Monthly Archives: January 2015

A Bubble of Confidence Obscures the Risk of Inflation

A quick scan of recent financial headlines would suggest that the Western World is on the verge of a major contraction in prices. One commentator after another argues that deflation is the great risk to global economies and markets.

Ironically, the current period of relatively low inflation is the flipside of the overvaluation in global bond and equity markets. More specifically, there is a bubble of confidence in all asset classes. This bubble of confidence is supporting not only debt and equity markets, but supporting the value of the major fiat currencies. It is this overconfidence in money that is keeping a lid on the price level in the major Western economies and helping to drive the price of commodities (and gold in particular) to new lows.

The Federal Reserve’s unprecedented actions since the 2008 crisis have led to a surge in confidence regarding the long-term economic prospects of the United States (and thereby the long-term prospects of the world economy). The notion that the United States is steaming ahead and will pull the rest of the world with it is a common theme in current financial market commentary.

This surge in confidence regarding the long-term outlook has permeated global asset markets. Government bond prices have soared (particularly in the European periphery ex-Greece) and this has fed a search for yield in corporate debt. Prospective risk-adjusted, nominal returns on a broad portfolio of global government and corporate debt are close to 0%. (You don’t have to have many positions go wrong in a global fixed income portfolio with an ex-ante 2-2.5% headline yield for the ex-post yield to be 0%).

Furthermore, as prospective fixed interest returns have collapsed, investors have chased global equities higher and higher to the point where prospective ten-year nominal returns on the US equity market are also close to 0%. (See John Hussman’s commentary for an excellent discussion of this issue replete with long-term valuation charts).

More interestingly, this surge in confidence has supported the market value of fiat money, the denominator of every “money price” in the economy and thereby suppressed prices as stated in money terms. Despite the massive increase in the US monetary base, the market value of the US Dollar has been supported by a surge in confidence regarding the long-term prospects of the US economy.

Why has the US Dollar seemingly ignored the massive increase in the monetary base? And why has the market value of the US Dollar been so sensitive to a surge in market confidence regarding the long-term economic future of the United States? The answer to both questions is that money is a long-duration, proportional claim on the output of society.

The theory developed in The Money Enigma, the first paper in The Enigma Series, is that money is a long-duration, proportional claim on the future output of society. In essence, what this means is that the value of money today depends upon expectations of what the ratio of real output to base money will be over the next 20-30 years. The ratio of output/money as it stands today is somewhat irrelevant to the value of money. What matters is the expected path of that ratio over the next 20-30 years.

Let’s break down this concept into its two main components.

  1. Money is a long-duration asset

If an asset is described as being a long-duration asset, then all this means is that a large part of the current value of the asset is tied up in benefits that should be received from that asset in the distant future. For example, a 30-year government bond is a long-duration asset because the principal repayment on that bond is not due for 30 years and the interest payments are spread out over the next three decades.

Money is a long-duration asset because its current market value depends largely upon benefits that will be received from spending that money in the distant future. More specifically, in a state of intertemporal equilibrium, we are indifferent between spending the marginal unit of money demanded now, in 5 years from now or in 20 years from now. (If this were not the case then the economy would not be in a state of intertemporal equilibrium). This somewhat complicated notion is explored at length in The Velocity Enigma, the final paper in The Enigma Series. Fortunately, there is a simpler way to think about this issue. The value of money depends upon a chain of expected future values.

When I buy a product from you and give you money in exchange, you expect that the money I give you should have a similar purchasing power (a similar market value) when you spend it. When you spend the money, the next person accepts it because they believe it will have a similar future purchasing power. This process continues all the way down a chain of thousands of people.

Therefore, if the market suddenly decides that money will have less value in some distant future period, then that will have an immediate impact on the current value of money.

Conversely, if the market is optimistic in regards to the future of money, then that confidence will support the current value of money, even if the monetary authority has recently created a lot more money (does this sound familiar?).

The point is that money is a long-duration asset and its value today depends upon future expectations. But future expectations of what? This brings us to the second part of the earlier statement.

  1. Money is a proportional claim on the output of society

Money is a financial instrument. This means that money derives its value contractually. More specifically, money is a special-form equity instrument issued by society (money is a legal liability of government, but an economic liability of society) and money represents a proportional claim on the future output of society. The view of The Enigma Series is that an implied-in-fact contract exists between the issuer of money (society) and the holders of money (again, society) that recognizes money as a proportional claim on the future output of that society.

Money is much like a share of common stock. One share of common stock is a proportional claim on the future cash flows of a company. If the number of claims rises (the number of shares on issue rises), then all else equal, the value of each claim falls. Similarly, if the expected future cash flows of the company fall, then the value of each proportional claim on those cash flows falls (the current value of each share falls).

Money is a proportional claim on the future output of society. If the number of claims rises (the monetary base increases), then all else equal, the value of each claim will fall. However, if the expected future output of society rises, then this will increase the value of the proportional claim on that future output (the value of money rises).

In summary, money is a claim on the future output of society and the current market value of money depends upon expectations of the long-term path of the “real output/base money ratio”.

So, how does a surge in confidence regarding the future prospects of a country impact the value of the currency issued by that currency? Clearly, such confidence will support the market value of that currency.

The near-term path of the “output/money” ratio is fairly irrelevant to the value of money. If the market expects the monetary base to decline over the next ten years and economic output to continue to grow strongly over that period, then that confidence is enough to support the value of money and, conversely, keep a lid on inflation.

However, there is a risk.

If confidence in the future prospects of the US collapse, then we would naturally expect the bond and equity markets to suffer. However, such a collapse in confidence will also impact the market value of the US Dollar.

As discussed in last week’s post, every price is a relative expression of the market value of two goods. If the market value of money suddenly declines, then, all else remaining equal, the price of all goods, in money terms, will rise sharply.

The markets are not prepared for this eventuality. But the prospect of a sudden and severe increase in the rate of inflation is a far more likely than a return of 1930s-style deflation. All it will take is one pin that pops the bubble of confidence that currently permeates all global asset markets.

Every Price is a Function of Two Sets of Supply and Demand

In last week’s post, we reviewed the theory that price is a relative expression of two market values. For example, the price of bananas, in money terms, depends upon both the market value of bananas and the market value of money. If the market value of bananas rises, the price of bananas rises. Conversely, if the market value of money rises, the price of bananas falls.

In more technical terms, we explored the idea that the price of one good, as measured in terms of another good, depends upon both the market value of the first good (the “primary good”) and the market value of the second good (the “measurement good”).

This week we will extend this idea and explore the theory that every price is determined by not one, but two, sets of supply and demand: supply and demand for the primary good, and supply and demand for the measurement good.

In simple terms, the key elements of this theory can be described as follows:

  1. Every price is a relative expression of two market values (the market value of the “primary good” and the market value of the “measurement good”);
  2. The market value of a good is determined by supply and demand for that good; therefore,
  3. Every price is determined by two sets of supply and demand, namely, supply and demand for the “primary good” and supply and demand for the “measurement good”.

Price Determination TheoryThis universal theory of price determination is illustrated in the diagram opposite.

The price of good A in good B terms, denoted P(AB), is a function of the market value of good A, denoted V(A), and the market value of good B, denoted V(B). Supply and demand for good A determines the market value of good A, V(A). Supply and demand for good B determines the market value of good B, V(B). Therefore, the price of good A in good B terms is determined by both supply and demand for good A, and supply and demand for good B.

Some readers may be thinking that this just can’t be right. After all, doesn’t supply and demand for a good determine its “price”, not its “market value”?

The key point that I would make here is that the model above is compatible with the standard supply and demand theory taught at college. The “price” of a good is just one way of measuring the “market value” of that good. More specifically, the “price” of a good is the market value of that good as measured in terms of the market value of another good.

Traditional supply and demand analysis, with “price” on the y-axis, simply assumes that the market value of the “measurement good” is constant. We want to be able to relax that assumption and analyze the impact on the price of a good if supply and/or demand change not just for the “primary good”, but also for the “measurement good”.

In order to understand how it is possible to represent a price as a function of two sets of supply and demand, we need to think about the different ways in which the property of “market value” can be measured.

Market value can be measured in absolute or relative terms. We are so accustomed to thinking of market value in relative terms (in terms of a “price”) that we struggle with the notion that market value can be measured in absolute terms. But all properties can be measured in either absolute or relative terms.

For example, let’s think about the property of “height”. The property of height can be measured in either absolute or relative terms.

Let’s imagine that we have a girl standing next to a tree. The tree is three times taller than the girl.

Typically, we might measure the height of the girl in inches. An “inch” is an invariable and universal measure of height. Similarly, we can measure the height of the tree in inches. By measuring the height of the girl and the tree in inches, we have measured the height of both in terms of an invariable and universal measure of height. In this sense, we have measured the height of both the girl and the tree in “absolute” terms.

But there is another way to measure the height of either the girl and/or the tree and that is in “relative” terms. For example, we could measure the height of the tree in girl terms. The tree is three times taller than the girl. Hence, the height of the tree, in girl terms, is three girls.

Similarly, we could measure the height of the girl in tree terms. The girl’s height is one-third of a tree.

Does the girl’s height change if we measure it in “absolute” terms (in terms of inches) or in “relative” terms (in terms of the tree)? No. The girl’s actual height doesn’t change. All that has changed is the way in which we measure her height.

We can apply this same principle to the property of “market value”.

“Market value” is a property of economic goods (goods that are traded in our economy). If goods do not possess “market value”, then they are not traded and there is no price for them.

The market value of goods can be measured in absolute terms or in relative terms. Typically, we measure the market value of goods in relative terms. More specifically, we measure the market value of most goods in terms of the market value of money. For example, a banana is twice as valuable as one dollar and hence the price of a banana is two dollars. This “price” is a relative expression of the market value of bananas relative to the market value of money.

However, we can, at least theoretically, measure the “market value” of each good in absolute terms. Just as we measure height in absolute terms, in terms of an invariable measure of height such as inches, so we can measure market value in terms of an invariable measure of market value.

However, since no good possesses the property of invariable market value (the market value of all goods varies over time), we need to create some theoretical measure of market value that is invariable. The Inflation Enigma proposes a standard for this called “units of economic value” or “EV” for short. Units of economic value are just like feet or inches, except that instead of measuring the height of an object, they measure the market value of a good.

Once we have created this standard and invariable measure of market value (“units of economic value”), we can measure the market value of all goods, including money, in absolute terms. More importantly, we can illustrate supply and demand for each good in absolute terms.

Price Determined by Two Sets Supply and DemandIn the diagram opposite, the price of good A in money terms is illustrated as a function of two markets. On the left hand side, supply and demand for good A determines the market value of good A. Note that the unit of measurement being used on the y-axis is not money (a relative measure of market value) but units of economic value (an absolute measure of market value).

On the right hand side, the market value of money is also being measured in terms of our theoretical and invariable measure of market value (units of economic value). Supply and demand for money determines the market value of money (not the interest rate!).

The price of good in A, in money terms, is a relative expression of both the market value of good A and the market value of money. Therefore, the price of good A is determined by two sets of supply and demand: supply and demand for good A (the “primary good”) and supply and demand for money (the “measurement good”).

Let’s quickly examine what happens if there is an increase in demand for good A. If demand for good A increases, the demand curve for A (on the left hand side of the diagram) will shift to the right and the equilibrium market value of good A will rise. Furthermore, if the market value of money is constant (there is no change on the right hand side of our diagram), then the price of good A will rise.

This is the standard outcome generated by traditional supply and demand analysis. In this sense, the model above is perfectly consistent with traditional microeconomic theory.

However, what happens if demand for money increases? In this scenario, the demand curve for money (on the right hand side of the diagram) shifts to the right and the market value of money rises.

Now, what happens to the price of good A in money terms? The price of good A falls.

There has been no change in supply and/or demand for good where supply and demand are expressed in terms of our invariable measure of market value. However, the price of good A will fall because the market value of the measurement good (money) has risen.

The theory that every price is determined by two sets of supply and demand is one of the key theories developed in The Inflation Enigma, the second paper in The Enigma Series.

It is important to note that this theory is a universal theory of price determination. It can be applied to price determination in a barter economy (“good/good” prices), price determination in a money-based economy (“good/money”) prices) and foreign exchange rate determination (“money/money” prices).

The Inflation Enigma extends this microeconomic theory of price determination to a macroeconomic theory of price level determination called the “Ratio Theory of the Price Level”. Ratio Theory is particularly helpful in framing discussions regarding the causes of inflation.

Inflation or Deflation: A Microeconomic Perspective

In this week’s post we shall consider a basic question: “why does the price level rise and fall?” This might seem like a simple question, but a roomful of economists probably couldn’t agree on a succinct answer to that question.

Rather than entering into an extended macroeconomic debate about the causes of inflation, we shall attempt the answer the question “why does the price level rise and fall?” by considering the issue from a microeconomic perspective.

More specifically, we shall consider a couple of the key microeconomic ideas developed in The Enigma Series, namely:

  1. “Price” and “market value” are not the same thing; and
  2. Price is a relative expression of two market values.

The key to understanding inflation (a macroeconomic phenomenon) is a comprehensive theory of price determination (a microeconomic phenomenon). After all, if we understand how one price is determined, then surely we should be able to understand how many prices are determined?

While many inflation commentators prefer to jump straight into a discussion of macroeconomic variables (i.e., the output gap and oil prices), very few begin by answering a couple of the most basic questions in economics, namely “what is a price?” and “how is a price determined?”

If you ask most economists “what determines the price of a good?” the standard answer you will receive is “supply and demand for that good”. However, this represents a very one-sided view of the price determination process.

Price DeterminationIn contrast, the view of The Enigma Series is that every price is determined by two sets of supply and demand: supply and demand for the ‘primary good’, and supply and demand for the ‘measurement good’. More specifically, every “money price” is determined by two sets of supply and demand: supply and demand for the good itself and supply and demand for money.

Before you say, “that’s impossible” or “that’s not what I was taught at college”, let’s step back and answer the first question.

What is a price?

Every price is a ratio of two quantities exchanged. For example, x dollars for y bananas, is the price of bananas in dollar terms. This is a “good/money” price. But the same principle extends to barter prices, or “good/good” prices, and foreign exchange rates, or “money/money” prices.

For example, in a barter economy (an economy with no money), the price of bananas in apple terms could be three bananas per apple. Again, it is just a ratio of two quantities exchanged (a quantity of bananas for a quantity of apples).

Similarly, a foreign exchange rate (i.e., the EUR/USD cross rate) simply represents the quantity of one currency exchanged for a certain quantity of another currency exchanged.

The point is that every economic transaction involves, at minimum, an exchange of two items (bananas for money, bananas for apples, Euros for US Dollars) and the “price” of the transaction is the ratio of the quantities of the two items exchanged.

Now, let’s move on to the more complicated second issue. How is this “ratio of quantities exchanged”, or “price”, determined?

In order to answer this question, it helps to think about what property a good must possess in order for it to “have a price”. For example, why does coffee have a price but sunshine does not? Most people would simply say that sunshine is “free”. But at a more fundamental level, the reason there is a price for coffee and not a price for sunshine is that coffee possesses the property of “market value”, whereas sunshine does not possess the property of “market value”.

For a good to have a price, it must possess the property of “market value”.

Frankly, this proposition should be rather obvious. What may not be as obvious is that for prices to be measured in terms of a particular good (the “measurement good”), that good (the “measurement good”) must possess the property of market value.

In other words, for any good (“good A”) to measure the market value of another good (“good B”), the first good (“good A”) must possess the property of “market value”. It is impossible to determine the price of B in A terms unless A possesses the property of market value.

Let’s consider our coffee versus sunshine example to illustrate the point.

If we chose to, we could measure the market value of all things in terms of coffee beans. For example, the price of bananas might be tens coffee beans, and the price of an apple might be six coffee beans. Coffee beans possess the property of market value and we can measure the market value of other items in the economy in “coffee bean terms”.

Now, could we express all prices in the economy in “sunshine terms”?

The short answer is “no”, but why?

Why is it impossible to express the price of apples or bananas or any other economic good in terms of units of sunshine? The reason that we can’t express prices in “sunshine terms” is because sunshine does not possess the property of market value.

Price as Ratio of Two Market ValuesAnd this brings us to our key point: price is a relative expression of market value.

In any simple two-good exchange, the price of the transaction depends upon the market value of the “primary good” and the market value of the “measurement good”.

If one unit of the “primary good” (for example, one banana) is three times as valuable as one unit of the “measurement good” (for example, one dollar), then the price of the primary good, in measurement good terms, is three units of the measurement good per one unit of the primary good (or, in the case of our example, three dollars per banana).

If the “measurement good” does not possess the property of market value, then we can’t express prices in terms of that good. We can only use money as a “measurement good” for our prices because it possesses the property of market value. Clearly, we can’t use sunshine as our measurement good (we can’t express prices in sunshine terms), because sunshine doesn’t possess market value.

So, let’s return to the main issue. What determines the price of one good, the “primary good”, in terms of another good, the “measurement good”? Is the price determined by the market value of the primary good, or is the price determined by the market value of the measurement good? The answer is “both”.

Price Determination Barter EconomyIn a barter economy, the price of bananas, in apple terms, depends upon both the market value of bananas and the market value of apples. The price of bananas, in apple terms will rise if the market value of bananas rises. More importantly, the price of bananas, in apple terms, will rise if the market value of apples falls.

Similarly, the price of bananas, in money terms, will rise if the market value of bananas rises or if the market value of money falls. If the market value of money falls, then bananas are relatively more valuable, even if they are not absolutely more valuable. Price is a relative expression of two market values. Hence, the price of bananas, in money terms, will rise if the market value of money falls (all else remaining equal).

Ratio Theory of the Price LevelWe can extend this microeconomic concept of price determination to a macroeconomic discussion of inflation.

In simple terms, rising prices across the economy can be caused either by (1) an increase in the market value of goods and services, or (2) a decrease in the market value of money.

Economic weakness and a fall in oil prices may contribute to a decline in the market value of goods. These are both deflationary pressures that act to lower “money prices” across the economy. However, both of these pressures could be more than offset by a decline in the value of money.

The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value. Any meaningful discussion must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).

Why Is There a Lag Between Money Printing and Inflation?

german-marks-from-the-weimarThe experience of the last five years has clearly demonstrated that an expansion in the monetary base doesn’t necessarily lead to an immediate rise in the price level. While the Federal Reserve has increased the monetary base in the United States by roughly five-fold over the past five years, inflation has remained subdued.

However, does this mean that inflation will be contained if the monetary base remains at these high levels? Furthermore, does the experience of the last five years imply that the long-term relationship between money and inflation is dead?

In each case, the answer is “no”.

Many financial market commentators seem to believe that the long-term relationship between base money and the price level is “broken”. Indeed, the prevailing view seems to be that the level of the monetary base is irrelevant to inflation, provided that the economy does not “overheat”.

The view that “money doesn’t matter” flies in the face of what is arguably the strongest empirical relationship in macroeconomics. While economists like to pontificate about the importance of the “output gap” in the determination of inflation, the fact is that the empirical evidence supporting the relationship between the output gap and inflation is weak and statistically tenuous.

John Hussman, a fund manager and economist, discusses the absence of evidence for the output gap/inflation relationship at length in his post “Will the Real Phillips Curve Please Stand Up?” Similarly, Professor John Cochrane discusses the non-existent relationship between the output gap and inflation in his excellent article “Inflation and Debt”.

In contrast, dozens of academic studies have repeatedly demonstrated a strong and statistically important long-term relationship between the monetary base and the price level. While it is a well-recognised fact that the relationship between money and inflation is weak in the short term, the long-term relationship between money and inflation is a core empirical observation described in every serious economics textbook.

If the long-term relationship between money creation and inflation is not broken, then this raises an obvious question: when will inflation in the United States “catch up” with the expansion in the monetary base? However, in order to have any hope at answering that question, we need to answer a more general question.

Why does inflation tend to lag money creation?

In order to understand why inflation tends to lag increases in the monetary base, we need to explore two fundamental concepts:

  1. The price level depends upon the value of money, and
  2. The value of money depends upon confidence.

We will explore each of these ideas in more detail in a moment, but first, let’s explain how these ideas can be used to explain the delay between monetary base expansion and inflation.

Ratio Theory of the Price LevelThe value of money is the denominator of every “money price” in the economy. All else remaining equal, as the market value of money falls, the prices of goods and services, as measured in money terms, will rise.

When a central bank prints more money, it may or may not have an immediate effect on the value of money. The reason for this is that the value of money depends upon a series of long-term expectations regarding the future of the economy and the future of the monetary base (or, more technically, the expected future path of the “real output/base money” ratio).

If markets believe that the increase in the monetary base is “temporary”, then such an increase may have little impact on the value of money. Furthermore, if markets believe that the actions taken by the central bank will increase the long-term growth rate of the economy, then such actions may even lead to an increase in the value of money. In other words, if the central banks actions are perceived to be temporary and these actions boost confidence in the economy, then printing money may have a slightly deflationary effect, at least in the short term.

However, what happens if expectations shift? What happens if markets start to realize that the “temporary” expansion in the monetary base is actually a “permanent” expansion in the monetary base? The value of money will begin to fall and, all else equal, the price level will begin to rise. Such a fall in the value of money can be quickly compounded if, simultaneously, the market becomes more pessimistic about the long-term economic prospects of society.

Currently, investors are very optimistic about the future of the US economy and seem to believe that the Federal Reserve is “on track” to reduce the monetary base over the next 5-10 years. This perception has supported the value of the US Dollar, which in turn, has been one of the major factors suppressing prices in the US.

But what happens if market confidence starts to slip? It is easy to imagine a scenario one year from now, where the US economy begins to weaken and markets start to doubt the ability or willingness of the Federal Reserve to significantly reduce the monetary base. If this does occur, then the value of money (the value of the USD) will begin fall, maybe gradually at first, but then more precipitously. As it does, inflation will begin to rise. While global deflationary forces may continue to put pressure upon the market value of goods/services, a significant decline in the market value of money can easily overwhelm this phenomenon, leading to a significant rise in prices.

Let’s step away from the US for the moment and think about what might happen in a small, less advanced economy that engages in money printing. The act of printing money tends to create an immediate boost in economic activity and an immediate boost in confidence (regardless of how that new money is spent). The simple fact is that as newly created money is flushed through the economy, jobs are created and people feel better about the economy and the world around them. Sometimes, this effect is so powerful that people believe that the economy will continue to grow strongly even as all this extra money is gradually retired at some point in the future. Consequently, the value of money is supported and the inflation is contained.

However, as historical experience has taught us, printing money rarely has any lasting effect on the growth of the economy. After a few years pass, people in our small, less advanced economy begin to realize that growth really isn’t that good (all the old problems remain) and that the economy is only being sustained at its current levels by the sustained creation of money. In other words, the economy has become addicted to the money-printing drug.

Inevitably, this collapse in confidence leads to a collapse in the market value of money. The exchange rate collapses and prices, in local currency terms, surge higher.

Inflation lags money printing because expectations can take a long time to change. The value of a long-duration asset (money) depends upon long-term expectations and it can take many years for changes in long-term expectations to occur.

Does this same principle apply to advanced economies? Absolutely.

The price level depends upon the value of money, and the value of money depends upon long-term expectations. Printing money may not have an immediate impact on the value of money because it does not have an immediate impact on long-term expectations. Rather, it may take several years before the markets begin to lose faith in the grand plans of policy-makers. But when the market does lose faith, the value of money can erode rapidly and prices can rise swiftly, even at time when real economic activity is falling.

For those readers that are interested, let’s briefly explore this argument in more technical terms. We have glossed over two important ideas that deserve further consideration.

The first idea is that the price level depends upon the market value of money.

More specifically, the market value of money is the denominator of every “money price” in the economy: as the market value of money falls, the price level, as measured in money terms, rises.

In order to understand this concept, it helps to think about the determination of prices in a barter economy. Let’s assume we have a two-good economy that produces only apples and bananas. What determines the price of apples in banana terms? Is it the market value of apples as determined by supply and demand for apples, or is it the market value of bananas as determined by supply and demand for bananas?

The answer is “both”. The price of apples in banana terms depends upon the market value of the primary good (apples) and the market value of the measurement good (bananas). All else equal, as the market value of the measurement good (bananas) falls, the price of apples, as measured in banana terms, will rise.

Price Determination TheoryEconomics struggles with this concept because it fails to recognize that the property of “market value” can and should be measured in the absolute. Every price is a relative expression of two market values. We can measure the market value of each item being exchange in absolute terms and plot supply and demand for each good in absolute terms. This somewhat abstract concept is explained in great detail in The Inflation Enigma, the second presentation in The Enigma Series.

Just as the price of apples in banana terms depends upon both the market value of apples and the market value of bananas, so the price of apples in money terms depends upon the market value of apples and the market value of money. If the market value of money falls, then the price of apples, in money terms will rise.

Ratio Theory of the Price LevelWe can extend this microeconomic theory of price determination to a macroeconomic level. If the market value of money falls, then, all else remaining equal, the price of all goods and services in the economy will rise. This is the “Ratio Theory of the Price Level” as developed in The Enigma Series.

The second leg of our argument, namely “the value of money depends upon confidence”, requires a much more technical discussion. There isn’t time in this post to cover all the elements of this second leg of the argument. However, we can briefly touch on the key ideas.

The view of The Money Enigma is that money is a special-form equity instrument. Fiat money derives its value from the liability that it represents. More specifically, money is a long-duration, proportional claim on the output of society.

The easiest way to think about this is to compare money to shares in a corporation. A corporation can issue fixed or variable entitlements against the future economic benefits it creates (future cash flows). Similarly, society can issue fixed or variable entitlements against its future output.

Money represents a variable entitlement to the future output of society. If the markets believe that there will be a lot more claims issued in the future, then the value of each of those claims will fall. Conversely, if people believe that economic growth will be stronger in the future, then the value of each of those claims will rise.

Critically, fiat money is a long-duration asset. The value of fiat money depends primarily upon expectations regarding the long-term future growth rate of base money relative to real output.

Changes in the current level of the monetary base are largely irrelevant to the value of money. What really matters are expectations regarding the level of the monetary base in 20-30 years and, similarly, the expected growth in real output over that extended period.

Therefore, in the short term, it is possible to dramatically expand the monetary base with little impact on the value of money. The value of fiat money depends on long-term expectations of the “real output/base money” ratio. If market participants believe that an expansion in the monetary base is only temporary, then it should have little impact on the value of money.

The notion that fiat money represents a proportional claim on the future output of society is discussed at length in The Money Enigma, the first paper in The Enigma Series. Those readers who are interested in a more technical discussion of the long-duration nature of money should read The Velocity Enigma, the final paper in The Enigma Series.