Where Oh Where Is the Excess Demand Going?
How is it that people can think that an excess supply of money can show up as an excess demand for financial assets–and thus produce large losses on leveraged portfolios and thus a financial crisis when it unwinds–without also showing up as an excess demand for currently-produced goods and services–and thus as inflation? That is the question that perplexes Paul Krugman as he tries to decode the thought of John Taylor and the BIS financial-stabilistas. It perplexes me too:
…I wonder whether it’s making the issue more complex than it needs to be…. The financial stability group… are all permahawks. Taylor and the BIS have often argued that money is too loose; have they ever, at least in the past two decades, argued that it is too tight?… But if monetary policy is too expansionary on a sustained basis, surely we expect to see accelerating inflation. And there have in fact been repeated warnings from this group that inflation is about to take off. But what we see instead is this:
You might expect some rethinking, given this absence of inflationary trouble to materialize. But the only rethinking that seems to happen is a search for new reasons to make the same complaints about loose money….
[And] if it’s really that easy for monetary errors to endanger financial stability — if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history — this is an overwhelming argument for draconian bank regulation…. Strange to say, however, I don’t seem to be hearing that from Taylor or anyone else in that camp. It’s all very odd stuff…
Originally, at least, the inflationistas and the financial-stabilistas were the same people, and had a coherent–but wrong–argument. The argument went roughly like this:
- The upshot of Federal Reserve policy–its current low interest rate policy, its extended guidance promises of very low interest rates far into the future, and quantitative easing–as been to over-liquify the economy: too much money in the hands of people.
- As a result we are about to have an outburst of inflation: the excess supply of money in the hands of the risk-loving will produce an excess demand for goods and services and then an excess demand for labor.
- Thus inflation will set in, and compound itself as inflation expectations lose their anchor.
- Too many of the people who now have the too-much money benefit from strongly-convex compensation structures: if asset prices go up, they gain fortunes; if asset prices go down, they declare bankruptcy and start over.
- Thus at the same time as inflation gathers force, those with too-much money will leverage up and pay too much for speculative financial assets. Positive-feedback trading will then set, so an asset price boom produced by supply-and-demand will turn into a bubble driven by extrapolative expectations.
- Central banks will then have to control inflation by raising interest rates to cool off aggregate demand. That negative shock will pop the bubble.
- And whenever the bubble pops and the crash comes, the resulting chain of bankruptcies and workouts will produce another, deeper depression.
The problem for this line of argument, of course, is that (2) never happened, so (3) never happened, so there will be no need for (6), and (7) will never come to pass.
And if there is no (2)–no excess supply of money spilling over into an excess demand for goods and causing inflation–why should there be a (4)? Why should there be an excess supply of money spilling over into an excess demand for financial assets pushing their prices up above sustainable levels?
This is a question that is, I think, still unanswered by John Taylor, or the BIS, or anyone greatly worrying about financial stability–let alone those greatly worrying about financial stability who also want to repeal Dodd-Frank.