© 2019 by Henry Thornton. 

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Ch. 18. Messages for Friedman, other 'monetarists' and Central bankers

January 8, 2020

The highly professional and detailed monthly central bank reports are designed to demonstrate that no stone has been left unturned. However, there is at least one apparently small stone that demonstrates that there is a large rock left unturned. The apparent small stone is this: ‘Members noted that the ongoing subdued growth in wages implied that there continued to be spare capacity in the labour market.’ 




For this subject we all need to stretch our minds just a bit, so please focus, gentle readers.


To be sure there is almost certainly spare capacity in the Australian economy and indeed in global labor markets. But that is far from the end of the story.  Paul Volcker’s big hit against US consumer inflation in the US economy in 1980 and 1980/81 fixed US goods and services inflation. US asset inflation rose in fits and starts while goods and services inflation remained low, reminding me of the roaring twenties in America. And modern monetary policy workers have yet to resolve the causes of asset inflation.



Self portrait with model of consumer inflation (red) and asset inflation (blue), 2014.


In other countries goods and services inflation took longer to fix.  But despite generally floating exchange rates low US inflation leaked into other economies.  In Australia leaking low inflation was working slowly in the 1980s but very low goods and services inflation was only created in the accidental severe recession in 1990/91.


Congratulations to Deputy Governor Ian Macfarlane for apologising, but not for lack of RBA research. Workers got the message that life was tough and outlandish wage demands became a thing of the past. Then the global crisis of 2007/08 gave workers in most of the globe another great shock, reinforcing the sense in resisting the old game of demanding large wage increases. The reinforced prudence became the global norm.  It is still a powerful force for low goods and services inflation.


Furthermore, even the excess money created by very low interest rates and devices like ‘Quantitative easing’ does little to boost workers’ wage demands. Low wages growth translations into low goods and services inflation. The state of mind of most global workers is ‘low Animal Spirits’.


With my colleague Clifford Wymer I have devised a way to embed hypotheses about the causes of Animal spirits of investors and speculators and Monetary disequilibrium into a long-term model of the British economy.  The wages equation contains the usual labor costs and inflation effects, and the goods and services inflation equation contains a measure of excess money which we call 'Monetary Disequilibrium'. Our model contains a fine equation for share price inflation, presumably giving happiness to the two Nobel Laureates who famously said: 'No-one has ever made rational sense of the wild gyrations of financial prices, such as share prices'. (Akerlof and Schiller, 2009, p 131.)


Insert graph of share prices and estimated share prices here.


Excess money must go somewhere. Asset inflation is an obvious place for it to go.  Investors and speculators in an environment of excess money and low workers Animal Spirits will cheerfully experience rising Asset inflation.  Animal Spirits of investors and speculators are boosted, creating further rises in Asset inflation.  Asset inflation, whilst rising in fits and starts, often goes up a long way with occasional drops until the big drop comes. Strong Animal spirits eventually become weak or even terrified  in our model by the steady hand of the Bank of England, and the downward direction builds upon itself.


The UK share price equation contains the 'Monetary Disequilibrium 'effect and also a measure of Animal Spirits of investors and speculators.  The relevant parameters are all significant and the coefficient on Monetary Disequilibrium effect in the goods and services equation is much smaller (0.131) than that in the share price equation (1.533). ???? And there is the additional impact of Animal Spirits of investors and speculators in the Asset (share price) equation. 


This is a first run at explaining why goods and services inflation can be low while asset inflation is strong.  The main implication is that central banks need a way to at least moderate Animal Spirits of investors and speculators.  Raising cash interest rates will help, as will sensible comment by central bankers about the need for caution in asset markets. If needed, the Prudential authority can be directed to reduce ability of banks and other financial enterprises to lend money.  And Monetary Disequilibrium, the main measure of the effect of monetary policy, must be kept to a fairly steady growth.  Direct effects of cash interest rate and monetary expansion both need to be coherent if Monetary Disequilibrium is to be under reasonable control.


As with fiscal spending and tax cuts, in a bad downturn Monetary Disequilibrium can be used wisely until recovery seems secure.

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