(Modern) Monetarist Thoughts on Wealth and Spending: Volume or Velocity?

May 21st, 2014 2 comments

I’ve bruited the notion in the past that “money” should be technically defined, as a term of art, as “the exchange value embodied in financial assets.”

In this definition, counterintuitively relative to the vernacular, dollar bills aren’t money. They’re embodiments of money, as are checking-account balances, stocks, bonds, etc. etc. Money and currency aren’t the same thing, and economists’ conceptual confution of “money” with “currency-like things” is central to the difficulties economics faces in understanding how economies work.

If this definition is safe, then the stock of money (I hate the term “money supply,” which suggests a flow) equals the total value of financial assets. Forget the endless wrangling about monetary base, M1, M2, divisias, and all that. Add up the value of all financial assets, and that’s the money stock. (There are certainly difficult measurement issues to discuss, but I won’t wrangle with those here.) Update: for this to make sense, deeds must be viewed as financial assets — claims on real assets.

People can exchange various financial assets for currency-like financial assets when they need to buy real stuff, but that’s largely mechanical.

In this definition “money” comes from two (or three) places:

1. Deficit spending.

• By government (federal — the sovereign “currency” issuer).

• By private individuals and businesses (using loans from banks, which are chartered by government to create new money for lending).

The second is of much greater magnitude overall, but it is also subject to big and fast periodic downswings (burning instead of printing money, when loans are paid or written off), which is much less true of the first.

2. Animal spirits, a.k.a. confident optimism. When the market thinks that the total value of financial assets under-represents the value of the real assets they’re claims against, prices of financial assets are bid up, and there’s more “money.”

You could call this the wealth effect, and at least in the short- to medium-term — because it can happen so fast — the magnitude of its effects can overwhelm the first method. This change can go in either direction, of course — either creating or destroying huge amounts of money very quickly.

Jesse Livermore explains this mechanism elegantly and simply based on portfolio preferences. If the market wants 60% of its portfolio in stocks and 40% in bonds/cash, and more bonds/cash are issued, the only way for a rebalance to happen is if stock prices are bid up. (He’s got a great graph showing that very little new corporate equity is issued relative to the existing stock, often a negative amount for years on end.) If animal spirits decline (less confident optimism), the market wants less stocks and more bonds; the price of stocks — hence the stock of money — declines.

3. Trade surpluses. This doesn’t actually create money in the world (or an imaginary closed economy) the way the first two do. But if a country exports more goods than it imports, the payments for those net exports bring more money into the country. Trade deficits, the reverse. (U.S. trade deficits of $30-70 billion a year are pretty small change compared to the first two money mechanisms. Correction: That is a monthly figure, so the total is quite significant — 3-5% of GDP.)

The first two methods create money — exchangeable credits, or claims — “out of thin air.” And they destroy it when the debt from that deficit spending is paid back, or markets decide that underlying real assets aren’t so valuable after all. The government, the banks, and the stock market have both printing presses and furnaces.

And it doesn’t much matter how much of that money is embodied in currency-like things. If people want to spend more of their money one year (on newly produced goods and services, the stuff of GDP), the Fed will always accommodate their need for transaction cash; it must do so, or it can’t control the Fed Funds Rate because banks will be scrambling for cash and will bid up the rate. People don’t spend more because there’s a higher proportion of currency-like stuff around. If they want to spend more, there will be more currency-like stuff around; the Fed will ensure it. (At this point there’s a massive superfluity of such stuff, so the Fed controls that rate via its interest-on-reserves rate.)

Which all brings me to a simplified version of the monetarists’ equation of exchange:

(M)oney * V(elocity) = GDP (often designated as Y)

(Forget about PT or PQ; both T and Q are designated in imaginary, circularly-defined “units” of output whose logical coherence was thoroughly eviscerated in the Cambridge Capital Controversy. See the last paragraph of this section.)

If there’s more money around and velocity stays the same (i.e. people spend a certain percentage of their wealth each year), GDP goes up.

We see this clearly when we look at recessions and the year-over-year change in real (inflation-adjusted) household assets — a measure of households’ total claims on real assets, and a proxy for the “money stock” in this definition. (Note that in this measure the net worth of corporations is imputed to households who own their stock.)

Every recession (GDP downturn) since the sixties was preceded by a decline in this measure of the money stock, and every decline in this measure since the sixties preceded a recession (with one exception/false positive: 2011).

When people have less money, they spend less, and GDP declines, or grows more slowly. That is hardly a counterintuitive conclusion.

But what about V(elocity)? How has that played out over the years?

Another of those early-80s inflection points: velocity has declined from about 26% annual turnover of the mony stock, down to the high teens. If you’re looking for an explanation of that, you probably don’t have to look much farther than the spectacular concentration of wealth over the last three decades. Rich people spend a smaller proportion of their wealth each year than poorer people. So if wealth is more concentrated, velocity is lower. Arithmetic.

But there is another, related effect at play as well. A greater proportion of our real assets have been “financialized” (read: indebted monetarily) over the decades. The runup in student debt is an obvious example — whereby students have capitalized/financialized/indebted their most valuable real asset, their future ability to work and produce. They (in cooperation with their lenders) have created money — financial claims – based on those real assets (and given it to colleges).

This effect is very hard to measure because it’s essentially impossible to measure (in dollars) the value of our most valuable real assets — knowledge, ability, skill, organizational setups, legal structures, natural resources, etc. The relationship between total financial asset values and total real asset values is irredeemably opaque.

Bottom line: if GDP (and more importantly, GDP/capita) is to go up, either M or V has to increase.

Increasing M is problematic because either you increase debt (which obviously has its problems) or you (somehow) ignite animal spirits.

How do you increase V? It’s pretty straightforward: reduce the concentration of wealth so it’s more widely held, by those who turn over their wealth more quickly. Like, raise the minimum wage. Or institute a tax regime that actually is progressive, and use that money to provide for the general well-being by increasing funding for a plethora of well-designed programs like the Earned Income Tax Credit, jobs programs, wage subsidies, infrastructure and research spending, or guaranteed basic income.

At the very least, the goal should be to reverse the rampant radical upward distribution of the last thirty years, and the extreme decline in money velocity that has been the direct result.

Cross-posted at Angry Bear.

Eighty percent of current jobs may be replaced by automation in the next several decades.

May 18th, 2014 4 comments

That’s the conclusion of Stuart W. Elliott in his recent paper, “Anticipating a Luddite Revival.” (Hat tip: RobotEconomics.)

We’ve seen that scale of transformation before. But this one promises to be roughly four times as fast, dwarfing Luddite-era concerns:

…the portion of the workforce employed in agriculture shifted from roughly 80% to just a few percent. However, in the shift out of agriculture, the transformation took place over a century and a half, not several decades.

But there’s a much bigger difference this time — a hard limit that time can’t ameliorate:

The level 6 anchoring tasks in Table 2 are not only difficult for IT and robotics systems to carry out, but they are also difficult for many people to carry out. We do not know how successful the nation can be in trying to prepare everyone in the labor force for jobs that require these higher skill levels. It is hard to imagine, for example, that most of the labor force will move into jobs in health care, education, science, engineering, and law.

I’ve said it before: the median IQ is 100, by definition. Fifty percent of people are below that level. We (and they) are facing a hard cognitive limit that the Luddites never approached. I don’t think anybody reading (or writing) this post can appreciate how hard it would be to make a go of it in today’s technological society — even get through high school, much less provide a healthy, happy, financially secure life for one’s family — with an IQ of 80 or 90.

Are people who aren’t born smart lacking in “merit”? That’s what meritocrats are claiming. (Though they will vociferously defend themselves, deploying endless arguments both specious and obfuscatory.) If you’re in the low-IQ group (and don’t inherit), your miserable position in life is fixed at birth. Get over it.

Currently, work is the only way for the majority of people to legitimately claim any significant share of our remarkable prosperity. (Social-support programs provide a pretty insignificant and tenuous, insecure claim that’s not generally viewed as legitimate, only unfortunately necessary.)

If those folks 1. can’t find jobs that they can do, and 2. receive negligible claims on our prosperity if they are lucky enough to find one of the few remaining, we’re facing a world of haves and have-nots. Sound familiar?

Here’s the depressing chart of fastest-growing job categories and their wage levels that Elliott provides, based on BLS data:


One fundamental belief has to change: that finding and doing a job is the only thing that gives you any claim on a decent life. Because for many, jobs that provide decent claims simply aren’t there, or won’t be soon. (Likewise the belief that rebalancing your financial portfolio annually — doing the arduous, taxing work of “allocating resources” — is extremely meritorious and gives you a just claim on an outsized share of our collective prosperity.)

Horses faced exactly this situation in the first industrial revolution. They could never learn to drive tractors and trains.

I’ll be the first to say that people aren’t horses. Which gives rise to the ugly next thought:

They shoot horses, don’t they?

Cross-posted at Angry Bear.


The Lump-of-Capital Fallacy

May 9th, 2014 No comments

Dean Baker gives me the courage, in his recent post on Pikkety, to reiterate a statement I’ve made some few times in the past:

Economists have no coherent or consistent idea of what they’re talking about when they use the word “capital.”

They lump together real capital — fixed, human, organizational, whatever — with “financial capital,” an oxymoron that confutes actual productive stuff with financial claims on that stuff.

Dean (emphasis mine):

This relates to the Cambridge controversies since the Cambridge U.K. people argued that the idea of an aggregate production function did not make sense. They pointed out that there was no way to aggregate different types of capital independent of the rate of return. The equilibirum price of any capital good depended on the rate of return. Therefore we can’t tell a simple story about how the rate of return will change as we get more capital, since we can’t even say what is more capital independent of the rate of return.

The takeaway from this, or at least my takeaway, is that we don’t have a theoretical construct that we can hope more or less approximates how the economy actually works. The theoretical construct doesn’t make sense. This means if we want to determine the rate of return to capital we should not be looking to elasticities of substitution, but rather the institutional and political factors that determine the rate of profit.

So it’s not just Steve Roth, internet econocrank, making this wild-eyed claim. You’ll find similar in Jamie Galbraith’s review of Pikkety. (His opening line? “What is capital?”), and I would suggest that every other review you’ve read wallows in the same quagmire of non- or multiple-definition.

As does Pikkety, unfortunately. He explicitly defines capital as being synonymous with wealth, which is a very tricky and messy conceptual proposition indeed. That does not obviate his work’s incredible value, but he should have called his book Wealth in the 21st Century.

“Capital” means, should mean, real, productive assets: real inputs to production that require real resources to produce, and that are consumed over time (through use, decay, obsolescence, and death). There’s the obvious “fixed capital” as tallied in the national accounts (broken out as structures, equipment (hardware), and software) and there’s all that other real capital that arguably constitute the great bulk of real capital, but that is so deucedly hard to measure — skills, knowledge, ideas, organizational structures and processes, human ability, etc. Then there’s all the tricky stuff that sits on the borderline between real assets and financial assets (thing which have exchange value but cannot be, are not, consumed): land, art and collectibles, etc.

“Financial capital” — all the financial assets out there, embodying all the “money” out there — is, roughly, all the outstanding claims on that real capital, or on the future production from that capital. Financial assets are not inputs to production (though they can be exchanged for such inputs), and they cannot be, are not, consumed.

The stock of financial assets can increase in several ways. 1. A sovereign currency issuer can deficit-spend. 2. A bank can print new money for lending ex nihilo (with the help of borrowers who want to monetize their real assets; think: student loans). 3. The market can decide that the real assets out there are worth more than the outstanding claims against them, and bid up financial-asset prices. Voila, more money, more financial assets, more so-called “financial capital.”

All of this points to the fundamental problem in economic thinking that Dean states so clearly: you can’t lump together, or really even measure, real capital in dollar terms. You certainly can’t just add together the value of real capital and the value of financial capital, which constitutes claims on that real capital.

And: The outstanding value of financial assets/”capital” is not any kind of reliable representation of the value of outstanding real capital. It’s all over the map, depending on how much of that real capital has been monetized/indebted/financialized (via private and public debt and money issuances), and based on the current state of investors’ “animal spirits” — their beliefs about future returns to that financial capital.

A minor aside: The whole “reswitching” business in the Cambridge Capital Controversy is just a carefully explicated special case, or example, of the fundamental confusion that the U.K. gang pointed out (and that Samuelson admitted to): the value of capital is a function of its future returns, and future returns are a function of the value of capital. Economics is based on a circular definition.

Or in Dean’s words, “The theoretical concept doesn’t make sense.” (This is some significant relief to me, because after more a decade of really struggling to make it make sense to me, it still doesn’t make sense to me.)

I’ve made some efforts to sort out this confusion is previous posts, which you can find by wandering through Related Posts, below. I would be more than pleased if those more worthy than I were to take up this task, and deliver an adequately and convincingly theorized understanding of the relationship between real capital and “financial capital.”

Cross-posted at Angry Bear.


Lane Kenworthy, Prosperity, and the Infinite Forms of “Redistribution”

April 19th, 2014 No comments

I haven’t beaten the drum lately for Lane Kenworthy — perhaps the best researcher out there on the economic effects of income and wealth distribution. His years of careful, diligent (and voluminous) statistical and analytic work, tapping the best data sets available, and his cogent, coherent explanations of his findings, should get a lot more attention in the econoblogosphere. Lane Kenworthy rocks.

He’s especially good at trying to suss out causation, which he will be the first to acknowledge is always a difficult business in a discipline that’s inevitably dependent on retrospective data — where you can’t rerun the experiment, much less run it from the start with a randomized control group. (And natural experiments/control groups like the ones that Arindrajit Dube exploited to look at minimum-wage effects — adjacent counties across state lines with different minimum wages — aren’t thick on the ground.)

Nevertheless there are some excellent statistical techniques that can give a good indication of causation. Well-executed, they can really move your Bayesian priors. At the very least, they’re excellent at ruling out causation. Put simply, if there’s a significant negative correlation between presumed-cause A and presumed-effect B (or no correlation at all), you can feel fairly confident that A didn’t cause B. It’s difficult to prove causation with correlation; it’s much easier to disprove causation — to falsify a hypothesis.

But enough with the philosophical throat-clearing. Let’s look at one recent paper (PDF), a multi-country multi-regression analysis comparing rich countries, looking at income inequality and middle-class income growth. He finds that from the late 70s to the mid 2000s (all emphasis mine for easy scanning):

an increase of 1 percentage point in the top 1 percent’s share of pre-tax income reduced growth of income for the median household by about USD530. In the most extreme case-the United States-the top 1 percent’s pre-tax share increased by 8 percentage points between 1979 and 2004. According to this estimate, that may have reduced median household income growth by a little more than USD4,000. The actual rise in the United States during those years was USD8,000, so the estimated impact of rising income inequality is not trivial

In other words, if the 1%’s share of income had not grown by 8%, median household income would have grown by $12,000 instead of $8,000. This bears out Lane’s rather intuitive, common-sense assertion earlier in the paper:

Household income growth is not a zero-sum game because the pie tends to get larger over time. Disproportionately large gains at the top, however, are  likely to come at least partly at the expense of those in the middle.

Always careful, he adds:

At the same time, the data suggest that the income-reducing impact of a rise in top-heavy inequality has been overshadowed by the income-boosting impact of economic growth and of increases in net government transfers.…even after adjusting for these other influences, change in top-heavy inequality is not a very good predictor of growth in middle-class incomes.

So yes: income inequality in and of itself seems to have reduced middle-class income growth significantly. But obviously, of course, that’s not the only economic effect at play. (Only a wild-eyed, ideologically blinded, axe-grinding, bought-and-paid-for Republican would make that kind of foolish claim about some particular economic effect.)

Which brings me to another recent paper (prominently citing the previous one), that questions the Left’s rhetorical emphasis on (in)equality:

I fear the American left’s recent move to put income inequality reduction front and centre might be harmful rather than helpful. It may foster a conviction that the key to addressing America’s social, economic and political problems is to reduce the top 1 per cent’s share or the Gini coefficient. That could distract attention from more direct and effective efforts to address those problems.

Such efforts include fully universal health insurance; improvements in eligibility, duration and benefit level for various social-insurance and social-assistance programmes; wage insurance; early education; enhanced financial support for college; a minimum wage indexed to prices; an expanded earned-income tax credit indexed to average compensation; and monetary policy less tilted towards inflation avoidance. Policy changes like these would go a long way towards improving economic security, enhancing opportunity (and mobility) and ensuring shared prosperity in the US. Inequality of political influence could be lessened via direct reforms, such as reversal of the Citizens United decision, introduction of a strong transparency rule and public funding for congressional election campaigns.

I think Lane’s right. I’ll say it again: if you talk about fairness and equality, Americans change the channel. (They’re only somewhat more open to hearing about “opportunity.”) They want to hear about prosperity — especially widespread prosperity. And the programs Lane points to have a decades-long history of delivering widespread prosperity. Expanding those programs (and funding them with a tax system that actually is progressive) would make us all more prosperous.

And that’s exactly what Lane’s first paper demonstrates. No: just reducing inequality through redistribution doesn’t make everything peachy. No duh. (Though in the current environment of concentrated wealth and income it does improve things a lot in and of itself.) If you really want to increase prosperity, you use methods of redistribution that increase prosperity – like the programs that Lane details above. (Plus publicly funded infrastructure, research, etc.)

So the two things aren’t mutually exclusive. You implement programs that deliver widespread prosperity in and of themselves, and distributive effects also deliver the prosperity benefits of reduced wealth and income concentration. It’s a virtuous cycle, rolling forward on a path to American prosperity. Rinse and repeat.

In brief, widespread prosperity both causes and is greater prosperity.

Cross-posted at Angry Bear.

Repeat After Me: The American Tax System is Hardly Progressive at All

April 19th, 2014 No comments

The latest numbers on 2014 taxes as share of income are out, and they’re saying pretty the same thing as last year:

Above about $80K a year in income, the American tax system is not really progressive. Like, at all:

The people making $100K a year pay about the same share of income as people making $10 million a year.

This is because — while federal income taxes are reasonably progressive — payroll, state, and local taxes are horribly regressive — particularly in (blush) my home state:

Screen shot 2014-04-19 at 9.32.10 AM

Read it and weep.

Cross-posted at Angry Bear.

The Global “Capital” Glut

April 17th, 2014 No comments

No, I’m not talking about Piketty hitting the Times bestseller list. And it’s not just wild-eyed lefty Frenchman who are expressing concern about the state of world capital these days. Mitt Romney’s shop was beating this drum loudly more than a year ago.

One of the central takeaways from Piketty’s Capital in the 21st Century is the U-shaped long-term trend in the capital-to-income ratio, especially in rich countries. He uses “capital” synonymously with “wealth.” Here are the latest numbers for the U.S. from his compatriots Saez and Zucman (source PDF):

Screen shot 2014-04-17 at 12.46.35 PM

The economic relationship between wealth (or net worth, financial assets minus liabilities) and real capital  is a sticky one, even if you’re only considering “fixed capital” — structures, equipment (hardware), and software. It’s even more so if you consider  human skills, knowledge (i.e. patents), organizational capital, etc. (The line between organizational capital and “software” is getting especially blurry these days; what would Vanguard’s, much less Google’s, value be without their web presence?) And more so again if you consider natural capital like land and what’s on/under it.

But “Wealth in the 21st Century” wouldn’t have had quite the same ring to it, so let’s just go with it, with the knowledge that we’re talking about wealth (“financial capital”), and wealth has some indeterminate but somewhat representative relationship to real assets/capital. We can at least say, loosely, that financial assets are claims on real assets, or on the production that’s enabled by those assets.

So what about Bain Capital, Romney’s shop? Here from their December 10, 2012 report (PDF; hat tip to the always-remarkable Izabella Kaminska, and to Climateer Investing).

World awash in nearly one quadrillion of cheap capital by end of decade, according to new Bain & Company report

Their takeaways include:

The capital glut will be accompanied by persistently low real interest rates, high volatility and thin real rates of return.

Sound like secular stagnation to you?


The ever-present danger of asset inflation will contribute to an overall steepening of the investment risk curve… companies will need to strengthen their bubble-detection capabilities

In short, there’s a huge amount of money floating around out there relative to income and production. (In Steve World, all financial assets embody money, and the money stock is the total value of financial assets — including dollar bills, deeds, or other formal financial claims — regardless of how currency-like those things are. Equating currency and currency-like things with money is conceptually incoherent.)

With so much money around, is it any surprise that people are lending it cheap?

As usual I have much more to say on this but instead I’ll hand it off to Jesse Livermore, who recently wrote one of the clearest and most cogent posts I’ve seen in years on financial asset values, hence wealth. I’ve been meaning to link to it. Read the whole thing.

The Single Greatest Predictor of Future Stock Market Returns

Hint: it’s about what the herd does with all that money.

Cross-posted at Angry Bear.

ALEC: Destroying the American Economy, One State at a Time

April 14th, 2014 No comments

The American Legislative Exchange Council — which authors ultra-conservative legislation and promulgates it to state legislatures nationwide — has a little index measure of states’ “competitiveness,” which supposedly results in greater prosperity for those states that rank highly.

Does it? Let’s let the numbers speak for themselves:

Screen shot 2014-04-14 at 8.14.01 AM Screen shot 2014-04-14 at 8.14.11 AM Screen shot 2014-04-14 at 8.14.31 AM Screen shot 2014-04-14 at 8.14.47 AM Screen shot 2014-04-14 at 8.14.58 AM Screen shot 2014-04-14 at 8.15.25 AM

Source (PDF).

Cross-posted at Angry Bear.

Thinking About Piketty’s “Capital”

April 6th, 2014 1 comment

The quotes in this post’s subject line are very much intended as a double entendre. I’m of course referring to the title of Piketty’s book (which I’ve read about 80% of, jumping around). But even more, I’m talking about his definition of “capital.”

I’ve ranted frequently about economists’ failure to define this term or agree on what it means, and Piketty is very much laboring under the burden of that failure.

Don’t take my word for it. This confusion about the nature of capital (and the associated term, wealth) is the central point of James Galbraith’s critique of the book:

First, he conflates physical capital equipment with all forms of money-valued wealth, including land and housing, whether that wealth is in productive use or not. He excludes only what neoclassical economists call “human capital,” presumably because it can’t be bought and sold. Then he estimates the market value of that wealth. His measure of capital is not physical but financial.

You’ll find that “capital” conundrum lurking or leaping out within every review you read.

Piketty deserves great credit. Unlike many or most economists, he makes a good-faith effort to define his usage of the term, and a not-altogether-successful effort to think coherently and consistently within the terms of that definition. He addresses his definition head-on on pages 47-49, and wrestles with various aspects of it throughout the book. See for instance page 149 (on the market value of assets), page 163 (on “human capital” that can be bought and sold in a slave society), page 188 (again on the market value of real capital), and page 210 (on “real” vs. “nominal” assets).

I’ll just highlight one subject: In the course of things he expresses disdain for the notion of “human capital.” Many will find this to be problematic, since most estimates would suggest that human capital — our ability to work and produce in the future — constitutes the great bulk of world and national capital. But Piketty’s stance is reasonable or even inevitable: it’s largely impossible to measure this kind of capital outside a slave society (and then you’re only measuring the “value” of the slaves). So for his purposes of analyzing the subject based on recorded numerical data, human capital is a non-starter.

But still, Piketty fails to address the extent to which human capital is increasingly being “capitalized” or “finacialized.” Think, for instance, of the extraordinary runup in U.S. student-loan debt, and asset-backed securities packaging those loans — debt and securities whose only collateral is those students’ enhanced ability to…work and produce in the future.

Here one measure that is at least a proxy for that runup: government-held student loans as a percent of GDP.

Where are the lines between “real” capital, “human” capital, and “financial” capital? What are their economic relationships? (If you’re under the impression that they’re obvious or clearly understood and agreed-upon, you’re not thinking very hard. At all.)

My purpose here is not to solve that capital conundrum — far be it from me. I come not to bury Piketty, but to praise him. His usages and definitions provide a very useful framework in which to discuss issues that have been hard to discuss coherently absent such framing. The evidence he’s assembled within that framework, and his remarkably cogent discussion of that evidence, gives ample evidence of that.

But even more: By tackling these definitional issues head-on (if not always successfully), he has brought an inconclusively theorized crux of economic thinking — the nature of capital (plus wealth, value, and even money) — back to the forefront of discussion. We can all hope that much good will come from that.

Cross-posted at Angry Bear.


The Incredible Vanishing Takeaway from the CBO Report on Minimum Wage

March 10th, 2014 1 comment

I’m surprised that nobody highlights what for me is the key takeaway from that report.

They predict, with a $10.10/indexed increase:

Low-end incomes increase $19 billion.

High-end incomes decline $17 billion.

For a net GDI increase of $2 billion.

Table 1, page 2:

Screen shot 2014-03-10 at 12.18.13 PM

Pie gets bigger, all that rot.

The increase is presumably explained by the last phrase in footnote F to that table:

increases in income generated by higher demand for goods and services.

Cross-posted at Angry Bear.

Why the Fed Hates Inflation: 1.2 Trillion Dollars of Why

March 10th, 2014 38 comments

Upate: Those who have qualms about the methodology and underlying assumptions here would do well to consider Thomas Piketty’s thinking on page 210 of Capital in the 21st Century. He distinguishes between “real” and “nominal” assets, pointing out that real asset values climb along with inflation and growth, while nominal asset values don’t.

A simple rule of economic arithmetic that economists seem to studiously ignore:

Inflation transfers real buying power from creditors to debtors, with nary an account transfer visible anywhere on anyone’s account books. Inflation means that debtors pay off their loans over time with less-valuable dollars — dollars that can’t buy as much bread, butter, and guns.*

Higher inflation causes, is, a massive transfer from creditors to debtors.**

And the Fed is run by creditors. Inflation is, always and everywhere, very very bad for them.

How bad? Look at the fixed-income assets and liabilities of financial corporations:

Screen shot 2014-03-10 at 8.41.15 AM

Financial businesses are net creditors to the tune of $9-$14 trillion dollars.

If inflation was 1% higher than it is, it would transfer between $90 and $140 billion dollars to their debtors. Every year. For every extra point of inflation.

Add it up: an extra point of inflation over the last ten years would have cost financial businesses $1.2 trillion dollars.

It’s enough to get a banker’s attention.

And that’s before you even consider the Fed powers-that-be in their roles as equity shareholders, and the Fed’s dual mandate. By emphasizing low inflation over low unemployment — and stomping on growth whenever the bogieman wage inflation threatens to rear its head*** — the Fed maintains a pool of unemployed and weakly compensated employees that cripples labor’s bargain power and empowers the steady growth of corporate profits over labor earnings.

It kinda makes you think about Mankiw’s fourth principle of economics: “People respond to incentives.”

I’ve said it before: if it weren’t for inflation, the rich really would own everything, instead of almost everything.

* Some will caveat: this is only true of unexpected inflation, because contracts are written with expected inflation in mind. The proper response: since the future is impossibly uncertain, all changes in the inflation rate are unexpected.

** Meanwhile economists fetishize notions about menu costs and the like, which in their largest estimations are an order of magnitude smaller than the inexorable arithmetic effect described here.

*** It’s happening now.

Cross-posted at Angry Bear.