Inflation’s macro myths

By Howard L. Simons
Is inflation one of those concepts you know when you see, much like the late Supreme Court Justice Potter Stewart’s definition of obscenity? Let’s hope not, because much of our instinctive reactions as traders and analysts depend on quick judgments whether the latest macroeconomic developments are likely to increase or decrease reported inflation. Worse, as all central banks have some measure of price stability as one of their stated objective functions, we live in a world in which policy must react to an absolute definition of inflation.

What, then, would transpire if we didn’t understand what inflation is, what causes it, or how we should address it from a policy standpoint? Despite a widespread consensus emerging from the monetarist economists over the years and gradually accepted elsewhere that inflation is nothing more than too much money chasing too few goods and services, these questions aren’t farfetched.

Breaking the banks
The principal reason is stunningly simple: The textbook explanations of money and banking simply don’t correspond to the real world of banking, notional finance, securitized lending, and global carry trades that has emerged since 1980. The simplistic Keynesian multipliers we were taught way back in Economics 101 — such as a 10-percent reserve requirement leading to a potential 1/(1-.1) or 9:1 monetary multiplier in a fractional reserve banking system — require an equally simplistic banking system.

In the 1950s and 60s, the Federal Reserve could affect the money supply by adding reserves to the banking system by purchasing Treasury securities for its own account or withdrawing reserves by selling Treasury securities from its own account. Because the banking system was the source of credit to businesses and households, changes in free reserves led to a change in lendable funds; this had a direct effect on macroeconomic activity.

All of that broke down during the 1980s. The elimination of Regulation Q interest-rate ceilings on time deposits in the early 1980s meant banks and savings & loans could pay more for their funds and direct credit to willing borrowers. Combined with developments in financial engineering and the growth of the notional finance or swap market, this led to the explosion in securitized lending and the transformation of banks from lending vessels to loan originators in the business of collecting fees. This model worked spectacularly well for a quarter-century — the U.S. had only two minor recessions between 1982 and 2007 — until it collapsed under the second bubble created by the Federal Reserve’s ill-considered policy of addressing every economic hiccup with ever-lower short-term interest rates.

For the complete article, see the April 2010 issue of Active Trader magazine. Click here to subscribe.



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