INTEGRAL ECONOMICS

Asset Price Bubbles: MonetaryInflation and Leveraged Speculation

Daniel O'Connor | Integral Ventures, LLC

Absent a major revision in central bank policy or massinvestor strategy, the self-reinforcing dynamic betweenmonetary inflation and leveraged speculation may buildinto a crisis sufficient to force such changes.

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Asset Price Bubbles: Monetary Inflation and Leveraged Speculation

Daniel O'Connor | Integral Ventures, LLC

One of the best resources in tracking the creditdimension of the unfolding drama of

stableinstability

is Doug Noland's excellent

Credit BubbleBulletin

, in the latest issue of which he offers somechoice excerpts from a panel discussion at a recentmeeting of the Western Economic Association:

Question from the audience: “Professor(Milton) Friedman, do you think there’s arole for the Fed in identifying and managingasset price bubbles?Friedman: “No.” Questioner: “Could you elaborate?” Dr. Friedman: “The role of the Fed is topreserve price stability. Period. And pricestability in a broad aggregate—in a broadindex. It should not be concerned with theasset markets as such, only as they effectindirectly—somehow—the price stability asa whole.” Federal Reserve Bank of St. Louis PresidentWilliam Poole: “If I could just add to that. Iabsolutely agree. And one of the reasons Itake that position—I’m really a hardliner onthis. Let’s suppose that the Fed—as youwould want with any good policyinstrument—had perfect control over assetprices. I think it is incompatible with amarket economy to have a governmentagency setting asset prices that are meantto allocate capital.” Dr. Friedman: “Asset prices embody a realmagnitude that is a real interest rate. Andthe Fed does not control the real interestrate.” Setting aside for the moment the incredibleimplication that the Fed's current monetary policy issomehow

consistent with a market economy

, aswell as the tedious fact that

overall price inflationsimply cannot be measured

let's continue withNoland's provocative commentary on the abovediscussion:Contemporary, unrestrained, asset-basedWall Street Finance—operating withoutdetermined central banks ready to identifyand hinder destabilizing asset inflation andasset Bubbles—is a recipe for “monetary” disaster. And it pains me to listen to Dr.Friedman still professing that pricestability—measured by some broad index—is dependent upon the Fed activelymanaging the “money supply” (he statedso during the discussion). For systemicprice stability—certainly including assetmarkets and the Current Account—theFederal Reserve must take an active role inregulating Credit expansions and systemliquidity (“monetary” in the broadestmeaning of “finance.”). Special attentionmust be given to monitoring and disciplin-ing the marketplace in the event of heightened leveraging and speculating.Admittedly, this would be a complex,radical and challenging departure fromsimply pegging short-term rates (or even “inflation targeting”), but one I believe isnecessary. And Dr. Poole may believe thata Fed role in “controlling” asset markets is “incompatible with a market economy.” Yet, pegged interest rates, Fed assurancesof abundant marketplace liquidity, andconsequent inflating asset markets arethese days dictating our system’s (grossmis)allocation of resources and “capital.” The current Monetary Disorder, and itsperversion of system pricing mechanisms,is anathema to our Capitalistic system.Having asset markets as a prime focus of central bankers is not a “good policyinstrument”—but an all-important processwe’ll have to learn to live with. TheCreation and Flow of (contemporary)Finance is no longer manageable under thecurrent system.The issue of asset price bubbles and the FederalReserve’s role in identifying and managing themhas become a particularly hot topic in recentmonths. As I addressed in Unprecedented Funda-mentals, the Federal Reserve’s own study of thehousing bubble hypothesis not only concluded thatthere is no such bubble but was silent on the Fed’sown role, indeed a central role, in facilitating the

unprecedented fundamentals

upon which the entiretrend in housing prices is based.

Thus, the framingof the above discussion—the Fed’s role in

identifying

and

managing

asset price bubbles—is

The framing of the above discussion—the Fed’s role in

identifying

and

managing

asset price bubbles—isproblematic in that it ignores theFed’s potential role in

facilitating

asset price bubbles prior toany such identification.

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problematic in that it ignores the Fed’s potentialrole in

facilitating

asset price bubbles prior to anysuch identification.Recalling the basic architecture of

stable instability

—the competitive/cooperative dynamic betweencentralized intervention policies of the state anddecentralized exchange strategies in the market—we can see that asset prices are influenced by bothforces simultaneously. Just as important as theseobjective asset prices are the subjective strategiesof investors and the subjective policies of bankers,which constitute the

actionable knowledge base

with which they design their actions, interpret theirresults, and learn from experience. Through thisexperience-based learning process, these assetprices then inform the gradual development of moreeffective investor strategies and monetary policieswhich, in turn, guide future actions by investors andbankers. These

single-loop

and

double-loop

learning

processes are therefore essential to both the short-term performance and the long-term sustainabilityof asset prices.

This model also highlights another point that istypically overlooked in discussions like the one withMilton Friedman and William Poole. By definition,everything the central bankers say and do isdesigned to produce prices in assets and othergoods that are

different

from those that would haveresulted in the absence of the central bankers’ interventions. Think about it. There is no otherreason for monetary policy but to effect some majorchange in the outcomes that would have otherwiseresulted in a market economy without a centralizedmeans of monetary inflation and credit creation.Therefore, if we can see that monetary policy hasbeen inflationary for several years and we can seethat certain asset prices have been rapidly appre-ciating in the wake of this policy and all the more sowhen increasingly-easy-to-acquire credit financingis being used to purchase these assets (e.g.,housing, mortgages, and mortgage-backed securi-ties), then it is not much of a leap in logic toconclude that the Fed is in part responsible forthese asset prices, bubble or no bubble.For example, in recent years, the Federal Reserve'sinflationary monetary policy of

lower short-terminterest rates

and

lower reserve requirements

forcommercial lending has been met by similarlyinflationary policies of some other central bankswho, in order to support their respective exportsectors, have attempted to stem the dollar's naturaldepreciation in relation to their own currencies byaggressively purchasing US dollar-denominatedTreasury securities. The combination of these twoopposing state interventions has produced

lower-than-market interest rates

which, in turn, havecreated valuable incentives for households to

saveless

borrow more

, and

consume more

. To theextent that the value functions among householdershave remained relatively stable, we can be surethat tens of millions of people have indeed savedless, borrowed more, and consumed more thanthey would have if the central banks hadmaintained policy neutrality.At the same time, the central banks' inflationarymonetary policies have resulted in

lower-than-market costs of capital

for businesses, which havetherefore tended to

raise more equity

borrow moredebt

save more cash

, and

invest more in capital goods

than they otherwise would have in theabsence of these policies. We might also add homeconstruction to this category of investment, whoseproduction certainly seems to have increased as aresult of the lower-than-market mortgage ratesoffered to builders and homeowners and the higher-than-market prices in mortgage-backed securities.These lower-than-market costs of capital haveresulted in

higher-than-market rates of appreciation

By definition, everything thecentral bankers say and do isdesigned to produce prices inassets and other goods that are

different

from those that wouldhave resulted in the absence of thecentral bankers’ interventions.