Inflation as Loss Function

Banks create money and then lend it to borrowers. The quality of projects that banks select will cause inflation, stable prices or deflation. The best quality projects would cause productivity to exceed the amount of money created, and so monetary expansion to be deflationary. If projects that banks select just equal the average quality of economic productivity then there will be neither deflation nor inflation. If banks consistently choose projects that are inferior to the average project with respect to productivity then there will be inflation.

This suggests that inflation can be viewed as a quality loss function (see discussion in Taguchi). The target loss should be negative. Economically, diminishing marginal productivity suggests that as more money is created losses will be greater. However, if banks are competently run and have adequate quality processes with respect to project selection, they can offer loans to projects and sustain zero inflation.

The management of banks becomes a critical problem to economic welfare if the banks themselves lack quality management capacity to select loans. This has been the case. It is impossible for outsiders to design quality processes that will improve loan selection because this depends on identification of borrower and project characteristics that are only known to lenders.

There is no literature on selection of entrepreneurial risk by lenders. This is not a topic that academics have treated and it is not a topic that bankers have carefully considered.

As a result of the absence of quality processes in making loans, the financial system has failed to make loans effectively. The current financial process results from quality losses, i.e., the Taguchi loss function among banks is large and so results in bad loans. Consistent inflation since the establishment of the Fed suggests that banks have failed to develop competent quality processes in lending.

Anecdotal evidence suggests that banks have consistently made loans based on incompetent criteria: to large institutions who cannot make good use of the funds; to firms with close connections to the banks and to firms engage in activities that loans other banks are making. This mimetic pattern suggests a financial system that is, in Deming's terms, "out of control". A competently run banking system would permit economic expansion coupled with stable prices.

The banking system requires restructuring to facilitate adoption of competent, quality driven practices with respect to lending. Banks must become competitive. Banks which fail to produce loans that generate net gains to society (i.e., deflationary loans) should be refused access to Federal Reserve bank credit.