Last Tuesday the Fed announced a surprise rate cut of 75 basis points, the biggest cut in 24 years. Even so, the stock market plunged, with the S&P 500 shedding 1.1% during the session, bringing its total losses to over 10% for 2008.
The Fed has now painted itself into a Keynesian corner. According to old-school Keynesianism, the government faces a Phillips Curve tradeoff. It can adopt a loose monetary policy, which spurs output but leads to price inflation. Or, the government can adopt a tight monetary policy, which keeps prices under control but leads to recession.
The sobering experience of the 1970s demonstrated that this Keynesian orthodoxy was nonsense. Ultimately, printing green pieces of paper doesn’t make a society richer, it just causes prices to rise. Once citizens adjust to the constant injections of new money, unemployment returns along with massive price hikes. Thus the term “stagflation”—meaning double-digit rates of unemployment and inflation—was coined.
Yet memories are short. It has been decades since Paul Volcker took over the helm at the Federal Reserve in 1979 and jacked up interest rates—yielding the painful recession in 1980—to wean the country off of his predecessors’ cheap-money policies. Since that readjustment, Americans have become used to the new paradigm, where unemployment can safely remain under 5 percent while inflation stays even lower.
Despite this clear-cut lesson, Keynesian thinking permeates the financial press. Those concerned about recession clamor for aggressive rate cuts, saying that inflation can be handled down the road. They ignore the fact that once the inflation genie is out of the bottle, it’s very difficult to get it back in again.
We are closer to the dark days of the 1970s than many people realize. During 2007, consumer price inflation was 4.1 percent, the highest it’s been in 17 years. The dollar is near record lows against the euro. Gold and oil prices have set all-time record highs in the past few months.
If the national discussion on monetary policy is bad, the debate over fiscal policy “stimulus” may be even worse. The politicians and pundits never explain how borrowing money from one group of Americans, in order to give tax rebates to a different group of Americans, is supposed to raise total spending. Things would be