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Since Trump’s announcement late last week that he would nominate Kevin Warsh to chair the Federal Reserve, the debate over Warsh’s qualifications has largely come down to whether he is a hawk or a hypocrite. Fans tend to share his deep, long-held suspicion of quantitative easing; critics see him as an opportunist who dispensed with his hard-money views when they became a barrier to professional ascent.
I’m less interested in Warsh’s motivations than in whether his views, as he states them now, make sense. His monetary prescription is dead simple: for higher growth and lower inflation, cut interest rates and shrink the central bank’s balance sheet.
Warsh thinks lower rates are consistent with lower inflation because AI is sparking a productivity revolution. From a recent interview:
The difficulty of [AI] for policymakers — let’s say central bankers, let’s say fiscal authorities — is that the economy is going to be growing, but it will not show up in the productivity statistics. So we are going to have to make a bet: is the economy becoming much more productive . . . my simple version of this is, everything technology touches gets cheaper.
So let’s say you are a central banker . . . if you are looking at the [economic] data, my view is you are backward-looking; you are going to be late. You are not going to realise the country is able to have non-inflationary growth faster. So you are going to have to make a bet. And the closest analogy I have in central banking is Alan Greenspan in 1993 and 1994, when the internet revolution was with us. He believed based on anecdotes and rather esoteric data that we weren’t in a position where we needed to raise rates . . . as a result we had a stronger economy, we had more stable prices.
What is most striking here is the notion that the US should bet on much higher productivity without seeing it in the data. This leap is what my colleague Chris Giles calls “conviction economics,” in contrast to the data dependency practiced by Chair Jay Powell.
Warsh thinks that shrinking the balance sheet is consistent with higher growth because he thinks that money printing — which is what he says balance sheet expansion amounts to — creates inflation by pumping up the financial system, without supporting growth in the real economy:
The Fed . . . should abandon the dogma that inflation is caused when the economy grows too much and workers get paid too much. Inflation is caused when government spends too much and prints too much. Money on Wall Street is too easy, and credit on Main Street is too tight. The Fed’s bloated balance sheet, designed to support the biggest firms in a bygone crisis era, can be reduced significantly. That largesse can be redeployed in the form of lower interest rates to support households and small and medium-size businesses.
Though Warsh does not say so explicitly, this is a bet, too. It’s a bet that the Fed’s $6.5tn balance sheet can be made significantly smaller without reducing the supply of credit to households and small businesses, and without causing a liquidity shortage that leads to a financial crisis, big or small. I don’t believe we have reliable data to guide us here, either.
The financial system would not require so much liquidity if it did not have to absorb mountains of government paper issued to support vast deficits. But Warsh believes that the deficits are mostly caused by the larger Fed balance sheet, not the other way around:
The Fed often presents itself as humble and technocratic, hewing closely to the remit. They say they take fiscal policy decisions as given, and then react. But, it’s no longer obvious whether monetary policy is downstream or upstream from fiscal policy. Irresponsibility has a way of running in both directions.
Fiscal dominance — where the nation’s debts constrain monetary policymakers — was long thought by economists to be a possible end-state. My view is that monetary dominance — where the central bank becomes the ultimate arbiter of fiscal policy — is the clearer and more present danger.
The test will come when one of these two bets begins to go wrong. If he convinces the Open Market Committee to bring down rates further in the face of stable employment and above-target inflation, and then inflation rises, how will he respond? If the balance sheet is shrunk and money markets seize up, what will he do? For 15 years Warsh has been able to criticise the Fed from the outside, with nothing at stake. Now he has to put his money, and ours, on the table.
