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Economic and Market Commentary

In Democracy We Trust

"The fiscal authority need not bow down to the monetary authority, as if the Great War Against Inflation were still being fought."

I never cease to be amazed by the degree of deference that politicians pay Fed Chairman Greenspan. It could be that he’s simply smarter than all of them. More likely, however, it is a case of Mr. Greenspan having more power than all of them. Thus, Congress exercising its constitutional oversight responsibilities for monetary policy is a case of the subordinate getting a performance review from a group of bosses that act as if they are actually the subordinates.

I can assure you that this is not the case at PIMCO. In performance reviews here, the bosses are the bosses and the subordinates are the subordinates, and everybody knows the difference. I like it that way, whether I happen to be wearing my boss hat or my subordinate hat. Accountability goes both ways, with the boss held accountable for clearly articulating objectives and knowing the facts, and the subordinate held accountable for understanding the objectives and owning up to the facts.

It’s an objective exercise, because we all have a common objective: collectively making money by providing a product that our clients collectively value with their fee money. In reviews, we leave our egos at the door as well as discussion of private proclivities. Almost all of us are personal libertarians, and performance assessment is about professional performance, not our private lives.

The figure is a line graph showing the year-over-year change in the core U.S. Consumer Price Index (CPI) from 1958 to 2004. By early 2004, the level is at about 2%, just off bottom of 1% at the beginning of the year, its lowest level since the mid 1960s. The chart uses a vertical line marking late 1979 to mark the beginning of the great war against inflation. Shortly afterwards, inflation peaks at almost 14% in 1980, then starts to sharply decline, reaching below 4% by late 1983, then rising to about 5% in 1985, then falling to about 4% by the late 1980s. It again peaks in the early 1990s around 6%, before beginning a steady decline to its 2004 level. The chart also marks May 6, 2003, as the day the War in Iraq is declared won and the start of a new campaign to win the peace of price stability.

Inside The Beltway Is Different
In Washington, such is not the case. For politicians, success is not about making money, but maximizing power. It does, to be sure, take money to win in politics, but money is not the objective, but merely a means to an end: obtaining power from we the people to legislate value judgments (sometimes also called morality) on behalf of we the people. Yes, that’s what government does: legally codifies property rights, both in matters of commerce and matters of personal liberties. And, there is nothing wrong with this!

Rules and regulations are the price of legally-transparent, enforceable commercial activities as well as the price of a morally-transparent, civilized society. Government is not inherently bad. Rather, it is inherently good. If it did not exist, we would have to invent it. While most in business easily applaud Adam Smith’s invisible hand of markets, it is much more difficult for many to applaud the visible fist of our collective will, as expressed by our government. This should not be.  

Democracy starts with the socialist notion of one person, one vote. Yes, socialist notion! Accordingly, the democratic political process is inherently about equity: a struggle for justice in the distribution of our collective economic pie, rather than the size of the pie itself. This exigency is in direct conflict with the cumulative voting system called capitalism, in which one dollar is accorded one vote.

The pursuit of profit, sometimes also called greed, is the energy directing Adam Smith’s invisible hand, with growth in our collective economic pie the time-proven result. The ethos of capitalism is, however, agnostic at best about whether the economic pie is distributed justly and, more cynically, is antagonistic to the idea.

Thus, democracy and capitalism are strange fellow travelers: visible socialist ideals dueling with the invisible enigma of greed.

But what does this have to do with the Federal Reserve, you ask? The Fed is, most simply and also most profoundly, the referee between the competing needs of democracy and capitalism.

Soft or Hard?
Democracy inherently favors soft money or, if you prefer, populist money:

  1. It lubricates the ability of our leaders to promise the electorate more in goodies than we are collectively willing to fund via taxes; and
  2. through unanticipated inflation, redistributes income/wealth from creditors to debtors, the latter who outnumber the former.

In contrast, capitalism inherently favors hard money or, if you prefer, honest money:

  1. It serves as a straight-jacket to keep democratically-elected fiscal authorities honest preventing them from trying to re-distribute a bigger economic pie than the invisible hand can create in a non-inflationary way; and
  2. protects the real value of the wealth of creditors, who are out-numbered by debtors at the ballot box.

The Fed’s mission is to straddle the competing interests of soft and hard money advocates. The democratically-elected legislature’s job (which constitutionally has the power to declare what is and isn’t legal tender, “good for all debts, public and private” – as it says right on front of the folding green in your pocket!) is to hold the Fed accountable for the trade-offs it makes between the competing interests of debtors and creditors.

This is not, of course, precisely how the Humphrey Hawkins Act of 1978 describes the Fed mission. Legislatively, the Fed is charged to:

“…maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Most economists – and certainly most Fed policy makers! – argue that in the long run, these three goals are not in conflict. More precisely, they argue that there is no long-term trade off between employment (unemployment) and inflation. More precisely still (for the wonks amongst us), they argue that the long-term Phillips Curve is not a curve at all but a vertical line anchored at the “natural” rate of unemployment.

This leads to the conclusion that the Fed cannot permanently “buy” lower unemployment with a higher inflation rate, and that attempts to do so will only result in higher inflation. Accordingly, modern-day monetary orthodoxy holds that in the long run, the Fed’s three-part mission collapses to a single mission: price stability, which will both foster the best possible outcome for employment and moderate long-term interest rates. This orthodoxy is, by the way, the raison d’etre of the European Central Bank’s single objective to maintain price stability, established by treaty amongst sovereign nations.

In America, legislation enabling the Fed’s operational independence is much more reflective of both economic and political reality. Most important on the economic front, the Humphrey Hawkins Act implicitly (if not explicitly) accepts the notion that in real time, the Phillips Curve does exist , even if not in the long-run. The legislation recognizes that there is a real-time trade off between the pursuit of price stability and the pursuit of maximum employment, and instructs the Fed to exploit that trade-off in real time, so as to maximize the welfare for the citizenry at large.

I hasten to add, in fairness to those of a more orthodox persuasion, that they accept that a real-time Phillips Curve does exist, as the Humphrey Hawkins Act assumes (or presumes). They just don’t want central banks to exploit it, because they believe that since there is no exploitable long-term Phillips curve, central bankers should not be tempted to nibble on the long-run inflationary apple.

I don’t harbor such fears, even as I recognize the proverbial slippery slope of inflationary bias that comes about when central banks are instructed to include real-time employment growth in their policy formation. Why? First and foremost, I believe that intellectual honesty demands symmetry in central banks’ pursuit of price stability. The dirty little secret of central banks fighting inflation in the long run is resisting “excessive” growth of employment in the short run.

The anti-inflation reaction function of central banks, always and everywhere is to fight inflation by throwing somebody out of work (or preventing her from getting a job in the first place)! Marx called these conscripted citizens in the fight against inflation the reserve army of the unemployed and he was right about that (although wrong, colossally wrong, about many, many other things).

Accordingly, I think that central bankers are too smug by half, or more than half, to argue that they should resist exploiting the cyclical Phillips Curve on the job-creating side of the equation, when they blatantly – even if implicitly – exploit it on the inflation-fighting side of the equation. Thus, strictly as a matter of intellectual honesty, I am offended by central bankers who pretend to their political masters that they can’t really do anything for employment in the long run but to nurture price stability in the long run.

Paul A McCulley
July 28, 2004

1 http://minneapolisfed.org/research/qr/qr531.pdf


3 http://www.federalreserve.gov./boarddocs/testimony/2001/20010125/default.htm


Past performance is no guarantee of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for educational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.  

The Personal Consumption Expenditures (PCE) deflator is published by the Bureau of Economic Analysis as part of the GDP report. It measures inflation across the basket of goods purchased by households, and is computed by taking the difference between current dollar PCE and chained dollar PCE.

No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2004, PIMCO.

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