“Though a house, therefore, may yield a revenue to its proprietor, and thereby serve in the function of a capital to him, it cannot yield any to the public, nor serve in the function of a capital to it, and the revenue of the whole body of the people can never be in the smallest degree increased by it.”
During the so called “Great Moderation” before 2007, we thought we had monetary policy nailed down. In the UK, an independent group of experts got together periodically to decide whether to raise or lower interest rates, dampen down or stimulate the economy. The dial on the dash board being observed was inflation, with an occasional glance at growth and unemployment. The lever being moved was the base interest rate. However, the most convincing analysis I have read regarding the 2008 crisis, is that private credit creation was the driver of the boom, and the bust. This is the central argument of Adair Turner's highly recommended book: “Between Debt and the Devil”. Although private credit growth was neglected by economists and governments as an issue, the targeting of inflation by authorities, kind of by proxy, had previously helped to restrain private credit growth. In the past, a growth in inflation was a reliable by product of the growth of new money generated by private credit, so therefore brakes were applied fairly effectively at roughly the right point in the business cycle, choking off the fractional reserve money creating machine during booms. In this roundabout way, the MPC could have in theory governed private credit generated money creation.
“The pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (the interest rate) produced an economic disaster.”
But, as Adair Tuner explains, there is a trend in developed economies for a higher and higher proportion of newly created money to be absorbed into real estate and other existing assets. This can partly explain why before 2007, the growth of money creation did not feed into general inflation … and therefore explain also why pre 2007 it did not trigger the monetary systems existing braking mechanism. If newly created money goes into existing assets, no more goods or services are being produced. The money is absorbed into increasing the price of existing assets, not the resource eating processes of of building new assets, which may then also be productive on going. Imagine every house in London which has recently changed hands, as a hole which money will disappear into, a crack in the waterproof pond of the economy, and it is easy to visualize why the water-level of inflation is not budging.
“At the core of macroeconomic instability in modern economies lies the interaction between the limitless capacity of unconstrained private banking and shadow banking systems to create credit, money and purchasing power, and the inelastic supply and rising demand for locationally specific urban land.”
Furthermore the nature of modern industry investment is changing. There are in our times less large scale production facilities being invested in. The costs for businesses to start-up or expand their activity is reducing, as cheap software and platforms plummet the price of outsourcing and coordination. The result is that while once much of the money created by banks filtered through into inflationary spending, now this is less the case. Newly created money can, to a large extent, quietly seep into specific isolated areas, without spilling out into the wider economy as extra aggregate demand.
“These falling rates of capital investment may in turn be explained by the falling cost of capital equipment goods relative to current goods and services, down 33% from 1990 to 2014, according to IMF figures. In many business sectors, each dollar of investment spent is increasingly buying “more bang per buck” as the dramatic progress of information technology drivers down hardware and software prices. The result is the phenomenon of massive wealth creation from minimal investment.”
Another problem with this changing monetary environment is that, as the Swede's found a tactical raising of the base rate by a few percent may well tip the balance on the modest business returns of proper investment, but can be quite impotent against a raging modern real estate bubble in full swing. Raising the base rate can restrain the businessman hoping to make a 5% return on capital, but not the real estate buyer whose assets are rising much faster.
“If households or commercial real estate developers expect that real estate prices will increase over the medium-term by, say, 15% per year, varying the policy interest rates by a few percentage points is unlikely rapidly to change behaviour … Between 2011 and 2013, for instance, the Swedish Riksbank attempted to slow the Stockholm credit and property boom by raising interest rates despite inflation being below target: the boom continued, but the Swedish growth slowed and inflation turned negative. The policy was abandoned in 2014.”
Given this scenario, Turner argues that other monetary policy levers are required, which have the potential to discriminate between productive and existing asset investment.
“Thus while the pre-crisis orthodoxy believed that one of the great merits of relying on interest rates was their neutral impact on the allocation of credit, in the face of multiple private expectations of return, that neutrality is a serious disadvantage.”
Many are relieved that QE and the like have not resulted in general price inflation, but that lack of inflation could also be seen as a sign of a new impotence in the link between contemporary monetary policy and the real economy, in a largely post-industrial / low capital costs / real estate obsessed economy.