Big Money Wants Hard Money—But Why?

Let’s see if we can shed some light on the dialogue between Paul Krugman and Steve Randy Waldman (or indeed between Paul Krugman and Paul Krugman).  It is an indisputable fact that the rich have a strong bias in favor of tight monetary policy and high real interest rates.  They panic at the slightest threat of higher inflation.  As Waldman pointed out, this surfaced as early as the 1896 presidential election, when tycoons invested heavily in the defeat of William Jennings Bryan.  The issue is not whether but why.

Broadly speaking, there are three types of financial assets anyone, rich or poor, can hold, money, credit and equity.  Money is money.  Credit is claims on debt service payments from borrowers.  Equity is claims on flows of net revenue from real, mostly corporate, assets.  In a perfectly certain world only money would be affected by changes in inflation, since forward-looking agents would build ups or downs in inflation into the prices at which they would buy or sell other assets.  If you knew that the nominal earnings of a corporation were sure to rise due to accelerated inflation, for instance, the nominal share price would have to rise correspondingly.  Same with credit terms.  Only unanticipated changes in inflation can affect real equity and credit values.

How would we expect this to play out?  The effect on credit is not disputed: creditors lose as a result of unanticipated increases in inflation and debtors gain.  The effect on equity is less clear.  To the extent that loose monetary policy is expansionary, episodes of rising inflation will also be times of near-to-full-employment, meaning greater demand for goods and services and healthier profits.  On the other hand, if loose monetary policy is undertaken during a period in which its impact on demand is small relative to its contribution to higher inflation, it will be need to be counteracted, sooner or later, by a subsequent tightening, with negative effects on profits and equity values, at least in the short run.  Think Paul Volcker in this context.  Thus, while hard money is good for creditors, its effects on holders of equity is less clear.

Now the stylized facts go something like this: (1) Rich people hold very little cash.  The direct effect  of inflation on their wealth is small.  (2) Rich people are distinctive in the extent to which their portfolios are balanced toward equities.  They can afford the greater risk and reap the higher returns, especially since they can afford to hire expert investment assistance.  (Piketty spends some time on this point.)  (3) Therefore the class interest of the rich with respect to monetary policy ought to vary with the business cycle.  They should be for soft money when demand is weak, as it is now, in order to support equities, and for hard money in the vicinity of business cycle peaks.  Yet the rich seem to be wedded to hard money throughout the cycle.  That is what needs to be explained.

Waldman argues that, for the truly rich, it is relative and not absolute wealth that matters.  Moreover, the rich are risk averse, and inflationary episodes tend to reshuffle the wealth orderings, since some equities shoot ahead of prices and others slip behind—not predictable in advance.  My response would be that this hypothesis is not very Occam: it rests on several assumptions, none of which, to my knowledge, is empirically established.  Is it true that wealthy folks are more driven by relative than absolute standing?  Are they sufficiently risk averse with respect to these standings?  What is the historical correlation between times of rising inflation and the stability of wealth orderings?  It’s a hard story to establish.

I do agree with Waldman on one count though: part of the explanation should rest on risk aversion.  We have a tendency to think about the political economy of issues like monetary policy and inflation by focusing on their effects on expected wealth, less on the role of dispersion around those central estimates.  Since the relationship between hard/soft money and real equity values is difficult to forecast, the (possible) neutrality of changes in inflation with respect to mean future values is not decisive.  I think the combination of anticipated losses (money and credit assets) and uncertainty costs (equities) goes some distance toward giving us the explanation we’re looking for.

But not far enough.  Surely during times of clearly depressed demand, such as the present, the prospective benefits to equity values should be compelling.  This, in fact, is exactly what Keynes was counting on from a political perspective.  His analysis of anti-recessionary policy is political-economic: it makes an economic argument that is intended to contribute to the formation of a political coalition in favor of expansion.  In his own life, Keynes was preoccupied with political maneuvering of exactly this sort.  What makes The General Theory a watershed is not just its economic content, but its role in precipitating Keynesian political coalitions during the post-WWII decades.

Of course, we all know that this political project has collapsed.  In no country today is there a significant portion of the capitalist class that is willing to align with working class movements (if they even exist) in favor of aggressive full employment policy.  Really, Krugman’s question—why don’t the rich recognize a positive effect of expansionary monetary policy on their equity holdings?—converges with this second one—why has the Keynesian coalition vanished from modern politics?

I like the specificity of the Krugman version of this question, which cuts through a lot of the abstract speculation of the political economy set on matters like financialization, globalization and the like.  Here we have a very concrete problem, the resistance of the rich to the notion that countercyclical monetary policy, under the right circumstances, could actually make them richer.

Personally, I think Krugman is partly right about what he calls false consciousness, and I would simply label as the relative autonomy of ideology.  For a variety of reasons (this post is getting too long!) an ideology hostile to low real interest rates has become prevalent among the affluent 20% or so, encompassing the very rich but extending well beyond them.  This ideology is very well established socially and in the media, and it exerts force even when it obscures actual economic relationships.  Consider the ubiquity of Type II money illusion, for instance.

But I do think that there are objective considerations as well.  Remember that portfolios of the rich are balanced in some fashion.  The extent to which wealth-holders can indulge in higher-risk equity investments depends on the cushion they acquire from lower-risk credit assets.  Indeed, when credit performs especially poorly investors are tempted to reach for yield, which even they recognize as problematic.  In short—and this really calls for a much deeper, more quantitative analysis—I doubt that the putative benefits to mean equity forecasts stemming from loose monetary policy fully offset the likely costs to credit assets.

Finally, there is the fundamental question: is Krugman right to see a predictable positive response of profits, and therefore equities, to Keynesian fiscal and monetary policy in the slump?  Consider the profit boom of the last few years.  To Krugman’s horror (and mine too), political elites in Europe and North America have simply turned their backs on Keynesian policy, accepting prolonged stagnation as the new normal.  Demand has remained weak, and investment is paltry at best.  But this has been good news for unit labor costs, as workers settle for less and less.  The upshot is a much higher profit share of a non-growing pie, and equities are doing just fine, thank you.  Understanding these dynamics gets us to the crux of the demise of the Keynesian coalition.  That is, the instability of the labor share in the post-1970 period is a key aspect of what differentiates it from former times.

Note: there is a longer but nonpartisan and open-ended treatment of these issues in my new macroeconomics textbook.  I felt it was not possible to depict the trajectory of 20th century macroeconomics without bringing in the political dimension.