Some insights from my visit to the ECB
Last week I attended a workshop at the ECB on Global Liquidity. Global Liquidity of course refers to money flowing throughout the world as a result of western central bank money printing—especially Fed printing. I thought it might be beneficial to highlight some insights gained.
1. Attended mostly by central bankers, the group of 40-50 people seemed to be in agreement that their—and particularly the Fed’s—monetary policy is a key driver of financial asset prices, including commodities and real estate.
I learned that while there is no consensus among central bankers that increased bank credit is the sole driver of higher asset prices (though I’m told many say that it is, and one economist I spoke with said that it was), there is a consensus that it is the sole driver of inflation in the long run. The short-run drivers are rather insignificant. One that I agree with is changes in the supply of imports. As a booklet I bought states: “Inflation is ultimately a monetary phenomenon.”
Why central bankers agree that rising consumer prices are ultimately a monetary phenomenon, but believe rising asset prices are only a partial monetary phenomenon is beyond me.
Just to be clear, I asked one central banker about the theory that unions can drive up prices. He said that they could—if there was an increase in money. He was spot on.
An very interesting insight came about when he said that I sounded like a monetarist. I said that I was actually more aligned with Austrians. He immediately replied that the school is not much different than monetarists with respect to what we had been discussing. Of course he was right, but it impressed me that he was that intimately familiar with Austrian views. After all, one Italian central banker I spoke with a few years ago asked: “what is an Austrian?”
2. The group also discussed that monetary policy has both a supporting and a destabilizing effect on the economy and financial system (we, of course would argue that it is the sole driver of asset prices and of GDP and consumption in the long run). One PPT presentation by an economist from the Bank for International Settlements, regarding the financial crises concluded: “Who to blame? Model says the Fed.” I agree with him. But it’s shocking that they actually state/admit this.
Another statement was “the central bank can create distortions.” Again, to us they are—absent acts of nature—the only ones creating distortions, but that they accept their influence as matter of fact is surprising to say the least.
3. The group kept commenting that it was increased credit driving leverage. They agree that it is leverage driving asset prices. As one person said “increased leverage has to come from somewhere” (i.e., you cannot create new leverage without creating more money/credit). (They defined leverage as total bank assets over bank equity and as equity of banks times leverage). Interestingly, several people discussed that the leverage of banks is inversely related to the VIX.
4. There is a whole area of research related to the following information that I too have previously learned the importance of: the transmission channel of money flow into consumer prices (i.e., bank loans) is a completely different transmission channel of money flow into asset prices. For asset prices, money flow is originated in the interbank market (money market) with the large banks and hits the hedge funds/brokerage houses/institutional investors in the form of “non-monetary bank liabilities such as money market papers, certificates of deposit, commercial papers, structured notes, or bonds, which [are bank credit but] not recognized as the common medium of exchange.”
As part of this, there is a large debate about which side of bank balance sheets are responsible for rising prices: the asset or liability side. This is known as the money view vs. the credit view. The money view is the liabilities view that argues that the creation of money in the form of bank deposits pushes prices higher. The credit view is the asset view (or loanable funds theory) that argues that the creation of credit in the form of bank loans is responsible for rising prices. They noted that credit has grown much more rapidly than money over the last 25 years.
This explains why both GDP growth and consumer prices have had low growth rates while asset prices of boomed (asset inflation has been high). It also explains why performance of the financial market is unrelated to the performance of the real economy (money can flow into asset prices without flowing very much into consumer prices, causing GDP to stay low).
5. Though there was some debate on this, it was said several times that “the U.S. is the global provider of liquidity.” I thought that Europe and parts of Asia were also providers, by way of coordinated monetary policy. But somehow the US is supposed to be the driver. Perhaps they simply mean that the Fed initiates policy first, and that other central banks follow in the footsteps of the Fed unofficially so as to keep their currencies aligned. By intentionally keeping their currencies at parity, they suck in capital flows pushing their asset prices higher. Thus, US liquidity evolves into global liquidity.
6. One paper argued that Europe is as large of a driver of US asset prices, but it’s not registered on the radar screen as such because the Eurodollars they use are held in the names of US banks, and thus show up as US assets. If this is the case, European banks affect our asset prices much more than previously expected.
7. I was surprised at how their language was so similar to that of Austrians, since mainstream economists usually cloak their points with obscure, “roundabout” language. These monetary economists spoke regularly of the central bank creating money, and kept noting that it was only possible in a fractional reserve system. They even used the term “Ex nihilo” as Austrians do. They also spoke of misallocation of capital, distortions, and booms and busts. Interestingly, one paper presented distinguished between “aggregate demand” and “aggregate real demand” differentiating between aggregate demand caused by money printing and true aggregate demand in the real economy (which, of course, can rise only with more production).
8. Though they know that they are aware causing rising prices, boom and bust asset movements, and financial crises, they still support fractional reserve banking and credit creation. They really, truly believe that economies need new credit in order to grow. That, is their originating flaw.
The main takeaway is that it is very surprising how aligned with Austrians these monetary economists are. I think this is so because these people focus in such a detailed fashion on money and prices that they cannot avoid the real facts. Within the scope of their daily work, they are not political propagandists; they are merely seeking—as are Austrians—to understand how things really work. It’s just too bad they don’t advocate different policy actions based on their conclusions.