President George W. Bush’s selection of his personal lawyer Harriet Miers for the Supreme Court has enthralled the blogosphere for three weeks, peeling off much of Bush’s support from the right. Yet Bush will soon make a selection with even more potential for good or ill in everybody’s lives: that of a successor to Fed Chairman Alan Greenspan, due to retire in January. In this selection however he should aim to be unpopular, as distinct from merely achieving unpopularity by accident.

As argued in this column for some years, Greenspan’s record as Fed Chairman is a mixed one. Early in his term, he maintained his predecessor Paul Volcker’s policies of tight control over the money supply, albeit with a short term loosening after the stock market crash of October 1987, when it appeared that tight money allied to shaky market conditions might cause an economic meltdown. Indeed, President George H.W. Bush blamed Greenspan’s restrictive monetary policy for his electoral defeat in November 1992.

Then in July 1993 Greenspan announced that money supply growth, the lodestone of Volcker’s highly successful restrictive monetary policy, would no longer be used as the principal guide to action: “The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy.” Having thus abandoned the policy that Volcker had used so successfully to bring down U.S. inflation Greenspan began to allow the money supply to expand rapidly.

In the 10 years from September 1995 to September 2005, M3 money supply expanded by 8.06 percent per annum compared to an increase in nominal Gross Domestic Product of 5.28 percent per annum. The ratio of M3 to GDP expanded during the period from 62.12 percent to 80.60 percent. There is some evidence of underlying long term growth in M3’s ratio to GDP – about 0.23 percent per annum in the period since 1960 — although one can reasonably argue that with more efficient payments technology, the M3/GDP ratio should have declined, not increased. In any case, it is clear that M3 money supply, even after taking account of the long term growth trend, was at least 10 percent of GDP further above that trend in 2005 than in 1995.

This would normally have been expected to produce a rise in inflation. It did indeed do so, but in asset prices, first of stocks and then of housing, rather than the prices measured by the Consumer Price Index. The stock price drop of 2001-02 and the artificial and unbalanced world economic recovery of 2003-05 have now driven continued rapid money growth worldwide to appear in commodity prices, particularly the price of oil, and are increasingly affecting “headline” consumer price inflation.

With U.S. consumer price inflation now at 4.7 percent over the last 12 months, significantly above interest rates on both long term and short term U.S. government bonds, there can be little doubt that interest rates must rise much further, and money supply growth be sharply restricted, before inflation is brought back under control. At this stage the hysteresis in the U.S. economic system would probably take consumer price inflation above 6 percent even if monetary restriction were begun now. Since a real short term interest rate of around 4 percent is required to begin suppressing inflation, it is thus likely that a Federal Funds interest rate of 10 percent will be necessary before inflation is re-conquered. Even this of course would be far below the 19.10 percent Federal Funds interest rate reached by the brave Paul Volcker in June 1981.

The Fed Chairman who puts the Federal Funds rate up to 10 percent will achieve new records of central banker unpopularity. Such a short term rate will cause both the stock markets of the world and the U.S. housing market to collapse, it will bring massive unemployment as overextended real estate and construction companies can no longer obtain funding, and it will make whichever political party is in power lose massively at the next Congressional or Presidential elections.

What’s more, the rise to 10 percent will need to be done fairly quickly. The current Fed policy is to increase the Fed Funds rate target by ¼ percent at each Federal Open Market Committee meeting, eight times a year, hoping that the U.S. economic frog never notices that the monetary water is reaching boiling point. This suffers from the problem that the rate of inflation is currently rising at more than 2 percent per annum, so monetary policy is becoming more stimulative rather than less. Only once a sharp monetary shock has been administered to the U.S. economic system will inflation begin to drop.

Delusions that a sharp rise in interest rates can be avoided, or that the cure is worse than the disease, betray thinking similar to that of Fed Chairman Arthur Burns in 1972-3, who allowed monetary policy to remain lax and inflation to continue rising, thus forcing a much more unpleasant deflation in 1979-82. The sharp rise in interest rates will not only bring down inflation, it will correct many of the other economic distortions of the last decade.

After it, stocks will no longer be overvalued, pensions will no longer be chronically under-funded, chimerical projects will no longer be swamped with venture capital, ugly and overpriced housing developments, built with the labor of illegal immigrants, will no longer disfigure the landscape, and crooks and charlatans will no longer flourish on Wall Street and throughout the U.S. economy.

Most important, tight money will affect the world as a whole, widening the disparities between rich and poor countries’ access to and cost of investment capital. The long term bank loan and high yield bond markets for emerging market credits will shrink to a fraction of their current size, and spreads between good and bad credit risks will markedly widen. Thus the United States’ cost of capital advantage over developing countries will once more outweigh much of its labor cost disadvantage against them, so U.S. manufacturing will no longer be artificially driven overseas to the shaky economies of the Third World.

This is not just a theoretical problem: if the bankrupt Delphi automotive parts company can now afford to operate in the United States only if its workforce accepts wages of $10 per hour, as reported Thursday, the U.S. economy has ceased to work properly.

Third world economic growth rates will decline, particularly in China and India. However that growth will become focused on healthy domestic development, with direct benefit to local populations, rather than on mercantilist growth in their export sectors. Money will cease piling up in sterile reserves at Asian central banks and will be redeployed to productive uses in their domestic economies.

The world of tight money will be hell for the crooks, sharp operators and over-expanding shysters financed by funny money who have infested the U.S. economy since 1995. After a brief if unpleasant recession, it will be (relatively) heaven for ordinary working men and women, whose jobs and pensions will become once more secure, and whose savings will once more earn a decent return.

It is fair to say that none of the candidates Bush is considering for the Fed Chairmanship is currently contemplating putting rates up to 10 percent (Volcker may be contemplating it, but at 78 he is probably not on Bush’s short list.) Ben Bernanke for example, current Chairman of the Council of Economic Advisors and tipped as front-runner for the job by many of the media, made his name in November 2002 by warning of the dangers of deflation – that at a time when the Federal Funds rate had fallen to 1 percent (well below even reported inflation) and the M3 to GDP ratio was at an all-time record. Bernanke’s approach to monetary policy, in which all economic problems can be solved by creating money, is that of the 1919-23 Weimar Republic, which achieved in September and October 1923 inflation rates of 2,500 percent per month.

As well as an outright inflationist, another danger would be to appoint a stooge, whether a monetary Harriet Miers who was very close to the President or someone like current Fed governor Donald Kohn, believed to be close to Greenspan and hence tarred with the money-creating policies of the last decade. Tight money, being unpopular, will meet with huge resistance from Bush and his modestly qualified economics team. Likewise, excessive deference to policies inherited from Greenspan and the inflationists will only delay the adoption of a monetary policy that does the job needed.

Of the various names being bandied around, two in particular have the intellectual heft, the track record of understanding free market economics and the independence of Bush and Greenspan to offer good prospects for doing a good job as Fed Chairman. They are Larry Lindsey and Martin Feldstein.

Lindsey, 51, a Fed governor in 1991-97, demonstrated his independence and free market credentials by pointing out in 1999-2000 that the stock market had formed a huge bubble and that recession must inevitably follow. He then became Bush’s Director of the National Economic Council, where he angered Bush by pointing out correctly that war in Iraq would cost $200 billion and then allegedly lost his job because of insufficient use of the White House treadmill. In terms of background, beliefs and independence, he would be a good choice.

Feldstein, 65, was Chairman of the Council of Economic Advisors in 1982-84 under President Ronald Reagan, and has been a full Professor of Economics at Harvard and President of the National Bureau of Economic Research since 1984. In the 1970s and 1980s he was one of the leading intellectual forces behind the supply-side, incentive oriented economic revolution of that period. He has been generally supportive both of the Bush administration’s economic policy and of Greenspan’s monetary policy, but is tied to neither, and has demonstrated throughout his career sufficient stature and intellectual self-confidence to act independently if he needs to.

Like their competitors, neither Lindsey nor Feldstein have come out in favor of a 10 percent Federal Funds rate. Nevertheless, both men have the ability, the understanding of the market’s workings, the intellectual independence and the courage under fire that are likely to lead them as Fed Chairman sooner rather than later to prescribe for the U.S. economy the temporarily unpleasant monetary medicine it requires.

Lindsey and Feldstein’s intellectual independence, of course, is the main reason why they are unlikely to be appointed to the job by President George W. Bush.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.