Wednesday, May 23, 2007

Income Distribution and Monetary Policy

One of the key aspects of economic policy that is only rarely discussed (and then usually with respect to highly charged racial issues such as bank redlining) is access to credit. The reason this issue is important is that the key assumptions that economists use with respect to the effects of credit expansion and inflation do not contemplate the effects of asymmetric access to credit. Economists assume that when the Fed makes credit available, it becomes available symmetrically throughout the economy. Of course, this is not true. Some people have easier access to credit, and it is they whom credit expansion benefits. Since it is generally the wealthy who have first and best access to credit, it is they who benefit. This has occurred in recent years through increases in real estate and stock market values, both due to low interest rates. Ultimately, though, the credit expansion cannot continue to prop up asset price increases. The reason is that even with access to the credit, the prices have become too high. The asset price inflation will spill over to commodity and then general inflation. As Howard S. Katz has pointed out, credit expansion creates a commodity pendulum. The pendulum works like a cobweb model in labor economics. Mining companies get easy access to credit, just like other firms. The easy credit causes more mines' opening. The increased mining activity due to low interest loans causes, in the short term, declines in commodity prices, as occurred in the 1990s. That's because the supply of commodities increases because of the increased mining. The declining prices because of increased supply cause closures of mines. The mines close just as commodity prices bottom. Over time, though, the credit expansion causes demand for commodities to increase, but this happens more slowly than the mines' opening. Increased demand for commodities and increasing commodity prices comes just as the mines close. Commodity prices start to rise just as the mines have closed. The closures coincide with an acceleration of the price increases. This intensifies the commodity price increases. The commodity price increases circulate through the economy, causing general inflation. The idea of "wage-push" inflation is chimerical. Workers' wages have been stagnant while stock market returns have accelerated. Inflation cannot be due to wages; it is due to increased commodity demand, ultimately due to credit expansion.

When the Fed or other countries' central banks create new money, they do so by retiring government debt that commercial banks hold. The liquidity created to retire the debt is then lent to firms and individuals on the basis of a multiplier, the required reserve ratio. When banks receive a dollar in new reserves from the Fed, they create five or six times that amount through loans. The way basic economics books used to describe this process is that the "banking system" creates the money rather than individual banks, but that is an absurd turn of phrase that deliberately obfuscates the reality: if the banking system creates the money, then individual banks are creating the money.

The key policy issue respecting the expansion of credit is who gets access to the new money. The new money amounts to food stamps that are being loaned at artificially low interest rates. The reason the rates are artificially low is that potential demand has been expanded throughout the economy, but prices have not yet been driven up by the demand. It is the same idea as counterfeiting. Counterfeiting is illegal because by increasing the amount of money in circulation, the counterfeiter takes something for nothing. If the counterfeit money were to stay in circulation, prices would rise.

The timing of access to credit determines who benefits from credit expansion. Those who work in fields that expand in the short run, such as construction, are likely to benefit. That may explain why the AFL-CIO has become a pro-inflationist force. In the early 19th century the workingmen's parties that appeared around the time of Andrew Jackson were anti-inflationist. In contrast, organized labor today tends to be pro-inflationist, even if the majority of members oppose inflation. This resulted in the "Reagan Democrats" of the early 1980s. The leadership of select unions, such as construction unions, probably supported inflation, while the rank-and-file in unrelated areas opposed inflation. The result was a rupture of the labor movement from which it has not recovered. Perhaps the labor movement has made a mistake in emphasizing the interests of its pro-inflation segment instead of representing the anti-inflation interests of the majority of the working population.

The chief beneficiaries of inflation have traditionally been the rich. This occurs because corporations expand with easy credit, and profit from it. Low interest rates (resulting in long term inflation) cause the stock market to rise; high interest rates (reducing inflation) cause the stock market to decline. Most stock ownership is by the wealthy. Therefore, the wealthy have a special interest in easy credit, i.e., inflation. There are several factors also at play. Hedge fund operators can borrow money at low rates and thereby purchase companies whose earnings can be slightly improved by exchanging bonds for stock (the reason is that interest is tax deductible). This increases the risk of the capital structure and may not be in owners' long term interests because the risk of bankrupticy is increased through increased borrowing. However, the hedge fund managers are often not concerned about long term risk because they re-sell the firms at a profit. The hedge fund manager profits in the short run but the risk to long term owners (along with greater profit) results. In addition, the hedge funds have borrowed at extremely low interest rates from which it is easy to profit. Therefore, it is easy to make money even if their deals aren't clever. Thus, quite a few hedge fund managers have been making $250 million per year recently even though the economy has not been particularly innovative since the 1990s.

Because of stock price increases; access to easy credit by hedge fund managers and investors; and low interest loans to corporations, the chief beneficiaires of monetary expansion are the wealthy. Interestingly, though, the "economists" who dominate our universities treat credit or monetary expansion and income inequality as two separate issues. They argue that the Fed increases in the money supply are necessary to stimulate aggregate demand; and that the money flows evenly throughout the economy, so that the effects of inflation are uniform. Of course, some do not invest their own money under such assumptions. For example, Harvard University's trust fund has been investing in commodities for the past few years with ample success.

There are two factors about the Greenspan credit expansion that are different from past credit expansions. First, financial institutions have broadened access to credit so that the poor and middle class have had significantly greater stake in the counterfeiting. This was done through the sub-prime lending that has received so much press and through increased access to real estate loans. This was done by banks' loosening the standards for mortgages. As Elizabeth Warren and Amelia Warren Tyagi point out in their book The Two Income Trap the chief cause for bankruptcy and financial ruin among the middle class has been too-high loans to income. These loans have created a high degree of risk (perhaps parallel to the risk that hedge fund managers create by increasing corporate debt) and have pushed up real estate prices in select markets, especially those near "good" elementary schools and in prestigious neighborhoods. The result is that more people work (two-wage earner couples are the norm now) but fewer have any savings. This has also likely pushed down wages for the middle class because the supply of labor has expanded (with two wage earners per family unit rather than one), with the result that average wages have remained stagnant because of increased labor supply. This also has the result that if one of the couple loses their job, the house is lost and the equity that they've put into it has been lost.

The second factor that is different is the large holding of US treasury bonds by China, Japan and other central banks. It has never before been true that central banks in foreign countries have been willing to subsidize the consumption of a client country. Americans have been eager to consume more than they produce. However, this will not sustain itself indefinitely. Chinese and Japanese workers work at artificially low wages to subsidize American consumption. Wal-Mart should not be blamed for this phenomenon. This amounts to an inflationary policy on the part of the Chinese and Japanese, who are sacrificing their workers' welfare to expand demand for employees at low wages. For how long will these countries be willing to add to their trillion dollar holdings of US treasury bonds that erode in value as the dollar declines? Should they decide to sell, the dollar will weaken further (it is already low) and inflation will result.

It is truly a compliment to the massive indifference to the poor and working class of liberal academics, such as Paul Krugman, social critics and Democrats, that they claim that government regulation and tax policy are the reason behind increasing income inequality. Liberal economists spend their time trying to define away inflation. For example, they claim that food and gasoline should not be part of inflation or that house prices should not be considered. The ultimate triumph of liberalism is development of measures of inflation that apply to homeless bulimic hitchhikers. It is a testimony to the cynicism or incompetence of the mass media that questions have not been raised about the nation's money and the far-fetched nature of an inflation measure that excludes the poor. People who have developed nonsense measures such as "core inflation" claim that they are concerned about the poor, whose income largely goes toward food. They do not discuss the implications of monetary and credit expansion for the poor and instead blame trade and tax policies for the increasing percentage of wealth that is attributed to the ultra-wealthy.

Despite the frequent chatter about tax and trade influences on income inequality, economists studiously avoid studying how credit is made available to the public. To what degree do the ultra wealthy (e.g., via ownership of stock) have access to credit compared to people of average means? What percentage of new reserves create loans that go to the wealthy? How does credit expansion influence the stock market returns? What percentage of stock price increases are due to credit expansion, and what percentage due to increased productivity and improved strategy? How does the new accessibility of credit to homeowners and the poor affect the distribution of wealth? What will be the effects on the distribution of wealth were stock and real estate prices to fall? Why aren't these questions being asked publicly?

No comments: