Art Laffer, John Taylor, Simon Johnson Respond to the Fed’s ‘Great Unwind’ Problem
Merle Hazard performs “The Great Unwind,” his latest economics music video, produced by Nashville Public Television.
In his latest song, Merle, aka Nashville money manager Jon Shayne, addresses the problem the Federal Reserve Bank faces with the more than $2 trillion it has created since the Crash of ’08. Remove the money from the banking system and risk another mega-contraction? Let it circulate and risk inflation? Find out how Jon developed the idea for Merle’s latest hit, and check out the lyrics below, then see how different economists are responding.
> When the crisis hit us in ’08, the Fed’s what got us through,
Buyin’ assets by the trillion. What else could they do?
Though they bailed out banks and brokerages, at the time, I didn’t mind.
But now I’m worryin’ about…The Great Unwind.
Our Fed’s the central bank to a deeply troubled nation.
If they sell off bonds, the markets tank. If not, some day, inflation.
Now, the money has been flyin’, but could the Fed be flyin’ blind?
That’s why I’m worryin’ about…The Great Unwind.
Some say the Fed can manage this without sellin’ off its bonds;
That they’ll pay high interest on reserves, and bankers will respond.
But payin’ bankers not to lend ain’t how the system was designed,
So I’m still worryin’ about…The Great Unwind
Will the Fed thread the needle? Or are they going to blow it?
Are we on the mend, or near the end of fiat money as we know it?
I would never wish to be a man who’s cruel, or unkind,
But I am worryin’ about The Great Unwind
Yes I’m worryin’ about…The Great Unwind
We asked a number of our economist friends to respond, and Thursday, we present three of them: John Taylor, Simon Johnson and Art Laffer. Friday, we’ll hear from Jamie Galbraith, Ken Rogoff, Justin Wolfers and Greg Mankiw.
The first is John Taylor, known for his so-called “Taylor Rule” of Fed monetary policy, which he and we explained in some detail a while ago. John, who has long taught economics at Stanford, was George W. Bush’s undersecretary of the Treasury for international affairs. Here is his reaction to Merle’s latest:
I’ve been writing about the costs of unwinding unconventional monetary policy since the Fed started its massive bond buying four years ago. Now, just in time for the actual unwinding, we have the online debut of Merle Hazard’s funny and informative “The Great Unwind,” a country and western song about the Fed’s current predicament. Like Merle’s earlier numbers — such as “Inflation or Deflation” and “Bailout” — his new song tells you a lot about monetary policy. Full disclosure: I’m a real fan of Merle Hazard as I said in this promotional video Merle Hazard Meets John Taylor for “Inflation or Deflation.”
Economists use the word “great” too much, but it’s quite fitting for Merle to use it here. We had the Great Moderation; good monetary policy played a big role in that. Then we had the Great Recession; a deviation from good monetary policy (I call it the Great Deviation) helped cause that. Now we have the inevitable Great Unwind of the Great Deviation. In a nutshell, the Great Deviation killed the Great Moderation, gave birth to the Great Recession and the Not-So-Great-Recovery and has left a troublesome legacy to undo — the Great Unwind — as Merle explains.
The second is Simon Johnson, economics professor at MIT, fellow at the Peterson Institute for International Economics and former chief economist for the International Monetary Fund. Here is his reaction to “The Great Unwind”:
Mr. Hazard starts out well — making the point that the Federal Reserve’s reaction to the crisis in 2008 was dramatic and largely appropriate. Faced with a precipitous decline in the availability of credit, Ben Bernanke’s Fed bought up assets in an effort to keep interest rates below what they would otherwise have been. Rather than just determining short-term interest rates — which is the way monetary policy usually works — the Fed has had greater than usual impact on longer-term rates, including what people pay for mortgages and other consumer loans. (For more basics, I recommend this interview with Joseph Gagnon, one of my colleagues at the Peterson Institute for International Economics.)
“The Great Unwind” refers to how the Fed will exit from these assets holdings because, presumably, at some point the economy will recover enough so the Fed would like to end this phase of extraordinary policy.
Mr. Hazard is also correct that if the Fed were to sell its bond holdings precipitately, the prices of those bonds would fall — and interest rates on those bonds would increase (bond prices and interest rates move inversely). The effects on the stock market and the broader economy could also be negative — primarily because the recovery is still so weak.
The sleight of hand here is when Mr. Hazard mentions his concerns about inflation, at the 50 second mark. But how do we get inflation when the economy remains soft — and unemployment relatively high? The idea that bond buying would destabilize inflation expectations has been proved completely incorrect. And repeated predictions that the economy would bounce back so fast that it would instantly overheat have also proved substantially off-target.
There is no sign that the Fed has lost control over monetary policy or that it would be unwilling to recognize signs of accelerating inflation, should those materialize. I’m also puzzled that Mr. Hazard does not mention what should be his bigger worry — the rise of moral hazard as we move through the credit cycle (even if inflation stays low — as it did in the run-up to 2007-08). The Fed and the rest of us can see inflation coming. But who is willing to address the messed up incentives that result from some financial institutions being “too big to fail” (or jail)? Financial regulation — and the lack of progress on this dimension — remains our Achilles’ heel.
It is fine to pay attention to the “Great Unwind” and this video makes a constructive point in an entertaining manner. But you (and Mr. Hazard) should worry more about what happens when bank executives backed by open-ended implicit government guarantees are paid to take excessive risk: they get the upside and the rest of us face the downside risk (mass unemployment), again.
Third is Arthur Laffer, whose “Laffer Curve” inspired the tax-cutting policy of the 1980s (and beyond) known as Reaganomics. He recently wrote about his theory’s application to state income tax policy on the Business Desk. Here’s what he had to say about Merle:
Merle Hazard has outdone himself with “The Great Unwind.” Humorous, catchy and infinitely entertaining and yet truly serious. “The Great Unwind” is the toxic legacy of “W,” Obama and Bernanke.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions