Crypto corruption and un-Stablecoins

by Michael Roberts

“Bitcoin is a speculation and not an investment. Not regulated, not backed by any asset, only worth what someone is willing to pay.” — Matthew Stephenson

“It’s totally absolutely crazy, stupid gambling” — the late Charlie Munger, speaking in 2023.

“Cryptocurrencies are highly volatile and therefore not really useful stores of value and not backed by anything,…  It’s more a speculative asset that’s essentially a substitute for gold rather than for the dollar. ” Federal Reserve Bank chair, Jay Powell

“Bitcoin, it just seems like a scam…. I don’t like it because it’s another currency competing against the dollar.”  Donald Trump, June 2021.

It’s crypto week in the US.  And the price of the leading cryptocurrency, Bitcoin, has hit a record $120,000 as the US Congress prepares to consider bills aimed at creating clearer regulatory frameworks for digital assets.  In the next five days, US lawmakers will consider the Genius Act, the Digital Asset Market Clarity Act, and the Anti-CBDC Surveillance State Act. The aim is to make “America the crypto capital of the world”.

The US Senate has already approved the Genius Act, a bill that enables private companies to issue ‘stablecoins’.  The Anti-CBDC Surveillance State Act would prohibit the Federal Reserve from issuing a central bank digital currency, thus ensuring all the private cryptocurrencies would not have to compete against a government one. 

Where is all this leading to? 

The rise of cryptocurrencies began over ten years ago after the end of the Great Recession.  Cryptocurrencies are digital tokens that are ‘mined’ like gold, not physically but digitally on powerful computers using what are called ‘blockchain transactions’ completely divorced from central bank issuance or control.

For a long time, the price of cryptocurrencies in dollars swung violently, but overall, cryptocurrency prices in dollars have continued to rise (along with stock market prices in the US in particular) as a new form of financial ‘asset’ to speculate with.  Increasingly, cryptocurrencies are becoming recognised financial assets. More than $11bn has flowed into global funds that track cryptocurrencies this year, taking total assets under management to $176bn, according to data from UK group CoinShares.

From the start, cryptocurrency craze has been riddled with fraud, criminality and corruption – the cases of which are too numerous to mention all.  In an annual report last September, the FBI revealed that fraud related to crypto businesses soared in 2023 with Americans suffering $5.6bn in losses, a 45% jump from the previous year. Sam Bankman-Fried, who founded the now bankrupt FTX crypto exchange, was sentenced to 25 years in prison in March 2024 by a New York judge for milking customers out of $8bn. Last month, the US Securities and Exchange Commission charged Unicorn, an investment platform that promised cryptocurrencies backed by real estate, with a $100mn fraud that misled more than 5,000 investors.

The dream of the techno enthusiasts that cryptocurrencies would replace state-issued currencies like the dollar or the euro and so free individuals from the ‘heavy hand of state regulation’ in a new free world of money has never materialised.  Instead, what has happened is that the mega financial institutions have taken over control of these currencies and are turning them into what they hope will be a highly profitable set of financial assets to suck in investors.

The epitomy of this approach is Donald Trump himself. Having previously condemned cryptocurrencies as a scam, Trump nowhas his own cryptocurrency and disclosed almost $60mn in income last year from one of his digital currency ventures. His wife Melania has her own digital currency too. These are called ‘meme’ coins, being related to internet memes, viral moments or current events. They have ranged from tokens representing a euthanised grey squirrel, a cartoon dog and a lewd joke.  Dubious promoters of these coins proliferate.  CoinMarketCap, the online platform and data provider, tracks around 16.9mn cryptocurrencies — but there are millions more, leaving suckers (sorry, investors) with a bewildering number to buy. This is consumer choice under capitalism at its best.

Crypto mogul Justin Sun has publicly flaunted a $100,000 Donald Trump-branded watch that he was awarded at a private dinner at Trump’s Virginia golf club. Sun had earned this for buying $20m of the crypto memecoin $Trump, ranking him first among 220 purchasers of the token who received dinner invitations. Trump’s much-hyped 22 May dinner and a White House tour the next day for 25 leading memecoin buyers were devised to spur sales of $Trump and wound up raking in about $148m, much of it courtesy of anonymous and foreign buyers.

Sun has invested $75m in another Trump crypto enterprise, World Liberty Financial (WLF) that Trump and his two older sons launched last fall and in which they boast a 60% stake.  The company, described as a “digital asset bank”, allows users to borrow, lend and invest in cryptocurrencies.  The US financial regulator SEC has now paused or ended 12 cases involving cryptocurrency fraud, including three Sun crypto companies that were charged with fraud by an SEC lawsuit in 2023.  They had their cases ‘paused’ in February by the agency, citing the “public interest” (!).

Does ‘crypto week’ mean that state-issued currencies like the US dollar or euro are going to be usurped by private cryptocurrencies?  What gives you the answer to that is two-fold: first, all cryptocurrencies are priced in dollars – the state-issued currency that everybody uses to buy things and services.  Bitcoin or other crypto currencies have not replaced dollars (or euros) for the billions of daily transactions. 

The other part of the answer is the emergence of stablecoins.  A stablecoin is a crypto currency coin that is tied to an existing fiat currency, namely the US dollar, making it easy to switch (if expensively) between a crypto currency like bitcoin and an official currency like the dollar.  Stablecoins are supposed to track real-world currencies and so play a central role in the stability of the broader crypto market by providing traders with a safe place to park their cash between making bets on volatile digital coins. 

But that gives the game away.  Stablecoins are an escape hatch out of cryptocurrencies back into ‘real money’ ie dollars or euros.  Stablecoin companies can only do business as long as they have a coin that is backed by US dollar assets.  These companies thus hold US dollar assets like treasury bills in order to meet any sale of their coins for dollars.

The problem here is that stablecoins are often not stable.  The largest stablecoin company is Tether.  Back in 2022, it was faced with a run on its coins when it emerged that it had only 4% of its assets in cash and the rest in risky commercial bills.  It was able to get away with this because stablecoins were not regulated and subject to regulatory supervision or deposit insurance requirements. Now they are to be regulated. But the Genius Act “will not prevent sanctions evasion and other illicit activity and lets big tech giants like Elon Musk’s X issue their own private money – all without the guard rails needed to keep Americans safe from scams, junk fees or another financial crash,” said Senator Elizabeth Warren.

The cryptocraze shows no signs of ending. The big change now is that the cryptocurrency companies are racing to expand into traditional banking in the US, as they seek to capitalise on the crypto ‘free for all’ initiated by Donald Trump.  The so-called Genius Act will tighten regulation of stablecoins and tie them more closely to US treasuries. Only regulated banks and some non-bank groups with licences will be able to issue stablecoins. 

But this really means the end of ‘free private currencies’. “It’s . . . a 180 turn from where a lot of these crypto companies started, saying ‘we don’t need banks, we don’t need laws, we’re above it all’,” said Max Bonici, partner at law firm Davis Wright Tremaine. “Now they’re saying ‘regulate us’.  And the big boys are moving in. Large banks, including Bank of America, are seeking to issue their own stablecoins once US regulation is finalised.

Goldman Sachs says it expects the value of stablecoins in circulation to grow from $240bn to more than $1tn within three to five years. Citigroup includes in its total addressable market estimates $195tn of cross-border transfers and $1 quadrillion of flows sent via SWIFT. JPMorgan says it’s “in the realm of possibility” for stablecoins to take 10 per cent of the $22tn US M2 money supply, or $2trn in assets.

But optimism by the big financial institutions, backed by the US president and Congress, about stablecoins becoming huge is just selling their own book. In practice, there won’t be that much demand for stablecoins as they pay no interest so that their value can be eroded by inflation.  Some banks are trying to get round that. JP Morgan says it is launching a so-called “deposit token” as an alternative to stablecoins — called JPMD. The bank says JPMD will eventually enable its institutional clients exclusively to send and receive money securely on a chain representation of a bank deposit, which will pay interest. 

But again this shows that private cryptocurrencies are not money.  JP Morgan’s tokens are just that, like gift vouchers or supermarket points that can be used by holders only within that company alone.  They are not universally usable.  Like stablecoins, they have to be turned into real money like dollars through another transaction. With bitcoin, your paper gain may look good, but cashing out and realising it is different. For any sizeable amount, you need to put the crypto in an ‘external wallet’. Then you pay a high transaction cost and are also immensely vulnerable to blockchain hackers and scammers.

In global trade and finance, it is hard to make goods and money transfer between parties at the same moment, which creates risk, delay and expense. But as Steven Kelly of Yale’s Program on Financial Stability points out, “When stablecoins purport to solve that, the problem is that supply chain payments now, and in the future, demand bank money.” 

Stablecoins are not money.  As the Bank for International Settlements put it:  proper money “can be issued by different banks and accepted by all without hesitation. It does this because it is settled at par against a common safe asset (central bank reserves) provided by the central bank…..Deposit tokens don’t have this property now and it’s hard to see how that could change”.

Money is the universal form of value; and it must be seen as universal to become money. BIS: “The foundation of any monetary arrangement is the ability to settle payments at par, ie at full value. Common knowledge of the value of money has a shorthand – the “singleness of money” – where money can be issued by different banks and accepted by all without hesitation. It does this because it is settled at par against a common safe asset (central bank reserves) provided by the central bank, which has a mandate to act in the public interest.” 

The state through a central bank guarantees the value of any state-issued currency with infinite liquidity to meet demand.  That does not apply to private tokens like stablecoins, even if they are now to be brought under the regulatory powers of the state.  At best, stablecoins become just another financial asset, like corporate bonds or bills, not cash that can be used universally.

Moreover, the BIS argues that “crypto lacks the scalability and coordination benefits of money. As the size of the ledger grows with the volume of transactions, it becomes harder to update it quickly. The cost of transacting with crypto increases with the volume of transactions and cryptoassets cannot scale without compromising security or their decentralised underpinning.”

Cryptocurrencies are vulnerable to corruption, fraud and money laundering; and as private tokens, they function at wildly varying exchange rates to state-issued money.  As such, they will allow the large financial institutions to make huge profits with no visible gain in value for society.

Bitcoins and other crypto currencies increasingly move in step with the prices of other forms of fictitious capital.  Recent studies and market analyses show that Bitcoin’s correlation with the S&P 500 has significantly increased over the past five years. Especially during macroeconomic crises—like COVID-19, inflation spikes, or monetary policy shifts—both assets have tended to move in tandem. For instance, the 30-day correlation between them has surpassed 70%, showing shared sensitivity to global risks and monetary decisions.

As such, any future instability in financial markets and any significant downturn in the so-called ‘real economy’ will hit the crypto market and its ‘stable’ coins hard. 

Inflation and interest rates: the US experience

michael roberts May 5 Once again the US Federal Reserve is in a quandary.  Does it cut its policy interest rate soon in order to relieve pressure on debt servicing costs for consumers and businesses and perhaps avoid a stagflationary economy (ie low or no growth alongside higher inflation); or does it hold its current interest rate for borrowing in order to make sure inflation falls towards its target of 2% a year? That’s what mainstream economists and investors in financial assets want an answer to.  But it’s not really the important issue.  What the Fed’s current quandary really shows is that yet again ‘monetary policy’ (ie central banks adjusting interest rates and money supply) has little effect on controlling inflation in the prices of goods and services that households and businesses must pay. Central bankers and mainstream economists continue to argue that monetary policy does make a difference to inflation rates.  But the evidence is to the contrary.  Monetary policy supposedly manages ‘aggregate demand’ in an economy by making it more or less expensive to borrow to spend (whether as consumption or investment).  But the experience of the recent inflationary spike since the end of the pandemic slump in 2020 is clear.  Inflation went up because of weakened and blocked supply chains and the slow recovery in manufacturing production, not because of ‘excessive demand’ caused by either a government spending binge or ‘excessive’ wage rises or both.  And inflation started to subside as soon as the energy and food shortages and prices ebbed, global supply chain blockages were reduced and production began to pick up.  I won’t go over the past evidence that inflation was supply-driven not demand-led, which is overwhelming.  But this meant that central bank monetary policy could take little credit for reducing inflation.  And here is the rub.  Inflation rates are beginning to creep back up again, particularly in the US.  US core inflation (which actually excludes food and energy prices) is now rising at over 4% a year on a 3m rolling average. And the reasons are two-fold.  First, food and energy prices have started to rise again.  Oil prices have picked up as the Houthis attack shipping in the Red Sea and Israel extends the war in Gaza towards Iran.  And a key raw material for industry, copper, is in short supply and now has a record price. The Fed is in a quandary and mainstream economists have been forced again to reconsider the efficacy of monetarism, the theory that inflation is caused by excessive money supply growth over output.  Central banks have been squeezing money supply growth supposedly to reduce inflation. But mainstream voices are showing uncertainty.  The FT published an article this week headed: The limits of what high interest rates can now achieve, commenting that “We need to be realistic about what monetary policy can and cannot do”. The article admits that “the effectiveness of monetary policy also depends on the structural economic drivers around it. After all, the era of benign inflation before the financial crisis was bolstered by elastic production and energy supplies. Looking ahead, using rates with unreliable lags to influence demand is a recipe for volatility, as supply shocks from regionalisation, geopolitics and less supportive demographics continue — unless there are offsetting productivity gains.”  The article concludes that “Fiscal and supply-side policy must get greater emphasis in the price stability debate. After all, a faulty faucet is even more useless if the plumbing has gone awry.” Nevertheless, the article continued to claim that monetary policy by the Fed and other central banks had helped to get inflation down.  The article cited various papers for this claim, from the Bank for International Settlements and the Bank of England.  But when you go to those sources, the evidence again is to the contrary.  Take the BoE paper quoted: it concludes that “UK inflation in 2021 is explained by shortages and energy price shocks, and in 2022 and 2023 also by food price shocks and labour market tightness. Inflation expectations have been more well-anchored than predicted by the model. Conditional projections suggest UK inflation will fall sharply in 2023 from disinflationary energy and food price effects, but the decline will slow markedly thereafter.”  So not much to do with ‘excessive demand’ Even at the home of monetarism, the Bank for International Settlements, is less than convincing in claiming that inflation was due to excessive money supply or even excessive demand.  The BIS paper focuses its attention not on the initial causes of the inflationary spike but on the likelihood that inflation will be ‘sticky’ and not come down much because of the risk workers taking advantage of ‘tight’ labour markets to boost wages.  The BIS is more worried about the hit to the profitability of companies than the fact that workers’ wages are still trying to catch up with a more than 20% rise in average prices since the end of the pandemic. “in tighter markets, there is a greater likelihood that bargaining power will shift in favour of workers and pass-through between wages and prices will gain strength.”  Oh dear.  But even the BIS admits that “adverse demographic trends and pandemic-related preference shifts on the supply side, can go a long way in explaining these dynamics.” The final mainstream argument for inflation is inflation expectations.  You see, households and even companies expect inflation to accelerate so households buy more and companies hike prices more, achieving even higher inflation.  The expectations theory is no theory at all.  It can only operate if inflation is already rising and so cannot explain the initial spike at all.  Expectations theory has been debunked as an explanation for rising inflation.  Now with falling inflation, the evidence for this ‘theory’ remains weak.  Allianz Research has disaggregated the 9 percentage point drop in America’s quarterly annualised inflation since the second quarter of 2022 using regression analysis. It found 5.5pp of the drop was driven by supply-chain snags simply unwinding. So that’s some 60% of the decline.  But AR reckons that 2.7pp of the 9% fall “was due to the Federal Reserve’s signalling, which helped to re-anchor inflation expectations.”  I leave you to believe what you make of the idea of ‘signalling’.  Another 2.2pp came from the impact of higher rates squeezing demand, which was needed to counteract the inflationary impact of supportive fiscal policy and labour shortages.  Even if you accept this analysis, it means that 60-80% of the decline in US inflation since the middle of 2022 was due to supply-side factors. And that brings us to the ‘stickiness’ of inflation.  Which components of the inflation index have not fallen despite central bank rate hikes?  The answer is housing costs and motor car insurance, which have risen sharply.  As the FT article admits: “Both are partly a product of pandemic supply shocks — reduced construction and a shortage of vehicle parts — that are still percolating through the supply chain. Indeed, dearer car insurance now is a product of past cost pressures in vehicles. Demand is not the central problem; there is little high rates can do.” The FT article concludes that “Either way, monetary policy is a catchall tool. It cannot control demand in a quick, linear or targeted manner. Other measures need to pick up the slack. Estimates suggest supply factors — which rates have little influence over — are now contributing more to US core inflation than demand.”  Well, actually throughout this inflation rise and fall, it has been supply that has been the main driver.  Where to now?  The risk now is that the US economy could slow down towards stagnation in output while inflation stays ‘sticky’ because of a new rise in commodity prices. The US economy ended last year growing in real terms (ie after accounting for inflation) at an annual rate of 3.4%.  This was greeted with euphoria by the mainstream and the financial media. “The U.S. economy is performing very well…We’re truly the envy of the world.” said one EconForecaster, James Smith.  But then in the first quarter of 2024, that real GDP growth annual rate slowed to 1.6%, the slowest rate since the first half of 2022. Moreover, the latest economic activity surveys, called PMIs, for the US make dismal reading.  Any level below 50 indicates a contraction.  In April, both the US manufacturing and services sector PMIs were below 50 for the first time together. Also, the jobs market is beginning to look frailer.  Sure, the official US unemployment rate is still below 4% (3.9%), but job hiring by US companies is dropping off, particularly among small firms as the National Federation of Independent Businesses survey of hiring intentions shows. And the NFIB survey seems a good forward indicator of jobs growth. And employees are now more reluctant to switch jobs, in case they do not get another. Indeed, over the past two years, most new jobs have been part time. While full-time employment (that always pays better and with better conditions) has stagnated. High interest rates as set by the Fed and other central banks are not controlling inflation.  Instead, they are raising debt servicing costs for particularly small companies just as corporate revenue growth also slows.  Profitability is thus being squeezed, except for the mega ‘Magnificent Seven’ companies.  The 'excess savings' that households built up during the pandemic lockdowns appear to have been exhausted. Confidence to spend among American households has fallen to its lowest level in almost two years as Americans become more pessimistic about future economic conditions. Back last November former NY Fed chief, William Dudley commented: “does the unemployment rate have to rise to 4.25-4.5 per cent for the Fed to achieve their “final mile” on getting inflation back down to 2 per cent? If you think it does, then a hard landing is highly likely.” Claudia Sahm, another former Fed economist reckons that if the unemployment rate runs some 0.5% pts above the bottom for three months, it is a very strong indicator of a recession in output.  Currently, this Sahm indicator is now 0.36 pp above the lowest such reading for the previous 12 months.  So not yet at the ‘recession’ threshold, but closing in. Much of the recent growth in the US economy has been achieved by large increases in immigration.  But from here, if the US economy will only avoid stagnation if productivity growth picks up. Moreover, what will keep inflation down would be a rise in output per worker per hour, ie an increase in new value.  Up to now, US productivity growth in the 2020s has remained relatively moderate. The hope is that AI will bring about a ‘productivity revolution’ setting the US economy on the road to a roaring 2020s where real GDP grows faster than the long-term average while inflation stays low.  At the moment, the opposite looks more likely.

 

Going the last mile: Inflation, Profitability and the Failure of Monetary Policy

  Going the last mile

michael roberts February 11

Headline inflation rates in the major economies have nearly halved since they peaked back in 2022.  Average consumer price growth across the advanced capitalist economies has dropped from more than 7% in 2022 to 4.6% in 2023, according to the IMF.

The reason for the acceleration of consumer price inflation from 2020-2022 has now been well established.  It was caused by a sharp fall in the supply of basic commodities and intermediate products which drove up prices of these suddenly scarce goods.  This was compounded by a breakdown in the global supply chain of goods transported and trade internationally.

The inflationary spiral from the end of the pandemic slump in 2020 to the peak in 2022 was not the result of ‘excessive demand’ caused by too much government spending or wage increases driving up costs for companies.  Study after study has shown that it was supply issues not wage demands that generated the price rises (an average rise of 20% over two years).  Indeed, if anything, it was excessive profit rises that contributed as companies with any ‘market power’ ie a monopolistic position took advantage of rising input costs to raise their ‘mark-ups’.  This was particularly the case from the energy and food majors which control the pricing in those markets.

And yet, central bankers continue to insist that inflation rates well above their policy target of 2% a year were caused by ‘too much’ demand or ‘excessive’ wage rises.  They have to say this because it is their raison d’etre.  Central banks are here to manipulate interest rates and money supply, supposedly in order to ‘control’ inflation and the economy.  They rest their policies on the monetarist theory that it is money supply growth and the cost of borrowing (interest rates) that control price inflation.  But the experience of the post-pandemic inflationary ‘shock’ exposed (yet again) the nonsense of monetarism.

Do we need to control inflation?  For workers, the answer is clearly, yes; because no inflation and even deflation means that their weekly or monthly pay checks are worth the same and any increase would mean better living standards.  But that is not the same for companies.  They like and want some ‘moderate’ inflation as it allows room to preserve profitability when costs of production rise or wage rises offer more demand.  That’s why central banks do not have a target of zero inflation, but instead something like 2% a year. 

But setting a target of 2% a year is really admitting that central banks cannot control price inflation.  Indeed, if we look at the history of monetary policy and its ability to achieve the (arbitrarily fixed) inflation target of 2% a year in the major advanced capitalist economies, it has been a total failure.   Take the ECB’s record.  In the 25 years of the existence of the euro, the ECB has only got close to achieving the 2% target once, in 2007.  In every other year, inflation has been either well above 2% or well below. 

Just by chance the 25-year average inflation rate is 2%, but as the chart below shows, there was a multi-year streak of undershooting the 2% from the end of 2013 (with an annual average inflation at just 0.7% to 2020, then the current overshoot (the annual average inflation since end-2020 has been 5.7%).  And before 2013, the inflation rate was always well above target, despite hiking interest rates and keeping money supply growth down.  In the 2010s, despite quantitative easing (monetary injections) and low and even zero interest rates, inflation did not reach 2% a year.  Overall, the inflation rate had a standard deviation from the 2% annual target of 1.8 times.

It is the same story with the US Fed.  The Fed was close to its target in only two years out of the last 24, and with a standard deviation of 1.2 times.  The Fed failed to keep inflation down to 2% in the 2000s and failed to get inflation up to 2% in the 2010s.  Neither tight monetary policy worked in the 2000s, nor did ‘loose’ monetary policy work in the 2010s.

And when it comes to the Bank of Japan, it totally failed to get inflation up to 2% a year until the recent inflationary shock, despite zero interest rates and massive quantitative easing (bond purchases). 

What the BoJ record confirms is that it is activity in the ‘real’ economy and the decisions of banks and companies regarding their profits (including whether to 'hoard' money) that decides inflation, not central bank monetary policy.

Despite the futility of their policies, central banks have ploughed on with trying to control inflation in the last two years by raising interest rates and tightening money supply.  Now they are claiming their policies are why inflation rates have dropped in the last year and are still falling (for now).  And yet it is clear that it is the sharp fallback in energy and food prices and prices for various intermediate products that has driven average inflation down. 

At the same time, global supply chain pressures have been reduced. 

New York Fed global supply chain pressure index (GSCPI).

Central bank monetary policy has had little to do with any of this. 

Isabel Schnabel is the most hawkish member of the ECB’s six-person executive board. The German economist has become one of the most influential voices on eurozone monetary policy.  She continues to argue that monetary policy has been effective in controlling inflation.  “Monetary policy was and remains essential to bring inflation down. If you look around, you see signs of monetary policy transmission everywhere. Just look at the tightening of financing conditions and the sharp deceleration of bank lending. Look at the decline of housing investments or at weak construction activity. And importantly, look at the broadly anchored inflation expectations in the wake of the largest inflation shock we have experienced in decades.”

Even Schnabel has to admit that, “It’s true, of course, that part of the decline in inflation reflects the reversal of supply-side shocks.” (only 'part'?). But she continues, “monetary policy has been instrumental in slowing the pass-through of higher costs to consumer prices and in containing second-round effects.”  By ‘second round effects’, she means inflation expectations.

But most of these signs are of tightening monetary policies with no causal connection to inflation.  The claim that inflation was curbed by central banks ‘anchoring inflation expectations’ is really a psychological theory of inflation.  Inflation expectations by consumers and companies only vary because of what is actually happening to prices.  Inflation expectations have fallen price inflation has slowed.

According to Schnabel, now the war against inflation was “at a critical phase where the calibration and transmission of monetary policy become especially important because it is all about containing the second-round effects.”  This was what she has called “the last mile” in the battle to get inflation down to 2% a year. 

And what is the difficulty here?  Yet again, it is not supply issues or even profit mark-ups, but “the strong growth in nominal wages as employees are trying to catch up on their lost income.”.  For Schnabel, it’s wage demands that are stopping inflation from falling further.

But Schnabel has to admit that if productivity growth (output per worker) were rising too, then wage costs per unit of output would not rise and profits would be secure.  Unfortunately, for corporate profits, “we’ve seen a worrying decline in productivity” so “the combination of the strong rise in nominal wages and the drop in productivity has led to a historically high growth in unit labour costs.” 

And indeed, there is a strong inverse correlation (0.45) between productivity growth and inflation rates over the last two decades.

Without sufficient productivity growth (more exploitation of labour), this could drive down profitability unless wage demands are curbed.  “How are firms going to react? Will they be able to pass through higher unit labour costs to consumer prices?”, worries Schnabel.  This is where central bank monetary policy comes in, namely to curb spending and investment by raising the cost of borrowing, she argues.

Schnabel is worried that the inflation beast has not been tamed yet and so high interest rates must be sustained.  She refers to an IMF study that claims to show that when interest rates are kept high until the pips of the economic orange squeak, this not only stops inflation coming back, but also eventually gets the economy going quicker afterwards.  This is the Volcker policy of the late 1970s in the US.  Volcker was the Fed chief then and to ‘cure’ the economy from inflation he maintained high interest rates until the US economy dropped into a slump.  Inflation then subsided but along with the economy and jobs.  But this ‘cleansed’ the economy supposedly for faster growth later in the 1980s.

But the cleansing solution comes at a price (sic). The IMF report’s key finding is that the successful resolution of inflation shocks was associated with more substantial monetary policy tightening.  “But those that resolved inflation with high interest rates experienced a larger decline in GDP growth than those that did not.” (IMF).

The problem with Schnabel’s monetarist theory is that it does hold with the reality of capitalist production.  Within this theory is the neoclassical concept of an ‘equilibrium rate of interest’ called R*, which is the interest rate level that supposedly keeps inflation to the set target, but also avoids unemployment and a slump.  Schnabel: “The problem is it cannot be estimated with any confidence, which means that it is extremely hard to operationalize …. What we really care about is the short-run R-star, because it is relevant to determine whether our interest rates are restrictive or accommodative. The problem is we don’t know where it is precisely.” (!)

Indeed, as Minneapolis Fed President Neel Kashkari recently explained, “The concept of a neutral stance of monetary policy is critical to assessing where policy is now and what pressure it is having on the economy. While we cannot directly observe neutral, economists have models to estimate it, which are imperfect even under normal economic circumstances. Our various workhorse models for the economy have struggled to explain and forecast the pandemic and post-pandemic periods given the extraordinary changes and disruptions the economy has experienced.  So I also look to measures of economic activity for signals to try to evaluate the stance of policy. In other words, the monetarist theory cannot be applied to reality and the reality is that economic activity drives inflation and money circulation, not vice versa.

Schnabel recognizes the past failure of monetarist policies.  “One is the period after the launch of the ECB’s asset purchase programme in 2015. That was a time when a lot of central bank reserves — base money — were created. But we did not succeed in lifting the economy out of the low-inflation environment. Why was that?” The reason was that “the balance sheets of banks, firms, households and governments were relatively weak. You remember, after the global financial crisis and the euro area sovereign debt crisis, there was little willingness to grant loans and to invest. Inflation did not come back as much as the ECB would have hoped.” Exactly.  

It was the state of the real economy, in particular profitability of capital and the low demand for credit to invest, not the price of money, not the mythical R*, that drove the economy.  The ECB was ‘pushing on a string’, to use Keynes’ phrase, and getting nowhere in reaching its arbitrary 2% inflation target.  Schnabel again: “the ECB’s asset purchases before the pandemic were not as successful in bringing inflation back to our target as we would have hoped, because their effectiveness depends on the economic environment.”

Indeed.  The truth is that central banks have little or no influence over the investment decision of companies – it’s the profitability of investment that matters, and from that, flows how much inflation emerges in an economy.  Given that profitability of capital currently remains low, investment growth is weak and productivity is not recovering much, this suggests that Schnabel’s ‘last mile’ is more like a horizon that she will never reach.