Speculative capitals and demand pull inflation below full employment Angel Asensio CEPN, University Paris 13 This draft, 22 October 2011 Abstract In a series of papers published in The Time in 1937, while the rate of unemployment was around 12% in the UK, Keynes expressed his concern with potential inflationary pressures owing to the government proposal to finance rearmament partly by means of borrowed money. The topic still was the central purpose in 1940 of his How to pay for the war: "Some means must be found for withdrawing purchasing power of the market; or prices would rise until the available goods are selling at figures which absorb the increased quantity of expenditures – in other words the method of inflation." This suggests, in accordance with Minsky's views, that a demand pull inflation may develop in Keynes's theory, in spite of unemployment, as a result of an excess "purchasing power" due to the banking system financing of expenditures that eventually prove unable to generate the revenues required for the debt repayment and for the withdrawal of the related amounts of purchasing power. Based on Keynes and Minsky arguments, the paper examines whether/how the financing of bad debts on a large scale - instead of rearmament - is capable of moving inflationary forces from asset markets (where they remained confined in the aftermath of the 2008 financial crisis) to the whole economy, thereby triggering a demand pull inflationary process in spite of strong unemployment. 1. Introduction The asset prices recovered rapidly in the aftermath of the 2008 financial crisis, partly because the Fed managed so that transactions could be made at increasing prices by providing the financial sector with the huge amounts of money it demanded at very low interest rates, and partly because authorities have been implementing the new prudential regulations rather smoothly in Europe and the US, so that unbridled speculative finance seems not to have been dissuaded severely. Hence, if one considers the recovery in the market valuation of assets since the financial collapse of 2008, the rapid 2009-2010 recovery of most financial institutions in developed countries (in comparison with the weakness of economic recovery) and the rapid comeback of big profits, one is led to the conclusion that the unsustainable trends of the pre crisis period have not been totally fought, which unfortunately is corroborated by the threats that are still hanging on international finance in relation to the so called "sovereign debt problem".1 1 The asset prices reflation mainly worked indirectly, but some central banks also have bought financial assets directly: "The measure adopted by the ECB have lead to an increase in its balance sheet higher than 45% between September 2008 and January 2009. These measures hitherto sought to increase the interbank market liquidity while other central banks also sought to influence some financial assets prices (public or private) through their purchases (Fed, Bank of England, Bank of Japan)." (translated from DGTPE, Lettre Trésor-Eco, n°56, Avril 2009, p 1). The 2009 recovery in financial markets has been documented for example by the IMF (Global Financial Stability Report, Market Uptdate, January 2010). 1 On the other hand, oil and raw material prices have been showing an increasing trend for months, so that central banks and commentators have been watching out for a possible return of inflation, although hitherto there was not significant signals of consumer price increases in advanced countries. The international financial system furthermore is still fragile, so that one may wonder whether the combined effects of higher financial uncertainty, of less optimistic expectations with respect to the financial assets future returns and of the progressive impact of the new regulations could divert significant amounts of speculative capitals from the financial market. As, in this case, speculative capitals would seek for investment in real assets and durables goods, this raises the question of whether the 'capital market inflation' could propagate beyond the financial sector.2 According to The General Theory, inflation is rather expected to develop in conditions of full employment, for, below full employment, prices increases are usually a short run by- product of output increases in the presence of decreasing returns, which is not what Keynes called 'true inflation'. Chick (1983) nevertheless pointed out that "there is nothing in [The General Theory] which actually impedes understanding of the conjunction of unemployment and inflation" (Chick 1983, p 280). And as a matter of fact, in a series of papers published in The Times in 1937, while the rate of unemployment was around 12% in the UK, Keynes expressed his concern with potential inflationary pressures owing to the government proposal to finance rearmament partly by means of borrowed money. The topic still was the central purpose in 1940 of his How to pay for the war: "Some means must be found for withdrawing purchasing power of the market; or prices would rise until the available goods are selling at figures which absorb the increased quantity of expenditures – in other words the method of inflation." (CW, vol.9, p. 378). This suggests that a demand pull inflation may develop in Keynes's theory, in spite of unemployment, as a result of an excess "purchasing power" due to the banking system financing of expenditures that eventually prove unable to generate the revenues required for the debt repayment and for the withdrawal of the related amounts of purchasing power. Such a kind of financing can be said to produce "excess money".3 The argument rejoins Hyman Minsky views on the causes of inflation: "Inflation is, first of all, the result of financing too many claims on the supply of consumer goods at the inherited prices. Any restriction on the supply of consumer goods –such as occurs in wartime or as the result of a drought— or any expansion of incomes that will be available to finance the demand for consumer goods, without any concomitant increase in the supply, will lead to rising prices." (Minsky 1986, p 261) 2 "There is no doubt that investment in financial derivatives markets for agricultural commodities increased strongly in the mid-2000s, but there is disagreement about the role of financial speculation as a driver of agricultural commodity price increases and volatility. While analysts argue about whether financial speculation has been a major factor, most agree that increased participation by non- commercial actors such as index funds, swap dealers and money managers in financial markets probably acted to amplify short term price swings and could have contributed to the formation of price bubbles in some situations. Against this background the extent to which financial speculation might be a determinant of agricultural price volatility in the future is also subject to disagreement. It is clear however that well functioning derivatives markets for agricultural commodities, could play a significant role in reducing or smoothing price fluctuations – indeed, this is one of the primary functions of commodity futures markets." ("Price Volatility in Food and Agricultural Markets: Policy Responses", Policy report to G20 coordinated by the FAO and the OECD, June 2011, p 12) 3 Clearly, excess money here does not refer to an excess of the supply over the demand for money, which would be inconsistent with the Post Keynesian approach to endogenous money. 2 This paper examines whether/how the financing of unproductive bad debts on a large scale - instead of rearmament - is capable of moving inflationary forces from asset markets (where they remained confined in the aftermath of the 2008 financial crisis) to the whole economy, thereby triggering a demand pull inflationary process below full employment. It is argued that enforced prudential regulation alone would not suffice. A demand pull inflation process requires the supply of goods to be inelastic. Arguably this could happen because of the combined effects of productive capacity destruction and of sluggish investment in the wake of the economic depression. Section 2 considers how the banking system was led to endogenously provide the economy with an excess money by means of bad debts financing. Section 3 deals with the topic in the formal term of an "equation of exchange" which captures the transactions on existing assets besides the transactions in the current output. Section 4 discusses how excess money could fuel inflation and section 5 considers the supply-side condition for a demand-pull inflationary pressure being able to effectively degenerate into inflation below full employment. 2. Easy money, capital market inflation and the making of (endogenous) excess money In a safe economic context, money quantity increases do finance income-generating projects that enable future repayments and money withdrawing. In the current context however, large amounts of money have been endogenously created which did not finance additional economic growth but, instead, fed the housing and financial assets prices beyond sustainable trends. Assets inflation is basically unsustainable when it rests on the illusion that assets will deliver returns that they eventually will not deliver. As Minsky put forward, such a process can hold for a while, insofar as authorities, by means of easy money, allow for the validation of the extra profits attached to the optimistic valuation of assets. The value of assets suddenly collapses, be it caused by an endogenous increase in the rate of interest (as suggested by Minsky) or caused by a slump in the expected return on capital (as Keynes suggested), when markets understand that assets will not deliver the optimistic return that was expected. After the crisis, part of the money amounts that had refinanced unsustainable debts on the basis of optimistic revenue expectations still circulates, since the full repayment of debts proves to be impossible, so that the related money withdrawal which should have occurred in safe financial circumstances did not operate eventually, or operated only partially through the forced liquidation of assets of excessively indebted agents .