Prosperity for All

An Interview with Arthur Laffer

OR: A number of thoughtful people feel that current monetary policy is a coordinated debasement of the currency. Do you think that we're beyond the point of no return?

Laffer: No.

OR: How do we get out at this point?

Laffer: We went from $840 billion monetary base before QE1 to about $4 trillion monetary base now. If I know my numbers correctly, I think the currency in circulation was about $800 billion and bank reserves were about $45 billion before the beginning of QE1. Now currency in circulation is around $1.2 trillion and bank reserves are at $2.8 trillion. The Fed has also extended the duration of their balance sheet, so that the maturity of their assets is extraordinarily long.

There are two issues I see as really critical in the Fed's balance sheet. One, by having such a long maturity, the mark-to-market value of the Fed's balance sheet is highly sensitive to changes in interest rates. If the 10-year were to go up to six percent, the Fed would have an unfunded liability of about $800 billion -- maybe even a little bit more. I find that extraordinarily worrisome. Though all of my colleagues do not worry about this: they say the Fed owes these liabilities to itself and that it can hold the assets to maturity. I don't think that's a good argument.

I'm very worried about the insolvency of the Fed. I'm very worried about the monetary base and that excess reserves are huge. Excess reserves are something like $2.7 trillion. I mean, it’s just an enormous number -- which means that if inflation gets started there would be no way to stop it.

OR: Could you actually go into why you are concerned about the Fed being owed money by itself to itself?

Laffer: Because my model of how the Fed behaves has proven to be very incorrect. I had the classic textbook model à la Bernanke, à la every Fed person, à la Milton Friedman. This holds that open market operations increase the monetary base. The monetary base through the money multiplier increases the money supply, and the increase in the money supply matched by the quantity of goods is the inflation driver. Inflation is everywhere and at all times a monetary phenomenon. That has been my mantra for years and years. It’s proven out pretty well -- until we got to 2008. It has proven to be a total loser since then. I’m still worried about it.

OR: Why do you think that is?

Laffer: I don’t know. I tend to want to go back to Fischer Black’s article on inflation, that it's a metastable equilibrium situation. I really have a hard time in my heart believing that.

OR: Do you think the Fed will raise rates?

Laffer: I think probably they will. That's what I'm worried about. If inflation starts there is no restraint on it coming from the monetary base. Excess reserves are about $2.5 or $2.6 or $2.7 trillion -- and that worries me. If excess reserves were zero today, I would have very little fear of inflation.

Imagine as I outline what follows that I have support from both the House and the Senate, that the President loves me and gives me full support, and that I have total control of the Fed and the Treasury. What I would do is to take the Fed's balance sheet and swap all assets of maturity two years or more with the Treasury for T-bills laddered between zero and two years. It would be a net-zero transaction. By doing that, even though the balance sheet of the Fed would still be the same, the risk, the sensitivity of the solvency of the Fed to interest rates, would be removed almost completely. Now, you could take the 10-year up to six percent or seven percent, and there's virtually no change whatsoever in the mark-to-market value of the Fed’s assets.

After that, I’d take all the excess reserves at the Fed and distribute them pro rata to all the major banks in proportion to their excess-reserves holdings until I brought excess reserves down to zero. By doing that I would remove the risk. Other people don't think it is a risk at all. I don't think they're being realistic.

OR: The conventional view holds that these massive excess reserves you’re talking about have already been sterilized, correct?

Laffer: Yes. They've allegedly been sterilized because interest is paid on them. Nonsense. It’s 25 bips. Give me a break. Take me through their process there. Look at an individual bank with $1 reserves and you'll find that 25 bips is nothing, if there are any interest rates out in the market to be had from lending.

OR: Do you think that they’ll be able to raise rates in view of the dollar rising? Do they seem to be very worried about that now?

Laffer: Let me get it out of rate context. If they raise the TIPS yield, I’d be really happy because the TIPS is the expected real return on the unit of capital over the maturity of the TIP instrument. If they raise the nominal yield because of expected inflation, I’ve got a problem. It’s not just what happens to yields. It’s how those yields are construed. Now, I think cutting tax rates, going to a lower-rate broad-based flat tax, imposing spending restraints, creating sound money, pushing free trade, setting up minimal regulations, and then getting the government the hell out of the way would increase the expected real return on capital dramatically and rates would rise a lot -- but not because of inflation. That, I think, would be wonderful.

OR: You don’t think that would pop a housing bubble or debt bubble?

Laffer: No. I don’t think there is any housing bubble. We’ve got the worst housing market since 2006 and it’s shown no signs of improving. None. New housing starts per 10,000 population is way below its historical trend and has been since 2006.

OR: Are you worried about the general credit market?