Asset inflation, price inflation, and the great moderation

Commenter “reason” asks a question:

…it is not clear to me that it is well understood why inflation sometimes can be seen in consumer goods and sometimes is manifested in “asset price inflation”. Do you have any ideas on this mechanism? I know some people deny there is such a thing as “asset price inflation”. Do you have a theoretical basis for your ideas in this area?

I have a very simple answer to this question: Follow the money. Whether an economy generates asset price inflation or consumer price inflation depends on the details of to whom cash flows. In particular, cash flows to the relatively wealthy lead to asset price inflation, while cash-flows to the relatively poor lead to consumer price inflation.

Why? In Keynesian terms, poorer people have a higher marginal propensity to consume. The relatively poor include people who are cash-flow constrained — that is they cannot purchase what they wish to purchase for lack of green, so their marginal dollar gets immediately applied to the shopping list. Also, poorer people may be different, there may be a correlation between poverty and disorganization, lack of impulse control, inability to defer gratification etc. Think of Greg Mankiw’s Spenders/Savers model.

Except when the world seems very risky, no one holds cash for very long. Poorer people disproportionately use their cash to purchase goods, while richer people disproportionately “save” by purchasing financial assets. If the supply of both goods and financial assets is not perfectly elastic, then increases in demand will be associated with increases in price. If relative demand for goods and financial assets is a function of the distribution of cash, what price changes occur will be a function of who gets what. [1]

This tale of two inflations helps to explain how we arrived at the unequal, credit-centric economy we have today. Central bankers are notoriously allergic to “wage pressure” as a harbinger of rising prices. Wages have two distressing properties: First, they are sticky. They represent repeated and persistent cash flows that cannot be downward adjusted en masse except during a serious crisis or dislocation. Second, a substantial fraction of wages goes to lower quintiles of the income distribution, who have a high marginal propensity to consume. Central bankers are not evil scrooges — they have nothing against consumption by poor people. But funding that consumption by wages limits the effectiveness of monetary policy. They’d prefer that the marginal dollar bound for consumption flow from a more malleable source.

During the “Great Moderation” in the US a variety of structural changes helped to increase the potency of monetary policy:

  1. The wage share of GDP decreased significantly over the 1970s and 80s. Compensation did not decrease as much, but much of nonwage compensation is retirement savings that is saved rather than consumed.

  2. Wage inequality increased, such that a growing fraction of wages went to “savers” rather than “spenders”, limiting the direct impact of wage growth on consumption.

  3. The growth and “democratization” of consumer credit provided consumers with an alternative source of purchasing power that was sensitive to monetary policy.

Prior to the Great Moderation, central bankers had to provoke recessions in order to control inflation. Broad-based wage growth led to increases in nominal cashflows by “spenders” that could only be tempered by creating unemployment or other conditions under which workers would accept wage concessions. In the post-Reagan world, growth in the sticky component of disposable income shifted to the wealthy, who tend to save rather than spend their raises. The marginal dollar of consumer expenditure switched from wages to borrowed money. The great thing about consumption funded by credit expansion, from a central banker’s point of view, is that it is not sticky downward — no one who gets a loan today assumes that she will be able to expand her borrowing by the same amount every year. Credit-based consumption is susceptible to monetary policy with far less impact on employment than wage-based consumption. (One of Ben Bernanke’s many claims to fame is his characterization of the credit channel of monetary policy transmission.)

By the middle 2000s, the credit economy was the air we breathed, and conventional wisdom held (and continues to hold) that economic growth and credit expansion are synonymous. We had those peculiar debates about the difference between “consumption equality” and “income equality”, and which mattered more, since middle-class consumption had become significantly credit-financed. But from central bankers’ perspective, we had stumbled into a good place, one where output growth was channeled into asset price inflation, but provoked consumer price inflation only indirectly and via a channel policymakers could regulate. This benign regime faced two threats, however. First, asset price inflation is unstable — while on any given day, price moves are determined by the flow of funds into assets, over time prices can become so unreasonable relative to the the asset’s cash or service flows that arbitrageurs and nervous fundamentalists appear, creating the potential for a collapse. Second, credit expansion is unstable, as chronic borrowers may become unable to service existing debt, let alone borrow more to sustain aggregate demand. Unnervingly, sustaining consumption has required a secular downtrend in the policy interest rate, and eventually you hit that zero-bound. [2]

The Greenspan/Bernanke doctrine can be summed up by three familiar words, “Yes We Can!” Greenspan famously concluded that we can “mop up” asset price bubbles after they burst, rather than interfering with the dynamic whereby asset price inflation substitutes for consumer price inflation. Bernanke devoted his life to studying the role of credit in monetary policy and the hazards of deflation and credit collapse, and he famously concluded that we have the technology to prevent “it” from happening here. We are watching his experiment play out, in real time and from inside the maze. The outcome is not yet known.

I have my own normative view of “the great moderation”, and it is not positive. I do not hope to see a return to the “good old days” of the 1990s and mid-2000s. But that isn’t because the moderation dynamic cannot work, in principle. In principle, we can periodically reset the stage with a money-funded jubilee. It’d go like this: When credit expansion reaches its natural limit, let the debtors default, but make creditors whole with new money. “Moral hazard”, rather than a problem, is the goal of the operation: Low marginal-propensity-to-consume “savers” are rewarded and encouraged to continue pouring their incomes into domestic financial assets, where any effect on goods price inflation is muted. Over several years, the balance sheets of debtors can be cured via some combination of bankruptcy, loan modifications, austerity, and youth. In the meantime, the Federal government adopts the role of consumer of last resort, in order to sustain nondeflationary levels of aggregate demand and limit unemployment. I think this is our current strategy. We are groping and stumbling towards the status quo ante, and it is not impossible that we will find it within a few years.

So what’s the problem? First, in exchange for apparent stability, the central-bank-backstopped “great moderation” has rendered asset prices unreliable as guides to real investment. I think the United States has made terrible aggregate investment decisions over the last 30 years, and will continue to do so as long as a “ride the bubble then hide in banks” strategy pays off. Under the moderation dynamic, resource allocation is managed alternately by compromised capital markets and fiscal stimulators, neither of which make remotely good choices. Second, by relying on credit rather than wages to fund middle-class consumption, the moderation dynamic causes great harm in the form of stress from unwanted financial risk, loss of freedom to pursue nonremunerative activities, and unnecessary catastrophes for isolated families. Finally, maintaining the dynamic requires active use of policy instruments to sustain an inequitable distribution of wealth and income in a manner that I view as unjust. In “good times”, central bankers actively suppress the median wage (while applauding increases in the mean wages driven by the upper tail). During the reset phase, policymakers bail out creditors. There is nothing “natural” or “efficient” about these choices.

The great moderation made aggregate GDP and employment numbers look good, and central bankers sincerely believed they were doing a good job. They were wrong. We need to build a system where changes in asset prices reflect the quality of real economic decisions, and where the playing field isn’t tilted against the poor and disorganized in the name of promoting price stability.


[1] “reason” asked about a “theoretical basis”. It’s important to note that my story betrays an anti-theoretical bias. In the perfect world of financial theory, the supply of financial assets should be infinitely price elastic at one true “fair price”, since arbitrageurs can increase supply indefinitely by selling an asset short if it is “overvalued” relative to the value of its future cash flows cash flows. In reality, the capacity of market actors to recognize, let alone to arbitrage away, mispricings is very limited. So cashflows to people more likely to invest than to consume can lead to diverse forms asset price inflation, depending on what sort of assets the cashflow receivers are interested in buying. Further, rather than causing arbitrageurs to short overvalued assets, as theory predicts, high asset prices often provoke entrepreneurs to increase supply by manufacturing similar assets as substitutes, which results in increased real investment in the overvalued sector (while short-selling should in theory help prevent overinvestment).

Also, while “clientele effects” play some role in theories of term structure and the effect of liquidity on asset prices, most theories of asset pricing don’t take seriously the idea that patterns of income or access to cash might affect prices. My view is that the asset pricing literature is descriptively wrong, for the most part, although it arguably has normative merit.

[2] There is a third threat: The increasing stock of assets leaves the system ever more vulnerable to “runs” into commodities or foreign assets. When the stock of assets is small, central banks can contain a run by serving as “market maker of last resort” and managing the cross-price between domestic financial assets and perceived safe havens. When the stock of effectively guaranteed financial assets is large relative to central bank reserves of whatever investors are fleeing to, the central bank may lack the ability to manage price volatility, which might be perceived as a violation of its price stability commitment and lead to further flight by domestic and foreign financial asset holders. This is the currency crisis/dollar collapse/gold bug scenario, and while a large stock of guaranteed assets increases its likelihood, it is by no means a foregone conclusion, especially for large states capable of employing a creative array of fiscal, diplomatic, and legal maneuvers to help manage and control market outcomes.


56 Responses to “Asset inflation, price inflation, and the great moderation”

  1. babar writes:

    > cash flows to the relatively wealthy lead to asset price inflation, while cash-flows to the relatively poor lead to consumer price inflation.

    i think your analysis is too easy.

    this asset price bubble had a lot to do with subprime lending — which basically allowed people to invest and consume independent of current cash flows.

    how does that fit with your statement?

  2. Excellent post!

    One additional reason that inflation in the past twenty years generated asset bubbles is that the mechanism of inflation was loans to buy assets. Banks were allowed to create money to buy bonds that were used to buy stocks in LBO deals. Other banks created money to buy mortgages. If the mechanism of credit expansion directly targets assets, asset prices will rise. It doesn’t necessarily have anything to do with putting money in the hands of the rich versus the hands of the poor.

    I’m not exactly sure how the 1970’s inflation happened ( the oil price hypothesis is inane, it cannot explain why wages and corporate profits also rose at 10% a year). It would interesting to examine the exact mechanism that injected new money during the 1970’s, and why that may have had less of an effect on asset prices.

  3. Meta Finance writes:

    An excellent post, Steve – informative, enlightening and thought-provoking in equal parts. Thank you for writing it.

    I think your description – follow the money! – of the divergence between consumer price inflation and asset price inflation is exactly correct. However, I am less convinced than you that the Fed was behind this development. While central bankers may have welcomed the divergence, I doubt they had either the knowledge or the tools necessary to engineer this outcome ex ante.

    No; we must look to external factors to explain why wages and retail prices stayed low, and asset prices increased, over the last few decades. In my opinion, the biggest such external factor was the entry of China into the mainstream of global commerce.

    The conventional wisdom holds that China ‘exports deflation’ to the world, but this is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles observed in recent years.

    So yes, the Fed played a role in creating the divergence, but it would not have come to fruition without the impetus provided by Chinese labor. I expand on this subject here.

    Note, incidentally, that my explanation is not inconsistent with yours; it merely addresses a different nuance of the situation. Thanks for reading!

  4. Meta Finance writes:

    PS. One quibble. In your first footnote, you state that “[in theory] the supply of financial assets should be infinitely price elastic at [the] one true ‘fair price’, since arbitrageurs can increase supply indefinitely by selling an asset short if it is ‘overvalued’ relative to the value of its future cash flows”. You then argue that this does not, in fact, happen, partly because traders have a limited capacity to recognize and arbitrage away mispricings.

    I think the truth is a bit subtler than that. When prices are close to fair value, traders can and do arbitrage away deviations; this is the classic ‘mean-reversion’ or ‘nickels-in-front-of-a-steamroller’ trade. But when prices move sufficiently far away from their fair value (in, for example, a bubble), the incentives faced by traders change dramatically. Specifically, it becomes rational for traders to ‘ride’ the bubble rather than to ‘countertrade’ it.

    I describe the dynamics of trading rationally in a bubble here. Do take a look!

  5. reason writes:


    thanks – excellent – and it has been picked up by Kevin Drum so the world will know.

    One thought though – I’m not so sure that we can repeat this episode. You noted the secular downward trend in equilibrium interest rates. I’ve seen serious speculation that the equilibrium (full employment) real interest rate is negative. We can’t keep going without goods inflation.

  6. reason writes:

    Devin Finnbarr,

    I think you misunderstand something there with the 1970s. In the 1950s and 1960s the labour market was not run on market prices. There was a loyalty pact between workers (often unionised) and there corporate employers (that in turn created the corporate social security system which is such a problem for us today). The 1970s was the time when the oil schock (and the increase in labour supply as the baby boom and the pill took effect) killed this system. It was absolutely true that at that time you had a choice between high inflation or high unemployment. The labour market is much more flexible now.

  7. reason writes:


    There were a series of asset price bubbles before the housing bubble. It is true that sub-prime (the collapse of lending standings) was the absolute killer at the end. In fact, that I think is another story that needs to be added to this one. The special danger lurking in the housing market. Welcome back the light – Henry George!

  8. JKH writes:


    There are some apples and oranges mixed in some of these relationships. Goods and services price inflation is about “new stuff” consumed. Asset price inflation is a combination of “new stuff” (new investment goods) and “old stuff”, but primarily it is about “old stuff” – existing houses, stocks, and bonds.

    So there’s a potential disconnect here between current forces in the form of wages and credit, which are essentially “new” things, and the way in which those forces affect economic choices about a grab bag of new stuff and old stuff.

    We know from accounting that total wages must somehow map into new stuff produced.

    Simplifying in the extreme, rich people map some of their current wages into credit for poor people, via the financial system. This is the income distribution problem.

    Rich people map the rest of their income into their own consumption and investment (or real investment intermediated by the financial system as saving).

    Rich people then do a lot of trading of “old stuff” – existing houses, stocks, bonds, etc.

    It’s really not a directional flow of funds per se that creates the pattern of trading – rather it’s the pattern of the bids and the offers and the trades. After all, rich people are just trading with each other when they move stock prices or existing house prices up. For every buyer, there is a seller.

    In that sense, because trading is essentially separate from real production, it’s really not possible to achieve the following:

    “We need to build a system where changes in asset prices reflect the quality of real economic decisions”

    Relative to price patterns over time, I’m surprised you don’t key in on interest rates as a critical source of long cycle asset price inflation.

    The graph you reference tells the story of the cycle. If central bank “success” in combating inflation is manifested in such a multi-decade interest rate reduction, it means also that the nominal discount rate for future cash flows has plummeted and the price to cash flow ratio has skyrocketed. This is most evident in the housing and mortgage markets.

    As interest rates approach zero, discounted cash flow prices become proportionately more sensitive to the same absolute change in rates – i.e. much more volatile and risky for the same change, compared to higher rate levels. This relationship came to the fore in an unusual way as “teaser” mortgage rate resets (which seem to have largely been overlooked as a source of risk at origin) drove both homeowner mortgage servicing capability and housing prices into the ground.

    Therefore, central bank success in achieving “moderation” in CPI and nominal interest rate levels means higher asset price risk.

    Stability creates instability. Success creates failure.

    My highly simplified explanation is that asset price inflation is in some sense the inverse of goods and services price inflation. Central banks increase asset price inflation risk as they bring good and services inflation and interest rates down to zero. The end result of this risk intensification is the apocalyptic world of Minsky deflation risk.

    Perhaps there are micro examples of why this is wrong in the short term, but it seems reasonable to me as a 30 year explanation, where central bank success in goods and services price control breeds failure in the bizarro world of asset prices.

  9. ahab writes:

    I’d like to hear you elaborate on your point about the terrible investment decisions made by the country in the last 30 years. Houses? Sure. Internet? Not so much. But of course I’d imagine you point to the dearth of investment in infrastructure and alternative energy.

  10. Mises writes:


    “It’d go like this: When credit expansion reaches its natural limit, let the debtors default, but make creditors whole with new money.”

    the one major error you are neglecting is you cannot make the creditors entirely whole via money printing. The debtors squandered real resources. The creditors invested real resources. However the means to make the creditors “whole” requires no real resources, but just a dilution of the currency. The fact creditors aren’t being paid back in real terms is the issue. And creditors arent the banking system btw. They are the debtors. Their depositors and have been the creditors. They simply issue unsustainable debts, inherently, and require money printing for the debts to have any chance of surviving. Over the whole process we are just getting more of a transfer of resources to debtors, and away from creditors, and continual punishment of creditors with no real restructuring or change in the habits of resource squandering by debtors.

    burried in this is the fraud in that many creditors dont realize they are creditors, and debtors keep pushing the rail further because of the moral hazard gaining momentum. eventually you have a huge collapse because the means to help the debtors further dies, as creditors no longer want a currency of sufficient dilution, and perpetual money printing of this kind is exactly the road to hyperinflation.

  11. Mike S writes:

    This is my exact thesis and was literally just thinking about this.

    It is a very useful asset allocation model.

  12. winterspeak writes:

    JKH: Nice post. It took me a long time to connect interest rates to asset prices, but I changed my mind, and your exposition is correct. I once believed that the value of AMZN was the same whether or not my broker gave me a special on my margin account. Now I see how the two are linked.

    SRW: An intriguing piece — thank you!

    I’m not sure I would equate the stagflation of the 70s with the way we traditionally think of inflation. I do believe that that was tied to the oil shock, and so is an example of a price shock feeding into general prices, and not an example of “too many dollars chasing too few goods” which is what I think of as “actual” inflation.

    I’ve also become much more skeptical of interest rates as a mechanism for macroeconomic control (hah! take that my first paragraph!) Look at today: low interest rates impoverish the parts of the private sector that are savers, while benefitting the parts of the private sector that are debtors. As the private sector is a net saver, I can see low rates having a net NEGATIVE effect now, and not being stimulative at all.

    Similarly, the high rates of Volker were bad for some, but good for others. They could have been net GOOD for the private sector, and stimulative, not depressive. Lots of other things happen at the same time, and it is difficult to tweak out the causality. Again, lots of people attribute our current “stabalization” as a combination of low rates, Obama’s fiscal stimulus, and TARP, but I would also attribute it to unemployment reducing nominal savings demand while funding what demand is left through automatic stabilizers driving deficits. Yes, it is the long dole queue that has put a floor under aggregate demand.

    Let me f%^&with your head further. The non-govt sector leveraging you describe, the growth of credit, was made worse by the SURPLUSES run under Clinton by Rubin, Summers, et al. In the private sector, you have balance sheets sitting on top of paid-in equity. Paid-in equity must precisely equal the paid-out equity from the Fed. Balance sheets can get larger when the sector takes on more credit, and shrink when the sector writes off or pays down credit.

    If the Govt runs surpluses, it takes the equity it paid-out back in. So the private sector, even if it does not take on any new credit, ends up being more leveraged since it has the same asset and non-equity liabilities sitting on a shrinking paid-in equity base.

    There are lots of very obvious dynamics that make large, mismatches assets and liabilities sitting on tiny equity bases unstable. We see those playing out now.

    (A final aside: people bring up Zimbabwe as an example of what happens when a Government deficit spends too much. Zimbabwe also reduced its real output by half through its land “reform” program. Since inflation is “too many dollars chasing too few goods” people seem to take it as a given that the problem in Zimbabwe as the “too many dollars” part and forget the massive decline in goods. Zimbabwe may have experienced hyper inflation even if the Govt was running a 0 deficit or a surplus.)

  13. anon writes:

    “In the perfect world of financial theory, the supply of financial assets should be infinitely price elastic at one true “fair price”, since arbitrageurs can increase supply indefinitely by selling an asset short if it is “overvalued” relative to the value of its future cash flows cash flows. In reality, the capacity of market actors to recognize, let alone to arbitrage away, mispricings is very limited. So cashflows to people more likely to invest than to consume can lead to diverse forms asset price inflation, depending on what sort of assets the cashflow receivers are interested in buying. Further, rather than causing arbitrageurs to short overvalued assets, as theory predicts, high asset prices often provoke entrepreneurs to increase supply by manufacturing similar assets as substitutes, which results in increased real investment in the overvalued sector (while short-selling should in theory help prevent overinvestment).”

    Note that this is basically a confirmation of Austrian Business Cycle Theory. The “cash flow” effect of monetary policy has widely studied by Austrians; it’s known as Cantillon effect.

    Saying that monetary expansion by the central bank can inflate asset prices is equivalent to the statement that monetary policy can depress interest rates in the short run; and the resulting increase in supply of assets is evidence of overinvestment.

  14. JKH writes:


    Of course, as you are no doubt aware, the PK/MMT/Chartalist prescription is to make low rates structurally permanent by running policy rates at zero forever. That is in itself deflationary for non government net savers, as you point out. To which the further MMT prescription is lower taxes as an inflationary offset.

    Lower rates increase the duration of tax cash flows, as well as their present value. It sort of makes sense to cut the principal amount of those cash values when their value has gone up, I suppose.

  15. reason writes:


    I’m a bit confused about what you are saying in your posts here. Are you suggesting money illusion? Monetary authorities would say that lower equilibrium interest rates just reflect either lower inflationary expections OR lower average returns on investment. Only the second should have the effect you describe and I wouldn’t have thought that monetary authorities would have regarded that as success.

  16. JKH writes:


    Low central bank policy rates reflect low inflation expectations. But this is inflation as measured in new goods and services prices – not in “old asset” prices. The long end of the interest rate yield curve tends to factor in expectations for these short term CB term policy rates.

    E.g. a house is an asset. Existing houses are traded as “old stuff” in the real estate market. The price of houses in this market is not captured in goods and services inflation measures. This omission makes sense to the degree that the price paid for the purchase of an existing house for the most part has no direct relationship to new production and income in the economy (real estate commissions and a few other related things being exceptions), whereas measures of goods and services price inflation are intended to capture inflation in the ongoing economic process of new output and income. Existing houses, being “old stuff”, are apart from that process of producing “new stuff” and measuring price inflation in that process.

    Although house prices aren’t part of goods and services inflation, explicit and implicit (“imputed”) rents from houses are included. But landlords don’t face inflationary pressures when their own cost of borrowing remains low, so explicit and imputed rents remain restrained. At the same time, if interest rates are low, and mortgage rates are low, it obviously becomes cheaper for people to borrow to live in houses, which drives up house prices.

    So there’s a divergence between goods and services inflation and asset inflation.

  17. anon writes:

    ‘Low central bank policy rates reflect low inflation expectations. But this is inflation as measured in new goods and services prices – not in “old asset” prices.”‘

    I think this is wrong. An expected rise in asset prices should be reflected in the market for bonds and commodities–oil, metals, gold etc. And a rising price for commodities feeds into consumer goods inflation by raising the prices of inputs for these goods.

    Rising bond prices should also incent firms to issue more debt and undertake new investment projects. In principle, this should raise the price of current goods and services for consumers.

  18. David Merkel writes:

    Good post. I used to get abuse for this point of view mid-decade when everything was running hot. It is not conventional wisdom yet, but I am hearing it a lot more. Even some central bankers are beginning to factor asset prices into their policymaking, even if quietly and informally. After all, they are the ones that start blowing the bubbles. The private sector simply follows them.

  19. Arjun writes:

    Thought-provoking post (and comments too).

    It’s good to have you back.

  20. winterspeak writes:

    JKH: Yup, I’m aware of the PK/MMT/Chartalist position on interest rates. I cannot bring myself to go there just yet, but given time, who knows?

    REASON: To add to JKH’s comment on housing, there was a dramatic rent/price divergence during the housing bubble. Indeed, that to me was the clearest evidence that there was a bubble (and why I held my AMZN shares have no connection to margin requirements).

  21. JKH – excellent insights. One question – when you suggest that low interest rates are deflationary, which interest rate are you talking about? The overnight federal funds rate? Or something else? And do you mean that they cause deflation, or are a result of deflation?

    Winterspeak –

    <i>I’m not sure I would equate the stagflation of the 70s with the way we traditionally think of inflation. I do believe that that was tied to the oil shock, and so is an example of a price shock feeding into general prices, and not an example of “too many dollars chasing too few goods” which is what I think of as “actual” inflation. </i>

    I’ve never understood the argument that the 70’s oil crisis caused the 1970’s inflation. I’m going to repeat a comment I once made on a different blog. I’d be curious to hear your thoughts:

    From 1972 to 1981, total national income grew by 10.1% a year (source: ). Oil price increases cannot explain why national income went up. An oil price shock of any quantity is profit neutral across the economy. Owners of oil will get windfall profits, everyone else will have higher expenses (or if the oil is owned by foreign governments, exporters will have windfall profits, and oil consumers will have increased costs). In order to get higher national income across the board, you need to have an increase in the money supply (or a fall in the demand for money).

    And indeed, we find that the M2 measure of money supply grew by 9% a year during that same period ( ).

    If productivity increases by 2% a year, while monetary inflation ( ie total aggregate income, M*V) increases by 10% a year, you’re going to get a price level increase of ~8% a year. Which is pretty close to what happened (all these numbers are approximate).

    The dollar is a fiat currency. Every note says “Federal Reserve Note” and it is illegal to print one without authorization. If the money supply increases by 10% a year, the fault lies entirely with the U.S. government.

  22. JKH writes:


    I use the terms “deflationary” and “inflationary” in a somewhat general, directional sense, as opposed to the outright literal interpretation of falling prices or rising prices; and in this case, in a marginal or local sense.

    So deflationary in the general directional sense means reduced aggregate demand, with resultant lower prices as a first or second derivative – e.g. a lower rate of price increase, which is disinflation, or a transition from inflation (rising prices) to deflation (falling prices), or a higher rate of price decrease (accelerating deflation).

    And deflationary in the marginal, local sense in this case relates to the “Post Keynesian” interpretation of the non government sector having a net saving position in financial assets – that being its holdings of government debt. The lower the interest rate is on that debt, the lower the interest income received by the non government sector, and the less the purchasing power and aggregate demand attributable to that income. Lower interest rates are directionally deflationary in that sense.

    The interest rate I’m referring to is any of the rates on any of the central bank or government liabilities – interest on reserves, interest on treasury bills, or interest on treasury bonds.

    And the cause effect is that the lower interest rate is directionally deflationary.

  23. winterspeak writes:

    Devin: In general, I think what you say makes sense. Oil is a special case.

    First, the Govt can increase money supply through deficit spending, but the private sector can increase money supply too by credit extension. Either can cause inflation. Australia is a great example where the Govt ran surpluses, but private sector credit extension created a real estate bubble anyway. The two effects means Australian households are extremely leveraged, and now in trouble.

    In your example, the supply of oil went down, and it’s price went up. The US is a net importer of oil, so as you say, owners get a windfall profit, while users have higher expenses. In this case, the users are (net) the US.

    This seems very straightforward — maybe I’m missing something in your question but you seem to have answered it yourself.

    (PS. You can get higher national income through higher V keeping M constant. V can actually change a lot, and I think best captures the term “animal spirit”)

  24. reason writes:


    Thanks for your reply, but you actually picked what I think is a bad example. The problem is that I interpret used house price inflation as land price inflation. Land like gold is a real asset with no intrinsic value (i.e. value independent of the economy it lives in) that people try to use to part there wealth in. But if rents and land prices are out of whack then something is wrong, and can easily be seen to be wrong (not so with gold which generates no cash flow). There is so some sort of blindness here. So you really are saying that the return on alternative investment is seen to have fallen. I’m not sure we have got to the bottom of the mechanism here. I still don’t think you can explain it, without explaining why leverage has increased.

  25. reason writes:


    “If interest rates are low it obviously becomes cheaper for people to borrow and live in their own houses.”

    Not if interest rates are low because inflationary expectations are low, and their own income will not rise. And certaintly not if the cost of the alternative – renting – is not rising.

  26. reason writes:

    Devin Finbarr

    “The fault lies entirely with the Federal Government”

    I take it you are including the central bank in that. In a way you are correct. But please note the institutional factors I mentioned. The fact was that at the same time as the oil crisis came, there was an acceleration in the rate of growth of the work force, and a deterioration of the foreign balance.

    A central bank that saw unemployment rising (starting from a very low base), will run a looser monetary policy.

    So basically, I’m saying yes – but there were extenuating circumstances.

  27. reason writes:

    Devin Finbarr,

    it may be relevant here, but I saw an interesting comment on another blog about that particular period on another blog. It was mentioned that a rise in the price of oil caused investment to go into energy efficiency and “not into productivity”. Well I would think that less input and more output WAS an improvement in productivity. So what has really happened is that relative terms of trade changes caused a fall in income and that fall of income is not being accurately reflected in the price indexes we are using to measure productivity.

    Essentially the monetary authorities may well have made an honest mistake – because their indexes were not appropriate to the circumstances. They interpreted an shift in relative prices as inflation.

  28. reason writes:


    Sorry that last paragraph is clearly 100% wrong. They got it more right than we are giving them credit for, our indexes are misleading our interpretation of what happened.

  29. JKH writes:


    Thanks for your comments.

    I agree that it’s not a perfect example, but not as bad as you suggest, I think.

    Land inflation is a big part of real estate inflation. That doesn’t alter the fact that housing provides a service along the lines of imputed rent, so it doesn’t really contradict my analysis. The land is roughly speaking subject to zero “real depreciation”, while the actual house has a finite life and is therefore subject to real depreciation. That’s all part of the economics of comparing housing prices to rent. Throw in asset inflation on top of everything including land and replacement cost, and no unique economics are associated with a zero real depreciation rate on land.

    On the effect of interest rates, I should have used the term “lower” rather than “low”. Above the zero bound, interest rates are more flexible on the downside than wages. So a decline in interest rates becomes attractive relative to the counterfactual of no decline.

    It’s trickier when you reach the zero bound, where interest rates become sticky on the downside while deflation risk doesn’t. That’s why low as opposed to lower rates aren’t working so well right now.

  30. pitchfork writes:

    Thanks for the superb post, head and shoulders above the milktoast “professionals.”

    But I think it could be elaborated by a world-economy context.

    The root cause of rising household income inequality in virtually all nations, and hence of the worldwide shift toward asset inflation, was the Malthusian shock to the world market system. (Obviously some nations adapted to this shock more effectively than others.) One causal path runs through the sharp rise in the supply of low-skill labor, and the other through the sharp rise in competition for capital among sovereign states.

    Welcome to the world of tulipmania on wheels. Already the next bubble appears to be inflating in Asian stockmarkets.

    Besides awful allocative efficiency, this world contains a couple of strong positive feedback loops. You thought 2008 was a crash? When the new world really does crash, all of Ben’s men will not be able to put it back together again.

  31. JKH-

    That makes sense.

    Winterspeak &Reason-

    From 1970 to 1980 there were following price changes

    Gasoline prices rose by 13.3% a year

    CPI grew by 7.8% a year

    Aggregate Personal Income grew by 11.5% a year

    M2 grew by about 9.2% a year

    The conventional wisdom is that the rise in oil prices caused the high CPI inflation of the 1970’s. According to this argument, the CPI inflation was not a monetary phenomenon.

    The problem is that the rise in oil prices cannot explain the rise in M2 or in personal income. Personal income can only rise if M*V rises (supply for money increases or demand for money decreases).

    What you would expect from an exogenous oil shock is that the incomes of exporters rise and the incomes of oil consumers fall. You’d also expect that people would spend more on oil, and cut back spending elsewhere (perhaps less travel and vacation). You would expect CPI inflation to rise, but aggregate income would remain the same and M2 would remain the same.

    M2 is not a perfect measure of the money supply. But the grow in M2 almost entirely explains the rise in CPI inflation. If M2 is growing at 9% and national income grows at 11%, you would expect a CPI growth of around 8%. Thus I hold that the inflation of the 1970’s was mostly a monetary phenomenon, and had little to do with the rise in oil prices.

    What I don’t know is what caused M2 to grow so fast (I suspect credit creation, but I’m wondering what changed to make credit expand so much faster than it did in the 50’s and 60’s).

  32. erghammer writes:

    I’ve lurked here for a while and never posted before, but had to this time.

    Damn, this is insightful. Blogging of the highest order. Kudos.

  33. winterspeak writes:

    Devin: Thanks for pulling up those figures.

    I think part of the issue is that with something like oil, you can’t just “spend more on oil, and less on everything else”. There’s oil in everything, either through plastics, transportation/gasoline, energy to make it, etc.

    So, higher oil prices means higher input prices across the board, thus you see broad based price changes and not just substitution (as you suggest).

    (By contrast, say a good like bananas went up 13.3% a year. This would play out as you suggest, with substitution and no broad based price change). Oil did not have a lot of substitutes in the 1970s (although the picture had changed a decade later. OPEC ceased to be the force it was, and I think there was a change in natural gas regulation in the US. Other stuff probably changed too that I don’t know about).

    You can’t look at an increase in M2 and say that that caused inflation. Suppose the quantity of real goods increase by even more, you should see falling prices then. Or suppose V falls dramatically, again you would see deflation.

    Mortgage securitization started in the 70s btw. Big change to the credit environment.

  34. winterspeak writes:

    Sorry, I would also add that, at a macro level, you cannot futz with prices without also futzing with income. If higher prices change inflation expectations (they certainly reduce the real debt burden) then you can see V changing too.

    This is not to say that there weren’t inflationary actions in the 70s. Volker’s high interest rates certainly had inflationary impact, which may or may not have outweighed the deflationary impact they had through reducing credit.

  35. reason writes:

    Dean Finbarr,

    you seem to have completely ignored my point – which was yes, but. It is not obvious that there was a better solution, given that there was a real income shock.

  36. reason writes:

    P.S. I’m assuming sticky wages and that unemployment has a real long term cost. If you just think inflation is a bad, and the only bad then you might think differently about what is “best”.

  37. reason writes:


    Devin Finbarr. Not Dean – sorry.

  38. Yancey Ward writes:

    I wonder where demographics fit into this- thinking specifically about the Baby Boomers. In the 70s, they were young consumers- in the 80s and 90s, they were 401K/IRA fanatics (and, don’t forget the Social Security fix of the early 80s). As the 00s end, the Boomers are about to return to a consumption mode.

    One other thing- your money jubilee is nothing new, and always, always has diminishing returns. You can never make creditors whole- what they have given up is not money, and money is all you are returning to them. Many, many governments of the past have tried this, and the result is always the same- the currency dies. I think we are on this path, and the outcome will be no different. We aren’t special in any significant way.

  39. Mike S writes:


    The group here is trying to extend the life of the U.S. dollar through understanding of the basics. But the U.S. dollar will die at some point.

    You are correct, this “money jubilee” as you call it is nothing new. But not the discussion here, and the one that is beginning to take place in the wider community – like at Naked Capitalism.

    This is the first time in human history where people are beginning to understand the levers of money. The understanding that taxation produces demand and government should run deficits equal to the demand for savings is totally new information and a conceptual framework that has never been thought before the last few years.

    It may help extend the life of the U.S. dollar. We know that austrian money theory doesn’t work because it has been tried over and over and has failed repeatedly.

  40. Yancey Ward writes:


    I disagree. The discussion you are talking about just sounds like more rationalizations for inflationism and centralization of monetary authority.

  41. J. MacKenzie writes:

    What’s needed to sort this mess out is a tww-tiered money sytem with two differing, non-exchangeable kinds of currencies. The first, I’ll call production dollars, could be spent only on essentials–food, shelter, medicine, clothing, etc. and for businesses it would be physical plant, labor, pension funds, and (possibly–or possibly not)debt servicing that funds day to day production activities. Production dollars would be printed differently and could only be spent on those items (adjusted by a consumer board of citizens and politicians–no lawyers) in a manner similar to food stamps. Money earned through wages or investment would first be paid out in production dollars until they accumulated above a preset level such as the poverty line, after which they would convert to the second tier–risk dollars–which could be spent or gambled in any fashion.

    Before rejecting this concept out of hand consider: basic needs are taken care of before betting the farm. In fact under this system you couldn’t bet the farm as it would be considered a production item.

  42. winterspeak writes:

    YANCEY: “The discussion you are talking about just sounds like more rationalizations for inflationism and centralization of monetary authority.”

    It is certainly an argument for anti-deflationism. You could argue that anti-deflationism is the same as inflationism, but I think that both deflation and inflation are vandalism — destruction for no good reason.

    Austrians are probably the staunchest anti-inflationists out there, and may take that position arguing that it’s good for the real economy long term. I find it ironic that people who claim to be so concerned about the real economy don’t seem to have a problem with 10% unemployment.

    As for centralization of monetary authority, LOL, I think that horse left the barn a long time ago!

  43. BSG writes:

    “As for centralization of monetary authority, LOL, I think that horse left the barn a long time ago!”

    With apologies to animal lovers everywhere, that “horse” needs to be hunted down and slaughtered. The sooner the better. It’s no laughing matter, out loud or otherwise.

    “anti-deflationism” is just a worn excuse to maintain an immoral transfer of wealth from poorer to richer.

    As for unemployment, you may have noticed that no central bank efforts have been applied to directly reducing it. All we get is more trickle down nonsense. (“By handing out trillions to bankers and allowing them to loot much of it, we’re saving the economy, thus helping main street, which, of course, is all we care about. Heh.”)

  44. BSG writes:

    Steve –

    In an otherwise fine post, I think you gloss over the nefariousness of the process and all of the malfeasance.

    I’m all for civility, but not at the expense of obscuring critical facts. Central bankers would love us to believe that they are simply trying their best to maximize economic growth within certain constraints. Sometimes accidents happen – or so they want us to believe.

    I don’t doubt that many respectable-seeming crooks have rationalized to themselves and others activities that stripped of the veneer and absent naked propaganda most would find nothing less than outrageous to the highest degree (e.g., say, ruining many lives in the process of looting the nation and the world.)

    If we want to eliminate this terrible financial system (and the accompanying devastation of so many lives) and replace it with one that in fact serves everyone fairly, I think we need to be more direct in calling out all of the outright corruption. By now it should be obvious that many so-called miscalculations were nothing of the sort.

  45. anon writes:


    Maybe you could explain to me how Richard Fuld “didn’t miscalculate” when he lost $ 1 billion in Lehman stock that he owned outright himself.

  46. BSG writes:

    anon – lots of people miscalculated, obviously, as with all nefarious schemes that blow up. I’m referring to the purpose of the calculations in question and the fact that most of the crooks got a way clean with most of the loot in broad daylight – with everyone looking!

    When ordinary bank robbers gets caught, you don’t see analyses about how they were trying to help society and then “stuff happened.” Any miscalculation is referred to in the context of their getting caught.

    The banksters that for all intents and purposes control central banks calculated all along how to extract (without earning) as much money as they can from as many people as they can. At the core of all of their schemes is the ability to create any amount of money/credit out of thin air. That’s the source of the bailouts that the Fed was created to provide to the scammers that had learned many times that their scams will inevitably blow up.

    As we can see, they calculated quite well for themselves (at least those at the top and close to it.)

    Dick Fuld remains a very wealthy man by just about any standard even though he lost most of his paper wealth (built up through aforementioned scam.) Almost all of the others (close to the top of the pyramid) simply had their otherwise fictitious wealth (it was all paper, after all) essentially realized by the Fed. Judging by recent statements, the Fed would have made him whole if they had to do it over, and perhaps if the Treasury Sec. hadn’t seen fit to seize an opportunity to easily lose a competitor of his firm.

    I’m obviously simplifying. All of the gory details are easily available to anyone who cares to look (including and especially in the archives of interfluidity.) There are also lots of shiny objects to [mis]direct attention away from what has been and is being done to us (“look, over there, it’s Fannie Mae!”; “hey, is that an asian saving glut over there?!”).

    I’m just trying to point out to anyone who cares what’s going on behind the curtain of economic/monetary/accounting “theories.” Steve does this so much better and with important details to boot, but I do sometimes wonder if he gives the powers that be the benefit of a doubt that, for all intents and purposes, doesn’t exist.

    Obviously, that doesn’t mean he’s wrong to do so. I’m simply offering what I consider a more direct perspective that often gets short shrift when it’s mentioned at all.

    BTW, I do realize you weren’t really looking for an explanation. Still.

  47. anon writes:

    My point is that your banksters who effectively bet the taxpayers’ money sometimes bet their own in front of it. I don’t think they calculate the socialization of losses to the taxpayer before calculating the privatization of losses to themselves. I think the story is oversimplified. Call it hubris and incompetence. But it’s not entirely the heads they win tails we lose story that is popularly depicted.

  48. BSG writes:

    “My point is that your banksters who effectively bet the taxpayers’ money sometimes bet their own in front of it.”

    And how do you think those near the top got “their own” in the first place? Aside from the easy come, easy go aspect, even the savviest “investors” don’t always get out in time. That doesn’t mean they misunderstood the system.

    “I don’t think they calculate the socialization of losses to the taxpayer before calculating the privatization of losses to themselves.”

    The evidence suggests that they had grown accustomed to getting bailed out (“socialization of losses”) and indeed most of them were. No miscalculation there.

    “I think the story is oversimplified. Call it hubris and incompetence. But it’s not entirely the heads they win tails we lose story that is popularly depicted.”

    Simplified, certainly, even greatly. Oversimplified? I don’t think so. See my comment above. Sure, it’s not _entirely_ the story, just a huge and critical part of it.

    You may be interested in the unofficial history of the creation of the Fed and even the first Bank Of U.S. to see how far back and how baked in to the system the “heads they win tails we lose story” is. I’ll deliberately leave out specific references because there is so much propaganda out there and appropriate suspicion of various sources. Good material is not that hard to find, if you approach the search with an open mind and the requisite critical thinking, combined with multiple independent sources. You know, the usual when one isn’t looking only to confirm their established point of view.

  49. anon writes:

    Let me try again.

    My point is that those who willingly accumulate stock in their own company are not behaving in a way that is consistent with entirely socializing the losses that might be incurred by the risks they take in managing the company.

    What’s so closed minded about that?

  50. anon writes:


    Another way of putting the question:

    If a man puts a billion of his own money at risk, how much does it affect his risk taking behaviour to know that the government may step in after he loses that billion?

  51. BSG writes:

    anon – first, I wasn’t directing my “open minded” comment _necessarily_ at you. Only you can tell if it’s applicable. With so much dogma on this topic, I thought it an appropriate reminder.

    To your point, I must be missing it. If you’re highly confident either that Uncle Sam will prop up your stock or that everybody and their brother believes that (thus effectively socializing losses that would materialize absent such intervention) and that you and your company have favored status such that you can engage in criminal conduct with impunity to goose your profits and even create fictitious profits, why wouldn’t you eagerly load up on that stock with the intent of dumping it at the right time? You may get the timing wrong, but that doesn’t mean your entire calculation was incorrect.

    This is before considering the vast sums of cash these people awarded themselves in bonuses from fictitious profits that were generated (if you can say that about something fictitious) with taxpayers bearing the risk of losses.

    Yves Smith at Naked Capitalism has repeatedly pointed out that Lehman’s negligible recovery in bankruptcy is evidence in and of itself that there must have been accounting fraud. I haven’t heard of any investigations, let alone prosecution of Dick Fuld and/or his lieutenants and auditors. Have you? If you have, please, do share. If not, is there nothing wrong with this picture?

    Again, what am I missing in what you’re saying?

  52. BSG writes:

    anon – I just saw your followup. If he believes that the government will step in soon enough to save him, the answer is obvious even if it turns out with hindsight that he miscalculated.

    His behavior can further be explained by his ability to easily extract ample amounts of cash from his business because of its favored status. Gambling recklessly with other people’s money that one misappropriated for himself is not that unusual, to put it mildly.

  53. anon writes:


    You argue your points well.

    I’m afraid my best response is to ask another question:

    Is there a difference in your view in inferring the motivation or behaviour of the Richard Fuld who held onto $ 1 billion in stock of his firm, versus an alternative Richard Fuld who took the same amount of money out of the firm along the way?

    Knowing what you know, would you tend to “assign blame” any differently between these two cases?

  54. BSG writes:

    anon – it just so happens that looters tend to be fast and loose with their ill-gotten gains. Even if he had given all of his loot to charity all along the way, it wouldn’t change the damage he and his cohorts caused (even from a societal point of view the damage would only be partially mitigated in the event.) So no, the blame would be the same (sorry for the, uh, lame rhyme, it was an accident, I swear :-)

    As I found out more about our monetary and financial system I was quite surprised that there is even a debate about the wisdom of allowing a relatively small number of private actors the authority and privileges we do. It demonstrated to me just how effective and pernicious propaganda can be in providing cover for corruption.

    I’m glad you brought up the good point that you did because it points to what I think is the crucial debate: if the gov’t engages in the same sort of behavior for actual public benefit, would that be an optimal approach?

    I think not. There is an underlying deception to our monetary system that is one of its more serious flaws. Also, it is next to impossible to control for any length of time. Most serious, I think, is that it redirects many (at times perhaps most) productive investments to unproductive pursuits (with mcmansions only the current example.)

    Setting aside the separate debate on the merits of gov’t redestributing wealth, it’s the destructive manner in which it’s done that makes our monetary and financial system particularly bad.

  55. anon writes:


    I sometimes play devil’s advocate because many of the popular bashing arguments are not particularly well put together.

    Your comments make me think a little more about this.


  56. Re: jobs creation

    Hello all,

    I have developed a business plan that has been praised by analysts at Microsoft, and top venture capital firm Draper Fisher Jurvetson.

    The plan presents a business case for a start-up provider of:

    * online markets that provide people with new and improved ways to customize education, and to showcase and earn money from expertise

    * media and software that complement said markets

    Canonical research findings (i.e., not mine) suggest that the best implementations of the plan will catalyze a lot of job creation.

    Toward raising awareness of this info re: job creation, I have adapted the plan at

    Any chance that you(r organization) can help to spread the word? If so, please contact me at your earliest convenience with any questions, comments, etc.

    Thanks kindly for your consideration.

    Best regards,

    Frank Ruscica