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Tuesday, February 16, 2010 7:36 PM

"Three Paths Forward" - Kansas City Fed on Current U.S. Fiscal Imbalance, Hyperinflation, Printing

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It's a rare and welcome event to see the Fed discuss the horrible fiscal policies in Washington D.C., monetary printing, and hyperinflation. For a voting member of the FOMC to do so makes it all the more welcome.

Inquiring minds are certainly interested in Knocking on the Central Bank’s Door by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City.

The United States is moving into an era in which government finance is taking center stage. Fiscal measures taken to bring the economy out of recession, mounting longer-term liabilities for Social Security and Medicare, and other growing demands placed on the federal government have invited a massive buildup of government debt now and over the next several years.

Congressional Budget Office (CBO) projections have the federal debt reaching an unsustainable level of two to five times our total national income within the next 50 years, which leads us to an inescapable conclusion—U.S. fiscal policy must focus on reducing this debt buildup and its consequences.

In managing our nation’s debt going forward, it strikes me that we have only three options. First, the worst choice for our long-term stability, but perhaps the easiest option in the face of short-term political pressures: We can knock on the central bank’s door and request or demand that it “print” money to buy the swelling amounts of government debt. Second, perhaps more tolerable politically, although damaging to our economy: We can do nothing so long as domestic and foreign markets are willing to fund our borrowing needs at inevitably higher interest rates. Or third, the most difficult and probably the least palatable politically: We can act now to implement programs that reduce spending and increase revenues to a more sustainable level. ...

As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well.

Lessons from History

Throughout history, there are many examples of severe fiscal strains leading to major inflation. ... German hyperinflation is one classic and often-cited example, and with good reason. When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a 500,000 Mark German note. He had been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house. In 1923, it would not even buy a loaf of bread. He said, “I want you to have this note as a reminder. Your duty is to protect the value of the currency.” That note is framed and hanging in my office.

Someone recently wrote that I evoked “hyperinflation” for effect. Many say it could never happen here in the U.S. To them I ask, “Would anyone have believed three years ago that the Federal Reserve would have $1¼ trillion in mortgage back securities on its books today?” Not likely. So I ask your indulgence in reminding all that the unthinkable becomes possible when the economy is under severe stress. ...

Last Friday, I read that an economist at the IMF raised a question of whether central banks should allow higher rates of inflation during normal times to give them more room to adjust for shocks. While this may sound like a reasonable theory from a credible economist, my concern is that it rationalizes solutions to short-term problems that too often take an economy down the wrong path. ...

Three Paths Forward

Returning to my opening comments, I see just three ways forward in dealing with our current and prospective fiscal imbalances. While each involves considerable pain only the third will resolve the imbalances without eventually causing inflation to accelerate or precipitating a financial and economic crisis.

Monetize. One option for dealing with a fiscal imbalance is for the central bank to succumb to political pressure and monetize the debt. ... This process often appears benign at first, but if it goes on unchecked, the outcome is almost always higher levels of inflation and ultimately a loss of confidence in the value of the currency and the economy. Walter Bagehot’s famous dictum about banks holds equally true for governments—once their soundness is questioned, it is too late.

Policy Stalemate. The second path forward is a stalemate between the fiscal and monetary authorities. In such a stalemate, the fiscal imbalance grows while an independent central bank maintains its focus on long-run price stability. ... Eventually, this combination of large debt, and high cost of borrowing and capital weakens economic growth and undermines confidence in the economy’s long run potential. Slowly, but inevitably, if the fiscal debt goes unaddressed, the currency weakens, as does access to global financial markets. And the cycle worsens, leading ultimately to a financial and economic crisis.

Equitable Fiscal Discipline. The Canadian experience in the second half of the 1990s is suggestive of the third—and the only responsible—way to resolve our growing fiscal imbalance: By addressing its source in an environment of price stability. ... In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation.

Knowing inflation is not an acceptable alternative to strong fiscal management, a government faced with rising debt levels must provide a credible long-term plan to reestablish fiscal balance. The plan must be clear, have the force of law and its progress measureable so as to reassure markets and the public that the country has the will and ability to repay its debts in a stable currency.

To be broadly accepted, the plan must be seen as fair, in which there is a sense of shared sacrifice across all segments of the economy. Without being specific, these requirements suggest an approach in which we are willing to disappoint a host of special interests. It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors, and resolving our banking problems and the perception that Wall Street is favored over Main Street, all of which would otherwise foster mistrust and cynicism among the public. ...

No Short Cuts

Finally, there are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth.


As I mentioned in the beginning, the fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis. ...

The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.
Hoenig Ridicules The IMF Chief Economist

It is good to see someone else ridicule the IMF. I did so in Inflation Targeting Madness and Economically Illiterate Fools at the IMF.

The big difference is that Hoenig in a position of authority.

Hoenig On Congressional Spending

That someone on the Fed would openly express fiscal concerns about Congressional spending and hyperinflation, while blasting the chief economist at the IMF is unprecedented.

Hoenig clearly hits the mark with concerns over "controlling budget earmarks, trimming subsidies to numerous economic sectors, and resolving our banking problems and the perception that Wall Street is favored over Main Street, all of which would otherwise foster mistrust and cynicism among the public."

Hoenig Dissents

Moreover, Hoenig is willing to take a stand against Bernanke. Please consider Hoenig Dissents Over FOMC’s ‘Extended Period’ Pledge on Rates.
Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, has called for an increase in the benchmark interest rate “sooner rather than later” in two speeches since October. He brought the message yesterday to his fellow policy makers in Washington.

Hoenig dissented from the Federal Open Market Committee’s pledge to keep rates “exceptionally low” for an “extended period.”

Hoenig has voiced concern inflation could surge within a few years with the economic recovery gaining strength and the benchmark interest rate at a record low of zero to 0.25 percent.

The central bank should lean toward an increase in the main rate even with unemployment at 10 percent, near a 26-year high, he has said in speeches and a Jan. 11 interview.

Hoenig said in a Jan. 7 speech that the central bank should move to reduce record amounts of stimulus, with a goal of boosting the benchmark interest rate eventually to “probably between 3.5 and 4.5 percent.” He didn’t give a timeframe.
I have never wanted to stand up and salute a Fed speech or a Fed Governor before, but I am saluting Hoenig now.

Mike "Mish" Shedlock
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