Getting it right on the asset boom and the recession

The Reserve has led the world's central banks in raising rates in the presence of a great deal of unemployment and idle capacity. Clearly the bank is making a pre-emptive strike against inflation. That this was also a strike against Keynesian orthodoxy went unnoticed, even by those who made the decision. According to Keynesian thinking inflation does not pose a danger while there still remains a great amount of idle resources. Evidently the Reserve has correctly concluded otherwise.

Now every economic crisis always supplies a crop of solutions to the problem of the so-called boom-bust cycle, and the current crisis is no exception. Sebastian Becker, an economist with Deutsche Bank in Frankfurt, defines the problem of booming asset prices as one of excess liquidity (fancy language for inflation) which he defines as a quantity of money in excess of an economy's needs. In other words, the supply of money exceeds the demand for money.

This line of thought leads to only one conclusion: to prevent another asset boom the central banks must reduce the rate of monetary growth when it appears that asset prices are accelerating. A policy of using the money supply to stabilise asset prices is a first cousin to the stable price-level fallacy which has it that a stable prices mean the absence of inflation, a fallacy that even the great Knut Wicksell succumbed to.

Peter Jonson (aka Henry Thornton) seems to have picked up on Becker's approach because, with the assistance of Julian McCrann, he constructed a series he calls True Inflation. Jonson argues that because of the asset boom the CPI understated the true rate of inflation. The problem here is that the CPI will always understate the rate of inflation to a considerable degree so long as it takes a stable price level as its starting point.

This stems from the fact that inflation is a monetary phenomenon, which means that if, for example, a continuous rise of 5 per cent in productivity is offset by a monetary expansion then the rate of inflation is 5 per cent. Therefore, if the official inflation rate is 3 per cent then the loss in purchasing power is actually 8 per cent per annum. (It was the nineteenth century classical economists John E. Cairnes who explained why a stable price level was a misleading indicator of inflation). As far as the vast majority of economists are concerned, this is a non-problem. This, as we shall see, is a very grave error.

Once we marry the notion of "excess liquidity" to Peter Jonson's "true inflation" rate we come to a policy that will establish and maintain monetary equilibrium. Unfortunately for Jonson and Becker — not to mention the rest of us — this is literally an impossible task and thus doomed to fail. As Peter Jonson ought to know (after all, I have raised this subject many times) the question of "excess liquidity" as we now call it was effectively dealt with more than 200 years ago during the Bullion Controversy. Lord Peter King brilliantly exposed the erroneous thinking of those who thought they could establish monetary equilibrium when he pointed out:

It is manifest . . . that the proportion of circulating medium required in any given state of wealth and industry is not a fixed, but a fluctuating and uncertain quantity; which depends in each case upon a great variety of circumstances, and which is diminished or increased by the greater or less degree of security, of enterprise and of commercial improvement. The causes which influence the demand are evidently too complicated to admit of the quantity being ascertained by previous computation or by any process of theory. (A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844 p. 67).

This returns us to the stable price-level fallacy. Our economists argue that expanding the money supply to offset rising productivity is essential to preventing deflation. What these economists have failed to grasp — and Cairnes explained in detail — is that deflation is also a monetary phenomenon. It happens when the money supply contracts. On the other hand, a productivity-induced falling price level does not depress business and raise the level of unemployment. Alfred Marshall explained:

...a manufacturer, though he has to pay for raw material and wages would not check his production on account of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same per centage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries,, comforts and luxuries of life as they did before. (Alfred Marshall, Economics of Industry C. J. Clay, M. A. & Son, 2nd edition, 1881, p. 156).

Our economists could perhaps argue that it is "much ado about nothing" because the central bank is only maintaining the currency's purchasing power. Time for a fact check: The Reserve Bank of Australia was established on 14 January 1960. Since then the Australian dollar has lost about 90 per cent of its purchasing power. During the same period the American dollar lost about 86 per cent of its purchasing power. So much for price stability.

It isn't understood that the same policy that has resulted in the destruction of purchasing power is the same one that is fuelling the boom-bust cycle. The classical economists understood that forcing the interest rate below its free market rate would stimulate business borrowing which would trigger a boom. Some of the them also understood that money is not neutral. (Even Ricardo, who believed in the proportionality principle, recognised the consequences of artificially forcing down interest rates). If money is not neutral this means — as Edward Copleston stated — "that the altered value of money does not affect all prices at the same time..."*.

Once it is accepted that money is not neutral then it follows that inflating the money supply must distort the structure of relative prices and hence the pattern of production. These distortions can only be maintained by accelerating monetary expansion. (That this sometimes leads to an asset boom is nothing new). Sooner or later, however, these distortions will emerge in the form of rising unemployment and idle capital. This can happen even if there has been no monetary slowdown.

The significance of the above analysis is that manufacturing is where the beginning of the end of the booms starts. The chart below shows that in December 2007 the PMI and the production index peaked at 58.4 after which they both began to fall before bottoming out last April at 30.1 and 28.8 respectively. The importance of this contraction in manufacturing was completely lost on our economic commentators. And it still is.

What this amounts to is that no matter how mathematically sophisticated any measure of inflation is — including Peter Johnson's "True Inflation" rate — it will never be able to quantify the real price effects of monetary expansion. Unfortunately, our free marketeers still adamantly refuse to debate this vitally important issue.

*The Rev. Edward Copleston, A letter to the Right Hon. Robert Peel, M.P. for the University of Oxford, on the pernicious effects of a variable standard of value, esecially as it regards the condition of the lower orders and the poor laws, John Murray, Albemarle Street, London, 1819, p. 25.

Gerard Jackson

Brookesnews.com

Also by Gerard Jackson

Gerard Jackson is Brookesnews Economics Editor