Out of Control Policy Blog

Oil Prices and Monetary Policy

“Most excellent article.   Off the charts, if only that could get published in the NY times or WSJ.   Thanks for taking the time to expound on critical issues.”

That is the lone comment on Jeffrey Snider’s most recent post published today at RealClearMarkets. As a peer, I regard him as one of the most insightful commentators on current Federal Reserve policy and by far the most underrated. An archive of his work can be found here.

His most recent work eloquently describes the distortions occurring in our economy as a direct result of monetary policy, a phenomenon I have highlighted numerous times since the Fed first opened it’s free money floodgates. Like all Snider articles, it is a must read.

From the article:

“At the heart of [artificial asset price inflation] is the misconfiguration of risk within monetary policy. For central banks, especially the Federal Reserve, risk is risk, undifferentiated. In reality, there is a chasm between financial risk and real risk. Certainly there are positives to convincing businesses and individuals to take and accept financial risk, but if it is not matched and then surpassed by true economic risk it is a doomed effort. Convincing an army of day traders to put money at risk speculating on stocks (or real estate) in the financial economy is wholly different than getting the same number of people to start their own business or to upgrade and invest in current businesses. At some point, should asset prices and paper "wealth" rise far enough, people stop working altogether and simply live off their accumulated paper wealth, all the while extinguishing true productive wealth that labor engenders. This is not a fine line either, it is night and day, yet the Fed does not distinguish between risks, expecting that an increase in financial risk-taking is a perfect substitute for an increase in real economy risk.

That is where the reflation attempt always falls apart. It encourages financial risk at the expense of, not in conjunction with, real economic risk. Current economic thinking is that getting participants to accept financial risk will eventually lead to a broadening of participation in real risk. But history shows rather conclusively that forcing financial risk-taking actually cannibalizes real risk-taking, thus reflations feature weak growth in both wages and real capital investment. When everybody is making easy money in asset markets, no one wants to work hard building or expanding a real business that might take years to bear fruit (and will likely be a net cost over the intermediate term), the mass psychology of asset bubbles. The economy at the margins is perverted into a kind of momentum-chasing price addict, herding the majority of marginal participation away from true production where it is really needed.

Again, it appears to work and is sustainable temporarily as long as there is a path to close the monetary circulation loop. In the recovery years since 2008, there has been no way to close that loop since the credit system has been chronically malfunctioning (the lack of balance sheet capacity and higher lending standards), and the overseas trade imbalance has now been recycled into regular US treasuries (at least until late 2011). Thus the reflation attempt has been fragmented into this yearly dance where optimism reigns around Christmas and early winter, then falling apart by summertime as monetary expansion fades and recession fears "unexpectedly" re-appear.

But in this new cycle of annual mini-reflations, there is a ratcheting upward of negative imbalances such as commodity prices, so it is not a neutral proposition. The economy has become zombified. Without a full circulation pathway, commodity prices cannot be matched by incomes, and thus consumers and households end up worse off than before each respective mini-reflation cycle. So as the economy "dies" with each commodity spike, the Fed and ECB return and revive it with even more asset prices - which only kill it again.”

Read the entire article here.

James Groth is Research Associate


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