Tuesday, July 17, 2007

Inflation - Different Schools of Thought

Inflation, as most people generally interpret it, is "a persistent rise in the general price level, as measured against a standard level of purchasing power." This is currently the way that inflation is measured in North America and subsequent attempts on controlling it are based on these measurements. In Canada, when referring to inflation, we reference CPI, or Consumer Price Inflation. The Bank of Canada attempts to keep CPI in a range of between 2% and 3% through controlling the overnight lending rate or "prime rate" and this policy meets with some success.

"Mainstream economists' views of the causes of inflation can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest and output dominate over other effects. Keynesians also tend to add a capital goods (or asset) price inflation to the standard measure of consumption goods inflation. Other theories, such as those of the Austrian school of economics, believe that inflation is caused by an increase in the supply of money by central banking authorities."

The thought I wanted to put forward today is this: What if the current Keynesian view and approach is faulty? What if inflation is more accurately termed as the Austrian school view it as an increase in the supply of money by central banking authorities? If this is true, what would we observe?


To illustrate I've put together a chart comparing recent Consumer Price Inflation with the Bank of Canada M3 total Money Supply. The question I have is: Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?

28 comments:

mohican said...

If the Austrian school's interpretation of inflation is correct then I believe that we would observe rapidly rising asset prices as money, once it is created, finds a place to rest through the purchase of assets such as stocks, real estate, or other monetary stores of value.

Paly said...

"Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?"

Your question is misleading by interpreting money having some value in and off itself. As you may learn in Econ 101, money does not have any value in and of itself. Money is the oil in the engine of the economy. It only has value in that people use it to exchange goods and services. If I give you a million dollars and place you in the middle of the forest, how much is that money really worth to you? It's good kindling. However, if I give you that money in a city, it becomes much more valuable.

Monetary policy affects economies only as much as they have interactions with one another. Furthermore, the interaction between the two must have a set of values assigned each other's economy.

Instead of asking where money goes, you should discuss if inflation is understood, measured properly and can monetary policy control it.

freako said...

Here is couple of tales/anecdotes that may help us wrap our head around what money supply and inflation really is. If you understand exactly what happened in these two, you are halfway there:

1. This one I have posted before. I saw it in UBC prof Maurice Levi's book on macroeconomics, and it is from an old exam:

A prominent British doctor vacations on a small Greek Island. He pays for his accomodation with a cheque. The hotell owner bought some things. Lacking handy cash, he endorsed the doctor's cheque and the merchant accepted it as payment because the doctor was so well known. The merchant then did the same thing, as did the next holder of the cheque. In fact, it was never cashed. But, who then, paid for the doctor's vacation?

2. This one Casual Observer posted to RETalks.

"Recently, while pondering the state of the financial world, I recalled a childhood experience. If you will bear with me for a few minutes, I would like to share my story. I was in the fifth grade and my teacher was Mrs. Hill. For the school year, Mrs. Hill devised a novel plan to reward students for good behavior. For this, she created "Mrs. Hill dollars," and granted them to deserving students. At the end of the school year these dollars would then be exchanged at auction for items – games, radios, books and such. She introduced this "system" one day by rewarding one of my classmates a Mrs. Hill dollar for collecting trash from the hallway. Soon, Mrs. Hill dollars were being granted for a variety of achievements. The winner of the Spelling Bee received one Mrs. Hill dollar. If you entered the school’s science fair, you received a Mrs. Hill dollar. If you read a book and wrote a report, you received two Mrs. Hill dollars. Later, a few students began picking up trash during recess and were rewarded with a couple Mrs. Hill dollars. On Arbor Day, some students planted trees on school grounds and they were rewarded a few Mrs. Hill dollars. And so on.

After several months, it was obvious that Mrs. Hill’s monetary experiment was a raging success. Her class was planting trees, picking up trash, reading books, and winning the school science fair. This was recognized and appreciated by teachers throughout the school. Quite impressed, teachers were happy to donate items for our auction. If there would have been a contest for "teacher of the year," Mrs. Hill would have won hands down. A very interesting thing happened, however, two weeks before the end of the school year and just one week before the big auction. Mrs. Hill "let her guard down." Maybe it was because there were so many items that had been donated for the upcoming auction. In this regard, Mrs. Hill had certainly created prosperity. Possibly, with most of the money being held by a relatively small group of hardworking students, Mrs. Hill believed that it would be nice to allow the rest of us kids the means to bid for items. That seemed harmless enough.

It was one of those rainy Oregon Spring days, and the students were stuck indoors and rambunctious. So for our 30-minutes of recess, a jovial Mrs. Hill decided to demonstrate how to make paper hats by folding together newspapers. She then offered 10 Mrs. Hill dollars for each hat made. Well, this was the break I needed. I wasn’t much of a reader back then and I saw recesses as a time for playing football and basketball, and not for picking up trash. As such, I didn’t have many Mrs. Hill dollars. But at the end of that 30-minute recess I presented to her 30 folded up newspapers that resembled hats. Mrs. Hill did not look happy, but nonetheless quietly paid me 300 Mrs. Hill dollars. At that point, there were no protests from other students and no appearance that anything had changed. In fact, there was a general euphoria throughout the classroom as everyone was excited for the chance to make some quick Mrs. Hill dollars.

But the reality of the situation became perfectly clear the day of the big auction. For in my 30 minutes of slopping together newspapers, I was rewarded 2 to 3 times more Mrs. Hill dollars than the hardest working students had accumulated throughout the school year. As the best items came up for auction, I simply bid up the price and bought them. For good reason, the hard working kids were not pleased by this injustice. After working diligently for most of the school year, it took just 30-minutes for one big transfer of wealth to me for folding together newspapers. The point I would like to make is that Mrs. Hill, after doing all the right things for months, lost control of her monetary system for 30-minutes. But that was all it took. Importantly, in just 30 minutes she completely distorted the pricing mechanism – the reward system that had so effectively encouraged redeeming behavior. The outcome was, I will call it, one big "asset inflation" and redistribution of wealth. I also propose that this big "inflation," would have changed student behavior. I do not believe that students would have continued to spend their recesses picking up trash for a Mrs. Hill dollar. Instead, I think most would have believed it much more rational to make newspaper hats.

Here, I would like to stress a key point: Excessive credit creation distorts the market pricing mechanism. And with our financial system having experienced an unprecedented explosion of credit – this has led to endemic distortions throughout both the financial asset markets and, importantly, the almost forgotten real economy. Massive credit inflation has impaired the ability of free markets to function properly. This has led to pricing distortions that have bred a massive misallocation of resources and a maligned economy - complete with an historic asset inflation, a subtle redistribution of wealth, over-borrowing by both the household and corporate sectors, and trade deficits that imperil the dollar and our standard of living."

- excerpted from a speech given by Doug Noland at the Credit Bubble Symposium, Sept. 21, 1999

freako said...

"As you may learn Econ 101, money does not have any value in and of itself."

Well, if it can be exchanged for items of value, it has value.

"If I give you a million dollars and place you in the middle of the forest, how much is that money really worth to you? It's good kindling."

Well, any object taken out of its useful domain has little value. Would a bar of gold be any more helpful out in that forest?

"Monetary policy affects economies only as much as they have interactions with one another. "

Meaning? The world is connected, no?

freako said...

"As you may learn Econ 101, money does not have any value in and of itself."

How is this? Money has value because it is such a convenient instrument for storing and transfering wealth? And I don't mean this in a smartass way.

el bbub said...

"But, who then, paid for the doctor's vacation?"

I believe it was also Mrs. Hill.

Paly said...

freako said...”How is this? Money has value because it is such a convenient instrument for storing and transfering wealth? And I don't mean this in a smartass way. "

Fraeko, your points are well made. And I did enjoy the classroom example.

I was trying to address the question posed in the original post. That is, money and inflation are related. However, one does not have a 100% pull on another. That is, a change in monetary policy will not have an equivalent affect on inflation. Inflation has several components to it (as the Keynesians argue) but is also largely determined by people’s behaviour (as the Austrian School argues).

As a general concept, people enjoy inflation because it gives a justification for getting more today than in the past. For example, let’s say you live in a country like Japan where inflation has been zero or negative for 8 years. If you were working the same job during this period, you would be making the same amount of money year in and out (since wages are sticky downwards). No change makes people complacent. If people get a small increase, even just a bit, people are much happier. It feels like they are gaining, even if inflation outstrips that gain (like BC’s teachers).

“Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?”
Answer: Depends on how the money created is distributed.
That is why I argue that money, and accompanying inflation, is not allocated to one place. The money in itself does not create inflation, people’s allocation and internal perceptions shape inflation.

freako said...

"That is, money and inflation are related. However, one does not have a 100% pull on another."

Yes, totally agree. Money is demanded as a store of value and medium of exchange. A growth in the economy and/or a change in individual propensities will increase the demand for money. If it is increased only sufficiently to meet demand, little inflation will result. Hence increasing the money supply does not necessarily cause inflation.

As I have mentioned untold times, on the fallouts of the late 70's era is to view inflation as an evil force that eats your money. Totally untrue. For the most part inflation is a zero sum game between long term lenders and long term borrowers. As long as inflation occurs as expected, there is no loser. Unexpected inflation, however, does cause a wealth transfer between these groups. Undoubtedly, that is one reason why the yield curve slopes upwards.

We must also remember that money is "taxed" by inflation and a hot potato in that sense.

If inflation is not evil, why do we fight it? Actually we don't fight inflation, we fight unexpected inflation. That is why the BoC has a target and sticks to it. This stability reduces risks and uncertainties in the economy, and this expectation allows the economy to thrive.

"If you were working the same job during this period, you would be making the same amount of money year in and out (since wages are sticky downwards). "

True, but with deflation, your real earnings go up.

"If people get a small increase, even just a bit, people are much happier. It feels like they are gaining, even if inflation outstrips that gain"

Yes, inflation is poorly understood, and that has its benefits AND drawbacks.


"“Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?”
Answer: Depends on how the money created is distributed."

IMHO, money doesn't go anywhere, it circulates. Again, think hot potato. You only want money (cash) when you need it to transact. In essence, you rent money. Whoever received it, will pass it on ASAP. And around it goes, leaving economic activitiy in its wake.

Wealthyboomer suggested on RETALKS that RE soaked up the excess money, keeping inflation low. I think that is totally incorrect. Nobody buys a house with cash, and even if they did the recipient wouldn't bury it in his matress, but instead pass it on ASAP. In fact, RE creates money as people borrow to buy their homes.

"The money in itself does not create inflation, people’s allocation and internal perceptions shape inflation. "

Well, it is human nature to pass on something which loses value, so it is would be expected that inflation result if the government jacked up the money supply. Thus, money does indeed create inflation.

Here is yet another tale:

Mr. Big likes show off by lighting cigars with crisp $100 bills. The people who see this cringe at the apparent waste. Is it really a waste?

BearClaw said...

Why is the inflation target 2% instead of 0%?

freako said...

"Why is the inflation target 2% instead of 0%? "

1. As mentioned, the goal isn't zero inflation but stable inflation. As long as inflation is predictable, it is no big deal.

2. Achieving zero inflation is a bit like achieving zero unemployment. As you approach zero, it becomes increasingly difficult to prevent. For example, as paly mentions, wages are sticky downwards, sometimes referred to as the "ratchet effect". There is always some minor jockeying for an increase, as one union or another negotiate a new deal, or catalogue prices are locked down. This jockeying leads to a forward creep. Think of a series of 100 yard dashes where the contestants always tries to sneak a few inches at the start, so the starting line is simply moved forward slowly.

3. Zero inflation is dangerously close to deflation, and a deflationary spiral can be as devastating to an economy as hyperinflation. As prices fall, people continue to wait, so demand falls, causing prices to fall and so on. Two percent inflation provides a bit of cushion.

4. A bit of inflation provides a "tax" on cash, so in that sense "greases" the economy by encouraging people to use the money.

el bbub said...

On the subject of inflation, I read this article, well, I think it's more of a research paper on globalisation and its effects on inflation, which I thought was quite interesting.

Check it out:
Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation

casual observer said...

I have argued in the past that if money supply is increasing at a faster rate than GDP, inflation will follow in some form or another, all other things being equal (ie: no increase in the savings rate).

Since the money supply in a debt dependent economy is increased primarily through credit creation, it is not surprising that, along with the growth in M3, credit (debt) has increased substantially as well.

The increase in money supply (credit) provides an increase in purchasing power. In other words, more consumers are able to compete for a limited supply of goods and services.

Since most of the goods that make up the CPI come from China or other low cost producers, who are increasing their capacity to provide these goods to us, these prices remain relatively stable or declining. Demand rises, but so does supply, so no noticeable price inflation.

When demand for RE is increased due to a sudden increase in purchasing power, brought about by a period of ultra-low interest rates and relaxed lending standards, things are different. Supply has a hard time catching up. It is not increased as easily as for consumer items. The result is rising prices.

To add further fuel to the fire, when RE prices rise, they provide a positive feedback loop, which tends to increase demand. This is opposite to what normally happens. When the price of an item rises, we normally buy less of it.

Whether or not RE price inflation should be recognized as inflation and targeted by the BOC is debateable. In my opinion, home ownership is a quality of life issue, and if owning a home becomes so costly that it becomes prohibitive for all but the very wealthy, then I would say that the nation's standard of living has decreased.

Another way of saying that could be that the cost of maintaining a stable standard of living has increased substantially, at least over the last few years.

It costs people a lot more to provide shelter, put food on the table, buy gas for their cars, pay for their kids university, buy any "commodity-related" item (ie: things that contain a lot of metal), pay their cable bill, etc. This is what I would refer to as "inflation".

IMHO, if you went up to ten people in any restaurant, and asked them what they thought the inflation rate was, I would argue that the answers they gave would be closer to the truth than what is measured in the CPI.

But hey, that's just my opinion.

freako said...

"Since most of the goods that make up the CPI come from China or other low cost producers, who are increasing their capacity to provide these goods to us, these prices remain relatively stable or declining. Demand rises, but so does supply, so no noticeable price inflation."

But then wouldn't it be fair to say that we would have had deflation if the money supply had not increased?


"When demand for RE is increased due to a sudden increase in purchasing power, brought about by a period of ultra-low interest rates and relaxed lending standards, things are different."

Well, the low rates are really a function of the increased money supply, for that is how the Fed sets rates, but that is a technicality. I agree.

"To add further fuel to the fire, when RE prices rise, they provide a positive feedback loop, which tends to increase demand. "

Yes, I have long argued exactly this, that the elasticities are reversed (well not exactly, but you know what I mean).

"Whether or not RE price inflation should be recognized as inflation and targeted by the BOC is debateable."

How is this for a reason: An imploding RE bubble would lead to deflation as measured by CPI, and all kinds of strange things would happen, such as wages getting rolled back.

RE is an asset that carries benefits into the future. That portion cannot possibly be deemed inflation any more than the stock market going up is inflation. The consumable portion of RE is rent and imputed rent.

"In my opinion, home ownership is a quality of life issue, and if owning a home becomes so costly that it becomes prohibitive for all but the very wealthy, then I would say that the nation's standard of living has decreased.
"

Oh, it is a misallocation allright. But of course, it is only temporary. The medium termp impact will be artificially low housing costs as a result of excess construction.

"It costs people a lot more to provide shelter, put food on the table, buy gas for their cars, pay for their kids university, buy any "commodity-related" item (ie: things that contain a lot of metal), pay their cable bill, etc. This is what I would refer to as "inflation"."

Anecdotally, I would put these costs in the ballpark of what official inflation has been. The exception is of course home ownership, but as mentioned, that is a temporary phenomenen.

As we have discussed in the past, long term debt is still quite cheap. If you think inflation is understated, why not borrow and buy inflating assets to maintain your standard of living.


"I would argue that the answers they gave would be closer to the truth than what is measured in the CPI.

But hey, that's just my opinion. "

And I think most economists would agree with you.

There is a strong argument that rising gas prices is NOT inflation. I agree with that argument. Yet, the MSM reports on every little change in gas prices as if it could mean that inflation is knocking at our door, as if it was a prowling beast that must be knocked down before damage is done.

el bbub said...

OT:

Man, this is really weird.
Just noticed that ScotiaBank raised interest on its GIC account.

What is happening?

1. RoyalBank 4.25% for 3 mo
2. HSBC 5.00% for 3 mo
3. ScotiaBank 4.85% for 1 year!

Something fishy???

casual observer said...

"But then wouldn't it be fair to say that we would have had deflation if the money supply had not increased?"

An interesting suggestion, and definitely plausible. I assume that you are talking about money supply increasing at the same rate as GDP (no excess growth), or were you talking about absolutely no growth in money supply?

Perhaps we would have had some prices rising, and others falling resulting in the proverbial "zero sum" scenario.

"Yes, I have long argued exactly this, that the elasticities are reversed (well not exactly, but you know what I mean)."

I know what you mean, but what people need to understand is that when RE prices are falling, the feedback loop reverses and demand decreases - which causes prices to fall further, which decreases demand, etc.

"How is this for a reason: An imploding RE bubble would lead to deflation as measured by CPI, and all kinds of strange things would happen, such as wages getting rolled back."

Maybe. But what if the BOC had recognized RE price inflation, and responded with increasing interest rates, thereby preventing a bubble in RE prices? Under that scenario - no bubble, no implosion. No deflation caused by implosion. No huge increase in household debt, or money supply.

"RE is an asset that carries benefits into the future. That portion cannot possibly be deemed inflation any more than the stock market going up is inflation. The consumable portion of RE is rent and imputed rent."

I understand the two components of RE as being an asset and a consumable, but ignoring the speculation that took place on the asset portion is a mistake, IMO, and the distortions that have been caused by the ignorance have a big impact in our lives.

If speculation takes place in the stock market, this also has an impact, but a much smaller one in comparison to RE. Everyone's life is touched by the RE market. We all need a place to live (own or rent). Not everyone needs to own stocks.

When speculation takes place in housing, even if one justifies it by the dual nature of the asset (investment/consumable), the price inflation causes huge dislocations and transfers of wealth that are disruptive and potentially damaging to the entire economy. (as per the Mrs. Hill quote)

"Oh, it is a misallocation allright. But of course, it is only temporary. The medium termp impact will be artificially low housing costs as a result of excess construction."

I'm fairly certain that you're right about being temporary. However, it could remain this way for some time. In the meantime though, people have to live their lives, and make plans, etc. The huge run up in RE prices has caused a great number of people to put their plans on hold (my family included).

"Anecdotally, I would put these costs in the ballpark of what official inflation has been. The exception is of course home ownership, but as mentioned, that is a temporary phenomenen."

I disagree. Food prices, gas prices, university costs, etc. have increased at more than the official CPI figure of 2.3%. My cable bill went up twice in ten months, for a total of about 12% inflation just this last year.

"As we have discussed in the past, long term debt is still quite cheap. If you think inflation is understated, why not borrow and buy inflating assets to maintain your standard of living."

The reason is that many of these assets are not supported by fundamentals, they are supported by a credit bubble. When the credit bubble stops expanding, as it started to do in the U.S. housing market, the artificial price supports start to unravel.

The longer this game of musical chairs continues, and the more people that join the game, the more risky it becomes to be a player.

Trees don't grow to the sky. When markets go up for long periods of time without major correction, people can come to believe that they go up indefinitely. This has happened in the RE market.

"There is a strong argument that rising gas prices is NOT inflation. I agree with that argument. Yet, the MSM reports on every little change in gas prices as if it could mean that inflation is knocking at our door, as if it was a prowling beast that must be knocked down before damage is done."

Yes, but when gas prices rise, it also impacts the price of all the goods that must be transported to the stores. That is inflation.

freako said...

"Perhaps we would have had some prices rising, and others falling resulting in the proverbial "zero sum" scenario."

Yes, during a previous debate, I think we came across the distinction between CPI and cost of living. Each person's basket is unique, so CPI measures a typical one. Some items up, some down.


"Maybe. But what if the BOC had recognized RE price inflation, and responded with increasing interest rates, thereby preventing a bubble in RE prices?"

Ok, but as we discussed earlier, other assets didn't appreciate as much. If we jacked up rates to contain housing, we'd cause general deflation in many non-RE CPI items. Perphaps to the point of net deflation, and the associated risks.

"Everyone's life is touched by the RE market. We all need a place to live (own or rent). Not everyone needs to own stocks. "

I understand and agree with the negative externalities, but I don't think housing in CPI is the answer.


"I disagree. Food prices, gas prices, university costs, etc. have increased at more than the official CPI figure of 2.3%. My cable bill went up twice in ten months, for a total of about 12% inflation just this last year."

Well, with official CPI low, either you the other items you don't mention are flat or down, or your consumption patterns are not typical.

"The huge run up in RE prices has caused a great number of people to put their plans on hold (my family included)."

Again no disagreement there. I think the simplest remedy is to squeese the lenders for tighter standards. IMHO, the lenders will be inclined to police themselves after this fiasco is over. And I don't think repackaging and resellling subprime crap will as frequent next time around.

"The reason is that many of these assets are not supported by fundamentals, they are supported by a credit bubble. When the credit bubble stops expanding, as it started to do in the U.S. housing market, the artificial price supports start to unravel. "

Right, so these items are on the cusp of deflating, and once that is over, we are back to where we started again.

"Yes, but when gas prices rise, it also impacts the price of all the goods that must be transported to the stores. That is inflation. "

But is it really? Let's take an Austrian slant on things. You have $100 dollar to spend. Gas goes up, and since that is inelastic, you buy the same quantity, but for more money. But since your money is finite, you have less to spend on say beer. Sure the butter industry would love to pass on the increased transportation costs, but since it is a somewhat discretionar item maybe they can't. You may instead switch to a cheaper brand, or buy less, or drink moonshine. In the end, higher gas prices mean less money spent on other things.

However, if all of a sudden you and everybody else had $150 to spend, and the supply of products remained unchanged, there would be inflation.

jesse said...

"Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?"

Money gets transferred. It does not "go" to a car. Instead you exchange the money for a car and someone else now has the money.

freako said...

"Money gets transferred. It does not "go" to a car. Instead you exchange the money for a car and someone else now has the money. "

Yes, I pointed that out earlier, but it kind of got buried in all the other tangents. It is a circulating hot potato.

rentah said...

Shiller today suggests that the "liquidity" we talk and hear about is the result of asset price bubbles (and thus could reverse very easily).

'Awash in liquidity' suggests bubbly market

freako said...

The first paragraph from rentah's link.

"WE increasingly hear that "the world is awash with liquidity," and that this justifies expecting asset prices to continue rising. "

As I have stated before, liquidity explains asset inflation, but does not justify it. Big difference.

"So its popular use seems not to reflect anything we can put our finger on, but instead a general feeling that markets are bubbly and a lack of confidence in their levels. "

He makes a good point. Banks have been tightening since 2003, yet most appreciation occured after this. I suppose conspiracists will look to M3 or something.

jesse said...

"I suppose conspiracists will look to M3 or something."

Do you mean Austrians? :-)

Alpha_Bear said...

"Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?"

Taxes

Paly said...

The liquidity article posted by rentah is an interesting discussion on liquidity and its definition.
IMHO, liquidity has been encouraged through a series of events. The first is that the CPI is skewed for many people's view. They look at large ticket items and forget about the regular things they buy everyday. People complain about China and its products, but do not realize this enhances our quality of life. Why can you go to Walmart with their "falling prices"? Because China increases their capacity, efficiency and therefore lowers prices. These goods are the little things you do not notice.
Since these goods are part of the CPI basket, it has a deflationary pressure on the CPI measure. That is, imported goods have lower prices due to their efficiencies and now our currency being so highly valued. This will keep the CPI down.
Housing prices do not have a huge effect on CPI because people do not buy a house every month. In fact the core CPI removes housing and gas prices due to their volatility. As casual observer mentions, everyone is affected by housing prices. This is only when you buy a house. People who have bought do not care what prices are. The RE market has little to no effect on their CPI related purchases.

The liquidity being discussed is being created by lowering standards for lenders. More lenders induces more spending and the requisite price increases. This is seen in the Subprime market in the states. In addition, Hedge funds are borrowing billions of dollars to buy out publicly held firms. This squeezes the supply of publicly held shares and induces price increases of other shares. Shareholders can take those profits and invest in a hedge fund, which uses the money as leverage to get a bigger and better loan. This self perpetuating circle is increasing the liquidity in the world on a huge scale. The main theme I see in the article is that liquidity spikes precede a market correction. Is this a warning for the future? We should be watching these hedge funds carefully. When one gets turned away from a bank, does that mean the liquidity train is over and we need to correct the market again?
Anyways, I digress. Sorry for such a long and wandering post

freako said...

"Housing prices do not have a huge effect on CPI because people do not buy a house every month. In fact the core CPI removes housing and gas prices due to their volatility."

Even more importantly, house prices are NOTdirectly included in any CPI. In the U.S. housing costs are measured as straight rent or rental equivalent. In Canada it is a messy formula that combines rent, non-land ownership costs among other things.

"The main theme I see in the article is that liquidity spikes precede a market correction. Is this a warning for the future"

Yes, that is a key point.

freako said...

" In Canada it is a messy formula that combines rent, non-land ownership costs among other things.
"

A year or two ago we had a good discussion on VHB about the absurdity of Canadian shelter CPI versus increases in prices.

For example, for BC it is up 8% since 2002, where as prices are up 70% plus. Why the disparity? Because the low rates reduce ownership costs as per Statscan methodology.

el bbub said...

"Hedge funds are borrowing billions of dollars to buy out publicly held firms. This squeezes the supply of publicly held shares and induces price increases of other shares. Shareholders can take those profits and invest in a hedge fund, which uses the money as leverage to get a bigger and better loan. This self perpetuating circle is increasing the liquidity in the world on a huge scale."

which makes bond holders very unhappy:
Bell Canada bondholders to sue company over LBO

patriotz said...

I understand and agree with the negative externalities, but I don't think housing in CPI is the answer.

You mean the price of buying a house of course. Rent definitely belongs in CPI.

As Freako said, asset prices have nothing to do with the cost of living (a.k.a. consumption). Nobody has to buy a house, ever. House buyers are making an investment decision exactly as someone buying a stock. If they decide to pay far more than is warranted by the present and future earnings of that asset (i.e. rents), that's their problem. The market will put an end to that folly in due course.

Monetary policy should be targetted toward consumer price stability, not the price of houses, stocks, or any other assets.

That said, I do fell speculative bubbles in housing are damaging to society in a number of ways, and the appropriate action is to impose taxation on speculative gains on RE. Don't throw out the macro baby with the micro bathwater.

Mark S. said...

1. the increase in the money supply has caused asset inflation - see house prices. This is where a great deal of the credit creation has gone into. It is an inflationary bubble caused by loose monetary policy (see US housing crisis, see any of the critical articles on the legacy of Allen Greenspan).

2. Increased demand for consumer goods can be inflationary, even in a relatively small country like Canada that imports most of its consumer goods. If we increase demand for, say, consumer goods from China we create inflation through exchange rates. The more we buy from China, relative to what we export to China, the more we demand their currency to pay for the imports. This pushes up the price of their currency relative to ours and thus the cost to import their goods and services. The only reason this is not happening now is because of China's strong demand for our resources (wood, metals, oil).

Lastly, we are all connected globally for the good and the bad. China depends on US demand for its consumer goods to fire its growth. If the US is headed for a big recession (as I believe it now is), then China's economy will suffer, as will its demand for our resources. The combination of a fall in demand for our resources from China and the US will be devestating for our economy, trade balance and possibly our exchange rate with China.