No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 284 good of the 4th order (as well as fertilizer and other inputs). Every higher order good has a price, and there are far more market purchases of goods in work than final finished goods in the economy. Retail sales are less than one-third of overall spending in the U.S. economy, so producer prices are very important in understanding the nature of inflation. We can think of consumer goods as retail goods, with wholesale goods a higher order good, goods-in-work still higher, and raw materials the highest order good. With this understanding of our structure of production, it should be clear that an exclusive focus on consumer prices is not only incomplete, but misleading as an indicator of monetary policy. In our banking system, most new loans (which create the new money) are not going to be for final consumer goods, but to invest in earlier stages of production. You would expect to see inflation first manifest itself in raw materials, then goods in work, then other producer goods, and only finally in consumer prices. Further, and what may not be clear, the bidding up of higher order goods will increase the profitability of the firms that produce those goods. This will result in a rise in the price of the stocks of the companies that produce those goods—investors always are quick to reallocate their scarce investment dollars to the highest possible reward. The increase in stock and other financial assets is simply called asset inflation when caused by monetary forces. Asset inflation can be more direct as well; the banks can use reserves provided by the Fed to loan money directly for asset investments (such as the stock market) with the asset as collateral. With the proliferation of hedge funds and other sophisticated financial actors, it is insufficient to consider traditional banking as the only source of inflation. Unfortunately, people seem to like asset inflation unlike consumer inflation, since they feel wealthier when assets they own go up in price. Asset GOOD DEFLATION VS. BAD DEFLATION One of the greatest problems in contemporary monetary policy is the failure to distinguish between “good” and “bad” deflation; most economists and financial market participants consider all deflation as bad. Yet, don’t we like it when prices go down? Why isn’t that good? Former Fed Chairman Ben Bernanke is at the head of the “all deflation is bad” class. He has given speeches saying not to worry about deflation since he has the printing press a nd stands ready to print our way out of any problem. As a student of the Great Depression, he fully understands the deflationary problems associated with financial system collapse. Bernanke rightly fears the “bad” deflation associated with a collapse in the money supply; yet this is not the only kind of deflation. Rather than an aggregate demand collapse, overall productivity gains can lead to an aggregate supply expansion and reduce prices. This is “good” deflation as workers are able to produce more and more product for cheaper prices. Consumer prices go down, yet profitability stays high. This is the case for many industries (such as the computer industry) and for the economy as a whole during the initial part of the industrial revolution. In the 1990s and 2000s, the Soviet Union fell, China emerged as a major supplier of low cost labor, and computer-led productivity was rapidly increasing. In that environment, it seems that consumer prices should have been declining with a “good” deflation rather than rising at low rates. Yet the Fed fretted and worried and kept an easy monetary policy. But that had nothing to do with a stock market bubble or the real estate bubble...naahh. Couldn’t have. Asset inflation: a general rise in prices of financial assets including stocks, bonds, and commodities as a result of expansionary monetary policy.