A Tale of Two Inflations: How We Arrived at Today's Economy

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 (pdf).)

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.

---

Notes

[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.

Comments

[Moon Kil Woong:]

Thanks Steve for your well thought out economic analysis of asset and price inflation.

My only major concern I have is the following: Although before perhaps one could argue that increased wealth at the top translated into increased savings and asset inflation, increasingly the majority of goods and services in dollar terms are actually generated by the wealthy as well. Thus a collapse in asset prices feeds directly in a large collapse in price inflation and vice versus.

Cartainly trickle down theorists would like this analysis to be true arguing everyone benefits when rich get richer these days. Unfortunately, what the wealthy purchase tends to be overseas goods and/or goods the lower end of the wage scale often don't make (although sometimes the less wealthy in say China makes them).

Perhaps increased spending by the wealthy leads to convergence in the two inflations and/or deflations.

Now maybe I can address potential convergence on the other side of the market. The government has been vigorous in trying to get the middle and lower class to invest in assets, specifically homes, even if not economically viable. This has lead to unforseen consequences like overproduction of assets. The fact that many of these assets are marketed to people who can't afford these assets makes the market distortion even worse. When the price collapses in these assets the reality that homes are not just assets but are also a form of consumption or cost becomes all too apparent. Compounding the error is the fact that many people buying these assets are led astray believing price is fixed and that they are free to borrow on them when prices rise. This in turn leads to not only asset deflation but a steep drop in prices as well on the lower end of the market in tandem as both demand for assets and goods fall.

Whereas the poor suckered into these "investment" are sold these assets they are not aware that they can mysteriously transform into expenses they can not afford. Certainly they would not buy a 1,000 square foot aparetment, yet they can be suckered into a 1,000 square foot "investment" with a "cheap" no down ARM.

The public at large needs to rethink the ramification of such a policy in that ARMs and subprime mortgages are in effect a means to increase total systemic debt not lead to asset accumulation as it would appear on the surface. Compounding this, we can add a layer of securitization and derivatives which only makes the situation worse while highlighting that the end goal of this is merely to increase total leverage. It is all too transparent that financial institutions wanted to gamble and play the "greater fool" with each other with these mortgages.

Thus calls for traditional economic controls on the velocity of money and leverage to me seem well founded over attempts by the Federal Reserve to manipulate interest rates to normalize both economic cycles and control inflation. By and large they do a horrible job at both mandates.

And of course, some well placed regulation and dismantling of government intervention in the housing market (especially by Fannie Mae, Freddie Mac, CRA, and FHA) are called for as well. To this, it seems we are in agreement.

Oct 28 06:28 AM

[aussiereader4:]

'My view is that the asset pricing literature is descriptively wrong, for the most part, although it arguably has normative merit.'

This comment is the a crucial observation by Steve Waldman. The capex pricing model allows small changes in Interest rates to drive multibillion dollar changes in valuation.

This is despite the earnings being relatively miniscule in comparison to the asset value changes. Given the significant risk involved with equities i am continually surprised by any company with a P/E over about 10. The capex model prices risk inadequately. It is no differnent to the way ratings agencies rating sub-prime debt.

Oct 28 07:24 AM

[Boxed Merlot:]

...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...

Definition of Debasement: a simple illustration. Items needed: (5) US coins, of various denominations, dated before 1964, and (5) US coins of same “face value” dated 2009. Hold the two similar “face value” coins 6” above a hard surface and drop. Note the “ring” vs. “clunk” in sound. Conclusion: our government has succeeded in completing the circle by providing us clunkers for cash.

Oct 28 07:24 AM

[chap08:]

Thanks for an interesting article that raises some important questions.

However, I think that, in trying to get to answers, you have made a number of conceptual leaps that are hard to justify. For example you say:

'In "good times", central bankers actively suppress the median wage'

You are making a claim of Fed actions beyond their general role in managing inflation. What is your evidence for that statement? In my view it is false. Clearly, central bank actions will have an impact on the median wage, but do they actively suppress it? Could they even hope to? I believe that business and government actions, beyond the direct control of the central bank, have far more impact on wages and the median wage.

So, I would question some of the foundations of your argument. I would also say that you ignore many of the other key factors that have shaped the two inflations e.g. globalization, persistent trade deficits and Asian savings.

Oct 28 07:49 AM

[User 353732:]

I suggest you consider the fundamental unifying cause: willful, sustained malallocation of resources by the Rulers over a period of decades.
Malallocation means two things in practice:
1. Forced resource concentration(and deliberate underpricing of these resources) in a few, highly favored sectors or lead companies within a sector. A bubble, of necessity, occurs in the sector or the spefic lead or favored or anointed company. This is, of course, Old World and Third World industrial policy with a dirty American face.
Returns are deceptively high and risks are falsely suppressed, creating the illusion of net wealth generation and real income production. This makes large parts of the economy seem much more productive and valuable than they are. In time, greater and greater resources at more and more subsidized prices must be allocated by WashDc and Wall St and touted by the MSM to prevent an implosion. Inevitably, real capital and real money run out so fake capital and fake money must be found: the Fiat dollar becomes the easy and (for a season) infinitely expandable "resource". The economic implosion can be delayed but it cannot be prevented.

2. Transfer payments from high value creators to low, no or negative value creators via various and diverse means in the form of entitlements, regulations, subsidies, handouts, price manipulation, inequitable allocation of credit, unjust risk/reward relationships. Collectively, these must lead to a systemic reduction in the capacity of the economy to create genuine wealth and therefore real jobs and true income.
To suppress these consequences, money/income illusion(through irredeemable debt to finance consumption well beyond means and via the Fiat Dollar) are resorted to. Again it takes escalating money/income illusion to prevent exposure but exposure there will be....... in the form of manifestly declining material and civic quality of life, collapsing dollar, extinguishing jobs, bankrupt small businesses; inflation in ,first, energy, metal and food prices and then in most other essential goods and services as the first wave of inflation infects the entire economy.

Oct 28 08:21 AM

[sethmcs:]

This problem is easy to sort out. Raise interest rates.

Oct 28 08:56 AM

[goldbug101:]

They can't raise interest rates anytime in the foreseeable future without a collapse of most consumer credit.

There are numerous performing loans (people) tied to the prime rate that would turn into non-performing loans overnight if the prime rate were to increase.

There are numerous potential consumer loans to be made at the current prime rate that the consumer would not want to take on (or be able to) if the prime rate was higher.

I think the author's point is that the policy only works if there is ever-low interest rates and 'outlet' valves for the overextended consumer, i.e. bankruptcy, so that the consumer can get back into the credit game, while the banks are continually bailed out by .25% money from the FED.


On Oct 28 08:56 AM sethmcs wrote:

> This problem is easy to sort out. Raise interest rates.

Oct 28 10:27 AM

[a fat panda:]

I think that the analysis also ignores the key driver of valuation in any asset class, productivity.

I worked in banking in the early 90s, and went through a wave of consolidation. The dept that I served went from 30 people managing 17,000 accounts to 4 people managing 165,000 accounts. No one ever got fired. While the bank raised pay many times, it couldn't keep pace with the market. It didn't want to because it could scale the existing resources.

Look at the impact, individuals became more productive and better paid. Technology repeated this process across the board whether it was a person, a desk, or a telephone. Every asset in the company became more productive. The cost of goods and services came down as the cost of production fell. At the same time, pay was raising (albeit not as fast as productivity).

When you look at grow, it was in technology, a high productivity sector. now you look at the grow it is in government which is a low productivity sector. Guess what is coming next.

Oct 28 11:01 AM

[a fat panda:]

Should Be :

When you look at growth in the 90s, it was in technology, a high productivity sector. now you look at the grow it is in government which is a low productivity sector. Guess what is coming next.


On Oct 28 11:01 AM a fat panda wrote:

> I think that the analysis also ignores the key driver of valuation
> in any asset class, productivity.
>
> I worked in banking in the early 90s, and went through a wave of
> consolidation. The dept that I served went from 30 people managing
> 17,000 accounts to 4 people managing 165,000 accounts. No one ever
> got fired. While the bank raised pay many times, it couldn't keep
> pace with the market. It didn't want to because it could scale the
> existing resources.
>
> Look at the impact, individuals became more productive and better
> paid. Technology repeated this process across the board whether it
> was a person, a desk, or a telephone. Every asset in the company
> became more productive. The cost of goods and services came down
> as the cost of production fell. At the same time, pay was raising
> (albeit not as fast as productivity).
>
> When you look at grow, it was in technology, a high productivity
> sector. now you look at the grow it is in government which is a low
> productivity sector. Guess what is coming next.
>
>

Oct 28 11:02 AM

[Leftfield:]

The comments above converge on the fact that society's resources have been funneled increasingly to low-return and depreciating uses.
The article takes pains to excuse the motives of central bankers. Somehow, though, it's their societal class that is the last to feel pain as a result of the income skewing to the top the last few decades.
It is a monumental failure of leadership that will play with people's lives, serve to reduce their income and then substitute debt upon which the wealthiest profit, with their policies, and call that goldilocks.
As the article mentions, not all people want every possible activity or facet of their lives subject to monetization which is necessary as they approach grinding poverty necessary to support this debt while incomes deteriorate. Unlike the upper and lower classes, the beauty of the middle class life in America was it's freedom to allow inspiration to govern life choices, not just the mindset that knows the price of everything and the value of nothing.
Of course, we haven't even encountered rising, or skyrocketing interest rates yet. That will be fun. US leadership has taken the greatest share for itself in history while incentivizing a growing, disgusting, entitled, government-served lower class via bloated government, taking record payments for themselves, serving crap for policies, and taxpayer bailouts for their friends.

Oct 28 12:26 PM

[Living4Divi...:]

Good post !

Oct 28 12:39 PM

[Economic Ph...:]

Perhaps a simpler answer still is Cantillon effects.

Oct 28 02:06 PM

[sethmcs:]

Well if you can't raise interest rates you cannot correct the imbalances. Malinvestment will continue. Have fun with it. Buy that new car and house with no money down.


On Oct 28 10:27 AM goldbug101 wrote:

> They can't raise interest rates anytime in the foreseeable future
> without a collapse of most consumer credit.
>
> There are numerous performing loans (people) tied to the prime rate
> that would turn into non-performing loans overnight if the prime
> rate were to increase.
>
> There are numerous potential consumer loans to be made at the current
> prime rate that the consumer would not want to take on (or be able
> to) if the prime rate was higher.
>
> I think the author's point is that the policy only works if there
> is ever-low interest rates and 'outlet' valves for the overextended
> consumer, i.e. bankruptcy, so that the consumer can get back into
> the credit game, while the banks are continually bailed out by .25%
> money from the FED.

Oct 28 02:13 PM

[Tetrapod:]

Great Article Steve!
This is one of the first articles I've seen that try to explain the causal difference between Consumer Inflation and Asset Inflation. We know both of these have the same root cause -- expansion of the monetary base relative to gdp. But your article explained why sometimes the Monetary Inflation results in CPI and sometimes in asset bubbles. It's a matter of who, in the society gets first use of the new money.
Thanks for the article!

Oct 28 02:19 PM