A voice in the wilderness: Are you listening?

Allan Meltzer, professor of political economy at Carnegie Mellon University, has a bee in his economic bonnet. In two outstanding op-ed pieces, he alerts us to some serious problems brewing in the overall economy. His first article, published in the New York Times on May 4, 2009 discusses the nascent inflation threat facing our country. The second article, published in the October 22, 2009 Wall Street Journal warns about specific threats to the economy and prescribes needed course corrections. I recommend you read both.

Meltzer is not some "sky is falling" fanatic. He is a well-respected academic and is the author of the multi-volume A History of the Federal Reserve. What's more, having earned his Ph.D. in economics from UCLA in 1958, Meltzer is a seasoned veteran of the inflation wars of the late '70s/early '80s.

According to Meltzer, the U.S. is headed toward a new financial crisis fueled by expected high money growth, unsustainable budget deficits, and a falling currency. This new crisis will involve a resurgence of inflation, a collapse in productivity and the implosion of our national wealth--similar to what the British economy experienced in the 1970s.

Meltzer's concerns are based on the following factors:

  • Banks' idle reserves now top $1 trillion. Idle reserves are funds the banks have on hand that they have not loaned out to customers. Once banks start lending these reserves, the money supply will explode leading to rapidly rising inflation and a sinking dollar.
  • The Federal Reserve has become a source of distortion in the capital markets. By making near-interest free loans to banks and buying huge amounts of mortgages, the Fed has bailed out banks at the expense of protecting the public.
  • While the Obama Administration projects budget deficits of $1 trillion per year for the next 10 years, it is clearly underestimating the actual deficit. The projections count on saving $200 to $300 billion from Medicare which just aren't going to happen.
  • Foreign governments are tired of funding our deficits. Many have serious deficit problems of their own and China is actively seeking to diversify its future reserve base. We have become the economic equivalent of house guests who have overstayed their welcome.
  • We are falling into the same traps that caused the stagflation of the 1970's. During the 1970's, the Fed was unwilling to pay the short-term price for long-term price stability. After vowing to fight inflation, they lost their nerve every time their anti-inflation efforts started causing a rise in unemployment. Not until Paul Volcker took the helm was the Fed able to find the resolve necessary to establish monetary discipline.

Though our situation is far from hopeless, these are credible threats and we need to pay attention. Meltzer recommends that we act now in a multi-year effort to get our house in order--specifically to reduce government spending. He says:

A weak economy is a poor time to reduce government spending or raise tax rates, but we don't require draconian immediate changes. We do need a fully specified, multi-year program to restore fiscal probity by reducing spending, and a budget rule that limits the size and frequency of deficits. The plan should be announced in a rousing speech by the president. The emphasis should be on reducing government spending.

Some readers might be tempted to dismiss Meltzer as a conservative taking pot-shots at a liberal administration. But Meltzer is refreshingly bipartisan in his assessment of our problems. He writes:

We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad....

Except for a few years in the 1990s, both parties have been at fault for decades.

Personally, I appreciate Meltzer's straight talk. I think it's time we pay attention.