Euro Crash

How Asset Price Inflation Destroys the Wealth of Nations

B. Brown

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137371492
• Edition: 3
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

Euro Crash is a unique analysis of the European Monetary Union, arguing that it was not sub-optimal currency areas or profligate government spending but instead fatal flaws in monetary design and an appalling series of policy mistakes by the European Central Bank that lead to the current and ongoing Eurozone crisis.

1

Asset Price Inflation: What Do We Know about this Virus?

Why did European Monetary Union (EMU) enter existential crisis so soon after its creation? According to the ‘Berlin view’ everything would have been fine if it had not been for a number of governments contriving to circumvent the strict fiscal discipline stipulated in the budget stability pact that accompanied the launch of the euro. The ‘Paris and Brussels’ view by contrast traces the crisis to a failure of the founding Treaty to provide for a fiscal, debt and banking union.

The leading hypothesis in this book puts the blame for the crisis and for the highly probable eventual break-up of EMU on the failure of its architects to build a structure which would withstand strong forces driving monetary instability whether from inside or outside. These flaws could have gone undetected for a long time. In practice though, very early in the life of the new union, the structure was so badly shaken as to leave EMU in a deeply ailing condition.

A severe economic disease, called ‘the asset price inflation virus’, attacked EMU. The original source of the virus can be traced to the Federal Reserve, but the policies of the European Central Bank (ECB) added hugely to the danger of the attack. Serious inadequacies in Europe’s new monetary framework meant that EMU had no immunity.

When the disease of asset price inflation ‘progressed’ into the phase of asset price deflation, the political elites in Brussels, Paris, Berlin, Frankfurt and Rome could not deny (though they could struggle to downplay the extent of) the damage to their union. Yet they remained united in their refusal to hear monetary explanations of the catastrophe. This unwillingness to listen continued amid the new wave of asset price inflation fever that started to spread around the global economy from 2010 onwards as the Federal Reserve chief, Professor Bernanke, pursued his Grand Experiment. (The hypothesis tested: ‘well-designed’ non-conventional monetary tools ‘applied skilfully’ can accelerate the pace of economic expansion in the ‘difficult aftermath’ of financial panic and great recession when the self-recovery forces of the capitalist economy ‘are feeble’.)

At first this new strain of disease largely passed EMU by but not altogether. As the US monetary experimentation intensified, however, with the launching of ‘QE infinity’ (summer 2012) and a new version of the Fed’s ‘long-term interest rate manipulator’ (2011–12), symptoms of speculative fever became apparent in the form of yield-hungry global investors buying recently distressed European sovereign and bank debt.

The speculative fever helped bring some transitory respite for EMU from its existential crisis. The eventual agreement of Berlin to a series of bail-out programmes for weak sovereigns in Europe reflected the contemporary German export machine’s particular success in selling to those countries around the globe (China, Brazil, Russia, Turkey, Middle East oil exporters) whose economies were ‘enjoying’ (during 2010–11/12) the temporary stimulus of speculative fever originating in the Bernanke Fed’s new asset price inflation virus. The tolerance of German taxpayers for such bail-outs – essential to Chancellor Merkel’s political calculation – could break if and when asset price deflation follows asset price inflation.

Disease denial and then acceptance

Asset price inflation is a disease about which still much is unknown. Indeed early leading monetarist economists were in a state of denial about the phenomenon. A reader of A Monetary History of the US by Milton Friedman and Anna Schwartz (1963) does not find one mention of this virus (asset price inflation) and the same is true for Allan Meltzer’s epic A History of the Federal Reserve (2004). Why were those economists so determined not to even entertain the idea that monetary disequilibrium could be the source of a virus which would cause speculative fever to build and spread in the asset markets, choosing instead to focus entirely on the potential consequences of goods and services inflation? The question is particularly pertinent to Milton Friedman, given that for many years he walked the paths of the same campus at the University of Chicago as Friedrich von Hayek who, in the 1920s, had written about the creation of asset price inflation by the Federal Reserve Bank of New York (then the centre of power within the Federal Reserve) under Benjamin Strong and who had warned about the likely denouement of bust and depression (see Hayek, 2008).

One answer lies in Milton Friedman’s emphasis on positive economics. Almost by definition the concept of asset price inflation is difficult to fit into positive economics. Measurement of speculative fever is notoriously challenging – so how can the positive economist design neat empirical tests of various theoretical hypotheses concerning the disease? Moreover, for Milton Friedman ‘asset price inflation’ would have meant the original Austrian concept built around distortions in the relative price of capital and consumer goods. The ‘Austrian’ hypothesis was that that monetary disequilibrium (with interest rates manipulated say, far below their ‘natural’ level) would cause the relative price of capital goods (in terms of consumer goods) to be artificially high. The result would be over-production of capital relative to consumer goods. That is a distinct and less widely appealing concept than asset price inflation as now widely understood albeit that the two ideas overlap.

According to this popular modern definition, monetary disequilibrium causes a wide range of asset markets to display (not all simultaneously but rather in a process of rotation – see below) excessively high prices (relative to fundamentals) due to a build-up of speculative fever (sometimes described as ‘irrational exuberance’). The ill-results include mal-investment and a long-run erosion of the risk-appetite essential to the free market capitalist economy delivering prosperity. Mal-investment means capital spending that would not have occurred if price-signalling had been undistorted by the monetary virus and which eventually proves to be economically obsolescent.

The writers of the Maastricht Treaty had no knowledge about the disease of asset price inflation let alone any prophetic vision of its potential threat to the survival of their cherished monetary union. The monetary constitution in the Treaty was put together by a committee of central bankers who made low inflation (euphemistically described as ‘price stability’), as measured exclusively in the goods and services markets, the key objective. The famed monetarist Bundesbankers of the 1970s (subsequently described in this volume as ‘the Old Bundesbankers’) had departed the scene to be replaced by politicos and econometricians.

The Old Bundesbankers, in fairness to their successors, also had no clear understanding of asset price inflation. But they did instinctively realize that strict monetary base control (MBC) in which interest rates were free of manipulation was essential to overall monetary stability in a wide sense (which transcended the near-term path of goods and services prices). Instinctively they applied a doctrine of pre-emption. According to this the pursuance of strict monetary control would mean less danger of various forms of hard-to-diagnose economic disease (possibly as yet unclassified), including those characterized by excessive financial speculation, with their origin in monetary disequilibrium.

The intuition of the monetarist Bundesbankers took them one stage further than Milton Friedman’s famous pronouncement that ‘inflation [goods and services] is always and everywhere a monetary phenomenon’. Indeed, we should say the same about asset price inflation. Goods (and services) price inflation and asset price inflation are the two forms of monetary disease that plague the modern economy. They have their joint source in money ‘getting out of control’.

J.S. Mill famously wrote (see Friedman, 2006) that: ‘Most of the time the machinery of money is unimportant. But when it gets out of control it becomes the monkey wrench in all the other machinery in the economy’. In modern idiom we would say that ‘most of the time the software of money does not matter but when it mutates it spreads a virus which attacks all the other software behind price signals (in both the goods and capital markets) that guide the invisible hands of the capitalist economy’. An economy afflicted by monetary disequilibrium will eventually display symptoms of one or both types of virus attack – goods and services inflation and asset price inflation.

These two forms of economic disease of common origin (monetary disorder) have many similarities and also some dissimilarity. Moreover, if the virus of goods and services inflation is rigorously specified in monetary rather than crude statistical terms, then it would be rare not to find this present albeit in a weak form alongside the virus of asset price inflation (see next section, p. 7).

The exact path and strength of each monetary virus (asset price inflation, goods inflation) varies considerably between different business cycles. Just as Balzac wrote that the author’s skill is to typify individuals and to individualize types so it is with business cycle analysis. The analyst realizes that the key dynamic in each and every business cycle is the path taken by the two monetary viruses and how these paths interact. Yet each cycle is unique in that the paths are never identical.

Sometimes the cycle is dominated by the virus of asset price inflation without clear symptoms of the goods inflation virus ever emerging. Sometimes the virus of goods and services inflation plays a disproportionately large role. Sometimes this large role is anticipatory – long-term interest rates spike due to fears of building goods inflation; this spike in turn causes asset price inflation to turn to asset price deflation.

Similarities and dissimilarities between the spread of asset and goods inflation

How the disease forms and spreads is somewhat different in the case of asset price inflation from that of goods and services inflation. In the spread of the latter disease (goods and services inflation) key catalysts can be the exchange rate (which often plunges at an early stage), inflamed expectations regarding future prices, and strong demand in several important commodity, product, service, rental, or labour markets (there are many markets for highly differentiated types of labour). In the spread of the former disease (asset price inflation), catalysts include positive feedback loops (price gains apparently justifying a tentative speculative hypothesis), the emergence of popular new stories (for example technological innovations), and central banks of countries subject to hot money inflows (many of these economies are regarded widely as dynamic and so provide fertile ground for exciting speculative stories) deciding to inflate rather than allow their currencies to appreciate sharply (see below).

As the disease of asset price inflation attacks the economic system, various forms of irrational exuberance emerge (see Shiller, 2005 and Brown, 2013). We can think of irrational exuberance as a state where many investors are wearing rose-coloured spectacles that exaggerate the size of expected returns and filter out the risks (the dangerous possible future scenarios). More technically, it is a state where investors tend to put too low a probability (relative to actual level) on bad possible future scenarios and too high a probability on one or more good possible future scenarios. How does monetary disequilibrium encourage them to do this? There are three possible connections (see Brown, 2013).

First, monetary disequilibrium characterized by medium-term and long-term interest rates manipulated far below neutral level creates some froth in capital markets. In those asset classes where there is an appealing speculative hypothesis (illustrations include Spain as the Florida of Germany; EMU financial integration causing yields in the various government bond markets – Greece, Portugal, Germany, etc – to converge and providing European banks with great new opportunities to expand; the Draghi–Merkel coup against the Maastricht Treaty ending the crisis of EMU; Abe economics bringing long-run prosperity to Japan), asset market froth is seen as evidence by investors that the hypothesis is true (positive feed-back loops as described by Robert Shiller).

Second, a long period of low interest rates, even if in line with neutral, may stimulate ‘yield desperation’ by investors if there are no periods during which monetary assets deliver a real bonus (as would occur under a regime of monetary stability where the prices of goods and services would sometimes fall and sometimes rise – consistent with stable prices in the long run – and where market interest rates fluctuate freely).

Third, monetary disequilibrium and distortion, by generating terror about an outbreak of high inflation at some distant point in the future, can stimulate a scramble into real assets in the present, where this scramble is characterized by some degree of irrationality.

Both viruses – asset price inflation and goods inflation – are hard to detect at an early stage. This difficulty is particularly great with respect to asset price inflation as there are no statistical yardsticks which could even half-reliably suggest the presence or severity of the suspected virus infection.

A senior Federal Reserve official, Professor Janet Yellen, once remarked that if price-earnings (P/E) ratios in the US equity market are below 15 and rental yields on housing above 4% there can be no irrational exuberance, but this totally misses the point that sometimes there are one or more potential future states of the world of significant probability of becoming reality which are highly menacing. At such times a failure of the earnings yield (inverse of P/E ratio) or rental yield to rise well above normal level could be evidence of irrational exuberance. Famously, in early summer 1937, on the eve of one of the greatest stock market crashes in US history, a sober-rational P/E ratio taking account of then huge political, geo-political and monetary uncertainty, might have been nearer 10 than the actual 15.

By contrast, for goods and services inflation, a diagnosis sometimes can be made with the help of direct statistical evidence. Even this is easier said than done! The confirmation of a rising trend in goods and services prices can take considerable time given the extent of white noise in the data. And even once reasonably sure of the trend, the analyst should then consider whether the rising trend is monetary in origin.

Moreover, there are occasions when monetary goods and services inflation is present even without any statistical finding of general price level rise being possible. This would be the case where equilibrium prices in some key labour and commodity markets have fallen. A driving force behind the fall could be strong productivity gain or severely increased competition from abroad.

As illustration, computerization and digitalization plausibly led to the substitution of capital or cheap foreign labour for domestic US labour in many routine ‘white collar’ jobs during recent years, with much of this substitution occurring suddenly in the wake of the Great Panic (2008). Simultaneously many one-time skilled workers suddenly found their human capital worthless as the mal-investment of the boom was laid bare. In consequence the equilibrium price in important segments of the labour market (and related service or product markets) has fallen.

The efforts of the Federal Reserve to ‘fight deflation’ meant that those falls were moderated in nominal terms, or even did not occur. Some fall happened in real terms due to a cumulative ‘moderate’ rise in prices on average. Hence monetary goods and services inflation could have been strong even though statistical measures stayed weak.

An additional complication in the statistical recognition of monetary goods and services price inflation is the possibility that a rising price trend could be consistent with monetary equilibrium (no monetary inflation) as during a period of famine or wartime shortages or falling productivity or during a recovery phase of the business cycle following a recession phase when prices fell to a below normal level. And when it comes to assessing whether money is in excess supply, thereby driving a process of goods and services monetary inflation, the equilibrium demand for money cannot usually be assessed with a high degree of confidence within a narrow range. (The emergence of asset price inflation is less closely tied to excess money growth and more influenced by central bank manipulation of short-term and ultimately long-term interest rates, albeit that this manipulation is likely to be accompanied by high-powered money growing ‘too fast’; this last concept though is hard to empirically test, particularly over short periods of time).

Hence by the time asset price inflation or goods inflation can be detected with any high degree of likelihood, each virus is likely to have been around for a considerable time – with that time (between creation and detection) probably, but not always, longer in the case of asset price inflation than goods inflation. Virus creation does not have to be a simultaneous process – the asset price inflation virus might come into being sooner than the goods and services inflation virus. In real time (if instant diagnosis were hypothetically possible) the lag between monetary disequilibrium forming and the emergence of significant inflation might well be shorter in the case of assets than goods and services.

Asset price inflation turns eventually into asset price deflation (endogenously and without policy action – see p. 11) and this process is accompanied by economic downturn. Depending on the characteristics of the given business cycle and in particular the path of monetary disequilibrium this metamorphosis can occur before any incipient inflationary virus in goods and services markets has gained strength. And so there can be a complete business cycle with no recognizable outbreak of goods and services inflation.

Both forms of inflation can emerge early in a business cycle expansion. Virulence at this stage, though, is more likely in the case of asset price inflation than goods and services inflation. An outbreak of early cycle asset price inflation is possible where the central bank ramps up the monetary base as part of a program of long-term interest rate manipulation and deliberately inflaming far-out inflation fears. Consistently the central bank may be holding short-term rates at very low levels while seeking to influence long-term interest rate determination by promising that low rates will persist for a long time given the seriousness of a ‘deflation threat’ (ECB and Federal Reserve policy of 2003–5).

This ‘fight against deflation’ is likely to create also a virus of monetary goods and services inflation. This may well not reveal itself at first as a rise in ‘the general price level’ but rather as a (hard to recognize) counterfactual benign fall which did not take place. Sometimes there is a rise of the ‘general price level’ even at an early stage, as when the monetary disequilibrium triggers a big fall in the national currency coupled with, say, rampant real estate speculation and thereby puts upward pressure on key items in the goods and services basket (including residential rents). In consequence inflat...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Foreword by Joseph T. Salerno
• Acknowledgements
• 1 Asset Price Inflation: What Do We Know about this Virus?
• 2 The Franco–German Dollar Union that Did Not Take Place
• 3 How the Virus of Asset Price Inflation Infected EMU
• 4 How the Bundesbank Failed Europe and Germany
• 5 The Bursting of Europe’s Bubble
• 6 Guilty Verdict on the European Central Bank
• 7 From Fed Curse to Merkel–Draghi Coup
• 8 emuemu Is Dead: llong Live emuemu!
• Bibliography
• Index