Chart of the Day: The Laffer Spike

posted at 10:11 am on June 11, 2009 by Ed Morrissey

Arthur Laffer, who brought us the Laffer Curve in the 1980s, has another kind of geometric shape for us today in the Wall Street Journal.  Let’s call it the Laffer Spike, and unfortunately this one isn’t hypothetical.  It demonstrates the massive boost in monetary supply pushed by the Fed and the government, and its historical singularity (via QandO):

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

Laffer says we don’t have a historical model for this kind of action, and cannot accurately predict its effects.  That’s not entirely true.  While the US has never done this before, we do have at least one historical parallel from the 20th century: the Weimar Republic government of Germany that preceded the Nazis.  In fact, they deliberately printed money and devalued their currency in order to pay off (in worthless currency, but at face value) the crushing national debt imposed on them by the Treaty of Versailles.

Some have suggested that the US will have to follow the same model to rid itself of the massive debt we’re incurring now, which makes investors much less enthusiastic about Treasuries.  We’ve already begun to see the effects of this policy on the bond markets, with investors demanding higher yields as a hedge against the runaway inflation of this model.  The Financial Times reports that the US had to push yields up to 4% to get buyers this week, and they expect more trouble in today’s auction:

US long-term interest rates rose to the highest level of the year on Wednesday, threatening the “green shoots” of recovery, after the latest sale of 10-year government debt met with a tepid response from inflation-wary investors.

Concerns about the growth of government borrowing forced the US Treasury to give investors in an auction of $19bn in 10-year notes a yield of 3.99 per cent – 4 basis points higher than the yield available before the auction. That constituted the biggest yield markup since a 10-year auction in May 2003, said Morgan Stanley. Yields on the 10-year note, the benchmark rate for US mortgages, hit a high of 4 per cent during the day, up from 3.6 per cent a week ago. …

The next test of the US Treasury’s issuance program looms on Thursday with the sale of $11bn in 30-year bonds. An auction of 30-year bonds last month went badly as investors signalled their concerns about the budget deficit.

“That did not go well last time, so there is also some additional concern,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

If we have to keep paying higher interest rates for the Treasuries, we’re going to see much bigger deficits in the coming years than either the White House or the CBO projected earlier, as our debt service will skyrocket:

Unless we cut spending now, we’ll be setting up an inflationary ride like nothing we’ve seen before.


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