My concern with the growth of finance as a cause of slow economic growth goes back to the cost-push inflation of the 1970s. That inflation was often attributed to rising wages or the rising price of oil. But I think it had its roots in the rising cost of finance, roots that go back further, at least to the 1950s.
A continuing-cost problem will result in either slowing growth or cost-push inflation, or some combination of the two, depending on the level of "accommodation" provided by economic policy. If they print money you get inflation. If they don't, you get slowing growth.
Many people say inflation is always demand-pull and never cost-push. They say inflation is always caused by printing money. They say the inflation of the 1970s was caused by accommodative policy, which dealt with rising cost by increasing the quantity of money. I say that when the accommodative policy is a response to rising cost that would otherwise have caused unacceptably slow growth, the inflation is caused by the cost-push pressure.
I agree with the demand-pull view to this extent: We cannot have inflation unless the quantity of money increases enough to support spending at the higher price level. However, the focus of that view is only on inflation, as if the pressure of rising cost has no impact on economic growth. In these days of persistently slow growth, that view is painfully incomplete.
I don't imagine that I'm the first person ever to identify rising financial cost as the source of the cost pressure that forces us to choose between inflation and slowing growth. So I went looking for studies and statements where other people have expressed a view like mine. I came upon The Interest Cost-Push Controversy (PDF, 8 pages) by Thomas M. Humphrey. It sounded promising.
Humphrey's paper describes a controversy between Thomas Tooke and Knut Wicksell regarding the cause of inflation. Tooke said high interest rates add more to the cost of output than do low interest rates, so high interest rates are inflationary. In response, Wicksell developed a whole theory. Today, Wicksell's thinking is embedded in our thinking. When I said above that we cannot have inflation unless the quantity of money increases enough to support spending at the higher price level, that's Wicksell. I didn't know.
Humphrey writes:
The Tooke-Wicksell controversy is important not only because it produced the first clear statement of the interest cost-push doctrine as well as the first rigorous and systematic attempt to disprove it, but also because it helped establish the case for tight money and because it introduced the prototype of the analytical macroeconomic model that most monetary authorities use today in designing anti-inflationary monetary policies.
I found the Wicksell stuff fascinating.
Thomas Tooke's argument, as presented by Humphrey at least, was disappointing. It is not about financial cost. It is only about the cost difference arising from a change in interest rates. The "so-called interest cost-push school," Humphrey writes, "... insists that higher interest rates are inherently inflationary because they raise the interest component of business costs".
Thomas Tooke, Humphrey says,
author of the monumental six volume History of Prices (1838-57), and foremost collector of price and monetary data in the 19th century, had advanced the interest cost-push argument that high interest rates cause high prices and low rates low prices.
Tooke's focus was the effect on prices of high versus low interest rates. Nothing else. Interest only. The difference in cost attributable to a change in interest rates.
Focusing solely on the cost aspects of interest and ignoring the influence on prices of interest-induced increases in borrowing, lending, the money stock, and spending, he asserted that a reduced loan rate “has no . . . tendency to raise the prices of commodities...”
The whole "interest cost-push" argument is based on the cost of interest being greater when interest rates are higher. I was looking for an argument about the cost of finance, not just the rate of interest. In this respect, the article was a disappointment.
It seems to me that Thomas Tooke considered his topic from a static microeconomic perspective, evaluating the cost of a loan at two different rates of interest. From a macroeconomic perspective, one would want to consider also whether the total number of loans increased over time, and the aggregate cost difference between the larger and smaller accumulations of debt.
If the rate of interest is constant while the accumulation of debt doubles relative to GDP, the cost of interest doubles, relative to GDP.
If the financial sector of the economy grows faster than GDP, it creates a continuing-cost problem for all other sectors of the economy. Depending on the level of accommodation by the Fed, the result is inflation, or slow growth, or both. This result will continue as long as finance continues growing faster than GDP.
And now you know how we got to where we are today.
