The Taiwan Banker

This summer, the journalist Nicholas Wapshott released a timely book entitled Samuelson Friedman outlining a long-running intellectual debate between two heavyweight economists – the former from a more traditional Keynesian perspective, and the latter the pioneer of monetarism. The setting of this rivalry was the inflation of the 1970s in the early 1980s, a period which forms the background for today’s rising prices. Monetarism offered a simple and intuitive demand-pull explanation: the central bank was creating too much money. The alternative, more nuanced perspective is cost-push, or supply side. In political terms, the former explanation decisively won the debate, due to its parsimony. At the same time, strict monetarism has also fallen out of favor since the 2008 financial crisis, which has demonstrated the continued necessity of fiscal policy. For the past ten years, the world been in a clear deflationary regime, despite consistent central bank stimulation. The moderate inflation taking place now has required unprecedented money creation. At the same time, the existence of such long-term monetary regimes in the first place implies a missing element to the inflation debate, both then and now. That element is the theories of economist Hyman Minsky – in particular, the fact that asset prices can never be eliminated from the discussion. A Minsky era After 2008, the term “Minsky moment” became better known in financial circles. This describes a situation in which the financial system collapses faster than any equilibrium-based model could capture, forcing an unconventional fiscal and monetary response. Behind this well known scenario, however, lies a deeper price theory which is also relevant in an inflationary context. According to the two-price model, assets like real estate may become detached from prices in the general economy to an arbitrary degree. Rather than central bank policy, it may be more useful to look to other factors, like demographics, to explain these prices. At present, due to aging, the balance of savers to participants in the real economy has shifted towards the former. This factor will likely start to reverse later this decade as retirees withdraw their funds. This explanation can also be run in reverse to explain the macro environment of the 70s. As the baby boomer generation entered the workforce and started demanding new consumption before they had the opportunity to contribute capital, the economy entered a state of secular capital scarcity. The central bank could print money, but doing so did not alter this fundamental shortfall, and thus only contributed to price increases. Economists of the period may not have considered the influence of such factors. In Wapshott’s narrative, only the minor character of Hayek questioned the usefulness of prices on a more fundamental level. Hayek’s Austrian theory of business cycles has however long been discredited, but Minsky’s theory preserves the useful aspects of this theory, while offering a more vigorous explanation. To be specific, Minskian cycles are based on the liability portion of the balance sheet, rather than assets. Because debt is a quasi-monetary instrument, this is still a monetary, rather than a “real” theory of the business cycle. Tug of war Returning to the present day, data present a quite mixed situation. The Consumer Price Index (CPI) hit a 39-year high of 6.8% in November. At the same time, real GDP is growing at a rapid clip of 5.5%, resulting in nominal GDP (NGDP) growth (the sum of the two) at a remarkable 12%. Nevertheless, as of December, 30-year mortgages are still available at 3%. As a rule of thumb, the fundamental value of investments generally tends to track NGDP growth, so extrapolating out, borrowers would earn 9% returns simply by owning a house. There is clearly some form of mismatch among these numbers. The housing market is a useful test to examine which of these theories might be best applied to the present. The short-term debate is between the cost-push and demand-pull theories. COVID has undoubtedly caused havoc in supply chains; its initial impact was on the supply side. Even though the disruptions could persist for up to several years, this theory ultimately assets that inflation could return to its original level, and thus considers it to be transitory. This situation alone would be insufficient to cause a wage-price spiral. Advocates of the alternative demand-pull explanation point to the unprecedented stimulus measures and monetary expansion taken in response to the crisis. The possibility of accelerating price levels is somewhat difficult to square with financial market expectations of such low inflation, but there is a one complicating factor: the extensive continuing intervention in the market by the Fed. Retirements have surged since the lockdowns, helping fuel a trend which has dubbed the “Great Resignation” – which may be attributed to some combination of surging asset prices and fear of COVID. The Fed is intervening in the housing market in particular, by purchasing US$ 40 billion of mortgage securities a month. In principle, these purchases could be driving down the cost of funding. Thus, not only demand factors, but also the non-neutrality of capital markets returns to the stage. Rates will almost certainly increase in the next year, although perhaps on an uneven path, as this issue works itself out. “The markets want to push rates higher while the Fed thinks inflation is transitory and does not require rate hikes anytime soon,” said Gordon Miller, owner of Miller Lending Group, in the Washington Post in November.“Expect volatility while we battle this tug of war.” (Since he made that remark, however, the Fed has announced that it would stop using the word “transitory”). In any case, the increase will be far from enough to resolve this inversion on its own. Regarding the larger economy, the crux of the debate is not the source of past inflation, but the course of future inflation. The multi-trillion dollar question is when the proper time comes – whenever it is – whether the Fed is credibly able to raise rates without triggering a worse crisis. In other words, the question of the decade will be debt as much as inflation itself. Assets are also for consumption In the housing market, credit standards remain strict, and there is little evidence of a bubble. Instead, the problem could be better characterized as an asset shortage. Chief Economist Mike Fratantoni of the Mortgage Bankers Association pointed out the importance of housing within the CPI, making up almost 1/3 of its weighting. Rather than the influence of inflation on the housing market, the more important effect may be the other way around. “Shelter prices continue to face upward pressures because of the lack of for-sale inventory and decreasing vacancy rates for apartments,” he said. This shortage has been a feature of the US housing market since the financial crisis, exacerbated by new migration patterns. The core problem is that due to zoning regulations, it is simply illegal to build suitable houses in most areas with strong employment. The impact on GDP easily reaches the scale of trillions of dollars, according to multiple studies. The real-economy aspects of the housing market are not typically considered in monetary analysis, but housing is a unique example of a solution that does not require choosing between these three theories of prices. Housing is not related to the current supply-chain problems, but more affordable housing would show a commitment to price stability over the medium and long term. Restraining the run-up in asset prices would marginally prevent seniors from retiring early, and a greater supply of assets would also give the central bank a wider range of policy options. It also goes without saying that any further measures to restrain COVID, without causing economic disruption, would be beneficial. Public health however does not directly impact asset prices. The 1970s can provide some guidance for the current moment, but the decades-long trend of declining interest rates will take some time to be reversed. There is as yet no sign of the stagflation which characterized that time. Modest structural reforms would help ensure that remains the case. Interestingly, this is also the conclusion of the “supply side economics” which became popular under the Reagan administration in the 1980s. The specific idea that tax cuts would solve everything quickly turned into a caricature of itself – mocked by the future president George Bush as “voodoo economics” – yet the underlying idea of supply side reforms remains sound. Some of the intellectual currents of that time remain relevant today, yet many aspects must be updated to reflect current realities.