Wednesday, March 11, 2015

The Two-Step Method for Controlling Inflation and Maintaining Steady Growth Rates

Given that I've focused a lot of attention recently on Dark Matter & Dark Energy, I've decided to switch gears and get back to topics of Energy&Currency.

The recent crisis in Russia has demonstrated the problems with basing a currency on any one commodity. In the case of Russia, approximately 26.5% of its GDP comes from the sale of petroleum products. The contribution of oil/tax taxes to the Russian government is roughly 50% of the total revenue for the government, which means that Russia's currency is strongly impacted by changes in the price of oil/natural gas.
But not all oil/gas producing countries are feeling the shock of low gas prices. The key to avoiding the shocks is to make sure that a large portion of the revenue from oil/gas needs is invested into stocks/bonds of companies/governments that will benefit from lower oil/gas prices. So, it's fine for a oil/gas-producing country to be specialized in one area production, provided that its revenue goes into investments that will make money when oil/gas prices drop.

So, this leads me to the question I've been trying to answer for years:  how can a country maintain constant inflation rates while also maintain steady growth rates?

There are some bad options available: (a) Gold-based currency  (b) Fiat currency without rules (c) Any currency based by only one commodity...such a PertroDollars

Second, I'd like to discuss the problem with leaving the control of the currency to just a Federal Board of Bankers. For example, there is a famous economist at Stanford named John Taylor. (You can check out his blog here.) He is credited with inventing the Taylor Rule to determine how Federal Reserves should change the interest rate as a function of the inflation rate and the growth rate of the economy.
While I'm a proponent of making the Federal Reserve rule-based, there is a clear flaw in John Taylor's Rule for controlling inflation and GDP:
There are two measured, independent variables (inflation and real GDP growth), but only one controlled, dependent variable (the federal funds rate.)

As such, the Taylor rule is doomed to fail. You can't control the fate of two, independent variables by changing only one dependent variable. In order to control both the inflation rate and the real GPD growth rate, then you need two free variables. The focus of the rest of this blog is on how to use 2 input variables to control the 2  output variables (inflation and real GDP growth rate.)

You need two keys, and the keys should be held by different people.


As such, here's my solution to the inflation / real growth problem:
(1) The Federal Reserve should maintain inflation rates at a constant value. (At this point in time, there will be the least impact on our economy if we pick the current inflation rate of ~2%/yr. While I like the idea of a 0%/yr inflation rate because it makes financial calculations much easier, I understand that a lot of people could lose/gain money if the target inflation rate were changed suddenly from 2%/yr to 0%.yr. As such, I'm okay with sticking with the current target of 2%/yr provided that energy prices are included in the calculation of the inflation rate.)
   The mechanism by which the Federal Reserve controls the inflation rate is by increasing or decreasing the amount of currency in circulation. While there are a number of ways of doing so (such as raising/lower the federal funds rate or raising/lowering the fraction of currency that banks must hold in reserve), these are not independent means of controlling both inflation and growth. They are simply two different ways of changing the amount of currency circulating through the economy. As such, there needs to be a separate control mechanism.


(2) The U.S. government (or the citizens themselves) should maintain a target growth rate of the economy, and it should do so, by buying or selling storable assets. Basically, the goal here is to maintain a stable growth rate, so that people can make educated decisions about the future of the economy (i.e. how much do I have to save for a child's education or for my retirement?)
What I'm imagining here is that when the growth rate of the economy goes above a certain value (let's say 3%/yr), then the government would start purchasing storable, stable, low-maintenance energy assets, such as oil/gas and water behind a hydroelectric dam. By low-maintenance, I mean an item whose cost to "buy, ship, store, sell, and ship" is a small percentage of the cost of the item.

The purchases of these energy assets would raise the price of energy and cause the growth rate to decrease to its target value. Then, sometime in the future, when the real growth rate of the economy drops below the target value, the U.S. government would sell the assets. The effect of selling the assets would be to lower the price of energy, and hence bring growth rates back up to the target growth rate.
Doing so would allow there to be some stability in funding of long term scientific projects (such as particle accelerators, fusion demonstrations, and space telescopes) and some stability for social welfare programs (such as unemployment insurance, medicare, medicaid, and social security.)

Through the control of a combination of these two independent variables (i.e. the amount of currency in circulation and the amount of stored energy assets), we can maintain both steady inflation and steady growth. The tough problem is picking the correction target growth rate for real GDP. How does the government determine what the target growth rate should be? As such, there needs to be some flexibility in this target growth rate. An important first step is to educate citizens that an effective means of getting an economy growing and out of recession is to decrease the price of energy.

All to often, governments attempt to "grow the economy" by increasing the minimum wage and spending money on pork projects. Instead, the key to getting out of a recession is to lower energy prices while maintaining a safety net for those people who have lost their jobs in a recession and who may need re-training in a different area of the economy.

The problem with spending money on pork projects (i.e. bridges to nowhere, cash-for-clunkers, and bailouts of failing industries) is that these pork projects consume energy and can raise the price of energy throughout the economy. The same goes for raising the minimum wage during a recession. The net effect could be higher prices throughout the economy. Instead, the government should sell stable assets during a recession and purchase assets when the economy is out of recession.

Still, with this having been said, governments are often slow to respond and I don't know if we can trust governments to buy or sell assets when they are required (purchases made out of cycle could worsen the economy...like what happened in 2007/2008 when the Bush Administration was filling the Strategic Petroleum Reserve during an all-time high in global oil prices.) As such, I encourage you to personally follow the general rule I've given above.

Purchase stable, low-maintenance energy assets when your personal finances are doing well, and sell the energy assets when your personal finances are not doing well. But when I say stable, low-maintenance energy assets, what I really mean is something like the U.S. Oil Fund, i.e. a stock whose price is directly related to the price of oil on the market. There are many other such stocks/currency you could purchase that track the price of oil (including purchasing Russian rubles.)
Note that I am not advocating for any particular investment.
But what I'm advocating for is that, if you are doing well off and if the price of energy is low, then purchase stocks in energy funds, and save them for a rainy day when you aren't doing well financially and when the price of energy is expensive. You will be doing yourself a favor, as well as the rest of us.
In other words, we can collectively help maintain stable growth rates without needing government if we each individually create a safety net by purchasing storable, energy assets when the price is low and selling the storable, energy assets when the price is high. When this is coupled with a Federal Reserve that maintains a constant inflation rate (i.e. picks an inflation rate somewhere between 0%/yr and 2%/yr and maintains that inflation rate), then we have a two-step recipe for maintaining steady inflation and steady growth (while maintaining a social safety net and maintaining steady funding for science.)

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