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So, it appears that Ben Bernanke is a
neo-Keynesian. This does not bode well, as neo-Keynesians are typically so
confused by theoretical foofoo that they are almost
incapable of doing the right thing at the right time. One example of such
"foofoo" is something called the
"sacrifice ratio," which is sort of an area-under-the-curve
rendition of the Phillips Curve. More specifically, the "sacrifice ratio"
indicates the amount of unemployment caused by higher Fed policy rates
compared to the amount of inflation prevented by Fed policy rates. A high
"sacrifice ratio" indicates that as the Fed raised rates to
"fight inflation," the economy would have to make a "larger
sacrifice" in terms of unemployment. The people who make up such
statistics tell us that the "sacrifice ratio" is presently quite
high. (Note again my regular use of quotes as a sort of conceptual condom.
Don't for a second take this stuff seriously. Please.)
David Kotok of the
investment fund Cumberland Advisors (quite a successful fund, by the way, and
clients of ours back in the day) has a good description of the "sacrifice
ratio" here. He thinks that the interpretation of a "high sacrifice
ratio" means that the Fed will tend to raise its policy rates further
than expected, to combat inflation now instead of allowing it to get out of
hand. Apparently some gnomes in the Fed have been calculating the
"sacrifice ratio" on a regular basis.
The problem with such concepts as the
"sacrifice ratio," and especially when they are taken seriously by
professors/writers of textbooks/chairmen of the Federal Reserve, is that
people begin to believe that the "sacrifice ratio" exists. Proper
monetary management, as we have been saying just about every week now,
involves direct base money adjustment (not an interest rate targeting
policy) to manage the value of a currency, thus preventing either
inflation or deflation. Where in the "sacrifice ratio" concept is
either direct base money management or currency value mentioned? They are
not. Thus, by adopting the "sacrifice ratio" concept, monetary
bureaucrats are virtually guaranteed to not think about what they should be
thinking about, and as a result, screw up somewhere down the line. (Thus the
incessant use of quotes to protect the innocent reader from being poisoned by
these very dangerous neo-Keynesian concepts.)
Yet it should be perfectly obvious by now that
a proper base money adjustment response to a weak currency/inflation
situation (if one has inflation, which one shouldn't if they've been doing
their job right), produces lower interest rates and typically less
unemployment. In other words, it fixes the problem, rather than
leading, as the "sacrifice ratio" concept implies is the result of
"fighting inflation", to higher interest rates and more
unemployment, i.e. hard evidence that a mistake has been made.
A very good notion, of which Ronald Reagan was
a fan, is this: an effective economic solution should result in a better
economy, immediately, not a worse one.
Okay, one should already be cracking a bit of
a smile at this Virgins-in-the-Volcano economics. But the "sacrifice
ratio" concept is actually a little more dangerous than that. For it
implies that, if one makes the necessary sacrifice (i.e. unemployment, aka a
crap economy), then one indeed fixes the problem of inflation. But that
doesn't work either. Throwing virgins in the volcano is just a waste of
good virgins. Actually, it is entirely possible that raising a central
bank's interest rate target will make inflation worse, because, as the
economy crumbles in response, the currency falls further in value (as
measured against the benchmark of monetary value, gold). Indeed, it is often
the case that lowering a central bank's interest rate target can actually
create more employment/better economy and a rising currency, i.e. less
inflation! We have been seeing that in Brazil and Turkey recently. However,
lest one think that the solution for the US is lower central bank interest
rate targets, let me point out that this phenomenon tends to work best when
starting interest rates are quite high, 8% or higher.
Behind the "sacrifice ratio" concept
lies the concept that inflation is cured by unemployment. This is not
entirely mistaken, as a recession does typically mean that businesses must
clear inventories by cutting prices, or that workers will take a lower wage
to get a job. The result is a depressive effect on the measured CPI. However,
real inflation is a monetary adjustment to prices resulting from a decline
in currency value. If the dollar goes to $0.50, then it will eventually
tend to cost two dollars to buy what one dollar used to buy. It does no
particular good to try to solve the problem of a change in currency value by
burning down the economy.
It's amazing that academic economists continue
to flog these ancient and long debunked Phillips Curve notions for generation
after generation, occasionally dressed up again in new terminology such as
the "sacrifice ratio." But then, if they didn't cling to the
Phillips Curve, they might find that they don't have any ideas at all!
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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