Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

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The rev­e­la­tion in the min­utes of the RBA’s Feb­ru­ary meet­ing that debate focused, not on whether there should be a rise, but on whether it should be 0.25 or 0.5 per cent, shows that the RBA wagers that the threats to the Aus­tralian econ­omy are upside ones–tighter labor mar­kets and higher inflation–rather than down­side ones–a global slow­down as asset mar­kets col­lapse dur­ing a credit crunch. The Feb­ru­ary min­utes implied that the RBA might really throw its cards on the table at the March meet­ing, with a 0.5% rise being a dis­tinct possibility.

This is in stark con­trast to the biggest gam­bler in the reg­u­la­tory stakes, the US Fed­eral Reserve. Not only did it drop US rates down by 1.25% last month, it is now sig­nalling another 0.5% fall dur­ing March.

So which reg­u­la­tory gam­bler is right–or, against the odds, are they both right? The answer depends on just how big a threat the cur­rent finan­cial mar­ket tur­moil poses to the global econ­omy, and how well Aus­tralia is pre­pared to weather any storm this might cause.

A key issue for the for­mer point is the size of the cur­rent finan­cial bub­bles, in both Amer­ica and Aus­tralia. They are obvi­ously burst­ing now, and the amount of pain that a bust can inflict clearly depends on how big the bub­ble itself was.

On that point, the answer is sim­ple for the USA: the USA’s recent bub­ble was the biggest in world finan­cial his­tory.

Robert Shiller, the man who coined the phrase “irra­tional exu­ber­ance”, makes that clear in the 2005 update to his book, where he com­pares Amer­i­can house prices and stock mar­ket indices to the CPI.

Houses are nor­mally pur­chased on credit, and while an indi­vid­ual can pay back his or her mort­gage debt by sell­ing the house to some­one else, soci­ety as a whole can’t do that. Ulti­mately there­fore, an economy’s mort­gage ser­vic­ing has to be financed from its income, which is derived from sell­ing goods and ser­vices. The ratio of asset prices to con­sumer prices gives the best mea­sure of how hard or how easy that is to achieve. While there is no obvi­ous “magic num­ber” for the ratio (and the ser­vic­ing cost of debt will rise and fall with changes in inter­est rates), its level tells us how sus­tain­able house prices are at any point in time. A low ratio implies very afford­able hous­ing; a high one implies very expen­sive housing–and one that tow­ers over the long term aver­age implies a bubble.

A sim­i­lar obser­va­tion applies to the Stock Mar­ket. Though the Price to Earn­ings (PE) ratio is a com­moner mea­sure of the verac­ity of the Stock Market’s val­u­a­tion, earn­ings can be inflated by tricks rang­ing from out­right fraud, to fancy “finan­cial engi­neer­ing”, to debat­able reval­u­a­tions of assets–something that is becom­ing painfully obvi­ous as the domi­noes fall in the cur­rent Aus­tralian and US stock mar­ket slumps.

No such prob­lems apply with the CPI, and since earn­ings have to come from sales of goods and ser­vices, the com­par­i­son of the asset index to the CPI gives a bet­ter idea of how sus­tain­able the share market’s prices are.

These cal­cu­la­tions gives the lie to Greenspan’s asser­tion that a bub­ble can only be iden­ti­fied after it has burst.

The US House Price Bubble

The bub­ble in US hous­ing prices is obvi­ous: between 1892 and 1995, the aver­age for this index was 103, while its pre­vous peak value–set over a cen­tury ago in 1894–was 133.6.

This long run max­i­mum was breached in 1989, two years after Greenspan took over as Fed­eral Reserve chair­man, after he “res­cued” Wall Street after the 1987 Stock Mar­ket Crash–a res­cue which sim­ply trans­ferred the Wall Street bub­ble into a Main Street one, in com­mer­cial and res­i­den­tial prop­erty. The prop­erty mar­ket crash in 1989 ush­ered in the 1990s reces­sion that helped Clin­ton come to power. House prices still hadn’t returned to the his­toric norm before the next boom began–fuelled by and feed­ing into the eupho­ria over the Inter­net. The hous­ing bub­ble con­tin­ued even after the Stock Mar­ket bub­ble tem­porar­ily burst, until it peaked in 2004 at 228, over twice the his­toric norm, and 70% above the high­est level the index had reached over a cen­tury ear­lier. If the index reverts to any­thing like its his­toric norm, then US house prices have much fur­ther to fall. Even now, after a ten per­cent fall from its peak, the index is still almost twice the pre-1995 long term average.

Com­men­ta­tors who are pre­dict­ing a fur­ther 25% fall in US house prices may turn out to be optimists.

Chart One: USA Real House Prices
 Chart One: America's CPI Deflated House Price Index

The US Stock Mar­ket Bubble

One intrigu­ing fact that the deflated Dow Jones index reveals is that the pre­vi­ous biggest Stock Mar­ket­bub­ble wasn’t in 1929, but in 1966.

n 1929, the index reached an inflation-adjusted value of 407 (before col­laps­ing to as low as 60 in 1932–an 85% fall). In 1966, theinflation-adjusted value of the Dow peaked at 567–after which it plunged for 16 years, to a low of 152 in mid-1982. This was a 73% fall in real terms.

Since then–with the dra­matic excep­tion of Black Mon­day in Octo­ber 1987–it was all up until 2000. The Stock Mar­ket had already exceeded its Roar­ing Twen­ties peak by the time Greenspan took office in August 1987. Just two months later, it plunged back into near long-term ter­ri­tory with Octo­ber 19th’s 23% crash. Rather than the rever­sion to the mean con­tin­u­ing, the Greenspan Put embold­ened the mar­ket, which sailed through the 1929 record in 1992, and kept right on going into an unprece­dented level of overvaluation.

By 1996, it had left 1966 behind, and at the height of the Inter­net frenzy, it hit 1252–almost five times the aver­age that had pre­vailed up until 1995. Then in 2000, just as Greenspan was reit­er­at­ing his belief that a bub­ble can only be iden­ti­fied in its after­math, the one he was rid­ing burst.

Chart Two: USA Real Stock Prices 

Chart Two: America's CPI Deflated Dow Jones Index

Quick res­cue work by the Fed–both injec­tions of liq­uid­ity, and drop­ping the reserve rate to 1%–and mas­sive gov­ern­ment deficits to finance the war in Iraq, turned the market’s rever­sion to the mean around by mid 2003. By late 2007, it revis­ited its 2000 peak.

Then its recent plunge began.

A more cur­rent value of this index must await the US CPI fig­ures for Jan­u­ary and Feb­ru­ary, but it must be of the order 1050 now. Even so, this puts it at more than four times the pre-1996 average.

Where could the index head to, if the mar­ket finally heads back to its his­toric norm? As the USA basked in the col­lec­tive delu­sion of the Inter­net Bub­ble, some authors put out books with the titles Dow 30,000, Dow 36,000, and even Dow 100,000 (Zuc­caro; Glass­man, Has­sett & Has­sett; and Kadlec; look for them in the remain­der bins of your local book­shop). On this data, Dow 3,000 looks more the go.

Of course, it is also pos­si­ble that the bub­ble could re-form–but that would require a renewal of the trend for an ever-increasing debt to GDP ratio, since lever­age is what has dri­ven house and share prices to their cur­rent levels.

This is pos­si­ble, but unlikely, for the same rea­son that a sim­i­lar “solu­tion” is unlikely here: America’s debt to GDP ratio is already at record lev­els. Even if the Fed drops offi­cial rates to zero (as Japan’s Cen­tral Bank did dur­ing the ‘90s), and aver­age com­mer­cial inter­est rates drop to three per cent, the debt ser­vic­ing bur­den on the econ­omy will still be immense. And a cut in offi­cial rates won’t res­cue home buy­ers who have signed up for fixed inter­est loans, which are the norm in the US mar­ket.
Chart Three: USA vs Aus­tralian Pri­vate Debt Ratios
Chart Three: Private Debt to GDP Ratios in the USA and Australia

How Big Are Our Bubbles?

How do the Aus­tralian house and stock mar­ket bub­bles com­pare to America’s? The bad news is that Australia’s hous­ing price bub­ble is at least 50% larger than America’s. I cur­rently lack really long term data for Aus­tralia, but Nigel Sta­ple­don at the Uni­ver­sity of New South Wales pro­vided the fol­low­ing per­spec­tive in his PhD the­sis: (the fol­low­ing chart, which com­pares Stapledon’s index for Aus­tralia to Shiller’s for the USA,is taken from:
http://www.whocrashedtheeconomy.com/?m=200801).

Clearly, the Aus­tralian house price bub­ble dwarfs America’s.

Some may wish to explain the diver­gence on the basis of real fac­tors such as Australia’s higher rate of pop­u­la­tion growth, etc. While these fac­tors undoubt­edly play some role, I very much doubt that they can explain the volatil­ity shown in Stapledon’s data. The two country’s house price indices were vir­tu­ally iden­ti­cal in the mid-1980s, for exam­ple, and then within a cou­ple of years, Australia’s was almost twice America’s. We didn’t take in that many more migrants then–nor could their influx explain a bub­ble focused on the mid­dle to upper-range sub­urbs.
 
Chart Four: USA vs Aus­tralian Long Term Real House Prices
Chart Four: USA vs Australian Long Term Real House Prices

It’s also appar­ent that Aus­tralian house prices have increased more than the USA’s since 1987, and remain in a bub­ble today, while the USA’s index has clearly turned.

Chart Five: USA vs Aus­tralian Recent Real House Prices
Chart Five: USA vs Australian Recent Real House Prices
Given that our house­hold debt to GDP level was half that of America’s in 1990, but is iden­ti­cal now, I expect that the true expla­na­tion of Australia’s greater hous­ing bub­ble is finan­cial, not “real”. If so, we face just as seri­ous a poten­tial down­side to house prices as does Amer­ica, if not more so. The dif­fer­ences in out­comes to date may result from the China Boom, com­bined with the very dif­fer­ent mort­gage default laws in the two countries.

Chart Six: USA vs Aus­tralian House­hold Debt Ratios

Chart Six: USA vs Australian Household Debt Ratios
So much for the bad news. The good news is that Australia’s stock mar­ket hasn’t been nearly as bubble-based as the USA’s since 1987. In 1984 (when the ASX data begins), the CPI-deflated value of the Dow Jones was 2.3 times that of the ASX; by 2000, when the DJIA first hit its his­toric peak, the US index was 5.2 times the Aus­tralian one.
 
Chart Seven: USA vs Aus­tralian Real Stock Mar­ket Indices
Chart Seven: USA vs Australian Real Stock Market Indices
On the other hand, it’s also appar­ent that its per­for­mance in the last four years has been more speculation-driven than the USA’s. By time time both indices had peaked, the diver­gence between the USA and Aus­tralia had fallen to 3.2 to 1. It is likely that the recent obses­sion with mar­gin lend­ing as a “wealth enhance­ment strat­egy” has played a role here.

Chart Eight: USA vs Aus­tralian Stock Mar­ket Indices Trends

Chart Eight: USA vs Australian Stock Market Indices Trends
Chart Nine: USA vs Aus­tralian Stock Mar­ket Indices Trends

Chart Nine: USA vs Australian Stock Market Indices Trends
 
So which Reg­u­la­tor is “on the money”?

Nei­ther the Fed­eral Reserve nor the RBA deserves acco­lades for its man­age­ment of the finan­cial sys­tem. While they are diverg­ing now over the threat posed by infla­tion, ver­sus that ema­nat­ing from sys­temic fragility, both have shared an obses­sion with keep­ing com­mod­ity price infla­tion under con­trol, while asset prices and debt have spi­ralled out of control.

That said, the Fed­eral Reserve clearly appears more real­is­tic about the major threat fac­ing the econ­omy at the moment–even if that threat was fuelled by its own com­pla­cency dur­ing the great­est finan­cial bub­ble of all time. Now is not the time to be fight­ing com­mod­ity price infla­tion, while ignor­ing both debt and asset price inflation.

An aside: “Low” Busi­ness Leverage?

I’ve seen a num­ber of media reports claim­ing that the cur­rent string of busi­ness defaults is unex­pected, since busi­ness lever­age is quite low these days.

That may well be true when debt to equity is the mea­sure of lever­age, but as I remark above, both asset prices (which deter­mine the equity denom­i­na­tor in debt to equity cal­cu­la­tions) and indeed earn­ings are rather rub­bery figures.

A far bet­ter guide is to com­pare busi­ness debt lev­els to Gross Oper­at­ing Surplus–the busi­ness com­po­nent of national income. On that basis, the level of busi­ness gear­ing today sub­stan­tially exceeds the pre­vi­ous peak set in 1990.

Chart Ten: Busi­ness Leverage

Chart Ten: Business Gearing

Of course, the debt ser­vic­ing bur­den on busi­ness is much lower than in 1990, when the rate of inter­est was twice what it is now. But when a cash cri­sis hits, the rate of inter­est is irrel­e­vant: what mat­ters is the cash flow you have on hand to ser­vice debts as and when they become due. The cur­rent tur­moil in our most heav­ily geared com­pa­nies empha­sises that point.

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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14 Responses to Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

  1. Pingback: Bad Debt » Blog Archive » Steve Keen’s DebtWatch No 20 March 2008: Double or Nothing?

  2. Ken says:

    A rea­son­able expla­na­tion is that the Fed­eral reserve isn’t being hon­est about their rea­sons. Rather than try­ing to pre­vent a reces­sion, they are try­ing to avoid the col­lapse of their finan­cial sys­tem. By low­er­ing whole­sale inter­est rates, they allow for increased mar­gin with­out an increase in retail inter­est rates, so lenders can off­set their defaults. For the moment it seems bet­ter than watch­ing the banks go bust, and hav­ing to clean up the mess. Not to men­tion the mort­gage insurers.

    We haven’t got there yet. It might be inter­est­ing to con­sider how secure the money lent by super funds for mort­gages is, as I sus­pect mort­gage insur­ance isn’t going to be worth a lot if the insurer goes broke. One of the more stu­pid things to hap­pen has been not to require at least 20% deposit. In the UK the required deposit is increas­ing rapidly, which is one rea­son for falling house prices as first time buy­ers leave the mar­ket. One more exam­ple of pos­i­tive feed­back in economics.

    A ques­tion: Does the RBA have any choice in how it man­ages the econ­omy, as it is restricted to cer­tain inter­ven­tions and for cer­tain rea­sons? I know they have done eval­u­a­tions but they seem restricted to ques­tions about whether our finan­cial insti­tu­tions will sur­vive a reces­sion than will it be pleas­ant for the population.

  3. david says:

    So good to see our M3 only grow­ing at around 22%. For a while I thought we might have had an infla­tion prob­lem here too. For­tu­nately our board of the reserve bank has a got a good han­dle on the cause of infla­tion, it’s a cou­ple of per­cent on the lend­ing rate that will make a dif­fer­ence! Mean­while our M3 growth is com­pet­ing with Zimbabwe..

  4. historyman says:

    Professor/Doctor/Guru Steve Keen, from the ABC 1 May 2006. Do you have any clue??

    A lead­ing econ­o­mist says even though infla­tion is at the upper end of the tar­get range, the Reserve Bank should not raise inter­est rates.

    There has been spec­u­la­tion that the bank will raise inter­est rates at its next meet­ing tomorrow.

    Asso­ciate Pro­fes­sor Steve Keen, from the Uni­ver­sity of West­ern Syd­ney, says house­hold debt lev­els are too high to with­stand a rise of even 0.25 per cent.

    He says putting up inter­est rates now could be disastrous.

    The thing which is at the upper end of the tar­get rate is the level of debt,” he said.

    Infla­tion might be touch­ing 3 per cent which is not exactly scary, but the level of debt is to me quite scary.

    Any­thing which could accel­er­ate that or make the bur­den that it is putting on peo­ple at the moment would be, as I said, play­ing with fire.”

  5. john h says:

    This is all very inter­est­ing and could ‘scare the pants off’ but what would help me (and every­one else who’s every thought of jump­ing out the win­dow after read­ing these) would be an acknowl­edge­ment of the data source.

    Not that I’m an unbe­liever but go to: http://www.as.wvu.edu/~sbb/comm221/chapters/attrib.htm to under­stand just how we can be influ­enced, espe­cially by peo­ple who know more than us.

  6. john h says:

    All this is very inter­est­ing but it would be help­ful to me at least, if the data source was achknowledged.

    Not that I don’t believe but go to http://www.as.wvu.edu/~sbb/comm221/chapters/attrib.htm for an idea how we are influ­enced by those who have more knowledge.

  7. Steve Keen says:

    Re His­to­ry­man,

    I pre­sume the “do you have any clue?” is a query about whether I was wrong in 2006 to say that the RBA shouldn’t increase rates?

    No, rates were too high then given the debt bur­den on house­holds and busi­nesses, and they are higher still now.

    Inter­est rate changes oper­ate with a lag. They are also ampli­fied by debt lev­els, which are not taken into account by stan­dard eco­nomic models.

    The momen­tum behind an asset price bub­ble can also mean that rate rises are inef­fec­tive at stop­ping it until they reach ridicu­lous levels–or have far greater impact than expected by those who ignore debt lev­els. Both applied dur­ing the 1989–91 period; both apply now, even with much lower rates than then.

  8. Steve Keen says:

    Dear John H,

    I wish I could say that I was mak­ing all this up, but unfor­tu­nately my data sources are the RBA, US Fed­eral Reserve, and Stan­dard & Poors, and Robert Shiller’s well researched data:

    http://www.rba.gov.au/Statistics/Bulletin/index.html
    http://www.federalreserve.gov/releases/z1/Current/data.htm
    http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html
    http://www.econ.yale.edu/~shiller/data.htm

    I sim­ply analyse this pub­licly avail­able infor­ma­tion from a per­spec­tive that takes debt seriously.

    My worry about the attri­bu­tion the­ory you refer to is that we have for too long believed neo­clas­si­cal econ­o­mists who have a flawed under­stand­ing of the econ­omy. One effect of this is that they have ignored debt, and now we’re see­ing the con­se­quences of that “omit­ted vari­able bias” in their models.

  9. Punchy says:

    Inter­est­ing Charts Mr Keen.
    Seems we have one less prob­lem or cat­a­lyst for a crash. We dont have the same over­built hous­ing mar­ket like the US. Will this make any dif­fer­ence in Aus­tralia? Or is the credit crash so big it wont mat­ter?
    I also think we have a prob­lem with China export­ing infla­tion to the world. The effects of Chi­nese infla­tion on Aus­tralia has been masked by our ris­ing dol­lar. If the AUD falls this infla­tion will be unmasked and infla­tion will shoot up. As infla­tion shoots up the RBA will put up inter­est rates. Neg­a­tive feed­back loops seem to be com­pound­ing every week and will even­tu­ally over­come all pos­si­tive news.
    The media are pro­vid­ing the pub­lic with mixed sig­nals every day now. The Bris­bane Sun­day paper reported a mas­sive increase in home repos and on the next page ran a story on home prices increas­ing 5% this year. This is con­fus­ing the pub­lic (and me).

  10. david says:

    Punchy,
    China export­ing infla­tion? Sorry, you haven’t fol­lowed the prob­lem back to it’s source: The U.S. is cre­at­ing the infla­tion with M3 growth around 16%. We are too — but worse: M3 Growth around 22%. Either inter­est rates keep going up here, or the dol­lar declines. The end result is the same; we will see much higher prices for any­thing imported — par­tic­u­larly energy.

    The trade deficit is approach­ing 7% here. We will not be able to sus­tain that if there is a global downturn.

    It’s quite obvi­ous that we are fac­ing a global de-leveraging, all asset prices will fall if cen­tral banks can’t get liq­uid­ity into the sys­tem — Or more specif­i­cally, to prop up lever­aged asset prices. The liq­uid­ity that they are pro­vid­ing is going into hard assets. i.e. commodities.

    Any­one who is lever­aged to the hilt to buy a house is doomed. Short­age of sup­ply means noth­ing if peo­ple can­not get credit. This is what is hap­pen­ing now. Watch houses prices tank as loans tank.

  11. david says:

    Steve,
    Do you really under­stand what causes infla­tion? Loose mon­e­tary poli­cies by both our reserve bank and that of the Fed­eral Reserve have con­tributed to a rise in money and even more sig­nif­i­cantly, credit.

    The answer is not to allow this to con­tinue, but rather to elim­i­nate the devalu­ing of our currency.

    Just look at the A$ in terms of gold. It has lost approx 40% in pur­chas­ing power in 5 years!

    The debase­ment of our dol­lar is scan­dalous. Any­one who thinks our reserve bank have been good stew­ards of the A$ are being deceived.

  12. Steve Keen says:

    Dear Punchy,

    The fact that Aus­tralia has a hous­ing shortage–a side effect of a truly insane hous­ing system–will atten­u­ate how far and how fast our house prices fall com­pared to the USA, where absolutely noth­ing is slow­ing the decline. But we’re still going to have to return to a rough his­toric bal­ance between house and con­sumer prices at some point, and that implies house prices falling–or ris­ing more slowly than con­sumer prices–for a very long time.

    As for China, it’s been export­ing DEfla­tion for a long time–its cost lev­els were so much below those of the West that as it took over man­u­fac­tur­ing, West­ern prices had to fall. But it now appears to be reach­ing its lim­its in that regard, so at some stage there could be infla­tion exported from China.

    Which brings me to Dave’s posts. More anon.

  13. Steve Keen says:

    Dear David,

    While I agree with a lot of your comments–deleveraging has to occur, unsus­tain­able deficit,e tc.–I don’t agree with your analy­sis of what causes inflation.

    You ask whether I really under­stand what causes it. Firstly, I don’t think any­body truly “really” does: we have mod­els of its cau­sa­tion, and there has been sub­stan­tial cham­pi­oning of rival mod­els, and pre­cious lit­tle com­par­i­son of them unfor­tu­nately, within economics.

    You appear to sub­scribe to the Aus­trian the­ory: “money growth IS inflation”–if I’ve remem­bered a state­ment by Con­trar­ian ear­lier. While money growth is a fac­tor, to me, this Aus­trian per­spec­tive is rather like a quote that I’m cur­rently using in an aca­d­e­mic paper:

    If you call a tail a leg, how many legs has a dog? Five? No, call­ing a tail a leg don’t make it a leg.” (Abra­ham Lincoln)

    Tech­ni­cally, infla­tion is mea­sured growth in com­mod­ity prices–and that gen­er­ates all sorts of index num­ber prob­lems which Aus­tri­ans rightly point out, but nonethe­less, that’s its tech­ni­cal def­i­n­i­tion. To say that “money growth IS infla­tion” is to con­flate a the­ory with the data.

    The dilem­mas for the “money growth is the only cause of infla­tion” perspective–which this effec­tively is, and there­fore puts it in the same camp as Neo­clas­si­cal theory–are:

    (a) that the stats fre­quently show sub­stan­tial short term (ie, a decade or two) diver­gences between money growth and mea­sured infla­tion. That’s hap­pen­ing right now–as it nor­mally does dur­ing asset price bub­bles. Of course, you can always find another com­mod­ity to rebase your price system–such as mea­sur­ing infla­tion in gold terms, as you imply–but money is used to buy com­modi­ties in our credit sys­tem, not gold (though I realise there are nuances there that I won’t go into now); and

    (b) more inter­est­ing tim­ing data shows the rela­tions between (A) money growth, (B) wages and © prices is often the reverse of this the­ory. Rather than being A–>C–>B, it tends to be B–>C–>A. In other words, changes in cost struc­tures in the econ­omy force, some­how, a change in money.

    For those empir­i­cal rea­sons, I am more per­suaded by the Post Key­ne­sian the­ory of inflation–which is that it is dri­ven by strug­gles over the dis­tri­b­u­tion of income, and cost pres­sures from com­modi­ties that can­not be repro­duced (min­er­als) or finely con­trolled (agri­cul­tural goods).

    The money sup­ply is then “accommodating”–it expands to suit these pres­sures, rather than caus­ing them via “too much money” in the first place.

    Of course, you can get sit­u­a­tions like Zim­babwe where “the gov­ern­ment print­ing too much money” is clearly the culprit–but those are hyper­in­fla­tions, not the gar­den vari­ety infla­tion we get typ­i­cally in the West.

    So no David, I don’t “really under­stand”, but I am aware of a range of empirically-oriented debates that advo­cates of one posi­tion or another (Aus­trian or neo­clas­si­cal pre­dom­i­nantly) don’t appreciate.

    Two key aspects of this argu­ment are:

    the nature of price-setting in an advanced econ­omy (see Alan Blinder’s “Ask­ing About Prices” for the best cov­er­age of that–or read my review of it on Amazon.com for a pre­cis); and

    How the money sup­ply can be accom­moda­tive to those cost pres­sures. Here the data is also AGAINST the stan­dard Aus­trian per­spec­tive: if the Aus­trian case was cor­rect, the accom­mo­da­tion would occur because the RBA and its cor­re­spond­ing insti­tu­tions will­ingly “printed (fiat) money” rather than con­fronting these cost pres­sures head on, and the “money mul­ti­plier” then gen­er­ated the addi­tional (credit) money.

    In fact, the empir­i­cal evi­dence is the other way around: credit money moves first, and then sub­se­quently gov­ern­ment money fol­lows. The mon­e­tary author­i­ties there­fore AREN’T in con­trol of the money supply–in effect, the money sup­ply is in con­trol of them.

    The best evi­dence of this actu­ally comes from the staunchly neo­clas­si­cal authors Kyd­land and Prescott in “Real Facts and a Mon­e­tary Myth”, (which you can locate on the web for free). To cite their con­clu­sions on that front:

    There is no evi­dence that either the mon­e­tary base or M1 leads the cycle, although some econ­o­mists still believe this mon­e­tary myth. Both the mon­e­tary base and M1 series are gen­er­ally pro­cycli­cal and, if any­thing, the mon­e­tary base lags the cycle slightly…

    The dif­fer­ence of M2-M1 leads the cycle by even more than M1, with the lead being about three quar­ters. The fact that the trans­ac­tion com­po­nent of real cash bal­ances (M1) moves con­tem­po­ra­ne­ously with the cycle while the much larger non­trans­ac­tion com­po­nent (M2) leads the cycle sug­gests that credit arrange­ments could play a sig­nif­i­cant role in future busi­ness cycle theory…

    Intro­duc­ing money and credit into growth the­ory in a way that accounts for the cycli­cal behav­ior of mon­e­tary as well as real aggre­gates is an impor­tant open prob­lem in economics.”

    So the empir­i­cal data “lets the author­i­ties off the hook” vis-a-vis the Aus­trian cri­tique of mon­e­tary pol­icy and the­ory of infla­tion. How­ever they are on another hook, from my point of view, with their atti­tude to asset price inflation.

    There’s a lot more I could say, but this is already almost blog-length, so I’ll stop here. I will at some point explain my model of money cre­ation in a pure credit model, but I’m too busy doing that for an aca­d­e­mic paper right now to write up another ver­sion here; maybe after I get back from the speak­ing tour I’m doing this week and next.

  14. Nuffield says:

    Get your cash behind agri­cul­tural based assets such as land. That’s why this farmer is with Rabobank. Purely agri­cul­tural lend­ing book and least exposed of major banks to cur­rent housing/commercial prop­erty deflation.

    Invest in organic infra­struc­ture — the stuff that builds itself. Trees that pro­duce sta­ple food com­modi­ties and prefer­ably oil. Once estab­lished low pro­duc­tion costs and depen­dency on imported resources for pro­duc­tiv­ity gains.

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