INTEGRAL ECONOMICS

Asset Price Bubbles: Monetary

Inflation and Leveraged Speculation
Daniel O'Connor | Integral Ventures, LLC

Absent a major revision in central bank policy or mass

investor strategy, the self-reinforcing dynamic between
monetary inflation and leveraged speculation may build
into a crisis sufficient to force such changes.
Asset Price Bubbles: Monetary Inflation and Leveraged Speculation
Daniel O'Connor | Integral Ventures, LLC
One of the best resources in tracking the credit
dimension of the unfolding drama of stable
instability1 is Doug Noland's excellent Credit Bubble
Bulletin, in the latest issue of which he offers some
choice excerpts from a panel discussion at a recent
meeting of the Western Economic Association:2
Question from the audience: “Professor
(Milton) Friedman, do you think there’s a
role for the Fed in identifying and managing
asset price bubbles?
Friedman: “No.”
Questioner: “Could you elaborate?”
Dr. Friedman: “The role of the Fed is to
preserve price stability. Period. And price
stability in a broad aggregate—in a broad
index. It should not be concerned with the
asset markets as such, only as they effect
indirectly—somehow—the price stability as
a whole.”
Federal Reserve Bank of St. Louis President
William Poole: “If I could just add to that. I
absolutely agree. And one of the reasons I
take that position—I’m really a hardliner on
this. Let’s suppose that the Fed—as you
would want with any good policy
instrument—had perfect control over asset
prices. I think it is incompatible with a
market economy to have a government
agency setting asset prices that are meant
to allocate capital.”
Dr. Friedman: “Asset prices embody a real
magnitude that is a real interest rate. And
the Fed does not control the real interest
rate.”
Setting aside for the moment the incredible
implication that the Fed's current monetary policy is
somehow consistent with a market economy, as
well as the tedious fact that overall price inflation
simply cannot be measured,3 let's continue with
Noland's provocative commentary on the above
discussion:
Contemporary, unrestrained, asset-based
Wall Street Finance—operating without
determined central banks ready to identify
and hinder destabilizing asset inflation and
asset Bubbles—is a recipe for “monetary”
disaster. And it pains me to listen to Dr.
Friedman still professing that price
stability—measured by some broad index—
is dependent upon the Fed actively
managing the “money supply” (he stated
Page 1
so during the discussion). For systemic
price stability—certainly including asset
markets and the Current Account—the
Federal Reserve must take an active role in
regulating Credit expansions and system
liquidity (“monetary” in the broadest
meaning of “finance.”). Special attention
must be given to monitoring and disciplin-
ing the marketplace in the event of
heightened leveraging and speculating.
Admittedly, this would be a complex,
radical and challenging departure from
simply pegging short-term rates (or even
“inflation targeting”), but one I believe is
necessary. And Dr. Poole may believe that
a Fed role in “controlling” asset markets is
“incompatible with a market economy.”
Yet, pegged interest rates, Fed assurances
of abundant marketplace liquidity, and
consequent inflating asset markets are
these days dictating our system’s (gross
mis)allocation of resources and “capital.”
The current Monetary Disorder, and its
perversion of system pricing mechanisms,
is anathema to our Capitalistic system.
Having asset markets as a prime focus of
central bankers is not a “good policy
instrument”—but an all-important process
we’ll have to learn to live with. The
Creation and Flow of (contemporary)
Finance is no longer manageable under the
current system.
The framing of the above discussion
—the Fed’s role in identifying and
managing asset price bubbles—is
problematic in that it ignores the
Fed’s potential role in facilitating
asset price bubbles prior to
any such identification.
The issue of asset price bubbles and the Federal
Reserve’s role in identifying and managing them
has become a particularly hot topic in recent
months. As I addressed in Unprecedented Funda-
mentals, the Federal Reserve’s own study of the
housing bubble hypothesis not only concluded that
there is no such bubble but was silent on the Fed’s
own role, indeed a central role, in facilitating the
unprecedented fundamentals upon which the entire
trend in housing prices is based.4 Thus, the framing
of the above discussion—the Fed’s role in
identifying and managing asset price bubbles—is
problematic in that it ignores the Fed’s potential
role in facilitating asset price bubbles prior to any
such identification.
Recalling the basic architecture of stable instability
—the competitive/cooperative dynamic between
centralized intervention policies of the state and
decentralized exchange strategies in the market—
we can see that asset prices are influenced by both
forces simultaneously. Just as important as these
objective asset prices are the subjective strategies
of investors and the subjective policies of bankers,
which constitute the actionable knowledge base
with which they design their actions, interpret their
results, and learn from experience. Through this
experience-based learning process, these asset
prices then inform the gradual development of more
effective investor strategies and monetary policies
which, in turn, guide future actions by investors and
bankers. These single-loop and double-loop learning
processes are therefore essential to both the short-
term performance and the long-term sustainability
of asset prices.5
This model also highlights another point that is
typically overlooked in discussions like the one with
Milton Friedman and William Poole. By definition,
everything the central bankers say and do is
designed to produce prices in assets and other
goods that are different from those that would have
resulted in the absence of the central bankers’
interventions. Think about it. There is no other
Page 2
reason for monetary policy but to effect some major
change in the outcomes that would have otherwise
resulted in a market economy without a centralized
means of monetary inflation and credit creation.
Therefore, if we can see that monetary policy has
been inflationary for several years and we can see
that certain asset prices have been rapidly appre-
ciating in the wake of this policy and all the more so
when increasingly-easy-to-acquire credit financing
is being used to purchase these assets (e.g.,
housing, mortgages, and mortgage-backed securi-
ties), then it is not much of a leap in logic to
conclude that the Fed is in part responsible for
these asset prices, bubble or no bubble.
By definition, everything the
central bankers say and do is
designed to produce prices in
assets and other goods that are
different from those that would
have resulted in the absence of the
central bankers’ interventions.
For example, in recent years, the Federal Reserve's
inflationary monetary policy of lower short-term
interest rates and lower reserve requirements for
commercial lending has been met by similarly
inflationary policies of some other central banks
who, in order to support their respective export
sectors, have attempted to stem the dollar's natural
depreciation in relation to their own currencies by
aggressively purchasing US dollar-denominated
Treasury securities. The combination of these two
opposing state interventions has produced lower-
than-market interest rates which, in turn, have
created valuable incentives for households to save
less, borrow more, and consume more. To the
extent that the value functions among householders
have remained relatively stable, we can be sure
that tens of millions of people have indeed saved
less, borrowed more, and consumed more than
they would have if the central banks had
maintained policy neutrality.
At the same time, the central banks' inflationary
monetary policies have resulted in lower-than-
market costs of capital for businesses, which have
therefore tended to raise more equity, borrow more
debt, save more cash, and invest more in capital
goods than they otherwise would have in the
absence of these policies. We might also add home
construction to this category of investment, whose
production certainly seems to have increased as a
result of the lower-than-market mortgage rates
offered to builders and homeowners and the higher-
than-market prices in mortgage-backed securities.
These lower-than-market costs of capital have
resulted in higher-than-market rates of appreciation
in the prices of many assets—e.g., stocks, bonds,
houses—which are often touted by government
economists as the increasing savings balances that
more than offset any downside associated with the
decreasing saving rates. In other words, as long as
wealthier householders see the value of their
houses, stocks, bonds, and others assets rising,
even in the absence of any new saving, then all
householders as a group are considered to be
relatively secure.
If this self-reinforcing dynamic
between monetary inflation and
leveraged speculation does not at
least give central bankers and
leading economists pause to reflect,
then it would seem that there is
very little learning of the double-
loop variety to be expected
in the near future.
Overall, with more consumption and more
investment, both funded with increasing degrees of
leverage, we are seeing rates of US economic
growth that are higher than what they would have
been absent the monetary policy interventions.
Furthermore, US economic growth appears to be
increasing all the more so because of the growth in
deficit-spending by the federal government, which
has been fueled by lower interest rates for its own
debt obligations as well as the seamless
monetization of its budget deficits as a critical
component of the Federal Reserve's inflationary
monetary policy.
Such is the basic argument for the use of monetary
and fiscal policies—increases in the supply of money
and credit and increases in deficit-financed
government spending—to drive economic growth,
particularly in the midst of recession. So much the
better if the US government can get foreign central
banks to play along with them because of the US
dollar's unique status as the leading global reserve
currency.
The critical weakness in this proto-global-Keynesian
policy, it seems to me, is that it relies on the
Daniel O'Connor is the managing director of Integral
Ventures, a strategy consultancy committed to foster-
ing more innovative and sustainable ways of doing
business. He has been a pioneer in the development of
integral praxis in business and economics, having
authored numerous articles and essays in this
emerging field.
email: daniel@integralventures.com
website: www.integralventures.com
Page 3
distortion of market prices—the observable,
measureable results of past market decisions—in
order to incent market participants to make future
market decisions that they would not have made if
they could have based these decisions on valid
market prices. Thus, as the model above suggests,
monetary interventions in the credit dimension of
asset markets can, through the distortion of asset
prices, undermine even leveraged speculators’
efforts to learn from their market experiences and
create more adaptive and sustainable market
strategies.
If rising asset prices appear to confirm the validity
of leveraged speculation while not disconfirming the
validity of monetary inflation, thereby encouraging
more of both, then we have a self-reinforcing
dynamic, the limits to which are as psychological as
they are financial. If this self-reinforcing dynamic
between monetary inflation and leveraged specula-
tion does not at least give central bankers and
leading economists pause to reflect, then it would
seem that there is very little learning of the double-
loop variety to be expected in the near future.
Absent a conscious second-order, frame-changing,
double-loop revision in central bank policy or mass
investor strategy, this self-reinforcing dynamic
would likely build into a crisis sufficient to force
such changes.
This July 2005 work is licensed under a Creative Commons
Attribution-Noncommercial-No Derivative Works 3.0 License.
1
Daniel O'Connor. (2005). “Stable Instability.” Catallaxis.
http://www.catallaxis.com/2005/02/stable_instabil.html.
Retrieved July 10, 2005.
2
Doug Noland. (2005). Credit Bubble Bulletin.
http://www.prudentbear.com/archive_comm_article.asp?categ
ory=Credit+Bubble+Bulletin&content_idx=44645. Retrieved
July 10, 2005.
3
Daniel O'Connor. (2005). “The Economic Philosopher’s
Stone.” Catallaxis. http://www.catallaxis.com/2005/03/
the_economic_ph.html. Retrieved July 10, 2005.
4
Daniel O'Connor. (2005). “Unprecedented Fundamentals.”
Catallaxis. http://www.catallaxis.com/2005/04/
unprecedented_f.html. Retrieved July 10, 2005.
5
Daniel O'Connor. (2005). “Stable Instability.” Catallaxis.
http://www.catallaxis.com/2005/02/stable_instabil.html.
Retrieved July 10, 2005.
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