Tuesday, 1 November 2022

How Liquidity Flows From Asset Markets Into The Real Economy - Part 1 of 17

Some years ago, I wrote about how QE was leading to a deflation of commodity prices, because, in directing money into the purchase of financial and property assets, thereby, creating speculative bubbles, it was also encouraging liquidity to move out of the real economy to finance such speculation, and so causing commodity prices to be deflated. In the seven years since then, I have written many posts setting out that, in fact, since 2010, this inflation of asset prices, with a simultaneous deflation or disinflation of commodity prices, has been a conscious aim of central banks and governments, hence the use of fiscal austerity, followed by limitations on trade, and, then, physical lockdowns of economies. But, now, this is being reversed, despite continued attempts to slow economies by draining disposable income into high energy prices, attempts to hold down wages and so on.

So, the question arises, if, in the previous period, the creation of asset price bubbles led to liquidity draining from the real economy into the fictitious economy, as individuals of all classes, sought to become part-time speculators, in search of a fast buck from guaranteed capital gains, does the opposite apply, when capital gains turn into capital losses, as asset prices crash? The answer is yes, but the further question is, then, how? First, let's summarise, how, speculative bubbles drain liquidity from the real economy, because that is relevant to how that ends, and reverses..

Firstly, if, say, the price of houses is rising, people think, “I must buy a house, now, before prices rise further.” So, they delay their consumption of other goods and services, in order to use the money for house purchase, even if only to provide a deposit. A part of their wages, obtained from producing goods and services, and which previously they used to buy such goods and services, is, now, not spent in that way, but is hoarded as savings, and then used as a house deposit, and subsequently to make mortgage payments and so on. The fact that they do this has two effects. Firstly, it reinforces the rise in house prices, and secondly, because, now, the money they would have spent on goods and services is not spent, it means the demand for these other commodities is reduced relative to their supply, and that causes their prices to fall. Of course, people have to live somewhere, so the subsequent mortgage payments replace the payment of rent (unless its single people currently living with parents, for which see more later). In that case, its a question of current consumption being deferred not replaced.

So, the narrative of inflating asset prices, and falling commodity prices is established and confirmed. Nor is it just a matter that money has been diverted from demand for goods and services into the purchase of assets, by simply bringing forward that demand. If, the price of a house is £100,000, and someone is intending buying a house at this price, deciding to do so a few months, before they planned, only means that this demand is brought forward. It is a transitional effect. However, if the reason that they make this decision is that they see the price of houses rising, so that, now, they see that the £100,000 house has risen in price to £150,000, its no longer just a matter of them bringing forward spending, but of engaging in additional spending. They must, now, divert £50,000 of money they would have spent on other goods and services, simply to buy the same house.

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