Download Speculative capitals and demand pull inflation below full

Speculative capitals and demand pull inflation below full employment
Angel Asensio
CEPN, University Paris 13
This draft, 22 October 2011
Abstract
In a series of papers published in The Time in 1937, while the rate of unemployment was
around 12% in the UK, Keynes expressed his concern with potential inflationary pressures
owing to the government proposal to finance rearmament partly by means of borrowed
money. The topic still was the central purpose in 1940 of his How to pay for the war: "Some
means must be found for withdrawing purchasing power of the market; or prices would rise
until the available goods are selling at figures which absorb the increased quantity of
expenditures – in other words the method of inflation." This suggests, in accordance with
Minsky's views, that a demand pull inflation may develop in Keynes's theory, in spite of
unemployment, as a result of an excess "purchasing power" due to the banking system
financing of expenditures that eventually prove unable to generate the revenues required for
the debt repayment and for the withdrawal of the related amounts of purchasing power. Based
on Keynes and Minsky arguments, the paper examines whether/how the financing of bad
debts on a large scale - instead of rearmament - is capable of moving inflationary forces from
asset markets (where they remained confined in the aftermath of the 2008 financial crisis) to
the whole economy, thereby triggering a demand pull inflationary process in spite of strong
unemployment.
1. Introduction
The asset prices recovered rapidly in the aftermath of the 2008 financial crisis, partly because
the Fed managed so that transactions could be made at increasing prices by providing the
financial sector with the huge amounts of money it demanded at very low interest rates, and
partly because authorities have been implementing the new prudential regulations rather
smoothly in Europe and the US, so that unbridled speculative finance seems not to have been
dissuaded severely. Hence, if one considers the recovery in the market valuation of assets
since the financial collapse of 2008, the rapid 2009-2010 recovery of most financial
institutions in developed countries (in comparison with the weakness of economic recovery)
and the rapid comeback of big profits, one is led to the conclusion that the unsustainable
trends of the pre crisis period have not been totally fought, which unfortunately is
corroborated by the threats that are still hanging on international finance in relation to the so
called "sovereign debt problem".1
1 The asset prices reflation mainly worked indirectly, but some central banks also have bought financial assets
directly: "The measure adopted by the ECB have lead to an increase in its balance sheet higher than 45%
between September 2008 and January 2009. These measures hitherto sought to increase the interbank market
liquidity while other central banks also sought to influence some financial assets prices (public or private)
through their purchases (Fed, Bank of England, Bank of Japan)." (translated from DGTPE, Lettre Trésor-Eco,
n°56, Avril 2009, p 1). The 2009 recovery in financial markets has been documented for example by the IMF
(Global Financial Stability Report, Market Uptdate, January 2010).
1
On the other hand, oil and raw material prices have been showing an increasing trend for
months, so that central banks and commentators have been watching out for a possible return
of inflation, although hitherto there was not significant signals of consumer price increases in
advanced countries. The international financial system furthermore is still fragile, so that one
may wonder whether the combined effects of higher financial uncertainty, of less optimistic
expectations with respect to the financial assets future returns and of the progressive impact of
the new regulations could divert significant amounts of speculative capitals from the financial
market. As, in this case, speculative capitals would seek for investment in real assets and
durables goods, this raises the question of whether the 'capital market inflation' could
propagate beyond the financial sector.2
According to The General Theory, inflation is rather expected to develop in conditions of
full employment, for, below full employment, prices increases are usually a short run byproduct of output increases in the presence of decreasing returns, which is not what Keynes
called 'true inflation'. Chick (1983) nevertheless pointed out that "there is nothing in [The
General Theory] which actually impedes understanding of the conjunction of unemployment
and inflation" (Chick 1983, p 280). And as a matter of fact, in a series of papers published in
The Times in 1937, while the rate of unemployment was around 12% in the UK, Keynes
expressed his concern with potential inflationary pressures owing to the government proposal
to finance rearmament partly by means of borrowed money. The topic still was the central
purpose in 1940 of his How to pay for the war: "Some means must be found for withdrawing
purchasing power of the market; or prices would rise until the available goods are selling at
figures which absorb the increased quantity of expenditures – in other words the method of
inflation." (CW, vol.9, p. 378).
This suggests that a demand pull inflation may develop in Keynes's theory, in spite of
unemployment, as a result of an excess "purchasing power" due to the banking system
financing of expenditures that eventually prove unable to generate the revenues required for
the debt repayment and for the withdrawal of the related amounts of purchasing power. Such
a kind of financing can be said to produce "excess money".3 The argument rejoins Hyman
Minsky views on the causes of inflation: "Inflation is, first of all, the result of financing too
many claims on the supply of consumer goods at the inherited prices. Any restriction on the
supply of consumer goods –such as occurs in wartime or as the result of a drought— or any
expansion of incomes that will be available to finance the demand for consumer goods,
without any concomitant increase in the supply, will lead to rising prices." (Minsky 1986, p
261)
2
"There is no doubt that investment in financial derivatives markets for agricultural commodities
increased strongly in the mid-2000s, but there is disagreement about the role of financial speculation
as a driver of agricultural commodity price increases and volatility. While analysts argue about
whether financial speculation has been a major factor, most agree that increased participation by noncommercial actors such as index funds, swap dealers and money managers in financial markets
probably acted to amplify short term price swings and could have contributed to the formation of price
bubbles in some situations. Against this background the extent to which financial speculation might be
a determinant of agricultural price volatility in the future is also subject to disagreement. It is clear
however that well functioning derivatives markets for agricultural commodities, could play a
significant role in reducing or smoothing price fluctuations – indeed, this is one of the primary
functions of commodity futures markets." ("Price Volatility in Food and Agricultural Markets: Policy
Responses", Policy report to G20 coordinated by the FAO and the OECD, June 2011, p 12)
3 Clearly, excess money here does not refer to an excess of the supply over the demand for money,
which would be inconsistent with the Post Keynesian approach to endogenous money.
2
This paper examines whether/how the financing of unproductive bad debts on a large scale
- instead of rearmament - is capable of moving inflationary forces from asset markets (where
they remained confined in the aftermath of the 2008 financial crisis) to the whole economy,
thereby triggering a demand pull inflationary process below full employment. It is argued that
enforced prudential regulation alone would not suffice. A demand pull inflation process
requires the supply of goods to be inelastic. Arguably this could happen because of the
combined effects of productive capacity destruction and of sluggish investment in the wake of
the economic depression.
Section 2 considers how the banking system was led to endogenously provide the economy
with an excess money by means of bad debts financing. Section 3 deals with the topic in the
formal term of an "equation of exchange" which captures the transactions on existing assets
besides the transactions in the current output. Section 4 discusses how excess money could
fuel inflation and section 5 considers the supply-side condition for a demand-pull inflationary
pressure being able to effectively degenerate into inflation below full employment.
2. Easy money, capital market inflation and the making of (endogenous) excess money
In a safe economic context, money quantity increases do finance income-generating projects
that enable future repayments and money withdrawing. In the current context however, large
amounts of money have been endogenously created which did not finance additional
economic growth but, instead, fed the housing and financial assets prices beyond sustainable
trends. Assets inflation is basically unsustainable when it rests on the illusion that assets will
deliver returns that they eventually will not deliver. As Minsky put forward, such a process
can hold for a while, insofar as authorities, by means of easy money, allow for the validation
of the extra profits attached to the optimistic valuation of assets. The value of assets suddenly
collapses, be it caused by an endogenous increase in the rate of interest (as suggested by
Minsky) or caused by a slump in the expected return on capital (as Keynes suggested), when
markets understand that assets will not deliver the optimistic return that was expected. After
the crisis, part of the money amounts that had refinanced unsustainable debts on the basis of
optimistic revenue expectations still circulates, since the full repayment of debts proves to be
impossible, so that the related money withdrawal which should have occurred in safe financial
circumstances did not operate eventually, or operated only partially through the forced
liquidation of assets of excessively indebted agents .
Authorities also have pumped huge amounts of high-powered money in exchange of bad
debts when they rescued the financial system. Banks therefore have accumulated lots of
reserves at low cost. Although authorities claim that they are withdrawing all the excess
liquidity without trouble, there is some doubt left, for most of this liquidity has been pumped
in exchange of public debts that governments will hardly be able to repay completely before
long, due to the sovereign debt turmoil. Furthermore, even if all the public debts could easily
be sold, the pumped high-powered money nevertheless has operated as an indirect massive
validation of private bad debts, since it allowed the whole financial system to continue pricing
much of them, although at a lower value. As a matter of consequence, banks did not register
the full sanction of the pre-crisis easy money policy, and, although the high powered money
did not produce any mechanistic "multiplier" effect on the money quantity, since it has been
largely hoarded by banks, it has worked as an a posteriori validating process, by which more
money remains circulating than the amount that should be circulating if the private debts had
been totally repaid. The outcome is an excess purchasing power in the economy.
3
Keynes (1940) dealt with such an excess money, though in the specific context of WWII.
As quoted in the introduction above, his focus was on the excess purchasing power induced
by the money earnings distributed to workers that produced arms instead of commodities. He
was then seriously concerned with the problem of potential inflation. In a context much closer
to the current situation, Minsky (1986) pointed out the inflationary pressures owed to the huge
amounts of liquidities that must be pumped into the capitalist system in order to avoid or get
out of a great depression.4
"Historically, an extremely robust financial system, dominated by hedge finance
and with a surfeit of liquid assets in portfolio, is created in the aftermath of either
a wave or a traumatic debt deflation and deep depression. Experience since the
mid-1960s shows that massive government deficits and Federal Reserve lenderof-last-resort intervention increase the robustness the financial system. That is, in
the modern economy the job that was done by deep depressions can be
accomplished without the economy going through the trauma of debt deflation
and deep depression. However, the government deficit and lender of last resort
interventions that abort the consequences of fragile financial structures lead in
time to inflation. Inflation enables firms, households, and financial institutions to
fulfill commitments denominated in dollars that they could not fulfill at stable
prices." (Minsky 1986, p 215)
In recent years, oil and raw materials prices shown somewhat increasing trends, with the
result that central banks and commentators have been watching out for a possible return of
inflation.5 Yet sustained inflation has not been observed hitherto in the developed countries
severely damaged by the 2008 financial crisis. Inflationary signals furthermore seem to have
been concentrating mainly in emerging countries like Brazil, India and China, which
recovered quite rapidly after the world financial collapse, while there was no significant
signals of consumer price increases in the U.S.A, nor in Europe, excepted maybe in the UK
(but no long-term price increases were still expected according to BOE's June 2011 Quarterly
Bulletin). Several reasons can be put forward. First, part of the excess money has been
absorbed by an increase in the liquidity preference and money holding, owed to the fear
triggered by the financial collapse. A second powerful factor is that money owners promptly
returned to the still lightly-regulated capital markets, thereby fueling asset-prices inflation
again, although to a lesser extent.6
But, when the cleaned up financial system regains the public confidence (maybe after
another financial collapse, given the sovereign debt problem), so that the excess money no
longer is absorbed by the above provisional effects, holders should seek to substitute real
assets and goods for money and for less attractive financial assets, which could trigger
4 According to Keynes's How to pay for the war, the excess purchasing power that had resulted from
financing rearmament could be withdrawn without harming employment, while Minsky looks more
defeatist, as he was mainly concerned with structurally fragile financial systems and the necessity of
validating bad debts to avoid severe instability.
5 "Overall, inflation risks have been driven up by the combination of dwindling economic slack and
increases in the prices of food, energy and other commodities." (BIS, annual report 2011, p xii).
6 Another reason is that part of the excess money flowed outside the U.S.A, as a result of international
payments and exchange rate management, notably to China where, owing to inflationary pressures, the
central bank adopted a restrictive policy.
4
inflationary pressures beyond capital markets (not necessarily inflation, as restrictive policies
might seek to repress them).
3. Capital market inflation and the flow supply price of goods in the right equation of
exchange
The story above can be stated formally by means of the "equation of exchange", provided the
definition of the transactions does not overlook the stock of existing goods and assets
(variable A), besides the flow supply of goods and services (variable Q):7
MV=PT=PQQ+PAA
Remark. V is not the income-velocity of money, since it does not apply to the sole
aggregate income, but to both the flow supply of goods and the value of the stock of
durables goods and assets.8
It is obvious, according to the duly extended equation of exchange, that it is possible for an
increase of the money quantity to go far beyond the speed of nominal income (PQQ), even
with a constant "wealth-velocity" of money, provided the money value of assets (PAA) is
allowed to increase accordingly.
It is also possible to see why the flow supply price (PQ) did not raise strongly in spite of the
collapse of financial markets (decrease in PAA) and of the recession (decrease in Q). The
reason is the strong decrease in the "wealth-velocity" of money owed to increased uncertainty
and liquidity preference. It is straightforward to see, as the quantity of money is equal to PT/V
and is also equal to the money demand, that PT/V is equal to the money demand, which
according to Keynes theory depends on the terms L1 and L2:
M = PT/V  PT/V = L1(PQQ) + L2(r)
Hence, the "wealth-velocity" of money is a function of the liquidity preference function L2.
V = PT/[L1(PQQ)+L2(r)]
7 When PT is assimilated to PQQ, it is implicitly assumed that money only serves to buy the flowsupply of goods, a very unrealistic –though usual- assumption.
8 "(... ) for the income-velocity of money merely measures what proportion of their incomes the
public chooses to hold in cash, so that an increased income-velocity of money may be a symptom of a
decreased liquidity-preference. It is not the same thing, however, since it is in respect of his stock of
accumulated savings, rather than of his income, that the individual can exercise his choice between
liquidity and illiquidity. And, anyhow, the term 'income-velocity of money' carries with it the
misleading suggestion of a presumption in favour of the demand for money as a whole being
proportional, or having some determinate relation, to income, whereas this presumption should apply,
as we shall see, only to a portion of the public's cash holdings; with the result that it overlooks the part
played by the rate of interest." (Keynes, 1936, p 194).
5
As a matter of consequence, a positive shift of L2 (given the rate of interest), that is an
increase in the liquidity preference aimed at preserving savings from increased uncertainty,
produces a decrease in V.
But when the depression ends and the economy is stabilized or starts recovering, which
supposes that the financial system has regained the public confidence, the liquidity preference
normally returns towards the pre-crisis level (though maybe to a higher level because of the
lasting difficulties the crisis has generated), while the transaction motive adjusts to the
depressed level of the economic activity. Hence, assuming that V and Q are not much higher
than their pre-crisis level, while PAA is substantially lower, the equation of exchange yields
an increase in the price of the flow-supply of goods. Of course, capital market inflation might
continue absorbing excess money for a while, but a transmission to the good markets is a
possible outcome, especially if the enforcement of the prudential regulation get to reduce the
market valuation of assets strongly enough for speculative capitals becoming less attracted by
the financial assets.
4. How (endogenous) excess money could fuel inflation
The possibility for the money quantity to have a positive effect on prices is not inimical to
Keynes's views on inflation in The General Theory:
"The view that any increase in the quantity of money is inflationary (unless we
mean by inflationary merely that prices are rising) is bound up with the
underlying assumption of the classical theory that we are always in a condition
where a reduction in the real rewards of the factors of production will lead to a
curtailment in their supply" (Keynes 1936, p. 304).
There are many things in this quotation, but let us emphasize two ideas comprised in the first
part of the sentence (before "is bound up..."): i) the quantity of money does affect the price of
goods and ii) an increase in the quantity of money may increase the price of goods without
being inflationary, which also means that, conversely, inflation may (although it need not) be
caused by an (excess) increase in the quantity of money.
Regarding the difference between inflation and rising prices, it is well known that
increasing prices of goods and services are the normal consequences of any increase in
aggregate demand and output under conditions of decreasing factor productivity (in the short
run). It goes along with a decrease of the real factors costs, provided the factors rewards are
not increased simultaneously in the same proportion. This, according to Keynes, is not true
inflation. True inflation starts when workers would curtail their supply of labour if the prices
increase was not compensated by a proportional increase in wages. As workers are more
likely to be able to impose wage indexation when the economy is working at full
employment, for the wage increase must compensate for inflation if entrepreneurs do not want
to suffer a curtailment in their labour force, it is rather in such a context that Post Keynesians
usually consider the possibility that a demand-pull inflation process becomes 'true inflation'.9
9 'When a further increase in the quantity of effective demand produces no further increase in output
and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective
demand, we have reached a condition which might be appropriately designated as one of true
inflation.' (Keynes, 1936, p 303).
6
Minsky nevertheless argued that "open inflation" had been triggered below full
employment during the late 1960s, 1970s and early 1980s as "defensive or institutionalized
reactions to profit generating government deficits that result in rising markups and price
increases during recessions" (Minsky 1986, p 261). Actually, according to the Post Keynesian
literature, inflation may develop before full employment as a result of a conflict over the
distribution of income or of an increase in the price of imported resources like oil (Davidson
1994, p 143).10
Interestingly, Minsky insisted on the role of finance in allowing for the income distribution
conflict to degenerate in inflation. 'Open inflation' occurs "when markets conditions are
conducive to rising money wages". When increases in money wages are financed, the result is
"too many claims on the supply of consumer goods" at inherited prices.11 This emphasizes
that inflation results from the conflict of financed claims over consumer goods. Inflation
therefore means that money has been endogenously supplied which allowed firms to pay
higher nominal rewards to the previously hired factors instead of financing more factors and
additional output capacity.12 In Minsky's words, "this view is in sharp contrast to the simple
assertions that inflation is everywhere a monetary phenomenon, or is caused by government,
or is the result of wage increases exceeding productivity increases. Both monetary and the
wage productivity phenomena occur in observed inflations; both are parts of the inflation
process, but they are neither the originating nor the entire mechanism. Furthermore,
controlling the money supply or money wages only addresses symptoms, not causes, of the
inflation disease." (Minsky 1986,p 265-66].
Regarding now the causes of demand pull inflation, it is worth noticing that, as a
consequence of endogenous money, the causal relationship between the effective demand and
the money supply is reversed in the Post Keynesian approach, as compared with the
monetarist approach:
"In our economy, the causal chain that leads to inflation starts with rising investment
or government spending, which leads to increases in markups; an increase in the
money supply or in money velocity is associated with the rise in investment or
government spending. Investment demand rests upon the availability of financing.
As the supply of financing through banks is responsive to demand, the money supply
changes to accommodate the activities that determine the demand for financing."
(Minsky 1986, p 256)
10 An increase in the price of import also is a mark of income distribution (international) conflict, and,
as far as taxes take part of the production cost, inflation can also be related to a private/public conflict
over the distribution of income.
11 "Money wage increases negotiated in collective bargaining can be realized only if the increase is
financed." (Minsky 1986, p 282)
12 It transpires that 'inflation in the flow-supply prices of producibles is everywhere and always a rise
in somebody's income' (Davidson 1994, p 143), so that there is a cost side in any demand-pull inflation
story, since an initial demand stimulus, provided it is accommodated by banks, goes along with a more
intensive use and demand for labour and capital, which offers opportunities for increasing the rewards
of such and such category (depending on their relative power). But there is also a demand side in any
cost-push inflationary process, for an initial cost push can hardly lead to an inflationary process if
monetary authorities aim at repressing it by means of a restrictive policy that depresses the effective
demand. Whatever the initial cause is a cost push or a demand pull, both the costs and the effective
demand are necessarily involved, as well as the distributive conflict.
7
Hence the causal relation is:
demand expansion --> money accommodation --> rising prices or inflation
instead of
money supply --> demand expansion --> inflation
Some additional arguments might be necessary here, for increased demand does not
produce true inflation necessarily, even at full employment. Indeed, as far as wages increase
along with the productivity gains and the normal repayment of inherited debts is assured,
firms do not need prices increase to validate debts. Things turn out difficult when the financed
investments do not deliver enough revenues in time as to repay the debts. In this case, firms
cannot but validate their debts by means of inflation, provided monetary authorities do not
counter them.13 According to this Minskyan approach, the Fed's increasing interest rate
policy stopped the validation of private debts which led to the 2007-2008 crisis.
"Furthermore, if an economy with a sizeable body of speculative financial units is
in an inflationary state, and the authorities attempt to exorcise inflation by
monetary constraint, then speculative units will become Ponzi units and the net
worth of previously Ponzi units will quickly evaporate. Consequently, units with
cash flow shortfalls will be forced to try to make position by selling out position.
This is likely to lead to a collapse of asset values." (Minsky 1992, p 8)
Since part of the bad debts therefore turned out unrecoverable, amounts of money
remained circulating which would have been withdrawn in a safe financial context. Asset
prices recovered subsequently, for the support authorities provided to the financial sector
encouraged capitals to stay in financial markets, but it costed a severe downgrading of public
finances and of central bank balance sheets, since they absorbed parts of the bad assets. The
worsening of sovereign debt problems in the mid of 2011 and the Dexia episode showed that
difficulties only had been transformed: the rise of public debts, which were directly and
indirectly caused by the crisis, led private institutions to hold public debts the rating of which
gradually worsened. Banks rating then downgraded and market anxiety grew, so that the
capacity of capital markets to continue absorbing excess money still was questionable.
5. Looking at the supply side
So far, we have identified a kind of demand-pull "mechanism" which can transmit inflation
from assets to the flow-supply price of goods, and thereby to the whole economy. A further
condition however is required for the mechanism to become effective below full employment.
The condition lies in the supply side of the goods market, for demand expansion cannot
degenerate into inflation when aggregate supply is amenable to the production of the
demanded goods at current prices. This brings back to the problem Keynes (1930) dealt with
13 "Inflation, which increases nominal cash flows, can become a policy instrument to validate debt."
(Minsky 1986, p. 170).
8
in terms of commodity or capital inflation, when spot prices increase relative to flow-supply
prices14. In normal circumstances, such a discrepancy between spot and flow-supply prices
sends a signal to producers in such a way that the production is reduced when the spot prices
are below the flow-supply prices (a contango), while it is increased in the reverse case
(backwardation). In both cases, the spot price eventually rejoins the flow-supply price, so that
only temporary capital inflation/deflation arises, but as Davidson (1994, p. 143) suggested,
though he did not discuss the possible reason, spot price "can affect [...] changes in flowsupply prices" and thereby produce what Keynes called 'income inflation'.
A reason why, in the current context, the normal process of backwardation might fail and
eventually induce an increase in the flow-supply prices is that, if/when speculative capitals are
diverted from financial markets and look for higher returns in durables, raw material and other
speculative goods, producers of these goods will hardly be able to provide within normal
delays the amounts that would be necessary to absorb the additional purchasing power at
current supply prices. Indeed the corresponding capacity of production did never exist, since
much money fed the demand for housing and financial assets, not the demand for a flowsupply of goods.15 Therefore, expectations of future increases of the flow-supply prices are
likely to feed precautionary and speculative demand in the spot markets, all the more since the
combined effects of productive capacity destruction and sluggish investment in the wake of
the economic depression are likely to make things even worse.16
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14 See Davidson 1994, p. 142
15 M. Hayes (2006, p 211-213) also suggests a "theoretical link between the quantity of money and
the price-level of output, via liquidity-preference and the liquid capital-goods employed in production,
which does not assume full employment". According to the author, "[...] stocks of liquid capital-goods
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10