Price Discipline vs Monetary Scarcity
How to discipline prices without making money scarce
Last time I talked about how credit systems fundamentally operate with two different kinds of assets: collateral assets and settlement assets. The settlement asset is typically directly tied to the unit of account, such that it is contractually stable, in that payments can be planned for and executed using the settlement asset, or obligations in that unit. The reason why credit systems are unstable, is because the price of collateral assets is both uncertain and unstable.
Lending as a part of payment systems is only necessary at all because of the uncertainty and illiquidity of collateral assets. Collateral assets are difficult to price and/or costly to transfer. If the price of collateral assets were stable and they were liquid, easily able to be transferred to another party, then there would be no need for interest based lending to operate payment systems. In such a case interest would only be used to redistribute resources, and to thus tax people who do not own resources, but still need to use them to keep the economy going.
The Mechanics of Interest: Equilibrium vs. Average Rate
Interest analysis is often based on measuring an average rate of interest and representing this as an equilibrium. But there is significant and fundamental mistake when people do this, and that is neglecting to keep track of the direction of lending.
In physics, we distinguish between speed and velocity. Speed is a quantity, velocity is a vector. The distinction is that velocity also includes the direction. When people lend or borrow, there is a directionality to that based on which side of the transaction they take. To discard this information is to fundamentally misunderstand how and why credit is executed, and what impact it has on an economy.
Importantly, you can use an average velocity over time to calculate displacement of an object. If you multiply the average velocity by the time elapsed, then you will get displacement. But if you do the same thing with the average speed, you don’t get the final displacement, you instead get the distance travelled. Displacement and Distance Travelled differ because motion in different directions can partially or completely cancel itself out.
Similarly, in analyzing credit we must also keep track of the direction of lending. This is why MMT and Post Keynesian academics distinguish between vertical and horizontal lending and payments. A vertical transaction happens between a public institution and private entities. A horizontal transaction is only between private parties.
For the purposes of inflation analysis, horizontal transaction can be considered neutral, in that they have no tendency to create inflation one way or another by themselves. This does not mean they never affect the path of inflation, such as why you might want to hike laterally across a mountain to find a better place to ascend or descend. But importantly, these horizontal transactions are not the source of price changes, even though they may provide detailed information about the price level.
The second way that horizontal transactions might affect the price level, is that they can lead to a concentration of wealth, and thus one group of private citizens may gain greater political or economic influence. If that group benefits from a higher or lower price level, they may be inclined to influence or allow prices to go in that direction, especially if public institutions reference private information about prices for guiding public policy. Importantly however, concentration of wealth is not deterministic in its effect on price path. It gives a group of people greater influence or agency to guide prices, but it does not reliably do this in one direction or another.
Horizontal interest payments, as a transfer between private parties, are completely neutral to the balance of payments between the public and private sector, which is what creates the potential for inflation or deflation.
Finally, this issue of directionality is also why the idea of “monetary velocity” is wrong. When people say “money velocity”, they are really measuring “monetary speed”, as they are discarding this directional information about money.
Uncertainty vs Instability
Uncertainty and instability may sound like the same basic idea, but instability happens when a bunch of uncertainty goes in one direction.
In financial terms we call this a “boom” or a “bust”. While uncertainty adds costs and difficulty to financial systems, instability creates much more significant problems.
What is Price Discipline?
Price discipline, on the monetary side, is about keeping the appraisal of collateral assets down so that you avoid bubbles or other similar financial hazards. In this process the important part is to target the critical parts of the financial system that serve as basic infrastructure: the banks.
Price discipline is potentially much more effective than monetary scarcity for managing inflation because collateral assets represent the much greater portion of financial balance sheets and total wealth than simple monetary savings.
Think of it this way. Monetary scarcity tries to limit how many dollars people have, so they feel stressed and want to save more. Price discipline is calling bullshit on what people claim their assets are worth. Attempting to create monetary scarcity without addressing price discipline tends to lead to more wealth concentration and hurting working people, while asset owners can still use their assets for collateral at inflated prices. In an economy with significant wealth concentration and that is prone to bubbles and crashes, monetary scarcity is not an effective or direct remedy to the fundamental problem, which is an increase in wealth concentration leading to rising prices for assets.
There are many potential ways to approach this, but the most important question is “why?” Why should governmental entities seek to discipline the appraisal of collateral assets for banks? What is the public interest in this regard?
Basic Consumer Protection
Critical Financial Infrastructure
The first reason why government should regulate banking asset pricing is a matter of "consumer protection”, the idea that when people buy something they need to know what they are getting. This is the same reason why governments require food labelling or drug testing before these products can be sold to consumers. The job of maintaining market honesty is a common effort, it can not be undertaken in an individual or isolated manner, as the ways of defrauding individuals are quite complex and can be difficult to find or correct. Now, this does not mean that industries can never be self regulated or market regulated. But to rely on such mechanisms in isolation without some level of government oversight, is like expecting professional athletes to call “foul” on themselves. What makes sense for a game of pickup basketball does not make sense for the NBA finals or Olympics. Many people who try to promote only market or industry based solutions for regulation, have either a special interest or are in general just anti-government. They may not understand or be willing to work with public and private solutions in collaboration. Regardless, public regulations can and should play an important role in managing fair market practices and transparency. However, there’s really no way to argue or prove this to someone who insists that we can creatively solve this problem without “government”.
The second reason to regulate bank asset pricing, is because banks are financial infrastructure. Employers pay employees through the banking system. People save money and send money through banks. When banks fail or cannot be trusted, then the larger payment system and economy can be compromised, everything becomes less reliable and more costly. Thus there is a public interest in regulating banks from this perspective, in that they represent shared critical infrastructure like a road or a bridge.
On the other hand, banks and private owners may have specific reasons why they like asset prices to rise. As banks take a profit from interest, their cut of that increases when the price of assets increases. Also not insignificant is that banks can often socialize their losses when they face failure, or simply exit taking their profits over time with limited liability and responsibility when things fail all at once. For these reasons there is a tension between a public interest to keep prices disciplined, and private interest in inflating asset prices higher. Often many apparently unrelated interests can align in this tug of war. For example, banks and homeowners may both like when home prices rise steadily over time, and homeowners tend to have more influence and permanence in local politics than renters. Renters are often self-gerrymandered into population centers and more likely to move, thus less able to build up a network of political influence. So their interests may be underrepresented in local politics. Renters, unlike owners, would prefer that home prices stay low.