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NEW YORK (TheStreet) -- The Federal Reserve has pumped trillions of dollars into the banking system and yet the economy has only responded modestly to this injection. Instead, a large portion of these funds have gone into what can be called the financial circuit of the economy and has helped to create asset price bubbles in various markets.

How did the Fed miscalculate? Why have officials at the Federal Reserve, as well as other policymakers, missed this re-allocation of resources within the economy? 

Keynesian economics may be one reasons. Let me explain.

This re-allocation may have been missed because the models used by the Fed and other policymakers are almost universally based upon Keynesian economic thinking that focuses on the side of the economy that deals with consumption and physical investment expenditures. And they are very skimpy on the monetary or financial side of an economy. (I know because I was once a Fed economist.) 

Most Keynesian models contain the following causal path: The central bank changes the money stock and this changes interest rates, which then impact the rest of the economy. This is very typical of most current approaches to macro-economic theory and practice.

As a consequence, what happens in the financial circuit of the economy is either ignored or is only clumsily appended to the analysis of what is happening to the production of goods and services.

A recent example of how the analysis of the financial circuit of the economy can get separated from the industrial circuit of the economy is the work of Kenneth Rogoff and Carmen Reinhart in "This Time is Different," a book that focuses on the financial aspects of economic crises. What the Keynesian economic models leave out is the ability of the economy to expand credit almost endlessly as inflation and inflationary expectations pick up in an economy.

In modern economies, financial institutions and businesses find ways to expand credit way beyond the simple model of bank deposits. Whereas commercial banks may be limited in the amount of deposits that can be created for a given amount of reserves in the banking system, other financial institutions and businesses can expand credit almost without limit through increasing financial leverage and financial innovation. Monetary inflation expanded into credit inflation.

Consequently, the inverted pyramid of credit created has done nothing but grow and grow and grow since the early 1960s. Most of the credit created in the early 1960s went into the industrial circuit: That is, it went into manufacturing and other productive outlets. Thus, consumer price inflation took off.

Inflation picked up in the 1970s along with inflationary expectations, and people and businesses found that asset prices also increased. Homes became the savings account of the middle class and more sophisticated investors found that gold and other commodities became good hedges against inflation.

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As consumer price inflation took off, so did asset price inflation. But, as Paul Volcker and the Federal Reserve stamped out consumer price inflation by the middle-1980s, asset price inflation stuck around. For the sophisticated investor, asset price inflation was easier, it was just a financial transaction. Returns did not have to wait for selling cycles or business cycles; one could just sell out when prices rose sufficiently. And, all kinds of new financial innovations could be created to support new opportunities for investment.

In the 1990s and 2000s, more money flowed into these financial games and less money went into the industrial circuit. Monetary policy seemed to have a shrinking impact on economic growth -- and on inflation

Keynesian models just do not pick up this behavior and so the federal policymakers just go ahead and pump more money into the economy, which mostly benefits the wealthy, sophisticated people that can take advantage of the rise in the price of assets.

And this, in turn, has led to bubbles.

A Note on Bubbles 

Asset price inflation caused people to be concerned about credit bubbles. Bubbles, however, were hard to define -- before they burst, anyway.

Perhaps the best explanation of a bubble is that presented by Atif Mian and Amir Sufi in "House of Debt" (on pages 108-110). The authors contend that when the buyers and sellers of an asset both believe they got a good deal and that the price of the asset will go higher, the market is not in a bubble and hence cannot be defined as being in a bubble.

This, however, is the problem for policymakers. If a rise in asset prices cannot be deemed a bubble, then policymakers cannot react and move to stop the bubble where it is. The policymakers continue to carry out policy, which in this case would usually be one aimed at expanding the economy.

Continuing to try and expand the economy when will only reinforce the belief that asset prices should go higher, thus given greater returns to the speculators betting on a further rise in prices. More money goes into the financial circuit of the economy -- and less money goes into the industrial circuit, that is, into the production of goods and services.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.