The Destruction of Capital and Central Banks

The Destruction of Capital and Central Banks

The Destruction of Capital and Central Banks

Inflation in assets inevitably leads to a burst of bubbles.

In the period when central banks were glad to see limited consumer price increases despite large increases in the money supply, they created massive inflation in assets. Throughout the quantitative easing era, bond prices spiked, equity valuations soared, house prices increased significantly above affordability levels, and multiples in private equity and venture capital rose to all-time highs. Asset inflation preceded consumer price inflation, and it may be a major source of financial instability.

The U.S. Bloomberg House Price Index has slumped 20% since the beginning of monetary contraction, and the evidence of the burst of housing price inflation is a clear signal of capital destruction. Monetary contraction leads to a decline in asset prices that subsequently creates a re-evaluation of the asset base in financial firms, from banks to venture capital firms.

The importance of capital destruction in the fight to curb inflation is often ignored. Economists tend to believe there is little correlation between the prices of every-day goods and services and the valuation of financial assets because many willingly reject the monetary cause of inflation, and rising valuations are also a monetary phenomenon.

In the same way that financial asset inflation precedes consumer prices in monetary expansion periods, capital destruction appears earlier than CPI inflation declines in monetary contraction times. Without significant write-downs in financial assets, it is exceedingly difficult to see a true disinflationary process. Why? Because elevated valuations of financial assets lead to looser lending standards, complacent levels of credit growth, and rising consumer prices,

When central banks become the lender of first resort instead of the lender of last resort and switch their focus from inflation to “financial stability” under the form of keeping high asset prices (equities, bonds, and houses), then they also abandon the reduction of consumer prices as an objective. The role of central banks is not to keep equities, bonds, and house prices rising, let alone to prevent a natural and even healthy correction.

You may say that central banks do not aim for rising financial asset prices, but the evidence supports the opposite argument. Central banks do care about markets because they believe in the wealth effect’s impact on the real economy. When people feel that their homes are more valuable and their stocks are worth more, they are inclined to spend more and take more credit. This wealth effect is also proof of what I mentioned before: financial asset prices lead the inflationary burst, and only capital destruction in those same asset prices can truly reduce the prices of goods and services.

The issue arises when central banks ignore excessive valuations in financial markets for an extended period. Once that situation arises and we live, as we did in 2020, in the “bubble of everything”, it becomes increasingly difficult to combat inflation without a financial market scare. The collapse of some regional banks in the United States is evidence of capital destruction. The asset base declines fast, deposits leave, and the unrealized capital loss is larger than the quoted market capitalization.

A massive increase in the quantity of money led to the inflation burst of 2021–2022. The recent findings of Borio (2023, BIS), Hanke (2020), or Congdon and Shaw (2023) show the undeniable causation effect on inflation of the substantial increase in money growth well above real GDP. We are now experiencing the opposite effect. Money growth is plummeting, credit impulse is fading, and the capital destruction manifested in the decline of most asset prices is starting to be a significant leading indicator of a more aggressive slowdown in the economy.

Central banks cannot engineer a soft landing for the economy when they created a large bubble that requires significant write-downs in most financial firms and a credit crunch with it.

The bubble of everything leads to the slump of everything, and capital destruction will be the leading indicator of disinflation.

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Daniel Lacalle

Global Economy Expert

Daniel Lacalle is one the most influential economists in the world. He is Chief Economist at Tressis SV, Fund Manager at Adriza International Opportunities, Member of the advisory board of the Rafael del Pino foundation, Commissioner of the Community of Madrid in London, President of Instituto Mises Hispano and Professor at IE Business School, London School of Economics, IEB and UNED. Mr. Lacalle has presented and given keynote speeches at the most prestigious forums globally including the Federal Reserve in Houston, the Heritage Foundation in Washington, London School of EconomicsFunds Society Forum in Miami, World Economic ForumForecast Summit in Peru, Mining Show in Dubai, Our Crowd in Jerusalem, Nordea Investor Summit in Oslo, and many others. Mr Lacalle has more than 24 years of experience in the energy and finance sectors, including experience in North Africa, Latin America and the Middle East. He is currently a fund manager overseeing equities, bonds and commodities. He was voted Top 3 Generalist and Number 1 Pan-European Buyside Individual in Oil & Gas in Thomson Reuters’ Extel Survey in 2011, the leading survey among companies and financial institutions. He is also author of the best-selling books: “Life In The Financial Markets” (Wiley, 2014), translated to Portuguese and Spanish ; The Energy World Is Flat” (Wiley, 2014, with Diego Parrilla), translated to Portuguese and Chinese ; “Escape from the Central Bank Trap” (2017, BEP), translated to Spanish. Mr Lacalle also contributes at CNBCWorld Economic ForumEpoch TimesMises InstituteHedgeyeZero HedgeFocus Economics, Seeking Alpha, El EspañolThe Commentator, and The Wall Street Journal. He holds a PhD in Economics, CIIA financial analyst title, with a post graduate degree in IESE and a master’s degree in economic investigation (UCV).

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