Asset price inflation

Asset price inflation is a rise in the price of an asset that does not reflect a relative change in the price of that asset. It is not a term that is currently widely used or carefully defined, although one sees it in print at various times (Schwartz, 2002; Piazzesi and Schneider, 2009). To formally define asset price inflation, one must define both inflation and asset, neither of which is easy or unambiguous.

In earlier times (pre-1930s), inflation was defined as an increase in the money supply (Bryan, 1997). At that time, in the definition, it was noted that such increases were often accompanied by increases in prices, but the determining factor of inflation was increases in the money supply. As long as the money supply was the numéraire, and was thought of as a physical asset (primarily gold), that served as a reasonable definition. Inflation was the inverse of the price of gold; that is, a fall in the price of gold relative to prices of other things that people bought (both assets and goods).

As money became thought of as separate from gold, that definition of inflation no longer remained clear-cut, but the convention of defining inflation in terms of an increase in the money supply remained. A problem remained, however, as it was unclear what the money supply was: there were many alternative definitions of money, and there was no compelling reason to use one over the other, and thus there was no unambiguous defini- tion of inflation. At that point, inflation started to be defined in terms of an increase in the price of produced goods, not in terms of an increase in the quantity of money.

Contested terrain

The question "Why do central banks do what they do?" seems like an obviously impor- tant question, especially considering that political straitjackets limit countercyclical fiscal policy, leaving central banks as the dominant macroeconomic policy-making institution in most countries. Yet, mainstream macroeconomics has given very little thought to ana- lysing the economic and political sources of central bank goals and conduct.

Rather, the implicit assumption of most mainstream analysis is that central banks try to make policy in the general interests of society as a whole. From this perspective, "poor" monetary policy stems from failures of theory, judgment or forecasting rather than from a lack of concern for the public interest.

Effective lower bound

The effective lower bound, hereinafter used as a synonym for zero lower bound (ZLB) on nominal interest rates, describes a situation in which the policy-controlled short-run interest rate - to wit, the overnight repurchase agreement (repo) rate at which depository institutions borrow short-term funds from the central bank - is reduced to close to zero: to a level where it cannot be, for practical reasons, brought down any further.

In mainstream economics, the ZLB is deemed to pose a serious challenge to central banks, as it may push the economy into a "liquidity trap", which, in turn, cripples the effectiveness of monetary policy and renders the latter unable to achieve the macro- economic objectives of low and stable inflation and sustained economic growth. This is so as, once the ZLB on nominal interest rates has been reached, central banks have no other option but to substitute standard interest rate policies (based upon the control of the nominal short-term interest rate) with non-conventional monetary policy instruments, whose ultimate impact on economic activity is highly uncertain.

Bubble Act

The so-called "Bubble Act" was a durable, if inconsistently enforced, feature of British law from its passage on 9 June 1720 to its repeal on 29 June 1825. To modern eyes, the central clauses of the Act are those that prohibited the establishment of joint-stock cor- porations issuing transferable stock unless a charter had been secured from the Crown. The Act has often been interpreted as the British Parliament's attempt to broadly con- strain speculative manias of the type that developed around the South Sea Bubble of 1720. Beyond the formal penalties prescribed for use against unincorporated firms, it has commonly been argued that the Act exercised a "symbolic force" that delayed the evolu- tion of corporate organization in Britain (McQueen, 2009, p. 20).

Bubble

A bubble is when the price of financial assets increases in an irrational way after a long period of optimistic expectations and high profits. When a bubble inflates, "specula- tors invest only because the asset price is rising" (Rapp, 2009, p. vi). Asset prices grow irrationally and speculators increase their purchases until the bubble bursts; this is when stock prices start decreasing (Fisher, 1933). Referring to the dangers induced by bubbles, Keynes (1936, p. 159) maintained that "speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation". According to Galbraith (1990 [1994], p. 13), the factors contributing to the euphoria inflating a bubble are manifold: "The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. [. . .] The second factor contributing to speculative eupho- ria and programmed collapse is the specious association of money and intelligence". In this regard, Kindleberger (1996, p. 13) noted that "[t]he word mania emphasizes the irrationality; bubble foreshadows the bursting. [. . .] [A] bubble is an upward price movement over an extended range that then implodes. An extended negative bubble is a crash".

Banking and Currency Schools

The debates between the Banking School and the Currency School are of central impor- tance in considering the role of money and banks in a capitalist system. They can be connected with the bullion controversy of the early nineteenth century, whose main protagonists were Henry Thornton and David Ricardo, and are also linked to the finan- cial revolution parallel with, and a necessary complement to, the industrial revolution in Great Britain (Cameron, 1967).

The debates focused on two central themes: (i) the criteria to adopt with respect to money emission; and (ii) the extent of the Bank of England’s power. The crises charac- terizing the first half of the nineteenth century (1825–26, 1836, 1839) largely conditioned attitudes, leading to much criticism against the Bank of England.

The Currency School was anchored in Ricardo’s theory that the quantity of money in circulation should be limited according to precise rules. Torrens (1837) and Overstone (1857) also assumed this position, adopting the quantity theory of money and the price– specie flow mechanism and underwriting a definition of money that included, besides metal-based money, banknotes issued by the Bank of England and by other banks. The task of the Bank of England was thus to control the quantity of money in circulation in order to ensure that prices remained stable.

Convertibility law

In March 1991, at the initiative of Domingo F. Cavallo (who was the Economy Minister of Argentina in the periods 1991-96 and 2001), the Argentine Congress passed a "Convertibility law" that established a Currency Board Arrangement (CBA). Contrary to the British colonial CBAs that existed from the nineteenth century to the end of the decolonization period, the most recent Argentine case was not aimed at encouraging a strong quasi-exclusive integration, but was conceived as an ultimate solution to hyperin- flation and exchange-rate instability (Ponsot, 2003). According to the Argentine govern- ment, the parliamentary decision reinforced its "credibility" in a framework of economic chaos.

The so-called Convertibility, supported by the Convertibility law and the reform of the central bank charter in September 1992, had the following three main features: (i) full convertibility between the domestic currency and the US dollar at a fixed exchange rate; (ii) lack of an unlimited lender of last resort (LLR); and (iii) a bi-monetary system (partial dollarization).