More on bubbles and bricks and mortar

Aug 16, 2013·Alasdair Macleod

In my last article I concluded there are all the signs of money moving from purely financial activities into assets such as residential property. Conventional thinking is on the lines that we are seeing yet another property bubble being generated, and along with bonds and equities, all these bubbles will end in tears.

A factual examination of the evidence casts doubt on this approach. There is only one true bubble, and that is the major currencies which are inflating in an alarming and co-ordinated fashion. The rising prices of various asset classes are the consequence of these currency bubbles and are not bubbles in their own right. The distinction is important, because it represents the early stages of an accelerating trend of falling purchasing-power of currencies, and not rises in asset prices as commonly supposed.

Unfortunately this distinction is poorly understood by the neo-classical economic intelligentsia, who basically view inflation as rising prices instead of depreciating currency. Worse, they think it is a relationship they can control despite all evidence to the contrary.

The path along which monetary inflation undermines a currency’s purchasing power was described by Richard Cantillon, who emerged from John Law’s Mississippi Bubble the wealthiest commoner in the world. The uneven spread of rising prices following the introduction of extra money and credit is now known as the Cantillon Effect. But Cantillon was writing about increased quantities of silver coin; today we are talking about fiat currency with no intrinsic value whatsoever. Crucially, this means as well as expecting a fall in the purchasing power of extra money as it chases the same amount of goods, we also have to deal with a paper currency whose value, being wholly dependent on the users’ perception, has the potential to collapse completely.

We must bear this in mind as we track the money-bubble unwinding from the purely financial system through residential property and other capital assets, into the hands of the secondary beneficiaries such as estate agents, lawyers, plumbers and carpenters; and thence into the hands of tertiary beneficiaries and so on. This is mystery to the neo-classicists, who will be surprised to find that firstly GDP, being simply a money-total of all recorded economic transactions, will grow more quickly than they first expect, without any material reduction in unemployment. And secondly, they will be mystified by the rapidity of the loss of purchasing power of their fiat currency.

The reluctance of the economic establishment to comprehend these few simple facts makes them likely to be too slow in raising interest rates to curb demand for money. They will still have an eye on the cost of financing government deficits, and the destruction to bank balance sheets from falling bond prices as well as potentially frightening losses on credit default swap derivatives. This reluctance will signal to the markets that central banks are no longer in control.

This is why it is so important to understand that the problems emanate from the money side, problems that seem certain to escalate. Some assets, such as fixed-interest bonds will suffer badly, while others will prosper. Understanding this difference made Cantillon very rich by cashing in paper for gold. Not understanding it impoverished John Law, who was the Keynes of his day.

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