Is asset price inflation equal to wage inflation?

November 24, 2008

President-elect Barack Obama’s new spending initiative, which is reported to involve massive infrastructure investments in education, clean energy, and others, is not the remedy to the economic crisis, but it’s nonetheless the best course of action for the government. Unlimited and indiscriminate temporary liquidity provisioning, and even permanent cash grants to individual firms have both failed to produce a perceptible improvement in the financial markets, despite the persistence and extravagance of the government authorities. Nor should these measures be expected to produce any results, because this crisis broke out as a consequence of money saturation, i.e. the explosion of a bubble, where the efforts of  central banks to further inflate the money supply, and increase risk appetite receive ever decreasing responses from the markets until such a point is reached that the central banks and government authorities become all but irrelevant to the behaviour of the markets.


One can speak of a money saturation event as the mirror image of hyperinflation which is nowadays more often seen in emerging markets and developing nations, where the ability of the financial system to mask inflation through speculative activity and sustained asset price rises is far more limited. In an advanced economy such as the US, where the political mechanisms are so formed that the wage-setting power of the employee is much less limited, the increasing money supply is directed to channels that cause inflation in a more subtle and less obvious way: instead of the employee causing prices to rise through increased demand, the  employer causes asset values to rise through speculative activity, the windfall from which is shared with employee through the transmission channels of an advanced economy, such as mutual funds, REITs, and others.


In other words, inflation caused by higher wages is the fruit of a more socialistically-inclined system. Inflation caused by higher asset prices, leading to money saturation, is the creation of a more capitalistic system, where political power is willing to check the irrational desires of labour, but is far more complacent with the nonsensical activities of the rich and powerful. The terms “rich” and “labour” are only used in a general sense here, without implying that the agents that cause asset price inflation are always the “rich” in the direct sense of the word.


Once a more unified understanding of inflation is thus achieved, it is also easier to see why gold is not gaining against the dollar nowadays, and why, for instance, despite the extreme profligacy of the government, the dollar is not collapsing. The simple fact is that the collapse in the value of the dollar that many in the market have been anticipating in the past years has already occurred: gold has already appreciated from around 220 dollar per ounce to more than 1000 per ounce in the course of around eight years. In that sense, the US was already going through a period of hyperinflation, however, the event was masked by asset price appreciation, as CPI remained relatively tame. Thus, whereas in a developing nation, or an emerging market, extreme rises in money supply will result in hyperinflation, and will essentially lead to money being to worthless to be used as a transaction mechanism, a money saturation event will lead to money being too valuable to be used as a tranaction mechanism, with the result, however being the same. Both hyperinflation, and money saturation lead to recessions. The hallmark of hyperinflation is extremely high nominal rates, while that of money saturation is negative rates.  


The implication of all this, of course, is that an economy without the structures (such as securitisation, investment banking, pension insurance) that can channel money supply in effective ways to create asset bubbles, will be faced with hyperinflation in the classical sense, provided that there is enough growth in money supply to create it. However, the characteristic of a money saturation event is the rapid shrinkage of money supply which essentially precludes any wage inflation until the underlying pessimism is overcome.


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