See also this latest paper by Borio et alii on measurement of assetprice inflation and output gap http://www.bis.org/publ/work404.

pdf ***********I may yet have to dedicate my work to those beautiful young (and even less young) "indignados" (indignant or outraged) who are occupying public squares across Spanish cities. This "revolt" was coming because the "reality" to which the owners of our social resources (what they call "capital") are "revolting" in every sense of the word. Amazing as it may seem, if there is one - I say One! exemplary paragon of the mortification of our youthful productive energies (those energies that "the natural rate of unemployment" would wish to mortify and enslave forever), one episode that encapsulates the putrefaction - economic, political and moral - at the core of the capitalist system, it is the behaviour of its "leaders" - from Strauss-Kahn to Berlusconi, from Sarkozy to Jurgen Stark - these are "leaders" that would sell us their geriatric corruption, their physical and moral decomposition and turpitude for the empty promise of a future that they know is rapidly spinning out of their control and whose entire "possibility" lies solely on our ability to wrest it from their sclerotic and desiccated hands. If you look at that Bordo and White paper I discussed in the last Blog, you will see that the authors argue that the "successful" targeting of inflation by central banks from the 1980s had a "parallel and related" consequence in the "swelling of financial bubbles" that culminated and exploded spectacularly with the Great Financial Crisis and Recession beginning in 2007-8. The authors genially summarised this thesis by saying that low inflation achieved by short-term monetary measures had the effect of making the consequent "market-led financial system" prone to far greater "elasticity". This is a wonderful "talisman" for macroeconomists: we have heard of "price elasticity", "demand elasticity" - now we have "credit elasticity"! Various "reasons" or "factors" are adduced for the growth of this "elasticity", which Bordo and Lown tackle in this other article titled "Asset Prices, Financial and Monetary Stability: The Nexus" - except that obviously they should have said "financial instability" instead! Here it is: http://www.bis.org/publ/work114.pdf The authors summarise the substance of this "elasticity" as follows: "....while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment.

One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other. A second is that the credibility of the policymakers' commitment to price stability, by anchoring expectations and hence inducing greater stickiness in price and wages, can alleviate, at least for a time, the inflationary pressures normally associated with the unsustainable expansion of aggregate demand. A third is that by obviating the need to tighten monetary policy, such conditions can allow the build up of imbalances to proceed further." You will see immediately that not a single one (!) of the "reasons" adduced by the authors comes anywhere near to "explaining why" financial instability or "elasticity" develops as a result of low inflation or disinflation. This is the theme we will consider next - in the context of Davies's discussion of the "possibility" inflation. For now, I want to leave you with the thought that whilst "inflation targetting" or even "price level targets" were products of the "fine-tuning" of the capitalist economy associated with the "Keynesian-Neoclassical Synthesis" which aimed at "the short term or short run" and focussed on the "trade-off" between inflation and employment - this new phase of capitalism is leading economists away from Keynes's "short run" to the "long run" that was the focus of people like Hayek and Schumpeter or Pigou, all of whom concentrated on the "quantitative fundamentals" of the economic cycle. This fresh or renewed "concern" about "the long run" that Keynes pooh-poohed takes the form of studies on the "regulatory and prudential" role of monetary authorities over "supervising" the entire "channels" of monetary and financial "transmission" of fiatmoney policy!! Here are our authors again: "In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory. If the imbalances are large enough, the end-result could be a severe recession coupled with price deflation. While such imbalances can be difficult to identify ex ante, the results presented in this paper provide some evidence that useful measures can be

developed. This suggests that, despite the difficulties involved, a monetary policy response to imbalances as they build up may be both possible and appropriate in some circumstances. More generally, cooperation between monetary and prudential authorities is essential." To say that the only constraint in a fiat money regime on credit expansion is proper regulation and supervision simply begs the question of precisely why these are necessary at all and why, indeed, it is the fiat money regime that invites credit expansion or the need for its regulation! This whole failure to state the problem in its proper form shows why and how information asymmetry theory is quite simply a rationalization based on game-theoretic platitudes (indeed, a language-game in which the problem, the asymmetry, is concealed in the definition of its premises and so is the solution!) see our notes on Mishkin. As is evident from the authors own review of the Prudential Framework as a policy response, the inevitable conflict arises (as reviewed by Mishkin under the principalagent caption) between regulators, regulated, and taxpayers. Hence we return (full circle as they put it) to monetary policy. The crucial point in my discussion of the "nexus" between financial instability and inflation targeting is that asset-price inflation has replaced consumer-good inflation. As you know, the dominant explanations of the Great Depression focused either on the simple contractual asset-price repayment structure (Fishers debt-deflation, which presupposed an "exogenous shock") or on Keyness role of banks and liquidity (which relied on expectations or animal spirits hinging on "real activity" see Keyness bank essay in persuasion of August 1931). Minsky combined and championed these two approaches (Stabilising an Unstable Economy). All these approaches failed to see "the paradox" that arises if we draw a "nexus", as Bordo and Lown do here, between inflation targeting and asset-price inflation: The fourth and related reason is that low and possibly falling inflation together with a high degree of credibility of monetary policy would give little reason for the authorities to tighten policy if they respond only to clear signs of inflationary pressures. Paradoxically [!!], these endogenous responses to credible monetary policy increase the probability that latent inflation pressures manifest themselves in the development of imbalances in the financial system, rather than immediate upward pressure on higher goods and services price inflation. Failure to respond to these imbalances, either using monetary policy or another policy instrument, may ultimately increase the risk of both financial instability and subsequently deflation (during the period in which the imbalances are unwound). The implication of

this is that central banks with a high degree of credibility need to remain alert to the possibility that inflationary pressures first become evident in asset markets, rather than goods markets. (p22) Once again, what is not explained, though the nexus is right, are the causes for the existence of this nexus namely, the possibility that inflationary pressures first become evident in asset markets, rather than goods markets! We need to know exactly why(!) there is inflation in asset markets! Whilst the authors busy themselves seeking to find empirically yet another gap between credit expansion and GDP (after the output gap and the negative real interest rate gap, after the Okun gap and the Verdoorn-Kaldor gap), they leave us none the wiser about (once more) why the credit expansion implodes at a certain stage: in other words, what does asset price inflation really mean? The truly remarkable coup de theatre or "tete a' coude" in this article comes when the authors courageously tie up the credit/financial side of the question with the wage/real side. Just look at this: If financial imbalances can build up in an environment of low inflation it stands to reason that a monetary policy reaction function that does not respond to these imbalances when they occur can unwittingly accommodate an unsustainable and disruptive boom in the real economy. The result need not take the form of inflation, although latent inflationary pressures would normally exist. Rather, it would be a contraction in economic activity, possibly accompanied by outright deflation, amplified by widespread financial strains. Accordingly, one could argue that the more serious bubble was in the real economy itself. (p26) If this is right, it follows that monetary policy must be set with both goods and asset price inflation (or the potential for it) well and truly in mind. But this invites a conception of the capitalist business cycle much closer to Hayek and Schumpeter, or even Haberler and Wicksell, than to Keynes and a return to the long run! Here are the authors: From a policy perspective, the modification in policy rules we are suggesting is in fact fully consistent with long-cherished central bank values. For one, it emphasises long horizons rather than short-term inflation control. It is precisely in order to maintain sustained price stability over horizons longer than two years, not jeopardised by deflationary pressures, which are harder to control, that a prompt response to financial imbalances would be called for. Financial stability would result as a by-product. In this sense, the

pursuit of price stability, properly defined, would still be the best contribution that monetary policy could make to financial stability. In addition, the suggested modification highlights pre-emptive actions. This has been a perennial concern of central banks. It is precisely one of the purported reasons for the increased focus on monetary aggregates in the 1970s: the fear that waiting to see clear signs of higher inflation would be too risky. In a way, the more explicit focus on financial imbalances harks back to this intellectual tradition. The emphasis, however, is on credit rather than money. And no automatic responses (strict targets) are being proposed. (See fn 48 for specific reference to Austrian School, and similar reference in previous paper I linked, Whither Mon Pol?) What the authors are implying is precisely what I have been arguing that the "elasticity" of the credit system that leads to bubbles and busts has its ultimate "anchor" in the wage relation. What the authors do not tackle, however, is precisely the reason why this is a "paradox": - namely, that any attempt by monetary authorities "to drain liquidity" would simply exacerbate the debt-deflationary spiral, whilst any "regulatory" attempt to restrain "market-led credit creation" would result in politically intolerable levels of unemployment. This is the "paradox" - in truth, the antagonism of the wage relation - that the renewed emphasis on "the long run" seeks to confront! _______________________ A couple of quick notes on "the level-playing field" in financial regulation. This is something that exemplifies beautifully the need for clear "theorisation" of economic reality - contrary to the garbage we get from professional economists. The wrestling and tussling around Basel III and derivatives regulation shows that higher capital and other banking standards will basically destroy European and then Asian banks, much to the advantage of the US counterparts. Here is Daniel Gros with the account, if anyone doubts it, of the dire state of European banking: http://lecercle.lesechos.fr/economistes-projectsyndicate/autres-auteurs/221135644/the-eu-rules-to-default-by But next comes the discussion on "level-playing fields" proper at the Economists' Forum (you can link on this page at Martin Wolf's Forum icon). Nietzsche was fond of "taking observations from the street" - and that "street" could easily be Wall Street or Threadneedle Street: Here he goes: this is taken from his "Human, All Too Human": "25.The older morality, namely Kant's, demands from the individual those actions that one desires from all men--a nice, naive idea, as if everyone without further ado would know which manner of action would benefit the whole of mankind, that is, which actions were

desirable at all. It is a theory like that of free trade, which assumes that a general harmony would have to result of itself, according to innate laws of melioration." (HATH) In other words, a theory like that of free trade, or the level-playing field, assumes a "general harmony" in the capitalist world market that would come into being "of itself, according to innate laws of melioration". And we know all too well that these "innate laws of melioration" simply do not exist - that in fact the capitalist world market is one of "competition", which means conflict and confrontation. It is imperative, then, given the clear and present tendency of this "conflict and confrontation" to destroy the very "competition" on which the capitalist world market is founded, that "regulations" be put in place to ensure that this does not occur. So, everyone can now see what is the deadly fallacy in the analysis advanced by Admati and Hellwig in the latest "Economists' Forum". For whilst we may all agree with them that "regulation" of financial services is absolutely indispensable to avoid another meltdown of the capitalist financial system, we cannot accept their "relegation" of the speculative wave that caused this meltdown to "externalities" in the functioning of the capitalist "market". If anything, the Global Financial Crisis was caused by "internalities" - that is, by the very "functioning" of the capitalist world market according to its own internal logic and pursuit of "profit" or "value"! To attribute the GFC to "externalities" that now require imperatively "regulation" is either an act of intellectual idiocy - or, what is worse, one of intellectual dishonesty!! What we require of "experts" such as the authors of this piece is that they come clean... and "tell it like it is" so that we may draw the proper conclusions.

***********Back to "financial repression" or "liquidation of public debt". Let me go through the basic propositions in this paper by Borio and White called "Whither Monetary and Financial Instability?" http://www.kansascityfed.org/publicat/sympos/2003/pdf/Boriowhite200 3.pdf You will notice instantly that Keynes's general approach to "economics" never but never asks two essential questions: "Whence?" and "Whither?" In other words, Keynes's exclusive focus was always the "now", the short run, not "the long run". He had no wish "to understand" the capitalist system: his "animal spirits", his

"uncertainty", his "money as a bridge between present and future" were all aimed at the "now" - in French, it's "main-tenant" or "holdingin-the-hand"; in German, "jetzt", "just" as in "just now", and in Italian "ad-esso", literally "to-being" or "pre-sent" - "present". If anything, his "outlook" or "per-" or "pro-spective" were decidedly pessimistic". The rate of profit - or his "long-term marginal efficiency of capital" - was negative over "volume" and "time". His "animal spirits" could not be "revived" by anything except the lowering of nominal interest rates until the system hit the "liquidity trap", at which point only a "deus ex machina", the State, could "revive" investment through taxation and deficits. Thus, the "tendency" of the Keynesian-Neoclassical "synthesis" was always "inflationary" and involved inevitably the swelling of "public debt", or the share of government in the economy, to be "compensated" through the "liquidation of public debt" or "financial repression". Here are Borio and White: "Like a good novel, each phase in economic history has its villains, heroes and defining moments. Often, it is only with hindsight that we can identify them. There is little doubt now that the great villain during much of the postwar period has been inflation. The breakdown of Bretton Woods ushered in an unprecedented phase for the world economy. At no other time in modern history had the world seen prices of goods and services rising so fast for so long in so many countries. The heroes have been those central bankers that, after a protracted war, finally succeeded in restoring price stability. The defining moment, perhaps, was the end of the 1970s, when monetary policy in the leading economy of the globe, the United States, purposefully sought to break the enemys back, thereby fostering a more favourable environment for similar battles elsewhere." This decision "to break the camel's back" was in fact quite "reactionary" - it involved the turning away from "financial repression" to the actual political repression of the working class. The entire "thrust" of Milton Friedman's "framework for monetary analysis" was to challenge the neo-Keynesian orthodoxy about a "trade-off" between inflation and employment: no such trade-off existed, for Friedman, because once employment rose to pre-inflationary levels, a fresh bout of inflation would occur as workers saw through "money illusion" (the phrase was Irving Fisher's) and sought a "compensation" for their lower "real" wages. The result would be "accelerating rates of inflation" in a

destructive upward spiral of wage-push and cost-pull forces. Hence the "decision" to "empower" (legally and ideologically) central banks with the necessary "mandates" and "instruments" (inflation targetting) to slay the inflationary dragon and set a "non-accelerating inflation rate of unemployment" (NAIRU). As inflation receded in the 1980s, and so did the role of government spending and public debt in the economy, two "compensating developments" occurred: the "slack" in government spending was picked up by "private industry" and "market-led finance" (the phrase was coined by Padoa-Schioppa, whom I discussed a few weeks ago on this Blog) on the "investment side"; and on the "consumption" side, steady or falling "real" wages were supplemented with higher debt levels and cheap imports mainly from China. This was the meaning of "the Great Moderation" (which I discussed with Bernanke recently). Again, here is the Borio and White summary: "At the same time, since the 1980s a new concern, financial instability, has risen to the top of national and international policy agendas. It is as if one villain had gradually left the stage only to be replaced by another. Episodes of financial instability with serious macroeconomic costs have occurred with greater frequency than in the past, in industrial and emerging markets alike. The costs of banking crises in terms of GDP forgone have been estimated to attain, not infrequently, double digits. For those that expected price stability to yield financial stability as a by-product, these events have represented a significant blow. Why has the full peace dividend of the war against inflation ostensibly failed to materialise? In this essay we explore the nature of this apparent paradox." In terms of how we have "structured" our analysis, the "reasons" for this "paradox" are obvious enough. By "repressing" industrial conflict over the wage relation in the workplace - through "cheap debt" and "cheap imports" - capital loses its most fundamental political essence: it loses its ability "to gauge", "to measure" the precise level of conflict and antagonism in the workplace which is where "real value" is "created" by living labour, only to be "realised" later in the "consumption" of "goods" or "dead labour" in the "marketplace"! The result is that, like a "sponge", the "market-led credit system" a b s o r b s the antagonism that has been taken out of the workplace and throws it over the wider society in the form of "private debt" or "asset inflation". Thus, the central-bank focus on "near-term" inflation-

targetting takes its gaze away from a far more dangerous development in the "financial" sphere!! Here are Borio and White once again (!): "Why should this be so? The story can be told in many ways, but a useful way of thinking about the issue is to consider what might be called the elasticity of an economic system under different regimes (Borio and Lowe (2002a)). This notion seeks to capture a systems inherent potential to allow financial imbalances to build up over time, with endogenous forces failing to rein them in, until the imbalances eventually unwind, possibly resulting in financial instability. The notion focuses on the upswing, when the seeds of the problems are sown, rather than on the downswing, when the problems materialise. This elasticity can be thought of as measuring the vulnerability of an economy to boom and bust cycles. The elasticity of an economy depends on the conjunction of arrangements in the monetary and financial spheres and corresponding policy regimes. The thesis is that the conjunction of a liberalised financial system with monetary policy reaction functions that respond solely to near-term inflation pressures, and not to the build-up of financial imbalances, may unwittingly raise the elasticity of the economy beyond desirable levels.2 Hence the need to put adequate, mutually reinforcing anchors in place in the two spheres." ....This "thesis" forms the content of the final chapter of my "Krisis" book. I hope you enjoyed it. Ciao.