The “Sacrifice Ratio”
March 12, 2006
So, it appears that Ben Bernanke is a neo-Keynesian. This does not bode well, as neo-Keynesians are typically so confused by theoretical foofoo that they are almost incapable of doing the right thing at the right time. One example of such “foofoo” is something called the “sacrifice ratio,” which is sort of an area-under-the-curve rendition of the Phillips Curve. More specifically, the “sacrifice ratio” indicates the amount of unemployment caused by higher Fed policy rates compared to the amount of inflation prevented by Fed policy rates. A high “sacrifice ratio” indicates that as the Fed raised rates to “fight inflation,” the economy would have to make a “larger sacrifice” in terms of unemployment. The people who make up such statistics tell us that the “sacrifice ratio” is presently quite high. (Note again my regular use of quotes as a sort of conceptual condom. Don’t for a second take this stuff seriously. Please.)
David Kotok of the investment fund Cumberland Advisors (quite a successful fund, by the way, and clients of ours back in the day) has a good description of the “sacrifice ratio” here. He thinks that the interpretation of a “high sacrifice ratio” means that the Fed will tend to raise its policy rates further than expected, to combat inflation now instead of allowing it to get out of hand. Apparently some gnomes in the Fed have been calculating the “sacrifice ratio” on a regular basis.
The problem with such concepts as the “sacrifice ratio,” and especially when they are taken seriously by professors/writers of textbooks/chairmen of the Federal Reserve, is that people begin to believe that the “sacrifice ratio” exists. Proper monetary management, as we have been saying just about every week now, involves direct base money adjustment (not an interest rate targeting policy) to manage the value of a currency, thus preventing either inflation or deflation. Where in the “sacrifice ratio” concept is either direct base money management or currency value mentioned? They are not. Thus, by adopting the “sacrifice ratio” concept, monetary bureaucrats are virtually guaranteed to not think about what they should be thinking about, and as a result, screw up somewhere down the line. (Thus the incessant use of quotes to protect the innocent reader from being poisoned by these very dangerous neo-Keynesian concepts.)
Yet it should be perfectly obvious by now that a proper base money adjustment response to a weak currency/inflation situation (if one has inflation, which one shouldn’t if they’ve been doing their job right), produces lower interest rates and typically less unemployment. In other words, it fixes the problem, rather than leading, as the “sacrifice ratio” concept implies is the result of “fighting inflation”, to higher interest rates and more unemployment, i.e. hard evidence that a mistake has been made.
A very good notion, of which Ronald Reagan was a fan, is this: an effective economic solution should result in a better economy, immediately, not a worse one.
Okay, one should already be cracking a bit of a smile at this Virgins-in-the-Volcano economics. But the “sacrifice ratio” concept is actually a little more dangerous than that. For it implies that, if one makes the necessary sacrifice (i.e. unemployment, aka a crap economy), then one indeed fixes the problem of inflation. But that doesn’t work either. Throwing virgins in the volcano is just a waste of good virgins. Actually, it is entirely possible that raising a central bank’s interest rate target will make inflation worse, because, as the economy crumbles in response, the currency falls further in value (as measured against the benchmark of monetary value, gold). Indeed, it is often the case that lowering a central bank’s interest rate target can actually create more employment/better economy and a rising currency, i.e. less inflation! We have been seeing that in Brazil and Turkey recently. However, lest one think that the solution for the US is lower central bank interest rate targets, let me point out that this phenomenon tends to work best when starting interest rates are quite high, 8% or higher.
Behind the “sacrifice ratio” concept lies the concept that inflation is cured by unemployment. This is not entirely mistaken, as a recession does typically mean that businesses must clear inventories by cutting prices, or that workers will take a lower wage to get a job. The result is a depressive effect on the measured CPI. However, real inflation is a monetary adjustment to prices resulting from a decline in currency value. If the dollar goes to $0.50, then it will eventually tend to cost two dollars to buy what one dollar used to buy. It does no particular good to try to solve the problem of a change in currency value by burning down the economy.
It’s amazing that academic economists continue to flog these ancient and long debunked Phillips Curve notions for generation after generation, occasionally dressed up again in new terminology such as the “sacrifice ratio.” But then, if they didn’t cling to the Phillips Curve, they might find that they don’t have any ideas at all!