OK, that isn’t what Wolfgang Munchau said in his Financial Times article today. His piece, “The princess’s cake gets an added crunch,” starts with the theory that inflation and our asset bubbles were ultimately monetary phenomena.
While the rest of Munchau’s piece, which focuses on why we should be worried about inflation, is useful, I wish he had spent more time on the discussion of its roots. Perhaps I am being a bit of a stickler, but my understanding is inflation in goods, which is a monetary phenomenon, has a different transmission mechanism than asset inflation, which is most often the result of an expansion in credit beyond the level needed for productive investments (however one might define that). While that level could conceivably be very large in an emerging economy, one should look at increases in systemic leverage (simple measures like debt/GDP) with considerable concern, particularly in a country like the US, which has not had a very high savings rate to begin with.
That is one reason I am a bit perplexed by the discussion to extend the Fed’s mandate to managing asset bubbles. As Australiia’s former Reserve Bank governor Ian Macfarlane pointed out, it’s hard for a central banker to know when an asset bubble has started, and even if he is correct, he will be unable to prove he was right:
There was a time when we felt that monetary policy, by returning the economy to low inflation, would have a stabilising effect on asset markets…. But the broader evidence does not support the view that low inflation will prevent booms and busts developing in asset markets….Some have even gone as far as to suggest that low inflation may encourage the build-up in asset prices.So, if low inflation does not provide any insurance, what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?…
Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.
First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected…..
Second…[e]ven if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….
That suggests that a potentially less controversial way to deal with this problem is more regulatory than monetary: to gain a better understanding of how much variance in leverage is healthy over an economic cycle, and what increases look likely to produce bubbles. This would also provide a better basis for communicating with the public. Saying “housing/stocks/wampum prices increased 18% last year, we think that’s too much” is a hard position to defend. Saying “leverage [however defined] increased x%, that puts the institutions and economy at risk” is far less controversial. But my impression is that regulators only have a partial picture of the sources and extent of borrowings.
Which gets back to the carry trade, What complicates the problem of understanding leverage is international capital flows. As the thorough analyses of Brad Setser show, we can track foreign flows into US assets with to a reasonable degree. But I wonder if we understand the mechanisms and operation of the carry trade as well. I am not certain that we fully capture the degree to which US domiciled entities (read certain hedge funds) fund in Japan. Similarly, a fair amount of private purchases out of London, the Caymans, and other hedgie ports of call benefit from low yen-based interest rates.
Back to Munchau. From the Financial Times:
“I remembered the way out suggested by a great princess when told that the peasants had no bread: ‘Well, let them eat cake.’”Jean-Jacques Rousseau, Confessions
When I saw reports of food riots, I was reminded of these immortal words, often attributed to Marie Antoinette, although there is no evidence that she used them. The modern equivalent to “let them eat cake” is: “Core inflation is well contained.” Core inflation is a measure that excludes goods whose prices are currently rising the most – food and oil. It is a popular concept among some central bankers and academics, and an insult to consumers: let them eat refrigerators.
The global rate of headline inflation is 4.5 per cent and rising. Some economists had us believe a year ago that the rise in inflation was just a blip. But it kept on blipping. They predicted it would fall back in 2008. Now, they say it will fall next year.
We can waste a lot of time talking about the mechanics of the oil market or about speculators. Persistent inflation is not caused by oil sheikhs, ethanol producers or retailers, but by monetary authorities. A point Milton Friedman once made, and accepted even by many of his detractors, is that “inflation is always and everywhere a monetary phenomenon”. The rise in commodity prices is the consequence of a credit-financed economic expansion that has hit natural supply constraints. It is a very familiar story, except for geography. This time it is truly global.
In a recent empirical study using data from the Organisation for Economic Co-operation and Development, the economists Ansgar Belke, Walter Orth and Ralph Setser* claim to have found a statistical link between the global liquidity glut, the real estate boom and inflation. The emphasis here is on global. The key result is that both house and consumer prices are determined by global monetary conditions – but at different speeds: the housing market reacts first, with consumer prices following after some delay. Too much money is still chasing too few goods – except that it creates an asset price bubble on the way.
Unsurprisingly, not everybody agrees. There are four common, and not very convincing, arguments. First, core inflation is under control. Yes, incredibly, people are actually making that argument. There is an economic theory that says core inflation is leading headline inflation. If the two diverge, headline should adjust to core. Unfortunately, the opposite is happening now. Higher oil prices are pushing up prices of final goods, and workers are demanding higher wages, as they sensibly ignore core inflation.
Second, financial market indicators do not show any strong evidence of a rise in long-term inflationary expectations. These indicators include the yield difference between Treasury inflation-protected securities and ordinary Treasuries and their respective European equivalents. In fact, some of these indicators have actually gone up a little. But more importantly, they are not really forward-looking. The yield difference tells us more about liquidity conditions in those markets than about future inflation.
Third, the expected slowdown of US and global economic growth will take care of the inflation problem. A devastating global depression would probably have that effect. But fortunately, the world economy will be spared this calamity. There is no reason to suspect that Asia will suffer a recession, rather than a moderate slowdown. As I explained last week, the eurozone may also be a little stronger than the consensus forecasts suggest. The US recession will put a temporary lid on US inflation but, once the recession is over, prices will go up.
Finally, there is an argument I have been hearing a lot more recently: why bother? Let inflation go up a little. It oils the wheels of the adjustment, in particular for house owners.
Unfortunately, this may work for people with high levels of mortgage debt, but not for the poor and those on fixed incomes. In Europe, and especially in the south, there are people who have difficulty paying the vastly increased prices for bread and grains. Since poorer people spend a higher proportion of income on food and petrol than middle-class people, the inflation rise hits them hard. Higher inflation is the transfer of wealth from the poor to the middle classes. You might as well say: if you cannot afford the bread, let me eat the cake.
What about the fact that the US has a negative savings rate? Surely the country would be better off with higher inflation, as this transfers wealth from foreign creditors to US debtors? My guess would be that under such a scenario the US bond market would implode, the current account deficit would become impossible to finance, the dollar would collapse, inflation would rise even more and the Federal Reserve would have to raise interest rates to high single digits or higher. In that scenario, nobody eats cake anywhere.
I expect that the biggest danger to global economic stability will be not the credit crisis, but the way we are overreacting to it. Both in the US, and increasingly in Europe as well, monetary policies are no longer consistent with price stability. Since a pre-revolutionary contempt for the poor is a side effect of this policy, I suspect Rousseau’s unnamed princess would have found our early 21st century most congenial.
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“If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks?”
Although I agree with this – you can’t argue by using a counterfactual in a system as complex as the national or world economy – , I think it’s missing an important point.
There is no popular support for the financial sector – none, zippo, nada – and there has been none for some time. Given a chance, the populace would prefer to draw and quarter and then impale every investment banker. Yet the Fed has ridden to the rescue of the financial sector in 1987, 1998, and 2007-8. So pretending that CBs would have lacked popular support for being tough is misleading. CBs could very well have been tough with the financial sector and would have still, I think, received a lot of popular support, even at the risk or cost of a recession. They have chosen not to, not because they were worried about recession or losing popular support, but for entirely different reasons, mostly ideological, that is, the idea that they could encourage financial stability in the short-term without encouraging financial instability in the long-. And that, I would claim, is a big mistake.
Even with super-low interest rates, does anyone really think that IBs would have been as stupid as they were in 2003 through 2007 if, to pick a name at random, Goldman Sachs had been allowed to go bankrupt in 1998 as it so richly deserved? If LTCM and GS had been allowed to go bust, my own firm would have lost a certain amount of money, which surely would have led us to close down or drastically cut back on risk-taking activities for many, many years if not forever.
So it’s not the pitchfork-holding mob which made CBs do it, against their better judgement. CBs did it themselves, because they were vain and lacking in modesty. CBs need to turn the spotlight on their own shortcomings, not blame others.