Thursday, December 22, 2011

The Untold Tale About Income Inequality

The annual OECD report on income inequality released a short time ago has once again received its ritual media coverage in Canada with headlines like “Rich-poor gap growing in Canada” and “The rich are getting richer and the poor are getting poorer”.

The explanation of the growing income gap found in these stories fundamentally involves blaming free markets for causing the export of middle class jobs to the developing world, the privileged who exploit consumers to get fat salaries and bonuses and the politicians who buy financial support from the rich by lowering their income taxes.

There is never any consideration of the really important causes of income inequality in Canada. One of these arises from the aging of the population, which increases the reported income of the growing numbers who are near retirement and have income from work as well as their nest eggs. Increased income inequality due to this phenomenon should not be considered a blemish on society and require corrective policies.

One of the most important causes of growing inequality in Canada never mentioned in the media is due to the country’s immigrant selection policies. Statistics Canada reports that the incomes of recent immigrants initially is about 60 percent of the incomes of Canadians and rises to a maximum of 80 percent after ten years in the country.

Government data show that these recent immigrants are over-represented by more than 20 percent in LICO poverty statistics. (Low income cut-offs, or LICOs, are a gauge of the income level at which a family may be financially stressed because it has to spend a greater share of its income on basic needs, such as food, shelter and clothing, than an average family of similar size.) Of the immigrants living in poverty, 38 percent receive housing subsidies while only 23 percent of Canadians do. Immigrants with low skills compete with low income Canadians, depressing their wages and increasing inequality.

During the last 10 years alone, about 2.5 million immigrants have entered Canada and contributed to the growth in income inequality. Should it be reversed by raising income taxes on the rich, who already pay for fiscal transfers worth $6,000 a year to each immigrant due to progressive tax rates and universal access to government benefits and who already pay much to support the larger number of Canadians who have been pushed into the low-income class by competition from the many immigrants with low skills?

The media reports on income inequality never mention the life cycle of earnings experienced by all Canadians. After schooling, incomes are low but increase with age, reaching a peak around age 60 and drop again in retirement. Would Canadian society really be better off if the government gave more money to the young starting their careers and take it away from those at stages in life where incomes but also family obligations are highest?

These reports also fail to note the presence of Canadian adults in the low income classes that is due to temporary influences like illness, divorce, unemployment or life style choices that see them travel the world or study for a different career. Similarly those in the top income brackets are there only for a limited period of time, like the athletes, performers and artists whose extra-ordinary success often lasts only a few years. Many entrepreneurs and executives in the private sector earn high incomes for a short time in their work lives.

The importance of life-cycle incomes and temporary influences on the distribution of income is documented in studies of the incomes of individuals through time. Statistics Canada tracked low-income earners between 2002 and 2007 and found that 60 per cent moved into a higher income group after one year, 79 per cent did so after two, and nearly 90 per cent after six. In the United States, of 100 workers who were in the bottom 20 percent of earners in 1996, 45 percent had moved to higher brackets nine years later. Of 100 in the top quintile of earners, 39 percent had moved to lower ones.

It is a tragedy that these truths about causes of income equality in Canada rarely reach the public and leave it with a seriously distorted view of conditions in Canada.

Tuesday, November 22, 2011

Bad News from the Immigration Front

Immigration Minister Jason Kenney announced recently that Canada will allow the entry of 240,000 permanent residents to enter the country next year. This is bad news for Canada struggling with a large fiscal deficit, unemployment, income inequalities and environmental problems.

A recent study, which I co-authored with Patrick Grady, showed that recent immigrants who arrived between 1987 and 2004 cost taxpayers an average of $6,000 every year. Applying this figure to the projected number of immigrants, by the end of next year, the tax payer burden will have increased by $1.4 billion and will continue to do so for many years.

This burden does not appear in any government budgets. It arises from a fact, found in data published by Statistics Canada: Recent immigrants on average earn about 70 percent of what other Canadians earn. Because of the progressive income tax system, they pay only half of what other Canadians do. Their low incomes also cause them to pay lower amounts of other taxes.

At the same time, the immigrants are entitled to and use all of the benefits provided by Canada’s welfare state. The result is the annual net fiscal burden of $6,000 per immigrant.

This cost does not account for the other negative effect the immigrants have on unemployment, congestion, pollution and the number living in poverty. Protests about income inequality should be directed at immigration and other government policies, not the free market system.

The Minister should be praised for a shift of emphasis on the selection of immigrants in the Canadian Experience Class program, which fast tracks skilled foreign workers and graduate students who have spent time in Canada on temporary permits or student visas, but the effect on the fiscal deficit is minimal. The number in the Canadian Experience Class in the first full year of the program in 2009 was 2,545. Assuming that on average they have a spouse and one child, under the existing classification system, the program will affect 7,635 immigrants, which comes to 3.2 percent of the 240,000 total to be admitted next year. Nor will the numbers grow much in the future. Only small numbers of temporary workers and students qualify.

According to the Minister, immigrants are needed to meet labour shortages. This argument involves circular reasoning. These immigrants create demand for labour through their needs for housing, schools, hospitals, universities, roads, bridges, sewers, water supply, consumer goods and services. In fact, most of the current and projected labour shortages are the result of recent mass immigration.

The demand for housing from immigrants is especially notable. Assuming an average family size of three and the same settlement pattern as in recent years, new immigrants next year in Toronto will require 27,272 dwelling units, 2,273 every month or 568 every week of the year. The corresponding weekly figures are 235 for Vancouver and 233 for Montreal. To build these accommodations requires much labour and scarce land. It will also lead to higher housing costs and the number of homeless.

Worth noting also is the effect of these immigrants on health care. Given that the average physician in Canada has 240 patients, by the end of next year one thousand additional doctors will be needed. Canada already has a growing shortage of physicians, so waiting lists will lengthen even more, as will crowding in the emergency departments of hospitals.

If the past is guide to the future, there will not be enough doctors in next year’s cohort to meet the new demand. The granting of medical licenses to all immigrants who claim to be a doctor is not a solution either. Canadians will not stand for the deterioration in the quality of services they receive from their doctors.

Canada’s immigration policy needs to be reformed. The influence of politicians, civil servants and the immigration industry on its formulation should be minimized. The heralded points system has failed and needs to be scrapped.

In its place should be market forces used in the selection of economic immigrants (refugees raise a different set of issues and are a small proportion of the total anyway). The basic concept is that landed immigrant visas will be issued only to applicants who have a verified, pre-arranged employment contract at a pay equal to at least that of the average of Canadian. They may be accompanied by spouses and under-age children.

With this minimum income, immigrants will no longer impose a fiscal burden on taxpayers and have a positive effect on average per capita incomes of all Canadians. In addition, the annual inflows will vary according to cyclical labour market conditions, reducing unemployment when economic growth is slow.

The adoption of the proposed policy will make immigrants serve Canada, not Canada serve immigrants. Voters, including past immigrants, are bound to reward politicians who make this change.

Herbert Grubel
Professor of Economics (Emeritus), Simon Fraser University
Senior Fellow, The Fraser Institute

Thursday, November 17, 2011

Bad Fiscal News from the Immigration Front

Immigration Minister Jason Kenney just announced that Canada will allow 240,000 permanent residents to enter the country next year. This is bad news for Canada struggling with a large fiscal deficit, unemployment, income inequalities and environmental problems.

The Minister should be praised for a shift of emphasis on the selection of immigrants in the Canadian Experience Class program, which fast tracks skilled foreign workers and graduate students who have spent time in Canada on temporary permits or student visas, but the effect on the fiscal deficit is minimal.

A recent study, which I co-authored with Patrick Grady, showed that recent immigrants who arrived between 1987 and 2004 cost taxpayers an average of $6,000 every year. Applying this figure to the projected number of immigrants, by the end of next year, the tax payer burden will have increased by $1.4 billion and will continue to do so for many years.

This burden does not appear in any government budgets. It arises from a fact, found in data published by Statistics Canada: Recent immigrants on average earn about 70 percent of what other Canadians earn. Because of the progressive income tax system, they pay only half of what other Canadians do. Their low incomes also cause them to pay lower amounts of other taxes.

At the same time, the immigrants are entitled to and use all of the benefits provided by Canada’s welfare state. The result is the annual net fiscal burden of $6,000 per immigrant.

This cost does not account for the other negative effect the immigrants have on unemployment, congestion, pollution and the number living in poverty. Protests about income inequality should be directed at immigration and other government policies, not the free market system.

The new policy aimed at increasing the earnings power and tax payments of immigrants is laudable, but in effect laughably small. The number in the Canadian Experience Class in the first full year of the program in 2009 was 2,545. Assuming that on average they have a spouse and one child, under the existing classification system, the program will affect 7,635 immigrants, which comes to 3.2 percent of the 240,000 total to be admitted next year. Nor will the numbers grow much in the future. Only small numbers of temporary workers and students qualify.

According to the Minister, immigrants are needed to meet labour shortages. This argument involves circular reasoning. These immigrants create demand for labour through their needs for housing, schools, hospitals, universities, roads, bridges, sewers, water supply, consumer goods and services. In fact, most of the current and projected labour shortages are the result of recent mass immigration.

The demand for housing from immigrants is especially notable. Assuming an average family size of three and the same settlement pattern as in recent years, new immigrants next year in Toronto will require 27,272 dwelling units, 2,273 every month or 568 every week of the year. The corresponding weekly figures are 235 for Vancouver and 233 for Montreal. To build these accommodations requires much labour and scarce land. It will also lead to higher housing costs and the number of homeless.

Worth noting also is the effect of these immigrants on health care. Given that the average physician in Canada has 240 patients, by the end of next year one thousand additional doctors will be needed. Canada already has a growing shortage of physicians, so waiting lists will lengthen even more, as will crowding in the emergency departments of hospitals.

If the past is guide to the future, there will not be enough doctors in next year’s cohort to meet the new demand. The granting of medical licenses to all immigrants who claim to be a doctor is not a solution either. Canadians will not stand for the deterioration in the quality of services they receive from their doctors.

Canada’s immigration policy needs to be reformed. The influence of politicians, civil servants and the immigration industry on its formulation should be minimized. The heralded points system has failed and needs to be scrapped.

In its place should be market forces used in the selection of economic immigrants (refugees raise a different set of issues and are a small proportion of the total anyway). The basic concept is that landed immigrant visas will be issued only to applicants who have a verified, pre-arranged employment contract at a pay equal to at least that of the average of Canadian. They may be accompanied by spouses and under-age children.

With this minimum income, immigrants will no longer impose a fiscal burden on taxpayers and have a positive effect on average per capita incomes of all Canadians. In addition, the annual inflows will vary according to cyclical labour market conditions, reducing unemployment when economic growth is slow.

The adoption of the proposed policy will make immigrants serve Canada, not Canada serve immigrants. Voters, including past immigrants, are bound to reward politicians who make this change.

Some Gossip about Famous Economists

When economists gather at conferences and conventions to share professional ideas, they often have social gatherings at which they love to gossip about their great and famous colleagues. Sometimes I am able to contribute to these conversations as a result of having known a number of famous economists while on the faculties of Yale University and the University of Chicago during the 1960s. On several occasions colleagues encouraged me to write down my stories and the following responds to these encouragements.

Yale University

During my graduate student days at Yale from 1958 to 1962, the economics department had a “golden age”. There were among others Nobel laureates James Tobin and Tjalling Koopmans. Arthur Okun, William Fellner, Henry Wallich, Robert Triffin (the latter two serving as my thesis advisers), Mark Blaug and Richard Ruggles rounded out the faculty that made important contributions to economic science but also held prestigious and influential positions advising presidents, governments and international organizations.

During these years my wife and I did some baby-sitting for the Tobins, encouraged by his bulletin board “earn while you learn”. As a result of this relationship, on a sunny Sunday morning in January of 1961 I received a phone call from Tobin: “Could your wife babysit for us today while you accompany us on a day of skiing?” Over night a foot of snow had fallen on Connecticut and he knew of my passion for skiing.

In short order, we piled into Tobin’s VW van with me sitting in the front seat next to him. A pause in the conversation about the weather was broken by Tobin’s son who asked “Herb, have you heard?..The President called last night?”

He referred to a conversation that was reported by Arthur Schlesinger, the historian and biographer of President John F. Kennedy in a book called A Thousand Days: Kennedy had called Tobin personally to invite him to become a member of his Council of Economic Advisers. Tobin is alleged to have said in response: “But Mr. President, I am an ivory-tower economist”, to which Kennedy replied “That is alright, I am an ivory-tower president”.

The Tobins had brought a picnic and bottle of wine for lunch on the slopes. The mood was a happy one. At one point Tobin said to his wife Betty (who had been his fellow graduate student in economics at Harvard): “Seymour Harris (a very prominent members of the Harvard faculty at the time) was right when he told us that if I wanted to have influence on public policy, it was best to establish first a solid reputation as an academic economist.” No one that I knew had any idea that that Tobin had ambitions to be involved directly in policy making.

Tobin worked in the White House 1961-62 before returning to his ivory tower, but during that year, according to Schlesinger, he became “the economic conscience of the President”. Long after his retirement from full-time teaching at Yale he was similarly considered to be “the economic conscience of the economics department” for his constant reminder about the need to use government policies for reducing the plight of the unemployed.

Somewhat ironically for someone who was most interested in scientific research, his idea that has most captured the imagination world’s policy makers is the “Tobin tax”, which if levied on all financial transactions might be expected to raise huge sums of money. When I queried him about this idea he noted that it was presented in a short memo circulated in Washington to which he attached little importance and on which he agreed with critics that it would be most difficult to enforce as there would always be countries that did not adopt it and profit hugely by attracting most of the world’s financial institutions.

Tobin was a legend in his time for his razor sharp intelligence. It became common knowledge that Herman Wouk in his famous book The Caine Mutiny had his hero admit that his ambition to be at the head of his class at the Naval Academy in Annapolis was blocked by a man named Tobit, who “had the mind of a sponge”. I had found a copy of Wouk’s book in the library and discovered readily the page containing this phrase. It was darkened from use by curious Yalies. When I asked him, he confirmed that he and Wouk had been classmates at the Academy.

Tobin at the time I attended his lectures and seminars was writing scientific papers that earned him the Nobel Prize. His lectures were based on these papers and were as terse and precise as his writings. He had all of us students in awe. However, social contacts with him were very intimidating. He never initiated conversations, made small talk or showed any interest in the personal lives of students.

Perhaps he was just shy, because I personally learned that he was very interested in the private lives of his students. After I had failed the comprehensive examination for admission to the doctoral thesis writing work, I had made plans to quit Yale and enter the business world. Tobin had learned about these plans and asked me to see him in his office. I went there with my heart pounding. He came right to the purpose of our meeting. He wanted me to know that he had confidence in my ability to earn a PhD and that he encouraged me to continue with my studies. He also offered to tutor me in taking examinations that I had found so difficult to pass, given my German background.

This conversation influenced my life decisively. I took another year of courses, passed the examination, all without having to take him up on his offer to tutor me. Many years after leaving Yale, many professional publications and a term as an elected member of the Parliament of Canada, upon a visit to New Haven he said to me “I am proud of you!”

This he said in spite of the fact that during an earlier visit, he invited William Brainard and me to lunch. On this occasion Brainard, a star in the economics department and a favourite of Tobin’s, mischievously challenged me to make the most controversial statement I could think of. I said “The idea that there exists a viable trade-off between inflation and unemployment, the Phillips Curve, was one of the most costly mistakes in the history of economic science”. Tobin and Okun had contributed to the analytical and empirical development of this idea and had pushed for its application in the design of monetary and fiscal policies. While Brainard and I discussed the issue, Tobin said nothing but I saw from his body language that he became increasingly agitated. Finally, he said to me “I resent your suggestion that I duped President Kennedy”. I have no recollection of what I had said to set off this reaction but will never forget the awkwardness of the conversation during the rest of the meal.

Tobin not only contributed significantly to my decision to earn a PhD, he also was instrumental in my joining the faculty of the University of Chicago in the Fall of 1963, the year I was awarded the degree. At the meetings of the American Economic Association in Pittsburgh, he had recommended me to his friend Harry Johnson who was looking for a research associate to work with him on a project that was financed by a generous foundation grant. The position was accompanied by the appointment as a regular Assistant Professor, but with one half of the regular teaching load.

Before turning to my Chicago experiences, I want to mention a couple more episode involving Yale faculty members. One of them was Henry Wallich, a cigar-chomping German-born economist known for his good taste in wine and food. He had published only few studies in economics but was best known for his work as a columnist at Newsweek, where for a number of years, his editorials represented the political middle between the liberal Paul Samuelson and the conservative Milton Friedman. He was also deeply involved in Washington politics, where he organized regular meetings of a group of academic consultants to the Secretary of the Treasury.

Wallich was a member of my thesis committee and made it possible for me to spend the turbulent year 1971 working in the Treasury. Many years later, we met at a conference at the International Monetary Fund and at the reception he introduced me to Paul Volcker as “a former colleague at Yale”. We all laughed when I said “Henry, are you hiding the fact that you were one of my thesis advisors?”

In the seventies I spent a year visiting at the Australian National University. Tjalling Koopmans, a Yale faculty member and Nobel laureate born and raised in the Netherlands, visited the university accompanied by his wife. I had the honour of hosting the two at a picnic in a national park near Canberra. During our conversation, his wife learned that I had been born and raised in Germany. She became very upset and directed some anger at me. Later I found out that she had lost dear family members to the Nazi occupiers in Rotterdam. Koopmans calmly said to her “Herb was only five when the war started”. This ended the incident and I will always remain grateful to Koopmans’ diplomatic intervention.

The University of Chicago

The 1960s were a golden age at the Economics Department of the University of Chicago. It was the home of seven future recipients to the Nobel Prize: Milton Friedman, Theodore Schultz, George Stigler, Merton Miller, Ronald Coase, Robert Fogel and Robert Mundell. There were other famous economists like Al Harberger, D. Gale Johnson, Greg Lewis, and of course Harry Johnson who Tobin once told me would also have been awarded the Nobel Prize if he had lived long enough. My contacts with Friedman, Johnson and Mundell resulted in a number of gossipy insights into their personalities and work that readers might enjoy.

Milton Friedman

The Economist described Friedman as "the most influential economist of the second half of the 20th century…possibly of all of it." In spite of his fame, he was always ready to convert people to his point of view, even if they had no particular interest in economics. I observed the process twice, when at dinner parties he sat next to my wife Toni in Chicago in 1963 and to my second wife Helene in Munich in 1989. In both instances Friedman engaged them in deep conversation for almost the entire dinner. Both women were much impressed by Friedman’s charm and patience and his ability to make them change their minds on some important economic and social issues of the day. When I thanked Friedman for spending so much time with Helene, he said he enjoyed the experience and noted that some people are naturally better economists than many of the highly trained economists he knows.

Friedman was also very understanding and patient with me. One summer we had rented his cottage in New Hampshire after he had moved to a new, hill-top home financed by royalties from the sale of his famous book Capitalism and Freedom and aptly named Capitaf. At the old cottage he showed me a large barn that had served for many years as his study while he was writing his Monetary History of the United States, co-authored with Anna Swartz. Along the four walls of the barn was a thin, continuous strip of paper, which he pointed out to me and identified as the record of the blood flow of the US economy. Stumped by that concept, I asked what that was. He patiently explained that the tape showed the weekly changes in the US money supply during the last 100 years. To this day I am embarrassed about my ignorance at the time but will always remember the gentle way in which Friedman accepted it.

He took great interest in some of my papers that I circulated in draft among the faculty. He was the only person to respond to a paper that had used newly available computers to show how a certain strategy of speculating in forward exchange markets would have resulted in annual profits of ten percent. His comments made me change this finding by pointing out that large currency devaluations could easily wipe out these high annual profits. This experience was indicative of the interest he took in the work of his students, who chose him as dissertation father in large numbers.

Friedman’s interest in his colleagues, even new assistant professors became evident when one morning I shaved off a moustache that I had sported for some months. My family did not notice that I had done so, nor did Johnson, my secretary and several other colleagues. However, as I was walking along a corridor Friedman stopped, looked me in the eyes and said “It is about time you took of that thing. You don’t need it to call attention to yourself!”

Thirty years later after I was elected to serve as a member of parliament in Ottawa, I proudly informed him of my election victory. He responded by saying “You have my condolences as you will quickly be frustrated in your new position.” Four years later after I had decided not to seek re-election, he said “Congratulations. You will now have more influence than you had before.” These exchanges reflect his view that academics can have more influence on policies by remaining outside government, free from political constraints and through research and students change public opinion so that politicians can do the right things. This view made him refuse offers by President Ronald Reagan and others to join policy advisory teams assembled in Washington, but did not prevent him from occasional involvement in public policy debates. He considered his most important influence on public policy to have involved his advocacy for the replacement of the military draft by armed forces staffed by professional, paid soldiers.

Friedman was a keen tennis player and skier. He loved playing doubles with George Stigler and they made quite an impression on the court. Stigler was a famous wit and at over six feet tall towered over the notoriously short Friedman. When my assistant professor colleague William Dewald and I stepped on the court to play, Stigler said “Remember now boys who has tenure around here”. Dewald promptly hit Friedman on the forehead with a ball and we all had a good laugh. Stigler continued to crack jokes all during the match, while Friedman was all business and used clever shots to win points.

Many years later during the 1980s Friedman visited Whistler near Vancouver to present a talk to benefactors of the Fraser Institute. He was a keen skier and I served as his guide. Unfortunately, there had been a big dump of wet snow over night and sunlight scattered by clouds made it impossible to see shadows and the details of the terrain. Skiing was quite easy on runs that had been smoothed by grooming machines, but it was very difficult to see where the untouched deep, soft snow started. To my horror, Friedman skied into this snow that sometimes causes people to fall and to get injured. I quickly skied to him and helped him turn around, showing where it was safe to continue. However, he promptly entered the dangerous terrain on the other side of the run, causing me to worry that I would become known as the man who killed Friedman. Fortunately, he again was safe but the next day he said “I will never again ski at Whistler”.

Friedman was a controversial figure not just among the public and politicians, but also among professional economists. There was a strong rivalry between him and Paul Samuelson, who was the dominant and best-known economist of the postwar years, with a long list of publications and an influential textbook that sold millions in many different languages. In public, both always professed respect for each other and even hinted at friendship. But in private, Samuelson could be quite petty.

One day in the 1960s I sat next to him on a plane to Chicago from Montreal, where we had attended a conference. During our conversation, he told me about the scandalous behaviour of Friedman’s son David, who had ratted on a fellow student who returned drunk to their residence at Harvard. I still puzzle over the purpose of the Great Samuelson telling this story to me, the struggling and insecure assistant professor. Was he trying to discredit Friedman in my eyes or was he just making small talk?

Samuelson also loved tennis. At the end of that Montreal conference we had a match during which, after I had made a good shot, he said “Show me a good tennis player and I show you a poor scholar.” Was he just amusing or had he hoped to increase his chances of winning? I will never know.

Here is another episode involving rivalries between Nobel laureates. At one time, whenever the occasion arose, I asked economists why they thought Friedman and Samuelson would both read the same newspaper with the result that both found stories that supported the positions they had taken on economic theory and policy. Friedman’s response to my question was to call his wife Rose and say to her “Herb has just raised an interesting question”. I never got an answer from the two as others joined the conversation and changed the topic. But James Buchanan, the recipient of a Nobel Prize for his work on public choice theory needed little time to respond, saying “Samuelson does not know any economics!”

Harry Johnson

Wikipedia said the following about Harry G. Johnson: “The enormous admiration and affection for Johnson was reflected in the numerous obituaries by members of the economics profession that appeared in 1977. ‘For the economics profession throughout the world, the third quarter of this century was an Age of Johnson’ (Tobin, 443). ‘He bestrode our discipline like a Colossus’, ‘He was an institution’ (ibid.). ‘Canada lost one of its greatest sons’. He was ‘larger than life’ (the most common remark). ‘The one and only Harry’ (The Economist, 14 May 1977, 121).”

Johnson travelled the world, collecting and storing a seemingly limitless amount of analytical insights, data and names, which he interpreted, integrated and published in his hundreds of articles and many books, one of which was co-edited by me. In the process he advanced and exposed to the world the current state of knowledge in economics. He was scrupulously careful to give full credit to the authors of new ideas and data. He was a kind person, supportive of colleagues and students, but I cannot avoid noting that he was also the victim of the demon alcohol, which often created problems in his inter-personal relationships, especially towards the end of his life. Friedman once referred to him as the “writing machine that feeds on alcohol”.

The seriousness of his alcoholism became clear to me when he asked me to his home for a discussion one day at nine in the morning. As we sat down at the desk he filled a tall water glass with scotch, saying “This is my breakfast.” At 11 that morning he lectured to a class of graduate students, who tended to be dazzled by the brilliance of his insights but were taken back by his habit of virtually reading from his unpublished notes and his lack of interest to engage in discussions with students.

The rivalry between Johnson and Friedman took many forms. In a jolly mood Johnson once remarked to me “Have you noted that at parties Friedman always says ‘Why don’t we all sit down’?”, implying that he did so because of his short stature. Professionally, the rivalry led to a clash of traditional Keynesian economics defended by Johnson for many years and Friedman’s monetarist models, which eventually won over much of the world and even Johnson, who extended the model to the international sphere.

During my visit for a seminar that led to my job offer in Chicago in the fall of 1963, I made it clear to Johnson that if I was hired, I would accept only if I did not have to accompany him and several of his drinking buddies for regular parties that took place after work. He agreed and I never felt any pressure to drink with him.

Johnson could be very generous. At the start of the fall 1963 semester when I moved to Chicago, he picked up my family and me at the airport in his own car and took us to an apartment that he had found for us. He helped me with my research and writing and passed on some slogans that are still vivid in my mind: “Don’t invent history”, “Do not trust intuition, use models”, “Write as if you wanted your mother to understand it”, the latter wisdom I often shared with my own students.

He also allowed me maximum freedom in the choice of research topics and only occasionally reminded me that his foundation grant out of which half of my salary was paid required me to do research on the development of a new theory that could explain international trade in differentiated products. But he did not help me to get started and it is ironic that only after I had left Chicago did I, in co-authorship with Peter Lloyd, contribute to the measurement and theoretical explanation of trade in such products, which became known as intra-industry trade and which earned Paul Krugman a Nobel Prize for publishing a mathematical version of the theory he called the New Trade Theory.

Johnson’s alcoholic escapades became famous. On more than one occasion during his visits to other universities, he passed out at dinner, once allegedly putting his head in the soup plate without waking up. He also sometimes became nasty. In the Fall of 1966 I moved to the University of Pennsylvania but spent the summer in Chicago, writing a paper for a conference that took place there in early September. I asked my secretary to type the paper for me and to indicate my affiliation with the University of Pennsylvania.

In August I received a letter sent by Johnson from India, ominously stamped “Urgent, Private, Confidential”. I opened it with shaking hands and found him accusing me, among other transgressions, of revealing Nazi tendencies consistent with my German background by asking a Chicago secretary to type a paper for a Pennsylvania professor. This letter made me fear meeting Johnson at the conference, but I should have known better. At a pre-conference reception Johnson saw me enter the large room, broke off a conversation he had with someone else, moved quickly through a crowd of people to join me at the other end of the room, shook my hand and exchanged pleasantries with a big smile. His letter had probably been written while intoxicated and his behaviour that evening was a close to an apology anyone could ever expect to receive from him.

His alcoholism led to a stroke. He continued to work and travel walking with a cane, but died in 1977 at age 54. He had many admirers who wished he had lived longer and enriched the economics literature. I remember him fondly and with gratitude for all the things he did for me, which in retrospect were much more important than the memories of his bad behaviour.

Robert Mundell

Mundell and I have enjoyed a friendship that started while we both were on the faculty of the University of Chicago and had children of the same age. He has many influential publications that have been on the reading lists of graduate students around the world. His most important paper was short and had been published just shortly before we met. In this paper he raised a fundamental question about the merit of freely floating exchange rates that Friedman had been advocating. This paper on optimum currency areas was mentioned in his Nobel Prize citation and has earned him the title “Father of the Euro”.

One day in the 1960s, Paul Samuelson was in Chicago to meet with George Shultz, a friend who was the Dean of the Graduate School of Business and later served as the US Secretary of Labour and Secretary of State in the Nixon administration in Washington. Both loved tennis and we played a doubles match in which I was Mundell’s partner.

Mundell and I had won the first set easily and were well ahead in the second set when suddenly the complexion of the game changed. Our opponents began to win points and Mundell’s quality of play deteriorated notably. He and I lost the second and third sets. I have never been able to get Mundell to discuss whether he had one of those episodes of poor play that hit all tennis players or whether he had been playing politics. Perhaps it was both, though when I told Friedman about the event, he assured me that Mundell would never play politics.

During the Spring break in one year a group of faculty members went to Vail for a few days of skiing. Mundell is a good skier, but I was beating him regularly to the bottom of the mountain. During the apr├Ęs-ski beer party in a bar, he got even with me. He said “Herb, why don’t we play a game of chess.” I responded that there was no chess set, which was just as well since I knew of his chess-prowess and my much diminished thinking capacity after an exhausting day on the mountain and a glass of beer. His response was “We don’t need a set, we can just play in our head. My first move is pawn to...” I quickly gave up and declared him a winner. He had proved to our colleagues that while I may be a better skier than he is, he was a much better chess player.

Mundell has been an inspiration to his economist colleagues and many of his students, who have became famous and successful themselves, like Michael Mussa, the former Chief Economist at the IMF; Jacob Frenkel, the former Governor of the Central Bank of Israel and executive in globally important financial institutions and the late Rudi Dornbusch, who taught at the Massachusetts Institute of Technology and whose early death caused his former students to place a full-page obituary in The Economist.

Mundell has been and to this day remains an inveterate organizer and inspirer of international conferences at which some of the most distinguished economists and public figures of the world exchange views and ideas about the global economy. One of the earliest of these conferences in Chicago in 1965 attracted the attendance of Valerie Giscard d’Estaing, France’s Minister of Finance and one of the latest conferences in 2008 saw the presence of Paul Volcker, former Chairman of the Federal Reserve and Under Secretary of the US Treasury for International Monetary Affairs.

I will forever be grateful to Mundell for the encouragement that came from inviting me to these events and from the stimulation to my own research they brought.

Friedrich von Hayek

Hayek was one of the most influential intellectuals of the 20th century, who in 1974was awarded the Nobel Prize in economics. One of his most important ideas concerned the role of markets as the supplier of information without which communist and socialist planning must fail. In his famous book “The Road to Serfdom” he confidently predicted the ultimate demise of societies like the Soviet Union. As a member of the Austrian School of Economics he fought Keynes and his views on the alleged pathologies of free market economies. He did all of this when the majority of economists were Keynesians and had strong sympathies for the socialist management of economies.

In most North American university he was ridiculed for his beliefs and his ideas were considered to be obsolete. He found refuge from this environment at the University of Freiburg, where some of the architects of Germany’s postwar economic miracle had taught.

My father lived in Freiburg and on one occasion when I visited him, I reached Hayek on the telephone and with some trepidation introduced myself, noting that we both were members of the Board of Editors at the Fraser Institute and that I would appreciate having the opportunity to meet him personally.

Without hesitation he invited me to have dinner with him at his favourite restaurant in town at noon the next day. Over a wonderful meal that he insisted on paying for, I asked him “What are you working on these days”. He replied “Socio-Biology”. Stumped, I asked what that was. He smiled as he said, “I had an audience with the Pope in Rome last week and he asked me the same question. I told him that social biology involves the application of Darwin’s theory of evolution to human behaviour and institutions. According to this theory, the existence of the Catholic Church for 2000 years implies that it must have been serving humanity well. The Pope loved it.”

Theodore W. Schultz and Arnold Harberger

The University of Chicago Department of Economics is worthy of Hayek’s study as an institution with a long history of success in attracting outstanding faculty and graduating highly productive students and teachers of economics. The secret of this success became obvious to me during an unforgettable faculty meeting, to which characteristically, three of us untenured Assistant Professors had been invited as a matter of routine.

The issue before the meeting was the need for a colleague to teach the graduate monetary economics courses during Friedman’s frequent leaves from teaching. The discussion was frank but it soon became obvious to me that the grey eminence in the department was Theodore W. Schultz, whose views and judgements were decisive.

Schultz was an agricultural economist who had moved to Chicago in 1943, where he became a pioneer in the field of human capital as an investment in economic growth and development, for which he was awarded the Nobel Prize in 1979.

He was a tall man with a high forehead, an aristocratic appearance, demeanour and way of speaking. He exuded Calvinistic values and together with his wife resembled the couple shown in the famous painting called “An American Gothic”.

Schultz hardly ever joined the daily faculty luncheons at the Quadrangle Club, where gossip and scientific arguments competed for equal time. He preferred instead to have lunch with only one other person. One day it was my turn to be subjected to his inquiring questions and hypothesis testing. Immediately after sitting down he advised me that one should never have lunch alone but always use the occasion for the productive exchange of ideas. I am not sure how well I held up my end of the task, because ominously, I was never asked to join him again.

At that faculty meeting he advocated that in the search for a monetary economist to replace Friedman during his leaves, a list of the world’s four best monetary economists should be compiled and that each should be approached in turn. His suggestion was adopted and the list was headed by Tobin. At the meeting was D. Gale Johnson, an agricultural economist who served as the Dean of the faculty of Arts and Sciences. He immediately announced that his office was ready to pay whatever salary and fringe benefits were needed to persuade the candidate to come to Chicago.

Later we were informed that Tobin had been flattered by having been approached but that he was irrevocably committed to Yale. What a shame. As Tobin told me years before, he respected Friedman’s efforts to link changes in the money supply to price level changes but that Friedman did not adequately explain the mechanism providing this link. Tobin’s goal was to study this mechanism, which he did successfully through the application of portfolio theory. Who knows what would have come of their collegial cooperation and competition for graduate students if they had been on the same faculty.

Later in my career I began to realize the uniqueness of this Chicago quest for the best, which has brought to its faculties more Nobel Prizes in economics and other fields than were received by the faculties of any other university in the world. One important ingredient of this success is evident from the episode just described. Another one stems from the way in which tenure issues were handled. Friedman told me that tenure did not mean much at Chicago. Professors who underperformed after having been granted tenure would receive no pay increases and be given loads of arduous teaching and administration jobs until they got the message and left.

In most other universities faculties and deans have their ambitions for the creation of outstanding institutions restrained by powerful committees and senates, which are dominated by members who are concerned with solidarity and fairness in the spirit of labour unions everywhere. Not so at the University of Chicago.

The selection of students for graduate study was similarly interesting, as I found out when Bill Dewald and I once were asked to rank the 100 or so applicants for admission. As we looked at the files, the first thing that surprised us was that no candidate had a standard achievement test lower than the 90th percentile, most were in the 99th percentile. Obviously, students with lesser scores did not even bother to apply for admission at Chicago.

When he had arranged the pile of application folders in the decreasing order of what in our judgement were students with the best prospects of successful studies, each of the senior faculty selected some for financial support. They used funds that were supplied by charitable foundations with the aim of furthering their research. Friedman opened the top folder and with a look of disgust put it at the bottom of the pile, saying that this student’s record of all As in undergraduate courses was worth nothing. He had been at his university and found the faculty totally incompetent. He rejected another student with excellent qualifications because he was too old, arguing that the return to the social investment in his education over his life-time was too low and that it was more efficient that his place was taken by a younger student, even if his previous record was somewhat inferior.

Another insight I gained from this assignment was that there are few reliable indicators of graduate students’ success in course and dissertation work. At the time, the major economics departments in the US had commissioned a study of the predictive value of grades, specific majors and standardized test scores. This study concluded that the number of courses in mathematics was the best but still weak indicator of graduate students’ success.

Gregg Lewis, the long-time power behind the graduate program did his own research on the topic and found that letters of recommendation from professors who obtained their PhDs from Chicago were the best and very reliable indicators of students’ success in this program. These referees knew how well their students would be able to deal with the pressures of work and competition that characterize the program and that they themselves knew first-hand. Observing these pressures, I sometimes wondered whether I could have handled them, even though Yale was not exactly easy.

Al Harberger

Harberger is known among his many friends and admirers as “Alito” – little Al in Spanish, which is an expression the love and admiration his students from Latin America have had and continue to have for him long after he and they left Chicago. He taught them much basic theory, but his secret of success lay in his emphasis on simple yet extremely important analytical tools that the students could apply readily in their native countries. The analysis of costs and benefits of government policies became the students’ strength and their deft application to important policy issues catapulted many of them into position of very great responsibility.

Some of these students became heads of central banks, ministers of finance and economics, some of them even became presidents of Latin American countries. The “Chicago Boys” who were so maligned by the left media for their influence on Chile’s economic policies under President Augusto Pinochet had been trained mostly by Alito, not Friedman as was alleged.

For at least a decade, a charitable US foundation and some private interests finance an annual gathering of economists in Alamos, a colonial town in the Sanoran dessert of Mexico. Almost all of these economists have a connection to the University of Chicago and market-oriented think tanks. Friedman attended the meetings until poor health made the long travel impossible.

I always observe with admiration the respect and love, which his former students show Alito. In 2012, they will honour him with sets of papers that recount the influence he has had on their own work and success.

Recently at one of these Alamos meetings I asked some Chicago boys from Chile how they came to become the architects of market reforms under Pinochet. They replied that the President had been in search of people who had a plan that would lead to the recovery of the country’s economy. As a general, he put much store in having a plan to reach strategic objectives. It was almost co-incidental that someone told him about these Chicago-trained economists in universities who had a plan.

He promptly gave them much free reign to implement it. It is amusing, if not ironic, that the Chicago plan in fact consisted of getting rid of economic planning and letting free market forces determine demand and supply. To the best of my knowledge, the work of the Chicago boys kept them away from involvement with repressive policies of the Pinochet regime that to this day remain the concern of human rights activists around the world.

While many socialists regret that Salvadore Allende was prevented from making Chile a socialist country modelled after Cuba, only few of them can dispute the fact that Chile today is the most prosperous nation on the continent and that the policies introduced by the Chicago boys provided the base of this success. Because of this fact, the vast bulk of the policies they had initiated were retained by left-leaning governments that have governed Chile in recent times.

As is well known, students learn as much from each other as from their teachers. Harberger encouraged this process strongly by creating an atmosphere in which the Latinos considered themselves to be members of a close family. With the help of his Chilean-born wife Anita, there were many happy parties at their huge home in Hyde Park. Beer not only helped soothe throats dry from animated discussions but also was used to marinate the short ribs and steaks that Alito grilled on his barbeque.

Harberger’s outstanding reputation extends beyond Latin America. When the Soviet Union moved from a planned to a market economy, he visited Russia several times for conferences with politicians and technocrats on how to best make this conversion. An insider told me that of all of the famous economists involved in such conferences, Harberger’s contributions were considered the most useful by far.

My personal relationship with Harberger and his family of students was quite limited. However, when in 1965 I saw him in his capacity as the Chairman of the department to discuss an offer for promotion, tenure and higher salary I had received from the University of Pennsylvania, he showed great sympathy for the difficulty of the decision I had to make. He told me that he could almost guarantee an extension of my Chicago contract by the faculty and dean, but that it was too early in my career to merit promotion and tenure. After insufficient thought, impulsively I rejected his offer for such an extension and committed myself to leaving the next year.

This was a life-changing decision for me but Alito’s reaction speaks volumes about his character. As he studied my folder, he said, your pay is much too low. I will make sure that you will get a decent raise. And he did.

Many years after I had lost complete contact with him, we met at a small conference. Shortly after I had arrived, he invited me for a ride in his car in the hills behind the conference site so that we could have an intimate talk about family and professional life uninterrupted by others. When I expressed regrets about the fateful decision to leave Chicago for Penn made in our meeting many years ago, he consoled me by saying that I had an outstanding career anyway.

I think that his invitation to the car ride and the intimate conversation we had provides insights into one why he enjoys the loyalty, admiration and love of so many of his former students and colleagues.

Tobin and Tobit

Bob Aliber, was a fellow student at Yale and prominent professor of international finance for much of his life at the University of Chicago Graduate School of Business. I asked him to comment on an early draft of my original gossip column. I thank him for this effort, which led to the correction of some factual errors and made me omit some gratuitous, negative comments about individuals. He also urged me to find out more about Tobin and his association with Wouk, which he believed I had described incorrectly. In response, I contacted Brainard at Yale, who had been Tobin’s long-time friend and colleague. Brainard sent me the following excerpt from an interview Tobin had with a journalist, which settles the issue.

TOBIN: That was said in The Caine Mutiny, in the first chapter, and, as you just read, referred to a midshipman, named Tobit, at the school. T-o-b-i-t. It wasn't a very deep disguise. This school was the midshipman's school for what used to be called those "90 Day Wonders." They would take us for 90 days and make us naval officers. We're talking about 1942, the early days of war after Pearl Harbor. We were assembled in this "ship" in Columbia University in a dormitory. We were taught to be naval officers, supposedly in three months. We were arranged alphabetically in the dormitory. At the top were the people with my first initial T, and also U, V, W. We knew the people adjacent to us and up and down better than the rest of the group, and one of those fellows was Herman Wouk. We were acquainted and were good friends. He was famous in the school because he had been a gag writer for Fred Allen and Allen's famous radio program of the day.

Wouk wrote The Caine Mutiny later and he wanted the protagonist in the book to go to the school that both Wouk and I attended. So that's how this matter came up. That's my only appearance in the book. Wouk and I never had any contact after those 90 days-I was not in the same theater of war that he was or on the same ship or anything. That's how all that came about. The first days after the war when I was beginning my teaching career, in the late '40s and early '50s, The Caine Mutiny became a very popular book which all the students seemed to be reading. So, when the word got around that, well, your teacher was in the book, that added to my reputation among undergraduate students, and graduate students, too. Incidentally, for having the best academic record in this school, I, like Tobit, was given a gold watch by J.P. Morgan.


I hope that my reminiscences of conversations with famous economists revealed some interesting aspects of their personal characteristics and professional interests. I doubt that the revelations would have embarrassed them, but this issue does not matter since all except for Buchanan and Mundell are dead.

I am sure that people with any interest in my accounts is small and shrinking quickly. Few of the current generation of economists have any interest in the famous economists of the post-war years. Citations to their work have declined very rapidly. I recently met a new economics PhD who had never read any papers or books by Harry Johnson, nor did he even know his name. Sic venit gloria mundi!

A Proposal for the Reform of Canada's Immigration Policy

On October 25, 201, I had the opportunity to discuss with the members of the Standing Committee on Citizenship and Immigration (CIMM) of the Parliament of Canada my views on how the government should deal with a large existing backlog of applicants for immigration.

This backlog was created by a Liberal government policy enacted in 2002, which promised consideration for immigration permits to anyone who had paid a small submission fee. The backlog consists of about one million applicants and keeps on growing, in spite of the fact that the government has increased the acceptance of applications and raised the level of immigration to the highest levels in decades.

Here is my message to the Committee:

Let me begin my presentation with a radical proposition. The question before this committee should be whether or not to get rid of the backlist altogether, not on how to make is shorter.

The question about the best immigration levels to shorten the list involves a moral, bureaucratic, political and practical morass. As you will have noticed already, no witness has produced any objective criteria for determining the number of immigrants. The reason is simple. There are none. All recommendations of numbers are basically arbitrary and driven by hidden moral and political motives.

Let me suggest that instead moral and political criteria should be replaced by the following fundamental principles:

• Let us set policies so that immigrants benefit Canada, not so that Canada benefits immigrants – a slogan clearly inspired by President Kennedy’s famous “Do not ask what the country can do for you, ask what you can do for the country”.

• Let us use our country’s desire to help foreigners only after we have provided adequately for the many of our compatriots who need healthcare, caregivers, housing, special educational attention, help with their addictions and many other problems. If we want to contribute to the welfare of foreigners, let us continue to admit genuine refugees and send foreign aid to the needy abroad.

My suggestions are based on the realization that there is almost universal agreement among economists that immigration has no significant positive effect on the incomes of Canadians but if it involves large numbers, depresses wages and raises profits, effects which are deemed undesirable by many citizens.

This traditional view on the merit of immigration that I have taught and written about for decades as a professor of international economics has become obsolete with the existence of the welfare state in which everyone in Canada is entitled to a large array of social benefits and the progressive income tax system requires recent immigrants with average low incomes to pay fewer taxes than the average Canadian.

In a joint study with Patrick Grady, we have estimated that these provisions of the welfare state are putting a fiscal burden of about $20 to $30 billion on Canadians every year. Since we do not wish to get rid of the welfare state, immigration does not benefit Canadians. Instead, it results in higher taxes and contributes to the current deficit.

All traditional arguments about the merit of immigration are bogus and do not stand up to careful analysis. To mention just a few of these arguments, immigrants are not needed to fill job vacancies, in fact they can create shortages with their demands for housing, infrastructure and doctors. They do not solve the problem of unfunded liabilities of social programs and may worsen it. Their contributions to multi-culturalism are marginal and at the border line of becoming negative. Many countries without immigration are doing very well indeed economically and socially, from Korea and Singapore, to China and India.

For these reasons, I recommend that we should adopt policies, which bring into Canada only immigrants who pay taxes high enough or have access to funds that match the costs they impose on our social programs.

Before I offer some thoughts on a system for attaining this objective, let me present my radical proposal for dealing with the backlog. Simply, pass a law, which repeals the existing legislation promising that anyone who pays a fee is guaranteed consideration for an immigrant visa. Dissolve the existing backlog by sending each applicant a letter saying, in diplomatic language of course, that “the parliament has decided that Canada is no longer obligated to consider your application. Attached to this letter is a refund of the fee you have paid, including interest.”

Parliaments pass this kind of legislation all the time. The Wheat Board will be dissolved. The Gun registry will be scrapped. The National Energy Policy no longer exists. Transfers to the Provinces were changed in the 1990s. I could go on, but the point is clear. No past legislation is immune from change or repeal by current parliaments. All such changes are accompanied by much opposition and debate, sometimes very heated, but this is not something to be regretted or feared. It is intrinsic to democracy. Elections are the ultimate arbiter of the public on the merit of such changes.

Now to a brief discussion of an immigration policy that brings benefits to Canadians living in the welfare state. Issue immigration visas only to applicants who have a pre-approved employment contract at a pay at least equal to the average earned by Canadians and subject to passing normal health and security standards. Parents and grandparents should be given such visas only if their offspring posts a bond large enough to cover their expected costs of healthcare and pays for their living expenses they might need. Under these provisions, immigrants no longer impose fiscal burdens on Canadians.

The principle underlying my proposal is simple and clear. Let market signals, not politicians, technocrats and vested interests determine who should be admitted and how many immigrants should enter Canada annually. Relying on market signals in the operation of the economy has served Canadians and the rest of the world well. It should do so for the selection of immigrants.

Let me conclude with some observations about the politics of immigration policy. Recent opinion surveys show clearly that most Canadians are in favour of reduced levels of immigration or the maintenance of current levels.

In considering these survey results it is important to note that these sentiments are strongest in the country’s largest cities, where immigrants have settled in the past but where, importantly also, the largest numbers of parliamentary seats are at stake.

Through my own limited contact with immigrants I have noticed that they are very much aware, more than the average Canadian, of the cost immigrants impose on us, fiscally, through congestion and pollution, high housing costs and other channels.

For these reasons, parties that embrace policy reforms of the sort I am proposing can expect electoral gains rather than losses in ridings in which immigrants reside in large numbers. To verify the correctness of my views, I urge politicians to make their own surveys and remain critical of survey results produced by organizations that may be supported by the immigration industry and allege to show that Canadians want more immigrants.

Wednesday, March 9, 2011


There has been much huffing and puffing by politicians, the media and immigrant lobbyists about the government’s plan to reduce the number of parents and grandparents joining their immigrant offspring in Canada next year.

Yes, the policy change is unfair. Many immigrants have come to Canada having been promised that their parents and grandparents could join them so that they can continue the cultural traditions of their homelands and receive help with family chores and child care.

While immigrants clearly benefit from the existing policy, the reality is that the benefits to immigrants come at the expense of Canadian taxpayers. New data and studies show just how great this fiscal burden is.

Official statistics indicate that recent immigrants have lower average incomes and tax payments than other Canadians, even ten years after their arrival. At the same time, these immigrants on average absorb at least the same amount of social benefits as other Canadians.

As a result, $6,000 is annually transferred to the average immigrant at the expense of Canadian taxpayers. In 2006 the value of these transfers to all of the 2.7 million immigrants who arrived between 1987 and 2004 and still live in Canada came to $16.3 billion. Taking account of the 1.5 million immigrants who arrived since 2004 the fiscal burden comes to $25 billion in 2010. These fiscal costs represent a significant proportion of the $55 billion deficit of the federal government projected for the fiscal year 2011.

Important here is the fact that parents and grandparents lower the observed low average incomes of all immigrants. The reasons are obvious. They tend to be elderly, have poor language skills and possess few marketable skills. The numbers of immigrating parents and grandparents are high: 84,917 or 6.7 percent of the 1.3 million immigrants admitted during 2006-2010.

The fiscal transfers to parents and grandparents are much higher than those of the average immigrant not only because of their low incomes but also because they tend to be of an age where their demand for costly medical services is at its highest level. In addition, many arrive in Canada with medical conditions that went untreated in their home countries. Recently, at the Dubai airport I noticed a long line-up of elderly persons in wheelchairs about to enter a plane headed for Toronto, presumably in transit from India.

In the light of these facts it is obviously in the interest of Canadian taxpayers to end the admission of parents and grandparents. This can be done fairly by stipulating that immigrants arriving after some future date will no longer have the right to have their parents and grandparents join them as permanent residents, though temporary visits would be allowed. Important for the present debacle, immigrants already in Canada or arriving before the set date should continue to be able to have their parents and grandparents join them permanently.

Under the proposed policy, the number of parents and grandparents admitted into Canada annually would decrease and ultimately become zero. The fiscal burden they impose on taxpayers would similarly decrease through time. These outcomes are not as prompt and large as is desirable fiscally, but this disadvantage is outweighed by the absence of the ethical and political costs of the alternative of reneging on past promises.

One problem with the proposed policy is that it may discourage some potential and otherwise desirable immigrants from applying for visas. However, Canada’s pool of applicants for immigration is very large and while it may shrink somewhat, there should remain enough highly qualified economic immigrants to be selected for admission.

Politically, the proposed policy would be a winner. All Canadians would welcome the fiscal benefits it would bring, including recent immigrants whose offspring would also face lower tax burdens in the future.

Thursday, February 24, 2011

Will there be a Great Inflation in the Wake of the 2008 Great Recession?

Abstract: The paper presents data on the level and composition of the actual and forecast debt of the US government. It argues that the real burden of this debt cannot be reduced significantly by inflation because the bulk of it is held by government agencies, is adjusted for inflation or is short-term. Inflation offers politicians low returns and high costs. The paper also presents data on the excess bank reserves that resulted from the efforts of the Federal Reserve to lower interest rates and that bring the potential of a future massive and very inflationary increase in the money supply. While the Fed can prevent the inflation technically, questions arise over its willingness to use the proper policies in time, given Congressional pressures to favour lower unemployment over inflation.

1. Introduction

The Great Recession of 2008 has left a legacy of deficits and debt that has created a widespread fear about the creation of a Great Inflation by the US government in order to reduce the real fiscal burden of the debt. The fear of inflation has been fed further through the purchase of unprecedented amounts of securities by the Federal Reserve and a correspondingly large expansion of commercial bank reserves that can lead to the expansion of the money supply.

History contains several important examples of countries that used inflation and monetization to deal with excessive debt loads, such as Germany and Hungary during the 1920s and most recently, Zimbabwe. Many pundits and investment advisers have called attention to this history and stoked the public’s fear that the US government will be tempted to follow these historic examples. One of the effects produced by this fear has been a large public demand for gold as an inflation hedge, which resulted in record prices for the metal.

This paper examines the likelihood that the fiscal condition of the US government will induce it to create a great inflation. The examination involves the analysis of the expected fiscal benefits relative to the economic and political costs from such policy. It furthermore examines the technical ability of the Fed to prevent the large stock of bond holdings from leading to inflation and assesses the strength of the political forces that could prevent it from engaging in the needed policies.

The first part of the paper presents the basic data that underlie the existing fear of inflation. The second part presents a benefit/cost analysis of using inflation to deal with the excessive debt. Part three deals with the likely Fed policies that determine the development of inflation.

2. Facts Stoking the Fear

Table 1 shows the actual size of the federal government deficit spending and debt for the years 1993-2009. The figures for 2010 and thereafter are the official estimates issued by the Office of Management and Budget that serves the White House and Congress in the evaluation of the effects of spending and taxation programs proposed by the administration in the context of projected economic developments.

To fully appreciate the magnitude of deficits and the debt in the future, it is useful to consider their levels in the recent past. Thus, as can be seen from the table, the imbalances during the four years 1993-97 produced $751 billion in deficits. During the four years 1998-2001 the imbalances turned into surpluses of $559 billion.

The deficits returned in 2002 and by 2007 had added up to $1.7 trillion. However, the public fear of future inflation is based mainly on the $4.7 trillion deficits recorded and forecast of for the four years 2008-2011, as well as the continued high levels expected to be recorded in the following four years.

Table 1

US Federal Budget Debt

(billions of dollars)
Year Outlays Receipts

Total Debt

1993 1,409 1,154 - 255 4,351
1994 1,462 1,259 - 203 4,643
1995 1,516 1,352 - 164 4,921
1996 1,560 1,453 - 107 5,181
1997 1,601 1,579 - 22 5,369
1998 1,652 1,722 69 5,478
1999 1,702 1,827 126 5,606
2000 1,789 2,025 236 5,629
2001 1,863 1,991 128 5,770
2002 2,011 1,853 - 158 6,198
2003 2,160 1,782 - 378 6,760
2004 2,293 1,880 - 413 7,355
2005 2,472 2,154 - 318 7,905
2006 2,655 2,407 - 248 8,451
2007 2,729 2,568 - 161 8,951
2008 2,983 2,524 - 459 9,986
2009 3,518 2,105 - 1,413 11,876
2010 3,721 2,165 - 1,556 13,787
2011 3,834 2,567 - 1,267 15,144
2012 3,755 2,926 - 828 16,336
2013 3,915 3,188 - 727 17,453
2014 4,161 3,455 - 706 18,532
2015 4,386 3,634 - 752 19,683

Source: Office of Management and Budget (2010)

Note: Figures for 2010-2015 are estimated

The last column of Table 1 shows the impact these deficits have had or will have on the size of the federal debt. Over the 15 years between 1993 and 2007 the debt more than doubled, in spite of the surpluses that occurred in 1998-2001. However, this growth in the debt pales in comparison with that forecast for the seven-year period 2009-2015. It is expected to double again from $10 trillion to $20 trillion, thus growing at twice the rate experienced during the preceding 15 years.

While the forecasts shown in Table 1 depend on expected economic growth and crucial assumptions about future spending and taxation policies and therefore they are highly uncertain, they provide a valid basis for public fears about the probability that the government will use inflation to reduce the real burden. Since the deficits may in fact turn out larger or smaller than forecast, the uncertainty about their size further feed public anxiety about future inflation.

However, the figures found in Table 1 need to be put into some perspective relevant to the assessment of their impact on inflation and other government policies. For this reason, it is useful to consider Table 2, which expresses the deficit and debt figures in relation to the actual and projected levels of nominal Gross Domestic Product, which is a function of the growth in population and productivity, as well as inflation and general business cycle developments. These percentage figures express more accurately than the absolute numbers the burden the debt imposes on the budget and individual Americans through the interest payments necessary to service it. This fact is evident if one considers that the burden of a given amount of mortgage payments on family budgets is smaller the greater is family income.

As can be seen, the level of the debt expressed as a percentage of GDP actually decreased from 66.1 percent to 64.4 between 1993 and 2007. However, again providing a basis for fears about inflation, the ratio is forecast to rise to 102.8 percent over the period 2008-2015.

This fact is especially significant since the projections contained in Table 2 are based on the use of assumptions about future economic growth and other variables determining revenues, which many economists consider to be excessively optimistic because the official estimates are made by the Office of Manpower and Budget (OMB) and assume that the full legislative spending and taxation proposals contained in the President’s budget are realized. Moreover, there is an institutional bias towards optimism about future growth that is inherent in the OMB acting as an agent of the President. It is therefore advisable to consider the estimates of future developments with some caution.

There is no agreement among experts on the optimum debt/GDP ratio. The academic debate over the consequences of zero debt levels suggests that the optimum is greater than that since the sovereign debt plays an important role in the management of private sector wealth portfolios.

On efficiency grounds, the debt level is proper if it is matched by the value of the legacy left by past generations in the form of economic infrastructure, the democratic and free society that was defended through war expenditures and the prosperity that was restored by Keynesian deficits during cyclical downturns. The proper valuation of this legacy is virtually impossible, especially in the light of the widely held view that a substantial part of the debt was incurred by politicians buying votes from special interest groups.

Table 2

US Federal Budget Debt
(as a percent of GDP)

Year Outlays Receipts
Total Debt

1993 21.4 17.5 -3.9 66.1
1994 21.0 18.0 -2.9 66.6
1995 20.6 18.4 -2.2 67
1996 20.2 18.8 -1.4 67.1
1997 19.5 19.2 -0.3 65.4
1998 19.1 19.9 0.8 63.2
1999 18.5 19.8 1.4 60.9
2000 18.2 20.6 2.4 57.3
2001 18.2 19.5 1.3 56.4
2002 19.1 17.6 -1.5 58.8
2003 19.7 16.2 -3.4 61.6
2004 19.6 16.1 -3.5 62.9
2005 19.9 17.3 -2.6 63.5
2006 20.1 18.2 -1.9 63.9
2007 19.6 18.5 -1.2 64.4
2008 20.7 17.5 -3.2 69.2
2009 24.7 14.8 -9.9 83.4
2010 25.4 14.8 -10.6 94.3
2011 25.1 16.8 -8.3 99
2012 23.2 18.1 -5.1 100.8
2013 22.8 18.6 -4.2 101.6
2014 22.9 19.0 -3.9 101.9
2015 22.9 18.9 -3.9 102.6

Source: Office of Management and Budget (2010)

Note: Figures for 2010-2015 are estimated

However, it is interesting to note that the European Economic Community Treaty specified that one criterion for admission to the economic union is a level of government debt at or below 60 percent and annual deficits below three percent of GDP. By these criteria, the US record before 2007 was acceptable, but has failed to pass thereafter and may be expected to do so into the indefinite future.

In the end, American voters will determine what level of deficits and debt are acceptable. During the Congressional election campaign in 2010 the issues were discussed widely and voters strongly supported candidates that promised to reduce the deficits and debt. Strong and vocal political movements at the grass-roots level are likely to further increase the number of politicians with these views in future elections. At the time of writing in early 2011, there are indications that the Obama administration’s legislative agenda will be modified in ways that will reduce future deficits.

In the meantime, Americans face the facts found in the two tables presented above. Public discussions and the analysis of investment advisors, as well as the purchase of gold as a hedge against inflation among other actions suggest that Americans (and people in the rest of the world) continue to be concerned about a future great inflation caused by government efforts to reduce the burden of the debt. The discussion in part three below sheds further light on the validity of this concern taking account of the limits and costs faced by the potential government policies to use inflation as an effective instrument for the lowering of the burden.

Monetization of the Debt

The hyper-inflations of the past like those in Germany and Hungary in the twenties of the last century were caused by deficits and accumulated debt so large that the private market for bonds disappeared. Wealth-holders were unwilling to purchase any more bonds at any promised yield that they believed could and would not be serviced or repaid in the future. Under these conditions, these governments instructed their central banks to buy the bonds and pay for them by new issues of currency. As governments put this currency into circulation to meet their obligations, too much money began to chase too few goods and inflation developed. Eventually, the expectation of continued and accelerating inflation induced the public to spend any currency they had earned as quickly as possible on goods and services that would cost more a short time later.

The vicious cycle of deficits financed by the printing of money, growing deficits, unwillingness to hold currency and accelerating inflation caused by this new money led to the collapse of the German and Hungarian economies. The inflation had benefited borrowers who repaid their obligations with worthless funds and dramatically reduced the real wealth of lenders. The resultant inequities and prolonged unemployment resulted in deep economic, social and political scars that shaped national life in these countries for generations. Germany’s hyper-inflation has been identified as paving the way for the Hitler regime and the Second World War, though more positively, it also decisively influenced the political agenda in the postwar years when Germany’s inflation rate was much below the average of developed countries.

Figure 1

Source: The document was obtained through the courtesy of Ambassador William Middendorf, who is the Chairman of the Committee for Monetary Research and Education in Washington, DC.

The government of Zimbabwe offers a contemporary example of how the vicious cycle of deficit spending and the printing of money leads to hyper-inflation, economic disaster and political upheavals. Figure 1 shows the extent to which the inflation has required the government to print currency in ever increasing denominations needed to pay for the goods and
services it provides to the public at ever higher prices. The economic and social miseries that accompany this hyper-inflation are horrendous and well known.

It is not realistic to believe that conditions in the United States will become like those in Germany’s and Hungary’s past and present day Zimbabwe. Nevertheless, there has been a development that is ominously similar to that in these countries. As can be seen from Figure 2, from the beginning of the Great Recession in 2008 until early 2011, the Fed’s holdings of securities rose sharply from $500 billion to $2,200 billion. This increase compares badly with the one that took place during more normal times between 1990 and 2007, when the Fed increased its holdings of securities at a rate that was roughly in harmony with the growth of the economy.

Figure 2

Source: Federal Reserve Bank of St. Louis (2011a)

The dramatic increase in Fed holdings of securities is referred to officially as involving “quantitative easing”. In early in 2011 the Fed announced that it would engage in the further purchase of securities under the name “quantitative easing II”. Whatever these policies are called, they are historically unprecedented and resemble those undertaken by countries that subsequently experienced hyper-inflations.

The Fed justified quantitative easing on two grounds. First, it was needed to lower interest rates and to create liquidity sufficient to induce economic recovery from the Great Recession of 2008. Second, many of the securities purchased were “toxic assets”, that is securities whose value was uncertain for a number of reasons, that therefore traded at substantial discounts and that threatened the viability of important financial institutions that owned them. It was believed that the failure of these institutions threatened by defaults of these assets would severely deepen and lengthen the recession.

As a result of quantitative easing the federal funds rate at which banks can borrow from the Fed fell to near zero. Figure 3 shows that this level is unprecedented during the postwar years. As a result the entire structure of interest rates in the economy was lowered as the Fed had wanted.

Figure 3
Source: Federal Reserve Bank opf St. Louis (2011b)

However, the economic recovery expected to follow developed only very slowly. One reason has been that commercial banks did not behave as they did in the past. The Fed paid for the securities it bought by creating deposits owned by commercial banks, a process equivalent to the historic “printing of money”, which the Fed can do without legal or practical limit.

Under normal conditions, banks use the new liquid assets yielding nothing or only a very low rate of interest to make loans to private borrowers at the market rate of interest adjusted for risk, an activity which gives rise to most of the banks’ profits. These borrowers use the funds to buy goods, services and assets. The sellers of these goods, services and assets redeposit their proceeds with other banks, which then make more loans that lead to redeposits and new loans, in a process that is repeated until the banking system creates demand deposits that amount to a multiple of the amount of deposits created by the Fed. The only constraint on this process is the requirement that banks keep a certain percent of loans as reserves with the Fed.

Figure 4 shows that during the period under consideration, this normal use of bank deposits created by the Fed did not take place. The amount of excess reserves held before 2008 was near zero. Since then, the excess reserves have grown rapidly and have stayed high, except for a small decrease at the end of 2010 and beginning of 2011. The banks’ behaviour was conditioned by concerns about the general economic and financial outlook during the Great Recession that made loans riskier than acceptable at interest rates borrowers could afford to pay.

Figure 4

Source: Federal Reserve Bank opf St. Louis (2011c)

The public fear of inflation is based on two important facts just presented. First, the Fed’s purchase of securities resembles the policies that were used by the central banks of countries that in the past experienced hyper-inflations.

Second, the behaviour of commercial banks could result in a dramatic increase in the US money supply M1, which includes currency and commercial bank deposits once banks return to their normal lending practices, which is likely to happen as soon as recovery from the recession is evident and economic as well as political developments lead to lower deficits and debt. The existing bank reserves will allow the money supply to increase by a very large amount and do so quickly as the so-called money multiplier returns to more normal levels.

The validity of fears of inflation based on these facts will be discussed in Part 3 below, where they will be seen to depend crucially on both the ability of the Fed to reduce the excess reserves through the use of policy instruments at its disposal and, importantly, on the political restraints on the exercise of this ability in the light of the fact that any tightening of monetary policy increases the risk that economic recovery will be slowed or even lead to a second dip in the recession.

3. Inflation and the Reducing the Burden of the Debt

The process by which inflation reduces the real burden of the debt and lowers the needed level of taxation to service it may be illustrated with the help of the following example.

Consider the government issues a bond for $100 thousand that matures in thirty years. The existing rate of inflation is zero and the bond has attached to it 30 coupons that pay the holder of the bond $5,000 at the end of each year. To pay this interest, the government requires that same amount in revenue, which is equal to the reduction in spending on goods and services by taxpayers.

Now consider that at the end of the first year, inflation goes to ten percent per year. At the end of the second year, the coupon payment still requires $5,000, but the amount of goods and services that it represents is only $4,500, causing the tax that needs to be collected and the burden on the taxpayers to represent the same diminished amount. If the inflation continues after the second year, the real burden continues to fall by ten percent every year. After 30 years, the $5,000 coupon has a purchasing value of only $285, which represents a significant reduction from the original.

The main conclusion from this example is that the real return from holding long-term bonds with a nominally fixed yield is diminished by inflation and that the real burden on taxpayers is lowered correspondingly. Politicians like this outcome since tax rates can either be lowered or spending can be increased without explicit changes in tax rates.

However, inflation cannot be used to lower the real burden of debt with short maturities. Consider a short-term bill maturing in one year and yielding 2 percent, which was sold while inflation was expected to be zero. Now consider what happens to the interest rate on short-term bills if the inflation rate goes to ten percent. This rate of inflation will cause lenders to insist on a rate of interest of at least 12 percent, ten percent of which represents compensation for the depreciation of the invested funds and the 2 percent is the normal return from short-term investments. Investors could possibly insist on compensation in excess of 12 percent if they expect an acceleration of the inflation rate during the year or simply to be paid for the increased risk about the future development of inflation.

Under the assumptions above, at the end of the year when the original bill matures, refinancing requires the payment of at least 12 percent, a rate at which the real value of the debt is maintained for the buyers of the new obligation and the real burden for taxpayers remains unchanged. In the real world where one-year bills are sold virtually every day, the average interest rate on notes quickly approaches the rate that reflects the inflationary expectations.

The preceding analysis leads to the following important conclusion: The benefits from using inflation to reduce the real burden of debt depend on the length to maturity of the outstanding debt.

Before data on the maturity structure of the US federal debt are presented, it is important to note the facts found in Table 3. As can be seen, of the $13.3 trillion of US Treasury securities outstanding at the end of June 2010 (December data not yet available), 34.6 percent or $4.6 trillion are held by agencies of the government. The most important of these agencies is the Social Security Trust Fund, which holds funds that the US pension system collected in years when contributions exceeded expenditures.

Table 3
US Treasury Securities Outstanding
(trillions of dollars, June 2010)

Total Held by
Govt. Public

13.3 4.6 8.7


100 34.6 65.4

Treasury Bulletin (2010), Table FD1

Whatever happens to the surplus of this fund in the future, for the purposes of the present analysis it is important to realize that inflation will mean increased spending on inflation-indexed pensions while at the same time, taxpayers’ incomes increase at the same rate and so do the taxes disguised as insurance premiums flowing into the fund. This analysis implies that the burden of the debt held by the trust fund cannot be reduced by inflation.

Since other trust funds within the government operate under conditions very similar to those of the Social Security System, it is clear that inflation does not produce a lower real burden on the near 35 percent of the federal debt held by government.

Maturity Structure

Table 4 shows that in June 2010 the public held $8,079 billion in marketable federal debt. For the present analysis it is worth noting immediately that seven percent of the total of this debt, $564 billion, consists of TIPS securities (Treasury Inflation Protected Securities). The interest payments on these securities are automatically adjusted for the rate of inflation so that inflation does not lower the real burden of serving them.

Table 4 also shows that $1,777 billion or 22 percent of the total marketable debt held by the public are bills, which are defined as securities that mature within a year. These notes have almost the same characteristic as TIPS. Every time they are rolled over, the Treasury will have to pay interest at a rate that reflects the current and expected inflation. Therefore, the relatively large amount of bills held by the public offers virtually no opportunity to reduce the real burden of the debt. Moreover, the higher interest rate expenses caused by inflation would add to the deficit and the growth in the nominal level of the debt.

Notes, which are securities that mature within one to five years, show a value of $4,935 billion and represent 61 percent of the total. If one assumes that the average length maturity of notes is 2.5 years, they offer a moderate opportunity to reduce the burden of the debt. Bonds, maturing after 5 years, are worth $803 billion, representing about 10 percent of the total. They offer the greatest opportunity for reducing the burden of the debt through inflation.

Table 4
Marketable Debt Held by the Public

($ billions, June 2010)

Bills 1,777 22.00
Notes 4,935 61.08
Bonds 803 9.94
TIPS 564 6.98

Total 8,079 100

Treasury Bulletin (2010), Table FD2

Another way of showing the maturity profile of the US debt is presented in Figure 5, which is based on data published in the Treasury Bulletin, US Department of the Treasury, using detailed data on the maturity of all series of securities outstanding. These data change continuously as outstanding securities come closer to maturity and new ones are issued. The table reproduced here is based on data for March 2010.

As can be seen, about $2.5 trillion of the outstanding US debt matures within one year while the amounts over longer periods are comparatively small and less, the longer is the time to maturity. Thus, about $1 trillion matures within two years and another $.7 trillion within three years.

Figure 5

Source: Crazy Nut Job (2010); raw data found at: Treasury Monthly Statement of the Debt (2010)

Currency Notes and Coins

The preceding analysis does not consider the existence of currency in circulation, which is valued at $1.23 trillion on September 30, 2010. Almost all of this currency has been issued by the Federal Reserve. The Treasury Bulletin does not count this currency a part of the public debt, even though the notes promise to pay bearer this nominal amount printed on the note. In practice, this promise is an historic relic from the time when the Fed redeemed currency into gold but has since become meaningless.

However, the existence of currency also has implications for the ability of the government to use inflation to reduce the burden of the debt. The reason is that the public holding of currency increases with both income and inflation (and decreases with the development of substitute means of payment, like credit cards). When the Fed prints currency to meet the increased demand due to inflation, it enjoys corresponding increases in profit. This profit is transferred to the Treasury and has the same effect on total revenue as tax payments.

This profit is not negligible. A ten percent inflation and increased demand for currency on the $1.23 trillion stock comes to $123 billion. However, the government cannot rely on a constant relationship between nominal income and the holding of currency since inflation represents a tax on holding it and thus induces the public to hold less.

A large proportion of the circulating US currency is held abroad and used as a store of value and means of payments, especially in developing countries with unstable and inflation-prone currencies. If the value of the dollar is diminished through inflation, these foreign holders of that currency will exchange it for Euros or other currencies that are not subject to the loss of value from inflation. When this happens, the dollar notes will flow back into the vaults of the Fed and will reduce the need to print more for domestic circulation, reducing profits that accompany this process. Most basically, the so-called seigniorage earnings accruing to the United States from the use of dollar currency abroad are diminished and the US economy loses the value of the imports that were paid for with this seigniorage.

Since the Treasury data do not include currency as part of the debt, this paper disregards the potential but dubious benefits from the use of inflation to reduce the burden of the debt by the devaluation of the outstanding currency.

Summary and Conclusions

The preceding analysis leads to the conclusion that inflation offers only a very limited opportunity to reduce the burden of the US federal debt. The reasons for this conclusion are as follows:

First, only about 65 percent of the debt is held by the public and can be used for the reduction of the real burden. The other 35 percent is held by government agencies and represent obligations that are fixed in real terms.

Second, about 90 percent of the outstanding, publicly held debt consists of inflation protected securities, bills and notes that mature in a relatively short time after inflation begins. These securities can be refinanced upon maturity only at interest rates that compensate lenders for inflation so that it no longer allows the real burden of the debt to be reduced.

The implications of these facts are important for assessing the probability that the US government will use inflation to reduce the real burden of its debt to the extent that economic, financial and social benefits and costs of policies enter into decisions about government policies. One can be cynical about the weight such benefit-cost calculations have in government decisions, the weight almost certainly is not zero, as is evidenced by the efforts of governments to collect and analyze the kind of data presented in this paper.

Thus, as the data suggest, the financial benefits from inflation are very limited. At the same time, inflation results in serious economic and political costs.

The economic costs arise from the misallocation of resources that accompany the efforts of the public to escape the losses from holding assets whose value does not increase sufficiently with inflation. Additional costs arise from recessions and unemployment that accompany government anti-inflation policies that historically have always followed periods of inflation.

The political costs arise from the public’s dislike of inflation and the unemployment that arises from anti-inflation policies. The public usually votes out of office politicians responsible for these conditions.

The bottom line of the preceding analysis is that the economic and political costs far outweigh the benefits from using inflation to reduce the real burden of the debt and the political benefits that flow from this policy. This fact should be considered before the US government decides on methods for dealing with the deficits and debt that have arisen in the wake of the Great Recession. Whether or not these considerations in fact will carry the day remains to be seen, but the analysis suggests that historic examples that saw countries inflate away the burden of the debt are no longer relevant in today’s world of efficient capital markets.

3. Fed Policies and Inflation

Assuming that the US government is unlikely to use inflation to reduce the burden of the debt because the costs are greater than the benefits, there remain two other issues that feed the public’s concern over a possible future inflation.

The first of these involves the technical ability of the Fed to eliminate the potential expansion of the money supply that arises from the excess reserves held by the commercial banks, the magnitude of which is evident from Figure 4.

The second issue involves the Fed’s timing in the use of its tools to reduce excess reserves and generate a non-inflationary money supply in the face of uncertainties about the strength of the economic recovery and pressures from politicians to err on the side of reducing unemployment rather than fighting potential inflation.

Technical Capabilities

The Fed has available three basic instruments for bringing commercial bank reserves to a level consistent with a non-inflationary money supply.

First, the Fed can sell the securities it has bought when it engaged in quantitative easing during the height of the Great Recession. The sale of assets to reduce the money supply has been used routinely in the past and in principle nothing stands in the way to prevent its use again. The resultant absolute decrease in reserves would be unprecedented in the history of the Fed , but so is the magnitude of excess reserves in existence.

One concern with the use of this policy involves potential losses from the sale of these assets. Some will have decreased in value and some will have increased between the time they were bought and their sale as a result of changes in the economic fortunes of the issuers of the securities. It is impossible to know the magnitude of these gains or losses from the future asset sales, but it is worth noting that in the end they will simply affect the amount of profits that the Fed transfers to general revenue every year. These profits tend to be substantial in absolute terms but are small in relation to total federal tax revenues and will have only a marginal effect on the budget balance. Another concern is that the sale of assets like mortgage-backed securities will result in a lower market prices and therefore higher yields. Such a rise in interest rates on mortgage could endanger the recovery of the housing market and thus of the entire economy.

The second instrument the Fed can use to reduce the money supply potential involves increases in required reserves. This policy has been used sparingly in the past, but in principle, there are no obstacles to its use to eliminate the excess reserves shown in Figure 4 except that existing regulations contain an upper limit for such requirements. Of course, if this upper limit is ever reached, new regulations could be passed to increase it to preserve the Fed’s ability to pursue its monetary policy objectives.

The third instrument available to the Fed is raising the interest rate it pays on reserves held by commercial banks. In principle, the interest rate could be set at a level high enough so that the commercial banks earn less from using the funds to make loans to private borrowers than they can from holding on to the reserves, especially after taking account of differences in risk associated with the two alternative uses of the funds. In practice, the cost of paying high rates on reserves may be high, especially if interest rates on private borrowing rise rapidly in the wake of growing fears of inflation. Congress might object on political grounds to the payment of interest to banks by this method and it might create difficulties for the Fed’s chairman advocating this policy.

In sum, the technical instruments available to the Fed to deal with the inflationary potential stemming from the excess reserves in the hands of commercial banks on balance appear to be adequate. The public’s concerns over the threat to price stability coming from these excess reserves are not warranted on technical grounds.

Timing and Political Issues

However, in practice, the record of the Fed regarding the timely use of the available technical instruments to deal with inflation is not outstanding. Allan Meltzer has written a book about the history of the Fed. He recently noted that his study of past inflation-fighting policies convinced him that the Fed is unlikely to deal adequately and in a timely fashion with the threat to price stability existing in the wake of the Great Recession and quantitative easing.
The poor history of the Fed on this issue is due to the following facts.

Since monetary policy influences inflation and economic activity with unknown and variable lags, all decisions about the supply of money and interest rates have to be made in the light of highly uncertain forecasts of economic developments. Given this uncertainty, the Fed has to choose between two possible biases. It can err on the side of restoring economic activity and lowering unemployment through the maintenance of low interest rates or it can err in favour of preventing inflation by tightening raising rates.

The public, many economists and most politicians consider inflation to be a lesser evil than unemployment. In the light of this attitude, the Fed faces strong pressures to err on the side of expansionary policies to lower unemployment and to put less weight on the possible inflation that such policies will produce.

During the 1960s and into the 1970s, this bias in favour of inflation was even stronger than it is today because the dominant economic theory believed in a trade-off between lower unemployment and higher inflation. While this so-called Phillips-curve trade-off is now quite discredited, attempts of the Fed to deal with cyclical downturns are subject to policy biases that arise from the uncertainty of economic forecasts just discussed.

In sum, the preceding analysis implies that the risk of inflation is uncertain and depends on the strength of the bias in Fed policies that favours lower unemployment, even if it carries the risk of inflation. This bias is influenced strongly by political forces, for while the Fed is nominally independent from political influence, in fact it is subject to considerable pressures from Congress, which periodically offers advice on policy to the Chairman of the Board of the Fed at hearings before a congressional committee. The politicians on this committee have more to gain at the ballot box if the Fed reduces unemployment than they do from losses if the Fed policies produce inflation.

Therefore, there is some reason to fear inflation resulting from poor timing of anti-inflation policies of the Fed caused by the uncertainties surrounding the optimum timing when future conditions are uncertain and by political pressures that value the lowering of unemployment higher than inflation.

4. Summary and Conclusions

There is widespread fear over the development of a great inflation in the United States that could arise from the legacy of debt and monetary ease due to policies used to deal with the Great Inflation of 2008.

The size of recent and projected deficits and debt is unprecedented and supports fears that the government will attempt to reduce the real burden of this debt through inflation. However, it turns out that about one third of the debt is held by government agencies whose obligations are fixed in real terms so that inflation does not affect the real budgetary costs of this portion of the debt. The maturity structure of two thirds of the US debt held by the public allows for only a relatively small reduction in the real burden since modern capital markets would force the US Treasury to pay an inflation premium on all newly issued securities. Therefore, the benefits from the reduction in the real burden of the debt are much smaller than the economic and political costs of inflation. Assuming that the results of this benefit cost analysis will be considered by politicians and policy makers, it is unlikely that they will resort to inflation to reduce the real burden of the debt.

The Fed’s policies following the Great Recession have been very expansionary, as its acquisition of securities under the TARP programs provided the banking system with excess reserves that can form the basis of a very inflationary increase in the money supply. However, while the Fed has the technical tools to remove the potential for the inflationary expansion of the money supply, there remain grounds for fear because of the uncertainties surrounding the timing of the effects of monetary policies and of future economic developments. In the face of these uncertainties, politicians could well apply successfully pressures on the Fed to use policies that are biased in favour of reducing unemployment rather than maintaining price stability.