The Great Supply Side Debate of 2007 Is Over

Posted: Dec 05, 2007 11:56 AM
The Great Supply Side Debate of 2007 Is Over

As the year comes to a close so does the inter-Nicene argument between free-market economists about gold and inflation. Both are passing because of the same cause – the passage of too many months without the end of the world as we know it.

For those of you who are just now joining the discussion, here’s the background:

The founders of the supply-side economics movement, such as Arthur Laffer, believed that in order to predict future inflation, it was necessary to look at various markets. Some of their followers, in an excessive reaction to liberal disdain for gold, took things further and claimed that gold and gold alone held the key to the financial future. As a general -- not a universal -- rule, people who made their living in investment markets tended toward the first view and people who made their living as part of a movement (columnists, advocacy group staff, bloggers, etc.) held more tightly to the gold-only view.

As the Fed not-so-gradually hiked interest rates (that is, tightened money) from 2004 into 2006, the fissure widened. Gold continued to signal inflation, but interest rates did not. I first wrote about this in the Summer of 2005 for National Review Online (Supply vs. Supply), and again a year later in TCSDaily (The Financial Paradox of Our Time) The Fed continued to tighten, gold continued to rise, but inflation remained tame. From time to time, I’d write another article pointing to yet another month of low inflation and I’d get courteous emails from some (and angry emails from other) gold guys who would say that the inflation would show up soon or was ‘just beginning to show’, etc. But the inflation never did show. It peaked in 2004, right on schedule, one year after the Fed’s presses were at their hottest, and has stayed low-to-average ever since.

Some of the gold guys modified their position a little, acknowledging that perhaps other indicators, such as the behavior of bond investors, should be looked at. Some kicked the can down the road a little, good-naturedly, and with little fanfare, postponing their inflation predictions from ‘06 to ‘07, or changing their Fed hike forecasts to a later date. Some simply refrained from addressing predictions of exploding prices or cratered bond markets, as if they had never been uttered.

On the other hand, some gold guys became angry and paranoid. They hinted darkly that the inflation optimists among us were somehow ‘pimping’ for the administration or in some way or another were ‘kept’ men. The government is lying, claimed some members of the lunatic right, and we were complicit. I’ll answer them separately; the X-Files forecasting guys deserve their own article.

Month by month, the tame inflation data have rolled in. Month by month, the sensible gold guys adjusted their positions, and the cranks adjusted their decibel levels. But now all of that is over. As of this writing, we are four years past the Fed interest rate trough. If the great inflation which is alleged to come from it hasn’t appeared yet, it never will.

Furthermore, the Fed has been easing since August anyway, so the tight Fed period is over. The experiment has run its course; from now on any inflation data has to take into account the large infusions of liquidity in the second half of 2007.

Strangely enough, some of the shrillest voices who had been warning us that the Fed was too loose over the past couple of years became some of the loudest voices pushing the Fed to loosen more this past summer. Somehow these guys managed to twist themselves into some kind of pretzel logic in which the Fed was too loose, but should loosen more to save the economy, but then tighten again after the economy was saved. But if the Fed was already too loose, how would loosening more save the economy? For the pretzel logic guys, the economy was suffering from rates that somehow were too loose and too tight at the same time. That’s way too complicated for me; I need things simple. The Fed was too tight and the credit crunch was the final proof of that fact, which even the toughest hawks could no longer deny.

So, where do we go from here? If we’re teachable, we learn. We adjust our models to account for what the data told us. We shift our vision forward and realize that we’re in a phase of easier money. We remain diligent about the inflation which might come from a 4% Fed Funds rate, but did not come from a 5.25% rate. We continue to take the slings and arrows of our blogging, editorializing and advocating brethren, and we continue to do what we got into this business to do in the first place: to learn the wisdom of the markets and to explain it to our clients, our readers, and our friends.