Stevens is from Mars, Bernanke is from Venus?
on February 2nd, 2008 at 8:37 pm
Note to Subscribers: I have been on study leave in Europe for the last month, and get back to Sydney late on Monday February 4th. I will be available for comment from the morning of Tuesday February 5th.
Chart of the Month: Who’s having a housing bubble then?
A SMH article claimed that 17 out of 19 economists surveyed expected the RBA to increase rates in response to the January CPI figure:
Dollar inches towards US90 cents on rates expectation
In that case, count me as number 18 of 20. But unlike the other 17, I believe that a rate rise now would be a mistake. The real danger to the Australian economy is not a mild resurgence in inflation, but financial fragility, caused by excessive debt–the phenomenon that is leading the US’s Federal Reserve to move rates aggressively in precisely the opposite direction.In fact, the disconnect between Australian and American interest rate policies is once again so extreme, that it seems the two Central Banks reside on different planets. Australia’s “Rambo” RBA is still waging the war against inflation, while the “Sensitive New Age” Federal Reserve is clearly trying to soothe the troubled financial markets. In mid-2006, Reserve rates had converged to differ by a mere 0.5%; now, they are 3.75% apart after the Fed’s dramatic January pre-meeting rate cut of 0.75%, and subsequent meeting cut of another 0.5%. Australia’s reserve rates are now 2.25 times those of the USA’s.
In 2002-06, when there was last such a policy disconnect, the difference was justified by clearly divergent economic conditions. The USA was severely affected by the bursting of the Internet Bubble, while Australia had escaped relatively unscathed. Then, the USA’s rate of growth fell to a barely positive 0.2%, while Australia’s real rate of economic growth slowed, but remained above 1.5% p.a. This time, a similar gap has opened up after the bursting of yet another bubble–the so-called Subprime Lending Crisis. To date, our RBA seems to have taken a punt that history will repeat itself, and the negative effects of this bubble’s collapse will also be confined to the USA.
But what if the wrong history repeats: what if, rather than replicating the 2000 experience, we replicate the 1990s?
Then, both countries experienced a stock market bubble and crash, followed in short order by a commercial property market bubble and crash.The Australian government increased interest rates far more aggressively that the US government, in an attempt to rein in both inflation and the rampant property market.It was excessively successful: not only was inflation driven out of the system, but growth collapsed as well. Australia’s rate of economic growth tumbled from more than 2 percent above the USA to over 3 percent below it. The 1990s recession in Australia lasted longer than in the USA, and drove unemployment higher. The Australian government was forced to rapidly change tack on interest rates, dropping them from 18 percent to under 5 percent over the next 3 years.
Which way should rates go?
Today, the US Fed clearly believes that rates have to fall substantially to avert a serious financial crisis and a possible recession, whereas the RBA believes rates have to rise to control inflation. Both Central Banks can’t be right, unless the fundamentals in the two economies are fundamentally different. So just how different are they?
Economic Growth
The difference in rates of economic growth are exaggerated by the US practice of multiplying the current quarter’s rate of growth by four to estimate the annual rate of growth; Australia, on the other hand, uses the rolling sum of the last 4 quarters to estimate the annual rate of growth. When the less volatile Australian standard is applied to both economies, Australia’s economy still appears to be growing more rapidly than the USA, but the current gap was just one percent–prior to the release of the anaemic growth result for the December quarter.
Inflation
The rates of inflation are almost identical today, and well below the mean for the last two decades, when generally Australian inflation was two percent higher than the USA’s. Today, as measured by the CPI, our inflation rate is the same as America’s.
So rates of economic growth are similar, and rates of inflation are almost identical. How different then are asset markets?
Asset Markets
Since the Subprime Crisis broke, the Federal Reserve has clearly been concerned that the collapse in US house prices will drive its economy into recession–and the precipitous fall in the US stock market since the beginning of 2008 has only added to the worries that a serious “credit crunch” is taking place. It is ignoring signs of a resurgence in inflation–driven by rising global energy prices–and driving interest rates down aggressively.The Australian RBA, on the other hand, has been outwardly confident that there is no local parallel to the Subprime Crisis, and more worried that a fast growing economy is inducing rising inflation. They seem to believe that Australian asset markets–both stocks and housing–are not as fragile as their US counterparts. They therefore regard the pain that higher interest rates might damage growth and asset markets are as worth the gain of lower inflation.I think the RBA’s judgment here is flawed. On the data, the Australian stock market has outdone the US market on irrational exuberance since mid-2004, while the Australian housing market makes the US look subdued by comparison. The historic parallels are not with 2000, but with 1987/89.On the stockmarket front, while our market has been growing more slowly and sanely than the US since 1984–and it clearly didn’t join the US in its orgy of speculation over the Internet–since mid-2004 the ASX has clearly been in a bubble. The annual growth rate doubled from the 1984-2004 average of just under 9% to almost 20%. On the other hand, the US market’s growth rate in the last three years has been 13%, only slightly above its trend rate of growth since 1984, of about 11%.
On the other hand, the long run rate of growth of the DJIA (since 1914) is only 6%, and the long run result for the ASX (since 1984) is 9%… So whatever way you cut it, both Australia and the USA have been Bubble Economies for the past two decades–and the stock bubble is clearly bursting in both economies. 
The real “gimme” though is in housing, where our bubble makes the USA’s look positively anaemic. Ours began earlier, climbed higher, grew faster, and is still growing–whereas the US’s market is clearly in free-fall.
The US price index is now falling at a rate that exceeds one percent per month–an unprecedented rate of decline.
Both asset bubbles in both countries were driven by the Ponzi-Scheme belief that house prices could forever rise faster than consumer prices, so that leveraged speculation on housing was a sure “road to riches”. But while Ponzi Schemes work for those who get in and out early, those who hang around too long find out the hard way that it’s the sure road to bankruptcy instead. Once a Ponzi Scheme ends, all that’s left at the national level are
- overvalued assets
- much higher debt, and
- a compromised financial sector.
These are the consequences that the USA is now grappling with–and while I think the Federal Reserve is right to worry about the state of the USA’s economy, it is also undoubtedly complicit in allowing these bubbles to develop in the first place.
As is obvious from the above graphs, Australia’s asset prices are just as overvalued–and just as shaky–as those that are currently tumbling in the USA. What we gain by way of a comparatively responsible stock market since 1987 (recent bubble behaviour excepted), we lose in terms of an even more overvalued housing market.
We can tick the first box on the Ponzi scheme checklist.
The second is even more easily ticked. Though the Subprime Crisis has distinctive features that are not replicated here–such as the widespread use of “Adjustable Rate Mortgages”–lending to households for real estate speculation has been even more rampant in Australia than in America. In 1985, Australia’s household debt to GDP ratio was half that of America’s; today, it is the same.
What about the third box–the state of the financial sector? Here, though there have been obvious casualties–RAMs, Centro and now Tricom in particular–the widespread banking trauma that has afflicted Wall Street has been notably absent here, and the levels of personal bankruptcies and mortgage foreclosures are much lower.One important reason as to why may simply be the nature of the housing market. In many American states, a borrower who can’t meet mortgage commitments has the option of a “key drop”, as an almost cavalier means to hand ownership of a house back to the lender. Mortgage originators are then obliged to sell as soon as possible–hence the precipitous decline in US house prices.Given that so many of these loans were syndicated into bonds, the collapse in house prices has in turn undermined the bond market, and in particular the “repo” business (when companies extend short-term loans to each other by selling a bond and an agreement to buy it back a short time afterwards at a higher price). The collapse in house prices can force these bonds to be “marked to market”, eliminating their notional values–and making holding them even for the short term of a repo agreement too risky for financiers to contemplate.In Australia, even though repossessions and bankruptcies are occurring at a heightened pace, the process of liquidating a repossessed house is much more cumbersome, and lenders prefer to pressure a mortgagor into a forced sale to avoid the 15-20% hit on prices that a mortgagee sale causes. So house prices hold up, bonds don’t need to be marked to market, and the financial system continues to function, albeit at a reduced pace.The role of the China boom also can’t be overlooked: just as China has boomed selling consumer goods to the USA, we have boomed selling the raw materials to China. As long as China continues to boom, we are to some extent quarantined from the US’s problems.
Sorry about the length of this post.
“Money supply growth of the kind we are experiencing now can easily pass into asset price inflation rather than commodities; and prices are far more determined by cost pressures than pure monetary forces.”
Okay, I’ll admit to being hopelessly out of my depth! But my innate curiosity won’t let me leave well enough alone and simply return to normal life knowing I’ll never know! I must try to understand!
I can accept, based on my own observations, that the link between money supply and inflation isn’t the simple causal relationship described by Friedman. I also accept and understand the past failed attempts to ensure price stability by controlling the rate of money supply growth. But I’m having difficulty completely separating (and I’m not certain you’re suggesting this) money supply growth and inflation. And even more trouble understanding how asset price appreciation can absorb money supply growth.
On the second of these, I note that as a result of the boom in house prices, households are now borrowing a net $100 billion per year or thereabouts. Even if house prices were to cease rising, this level of borrowing would need to continue for many, many years just to maintain existing prices. Now as I see it, $100 billion in extra debt will end up in the hands of people or firms to be spent, saved or invested. Sure, for that $100 billion, around $10 billion will be added to the national annual debt servicing and repayment bill, but surely the remainder will feed into ‘the economy’ and increase our spending potential? That’s not to suggest it will directly cause prices to rise, but won’t it at least enable people to pay higher prices if they are rising?
Which brings me to my first point. Isn’t there a link between an increase in the money supply and inflation in that increased money is a prerequisite to people paying increased prices? I’m sure I’m missing large chunks of the economic knowledge required to piece all this together. That’s my fault for taking physics and maths instead of economics. I really enjoy the powerpoint notes on the debunkingeconomics site (though I abhor the comic sans font), and wish I had the lectures to accompany them.
So I’ve tossed Friedman in the rubbish, though I may have to retrieve the fascinating tale of Yapp money. Now I need something to fill the void. I take it much of the Austrian stuff is out too? Contrarian Investor would no doubt have me believe that inflation is the loss in purchasing power of existing money due to excess creation of additional money. That sounds rather too much like Friedman. Do I need to reject that too? It’s so simple an explanation…
I’ve tried to study the powerpoint notes, but still can’t grasp the essence of inflation. So perhaps if I just look around me I’ll see where it is coming from? The favourite culprit on the news.com.au forums is the evil plasma TV. We’re buying too many apparently, and this is driving up inflation. I bought a nice big LCD last year. But it was half the price of a year earlier! I can’t see excess demand for televisions driving up inflation! The more popular they become, the cheaper they get!
The price of fuel keeps rising. That reflects increased global demand for oil, and variations in our tiny local demand would surely have minimal impact on prices in the global market. But absent increased money, I would expect higher prices for fuel to dampen demand for other consumer goods for any given level of expenditure and savings.
And food! Wow, every time I go to the supermarket I’m shocked. Prices for meat, dairy, fruit and grain products seem to be rising fast. Perhaps it’s the drought. Whatever the cause, I can’t help but think that if people continue to pay higher prices they must be accessing more money, reducing consumption of other goods or saving less.
Then there’s housing costs. Buyers continue to pay ever-higher prices for houses. Rents are rising. I notice rents are rising fastest in more desirable areas. Perhaps that reflects a change in priorities or affluence. Perhaps there really is an undersupply of construction (I don’t think there is). But whatever the reason, people continue to pay higher prices. Again, unless they have access to more money they must be curbing other expenditure or reducing savings.
The big picture, as I understand it, is that spending is growing by around 6% per annum, while wage income is growing by ‘only’ around 4%. That spending must be coming from somewhere! Regardless of the cause of inflation, aren’t people, by increasing spending faster than their incomes rise, enabling it? Although there are items that will not be affected in price by reduced local demand (fuel, tele’s etc), surely there are other goods whose prices are demand dependant? So prices for something would have to fall if the purchasing power of the masses didn’t rise?
In summary, my main confusing now is, isn’t at least part of the increase in purchasing power of the people somehow be related to, or enabled by, the increased money supply that is caused by debt creation? And if so, isn’t the most obvious way to stop this purchasing power from rising to slow the rate of credit (debt) growth?
On a related note. If our debt level is the biggest threat to our future prosperity (and I believe it is), wouldn’t a 1% increase in interest rates now be better than another $100 billion+ in debt 12 months from today? The former would cost $9 billion in extra mortgage repayments over one year and be reversible. The latter would cost an additional $9 billion in extra mortgage repayments for the indefinite future and still leave us $100 billion further in debt!
Hi foundation!
In the long-run, there’s a connection between money supply growth and price and wage inflation. Don’t quote me on that, but I read somewhere that Ben Bernanke admitted that this is true. The trick is that, in the short run, all bets are off.
Both the Austrian monetary theory and Friedman’s monetarism is based on a very very old economic idea- see the link in our previous comment about the Quantity Theory of Money. But that’s just where the similarities between the two school of thought ends. That math equation in the Quantity Theory of Money is inherently true because it is just a mathematical relationship. The problem is in the application of that theory into economic policy. For example, how do you define what money is? If you can’t really define what money is, how do you really measure it. Next, is the question of price levels. How do you really measure price levels? Can you subsitute the CPI into the ‘P’ into the equation?
Based on that Quantity Theory of Money, monetarism prescribed policies by targeting money supply. History tells us that such policies were a failure. The difference between monetarism and Austrian theory is that monetarism talks about the absolute price levels while Austrian theory emphasis is on the relative price levels. By having inflation defined as what it was a long time ago (i.e. inflation is defined as expansion of money and credit), it looks to me that Austrian School theory side-step a lot of never-ending arguments about price inflation i.e. re-define the frame of argument.
Yes, you’ve hit it on the nail. Our latest article, Does wage growth cause price inflation? quoted Henry Hazlit, an esteemed Austrian School economist. The emphasis on Austrian monetary theory is that monetary inflation causes distortion in prices. As we all know, if you distort prices, you affect the free market, and along with it, comes other undiserable side effects.
Hi Foundation,
Here’s one of the many points where I part company with Austrian (and neoclassical analysis). The basic causal link in those theories is “change in money supply causes change in prices”. The empirical data in fact supports the opposite conclusion: “change in prices causes a change in money supply”.
The reversal of causation is very important, and also inherently straightforward logically. If a firm faces an increase in the price it has to pay for a key input (say oil), then it dips into its Line of Credit and instantly increases the money supply.
Ditto a shopper who buys an extra (even if less expensive) plasma tv–or has to fork out more money than planned for a new car, let’s say. He/she dips into the unused portion of the credit card limit.
The fact that we live in a credit world changes everything from the Austrian/neoclassical shared vision of a fundamentally barter driven world. In the barter/commodity money world, without hoarding and without debt, an increase in “specie” can only cause an increase in prices, ultimately.
But in the credit-based world in which we actually live, where the supply of money is elastic and there are also debts to be paid off, and accumulated funds to be added to, and assets to be bought (at volatile speculation-driven prices), the causal system is far more complex AND it tends to be changes in production yields (oil, food,…) and relative class power (wages vs profit margins) that drive price changes.
Then the monetary system adjusts to accommodate.
The main dilemma is that, under peculiar circumstances, the monetary system comes back into its own with a vengeance: when there is a “credit crunch” and the level of loans (and hence deposits) falls, then deflation can occur as borrowers who are trying to raise funds to pay off debt try to increase turnover by reducing prices.
Bit in general I hit the nail in the opposite direction to Contrarian: rather than “increased money supply is a prerequisite to people paying increased prices”, during a period of economic growth, “paying increased (commodity or asset) prices is a prerequisite to increased money” (and so is an increase in the level of output).
From my point of view, the Austrian/neoclassical view is rather like the belief that the sun rises in the morning, when the real mechanism is that the earth rotates on its axis. It’s understandable how the idea developed, but it gets the causal mechanism wrong.
Foundation, I’m not an economist but I think I have this worked out, the whole system works, at least for a while, because we borrow more and we also pay interest, so it almost balances out. So at the moment there is roughly about $1600 billion in debt which will require about $150 billion in interest. We have over $200, maybe $250 billion in new debt (nicely this is mainly funded by the interest payments) which means there is a net stimulus of at least $50 billion. This means we have lots of money to spend which is causing the inflation and also allows higher wages and higher employment. This in turn encourages more debt. There are probably other factors that reduce the inflation.
The whole crux of the matter is what happens when next year we decide to only borrow a $100 billion and still have to pay in excess of $150 billion in interest. It goes downhill from there.
This might be wrong in minor details but hopefully I’ve got the main parts right.
Hi Steve!
Good point.
I’m exploring another idea about this money supply/prices, which is from me. Rather than arguing about which is the cause and effect (i.e. whether prices/money supply is the cause/effect), I would adopt ideas from Systems Thinking. The idea from Systems Thinking is that for such a complex thing as the economy, it is a system. Systems exihibit characteristics like feedback loops (both augmenting and cancellation variations).
In this case, the increase in money supply causes increase in prices, which feed-back into the system to cause an increase in money supply. This is an augmenting feedback loop. An example of an augmenting feedback loop is when you put the microphone near the speaker. So, inflation will continue and continue, until something happen to break the circuit i.e. say, deflation. Deflation has its own feedback mechanism.
Agreed–in fact, that’s how I model the economy, using systems theory techniques.
I’ve just built a stylised model of a credit crunch using those tools, and it has an interesting unexpected feedback on prices. I’m writing this up for an academic journal now, and I’ll post it to the site when it’s finished. But the essence is the existence of feedbacks, which can give unexpected outcomes in terms of cause and effect, and the need to account for all the “sources and sinks”, to use their technology. The verbal models of economists of all persuasions, and the non-dynamic mathematical models of neoclassical economists, almost always omit important sources and/or sinks, and certainly omit the complex feedback links that can result from such a highly coupled system as the economy.
Hi Steve,
I consider myself to be somewhat illiterate when it comes to economics (coming from an engineering background as I do) but I have taken an interest in what you have had to say since I heard you on the PM program on ABC radio last year. I have read your “Deeper in Dept” paper and what you say makes a lot of sense to me. I have also enjoyed the Debtwatch podcasts and look forward to the next installment. I was just wondering what your opinion is of where the RBA is taking us given there current stance on inflation & interest rates? Do you think that the rate rises that the RBA has indicated will be needed (in their view) to control inflation will be the straw that breaks the camels back and tips us into “the recession we can’t avoid”? I have read that some economists are suggesting there may be up to 4 more increases in rates during this cycle. How close do you think we are before things start to go pear shaped and we end up in a debt induced downturn?
Keep up the good work.
I think Friedman is in principle still correct and it’s a bit rough to throw his thoughts into the garbage! It is still a monetary phenomenon even if the causality is in reverse. To explain, what if the RBA decided not to accomodate the demand for an increase in the money supply? Interest rates would skyrocket until savings and investment was in balance again and asset price inflation (or traditional inflation) would not occur. Is this thinking sound?
This has been a busy discussion!
On Phil’s question, I think the straw that broke the camel’s back was probably laid on the animal about 2-3 rises ago. Even conventional economists concede that monetary policy operates with long lags, and the RBA has been, in my opinion, too aggressive even on conventional thinking in increasing rates without giving time to assess what the impact of the rate rise has been.
As for when the pear-shaped scenario could apply, that depends on when aggregate debt growth slows down. My rule of thumb here is that aggregate expenditure is the sum of GDP plus change in debt. Currently annual change in debt is running at 25% of GDP per annum, so that increasing debt is providing 20% of aggregate spending in the economy. Even a slowdown in the rate of growth of debt would therefore be enough to trigger a recession in aggregate demand.
Were it only up to households, that slowdown would be close: mortgage debt grew 12% in the last year, and while that’s faster than nominal GDP, it’s 3% below the average for the last two decades. However business borrowing has stepped into the breach, growing at over 25% for the year. This has more than compensated for the slowing pace of mortgage borrowing.
At some point, I expect household borrowing to cease growing–which will take roughly $110 billion out of aggregate demand. That, I suspect, will occur some time in 2008. That could be balanced by growth in GDP plus additional business borrowing at the same pace as today’s rate of growth. A greater level of business borrowing would be needed to augment expenditure to a level that would keep unemployment at its current lows.
So I expect the unemployment rate to start growing at some time in 2008, and the real whammy to be delayed until business borrowing peaks–which is dependent on how successful this round of borrowing is in boosting exports to China, etc. I’d pencil in 2009 as a possible date for that. At that time, growth in debt would be of the order of 30% of GDP, so that a cessation of borrowing could reduce aggregate demand by up to 25%.
Steve
Are you familiar with “PEOPLE For Mathematically Perfected Economy” at
http://perfecteconomy.com/
There are series of spread sheets available on the right hand side of the web page which are trivial to understand. It seems to prove that the debt based monetary system collapses when the amount of money in circulation becomes less than the amount of debt owing to the banks.
The proof seems correct under the assumption that all interest payments to the banks are used to generate more debt. In my opinion however this assumption is not strictly correct as some interest payments end up as bank profits which are then paid to banks depositors (people that lend money to banks) and share holders of the banks in the form of bank dividends. These dividends and deposit interest can then be used to redeem debt. Now if everyone in society owned bank shares, proportionally given at birth say, then the system would be fair. Of course debt can still increase as people seek more material wealth, bigger houses etc….
My observation therefore is that it seems we may have a system that is prone to collapse depending on how banks are allowed to operate.
Foundation – M3 money supply
Banks has spawned a shadow banking system which initially removes assets from their balance sheets. This virtual money world is collapsing and a lot of this stuff is coming back onto their banks balance sheets. This I believe is what is spiking the M3 money supply.
Contrarian – on price inflation
Psychology plays a big part as in for example the 400% increase in oil in the 70s due to a 5% decline in supply. Or, gold at present being bid up to high levels based on inflation fears. Thus the exact price of an item is really based on whether it is deemed an essential item. If an item is deemed essential (food or the latest shoe craze even) then small supply fluctuations would lead to large price fluctuations – my guess is that programming fear, greed, fashion into a computer program is difficult.
Punchy said
>To Aac I would say i am not a fan of Elliot
>Wave. The wave guys have been predicting a
>global financial melt since the mid eighties!!
Irrespective of where the article was published I think it makes sense. For example, why would people lend money to a bank at 7% return when they could buy government debt at 7.81% (the 90 bank bill at present) or corporate bonds with spreads ~2% higher.
Thus interest rates in Australia, like in the US, are governed by the cost of debt and primarily government debt; where the latter is typically sold at auction.
Bank lending rates also depend on how much money banks can lend due to bank capital reserve requirements and fractional banking, the risk involved, and the rate at which people are willing to lend money to banks.
Typically mortgage rates in the US from the government sponsored enterprises are coupled to their 10 and 30 bond yields. At present even this is decoupled to a certain extent as mortgage rates in the US are now 6.5% which is ~0.75% high than it was six months ago when interest rates were much higher. Personal loans from commercial banks are now at 8.9% (see BOA calculator). Thus lending rates in the US is not directly related to their interbank lending rate.
The same could happen in Australia with rates sky rocketing due to banks unable to obtain money cheaply from depositors, risk repricing or foreigners unwilling to buy Australian government debt.
There are a few posts I have to respond to here; I’ll start with Dave and then discuss Aac’s post on the “mathematically perfected economy” in a second post.
Dave, throwing Friedman’s thoughts into the rubbish bin is kind treatment. At a glib level–”inflation is caused by too much money chasing too few goods”–it seems to be folk common sense, and most people assume there is good economic logic backing up that folk conclusion.
It’s not. In my opinion, the model from which Friedman derived his conclusions about money supply growth and inflation is an insult to logic. But you have to read the original article to know that.
This is why, in my teaching, I insist that my students “read the originals” rather than relying on second or third hand accounts in textbooks and the like.
Friedman’s case was made in a paper entitled “The Optimum Quantity of Money”. His model of money creation in that paper was that a helicopter magically appears over an economy and drops dollar bills at random out of the sky.
You think I’m joking?:
“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community…”
“When the helicopter starts dropping money in a steady stream-or, more generally, when the quantity of money starts unexpectedly to rise more rapidly-it takes time for people to catch on to what is happening…”
This is where the jibe at Bernanke as being “helicopter Ben” came from, when he argued in 2003 that, if deflation occurred, it could be countered by “the simple expedient of the printing press”.
Hello Milton, where does credit figure in this? And debt?
It gets worse when it comes to practical recommendations. Whereas the simple summary of Milton argues for increasing the money supply at, say, 5%, to get a 2% rate of inflation, his preferred recommendation was for continuous deflation:
“These practical considerations, I believe, make it unwise to recommend as a policy objective a policy of deflation of final-product prices sufficient to yield a full optimum in the sense of this paper. The rough estimates of the preceding section indicate that that would require for the U.S. a decline in prices at the rate of at least 5 per cent per year, and perhaps decidedly more…”
He followed this with an observation that the transition to this regime would be costly, and ended up recommending 2 percent increase p.a. to keep prices constant. But the entire discussion did not once consider the impact of deflation on outstanding debt levels–because, in his model, THERE IS NO DEBT. Money is simply an asset to the holder but a liability to no-one.
That is not the credit world in which we actually live. His model is both laughable and irrelevant to our actual economy.
It is also a very serious mistake in modelling to reverse the direction of causation. If price rises cause growth in the money supply, rather than vice versa, then trying to limit growth in the money supply (a) will not work to control iflation and (b) will probably have unexpected and unintended consequences.
This was the experience of Central Banks when they followed Milton’s creed and tried to control the rate of growth of the money supply. Firstly they missed monetary targets by huge margins–they’d set a target of, say, 10% increase in the money supply for one year, and actually get a 22% increase.
Secondly, whereas Milton argued that the economy would very rapidly adjust to the change in money supply predominantly by changes in the rate of inflation, the main impact of the attempt to limit money supply growth was borne by output rather than prices–and the ensuing long-lasting recession was the ultimate cause of inflation falling, rather than the simple expedient of trying (normally unsuccessfully) to limit money supply growth.
The only instances where anything like monetarism had success was where the economy was experiencing runaway inflation–like Zimbabwe’s 100,000% annual rate now–caused by literally profligate money printing by the government. But when the economy was a more conventional OECD nation experiencing 5-20% inflation, the policies were impossible to achieve (the failure to reach targets) and had dramatically different results to those he predicted (recession rather than price adjustment).
We need a much more sophisticated appreciation of the dynamics of credit money, and Friedman’s simplistic non-credit model of money is detracts from that ultimate goal.
To Aac re the arguments on http://perfecteconomy.com/;
I had a quick look, but as soon as I saw “Do the Math.. Calculate the inherent multiplication of debt to systemic collapse yourself!”, I lost interest–if you’ll pardon the pun!
The basic argument the site makes is the same one that some of my non-neoclassical colleagues made when they attempted to model endogenous money creation, working from the propositions of the European Circuitist School. Effectively, they argue that if you borrow a Loan, all that it can do is finance an equivalent amount of expenditure–and since interest is charged on the loan, there is no possibility of paying it back.
Certainly, they felt, it wasn’t possible to borrow money, repay it plus interest, and make a profit. As one of my good friends in this field put it:
““The existence of monetary profits at the macroeconomic level has always been a conundrum for theoreticians of the monetary circuit… not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest. In other words, how can M become M`?” (Rochon 2005: 125)”
I set out to solve that problem, and developed a simple model of a pure credit economy that showed it was quite possible to borrow money, make a profit, and repay the loan over time–with positive profits to capitalists, positive wages to workers, and positive interest income to bankers.
I’ve avoided posting this to my blog for quite a while, because it requires delving into some moderately difficult logic; but given the extent to which posters here bring this topic up, it looks like I’m going to have to make a post on it.
The argument is too complex to make in a reply like this, but the essence is that the proposition that interest necessarily causes debt to accumulate to unsustainable levels involves a confusion of stocks with flows. An initial loan is a stock; it enables a flow of income to be generated (assuming the existence of a productive economy which generates a physical surplus of outputs over inputs) that enables the flow of interest payments to be met; and so long as the physical productivity of the economy substantially exceeds the rate of interest, there is a sufficient surplus flow of profits over interest payments that can be used to pay debt down to zero over time, if desired.
Clearly in the real world, debt has accumulated close to exponentially; but this phenomenon requires a more sophisticated explanation than that proferred by perfecteconomy and the like.
So for the moment, take it from me that perfecteconomy’s arguments are flawed. Then give me a few weeks to develop a post on this–I have another Debtwatch to get ready for March, and a ton of formal academic writing commitments to reach.
Hi Steve,
Thanks for your work.
I’m just a non economist out here with a family and a pretty high income. What’s quite unusual about me is that I have no housing assets but do have large savings. I can see that the speculative housing mania has made it so much cheaper for me to rent than to own a house that I am far better off without even one house let alone the usual three or six of most people with my income.
I’m just trying to think through the implications to the individual of the idea that we should allow a little bit of inflation to avoid the ‘disaster’ of asset price falls and the economic contraction that will go with the reduction in credit growth that the asset price falls cause.
So if we imagine that rather than raising rates above 7%, rates had been left back at 6 or 5% and inflation allowed to rise to 5% or so. What would that do to the incentives placed on me? What would it do to the incentives placed on the geared housing (or other) speculator? What about the person with a home loan line of credit looking at a nice new car or lounge?
For those who earn more than they spend like me, if it became clear that the value of our savings were going to be systematically eroded as a matter of policy and thus slowly transferred to the people we lend them to, then it would not seem rational to continue to save. It seems that it’s almost impossible to convince people to save as it is, let alone if we intentionally make real (before tax) interest rates tiny or negative. I might not buy a house at more than three times the cost of renting one, but I might consider buying antiques, or something (anything?) else tangible that amused me and that government cannot decide to steadily nick from me to transfer to other people. Even extra concert tickets now would seem more rational than saving the money only to find that in a few years the same money plus interest will not buy the same concert tickets. Maybe I should even borrow to buy the concert tickets under those circumstances – as long as I never paid my loan back it would disappear eventually. How would my and a zillion other people’s behavior feed back into inflation?
A realisation that we will intentionally allow some inflation will surely show geared price speculators that they were right all along and reinforce their irrational behavior (well, in fact make it rational), so lead to more of it.
I can’t see how the economic contraction that may go along with a reversal of the credit expansion and asset price bubble can be a disaster. Sure, lots of people will realise that they are broke, but hiding it from them for longer does not change it.
If there was a lot more employment up to and including now because of unsustainable credit growth in a great house price bubble ponzi scheme, then that employment maybe was a kind of a “goodness” over and above normal, rather than the inevitable return to sustainable economic behavior being seen as a “badness” beneath normal.
There is an issue of both moral fairness and operant learning here as well. Should those people who recognised that house prices were irrational be penalised for having thought about what they do and decided to save instead? Should those people who use the investment technique of ‘look for something that somebody recently paid more than guy before him for and pay even more’ not suffer the expected consequences at the expense of those who behaved rationally? What future behaviors would this constellation of penalties for rational behavior and and non-penalties for irrational behavior induce?
I guess in short I’m asking, won’t keeping interest rates low and allowing “a bit more” inflation just hide the problem of household speculation and insolvency from us for a bit longer, allowing or even inducing more new players to join the ponzi scheme, and making it worse in the long run?
That was a great post. I really like the graphs.
Hi Icancount,
You are unusual!
Firstly, let me say that your financial prudence is probably in no practical danger. I do advocate that deliberately engineered inflation is a solution for a debt-induced recession (in the same way that chemotherapy is a solution for cancer–it may work, it’s dreadful, but better than the alternative). But I have complete confidence that the rest of my profession will fight tooth and nail to avoid inflation–and they will win the initial policy battle, and I will lose.
Secondly, once they realise (in about 4-6 years) that inflation is needed–certainly if deflation takes hold, as it did in Japan–the method they use to try to cause it will fail.
So I think that, practically speaking, you have nothing to worry about.
More likely, a combination of a debt-induced recession, falling asset prices, and possible deflation, will put you in a better situation than the one you already occupy.
On the theoretical points, there’s much to discuss. The bubble we’ve been through has primarily driven up asset prices, with a spillover as well into additional commodity spending; but if the bubble hadn’t occurred, it’s quite possible that economic growth would have been as high or higher. If our institutional framework had encouraged actual investment rather than speculation, we could well have seen the benefits of real innovations–low cost solar panels for example, or a low cost maglev transportation system–rather than simply inflated asset values.
So I don’t think the depression that a collapse in asset prices will cause will simply balance out an excessively high period of growth caused by the borrowing. The borrowing binge quite possibly reduced growth over what it could have been without it, while the negative impact of a debt-driven slump will be substantial.
As noted, you are a true exception: most people who are in your cash-rich situation got there via asset speculation–and getting out early before the bubble burst. Those who rode that route to riches and then found it eaten away (via a successful program of deliberately caused inflation) would not get my sympathy. You would–but as noted, in practice I doubt that you’ll need it.
The real long term solution that I’m angling for is to relate loans to the income stream the asset purchased by the loan will generate. That would stop these bubbles in their tracks–indeed the only avenue for large gains for lenders would come from backing truly innovative investment, rather than speculation on the prices of existing assets. But in the meantime, once a crisis caused by excessive debt comes along, I also have a responsibility to suggest a short-term palliative as well–hence noting the beneficial role of commodity price inflation in such a setting.
There is also one aspect of today that will quite possibly cause inflation, independent of any policy: global warming and peak oil will drive up commodity prices, without any policy input. China’s boom is also doing the same thing–though that may prove fragile for ecological as much as economic reasons at some stage in the near future.
On interest rates, I would have less of a problem with the RBA’s hawkishness on this if it were actually directed at spiking the property market bubble. It’s a blunt, dangerous way to do that, but yes a rate rise now–or sharper ones earlier–could have stopped the debt bubble earlier.
My concern instead is that the RBA is focusing simply on keeping commodity price inflation low.
Now if they did the right thing for the wrong reason, that in itself would be a lesser evil. But there is a possibility that they will do a right thing and a wrong one: stop the bubble, ultimately, years after it should have been pricked; but also set off deflationary forces.
I hasten to add that I expect inflation courtesy of global warming (GW) and peak oil (PO), no matter what the rate rises independently do to inflationary pressures. But even then there is a chance that a sudden debt-induced recession here, and in the rest of the OECD, could lead to deflation even with GW & PO.
Then we’d be in the worst of all worlds.
Finally, while I’m advocating inflation as a policy, it’s as much a “hold the line” advocacy as anything else. Inflation of the order of 2-4% has been a commonplace over the last two centuries–most of the episodes of falling prices have been in conjunction with bursting debt bubbles, while higher inflations have been associated mainly with wars. People like yourself have prospered despite that inflation.
So the RBA being paranoid about a level of 4% now is, to my mind, a bit like obsessing about a cracked nail when you’re on the verge of getting pneumonia. Ignore the nail for a while, and do something about your chest would be apt medical advice.
Thanks very much for your comprehensive reply Steve.
It’s like I am an individual imaginary number trying to understand the Mandelbrot set, only with far more dimensions.
Hi Steve
following is a chart on US Household debt and debt service from Nouriel Roubini’s Global EconoMonitor website.
http://www.rgemonitor.com/blog/roubini/archive/2008-02/
Can you tell me if Australia household debt and debt servicing
is in better or worse shape the the US.
Thank you
Keith MacLennan
Thanks for the comprehensive reply. Friedman was talking very conceptually (helicopters with cash!) which is actually the world I am most comfortable in. I find the real world rather limiting as you can’t assume away everything that doesn’t fit!
Here is a link for an interview with Friedman when he came to Australia in 1998 which is interesting.
http://www.abc.net.au/money/vault/extras/extra5.htm