more loans, 3) debt spending for a presumed public purpose and 4) printing more fiat currency, ultimately create a currency valuation problem and do not solve the unemployment problem. New hyper interventions are not administered because of any particular knowledge that they will work, but merely due to the failure of the old interventions.

At a time of persistent negative real interest rates and hugely increasing public debt, it is incumbent to raise these questions regarding the efficacy of Keynesian stimulation in a high debt environment. It is vital to review and fully understand how changing interventionist policies by government have evolved and grasp their likely consequences before they affect us in unexpectedly negative ways.

PHILLIPS CURVE (A FRAME OF REFERENCE)

Alesina and Sachs’ contributions to political business cycle theory suggest a “partisan theory” of macroeconomic policy that accounts for rational and forward-looking expectations. They argue that the Democratic Party is willing to accept higher inflation levels when the payoff is maintaining unemployment at or below the “natural” rate. The Republican Party is willing to accept higher unemployment when the payoff is maintaining inflation rates at or below a “normal” rate [perhaps 1-4%]. These partisan preferences translate to different optimization points of inflation and unemployment along the Phillips Curve.

Their model predicts that at the beginning of a Democratic Presidential term we should observe “output expansion above trend with high money growth.” Conversely, when a less expansionary Republican Party takes office, a “recession with low money growth” should occur. This theory does not predict electoral surprises in the second half of Presidential terms. It also does not take into consideration the considerably long inside and outside lags in fiscal and monetary policy.

However, empirical evidence suggests there is a significant difference in real GDP growth between the first two years of the different parties’ administrations. Alesina and Sachs find that real growth averaged 5% for Democratic administrations and 1.2% for Republicans in the first halves of their terms during the period from 1949–1985. How and why have policy tools changed? Comparing these figures to a mean real GDP growth for all administrations of approximately 4.2% per year confirms that the Democratic Party was more concerned with raising output while the Republican Party was more focused on inflation targeting during this period (White, 1999).

THE FIVE DEFLATIONARY RECESSIONS SINCE 1972

Examining the five major deflationary recessions since 1972 and the reflationary periods1 that followed each downturn highlights how monetary and fiscal tools have become increasingly ineffective as time went on. Also, accounting for the federal debt accumulation following each recession and tracking its effect on subsequent reflationary periods illustrates how the accumulation of debt has rendered traditional partisan policy tools essentially ineffective in the latest and most severe recessionary deflation. The burden of increased debt carried forward throughout each of these recessions required greater FFR discounting to create the same stimulus in the subsequent reflationary periods. As federal debt increased over the decades, the real short-term interest rate structure declined until it was less than prevailing inflation. The real FFR became negative, where it has remained for 6 out of the last 8 years. The collapse of the nominal FFR, which effectively sits at zero, has rendered the FFR an ineffective tool to stimulate. Similarly, the declining effectiveness of fiscal policy also appears to have been impacted by the increasing level of debt. The increasing use of discounted and negative real interest rates has been required to obtain desired levels of fiscal and monetary stimulation in a high-debt environment.

The 1973–75 Recession and Beyond

The US recession of the 1970’s marked a period of economic stagnation that put an end to the general post–World War II economic expansion. According to the National Bureau of Economic Research (NBER), it lasted sixteen months: from November 1973 to March 1975. During the recession, US GDP fell 3.2%. Though the recession ended in March 1975, the unemployment rate did not peak until May 1975, when it reached a high of 9% (Bureau of Labor Statistics (BLS)). Towards the tail end of the recession in August of 1974, Republican candidate Gerald Ford assumed the presidency from the resigning Republican President Richard Nixon. Consistent with the Alesina and Sachs theory, Ford exhibited the Republican bias of cutting inflation at a time of high unemployment by immediately encouraging the public to Whip Inflation Now.

The reflationary period following the 1970’s recession that lasted from approximately late 1974 into 1980 was keynoted by an extravagant use of monetary tools to stimulate the economy. During 6 of 7 years from 1974–1980, the average real FFR remained negative, meaning that the government essentially paid banking intermediaries to borrow money in real terms [Chart 1: Real FFR].2 For instance, the Fed lowered the FFR from an average of 10.5% in 1974 to an average of 5.82% in 1975, an astonishing 3.28% below the prevailing inflation rate of about 9.1%.

With too much money chasing too few goods, the consequence of long-term negative interest rates was an inflationary period from 1979–1982, which necessitated an immediate increase in the FFR in real terms from about 1981–1984 [Chart 1: Real FFR]. Although the economy expanded from 1975, inflation remained high for the rest of the decade and spiked from 1979–1981. Further, while debt during this first reflationary period only increased from 30.99% of GDP in 1974 to 31.22% in 1980 [Chart 2: Debt/GDP], this effect soon evolved into debt expanding at an increasing rate in each of the next four reflationary periods.

The Early 1980’s Recessions

There were technically two recessions in the early 1980’s, the shorter one lasting from January–July of 1980 and the longer, more severe recession persisting from July 1981–November 1982 (NBER), having a duration of 16 months—equal to the 1973–1975 recession. The unemployment rate finally peaked at 10.8% in November 1982, 1.7% higher than the prior recession. GDP declined 2.2% in 1980 and fell by about 2.7% from 1981–1982 (BLS).

The primary cause of these twin recessions is often thought to be contractionary monetary policy instituted by the Fed to control inflation, which had soared to a high of 13.5% in 1980 (CBO 1982). The central bank’s contraction was in direct response to its own prior loose policy, believed to have caused the inflation. Confirming Alesina and Sachs’ hypothesis, Democratic President Jimmy Carter, who held office from 1977–1981, oversaw four years of highly stimulative negative real FFR’s and consequently high inflation rates. However, he could not influence Fed Chairman Paul Volcker’s “hawkish” anti-inflationary policies. Determined to wring inflation out of the economy, Volcker “slowed the rate of growth of the money supply and raised interest rates” (Cowan, 1981). Specifically, the nominal FFR, which was about 11.19% in 1979, rose to nearly 20% by June 1981. Real FFR had the highest positive values from 1981–1984 for the entire period under consideration [Chart 1: Real FFR]. It would not be until the next century that real negative FFR would once again be used for a protracted period as a monetary tool to reflate following the onset of a recession.

The reflationary period following these two recessions, which lasted from approximately 1985–1990, did not rely on decreases in the FFR. A positive real FFR existed from 1981–1984 and this continued from 1985–1988, though to a lesser extent [Chart 1]. President Reagan’s administration instituted across-the-board tax cuts, thereby stimulating employment by ushering in the longest period of peacetime economic growth in US history. Since this method of structural stimulus did not require increased fiscal spending, it also effectively avoided the unintended consequences of inflation from monetary stimulation (Mitchell, 1996). Still, since the Reagan administration lacked the political will to cut expenses, this reduction in taxes, or revenue, significantly increased the national debt from 1981 on [see Chart 2].

Although large positive real FFR’s were needed from 1981–1984 to choke off high inflation, these increases likely offset the dramatic easing efforts that preceded them and hence kept debt growth to a minimum between the first two recessions. Still, the benefits of higher GDP growth and employment that the Republican era brought were somewhat subdued as debt increased: in 1981 the ratio of debt/ GDP was 31.22%, but by 1990 under Republican George H. W. Bush, at the onset of the third recession, it had increased to 55.29% [Chart 2: Debt/ GDP].

As the Zero Hour [Graph 1] shows, a disturbing trend began to emerge that illustrated the declining effectiveness of an additional dollar of debt spending to stimulate GDP growth and, by extension, income and employment. This introduces the possibility that as debt continued to increase, the declining effectiveness of fiscal policy intervention to increase employment was accompanied by the reduced effectiveness of traditional monetary tools a decade later.

The Early 1990’s Recession

The next key recession, of the early 1990’s, lasted for only 8 months, from July 1990–March 1991 (NBER), and was chiefly caused by the savings and loan (S & L) crisis of 1989. Despite its brevity, the economic damage caused by this recession was substantial. Unemployment peaked at 7.8% in June 1992 and GDP growth declined 1.4% throughout the recession (BLS). George H. W. Bush was President from January 1989–January 1993. In early 1993, the effects of a mild monetary reflation had not yet taken hold when President Clinton took office.

The reflationary period following this recession lasted roughly from 1991–1994, when the real FFR stood at 1.49%, .52%, .02% and 1.6% respectively [Chart1: Real FFR]. Although the price of money was discounted to assist the reflation effort from our theoretic value of inflation plus 2%, the stimulus was mild and never reached negative values. This reflation was keynoted by the introduction of the Resolution Trust Corporation (RTC). The RTC expanded the debt brought forward from the previous recessionary period by an estimated $450 billion (Curry 2000). More specifically, in 1995 debt as a percentage of GDP had risen to 66.12%, a vast increase of 20% in merely 5 years [Chart 2: Debt/GDP ratio].

The doubling of the size of federal debt from 30.99% of GDP in 1974 to 66.12% in 1995 raises the issue that the increased carrying cost of the debt after reaching a level seems to serve as a drag on economic growth, this is supported by the measurable reduced effect of deficit spending on growth in high debt environments. After a brief break from debt expansion from 1995 through 2003, [see Chart 2 & p. 13, para.4] the same fast-paced increases in debt resumed from 2000 to the present. Graph 1 also indicates that the effect of a dollar of added federal debt on GDP growth declined from an average of $.70 in 1974 to about $.38 in 1995. That is, almost two dollars of debt spending were required in 1995 to expand GDP by the same amount one dollar of new debt accomplished in 1974. Not surprisingly, neither political party has broadcast this decline in effectiveness because they are both partial to increased government spending to address perceived problems.

By the dawn of the 21st century, the ability of deficit spending to increase growth and employment had declined from one dollar of deficit spending ($1.00) being associated with approximately sixty-eight cents ($.68) of growth to that same dollar of deficit spending accompanying only a quarter dollar ($.25) of growth, a staggering decline of 63%.

The Early 2000’s Recession

Republican President George W. Bush was inaugurated only two months prior to the beginning of the financial markets’ collapse in March of 2001, so he was not blamed for the fourth deflationary recession in the period analyzed. It lasted eight months, from March–November 2001 (NBER). GDP declined 0.3% and unemployment reached 5.7% during this recession, but continued to rise to 6.3% in June 2003 (BLS). High productivity and relatively low unemployment minimized the decline during this brief recession [see p.13, para.4].

During the reflationary period of 2001–2005, the Greenspan Fed launched an extended period of negative real FFR’s that had not been seen since the 1974–1980 reflationary period. The ability of monetary policy to influence Phillips Curve tradeoffs became less effective as the nominal FFR approached zero and real FFR remained negative from 2001–2005 (see Chart 1-Real FFR). For the first time nominal FFR was reduced by the Fed to 1%. This excessively loose monetary policy was complemented by the Republican administration’s high level of spending, which extended unemployment payments among other things (Foertsch 2007). Debt as a percentage of GDP at the end of 2005 stood at 62.48% and advanced steadily to 75.08% in 2008 [Chart 2: Debt/ GDP]. However, the combination of monetary, fiscal, and regulatory stimuli that were crafted to lift the economy out of the 2001 recession, by stimulating home mortgage demand, merely set the stage for the next bubble that caused the severe 2007-2009 banking centered deflationary recession when the housing bubble burst.

The Late 2000’s Recession

The financial crisis that started in Q4 2007 is the most severe discussed thus far in several respects. GDP has declined an average of 3.9% at an annual rate while the unemployment rate jumped from 4.9% in December 2007 to 10.2% in October 2009 (BLS). At the beginning of this fifth reflation, federal debt stood at 64.2% of GDP, the highest level of any prior reflation. However by December of 2009, although the recession had ended the debt as a percentage of GDP had advanced to 93%, a post WWII high, and an increase of 45% in merely 24 months. The extremely liberal use of the low FFR from 2002–2005 following the downturn of 2001 was extended and expanded from 2007 to the present, along with high and rising federal deficits, mostly occurring during a Republican administration with a Republican Congress until 2007 . In contrast, both fiscal and monetary stimulus measures have radically expanded beginning in early 2009 under the current Democratic administration.

Traditional monetary policy tools effectively collapsed during the reflationary period that started in 2008, when the FFR sat at 0.0% for the first time ever. From 2002–2009, the Greenspan/ Bernanke Fed actually decreased the FFR to new lows that also sat below the prevailing inflation rates for 6 out of 8 years. For instance, the Fed set the nominal FFR from 0.0% to 0.25% for most of 2009, even with the expected inflation rate sitting at about 2%, which causes a -1.75% real FFR. These negative rates are eerily similar to those of the 1974–1980 reflationary period, which fostered runaway inflation soon thereafter. [Perhaps more importantly, the Fed has instituted new “quantitative easing” processes to insert money into sectors of the economy never before addressed by monetary policy and the federal government has created unimaginably large potential liabilities through bailouts of financial and other institutions. The effect on traditional monetary tools will only become clear as the Fed withdraws their insertions and the government exits the equity positions gained during the crisis.]

Due to the misuse of the traditional monetary policy tool of FFR, more emphasis has been placed on using fiscal policy to affect desired Phillips Curve tradeoffs and to ostensibly secure incumbent reelection. It appears that the Democratic administration hugely expanded the use of fiscal policy in an attempt to affect growth, income, and employment in the wake of the recent financial crisis. Most notably, the11-month period through December 2009 has been earmarked by an unprecedented degree of fiscal and monetary interventions, including but not limited to the Recovery and Reinvestment Act, the creation of various liquidity “facilities” for lending to and buying illiquid or toxic assets from non-banks, the federal “Cash for Clunkers” program, the provision of first-time homebuyer tax credits, and an extension of 3% down payments by the Federal Housing Administration [FHA]. Unfortunately for the U.S. economy, these dollars of added debt will have an increasingly less significant impact on employment than they would have had in previous reflationary periods when lower levels of federal debt existed.

The large accumulation of debt from prior interventions has reduced fiscal policy effectiveness from about $.70 of growth for each dollar of debt spending in 1972–1974 to less than $.10 of growth for each dollar spent in 2009 [Graph 1]. On November 10, 2009, debt as a percentage of GDP sat at 88.7% and is expected to pass 100% of GDP in 2010. When this happens, the small remaining positive effects of debt on unemployment will most likely decline to zero or actually become negative. Also noteworthy, the depth and breadth of this severe recession did not benefit from the underlying high productivity of 3% evident from 1996-2004 [Chart 2, Productivity], therefore the presumed recovery will not benefit either.

DISCUSSION

Chart 1, 2, 3 & Graph 1, show the declining influence of traditional monetary and fiscal tools, particularly the extreme use of FFR, to stimulate loan demand thereby influence general economic growth and employment growth. When we assume that FFR has a positive real value of 2% (the 47 year average for real FFR was 1.97%), and we add this to inflation (I), the magnitude in the change in discounting by the Fed is fully apparent and is measured in Column 5 of Chart 1. Column 4, marked inflation plus 2%, is a theoretic value at which we believe FFR would be neutral (neither restrictive nor stimulative). Therefore the degree of reduction (discounting) or increase from this value shown in column 5, is a proxy for stimulation and constriction efforts by the Fed. Moreover, two other noteworthy trends appear in Chart 1. First, monetary stimulation following deflationary recessions takes a longer time and a deeper discount to affect reflation. Moreover, the recurring use of negative rates has depressed the spectrum of nominal rates such that negative real FFR from 1974–1980 averaged about 8.3% compared with average nominal FFR from 2001–2009 of about 2.6%, for a decline of 69% and a nominal FFR in 2009 averaging a paltry 0.125% and leaving the Fed stripped of its ability to further stimulate by lowering the nominal FFR. This process over five reflations has rendered the FFR ineffective to reflate by further stimulation with the FFR at zero.

Chart II supports the idea that this dramatic decline in nominal FFR is inversely related to the dramatic increase in public debt as a percent of GDP. With the nominal rate of FFR at zero, the ability of the Fed to sustain negative real rates solely rests with the economy’s ability to sustain a positive inflation rate. Inflation is running at about 2.5% in 2009.

For a zero nominal FFR rate to remain marginally stimulative, inflation must remain above zero. As federal debt approaches 100% of GDP, inflation may become increasingly unlikely during the deleveraging period while debt is retired or fails. The ineffectiveness of monetary policy to stimulate during this debt deleveraging period is complemented by the diminished influence of fiscal spending by partisan incumbents [graph attached].[1]

The evidence from reflations since 1974 clearly shows that traditional monetary and fiscal tools relied on in the past have become greatly diminished or are ineffective in stimulating GDP. Rather than a careful examination of the causality of their dysfunction, this has led to the present period of massive interventions in a joint effort by partisan incumbents and the Federal Reserve to stimulate without any evidence to support its effectiveness. With the failure of traditional monetary tools not widely understood, the central bank did not hesitate to broadly expand its scope of interventions in the 2007–2009 financial crises. One common feature of the new tools being employed: “They all make use of the asset side of the Federal Reserve’s balance sheet. That is, each involves the Fed’s authorities to extend credit or purchase securities.” [Credit Easing]. In so doing the separation between fiscal and monetary stimulus has been blurred. As traditional tools of monetary and fiscal intervention are dulled or ineffective, expansive new interventions are introduced in the absence of a clear understanding of the dysfunction of the traditional tools or a thorough vetting of the effects of the new ones. The Fed has put money in places we didn’t even know existed. The economic buoyancy from this flood of money is artificial. However the debasement from printing money and the public debt left in its wake will lower our standard of living and represent an increased liability on our future income and social wealth.

It proceeds as follows:

1) Term Auction facility (“TAF”) in December of 2007, similar to Fed discount window with no stigma for borrowers;

2) To deal with “the shortage of Collateral” in early 2008, the Federal Reserve introduced two new policies: the Term Securities Lending Facility (“TSLF”) and the Primary Dealer Credit Facility (“PDCF”). TSLF allowed primary dealers to provide less liquid securities as collateral and hold the loans for 28 days as opposed to overnight, while the PDCF authorized the New York Fed to lend against a broad range of investment grade debt;

3) Currency swap lines of credit were increased with Japan, Bank of England, and bank of Canada;

4) Under 13(3), the Fed was purportedly allowed to extend its lines of credit directly to distressed financial institutions, namely AIG;

5) Fed’s Commercial Paper Funding Facility (“CPFF”) was introduced in October 7, 2008. The CPFF is intended to alleviate the rollover risk of commercial paper;

6) Maiden Lane LLC’s are some of the most esoteric components on the Federal Reserve’s balance sheet. Maiden Lane, Maiden Lane I & Maiden Lane II are tied to specific pools of assets the Fed has lent against. The Fed has also extended billions of Credit Default Swaps (“CDS’s”) for credit protection on mortgage backed securities.

Finally in November of 2008 the Federal Reserve announced the Term Asset-Backed Securities Loan Facility (“TALF”). The Fed through TALF has purchased, in largely opaque transactions, up to $1.3 trillion of mortgage backed Securities (“MBS”) and $300 billion of government securities. TALF has also purchased GSE’s (Government Sponsored Enterprises) that were government created and hold or pool approximately $5 trillion of mortgages that were transferred directly from Fannie and Freddie, the failed quasi-government entities that were taken over by government. Since the advent of TALF the monetary base has grown by 250% from about $800 billion to over $2 trillion [St. Louis Fed]. The program is scheduled to end in March of 2010.

The fiscal side of this stimulus orgy has been equally active and equally devoid of evidence of success. Bush passed the economic stimulus of 2008 on February 13, 2008, for $152 billion; then, with no evidence that it worked, there was a bipartisan effort to pass the Troubled Asset Relief Program (“TARP”) for $700 billion, promising to return unspent money for deficit reduction—a promise not kept. Finally almost precisely one year after the first Bush fiscal stimulus, Mr. Obama passed the American Recovery and Reinvestment Act for an unprecedented $787 billion, stating that it would prevent unemployment from going above 8%. This bill is best described as the largest collection ever of self-serving Congressional special interest bills so egregiously perverse that they had failed to make it through the extra-Constitutional earmark process. Additional fiscal stimulus funding includes 1) General Motors, 2) Chrysler, 3) Cash for Clunkers, 4) $8K home purchase credits, 5) mortgage buy-downs, 6) extending unemployment and of course 7) AIG.

Whether or not all these unprecedented interventions by government are an uncertain road to recovery or a certain road to currency debasement will be discussed in Part II, The Price of Money-Currency Debasement. During 2009 and 2010 federal deficits will swell by $1.5 & $1.6 trillion or more. Two things should be remembered; 1) borrowing money is unsustainable and perceived debt financed economic recovery is artificial and 2) continuation of this magnitude of debt leveraged stimulation will mean it becomes increasingly unlikely that the US will be able to pay its obligations and the world will become increasingly aware of our future inability to pay.

MORE DISCUSSION ON FFR

From 1954 through 2000 inclusive, 47 years, the average real FFR was 1.97% [see Chart 3]. Surprisingly within three hundreds of our theoretic value for real FFR of 2% and nominal FFR averaged 6.04% during the same time frame. Let’s first take a look at both real and nominal FFR in smaller time segments.

1) From 1954 through 1970, 17 years, real FFR averaged merely 1.45% and nominal FFR averaged 3.68%.

2) From 1071 through 1980, 10 years, real FFR averaged a negative <-.28%> and nominal FFR averaged 7.78%.

3) From 1981 through 1990, 10 years, real FFR jumped to 4.68% and nominal FFR went up to 9.42%.

4) From 1991 through 2000, 10 years, real FFR averaged merely 2.1% and nominal FFR dropped to 4.93%.

5) From 2001 through 2010 (to date) real FFR went negative again at <-.23%> and nominal FFR declined to a 57 year average low of 2.3%.

Since nominal FFR correlates with inflation most economists believe that the collapse of nominal FFR merely reflects the hard won triumph over double digit inflation in the early 1980’s, engineered by then-Fed chairmen Paul Volcker, qualifies as one of the greatest economic achievements of economic policy during the post WWII era. However since 1990 when the nominal rate was 9.42% the increasing uses of FFR by the Central bank to influence loan demand is a better explanation of the decline in nominal FFR over two decades all the way down to zero. Rather than attributing declining inflation to the Volcker years the central bank might be better advised to review the consequences of the last period when it ran negative FFR from 1974-80’ and its consequences. Than to consider the destabilizing consequences of negative real FFR in a public debt environment today that is three times larger as a percent of GDP.

During the second and fifth time frames real FFR averaged a negative value for 7 out of 8 years and for 7 out of nine years, an extremely high level of central bank stimulation for long periods of time. However nominal FFR, on average, declined from 7.78% to 2.3%. This decline in nominal FFR occurred in a high public debt environment. On average total public debt as a percentage of GDP increased from approximately 31% from 1971 through 1980 to 87.5% presently. The average decline in nominal FFR between 2001 through 2010 of 2.3% further declined to a range of 0%-.25% for most of 2009 and January of 2010. It is highly unlikely that the Central bank would further reduce the nominal rate to below zero. It is highly likely that nominal FFR will be raised in coming months. The fact that nominal FFR reached zero and that the range of FFR has declined steadily over the last 29 years, since inflation peaked in 1981-1982 raises the legitimate question of whether or not future lowering nominal FFR will be effective to stimulate in the next deflationary cycle, or even possible given political constraints against going below a -0- nominal rate.

It is important to understand the direct relationship between the increasing debt, largely accrued from past reflation efforts, and the collapse of nominal FFR. Over the latest decade nominal FFR has declined 62% when compared to the preceding 47 year average (6.04%). When we compare the two decades of negative real rates the [1971-1980] period when real rates averaged negative .28% and the [2001-2010] period, when real rates averaged negative .23% with nominal FFR the decline is even more, on average 70.4%.

Going forward if we are unable to sustain a positive nominal value for FFR a positive Price of Money will also be unsustainable. When the central bank purposely holds the Price of Money near zero for a sustained period it contributes toward debasement which one must conclude is an accepted, even if undisclosed, cost by the Central bank which is committed to the reflation by monetary means. Private sector effects of this unprecedented discounting of FFR will be discussed in Part 2, of The Price of Money but deserve some mention.

The central banks extended use of discounted and or negative Fed Funds Rates changes the nature of private sector borrowing. During a reflation the Fed is focused on increasing the quantity of loans and not whether the borrowed funds go into bad investments. Individuals and companies borrow primarily based on the cost to borrow. When the cost of federal funds is discounted it is understated. This understatement of the FFR understates the entire rate spectrum. The understatement of loan cost also distorts real risk associated with the investment. If the Fed distorts risk through discounting the price of money than the risk to the borrow associated with a given price is also distorted by understatement. For example an individual might determine that an unfettered loan with an 8% mortgage rate would be uneconomic while a 4% loan, associated with lower business risk, would be economic. However if the real economic risk is 8% than the lowered rate by the central bank of 4% conveys an understated risk and will likely lead to misinvestment.

The private market player is being bombarded by discounted and negative FFR over long periods of time which distort the real risk of borrowing. If the Price of Money should be 2% plus inflation, in a riskless loan and higher when time cost and risk of repayment increase than the distortion of real loan risk by the Central Bank which offers money for extended periods below its real price leads directly to private loan misinvestment. Misinvestment occurs when the borrower faced with a mispriced loan borrows based on an understated risk. The borrow would not have borrowed if the loan reflected the real risk at a higher interest rate. The ability of mispriced loans to create loan demand can best be illustrated by envisioning what you might invest in if the loan cost was zero, one percent, two percent, three percent and so on. As The price of money (the cost) increases you become more selective in what you may borrow for.

When the price of money is artificially depressed by the central bank the real risk associated with that particular loan remains unchanged. Just because the Fed distorted the cost of the loan does not influence the real risk of the loan in the economy. This distortion of risk by the Fed lulls borrowers into borrowing to much, quantitative errors, as well as investing in uneconomic projects, misinvestment which directly leads to bubble creation. The substantial destruction of social wealth and welfare brought on by bursting bubbles is well documented. The central banks involvement in creating the bubble through extended use of discounted and negative Federal funds rates is not broadly understood.

THE FEDERAL FUNDS RATE and DERIVITIVES

In an environment of essentially zero cost FFR bad derivatives like overextended commercial real-estate can be held on the balance sheets of large banks in a dormant state. When Central Bankers misprice risk through severe discounting of the FFR, lenders will attempt to get paid for their true risk and therefore will write derivatives to take in premium for the risk of the artificially low rate going up. This is especially true when the Central Bank is paying banking intermediaries to borrow or when the real FFR is negative. In 17 out of the last 20 years the central bank has discounted the FFR rate. This mispricing of risk is directly responsible for a significant portion of the derivatives written in the last 20 years. Two thoughts on derivatives:

1) Central to mitigating the use of derivatives is a plan that restores the real price of money to the FFR. Establishing the rule that only interested parties can write derivatives would greatly limit their speculative use. 2) Life insurance has required that insurance on an individual can only be written by an interested party.

CONCLUSION

Part 1 of The Price of Money focuses on the public side of the economy. The proposition forwarded herein states that monetary and fiscal tools used by policy makers to moderate economic cycles and restore growth loose their ability to stimulate and indeed become dysfunctional in high debt environments. Decision makers, judging by the recent

number of interventions do not believe this theory is correct. The nature of the dysfunction in these policy tools becomes apparent by showing evidence over roughly 40 years supporting the proposition that the past use of traditional monetary and fiscal tools is partially responsible for the present inability of these policy tools when applied to return the economy to traditional growth and employment patterns. Moreover, overtime, after repeated use of debt related or dependant tools it becomes apparent that monetary and fiscal tools serve to prop up private debt and at an inflection point inhibit or prevent growth while often expanding public debt.

Moreover the reflationary periods that rely on traditional fiscal and monetary stimulus also prop up higher levels of private debt buy interfering with the deflationary process and in so doing have the unintended effect of inhibiting private business participation in an environment which is artificially overpriced by government reflation policies. For these reasons it appears that reflationary policies, fiscal and monetary, generate both increased public and private debt in their wake which in turn reduces the effectiveness of policy tools in the next reflation cycle because they enter the cycle with ever increasing piles of debt a portion of which was carried forward by the private sector in addition to the increasing public debt.

Specifically, the post-recession reflationary efforts observed following in particular, the last four deflationary recessions over 29 years have evidenced an increased reduction in both the nominal and real federal funds rate, (“FFR”) until the nominal rate crashed into zero. In the prior 47 years average nominal FFR was 6.04% and in the last decade average FFR is 2.3%, a decline of over 61%.

This destruction of nominal FFR during the last decade, a largely negative rate environment may not correlate well with the prior negative real rate environment which occurred from 1974 through 1980 when nominal FFR averaged 7.78%. Although in the present decade real FFR averaged negative .23% and in the prior decade real FFR averaged negative .28% which lead directly to an inflation and an inverse policy response of a spike in nominal FFR that induced a second severe recession.

However there were dramatic differences in nominal FFR between the two periods. In the prior period (1974-80) nominal FFR averaged 7.78% compared to the present average of 2.3% (2001-10). The prolonged earlier period of negative FFR had a destabilizing and distinctly inflationary effect on the economy. During the prior period the Fed sharply increased both real and nominal FFR rates to smother double digit inflation which caused the economy to lapse into a sharp deflationary recession (the 1981-82 periods) at least as severe as the prior recession (1973-75) when negative rates prevailed. During the prior period the debt level as a percent of GDP was around 31% and now it is approximately 93%, three times the prior period’s public indebtedness. This elevated level of has dramatically reduced the effectiveness of further fiscal and monetary stimulus measures. If high debt will limit future fiscal stimulus than an average nominal FFR which is presently merely .125% with a range of 0-.25% gives no room for monetary stimulus through further nominal FFR rate reductions.

Both public and private sectors are burdened by debt directly attributable to traditional fiscal and monetary reflations. Monetary stimulus interferes with the deflation to correct the debt excess in the private sector and allows debt that would otherwise fail to survive. It also encourages new borrowers by offering them discounted interest rates and greatly increasing the availability of money to borrow through the banking system. Fiscal Stimulus usually requires direct loans for spending programs by the government and directly increases public debt in an effort to stimulate economic growth. Debt-financed fiscal policy has declined in its ability to expand growth. Overtime the cumulative results of these efforts to stimulate result in increased federal debt which circuitously requires ever increasing doses of stimulus to cause the same effect. Additionally, the accumulated private debt dampens the public’s appetite for more debt as increased public debt eventually dampens investor’s appetite to invest more as the certainty of repayment is called into question. These twin results from the induced reflation impacts rates, credit worthiness and economic activity going forward and in subsequent periods, eventually traditional reflation efforts become ineffective.

Although it is intuitively appealing based on similar negative real rate periods, to conclude that prolonged periods of highly stimulative negative real FFR leads to an inflationary period such as 1979–1983, when the level of public debt at the time was merely 30% of GDP, today it is close to 93% and expected to be at 100% by mid 2010. The drag from large federal debt was not present in the 1974–1980 reflation and could reverse the earlier inflationary result with a period of deflation. The conclusion therefore has to be that Keynesian Stimulus efforts in a high debt environment are destabilizing and will most likely lead to exaggerated inflationary or deflationary or both cycles.

As a result of the destruction of intervention effectiveness over repeated reflation cycles the positive effect of a dollar of spending on increasing GDP has declined, so too has the ability of politicians to influence desired Phillips Curve tradeoffs effectively [Zero Hour graph]. What’s more, the recent extensive reflationary efforts of the Fed and partisan incumbents recently has been taken without regard to the root causes of the imbalances that appear to be tied to prior excessive uses of these same policy tools. The diminishment of traditional fiscal and monetary policies’ effectiveness is supported by a 40-year review of reflationary periods and documented in Charts 1, 2 & 3, as well as the Zero Hour Graph.

Although the Zero Hour Graph suggests causality between increased total debt and declining growth from spending, it is intuitively appealing. Admittedly it is insufficient to prove the case that the decline in effectiveness of traditional monetary and fiscal interventions is directly related to increased public debt however it is equally irresponsible to not seriously consider the possible dysfunction of public spending in a high debt environment. In this context one would be amiss to avoid the positive relations between increased prior public debt and prior reflation efforts. However, it helps to explain the declining influence of traditional fiscal spending on employment and the central bank’s increasing dependence on discounting the price of money to lower the drag from federal debt interest requirements.

When the economic system reaches the point (in a Zero Hour environment) when nominal FFR is sustained near Zero and real FFR is Negative then the evidence suggests that even an infinite amount of quantitative easing will have no positive influence on growth. At that point maintaining discounted or negative rates merely appears to pad banks reserves through increased nominal earnings but does not stop the decline in bank portfolios due to low market participation. The destruction of the price of money is a bad substitute to stimulate growth when compared to market demand for goods and services. The proposition that the declining effectiveness of fiscal stimulus is inversely correlated to increased public debt is sufficiently supported when FFR crashes to zero and the real rate of FFR is negative to bring our present novel methods of intervention into question.

The public policy process of sustaining inflated values to counteract de-leveraging of excess loans resulting from the prior reflation represses market transactions by supporting artificially high prices and is counter-productive.

The diminished effect of traditional fiscal spending in a rising public debt environment has left partisan incumbents groping for new methods to extend incumbency by influencing employment (Phillips Curve) or alternately through directed transfers and coercion (outside the Phillips Curve). The incumbents have also shown little interest in the interrelationship and the derogatory carry-forward effects of debt from their past interventions.

With the traditional links of federal intervention broken, partisan incumbents will no doubt continue to adopt new tools to protect and extend their incumbencies, whether or not they influence Phillips Curve tradeoffs to do so. New tools will probably involve laws and coercive regulations like those targeted to special interests that restrict salaries or reward owners of certain types of vehicles. An indication of future policy measures is therefore the array of new tools utilized by the current administration to “reflate” the economy in the wake of the financial crisis of 2007–2009.

This new, broadened effort to reflate through numerous new interventions still relies on the expansion of public debt, which is clearly shown to be an obstacle to the reflation efforts.

In an unprecedented effort to buttress the reflation efforts, the Federal Reserve has made extensive and unorthodox purchases of GSE’s and MBA’s , placing a trillion new dollars into the monetary base by the end of 2009. These funds selectively re-liquefied certain large banks. Political incumbents and the Fed have apparently united in what might prove to be an erroneous effort to restore growth through currency debasement.

Another scenario, which in many ways is worse than the inflation scenario, is that significant increases in debt-to-GDP ratio tend to increase the real interest rate (Japan). One recent study concluded that “a 20 percent point increase in the US Government debt-to-GDP ratio should lead to a 20-120 basis points [0.2-1.2 percent] increase in real interest rates.” This can happen in one of three ways: the nominal interest rate rises and inflation stays the same; the nominal rate stays the same and inflation falls; or, the nightmare case, the nominal interest rate rises and inflation falls. [Niall Ferguson]

Even though the destabilizing consequences of the myriad of new debt-dependent interventions by government are apparent to all objective economic observers, the sequence of how the consequential debt will unfold requires more study. Thus fiscal and monetary evidence supports the social devolution and dysfunction in effectiveness of Traditional Keynesian stimulation in an environment of high public debt, particularly when the administrations of these public policies are highly debt dependant.

In an effort to treat economic symptoms of distress, partisan incumbents have rolled out new and unprecedented debt-financed interventions with little interest in the causes of the present deflationary recession. Nor are they able to understand the impact prior reflation interventions have had on the present recession. To the partisan incumbents, if monetary policy is a screwdriver, then the screw and the driver have been stripped; and if fiscal policy is the hammer, everything looks like a nail.

The evidence shows that repeated use of the FFR rate to stimulate has derogatory long-term effects on wealth and social welfare. The Central bank while maintaining artificially low rates for prolonged periods of time undermines the Price of Money. Risk is distorted such that borrowers are lulled into low rate loans they wouldn’t make had the fed not intervened.

In Part 2 of The Price of Money we strive to shed more light on how the outlined destabilization may manifest itself over the next two to five years. By looking at the effects of mispriced money on private markets and its effect on individual borrowers, focusing on the period from 2000-2010 risk distortions are apparent and will be focused on. We will show how prolonged periods of mispriced money will misprice risk and lead to reckless borrowing (the Austrian School). Finally the disequilibrium ushered in by these multiple public interventions, must be associated with the interventions themselves. Showing the private effects of these multiple interventions may flush out the magnitude of the social costs we chose to sustain as we proceed on this course.

Nothing has changed since this paper was written except the level of US debt has gone from 30% to 130% of GDP. On 8/24/24 the consequences of Gerome Powell’s flooding the economy with newly printed money and the profligate spending by Trump and Biden/Harris which led to elevated inflation, and has transferred huge wealth from the middleclass to the upper 1%. [drove the money stock(M2) from $15.3 trillion in December of 2019 to $21.7 trillion in April 2022, a 42% increase in merely 28 months. 1) the Coronavirus relief Act, 12/2720 of $2.3 trillion, 2) the American Rescue Plan Act, 3/11/21 of $1.9 trillion, 3) the ongoing Inflation Reduction Act, 8/16/22 of $1.8 trillion(Cato estimate) and numerous other spending programs In June of 2022 the Fed started reducing its balance sheet by over 20%, after increasing it over 100% since 2016, inflation has dropped to below 3% and money supply has come down nominally to $21.025 in June of 2025 M2]. The by product, the gargantuan national debt, remains, unpaid and in many views unpayable.

REFERENCES

Phillips, William, 1958 The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957. Published in the Quarterly Journal Economia

James Bullard, Saint Louis Federal Reserve Bank, president, & W.S.J., Mike S. Darby Dow Jones News release both on Dec. 4, 2009

Alesina, A. and Sachs, J., 1998: “Political Parties and the Business Cycles in the United States, 1948–1984”, Journal of Money, Credit and Banking, 20 (February 1989), 63–82

http://www.jstor.org/pss/1992667.

Lawrence H. White, The Theory of Monetary Institutions, (Malden, Massachusetts, Blackwell Publishers, 1999), 189–192.

The National Bureau of Economic Research, NBER,

Public Information Office: “US Business Cycle Expansions and Contractions,”

http://www.nber.org/cycles.html in “List of Recessions in the United States,” http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States.

Bureau of Labor Statistics, BLS, “Labor Force Statistics from the Current Population Survey” http://www.bls.gov/CPS/ in “List of Recessions in the United States,” http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States.

Congressional Budget Office, CBO, "The Prospects for Economic Recovery," February 1982, http://www.cbo.gov/ftpdocs/51xx/doc5135/doc03b-Entire.pdf.

Edward Cowan, “Bank Lending Rate Set at Record 14% by Federal Reserve,” The New York Times, Financial Desk: May 5, 1981, Section A, Page 1, Colum 1 http://www.nytimes.com/1981/05/05/business/bank-lending-rate-set-at-record-14-by-federal-reserve.html.

Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and Consequences,” FDIC Banking Review, December 2000, http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf.

Daniel J. Mitchell, “The Historical Lessons of Lower Tax Rates,” Backgrounder #1086, The Heritage Foundation, July 19, 1996, http://www.heritage.org/Research/Taxes/BG1086.cfm.

Tracy Foertsch & Ralph A. Rector, “The 2001 and 2003 Bush Tax Cuts: Economic Effects of Permanent Extension,” Webmemo # 1361, The Heritage Foundation, February 15, 2007, http://www.heritage.org/research/taxes/wm1361.cfm.

James Bullard, President Federal Reserve Bank of Saint Louis, “Fed’s Bullard Urges Shift” by Michael S. Derby, Wall Street Journal, Friday, December 4, 2009.

Niall Ferguson, Lawrence A. Tisch professor of history at Harvard. “An Empire at Risk” Newsweek, Dec. 7, 2009.

“Credit Easing: A Policy for a Time of Financial Crisis” by J. Carson, J. Haubrich, Kent Cherny, and S. Wakefield. [Economic Trends].

Chart 1: Monetary Policy Intervention [“FFR”]

Federal FFR Real FFR Theoretic FFR +/-Theoretic

Year Nominal[2] Inflation [I][3] [FFR]-[I]=[4] [I+2%=][5] FFR[6]

1971 4.66 4.4 0.26 6.4 -1.74

1972 5.5 3.2 2.3 5.2 .30

1973 8.23 6.2 2.03 8.2 .03

1974 10.5 11.0 -0.5 13 -2.5

1975 5.82 9.1 -3.28 11.1 -5.28

1976 5.05 5.8 -.75 7.8 -2.75

1977 5.54 6.5 -.96 8.5 -2.96

1978 7.93 7.6 .33 8.6 -1.67

1979 11.19 11.3 -.11 13.3 -2.11

1980 13.36 13.5 -.14 15.5 -2.14

1981 16.38 10.3 6.08 12.3 4.08

1982 12.26 6.2 6.06 8.2 4.06

1983 9.09 3.2 5.89 5.2 3.89

1984 10.22 4.3 5.92 6.3 3.92

1985 7.41 3.6 3.81 5.6 1.81

1986 7.3 1.9 5.4 3.9 3.4

1987 6.66 3.6 3.06 5.6 1.06

1988 7.57 4.1 3.47 6.1 1.47

1989 9.22 4.8 4.42 6.8 2.42

1990 8.1 5.4 2.7 7.4 0.7

1991 5.69 4.2 1.49 6.2 -.51

1992 3.52 3.0 .52 5 -1.48

1993 3.02 3.0 .02 5 -1.98

1994 4.2 2.6 1.6 4.6 -.4

1995 5.84 2.8 3.04 4.8 1.04

1996 5.3 3.0 2.3 5 0.3

1997 5.46 2.3 3.16 4.3 1.16

1998 5.35 1.6 3.75 3.6 1.75

1999 4.97 2.2 2.77 4.2 0.77

2000 6.0 3.4 2.6 5 0.6

2001 3.77 2.8 .97 4.8 -1.03

2002 1.25 1.6 -.35 3.6 -2.35

2003 1.0 2.3 -1.3 4.3 -3.3

2004 1.75 2.7 -.95 4.7 -3.95

2005 3.375 3.4 -.025 5.4 -2.025

2006 4.975 3.2 1.775 5.2 -0.225

2007 4.5 2.8 1.7 4.8 - .3

2008 2.21 3.8 -1.6 5.8 -3.6

2009 0.25 2.5 -2.25 4.5 -4.25

Chart 2— Federal Debt

Real GDP Federal Debt Debt/ Trade Deficit

Year Billions $[7] Trillions $[8] GDP (%)[9] Billions $[10] Productivity

1971 1,127.1 .398 34.59 -1.302 4.1

1972 1,238.3 .427 33.36 -5,443 3.2

1973 1,382.7 .458 31.99 1,990 3.0

1974 1,500.0 .475 30.99 -4,293 -1.6

1975 1,638.3 .533 31.09 12,404 3.5

1976 1,825.3 .620 32.91 -6,082 3.1

1977 2,030.9 .698 33.09 -27,246 1.7

1978 2,294.7 .771 31.92 -29,763 1.1

1979 2,563.3 .826 31.06 -24,565 0.0

1980 2,789.5 .907 31.12 -19,407 -0.2

1981 3,128.4 .997 31.22 -16,172 2.1

1982 3,255.0 1.14 36.44 -24,156 -0.8

1983 3,536.7 1.37 37.32 -57,767 3.6

1984 3,933.2 1.57 38.96 -109,072 2.7

1985 4,220.3 1.82 42.18 -121,880 0.5

1986 4,462.8 2.13 46.75 -138,538 2.9

1987 4,739.5 2.35 48.57 -151,684 0.5

1988 5,103.8 2.60 49.54 -114,566 1.5

1989 5,484.4 2.85 51.17 -93,141 1.0

1990 5,803.1 3.23 55.29 -80,864 2.1

1991 5,995.9 3.66 60.13 -31,135 1.6

1992 6,337.7 4.06 62.69 -39,212 4.3

1993 6,657.4 4.41 64.88 -70,311 0.4

1994 7,072.2 4.69 64.89 -98,493 1.0

1995 7,397.7 4.97 66.12 -96,384 0.1

1996 7,816.9 5.22 65.31 -104,065 3.0

1997 8,304.3 5.41 63.90 -108,273 1.9

1998 8,747.0 5.53 61.72 -166,140 2.8

1999 9,266.4 5.65 59.42 -265,126 3.1

2000 9,817.0 5.67 57.01 -379,835 2.9

2001 10,128.0 5.81 56.79 -365,126 2.5

2002 10,470.0 6.23 58.81 -423,725.2 4.1

2003 10,961.0 6.78 60.46 -496,915 3.8

2004 11,686.0 7.38 63.15 -607,730 2.9

2005 12,422.0 7.93 62.48 -711,567 1.8

2006 12,178.0 8.51 63.63 -753,283 0.9

2007 13,808.0 9.01 64.20 -731,258 1.5

2008 14,441.4 10.57 73.18 -673,300 1.3

2009 13,200 12.18 92.27 -372,000 2.5

CHART 3- FFR Addendum

Year FFR Inflation Rate Real FFR Discounted Price

1950 1.3

1951 7.9

1952 1.9

1953 0.8

1954 1.01 0.7 0.31 -2.69

1955 1.79 -0.4 2.19 -.81

1956 2.73 1.5 1.23 -1.77

1957 3.11 3.3 -0.19 -3.19

1958 1.57 2.8 -1.23 -4.23

1959 3.31 0.7 2.61 -.39

1960 3.21 1.7 1.51 -1.49

1961 1.95 1.0 .95 -2.05

1962 2.71 1.0 1.71 -1.29

1963 3.18 1.3 1.88 -1.12

1964 3.5 1.3 2.2 -0.8

1965 4.07 1.6 2.47 -0.53

1966 5.11 2.9 2.21 -0.79

1967 4.22 3.1 1.12 0.12

1968 5.66 4.2 1.46 -1.54

1969 8.21 5.5 2.71 -0.29

1970 7.17 5.7 1.47 -1.53

http://www.federalreserve.gov/releases/h15/data/Annual/H15_FF_O.txt

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Graph I: The Zero Hour

Graph 1: The Zero Hour shows the dramatic decline in the effectiveness of fiscal spending from 1966 through 2002. The Graph measures the dollar increase in Nominal GDP per $1 increase in total US debt. The trend line intersects zero when new debt has zero effect on GDP. The effect of debt spending on boosting GDP has significantly declined since 1966 and 198

1 Reflationary periods are estimated to occur when the FFR is negative and/or discounted below the real price of money (1 + 2%) following each deflationary recession [see Chart 1 for more details]. Money is assumed to have a real positive value of 2%. If the real FFR is below 2% and above zero, the price of money is being discounted by the Central Bank. If real FFR is below zero the Price of Money, it is said to be “negative”.

2 Throughout this paper it is assumed that when the FFR is set below the inflation rate to stimulate the economy in recessions, the Fed essentially incentivizes banks to loan by “paying” them to borrow funds. Conversely, when the Fed wants to choke off loans to slow economic activity, it sets the FFR sufficiently above inflation to inhibit borrowing. The Central Bank is said to be restrictive.

[1] A note to remember: high productivity with low unemployment is the best medicine for the instabilities and imbalances of a deflationary/inflationary environment. From 1996–2004, we experienced high productivity of approximately 3.0% compared to 1.3% during the remaining 26 year period that spanned 1974–2009. This period of high productivity was clearly affected by the extension of the personal computer and Internet to places where they actually revolutionized economic reality. No longer just payroll generation machines, computers added to output by normal people. The technology surge buffered us from the imbalances that would have led to destabilizing deflation and inflation. Abnormally high productivity also minimized the duration and length of the 2001 recession. However, high productivity is unlikely to repeat over the next decade because it is unlikely that innovation of the magnitude of the Internet will appear in that time frame. Moreover, high productivity in a low unemployment environment is not present to mitigate the length and depth of the present recession.

[2] Nominal Federal Funds Rate annualized.

[3] Average Annual Inflation Rate based on CPI.

[4] Real Federal Funds Rate, which equals [FFR]-[Inflation].

[5] Theoretic Value of the Federal Funds Rate, which is the Average Annual Inflation Rate plus 2%.

[6] The subtraction or addition from or to the theoretic value, which is the Nominal FFR minus the Theoretic Value of FFR. Shows magnitude of change in value of theoretic FFR by the Fed.

[7] Bureau of Economic Analysis http://www.bea.gov/national/nipaweb/DownSS2.asp?3Place=N#ZXLS

[8] U.S. Department of Treasury http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo4.htm

[9] O.M.B. http://www.whitehouse.gov/omb/budget/fy2009/pdf/hist.pdf

[10] U.S. Census Bureau http://www.census.gov/foreign-trade/statistics/historical/gands.pdf

Dane Krich