Originally posted on LibertariaCenterForTolerance.org
In a previous article I discussed that redistribution of income isn’t necessary to create equality, instead you should unleash market forces by reducing barriers into wealth markets. In this article I’d like to make the argument that another culprit which creates inequality is not only market controls, but also monetary policy, especially expansionary policy.
What is Monetary Policy?
Monetary policy is a policy tool, often controlled by central banks, that revolves around the control of a country’s money supply and credit. Monetary policy mechanisms usually consist of interactions with the banking system that make it easier or more difficult for banks to extend more credit. A couple of major mechanisms include:
Discount Lending: When banks have liquidity or solvency issues, they may borrow from other banks to keep things going. But when there isn’t a bank to borrow from they can go to the central bank and borrow against typically high quality assets (“safe” stable liquid assets, like government debt). These loans are usually in the form of deposits on the bank’s balance sheet (record of asset and liabilities).
Open Market Operations: Another way of getting money in and out of financial institutions, is to enter short term contracts called Repurchase Agreements (repos for short), where the central bank lends money by purchasing an asset today with a contractual promise that the bank will repurchase it from the central bank in coming days (the reverse of this is called a ‘reverse repo’, when central banks need to take money from the banks).
Quantitative Easing: Similar to open market operations without the agreement to repurchase, basically the central bank outright sells or buys assets depending on their goals which can have the largest impact of three mechanisms discussed in this article.
What are contractionary and expansionary policy?
The central bank usually conducts either contractionary policy or expansionary policy:
Expansionary Policy: By increasing the amount of money in the economy (usually in the form of lending to banks), the amount of credit available increases. This is usually done when central banks are worried about unemployment (due to what I believe is a misguided belief in a trade-off between unemployment & inflation). So by inflating the money supply several things happen, such as:
– The lowering of real interest rates (rates after inflation) makes it unwise to hold money, or even relatively safe investments (since the return will still be negative after inflation), encouraging investment in riskier higher return investments.
– Lower interest rates will encourage more borrowing (although the lower rates would discourage lending, the low real rates make it even worse not to).
Contractionary Policy: By decreasing the amount of money in the economy you end up with the opposite result.
How does this affect inequality?
While inflating the money supply may not immediately in the short run inflate the price level, it can have several pernicious effects on the distribution of wealth.
1. Drives up the prices of capital goods: The low nominal and real rates will make longer term, capital intensive investments more attractive, resulting in driving up the prices of capital (natural resources, property, etc.). The result is that this increase in capital asset values increases return to the owners of capital (often the wealthier portion of the population) and squeezes out the resources available to firms to pay labor, even if the purchasing power hasn’t depreciated yet (the low income population depends on wages a bit more).
2. Financial assets will also be driven up in value: Since financial institutions are the mechanism for increasing the money supply, money that isn’t lent will often go into buying financial assets like stocks. One signal that prices of stocks may be drifting away from the real value of the company is rising price/earning ratios (often referred to as ‘expanding multiples’ on financial television). This means the owners of financial assets (often the wealthy) get a pseudo-free gain on their assets increasing disparities in wealth. This is often justified under the idea of the “wealth effect” that people seeing their assets increase in value will spend and invest more.
While there is nothing inherently wrong with consumer prices and asset values rising, the intervention of the central banks creates a one sided arbitrary and regressive redistribution of wealth in the name of financial stability.
This post was written by Alex Merced.
The views expressed here belong to the author and do not necessarily reflect our views and opinions.
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