Author Archives: themoneyenigma

Will Inflation Rise or Fall in the Next Recession?

The conventional view held by most economists and market commentators is that the rate of inflation falls in a recession. In this week’s post we will challenge the conventional view and discuss the circumstances that could lead to accelerating rates of inflation during a period of recession.

At the end of this article, we will discuss why inflation, not deflation, might be the surprise outcome of the next recession in the United States.

Intuitively, the notion that inflation falls during a recession seems quite reasonable. After all, the first lesson we learn in microeconomics is that if demand for a good weakens, then the price of that good will fall. So why not extrapolate this idea to macroeconomics? Why can’t we simply assume that inflation will slow if the economy begins to contract?

The problem is that a microeconomic level, basic supply and demand analysis assumes that the market value of money is constant. At a macroeconomic level, we simply can not make this assumption. Rather, we need to think about the impact a recession has on expectations regarding the long-term future of society and how changes in those expectations impact the value of money.

In a recession there are two opposing forces that act upon the price level, one is deflationary in nature, the other is inflationary.

The deflationary force is the impact of the recession on aggregate demand and the resultant fall in the market value of goods.

Note the use of the term “market value”, not “price”. The price level is a relative measure of market value: just because the market value of the basket of goods falls does not mean that the price of the basket of goods falls.

The inflationary force is the potential negative impact of the recession on long-term expectations and, consequently, a fall in the market value of money.

Typically, a recession is accompanied by some moderation in expectations regarding the long-term economic future of society. If people become more pessimistic about the long-term prospects of society, then the market value of money will fall and, all else remaining equal, the price level will rise.

While the nature of the deflationary force is simple and obvious, the nature of the inflationary force is far more nuanced and complex. The final outcome in a recession depends upon whether the deflationary force is stronger or weaker than the inflationary force.

If the deflationary force is stronger (if the market value of goods falls by more than the market value of money) then the rate of inflation will moderate. For example, if people believe that the recession is just a “bump in the road” that won’t damage the economy over the long term, then it is likely that the rate of inflation will fall.

However, if a recession badly damages confidence in the long-term prospects of society, then any decline in the market value of goods can be more than offset by a decline in the market value of money. In this scenario, the rate of inflation can accelerate markedly, particularly as economic activity begins to stabilize at lower levels.

The Price Level is a Relative Measure of Market Value

Before we begin to discuss how a recession may impact the rate of inflation, we need to step back and think about the nature of the price level.

While most of us think of the price level as an index (the consumer price index), strictly speaking the price level is a conceptual notion, not an index. More specifically, the price level is a hypothetical measure of overall prices for the set of goods and services that comprise the “basket of goods”.

At a more fundamental level, the price level is a relative measure of market value. The price level measures the market value of the basket of goods in terms of the market value of money.

From a mathematical perspective, if we can measure the property of “market value” in terms of a standard unit of market value (a unit of measure that is invariable in the property of market value), then the price level can be expressed as a ratio of two market values. More specifically, the price level is a ratio of the market value of the basket of goods (the numerator) divided by the market value of money (the denominator).

In simple terms, the price level can rise either because (a) the market value of goods rises, or (b) the market value of money falls.

This theory is discussed in a recent post titled “Ratio Theory of the Price Level”. While we won’t discuss this theory at length, we should briefly touch on the keys points.

The derivation of Ratio Theory begins with the microeconomic premise that every price is a relative expression of market value.

For example, if one apple is twice as valuable as one dollar, then what is the price of apples? Clearly, the price is two dollars. The point is that the “price of apples” is a relative measure of the market value of one apple versus the market value of one dollar.

What happens to the price of apples if the value of money falls? For example, what would be the price of apples if, all else remaining equal, the dollar lost 50% of its value? One apple would now be four times more valuable than one dollar. Therefore, the price of apples would be four dollars. i.e. the price of apples would double.

In more general terms, the price of one good (the “primary good”) in terms of another good (the “measurement good”) is a relative measure of the market value of the primary good in terms of the market value of the measurement good. The price of the primary good can rise either because (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

In order to understand this concept at a more technical level, one must be able to appreciate the difference between the relative and absolute measurement of market value. This is a somewhat complicated idea that is addressed in detail in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

We can extend this microeconomic theory of price determination to a macroeconomic level (“Ratio Theory of the Price Level”) by recognizing that the market value of money is the denominator of every “money price” in the economy.

The price level is merely a measure of overall prices for a basket of goods: roughly speaking, it is an “average” of prices. If money is the “measurement good” in our economy, then the market value of money is the denominator of each “money price” in our economy. Moreover, if every price in the basket of goods shares a common denominator (the market value of money), then this common denominator is also the denominator of the average of these prices (the price level).

Ratio Theory provides us with a useful starting point for any discussion regarding the inflationary or deflationary impact of a change in economic conditions. Most importantly, it reminds us that we need to consider the impact of a change in economic conditions on both the market value of goods and the market value of money.

We can illustrate Ratio Theory with the “Goods-Money Framework” that is developed in The Inflation Enigma, the second paper in The Enigma Series. On the left hand side, the intersection of aggregate supply and aggregate demand determines the equilibrium market value of the basket of goods, denoted “V_G”. On the right hand side, supply and demand for money determines the market value of money, denoted “V_M”.

Again, the key to the Goods-Money Framework is that market value, on the y-axis of both charts, is measured in absolute terms, that is to say, in terms of a “standard unit” for the measurement of market value.

With this basic framework in mind, let’s think about how a recession may impact the price level.

For the purposes of this post, we shall assume that a recession leads to a decline in the market value of goods, the numerator in our price level equation.

In terms of the Goods-Money Framework illustrated above, a recession pushes the aggregate demand curve to the left and the market value of the basket of goods V_G falls.

We could argue about whether this is always the case. For example, an oil price shock may lead to a rise in the market value of the basket of goods as tightness in the oil market pushes the aggregate supply curve to the right. But for the purpose of this exercise, it is reasonable to assume that a recession leads to a fall in aggregate demand that, in turn, that leads to a fall in the market value of the basket of goods.

The question we need to ask now is what happens on the right hand side of our Goods-Money Framework? Does a recession have any impact on the market value of money, the denominator in the Ratio Theory equation?

The Impact of a Recession on the Market Value of Money

In order to understand the potential impact of a recession on the market value of money, we need to understand both why money has value and what factors influence the value of money. These are topics that we have discussed at length in recent posts including “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that fiat money has value because it is a liability of society. More specifically, fiat money represents a proportional claim on the future output of society.

The key implication of this theory is that the value of fiat money depends upon confidence in the long-term economic future of society.

When people are confident in society’s long-term economic prospects, the value of the fiat money issued by that society is well supported. However, when people lose faith in the long-term economic future of their society, the value of money falls.

In simple terms, fiat money is only as good as the society that issues it.

Fiat money represents a claim against our collective economic wellbeing. If people begin to doubt the long-term future of their society, then the value of a claim against that future, i.e. the value of fiat money, will fall.

Fortunately, expectations regarding the long-term future of society tend to be relatively stable over time. As a result, the value of fiat money tends to be relatively stable over time.

Nevertheless, confidence in the long-term future of society can erode suddenly, particularly if structural economic problems have been quietly accumulating over a long period of time.

A severe recession is one event that may lead to a sudden decline in confidence regarding the long-term economic future society and, consequently, a sudden decline in the market value of money.

While economists might debate the cause of the economic cycles, most of us are accustomed to the idea that the economy moves in cycles. Therefore, an economic recession may create a period of uncertainty, but in most cases, people will remain relatively confident in the long-term economic prospects of society. Indeed, if there has been an economic boom, particularly in one sector of the economy (technology in late 1990s), then many people may feel as though the recession that follows that boom is just “business as usual”.

The point is that a recession does not, prima facie, lead to a collapse in confidence regarding the long-term prospects of society.

However, a recession can expose serious structural problems that have been accumulating. Moreover, recessions tend to become a “test of faith” in the sense that they test the market’s confidence regarding the ability of policy makers to steer the economy back on to the right path.

For example, in the last recession (the “Great Recession” of 2008/2009), several structural issues were exposed. Most notably, markets suddenly became aware of the relatively poor fiscal position of the United States. Government debt suddenly surged from 65% of GDP to 90% of GDP as the federal government began to run deficits in excess of $1 trillion a year. Moreover, concerns began to resurface regarding the long-term sustainability of key entitlement programs such as Social Security and Medicare.

However, for most people, these concerns were offset by confidence that policy makers, most notably the Federal Reserve, could steer the economy in the right direction. Indeed, since the Federal Reserve embarked on its program of quantitative easing, confidence in the long-term prospects of the United States have improved markedly as measured from the low point in confidence that occurred in about 2010/2011, the same time the price of gold peaked.

On this occasion, a recession did not significantly damage confidence in the long-term prospects of the United States. Consequently, the market value of money (the US Dollar) did not decline significantly and inflation remained subdued.

Nevertheless, every recession represents a test of confidence. If a recession severely damages long-term confidence, then the market value of money can fall sharply, more than offsetting a decline in the market value of goods. If this scenario, inflation will accelerate.

Ultimately, the view of The Money Enigma is that there is a simple rule of thumb in regards to the relationship between inflation and recession.

If a recession does not significantly impact long-term confidence in the economic future of society, then the rate of inflation will probably fall during the recession. However, if a recession does badly damage long-term confidence, then the value of money will decline sharply and the rate of inflation is likely to accelerate.

If this theory is correct, then what implications does it have for the next recession in the United States? Should we expect the next recession to result in a period of outright deflation? Or will the next recession see an acceleration of the currently subdued rate of inflation?

Will the Rate of Inflation Accelerate in the Next Recession?

If you did a quick survey of market commentators and asked them whether inflation would rise or fall in the next recession, I suspect that nearly 90% of respondents would say that inflation would fall.

This worldview has been reinforced not only by the experience of the past thirty years but also by memories of the Great Depression.

So, let’s play devil’s advocate and think about why this may not be the case when the next recession hits.

First, it is worth noting that the Great Depression should not be used as a guide for how the prices will behave in a recession, even a severe recession, under a fiat currency system. The reason for this is simple. During the Great Depression, the market value of money was fixed. More specifically, the market value of money (the US Dollar) was fixed to the market value of gold.

Therefore, when the Great Depression hit, the market value of money (the denominator in our price level equation) was relatively constant, even as the market value of goods (the numerator in our price level equation) declined dramatically.

This will not happen under our present fiat regime. Rather, under our present system, the value of money fluctuates depending upon confidence in the long-term prospects of society. If an event of the scale of the Great Depression was to occur again, then it is likely that the value of money in our present fiat system would collapse, more than offsetting the decline in the market value of goods.

Second, if we think about the experience of the last thirty years, none of the recessions during that period (1990, 2001, 2008) badly dented confidence in the long-term prospects of the United States. As discussed, the 2008 recession came the closest to challenging the consensus view on this issue, but in each case, long-term confidence was not badly damaged and the value of money was not significantly impacted.

So, what will happen to long-term confidence and, consequently, the value of money in the next recession?

Clearly, we can not say for certain. However, we can speculate on issues that might arise should a recession occur in the next few months.

First, it is likely that some of the structural problems that were exposed in the last recession will become issues of greater concern in the next recession.

The US government has made no progress in reducing government debt as a percentage of GDP (government debt now stands at over 100% of GDP versus only 65% at the beginning of the last recession).

Perhaps more importantly, the US government has made no progress on entitlement reform. Indeed, the CBO projects that fiscal deficits will climb as a percentage of GDP over the next twenty years, even if the US economy continues to grow at a reasonable pace.

While these structural issues remain largely unresolved, the view of The Money Enigma is that the bigger test during the next recession will be the markets confidence in the ability of policy makers to stabilize the economy.

Consider what would happen if the US economy entered recession today.

What would be the likely response from the Federal Reserve? Short-term interest rates are already at zero. Moreover, the Fed has made no attempt to unwind the monetary base that has quintupled since the last recession began.

The likely response from the Federal Reserve would be to embark on a new program of quantitative easing, thereby expanding the monetary base from its already unprecedented level. But would this next round of quantitative easing have the same impact as previous rounds? The law of diminishing marginal returns would suggest that it probably wouldn’t.

If the markets begin to feel that Congress and the Federal Reserve have lost control of the situation, then confidence regarding the long-term prospects of the United States could decline sharply. If this were to occur, then it is likely that the value of money would decline sharply, leading to a sudden rise in all prices as expressed in money terms and an acceleration in the rate of inflation.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

What Determines the Price of Gold?

Over the course of the last century, the gold price has experienced numerous extended bull and bear markets. These market cycles tend to persist for many years at a time. In this week’s post we will examine the one key factor that drives these bull and bear markets.

While there are many theories regarding the factors that influence the price of gold in the short term, there is one common denominator that can explain each of these major gold price cycles. The gold price rises as confidence in society’s long-term economic future deteriorates. Conversely, the gold price falls as confidence in society’s long-term economic future improves.

The level of confidence in the long-term future of society tends to move in long cycles that last many years. The gold price follows these cycles, although the gold price moves inversely to the level of confidence.

Gold is leveraged to the misfortune of fiat money. When confidence regarding society’s long-term economic future improves, the value of fiat money finds support and gold becomes less appealing. Conversely, if economic confidence is eroded, the value of fiat money falls and the gold price rises.

Indeed, a long-term chart of the USD gold price tells the story of optimism and pessimism in the future of the United States.

In the early 1930s, the gold price soared (the US government was forced to devalue the USD against gold) as the depression took hold and people became much more pessimistic about the United States. The gold price was stable through the 1950s and early 1960s as the post WWII boom fueled confidence in the future of the United States. The 1970s, a period in which the gold price soared, saw the return of pessimism as the costs of the Cold War mounted and as the Vietnam War challenged America’s sense of self-confidence.

In contrast, the 1980s and 1990s marked a period of increasing confidence, peaking in the late 1990s with the technology boom, the same point at which gold bottomed. However, as cracks began to appear in the US economic story in the 2000s, the price of gold rose sharply. Over the last several years, confidence in the long-term outlook for the US has picked up markedly and the gold price has fallen. The question today is whether that confidence is justified.

In summary, the gold price is a vote of no confidence in the long-term economic prospects of society. Our primary objective in this week’s post is to explain why this is the case. In order to do this, we will discuss why gold has value, why fiat money has value and the intimate relationship that exists between gold and fiat money.

Why Does a “Pet Rock” Have Value?

gold bars Before we begin, it is worth noting that the question of whether gold has any role or value in a modern society is a divisive one. Indeed, a discussion regarding the value of gold can quickly deteriorate into a debate that seems almost religious in nature. On one side of the argument are those that believe that “everyone must own some gold”, “gold is the only true money” and that “fiat money is a government conspiracy”. On the other side of the debate are those that believe that “gold is little more than catastrophe insurance”, “gold is a relic” and “gold is a pet rock”.

Debates about gold tend to be contentious for two reasons.

First, gold and fiat money are both poorly understood. Topics that are poorly understood make for chaotic debates. The view of The Money Enigma is that a sensible debate about the price of gold is impossible without a solid understanding of (a) why gold has value, (b) why fiat money has value, and (c) the complex and competitive relationship that exists between gold and fiat money.

Second, for reasons that we shall discuss, gold is a barometer for pessimism regarding the long-term economic prospects of society. A debate regarding the long-term prospects of society is, in and of itself, a divisive one. Optimists tend to feel that pessimists are “ignoring the march of progress” and underestimate that power of innovation, while pessimists tend to feel that optimists “just don’t get it” and that “this time isn’t different”.

Amidst all this debate, the primary goal of this week’s post is to develop a simple and objective framework that can help the reader think about what drives the price of gold, or at least what drives the major bull and bear market cycles in the gold price. Hopefully, both “gold bugs” and “gold bears” can use this framework, not only to challenge each other, but also to challenge their own views.

So, let’s begin this process by asking a simple question: “Why does gold have value?”

Gold is a real asset and derives its value from its physical properties. In other words, gold’s physical or tangible properties make it “useful”.

But what is so “useful” about gold? After all, we can’t eat it, we can’t drink it and we can’t grow crops with it. As gold’s critics point out, we don’t consume gold. Most commodities (wheat, oil, iron ore) are “consumed” in the sense that they are either eaten, or used for energy, or transformed into useful secondary goods.

In contrast, gold isn’t consumed: it just sits around.

Ironically, this is part of what makes gold so valuable. The fact that gold is rare and that we don’t consume gold, means that the stock of gold is relatively stable over time. Moreover, the growth in the stock of gold is slow and relatively predictable.

Why does this make gold valuable?

In simple terms, gold acts a constant. Gold is as close as we come to a “constant” in an economic world that is dominated by “variables”.

While most people never think about it, the property of “invariability” is remarkably rare in nature. It is so rare that most, if not all, of the “standard units” that we use to measure physical properties are invented. Feet, inches, kilometers per hour, kilograms are all standard units of measure. They are standard units in the sense that they are invariable in the property that they measure (for example, an inch is invariable in the property of length). None of these standard units occur in nature. Rather, we had to make them all up.

Gold is not invariable in the property of market value and therefore is not a standard unit for the measurement of market value in a technical sense. However, in a practical sense, the relative lack of variability in the stock of gold encouraged people to treat gold as the standard unit for trade. In a world full of variables, gold was the closest thing we could find to a constant.

It needs to be remembered that the economic life of pre-modern human society was far from stable. Most of human history, until relatively recently, has been characterized by war, disease and famine. Commodities that were in abundance one day might be scarce the next, and visa versa.

As a participant in a pre-modern economy, this creates an obvious dilemma. What goods do you accept in exchange for the goods that you produce? Ideally, you want a good where there isn’t a scarcity one day and an abundant oversupply the next.

In a sea of variability, gold became attractive as a pseudo-constant. One could accept gold in trade knowing that the broader economic community wasn’t going to grow lots more of it, build lots more of it or dig up a lot more of it next year. This quality became particularly valuable as trade extended over great distances and across cultures.

In short, gold’s physical properties make it valuable. The rarity of gold and, ironically, its lack of apparent usefulness make it “useful” in the conduct of economic life. More specifically, the relative invariability in the stock of gold makes it an excellent form of money in the sense that it is a useful medium of exchange, a good unit of account and acts as reliable store of value over very long periods of time.

However, in modern times, gold faces competition. Ironically, that competition comes from a form of money that was born of gold: fiat money.

The Competitive Relationship between Gold and Fiat Money

If gold was the father of money, then fiat money is the prodigal son.

The relationship between gold and fiat money is, like most relationships between father and son, “complex”. There is a competitive tension between gold and fiat, but fiat probably wouldn’t have come into existence without the help of gold and gold is always there to welcome fiat home if it gets into trouble, although not necessarily on fiat’s terms.

Gold and fiat money are in a war for hearts and minds. Those who might believe that fiat money has won the battle and that gold is a relic need to remember that, viewed from a historical perspective, fiat money is still in its infancy.

Gold has served as money for thousands of years. Representative money, paper money that is backed by gold, has served as money for centuries. But fiat money has occupied a primary place in world affairs for less than a century. Viewed in this historical context, fiat money is still a child that remains relatively untested.

Nevertheless, the early success of the prodigal son has chipped away at the importance and, arguably, the value of gold. Moreover, if the experiment with fiat money continues to be successful, then this will gradually debase the value of gold over the decades to come.

Every time fiat money proves it worth, the attractiveness of gold as a form of money declines, if ever so marginally. Conversely, every time a fiat currency stumbles, people are reminded of the extraordinary properties of gold.

In this sense, gold is a leveraged “anti-fiat” asset.

A rise in the value of fiat money has a negative “double whammy” impact on the price of gold.

First, if the market value of a fiat currency rises, then, all else remaining equal, the price of all goods in terms of that fiat currency will fall, including the price of gold. Second, as the value of fiat money rises, or even as the value of fiat money remains constant for a prolonged period of time, fiat money chips away at the relative attractiveness of gold.

Conversely, a rapid fall in the value of fiat money has two positive impacts on the price of gold.

First, as the value of a fiat currency falls, all else remaining equal, the price of all goods as expressed in terms of that fiat currency terms will rise, including the price of gold. Second, a sudden fall in the value of fiat money reminds people of the fact that fiat currency is always vulnerable to a sudden decline in long-term economic confidence, a unfortunate property which gold does not share. As people become nervous about the economic future of their society, demand for an asset that does not rely on this metric improves.

This last point highlights an important difference between gold and fiat money.

Fiat money is only as good as the society that issues it. While gold derives value from the relative invariability of its stock, fiat money derives its value from the expected economic prosperity of society.

In order to understand why the value of fiat money depends upon long-term economic confidence, we need step back and think about the evolution of “paper money”.

Why Does “Paper Money” Have Value?

In order to answer the question “why does paper money have value?” we first need to answer a more fundamental question: “why does any asset have value?”

The view of The Money Enigma is that assets can only derive their value in one of two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.

In simple terms, if something doesn’t derive any value from its natural or intrinsic properties, then the only way it can derive value is if it creates an obligation on a third party to deliver something of value.

This paradigm is so fundamental that it is used as the basis of classification of assets for accounting purposes. For accounting purposes, every asset must be classified as either a “real asset” or a “financial instrument”.

Real assets derive their value from their physical properties, whereas financial instruments derive their value from their contractual properties.

In nearly every society, the first form of money used was “commodity money”. Gold is a perfect example of commodity money. Commodity money is, by definition, a real asset that derives its value from its physical properties.

The problem with commodity money is that it restricted the capability of governments to finance wars and other public expenditures. After all, you can’t pay your armies in gold coin if you run out of gold.

This problem led to the invention of the first paper money, otherwise known as “representative money”. Rather than paying the armies in gold, the ancient kings and emperors decided to pay soldiers by issuing pieces of paper that were promises to deliver gold on request. This first paper money was an explicit legal contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king.

This first form of paper money, “representative money”, was a financial instrument and, in common with all financial instruments, it derived its value from its contractual properties. Representative money had value solely because it represented a claim on a real asset (gold).

While the use of representative money did provide government with more flexibility in the way it could finance its operations, it still restricted the amount of paper money that government could issue.

The ingenious solution to this problem was to remove the gold convertibility feature, thereby effectively cancelling the explicit contract that governed paper money.

This is the point that representative money became fiat money.

The question that mainstream economic fails to provide a good answer for is why did paper money maintain any value once the explicit contract that governed representative money was rendered null and void. After all, paper money was originally accepted only because it was “as good as gold”.

So, why did paper money maintain any value?

The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that still governs fiat money to this day.

Fiat money is not a real asset and does not derive its value from its physical properties. Therefore, prima facie, fiat money is a financial instrument and must derive its value from its contractual properties, even if that contract is implied rather than explicit

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Fiat money is an asset to one party because it is a liability to another. More specifically, fiat money is a liability of society (the ultimate issuer of money) and represents a proportional claim on the future output of society.

In more technical terms, fiat money is a long-duration, special-form equity instrument and a proportional claim on the future output of society (“Proportional Claim Theory”).

The notion that money is a proportional claim on the future output of society is a complex idea that we have discussed extensively in recent posts. For those that are new to The Money Enigma, I would highly recommend reading “What Factors Influence the Value of Fiat Money?” and “A New Theory of Fiat Money”. Readers with a financial background may also be interested in reading “Money as the Equity of Society”, a post which compares fiat money with shares of common stock.

So, what does this theory imply about the value of fiat money?

In simple terms, if fiat money (the monetary base) is a proportional claim on the future output of society, then the value of fiat money primarily depends upon expectations regarding the long-term economic prospects of society.

More specifically, the value of fiat money is positively correlated with expected long-term real output growth and negatively correlated with expected long-term monetary base growth.

If this still seems a bit complicated, then think of it this way.

The value of fiat money is a slice of cake that we hope to eat at some point in the distant future. The cake is “expected future output” and the number of slices we must cut the cake into depends on the “expected size of the monetary base”.

As each slice of our cake gets smaller, the value of fiat money falls.

The expected size of each slice of future output cake can shrink (the value of fiat money can fall) either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

In the most basic terms, we can say that fiat money is only as good as the society that issues it. If people are optimistic about the economic prospects for a society, then the value of fiat money issued by that society should be well supported. However, if people become more pessimistic about the future path of the economy, then the value of fiat money will start to decline.

The Gold Price and Economic Confidence

Now we have all the pieces of the puzzle, we can bring them together to think about what drives extended bull and bear market cycles in the gold price.

If gold is a leveraged “anti-fiat” asset and the value of fiat money is positively correlated with the perceived long-term economic prospects of society, then the gold price is a barometer of pessimism regarding the long-term economic future of society.

In the context of the United States, the gold price, as measured in US Dollar terms, rises if confidence regarding the long-term economic future of the United States deteriorates. Conversely, the gold price falls as market confidence in America’s long-term future improves.

It is important to note that the gold price is not a measure of confidence regarding current economic conditions. People can feel bad about the “here and now” and the gold price can still fall. Rather, gold is a proxy for pessimism about the long-term (30-40 year+) future of the United States.

While confidence about current conditions is rather volatile, confidence regarding the long-term future of a society tends to move in extended cycles. These cycles often last for years, if not a decade or more.

People’s expectations about the long-term prospects of their society tend to be slow to adjust. Most of us don’t wake up one morning and completely change our view on the 30-year economic prospects for the country we live in. Rather, our view tends to be changed slowly by the accumulation of data points, both positive and negative.

It is these extended cycles of rising and falling long-term confidence that create the extended bear and bull market cycles that we see in gold.

What does this mean for gold investors today?

In simple terms, if you believe that markets are generally too pessimistic about the long-term future of the United States and other major global economies, then you should expect the gold price to continue to fall. Conversely, if you believe that markets are too optimistic about the long-term economic future of the US, then you might reasonably expect the gold price to rise.

It seems reasonable to believe that confidence in the long-term future of the West peaked in 1999/2000 when it seemed that advances in technology would drive a permanently higher level of productivity growth. Not surprisingly, this point also marked the low point in the price of gold.

Confidence slowly deteriorated over the course of the next ten years and hit a nadir in August 2011 when S&P downgraded the credit rating of the United States. Again, this was the point at which the gold market turned and a bear market began.

Since then, confidence regarding the long-term future of the United States has improved markedly and the bear market in gold has continued. However, the view of The Money Enigma is that much of this improvement in confidence has been driven by a monetary experiment called quantitative easing. Whether this improvement in confidence turns out to be permanent in nature is far from certain, but the odds are against it.

Those readers who are interested in my view regarding the challenges associated with quantitative easing might want to read “The Case for Unwinding QE” and “Monetary Base Expansion: The Seven Stages of Addiction”.

Author: Gervaise Heddle

A New Theory of Fiat Money

The view of The Money Enigma is that fiat money is a financial instrument and a proportional claim on the future output of society.

Assets can only derive their value in two ways: from their physical properties (“real assets”) or from their contractual properties (“financial instruments”). Fiat money is a financial instrument and derives its value from an implied-in-fact contract between the holder of money and the issuer of money.

Although the fiat monetary base is legally a liability of government, economically it is a liability of society itself. More specifically, fiat money is a special-form equity instrument and a proportional claim on the future output of society.

In this week’s post, we will examine why the “liability nature” of fiat money is important. Not only does focusing on the liability nature of fiat money provide us with a better perspective on why money has value, but it also allows us to create a better framework for thinking about what factors influence the value of fiat money.

Fiat Money: A Liability Ignored

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, is both an asset and a liability. More importantly, fiat money only has value as an asset to its holder because is a liability of society.

Most theories of fiat money focus solely on the “asset nature” of fiat money and therefore struggle to explain why fiat money has value. By focusing solely on the asset nature of money, economists are forced to invent new paradigms in an attempt to explain why fiat money can derive value in a way that no other asset can. Such attempts invariably result in the creation of circular arguments that fail on closer inspection.

In contrast, focusing on the “liability nature” of money has several advantages.

First, we can use the well established “real assets/financial instrument” paradigm to explain why fiat money has value, as opposed to creating an exception to this paradigm specifically for fiat money. Fiat money is a financial instrument and derives its value from an implied-in-fact contract: it has value to its holder because it represents a liability to society. More specifically, fiat money represents a proportional claim on the future output of society.

Second, it allows us to more clearly distinguish between how different types of “money” derive their value. The monetary base is an equity instrument and derives its value as a proportional claim against the future output of society. In contrast, a banking deposit is a debt instrument. In simple terms, a banking deposit has value because it represents a claim to money; money has value because it represents a proportional claim to the future output of society.

Third, it avoids circular arguments regarding the “demand for money” and the “functions of money”. Most theories of money demand argue that there is demand for money because it is accepted as a medium of exchange. But this represents a circular argument because money can only perform its role as a medium of exchange if there is demand for it. Proportional Claim Theory breaks the circular argument. Money can perform its functions because it has value; money has value because it is a liability of society.

Fourth, and perhaps most importantly, it provides us with a framework for thinking about what determines the value of fiat money. If fiat money (the monetary base) is a proportional claim on the future output of society, then the value of fiat money primarily depends upon expectations regarding the long-term economic prospects of society. More specifically, the value of fiat money is positively correlated with expected long-term real output growth and negatively correlated with expected long-term monetary base growth.

In simple terms, we can think of the value of fiat money as a slice of future output cake. As the expected slice of future output cake gets smaller, the value of fiat money falls. The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

Why Does Fiat Money Have Value?

The view of The Money Enigma is that the market 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 price of a good, in money terms, will rise.

However, what determines the market value of money? Indeed, why does fiat money have any value at all? After all, fiat money is, at least superficially, nothing more than paper with pictures printed on it. So why should something that is so easy to create have any value?

In order to answer this question, we need to step back and consider a more fundamental question: “why does any asset have value?” The view of The Money Enigma is that if we can find a paradigm that describes why various assets have value then we have an obligation to see how that paradigm applies to fiat money.

Why Does Any Asset Have Value?

The view of The Money Enigma is that rather than trying to answer the question “why does fiat money have value?” by treating money as special, we should begin our analysis by treating money as if it is just another asset. More specifically, we should first answer the question “why does any asset have value?” and then, once we have established a sensible answer to that question, see how money fits into that context.

Fortunately, there is a well-established paradigm in finance that we can use to answer this question.

Assets can only derive their value in two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.

Despite the fact that the “real asset/financial instrument” paradigm can usefully explain why assets have value, most economists choose to ignore this paradigm when it comes to the subject of fiat money. This is a mistake. Prima facie, a theory of money that does fit within this general paradigm is much stronger than a theory that requires money to be an exception to this paradigm.

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Money is an asset to one party because it is a liability to another. More specifically, money is a liability of society (the ultimate issuer of money) and represents a proportional claim on the future output of society.

The notion that money is a proportional claim on the future output of society is a complex idea. In order to understand this point, it helps to think about the evolution of money over time. By tracking the development of money over time, it is easier to see why there is a good prima facie case for the view that fiat money derives its value from an implied-in-fact contractual relationship.

The Evolution of Money: From Real Asset to Financial Instrument

In nearly every society, the first form of money used was some sort of “commodity money”. Commodity money is, quite literally, money that is a commodity. Early examples of commodity money included grain, rice, gold and silver. All of these early forms of commodity money were real assets: assets that derived their value from their physical properties.

The problem with commodity money is that it restricted the capability of governments to finance wars and other public expenditures. In simple terms, you can’t pay your armies in gold coin if you run out of gold.

This problem led to the invention of the first “representative money”. Rather than paying the armies in gold, the ancient kings and emperors decided to pay soldiers by issuing pieces of paper that were promises to deliver gold on request.

This first paper money was an explicit legal contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king. By definition, this representative money was a financial instrument and derived its value solely from its contractual properties.

Ultimately, the issuance of representative money also limited the amount of money that governments could create. Therefore, at some point the gold convertibility feature was removed. This point marks the shift from representative money to fiat money.

In effect, the explicit contract that governed representative money was rendered null and void. So why did paper money maintain any value? The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that governs fiat money to this day.

A New Theory of Fiat Money: Proportional Claim Theory

The challenge for economics is unraveling the terms of the implied-in-fact contract that governs fiat money (what we might call the “Fiat Moneyholders’ Agreement”). Fortunately, we can leverage elements of traditional finance theory to help us create a basic outline what this implied-in-fact agreement might look like.

There are four basic steps in this process. First, we need to identify the parties to the agreement. Second, we need to identify the economic benefit that is promised by the issuing party under the agreement. Third, we need to consider whether the claim represents a fixed or variable entitlement to that economic benefit. Fourth, we need to consider the specific terms of that fixed or variable entitlement.

[Before we begin this process, it is worth reminding readers that we are discussing the implied agreement that governs the fiat monetary base. Going forward, the use of the term “money” means “the monetary base”.]

Parties to the Agreement: The first party to the agreement is the holder of money. The second party to the agreement is the issuer of money. While the legal issuer of money is the government, the ultimate economic issuer of money is society itself.

Society can not issue liabilities directly because “society” is not a legal entity. Rather, society must create and authorize a legal entity (government) to issue liabilities on its behalf. Money is a legal liability of government but an economic liability of society itself.

Economic Benefit: If society is the economic issuer of money, then what economic benefit can society promise to the holder of money? The answer is the future economic output of society. In order for any financial instrument to be effective, the issuing party must be able to offer the subscribing party a claim against something of value. For example, a share of common stock represents a claim against the future cash flow of the issuing corporation. Similarly, fiat money represents a claim against the future economic output of the issuing society.

Fixed or Variable Entitlement: Once we have established the parties to the agreement and have identified the economic benefit that is being promised, we need to determine whether the financial instrument represents a fixed or variable entitlement to that economic benefit. This is an important distinction because it also helps us classify the financial instrument as being a debt instrument (a fixed entitlement) or an equity instrument (a variable entitlement). So, does money represent a fixed or variable entitlement to the future economic output of society?

The view of The Money Enigma is that money represents a variable or proportional entitlement to the future economic output of society. In this sense, money is a special form of equity instrument.

Again, we can compare money with shares of common stock. A share of common stock represents a proportional claim on the future cash flow of a business. Similarly, one unit of money represents a proportional claim on the future economic output of society.

We can use this analogy to think about the value of money. A share of stock becomes more valuable if expected future earnings per share rise. Similarly, one dollar becomes more valuable if expected future output per unit of monetary base rises. Conversely, one dollar becomes less valuable if the market suddenly decides that either (a) the future monetary base will be higher than expected, or (b) future real output will be lower than expected.

Clearly, there are significant differences between money and a share of common stock. This brings us to the final point: what are the specific terms of the variable entitlement to future output?

Specific Terms: One important difference between money and a share of common stock is that a share of stock entitles you a stream of future cash flows, whereas the dollar in your pocket entitles you to a slice of future economic output. In simple terms, you can only spend the dollar in your pocket once. Therefore, money represents a claim to a variable slice of future output, not a variable stream of future output.

However, what is the exact nature of the variable slice of future output that is “promised” to the money holder under the agreement? This is a difficult question to answer, but again we can draw on finance theory to help us create a framework to answer it. [Note to the reader: the discussion that follows is very complicated. Please read The Velocity Enigma, the final paper in The Enigma Series, for an extended discussion of this issue].

In order for a financial instrument to be defined and hence have value, the nature and scope of the entitlement must be fixed. In the case of a variable or proportional entitlement, the collective entitlement of the set of proportional claims must be fixed. For example, the collective entitlement for the set of outstanding shares in a company is, typically, 100% of residual cash flows.

In the case of fiat money, the scope of the collective entitlement, the theoretical entitlement of the entire monetary base to real output, is set at the date the fiat currency is launched (typically, the day gold convertibility is removed) and, at least in principle, is fixed at that level for all future periods. For example, if the value of the monetary base at that date is 150% of annual real output for that same period, then the “in principle” collective entitlement of the monetary base is set at 150% of real output for all future periods.

Once the “in principle” collective entitlement to future output is fixed, economic agents can begin to make a critical calculation: the baseline proportion of output that a unit of money can claim in a given future period. The baseline proportion (“β”) represents the “in principle” or “theoretical” proportion of output that a unit of money should claim in a given future period. The expected baseline proportion in a future period is calculated simply as the scope of the collective entitlement divided by the expected monetary base in that future period.

Importantly, the baseline proportion is not the actual or realized proportion of output (“α”) that money will claim in that future period. Rather, the expected baseline proportion for a given future period is the “in principle” or “theoretical” proportion of output that money should claim for a given future period and, therefore, provides the best unbiased estimate of the expected realized proportion of output that one unit of money might claim in that given future period.

Value of Money Depends Upon a Chain of Expected Future Values

Once the terms of the implied-in-fact Fiat Moneyholders’ Agreement are established, we can begin to analyze what determines the value of fiat money.

The value of money today depends upon a chain of expectations regarding the value of money in future periods. When expectations change regarding the future market value of money, it has a cascading effect all the way down along the chain of expected future values until it reaches the present market value of money. Any change in the expected future market value of money creates an incentive to act now. For example, if people suddenly expect the value of money to fall at some point in the future, then this creates an incentive for them to spend money now and, at the margin, the value of money falls.

In more technical terms, if expectations shift regarding the future value of money, then a state of intertemporal equilibrium (a state of indifference) that previously existed is disturbed. In order to restore intertemporal equilibrium, the current market value of money must adjust to reflect these new expectations.

Now, we can begin to create a high-level picture of what factors influence the value of fiat money. If fiat money is a proportional claim on future output (as described earlier), then the value of fiat money will fall if either (a) the expected long-term growth rate of real output falls, or (b) the expected long-term growth rate of the monetary base rises.

It is important to note that the value of money depends on long-term expectations (20-30 year expectations) of the path of both real output and the monetary base. The reason for this is that fiat money is a long-duration asset. This idea is explored further in The Enigma Series.

A Valuation Model for Money

One of the compelling aspects of Proportional Claim Theory is that we can combine this theory with the notion of intertemporal equilibrium to build a valuation model for fiat money.

If fiat money is a financial instrument (a special-form equity instrument) and if we isolate the “market value of money” by measuring the market value of money in terms of a “standard unit” for the measurement of market value, then it should be possible to build a valuation model for fiat money, just as one might build a valuation model for any other financial instrument.

More specifically, we should be able to create a “Discounted Future Benefits Model for Fiat Money” based on the principle that the value of a financial instrument is equal to the present value of the future economic benefits that the marginal holder of that instrument might reasonably expect to receive from the nature of the claim that the instrument represents.

Creating a discounted future benefits model for money requires a number of special adaptions to the familiar “discounted future cash flow model” used to value most financial instruments.

First, the valuation model for money must be expressed in terms of a “standard unit” for the measurement of market value, not “dollars”. Second, money is a claim on real output, not cash flows: the present market value of money depends on the discounted future market value of the real output that it is expected to claim.

Third, money represents a claim to a slice, not a stream, of future output. But if the value of money could be equal to any one of a number of future slices of output, then how do we determine the current market value of money?

Mathematically, the question becomes one of probability: what is the probability that the marginal unit of money demanded is spent in any one of the n future periods in the spending horizon? Fortunately, there is a simple way to answer this question. In a state of intertemporal equilibrium, the current possessor of money is indifferent between spending the marginal unit of money now or in any of the n periods in the spending horizon. They are also indifferent between spending the marginal unit of money in one future period or another future period. If someone is indifferent between all n future periods, then the probability that they spend the marginal unit of money in any one of those periods is equal to (1/n). This simple probability distribution allows us to weight (1/n) each of the expected discounted future values of money.

The fourth challenge in building the valuation model for money relates to the role of expected nominal investment returns. All else equal, as the nominal interest rate rises, the expected future benefits received from money rise and hence the present market value of money rises. Whereas most assets must be “held” in order to receive the benefits that accrue to them, money does not have to be “held” in order to receive its future benefits. Rather, money can be invested before it is spent. These investment returns must be included in the expected discounted future benefits model.

The end result of resolving these challenges is to produce a valuation model for fiat money that looks remarkably similar to a valuation model for a share of common stock.

In simple terms, the valuation model for money implies that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. More generally, if expectations about the long-term prospects of the economy become more pessimistic, then the market value of money will fall.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Monetary Base Expansion: The Seven Stages of Addiction

Monetary base expansion is a powerful drug. Used correctly and judiciously, it has a critical role to play in the successful management of a complex economic system that relies heavily on fractional reserve banking. However, the powerful and immediate effect of monetary base expansion makes it a highly addictive drug.

In this week’s post, we will attempt to illustrate the highly addictive nature of monetary base expansion by applying the “seven stages of addiction” model for methamphetamines to the current cycle of monetary base expansion. There are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.

“The Seven Stages of Addiction” for methamphetamines are: (1) the Rush, (2) the High, (3) the Binge, (4) Tweaking, (5) the Crash, (6) the Hangover, and (7) Withdrawal.

The view of The Money Enigma is that markets and policy-makers are currently passing from the “Binge” stage into the “Tweaking” stage, a stage characterized by increasingly erratic (market) behavior and delusions so strong that the participants become disconnected from reality.

For first-time users, monetary base expansion has a positive and immediate impact on the economy (the “Rush”). This immediate success creates a false sense of confidence among both market participants and policy makers regarding the long-term economic prospects of society (the “High”).

This false sense of economic confidence fuels more monetary expansion (the “Binge”) and higher levels of current economic activity. Moreover, it engenders great confidence in the value of fiat currency, thereby suppressing prices as measured in money terms. Ironically, this occurs just at the point when the value of fiat currency is most at risk.

Over time, each additional round of monetary expansion becomes less effective: the market has become accustomed to the drug and every additional dose of the drug has less impact. This occurs right at a point where dangerous extremes in market sentiment have become commonplace. Market behavior becomes increasingly erratic and volatile (“Tweaking”). Markets begin to behave in ways that are “out of character” from a historical perspective and would be impossible without the drug: for example, negative nominal yields on debt securities.

Finally, the longer-term consequences of monetary base expansion become clear (the “Crash”). As confidence erodes, the value of fiat money falls and prices begin to rise. Policy makers discover that the drug no longer has any net positive impact on the economy and the economy enters into a prolonged period of stagnation (the “Hangover”). In the final stage, new regulations are introduced to prevent the future abuse of such a potent and important policy tool (“Withdrawal”).

A Powerful Drug with an Important Role to Play

Monetary base expansion is an important and powerful instrument for the conduct of economic policy. The ability to create money allows a central bank to perform a “lender of last resort” function that is critical in maintaining confidence in a fractional reserve banking system.

Moreover, the central bank’s ability to “print money” allows the government to respond quickly and decisively when other non-banking crises occur. For example, if a major war started today, monetary base expansion provides the government with a mechanism to quickly finance any emergency war-related spending.

In this sense, we can think of monetary base expansion as the morphine of our economic system. Morphine is a vitally important drug that has clear positive benefits when used judiciously. However, just like morphine, monetary base expansion only tends to mask the symptoms of underlying structural problems, rather than “curing” the patient. Nevertheless, printing money has a clear and positive role to play in times of genuine national crisis.

Unfortunately, monetary base expansion shares another common characteristic with morphine and other powerful drugs such as methamphetamines: it is highly addictive.

Why is Monetary Base Expansion so Addictive?

The history of monetary base expansion abuse is nearly as long as the history of civilization itself. For example, we know that the Roman Empire systematically reduced the gold and silver content in their coins, an act that ultimately resulted in a dramatic devaluation of Roman currency.

Invariably, experiments with currency debasement end badly. So why is the history of civilization littered with examples of currency debasement and money printing?

Monetary base expansion, or “printing money”, has always been an attractive option to politicians and governments. The reason for this is twofold:

The creation of vast sums of money, seemingly out of thin air, allows politicians and governments to achieve short-term ends that would be impossible without that ability; and
In the short term, printing money can seem like a “free” source of financing. Printing money allows politicians to avoid raising taxes or issuing more debt to pay for government expenditures. Moreover, if expectations are cleverly managed, then printing money may have no short-term impact on the value of money and, consequently, no adverse short-term impact on the price level.

In many ways, monetary base expansion can seem like a “miracle drug”. It has immediate positive effects on the economy and, at least in the short term, it can appear to have no negative side effects.

This raises an interesting question. If the long-term side effects of monetary base expansion are well understood (expansion of the monetary base at a rate higher than real output leads to inflation), then why is it possible for monetary base expansion to have no adverse impact on the value of money and the price level in the short to medium term?

This is a question that was addressed in a post earlier this year titled “Why is there a lag between money printing and inflation?”

The view of The Money Enigma is that fiat money is a financial instrument and only has value because it is a liability of society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.

That’s a mouthful: so what does it mean?

In simple terms, we can think of fiat money as a slice of cake that we hope to eat at some point in the future. The value of fiat money varies according to the expected size of that slice of cake. The cake is future output and the number of slices the cake has to be cut up into is determined by the size of the future monetary base.

The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

So, why is it possible for central banks to print money with no adverse short-term impact on the value of money? The answer is that the value of money depends on long-term expectations.

If market participants believe that an expansion in the monetary base is only “temporary”, then this means that the cake (future output) will be divided up into a small number of slices. However, if expectations shift and the market decides that the expansion in the monetary base is more “permanent” in nature, then our future output cake will need to be divided up into more slices: the expected size of each slice falls and the value of money falls.

Readers who are interested in learning more about this theory should read “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

In summary, monetary base expansion is a powerful drug that appears, at least in the short term, to have limited negative side effects. This potent combination makes it highly addictive to both markets and policy makers.

Unfortunately, excessive monetary base expansion has terrible long-term consequences, a concept that is (or at least should be) well understood by policy makers and markets.

So why has the Federal Reserve not made any attempt to reduce the size of the US monetary base nearly seven years after in began to experiment with quantitative easing? Moreover, why are markets failing to price assets to reflect the increasing risk of severe inflationary outcomes?

In order to answer these questions, it helps to think about the psychological cycle that accompanies monetary base expansion. This can be illustrated by comparing the monetary base expansion cycle with the addiction cycle associated with methamphetamines.

The Seven Stages of Addiction

1). The Rush – The rush is the initial thrill that market participants and policy makers feel when monetary base expansion is first announced and implemented. For those societies with little recent experience of monetary base expansion, the impact of this new policy is immediate and exciting.

The initial implementation of monetary base expansion has an almost immediate narcotic effect on the markets. Risk assets rally in a knee-jerk reaction as market participants realize that the safety net has been activated. In the case of QE1, markets that had ceased to function, such as the market for mortgage-backed securities, begin to return to life.

In a crisis, there is tremendous pressure on policy makers to appear to be doing something. When monetary base expansion is announced, the immediate political pressure on policy makers is relieved, even if the action is considered by many to be controversial.

2). The High – The early success of monetary base expansion begins to shift the focus of markets away from “risk” and towards “opportunity”. Early doubts about the effectiveness of the policy begin to dissipate. Market participants and policy makers begin to feel more confident in the economic outlook.

This rising confidence begins to feed the delusion that “this time is different”. Rising confidence in the long-term economic future of society not only leads to higher asset valuations and higher current levels of economic activity but also, somewhat ironically, acts to support the value of fiat money, thereby depressing prices as measured in money terms.

As discussed earlier, if fiat money is a proportional claim on the future output of society, then rising levels of confidence regarding the long-term growth of real output will support the value of fiat money. Furthermore, near-term economic strength fuels the belief that the monetary expansion is only a “temporary” phenomenon. A temporary increase in the monetary base has little to no impact on the value of fiat money because fiat money is a long-duration asset.

Those who might have warned against the inflationary consequences of monetary expansion look foolish as rising levels of confidence actually bolster the value of fiat currency and, in turn, create a deflationary environment. This outcome seems to vindicate the bold action of policy makers and sets up the environment for the next stage of addiction.

3). The Binge – The binge is a period of uncontrolled, or poorly controlled, use of the monetary expansion drug. In the context of recent experience, QE2, QE3 and QE Japan/Europe could all be considered to be part of “the binge”.

After the initial apparent success of the experimentation with monetary base expansion, markets and policy makers both start to believe that if a little is good, then a lot must be even better. Moreover, since the initial experimentation occurred without any obvious negative side effects, people begin to believe that it must be reasonably safe to continue with additional stimulus.

The binge is characterised by increasingly aggressive and risk-seeking behavior on the part of markets and overconfidence on the part of policy makers.

Market participants begin to lose touch with the underlying reality of the economic situation. In the case of QE, monetary base expansion allows the Fed to purchase long-term government bonds, thereby pushing up the price on those bonds and lowering the long-term interest rate, or “risk free rate”. This creates a waterfall effect across the entire spectrum of risk assets. As the risk free rate falls, the required return on capital for all assets falls, thereby pushing the price of all risk assets. See “Has the Fed Created the Conditions for a Market Crash?” for a full discussion of this issue.

Markets begin to create myths to sustain the binge. One of these myths is that elevated risk asset prices can be sustained by strong economic growth even when the monetary base is reduced (see article above for why this is a complete fiction). The second myth that begins to take hold is the notion that there will be no adverse inflationary consequences even if the central bank fails to reduce the monetary base from its historically high levels.

This second myth is fed by “economic principles” for which there is little empirical support such as the notion that “inflation is caused by too much demand”. Markets begin to believe that there will never be inflation as long as the central bank prevents the economy from “overheating”: the size of the monetary base is somehow irrelevant, despite the fact that long-term empirical evidence overwhelmingly supports the notion that “money matters”.

4). Tweaking – Market conditions are most dangerous when they cross into the “tweaking” phase, a condition reached when, after a long period of binging, the market begins to experience diminishing marginal returns from the application of additional monetary stimulus.

Judging by historical standards of behavior, markets might seem to have completely lost touch with reality. Markets become increasingly erratic and momentum driven. Asset pricing outcomes that previously might have seemed impossible become commonly accepted. Negative nominal interest rates on government securities and the second coming of a “once-in-a-lifetime” tech and biotech stock bubble are just two of the more obvious symptoms of this delusional-type behaviour.

Ironically, this is also the point where confidence in fiat money is at its highest and sentiment regarding anti-fiat assets (gold and other precious metals) is at its lowest. Despite the fact that the market is still benefitting from a high dosage of the drug in the system, the market is supremely confident that either the monetary base can be reduced with no ill effect or that inflation can be contained even if the monetary base is not reduced. Confidence in policy makers and the economic future of society is so strong that inflation is regarded as a complete “non-issue”.

Nevertheless, warning signs begin to emerge. Various segments of the global markets might begin to break down in a violent fashion. Stock market breadth begins to falter. More and more countries and industries begin to experience difficult economic times. All of these signs are explained away as being special cases, but each new event begins to highlight the underlying fragility of the system.

5). The Crash – The crash occurs as the positive effects of the drug suddenly wear off and the bubble of overconfidence begins to pop.

This sudden erosion of confidence sets up a negative feedback loop that begins to feed on itself, just as the bubble of confidence associated with monetary expansion created a positive feedback loop.

In the first instance, a sudden erosion of confidence leads to a lower risk appetite and a higher required rate of return on risk assets. Asset prices fall and economic activity begins to falter.

When this first begins to happen, markets may comfort themselves in the belief that the central bank will be able to provide more monetary stimulus “if things get really bad”.

However, this loss of market confidence is likely to coincide with a second and very unwelcome development: a sudden erosion in the value of fiat money and an unexpected rise in the general price level.

The view of The Money Enigma is that fiat money is a proportional claim on the future output of society. Therefore, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.

If people start to believe that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. In that scenario, people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected. This combination of shifting expectations can lead to a sudden decline in the value of money and, conversely, a sudden rise in prices as measured in money terms.

6). The Hangover – At some point, markets and policy makers begin to realize that “this time wasn’t different”. Monetary base growth far in excess of real output growth leads to the same end results as it did every other time: higher inflation.

The required nominal rate of return on risk assets surges higher, leading to forced sales, massive private sector deleveraging and a cycle of declining asset values. Policy makers that seemed to be invincible are suddenly impotent. Real economic activity declines sharply while higher prices erode the general standard of living.

7). Withdrawal – Society vows “never again”. A major new round of regulations are introduced to prevent future generations from repeating the same mistakes. Unfortunately, they will.

Why Do Currencies Collapse?

Over the past few years, there has been no shortage of people calling for the collapse of fiat currency. Marc Faber, Kyle Bass and Peter Schiff have all talked about the imminent collapse of at least one fiat currency or another. Yet the days roll on and nothing happens. So, why do fiat currencies collapse? What are the circumstances that might trigger such a collapse? And why are these gentlemen so agitated about the prospects for the major Western fiat currencies?

In order to understand why the value of fiat currency might suddenly collapse, we need to understand (a) why that fiat currency has value in the first place, and (b) what factors determine the value of fiat currency.

The view of The Money Enigma is that fiat money is a liability of society. More specifically, fiat money represents a proportional claim on the future output of society.

What does this mean in simple terms? Well, we can think about fiat money as a slice of pie that we hope to eat at some point in the future. The pie is the future output of society. The number of slices that the pie has to be divided into is determined by the size of the future monetary base. The value of fiat money varies according to the expected size of each slice of this “future output pie”.

Clearly, there are two reasons for why the expected size of our slice of future output pie might shrink: either (a) there is a smaller pie (less future output), or (b) there are more slices (higher future monetary base).

Fiat currencies tend to collapse when expectations regarding both of these factors shift violently in the wrong direction. If the market suddenly decides that there will be a smaller pie (less future output) and more claims to that pie (a higher than expected future monetary base), then suddenly people expect each slice to be a lot smaller. Consequently, the value of fiat money collapses and prices as measured in terms of that currency surge higher, often leading to what is known as hyperinflation.

Why Does Fiat Money Have Value?

One of the best aspects of writing these weekly posts is the feedback that I receive from readers. Recently, I received a couple of comments from one of my regular readers regarding a post that was first published in February 2015 titled “Why Does Money Exist? Why Does Money Have Value?” This reader, who is a professional bond trader working for one of the big banks in Europe, simply observed, “Deserves to be studied line by line”.

While you may not have the time or the inclination to study that article “line by line”, the subject of why fiat money has value is an important one for which mainstream economics doesn’t provide good answers.

The view of The Money Enigma is that in order to understand why fiat money has value we need to answer a more general question: “why does any asset has value?”

Fortunately, there is a well-established paradigm that we can use to answer this question: a paradigm that can be applied to every asset, but one that for some reason is ignored by economists in discussions regarding money.

The paradigm is this: every asset is either a real asset or a financial instrument.

This distinction is important because it relates to how different assets derive their value. Real assets derive their value from their physical properties. Financial instruments derive their value from their contractual properties.

Real assets such as land and commodities derive their value from their tangible or physical nature. In contrast, financial instruments, such as bond and stocks, have little or no physical value. Rather, a financial asset is, by definition, a contract: financial instruments only have value to their holder because they represent a liability to another party.

Now, let’s apply this paradigm to the evolution of money.

Money began life as a real asset.

In ancient societies, it is likely that basic agricultural products were used as the first medium of exchange. Over time, gold and silver coins became a more popular and widely circulated form of “commodity money”.

This commodity money derived its value from its physical properties. Agricultural commodities could be consumed; gold and silver had value because they were rare and desired for their unusual physical properties.

At some point, the ancient kings and rulers decided that they didn’t want to pay their armies and workers in gold, so they decided to create something that would be “as good as gold”: a piece of paper that promised its bearer some quantity of gold or silver from the royal treasury.

This “representative money” marked the beginning of money as a financial instrument.

Representative money was nothing more than an explicit contract, written down on a piece of paper that promised the bearer some quantity of gold or silver on demand. Representative money only had value to its holder because it represented a liability to its issuer, normally the king or government of the day. More specifically, it represented a claim against the royal treasury for delivery of a real asset (gold or silver).

It is important to note that this representative money only had value because it created a contractual obligation upon its issuer. Representative money didn’t have value because it was a convenient medium of exchange. It didn’t have value because it was a useful unit of account. Nor did it have value because it was a “store of value”. It had value because it was an explicit contract and created a liability against its issuer.

All of these functions of representative money (medium of exchange, unit of account, store of value) could only be performed because representative money had value. Moreover, representative money only had value (and therefore, could only perform these functions) because it created an explicit liability against its issuer.

If we wind the clock forward another couple of hundred years, we begin to see the emergence of fiat money. The gold convertibility feature of representative money was removed.

In essence, the explicit contract that gave representative money its value was rendered null and void. So, why did this new fiat money retain any value?

The view of The Money Enigma is that when the switch was made from representative money to fiat money, the explicit contract that governed money was replaced by a new implied-in-fact contract. The old explicit contract that guaranteed gold on demand was cancelled, but it was replaced by a new implied contract that did promise something of value to the holder of money.

Why must this be the case? Well, as we discussed at the beginning of this article, every asset is either a real asset or a financial instrument. Fiat money is, quite clearly, not a real asset. Therefore, fiat money is a financial instrument and must derive its value from its contractual properties, even if the contract is implied rather than explicit.

There is a popular and nonsensical view that fiat money has value because it is a convenient medium of exchange. The problem with this view is that represents a circular argument: fiat money has value because it is accepted as a medium of exchange; fiat money is accepted as a medium of exchange because it has value.

The view of The Money Enigma is that fiat money can only perform its functions because it has value: it does not derive its value from its functions. Rather, the value of fiat money is derived from an implied contract that exists between the issuer of money and the holders of money.

So, when the explicit contract was rendered null and void, what was the new implied contract that replaced it?

While it is difficult to speculate on the exact nature of the implied contract that governs fiat money, there are a few things that we should be able to deduce with reasonable certainty.

First, the ultimate issuer of fiat money is society itself. While government may be the legal issuer, the ultimate economic responsibility for fiat money lies with society. Society can’t be the legal issuer of money because society doesn’t exist as a legal entity. Therefore, society authorizes government on its behalf to issue fiat money. However, while money may not be the legal liability of society, it only has value because it is an economic liability of society.

Second, if fiat money is a liability of society, then what does society have to offer the holder of money? The answer is the future output of society.

Fiat money is a claim against the future output of society.

When the government prints fiat money, the only reason we accept it is because we recognize that there is an implicit agreement between our society and ourselves that we can use that money to purchase real output at some point in the future.

In essence, when society creates fiat money, it is creating a claim against its future output. This leads us to our next question. Is the claim that fiat money represents a fixed or variable entitlement against that future output?

For those of you who are not familiar with finance theory, one of the defining characteristics of a financial instrument is that it typically provides either a fixed or variable entitlement to some future stream of economic benefits.

The view of The Money Enigma is that fiat money represents a variable entitlement to the future economic output of society. The entitlement to future output varies according to the amount of money on issue at that future point in time (the expected size of the monetary base).

In this sense, we can say that fiat money is a proportional claim on the future output of society. Therefore, the value of fiat money primarily depends upon (a) the expected path of real output growth, and (b) the expected path of the monetary base.

This isn’t easy stuff to understand, so let’s use a simple analogy.

Imagine that we are hoping to eat a big cake that is the future output of society.

Every dollar that is issued by the time the cake is served represents a claim to a slice of that cake.

Proportional Claim Theory implies that the value of the dollar we have in our pocket today depends upon the size of the slice of the future output cake that we expect to receive in the future.

Clearly, there are two reasons for why the slice of cake that we expect to receive could shrink.

First, the cake itself could shrink. For example, the market might suddenly decide that future output growth will not be as strong as previously expected. If this happens, then the value of a proportional claim on future output will be worth less and the value of fiat money falls.

Second, the cake may be cut up into more slices. For example, people might suddenly decide that the monetary base will be a lot higher in the future. If this happens, then there are more claims against future output, hence every claim is worth less and the value of fiat money falls.

In either case, the value of fiat money would fall.

The important point to emphasize here is that the value of fiat money depends on long-term expectations. This isn’t a cake that we expect to eat tomorrow or next year, but a cake that we expect to eat in twenty years from now. I won’t bore you with why this is the case, suffice to say that fiat money is a long-duration asset and in a state of intertemporal equilibrium the current value of fiat money is determined by a long chain of expected future values.

In summary, this theory provides us with a basis for understanding why the value of fiat money might fall. But why does the value of fiat money collapse? What could cause such a sudden and violent loss of value in something that we use so frequently in our everyday life?

Why Does the Value of a Fiat Currency Collapse?

The collapse of a fiat currency normally requires an event to occur that results in the sudden realization that the future economic prospects of a society are greatly diminished.

The most obvious negative event that can cause a fiat currency to collapse is the outbreak of war.

Why might the outbreak of war cause a currency to collapse? Well, let’s think about it using our slice of cake analogy.

First, how might war impact the expected size of our future output cake? While there might be some near-term boost in war-related production, there would be a clear negative impact on long-term output if it became an extended war with high casualties.

Second, how might war impact the expected number of slices of that cake? In this case, the impact is clearly negative. A war is expensive and almost inevitably requires the government to print money in order to finance it.

If we take these two factors together, then clearly the expected size of our slice of cake will be a lot smaller: future output will be diminished and there will be a lot more claims against that output. In this scenario, it is likely that the value of our fiat currency would fall immediately. If a few key battles were lost and the outlook for the very survival of our society was in doubt, then clearly you would expect the value of our fiat currency to collapse.

This much should be obvious. But why, if there are no immediate wars on the horizon, are some market commentators calling for the collapse of the Yen, the Euro and/or the US Dollar? Why might a fiat currency collapse in peacetime?

In many respects, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.

If the underlying economic strength of a society is strong, then it is reasonable for people to believe that long-term output growth will be solid and that the central bank will be able to limit the long-term growth of the monetary base to a modest level. In this scenario, the value of the fiat currency issued by that society should be well supported: people expect that the cake will be large and that they won’t have to divide the cake into too many slices.

However, if people suddenly discover that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. For example, imagine that the US economy suddenly started to deteriorate and nothing that policy makers did seemed to help. What might people start to think about the long-term economic prospects for the US?

If it became apparent that the US economy was structurally weak, then people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected.

How would this shift in expectations impact the value of the US Dollar? Clearly, this shift in expectations would have a very negative impact on the value of the US Dollar. Using our analogy, the cake would be smaller and it would have to be cut up into many more slices. The value of the dollar in your pocket would decline precipitously and prices, as expressed in dollar terms, would rise sharply.

The perfect storm for a currency collapse involves a violent shift in expectations regarding both long-term output growth and long-term money supply growth. Such a violent shift in expectations does not happen easily, but it can happen, even in peacetime.

My personal perspective is that the developed country at greatest risk of such a violent shift in expectations is Japan. Japan has accumulated staggering levels of government debt. The demographics of Japan are terrible: over the next couple of decades, there will be fewer workers to support more retirees. Moreover, Japan has expanded its monetary base at an unprecedented pace.

Frankly, it seems as though the market is in a state of denial regarding the outlook for Japan. For some reason, people seem to believe that Japan can grow its economy over the next twenty years while reducing the monetary base from its current extended level. This scenario seems very unlikely. But let’s hope that Japan can find a new way to reinvigorate its economy, a path that doesn’t involve printing money.

On a final note, if you are interested in the determination of foreign exchange rates then I would recommend “A Model for Foreign Exchange Rate Determination”. If you are interested in learning more about Proportional Claim Theory and why fiat money has value, then I would recommend the following posts: “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

Saving Monetarism from Friedman and the Keynesians

Monetarism is a good idea that has been poorly executed. At its heart, the core principle of monetarism is that “money matters” to economic outcomes. More specifically, money creation, in excess of growth in real output, is the leading cause of inflation over long periods of time.

This is a “good idea”, an idea that has been shown to be true in hundreds of empirical studies. Unfortunately, monetarism has largely faded from view due to its one key underlying weakness: its inability to correctly articulate the transmission mechanism from money creation to inflation.

Monetarism’s failure in this regard stems from the fact that most advocates of monetarism were (and still are) in-the-closet Keynesians.

Monetarism, as it is presented in the textbooks today, is built on a foundation of Keynesian theory. More specifically, monetarism accepts wholeheartedly the inherently Keynesian notion that supply and demand for money determines the interest rate.

For all the great work done by Milton Friedman, Friedman never challenged this core principle of Keynesianism. And yet, it is this one flawed Keynesian principle that undermines the true potential of monetarism.

The view of The Money Enigma is that monetarism needs to be reinvented. This reinvention needs to start at the most fundamental level by recognizing that (a) the price level is a function of both the market value of goods and the market value of money, and (b) supply and demand for money (or more specifically, supply and demand for the monetary base) determines the market value of money, not the interest rate.

The market value of money is the denominator of the price level. Creating too much money, relative to output growth, over long periods of time reduces the market value of money, thereby raising prices as expressed in money terms. This is the primary transmission mechanism from too much money to inflation. The Keynesian view of the transmission mechanism, namely that too much money lowers interest rates and creates “too much demand”, is at best a secondary transmission mechanism.

A Quick Overview

The view of The Money Enigma is that the price level is a ratio of two market values: the market value of the basket of goods (“V_G”) and the market value of money (“V_M”). The market value of goods is the numerator of the price level: as the market value of goods falls, the price level falls. The market value of money is the denominator of the price level: as the market value of money falls, the price level rises. This theory is called “Ratio Theory of the Price Level” and was discussed in last week’s post.

At the most basic level, Ratio Theory implies that the inflationary outcome of any policy action needs to consider the impact of that policy on both (a) the market value of goods, and (b) the market value of money.

Historically, most monetarists have focused only on the impact of money creation on the numerator in our equation: the market value of goods. In essence, the traditional monetarist view is that base money creation leads to lower interest rates and, in turn, lower interest rates lead to an increase in aggregate demand. This lift in economic activity leads to “tightness” in the system as demand outpaces supply, the market value of goods rises and, therefore, prices rise.

This “monetarist” view is, in fact, an inherently Keynesian view of the world. In essence, it is a modified version of the view that inflation is created by “too much demand”.

The only real adaption by the monetarists is that it is too much money that creates too much demand which, in turn, leads to higher prices as the economy pushes up against its capacity limits. Moreover, this view implicitly assumes that money creation can not create inflation if the economy does not “overheat”.

The problem with this view of the monetary transmission mechanism is that it denies any role for the impact of money creation on the market value of money, the denominator in our equation.

Traditionally, monetarists have left themselves no other choice but to ignore the role of the “value of money”. The reason for this extraordinary oversight is that most monetarists, including Milton Friedman, ascribe to the view that supply and demand for money determines the interest rate. There is no role for the “market value of money” in current monetarist thinking because monetarists don’t recognize the market value of money as a variable in their equations nor do they recognize that supply and demand for money determines the market value of money. Therefore, monetarists are left with only one avenue to explain the impact of money on the price level: more money equals lower interest rates equals too much demand equals higher prices.

The view of The Money Enigma is that this (Keynesian) transmission mechanism is, at best, only a secondary transmission mechanism. This sequence of events can lead to higher prices, but it is of secondary importance.

The primary transmission mechanism from money creation to inflation is far more direct. Supply and demand for money determines the market value of money (see recent post “Supply and Demand for Money: Where Keynes Went Wrong”). Creating “too much money” leads to a fall in the market value of money and a rise in the price level.

Over long periods of time, creating too much money, relative to output growth, leads to a direct reduction in the market value of money. The market value of money is denominator of every money price in the economy. Therefore, as the market value of money falls, the price level rises. This is the primary transmission mechanism and is the primary reason for why base money growth in excess of real output growth leads to a rise in the price level over time.

Monetarism needs to throw out Keynes’ liquidity preference theory playbook and focus on what really matters: the impact of money creation on the market value of money. Once monetarists begin to do this, we can have a much more sensible debate about the role of monetary policy and the risks of aggressive monetary policies such as quantitative easing. Moreover, monetarists may be able to construct a better model to explain why significant levels of monetary creation lead to high inflation on some occasions but not on others, an issue we will discuss briefly at the end of this article.

But before we continue with this debate, let’s step back and see put these ideas in context.

Why Do Prices Rise?

Before we can begin a discussion about the role of money in price level determination, we need to be able to answer a simple microeconomic question: “why do prices rise?”

Let’s ignore complicated macroeconomic theory for a moment and think about the price of apples in money terms. What could explain a rise in the dollar price of apples?

In order to answer this question, we need to ask a more fundamental question: “what is a price?”

A price is a ratio of two quantities exchanged.

The price of apples, in dollar terms, is the ratio of two quantities exchanged: a quantity of dollars for a given quantity of apples. For example, the price of an apple might be two dollars for one apple.

At the most basic level, this ratio of quantities exchanged is determined by the relative market value of the two items that are being exchanged. More specifically, the ratio of the two quantities exchanged is the reciprocal of the ratio of the market value of the two goods. This relationship is illustrated in the slide below.

What does this means in non-technical language? Well, all the formula above is really saying is that if one apple is twice as valuable as one dollar, then the price of one apple, in dollar terms, is two dollars.

That’s not rocket science. If one thing is worth twice as much as another, then you will have to offer two of the second thing to purchase one of the first thing.

What makes the slide above slightly more technical is the way in which the property of “market value” is being measured.

Price is a relative measurement of market value: a price measures the market value of one good in terms of another. However, it is also possible to measure the market value of a good independently of the market value of another good by adopting a “standard unit” for the measurement of market value.

In the slide above, V(A) and V(B) represent the market value of goods A and B respectively as measured in terms of a “standard unit” for the measurement of market value. In this sense, both measurements can be considered to be absolute measurements of the market value of A & B.

The measurement of market value is an important and somewhat complex subject. I highly recommend that you read the following post “The Measurement of Market Value: Absolute, Relative and Real” when you have some time.

So, let’s return to the original question: “Why do prices rise?”

If price is a relative expression of the market value of two goods, then there are two primary reasons for why the price of a good may rise. The price of one good (the “primary good”), in terms of a second good (the “measurement good”), may rise for one of two basic reasons: either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

The first explanation for a rise in the price of the primary good should be obvious. If the primary good becomes more valuable, then it will require more units of the measurement good to purchase it.

The second explanation is less obvious and, for some reason, seems to evade professional economists. If there is no change in the value of the primary good, but the measurement good becomes less valuable, then it will require more units of the measurement good to purchase the same number of units of the primary good.

In our money-based economy, the good most often used as the “measurement good” is money. The market value of all things is measured in money terms. Therefore, if the market value of money (the measurement good) falls, all else remaining equal, it will require more units of money to purchase the same basket of goods and services.

In the slide above, we have isolated the market value of the basket of goods and the market value of money by measuring each in terms of a “standard unit” of market value (a theoretical and invariable unit). By doing this, we can clearly see that the price level is a function of two variables: (a) the market value of the basket of goods, and (b) the market value of money.

How Does Creating Money Impact the Price Level?

Let’s think about this question using the Ratio Theory framework presented above. How might creating money impact: (a) the market value of the basket of goods (the numerator of the price level); and (b) the market value of money (the denominator of the price level).

(a) Impact on The Market Value of Goods

Arguably, we might expect that an expansion in the monetary base leads to an increase in the market value of goods. I use the term “arguably” because it is not clear, nor certain, that an expansion in the monetary base leads to an increase in the market value of goods.

When money is created, that money is used. In the current system, the central bank uses that money to buy government fixed-income securities, thereby raising the price of those securities and lowering the interest rate on those securities.

The Keynesian view is that this process of creating money and using it to suppress interest rates leads to higher aggregate demand (more consumption, more investment). This increase in demand leads to tightness in the economic system that, in turn, leads to higher prices and wages.

As is common with Keynesian theory, this analysis seems quite plausible. Unfortunately, it also misses half of the picture.

The view of The Money Enigma is that lowering interest rates increases both aggregate demand and aggregate supply.

When the central bank lowers “the interest rate”, the central bank effectively lower the required return on capital across the entire risk spectrum. This is a subject that was discussed in a recent post titled “Interest Rate Manipulation and the Illusion of Prosperity”, so I won’t discuss it in too much detail here. But the bottom line is that when the Fed buys government bonds, it creates a domino effect across all risk assets, raising the price of those assets and lowering the expected/required return on those assets.

Lowering the required return on capital leads to an increase in aggregate supply. At the margin, a lower required return on capital allows more new businesses to be formed and allows more existing business to expand capacity.

If both aggregate demand and aggregate supply curves shift to the right, then the impact on the market value of goods is likely to be negligible. While there may be an increase in economic activity, that increase in economic activity is met with an increase in capacity. Therefore, the net effect on the market value of goods is likely to be small.

In summary, contrary to Keynesian wisdom, expanding the monetary base and using this money to buy government securities may have little to no impact on the market value of the basket of goods, the numerator in our price level equation. Moreover, while there may be some short-term positive impact on the market value of goods, that impact is unlikely to be sustained on a longer term basis: ultimately, aggregate supply will react to the increase in demand.

(b) Impact on the Market Value of Money

If an increase in the monetary base is unlikely to have any significant impact on the market value of goods, then how does an expansion in the monetary base lead to inflation? The view of The Money Enigma is that the answer to this question involves an analysis of the impact of money creation on the market value of money, the denominator of every money price in the economy.

The view of The Money Enigma is that, over long periods of time, growth in the monetary base that is in excess of growth in real output will lead to a decline in the market value of money and that it is this decline in the value of money that is primarily responsible for the rise in money prices over long periods of time.

This notion represents what one might consider to be a “pure” or “true” monetarist perspective on the world: a version of monetarism that is unadulterated by the Keynesian worldview.

The challenge for this pure version of monetarism is explaining why the market value of money depends on the level of the monetary base relative to real output. After all, why should it matter to the value of money if money growth dramatically exceeds real output growth?

The answer to this question involves a reexamination of economic theories regarding the nature of money.

The view of The Money Enigma is that fiat money is a financial instrument: fiat money derives its value from it contractual properties. More specifically, fiat money represents a proportional claim on the future output of society. In more slightly technical terms, the fiat monetary base is a special-form, long-duration equity instrument issued by society under an implied-in-fact contract.

The key phrase in that last paragraph is “proportional claim on the future output of society”. To its holder, fiat money represents a variable entitlement to the future economic output of society.

One way to think about this is to imagine that future economic output is “the pie” and each unit of the monetary base represents “a share of the pie”. Clearly, each unit of money is more valuable if either (a) there is a bigger pie, or (b) there are fewer shares to that pie.

In slightly more formal terms we can say that the market value of fiat money depends upon long-term (20-30 year) expectations of the path of real output relative to the monetary base. The market value of one unit of fiat money will become more valuable if either (a) people decide that future real economic growth will be stronger than previously expected (“there will be more pie”), or (b) people decide that the growth of the monetary base will be lower than previously expected (“there will be fewer shares of the pie”).

This is a complicated subject which is addressed in several recent posts including “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

In the short term, the market value of money is highly sensitive to changes in these long-term expectations. This shouldn’t be surprising: the value of any long-duration asset (equities, property, 30-year bonds) is highly sensitive to small changes in long-term expectations.

Similarly, one of the unexpected but important implications of this theory is that in the short term, the market value of money can be highly insensitive to the current level of the monetary base. A massive increase in the monetary base can have little or no impact on the market value of money, particularly if that increase in the monetary base is perceived to be “temporary” in nature.

However, the other implication of this theory is that over very long periods of time, the market value of money will fall if the growth in the monetary base far exceeds the growth in real output.

These observations can explain why quantity theory of money works in the long term but not in the short term. “Too much money” (relative to real output) will reduce the market value of money over long periods of time, but not necessarily over short periods of time. It is this decline in the market value of money that is the key driver of higher prices and inflation.

In summary, the challenge for monetarism is to retake the high ground in the economic debate. There is a clear path to do this, but it involves the recognition that the price level is a relative measurement of market value: the market value of the basket of goods in terms of the market value of money. Once the “value of money” is isolated as an independent variable, the challenge for monetarists is to provide a credible theoretical framework for the determination of the market value of fiat money.

Ratio Theory of the Price Level

Ratio Theory of the Price Level states that the price level is a relative measure of market value. More specifically, the price level measures the market value of the basket of goods in terms of the market value of money.

Mathematically, the price level is a ratio of two variables: the market value of the basket of goods divided by the market value of money.

The numerator is the market value of the basket of goods: all else remaining equal, as the market value of goods rises, the price level rises. The market value of the basket of goods can rise for all manner of reasons, but a couple of reasons might include a sudden increase in aggregate demand (“too much demand”) or a sudden decrease in aggregate supply (“supply shock”).

The denominator is the market value of money: all else remaining equal as the market value of money falls, the price level rises. The market value of money is poorly understood by modern economics because most economists don’t explicitly focus on the “value of money” as a factor in their equations. Indeed, the “market value of money” can only be isolated as a variable if market value is measured in terms of a “standard unit”, i.e. in absolute terms.

The key to appreciating Ratio Theory is understanding two microeconomic concepts: (a) the property of “market value” can be measured in both the relative and the absolute, and (b) every price is nothing more than a relative measurement of two market values, both of which can be measured in absolute terms. In this week’s post we will explore both of these microeconomic concepts and then extend them to develop a macroeconomic theory of price level determination, namely “Ratio Theory of the Price Level”.

Ratio Theory of the Price Level: A Useful Concept for Analysis

There are many competing theories regarding price level determination. Economists trained in the Keynesian school tend to believe that inflation is caused by “too much demand” and that one of the primary roles of the central bank is to manage the economy to ensure that it doesn’t “overheat”.

Monetarists tend to believe that “too much money” is the primary cause of inflation, although many monetarists seem to ascribe to a Keynesian transmission mechanism: “too much money” creates “too much demand” which leads to rising prices. Other economists believe that “too much government debt” is the primary cause of inflation, particularly severe inflation (Fiscal Theory of the Price Level).

Each of these schools of thought suffers from a rather narrow perspective regarding the way the economic world works. Economists have made countless efforts to improve these one-sided models by the inclusion of various “expectation terms”, but this has only led to more vague notions such as the idea that inflation is determined by “inflation expectations” (even if this is the case, what then determines “inflation expectations”?).

The view of The Money Enigma is that all of these schools of thought could improve their models by acknowledging what should be a simple notion: the price level is a ratio of two market values.

The price of a good, in terms of another good, is a relative expression of the market value of both goods. The price of a good, in money terms, is a relative expression of the market value of the good itself and the market value of money. Therefore, the price of the basket of goods, in money terms, (also known as “the price level”) is a relative expression of the market value of the basket of goods in terms of the market value of money.

In mathematical terms, the price level is a ratio: the price level is equal to the market value of the basket of goods (the numerator) divided by the market value of money (the denominator).

We can use this simple model of the price level to ask more probing questions about traditional theories of inflation. For example, does “too much money” create inflation because (a) it increases the level of economic activity and raises the market value of goods (V_G rises), or (b) increases the monetary base relative to economic output thereby reducing the market value of money (V_M falls)?

Similarly, does “too much government debt” lead to rising prices because the fiscal spending increases economic activity (V_G rises as there is “too much demand”) or because markets become fearful about the economic viability of society and the value of the fiat currency issued by that society falls (V_M falls)?

Ratio Theory also provides a good starting point for any “inflation versus deflation” debate. For example, does economic weakness lead to deflation? While economic weakness should put downward pressure on the market value of goods, the other side of the equation (which is often ignored by Keynesians) is what will happen to the market value of money if confidence in the long-term economic prospects of society begins to falter?

While all these questions represent interesting topics for discussion, the primary goal for this week is to explain the concepts behind Ratio Theory. In particular, most economists will probably struggle with the terms V_G and V_M in the equation above.

Both of these terms represent market value as measured in the “absolute”: V_G is the market value of the basket of goods as measured in absolute terms, and V_M is the market value of money as measured in absolute terms.

In order to understand what it means to measure the market value of a good in the absolute, we need to go back to basics and think about the different ways in which scientists can measure physical properties.

The Measurement of Market Value: Absolute versus Relative

The view of The Money Enigma is that “price” and “market value” are not the same thing. While some may believe that these terms are synonymous, there is a subtle but important distinction between the two.

“Market value” is a property possessed by an economic good. For any good to be exchanged in trade that good must be “valuable”, i.e. it must possess the property of “market value”.

The “price” of a good is not a property of that good. Rather, the price of the good is a way of measuring the property of “market value”. More specifically, price is a relative measure of the market value of a good: a price measures the market value of one good (the primary good) in terms of the market value of another good (the measurement good).

If price is a relative measure of market value, then this raises an interesting question: “Is it possible to measure market value in the absolute?”

In order to answer this question, we need to go back one more step and answer a more general question: “What does it mean to measure any property in the absolute?”

Fortunately, science has a well-established paradigm that distinguishes between the absolute measurement of a property and the relative measurement of a property.

The act of measurement is, by definition, an act of comparison. In this sense, all measurements could be considered to be “relative”. However, even though all measurements involve an act of comparison, scientists designated some measurements as being absolute while others are relative.

So, what does it mean to say that a measurement is “absolute”?

A measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement.

What makes something a “standard unit” of measurement?

In order for something to perform as a standard unit for the measurement for a certain property, there are two key characteristics that thing must possess. First, it must possess that property. Second, it must be invariable in that property.

These are the two key characteristics of a standard unit of measurement, but there is a third characteristic that most standard units possess: most “standard units” of measurement are theoretical.

Let’s think about this in the context of a simple example: the measurement of height.

We can measure the height of a building in absolute or relative terms. For example, we can say that one building is twice as tall as another building. This is a relative measurement of height.

In contrast, we can measure the height of the building in absolute terms. In order to do this, we need a standard unit for the measurement of height, such as “feet and inches”. Feet and inches are standard units of height: they posses the property of height and they are invariable in that property. Therefore, if we measure the height of the building in feet and say it is 250 feet tall, then that is an absolute measurement of the height of the building.

What we should also note about this example is that feet and inches are theoretical units of measure. The length of one “inch” is not something that exists in nature. We made it up. We decided, on a fairly arbitrary basis, that the length of one inch is “about that much”.

This is true of most standard units of measure: one hour, one mile, one kilogram – they are all theoretical measures of a particular property that we made up to help us measure various physical properties.

Why are most standard units of measurement theoretical? The reason we use theoretical entities as standard units of measure is because nearly everything in nature is variable. By definition, we can’t use objects that are variable in a property as “standard units” of measurement for that property.

In summary, the key difference between an “absolute” and a “relative” measurement is the unit of measure being used. In the case of an absolute measurement, we use a “standard unit” of measure. Most standard units are theoretical units of measure and, importantly, they must be invariable in the property that they are measuring.

In contrast, a relative measurement is merely a comparison of one object (the primary object) with another (the measurement object): it does not require that the second object (the measurement object) is invariable in the property being measured.

Now, let’s return to the main topic at hand: the measurement of market value.

Can we measure the property of “market value” in the absolute? The answer is yes, at least theoretically. But in order to measure market value in the absolute, we need to create a standard unit for the measurement of market value.

Unfortunately, a standard unit for the measurement of market value must be theoretical in nature. Why? It must be theoretical because there is no real-life good that is invariable in the property of market value.

So, what is the key advantage of measuring market value in the absolute? By adopting a standard unit for the measurement of market value, we can now measure the market value of each good independently of the market value of other goods.

Let’s use a simple example: the price of apples in money terms. Let’s assume that the current price of apples is two dollars per apple. This ratio exchange implies that one apple is worth twice as much as one dollar.

Now, let’s assume that next year the price of apples rises to three dollars per apple. What can we say about the market value of apples and the market value of dollars?

What we can say for certain is that the value of one apple has risen relative to the value of one dollar. One apple is now worth three times as much as one dollar.

But what can we say about the value of apples? Has the value of apples risen or fallen? From the facts provided, we can’t answer this question. We know that the relative value of apples has risen, but we can’t say whether the absolute value of apples has risen or fallen.

The price of apples could have risen either because (a) the market value of apples rose, or (b) because the market value of money fell.

In order to know whether the price of apples rose because of (a) or (b) above, we need some way to measure the market value of each good independently from other goods. Our standard unit for the measurement of market value gives us a means to make this type of absolute measurement.

Price as a Ratio of Two Market Values

Introducing a standard unit for market value for the property of market value allows us to measure the market value of goods independently of each other. The key advantage of this approach is that it allows us to express price as a ratio of two market values.

The view of The Money Enigma is that price is a relative measurement of market value. This is hardly a new concept. Adam Smith in “The Wealth of Nations” (1776) seeks to explore the rules that “determine what may be called the relative or exchangeable value of goods”. While Smith may not have explicitly stated that “price is a relative expression of market value”, it was clear that Smith considered price to be “relative” in nature.

Nevertheless, what does it mean to say, “Price is a relative measure”?

In simple terms, if the price of an apple is two dollars, then this implies that the market value of one apple is twice that of one dollar. The money price of an apple is merely a measure of the market value of an apple relative to the market value of a dollar.

This is simple concept, but how do we express this in mathematical terms? The key is measuring the market value of apples and money independently using the standard unit of market value that we discussed earlier.

Let’s think about this in general terms.

If the market value of good A as measured in terms of our standard unit is denoted as V(A) and the market value of good B as measured in terms of the standard unit is denoted as V(B), then the price of good A, in good B terms, is merely the ratio of V(A) divided by V(B). The price of A, in B terms, can rise either because (1) the market value of A rises, or (2) the market value of B falls.

If “good A = apples” and “good B = money”, then we can say that the price of apples, in terms of money, depends on both the market value of apples and the market value of money.

Importantly, the market value of money is the denominator of the price of apples. All else remaining equal, if the market value of money falls, the price of apples, as measured in money terms, will rise.

Moreover, this is observation is true for every “money price” in the economy: the market value of money is the denominator of every money price in the economy.

The price of apples, the price of bananas, the price of milk… all of these prices, as expressed in money terms, are determined by both the market value of the good itself (apples/bananas/milk) and the market value of money. All else remaining equal, if the market value of money falls, then the price of all these goods, as measured in money terms, will rise.

We can take this one step further.

The price level is a hypothetical measure of the price of the “basket of goods”. In a simplified sense, the price level is an index of prices. If every price in that index is a function of a numerator (the market value of the good) and a denominator (the market value of money), then it follows that the price level itself is a function of a numerator (the market value of the basket of goods, denoted V_G) and a common denominator (the market value of money, denoted V_M). [The market value of the basket of goods V_G can be thought of as an output-weighted index of market values for the goods contained in the basket of goods, where market value is measured in terms of the standard unit.]

The Market Value of Money

Ratio Theory raises an interesting question. Namely, what determines the market value of money, the denominator of the price level?

Economics has largely failed to answer this question because most economists have failed to ask it. Mainstream economics does not have any variable called the “value of money” or the “market value of money” in its equations.

The reason for may not be obvious, but in essence, if you don’t recognize that market value can be measured in the absolute using a standard unit for the measurement of market value, then you can’t isolate the “value of money” as a variable.

Economists will talk about the “purchasing power of money”, but the purchasing power of money is a relative expression of the market value of money. The purchasing power of money is merely the inverse of the price level, itself a relative measure of market value.

The Enigma Series develops a theory of money that might be used to help think about the determination of the market value of money called “Proportional Claim Theory”. In essence, the view of The Enigma Series is that money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.

Moreover, The Enigma Series uses this theory to develop a “valuation model” for money. Importantly, this valuation model is expressed in “standard unit” terms and is the first model to solve for the value of money as measured in the absolute. This valuation model for money can also be used to create expectations-based solutions for the price level, the velocity of money and foreign exchange rates.

Readers who are interested in exploring these concepts further should read “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

If you would like to learn more about Ratio Theory, then please visit the Price Determination section of The Money Enigma or read The Inflation Enigma, the second paper in The Enigma Series.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Supply and Demand for Money: Where Keynes Went Wrong

The notion that “supply and demand for money determines the interest rate” is an idea that seems innocuous and entirely plausible. In fact, it is a very dangerous and misleading idea: an idea that has sent the science of economics on an 80-year journey down the wrong path.

The fundamental problem with this Keynesian theory is that it implicitly denies a role for the market value of money in the determination of “money prices”. The view of The Money Enigma is that supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy. (As the market value of money falls, prices rise).

Let’s start with what should be a simple concept: “every price is a relative expression of the market value of the two items being exchanged”. Think about a simple trade in which two items are exchanged, for example, a certain amount of money for a certain number of apples. Both items being exchanged (apples and money) must possess the property of market value in order for a trade to occur (no is going to part with something of value for something that has no value).

The ratio of exchange of one item for another (also known as the “price” of the trade) depends upon the market value of the first good (apples) relative to the market value of the second good (money). For example, if an apple is three times as valuable as one dollar, then the price of an apple is three dollars.

If this theory of price determination is correct, then something must determine the market value of money. By far the best candidate for this role is supply and demand for money (or, more specifically, supply and demand for the monetary base).

Where Keynes went wrong is that he assumed that every price is determined by only one set of supply and demand. For example, he assumed that the price of apples is determined solely by supply and demand for apples. Therefore, supply and demand for money, to Keynes’ mind, doesn’t have a direct role to play in the determination of the price of apples.

The view of The Money Enigma is that this traditional model is wrong: every price is a function of not one, but two sets of supply and demand. In terms of our example, this means that the price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.

In summary, supply and demand for money can determine only one of two things: either it can determine the interest rate (Keynesian view), or it can determine the market value of money (Money Enigma view). It can’t determine both. If you choose “the interest rate”, then implicitly you are denying any role for the value of money in the determination of money prices.

Liquidity Preference Theory: a Naïve and Dangerous Idea

Keynes’s liquidity preference theory states that supply and demand for money determines the interest rate. It is one of the core theories of modern economics and stands largely unchallenged in orthodox economics circles to this day.

The view of The Money Enigma is that liquidity preference theory represents a naïve and dangerous view about the nature of money and the role of money in the price determination process. Moreover, liquidity preference theory has only survived because microeconomics has failed to develop a sensible theory of universal price determination (a theory of price determination that can be applied to the determination of all prices, not just money prices).

We will explore these assertions in more detail in a moment. But first, let’s step back to the year 1935, the year John Maynard Keynes wrote “The General Theory of Employment, Interest, and Money” and think about why Keynes might have come up with the notion that supply and demand for money determines the interest rate.

Keynes was a student of the great economist Alfred Marshall. Although Keynes never officially graduated with an economics degree, he did do one term of postgraduate work with Marshall and it was Marshall that gave Keynes the job lecturing in monetary economics at Cambridge when Keynes finished his short 18-month stint as a clerk at the India Office. (See Robert Skidelsky’s fawning biography of Keynes titled “John Maynard Keynes: Economist, Philosopher, Statesmen”, page 125).

You might think that someone with such limited qualifications shouldn’t be teaching economics at Cambridge. But, as fairly noted by Skidelsky, there really wasn’t much economics to teach at that point in time. [Or at least there wasn’t much “English” economics: there was quite a bit of “German/Austrian” economics that had been written but most respectable English gentlemen in the 1930s weren’t that interested in what the Germans had to say].

For those studying economics at Oxford or Cambridge in the 1930s, there were only a small number of books that would have been considered “required reading”. One of those books was Alfred Marshall’s “Principles of Economics”.

Marshall’s “Principles of Economics” is an important book in the history of economics because that book, more than any other, was instrumental in popularizing the supply and demand diagram that we use today. Marshall’s supply and demand diagram, with “price” on the y-axis, remains one of the most fundamental concepts in economics today and Keynes would have been well versed in this theory.

The problem is that the modern-day interpretation of Marshall’s work presents a very one-sided view of the price determination process. Marshall appreciated that his representation of price determination, the standard supply and demand diagram that we use today, implicitly assumes a constant or uniform value for money.

In Chapter III.IV.17-19, Marshall discusses the issues with his derivation of the standard demand curve: “So far we have taken no account of the difficulties in getting an exact list of demand prices… To begin with, the purchasing power of money is constantly changing, and rendering necessary a correction of the results obtained on our assumption that money retains a uniform value” (my emphasis added in italics).

At least superficially, Marshall seemed to appreciate that the standard supply and demand diagram that we use today assumes a constant market value for money. However, a naïve view of Marshall “scissors analysis” is that the price of a good is determined solely by supply and demand for that good.

The naïve view of Marshall’s work leaves open an obvious question: if supply and demand for a good determines the price of a good, then what does supply and demand for money determine?

For Keynes, the most obvious answer to this question was “supply and demand for money determines the interest rate”. It’s the obvious answer and it is wrong.

The problem is that Keynes has implicitly assumed that a price is determined by only one set of supply and demand. For instance, if supply and demand for apples determines the price of apples, then supply and demand for money must determine something else.

The problem with this theory is that it does not recognize the notion, as implicitly acknowledged by Marshall, that every price depends on not only the market value of the good in question, but also the market value of money.

Unfortunately, Marshall failed to take his work one step further. Namely, if price is a relative expression of the market value and market value is determined by supply and demand, then every price must be determined by two sets of supply and demand.

Keynes never entertained the notion that price is determined by not one, but two sets of supply and demand. Therefore, he never considered the idea that supply and demand for money determines the market value of money, which, in turn, is the denominator of every money price in the economy.

The view of The Money Enigma is that the “money price” of a good (the price of a good in money terms) is a function of both supply and demand for the good itself and supply and demand for the monetary base. This concept is illustrated in the slide opposite.

The key to this diagram, as we will discuss in a moment, is the y-axis unit of measurement. “Market value” on the y-axis is measured in absolute terms, using a “standard unit” for the measurement of market value.

Every Price is Determined by Two Sets of Supply and Demand

As young economists, we are all taught the price of a good is determined by supply and demand for that good. So, how is it possible for a price to be determined by two sets of supply and demand? This is a good question and one that we have discussed in several previous posts including “A New Economic Theory of Price Determination”, “Every Price is a Function of Two Sets of Supply and Demand” and “Is the Price of Apples Determined by Supply and Demand for Bananas?”

I find that the easiest way to explain this theory is to use a simple example.

Consider the following question: “In a barter economy, what determines the price of apples, where the price of apples is measured in terms of bananas?”

Is it (a) supply and demand for apples, or (b) supply and demand for bananas?

The answer is (c), “both”.

Clearly, the price of apples, in banana terms, depends upon supply and demand for apples: if there is a supply shortage of apples, then the market value of apples will rise and the price of apples, as measured in banana terms, will rise.

But what about supply and demand for bananas? Does supply and demand for bananas have any impact on the price of apples as measured in banana terms?

The short answer is “yes”. Imagine you live in that barter economy and then think about what happens if there is a supply shortage of bananas.

If there is a supply shortage of bananas, then bananas become “more valuable”. If you have bananas and bananas become more valuable, then you would expect more apples for every banana that you sell.

The ratio of exchange, apples for bananas, will shift such that there are more apples required for one banana. One way to say this is that the price of bananas, in apple terms, would rise. The other way to say this is that the price of apples, in banana terms, would fall. A decrease in banana supply will, all else remaining, lead to a fall in the price of apples, where that price is measured in banana terms.

The general principle is illustrated in the slide opposite. The market value of the “primary good”, denoted as “V(A)”, is determined by supply and demand for the primary good. The market value of the “measurement good”, denoted as “V(B)”, is determined by supply and demand for the measurement good. The price of the primary good, in terms of a measurement good, is determined by the market value of the primary good relative to the market value of the measurement good.

What Keynes missed is that this principle also applies to the determination of “money prices”. The price of a good, in money terms, depends upon both the market value of the good (as determined by supply and demand for that good) and the market value of money (as determined by supply and demand for money).

On the left hand side, supply and demand for the good determines the market value of the good. On the right hand side, supply and demand for the monetary base determines the market value of money. The price of the good, in money terms, depends upon the numerator (the market value of the good) and the denominator (the market value of money). If the market value of money falls, then, all else remaining equal, the price of a good, in money terms, will rise.

First time readers may have trouble interpreting some of these diagrams. The key to appreciating these diagrams is getting your head around the y-axis unit of measurement.

Traditional supply and demand diagrams use price on the y-axis: “price” is a relative measure of market value. The diagrams above use a “standard unit” for the measurement of market value: in this sense, supply and demand in the diagrams above are plotted in terms of “absolute market value”.

This is a complex subject that is addressed in detail in “The Measurement of Market Value: Absolute, Relative and Real”. Please read this post if you really care about this subject.

Conclusion

So, where did Keynes go wrong?

The short answer is that Keynes assumed that a price is determined by only one set of supply and demand.

By assuming that supply and demand for money can have no direct role in the determination of “money prices”, Keynes was forced to look for something that supply and demand for money could determine. The obvious candidate may seem to be “the interest rate”, but this doesn’t make it right.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The price of a good in money terms is a relative expression of both the market value of the good and the market value of money. Therefore, the price of a good in money terms is determined by two sets of supply and demand: supply and demand for the good and supply and demand for money.

Supply and demand for money determines the market value of money, the denominator of every money price in the economy.

Interest Rate Manipulation and the Illusion of Prosperity

It is nearly nine years since the Federal Reserve last increased interest rates. During that time, the Fed has embarked on an extraordinary program of interest rate manipulation, otherwise known as quantitative easing.

Partly as a result of these actions, the US economy has continued to grow, albeit at rates below the historical average, and today most commentators believe that the long-term economic prospects of the United States are strong.

But has the aggressive manipulation of interest rates over the past couple of decades masked a structural growth problem in the United States and other Western nations? Has the Fed created an illusion of prosperity, an illusion that in and of itself has been sufficient to maintain inflation at very low levels, or at least for the time being?

There is a popular view amongst economists that suppression of interest rates is fine as long as it doesn’t lead to the economy “overheating”. In their view, serious levels of high inflation can only return if the Fed let’s the economy grow too fast. But is this quintessentially Keynesian view accurate in theory and practice? Is the greatest risk to inflation an “overheating economy”?

The view of The Money Enigma is that this Keynesian view of inflation is flawed. Rather, the primary driver of inflation is a decline in the market value of money, the denominator of every money price in the economy. In turn, the market value of money depends upon confidence in the economic prospects of society: as long-term economic confidence declines, the value of money declines and prices rise.

Currently, confidence in the long-term economic future of the United States is strong. But is that a fair reflection of reality? Has that perception been skewed by the extraordinary actions of the monetary authorities?

The view of The Money Enigma is that the suppression of interest rates over the past twenty years has created an illusion of prosperity. Low interest rate policy has pushed out both aggregate demand and supply functions, driving real output growth and keeping the market value of goods in check.

Moreover, the illusion has propped up the market value of money. In effect, growth has been pulled forward and this perceived “economic success” has reinforced confidence in the value of money, thereby keeping a lid on prices as expressed in money terms.

But what happens when interest rates rise? What happens as economic growth continues to serially disappoint? What happens if our current economic prosperity turns out to be an illusion?

Overview

Why does the Federal Reserve bother to cut interest rates when it perceives the economy as being weak? And why does cutting interest rates seem to have such a powerful effect on economic activity, at least historically?

Lowering interest rates, particularly long-term interest rates through programs such as quantitative easing, impacts the economy in two basic ways:

Increases Aggregate Demand: Lowering interest rates reduces the cost of borrowing. A lower cost of borrowing allows more consumers to borrow money and “pull forward” consumption. A lower cost of borrowing also encourages firms to borrow and invest. In this way, lowering interest rates stimulates what economists call aggregate demand and this increase in aggregate demand works to increase output and raise prices.
Increases Aggregate Supply: Less well acknowledged is the impact of lower interest rates on aggregate supply. When interest rates are lowered, particularly long-term interest rates, this reduces the cost of capital for all businesses in the economy. A lower cost of capital encourages more business to invest and, at the margin, encourages new business creation. These actions lead to an increase in aggregate supply and this increase in supply works to increase output and reduce prices.

As you can see, both the increase in aggregate demand and the increase in aggregate supply have the same impact on output: they both lead to an increase in output as demand is pulled forward and as firms are encouraged to invest. In this sense, lowering interest rates has a “double whammy” effect on economic activity, stimulating both demand and supply.

However, these two phenomena have different effects on the price level. An increase in aggregate demand will tend to raise prices, while an increase in aggregate supply will tend to reduce prices. In this way, the inflationary impact of an increase in demand is largely or completely offset by the deflationary impact of an increase in supply.

Surely, this is a recipe for economic nirvana?

Here is a policy that seems to lead to faster growth and no inflation. Indeed, the experience of the last twenty years seems to confirm the benefits of interest rate suppression. Over this period, the United States has generally experienced modest-solid growth while inflation has remained contained.

So, what is the catch?

The problem exists behind the scenes. While there are a couple of different methods the Fed can use to suppress interest rates, the main method the Fed uses to suppress interest rates (particularly, long-term interest rates) is creating money and using this money to buy government debt (in Fed speak this is called “Open Market Operations”).

Over the past seven years, we have seen an extraordinary demonstration of this policy in action: the Fed has created roughly $4 trillion in new money and used this money to buy predominantly longer-term government debt securities. Not surprisingly, this flurry of buying has pushed up the price of government debt, thereby lowering the interest rate on government debt.

So, what is the problem with creating lots of money?

Ultimately, the problem with creating money at pace faster than the growth in economic output is that it leads to a fall in the value of money and a general rise in the money price of all goods.

In the short term, a significant increase in the monetary base may have little to no impact on the value of money and the general price level, particularly if that increase in the monetary base is regarded as “temporary”. However, in the long term, an increase in the monetary base that dramatically exceeds output growth will create inflation.

The view of The Money Enigma is that the market believes that the current expansion in the monetary base is “temporary”. A temporary expansion in the monetary base should have little impact on the value of money because money is a long-duration asset.

However, should the market start to suspect that the current high levels of base money are more “permanent” in nature, then this could easily induce a fall in the value of money and a sharp rise in prices.

In essence, the Fed has backed itself into a corner.

If the Fed begins to unwind the monetary base and raise long-term interest rates, then all of the positive impacts associated with lowering interest rates will be unwound: consumption will fall, investment will fall and economic growth will stall if not go into reverse.

However, if the Fed does not reduce the monetary base, then the value of money will fall and inflation will return.

A return to high-single digit levels of inflation would create a series of poor outcomes for markets and the economy more generally. Moreover, a return to this type of inflation would force the Fed’s hand, potentially leading to a significant fall in real GDP.

A Theoretical View: Ratio Theory and the Goods-Money Framework

So far we have touched on several important theoretical concepts that I would like to discuss in more detail.

Over the past few months, we have talked a lot about a new microeconomic theory of price determination “Every Price is a Function of Two Sets of Supply and Demand” and its application to certain markets “Is the Price of Apples Determined by Supply and Demand for Bananas?”

This week, I want to extend this microeconomic theory of price determination to a macroeconomic level. More specifically, we will introduce a macroeconomic model of price level determination called “The Goods-Money Framework”.

The Goods-Money Framework, illustrated in the slide immediately below, can be used to examine the impact of interest rate suppression on real output and the price level. Moreover, it can be used to demonstrate concepts that standard Keynesian or Monetarist models struggle to accommodate.

In simple terms, the Goods-Money Framework implies that the price level (“p“) depends upon both aggregate supply and demand for goods/services and supply and demand for money.

Aggregate supply and demand for goods determines, in the first instance, the market value of goods (“VG“), the numerator of the price level. Conversely, supply and demand for money determines the market value of money (“VM“), the denominator of the price level.

The price level, the price of a basket of goods in money terms, is a relative measure that measures the market value of goods in terms of the market value of money.

The key concept behind Ratio Theory is that every price is a relative expression of the market value of the two goods being exchanged. Therefore, the price level is a relative measurement of the market value of goods V_G in terms of the market value of money V_M.

At a microeconomic level, the price of a primary good, in terms of a measurement good, is merely an expression of the market value of the primary good relative to the market value of the measurement good.

For example, if one apple (the primary good) is three times more valuable than one dollar (the measurement good), then the price of an apple, in dollar terms, is three dollars.

In order to state this concept mathematically, we need to recognize that market value can be measured in both absolute and relative terms. This is an issue that was discussed at length in “The Measurement of Market Value: Absolute, Relative and Real” (published 04/21/15).

In simple terms, in order to measure something in absolute terms, all we require is a “standard unit” for the measurement of that property. If we adopt a standard unit for the measurement of market value, then we can measure the market value of two goods (A and B) in terms of this standard unit. If the market value of good A as measured in terms of the standard unit is denoted as V_A and the market value of good B as measured in terms of the standard unit is denoted as V_B , then the price of good A, in good B terms, is the ratio of V_A divided by V_B.

If we extend this microeconomic principle to a macroeconomic level, then we can say that the price of the basket of goods (the general price level) is a ratio of (a) the market value of the basket of goods, as measured in terms of the standard unit, divided by (b) the market value of money, as measured in terms of the standard unit.

This principle is reflected in the slide below and is called the “Ratio Theory of the Price Level”. In simple terms, if the market value of the basket of goods V_G falls, then the price level p will fall. Conversely, if the market value of money V_M falls, then the price level p will rise.

If the price level is determined by the ratio of (a) the market value of goods, and (b) then market value of money, then the next obvious question to ask is what determines each of these two factors.

The view of The Money Enigma is that the market value of goods is determined by the intersection of aggregate demand and aggregate supply, as demonstrated on the left hand side of the slide immediately below. Furthermore, the market value of money is determined by the intersection of supply and demand for the monetary base as illustrated on the right hand side of the slide below.

We can now use this framework to think about what might happen when the Federal Reserve suppresses interest rates by increasing the monetary base.

As discussed in the first section of this post, the view of The Money Enigma is that lowering interest rates pushes both the aggregate demand and aggregate supply functions to the right. The net effect is a dramatic increase in real output, but very little change in the market value of goods as measured in terms of the standard unit.

The more complicated issue is what impact does the increase in base money have the market value of money?

If we take the diagram above at face value, then an increase in the monetary base should lead to a fall in the market value of money and a commensurate rise in the price level (remember: the market value of money is the denominator of the price level).

But in the short term, this may not be the case.

The reason for this is that money is a long-duration claim on the future output of society. The value of money depends not just on the current levels of real output and the monetary base, but also on expectations regarding the long-term future path of both real output and the monetary base. An increase in money supply may be accompanied by an increase in money demand if the increase in money supply is viewed as being “temporary”.

This is a complicated issue that has been discussed in several recent posts including “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that the suppression of interest rates can create a growth illusion that bolsters confidence in the long-term economic prospects of society, thereby supporting the value of money, even in the face of a dramatic expansion in the monetary base.

However, if confidence in the long-term economic prospects of a society begins to falter, or if market participants start to believe that a temporary expansion in the monetary base is actually more permanent in nature, then the market value of money can quickly erode leading to a rapid rise in prices.

In summary, the manipulation of interest rates can create an illusion of prosperity. In the short term, there is no doubt that lower interest rates bolster growth. This higher level of growth fuels confidence in the long-term economic prospects of society that, in turn, supports the value of money and keeps a lid on prices. However, should this confidence begin to fade, then the market value of money can quickly erode, shattering the dream that we have created.

Is the Price of Apples Determined by Supply and Demand for Bananas?

Imagine that we live in a barter economy. What determines the price of apples in banana terms? Does the price of apples, in banana terms, depend upon (a) supply and demand for apples or (b) supply and demand for bananas?

The correct answer is (c), “both”. The price of apples, in banana terms, depends upon both supply and demand for apples and supply and demand for bananas. In this week’s post, we will explain why this is the case and we will outline a novel method for illustrating this phenomenon.

In last week’s post, “The Matrix of Prices in a Barter Economy”, we examined the theory that every price is a relative measurement of market value and explored the implications of this for price determination in a barter economy. In this week’s post, we will extend this concept and use a couple of simple examples to illustrate the principle that every price in a barter economy is a function of two sets of supply and demand.

Intuitively, the notion that the price of apples in banana terms depends upon supply and demand for both apples and bananas is not that difficult: the ratio of exchange “apples for bananas” must be determined by market forces for both of the goods being exchange. The real trick with this theory of price determination is illustrating the concept that every price is a function of two sets of supply and demand.

In order to illustrate the theory that every price is a function of two sets of supply and demand, we need to appreciate the difference between the relative measurement of a property and the absolute measurement of a property. More specifically, we need to introduce a “standard unit”, or “invariable” unit, of measurement for the property of market value. By adopting such a “standard unit” we can show, by example, how the price of one good, in terms of another, will react to changes in supply and/or demand for either of the goods.

Two Questions, One Answer

Let’s begin by contemplating two questions that relate to price determination in a barter economy.

Question One: What determines the price of apples, as measured in banana terms, in a barter economy?

At first glance, most students of economics will think that this is a very simple question. The vast majority of economics students would probably offer an answer along these lines: “The price of a good is determined by supply and demand for that good. Therefore, the price of apples is determined by supply and demand for apples.”

OK, let’s stick with that answer for a moment. Now, let’s ask our second question.

Question Two: What determines the price of bananas, as measured in apple terms, in a barter economy?

Once again, the most common answer to this question would be: “The price of a good is determined by supply and demand for that good. Therefore, the price of bananas is determined by supply and demand for bananas.”

At first sight, these might seem like reasonable answers to both of these questions. But if we dig a little deeper, we can see that a problem exists.

Let’s step back and think about the concept of “price”.

What exactly is the “price of apples in banana terms”? The price of apples in banana terms is merely a way of expressing the ratio of two quantities exchanged: a quantity of bananas for a quantity of apples. In essence, it is the number of bananas that must be exchanged for one apple in order for an exchange to occur in the current market environment. For example, the price of apples might be two bananas (if I want to buy an apple from you, I need to give you two bananas).

Now, let’s look at the other side of the picture. What is the “price of bananas in apple terms”? Once again, it is a ratio of exchange, “apples for bananas”. Indeed, it is exactly the same ratio of exchange but simply stated in different terms.

For example, if the price of apples is two bananas, then the price of bananas, in apple terms, is half an apple. Both described the same ratio of exchange: “two bananas for one apple” is exactly the same as saying “half an apple for one banana”.

In more technical terms, the price of apples in banana terms is simply the reciprocal of the price of bananas in apple terms. Both are merely different ways of stating the same “ratio of exchange” between apples and bananas.

Let’s return to the first question: “what determines the price of apples in banana terms?”

Is it correct to say that the price of apples, in banana terms, is determined solely by supply and demand for apples?

No. The market forces that determine the price of apples in banana terms must be the same as the set of market forces that determine the price of bananas in apple terms. Why? These two “different” prices are merely different ways of describing the same ratio of exchange.

So, how do we reconcile the notion that the price of apples, in banana terms, has something to with supply and demand for apples, while the price of bananas, in apple terms, has something to do with supply and demand for bananas?

There is a simple solution.

The price of apples in banana terms depends upon both supply and demand for apples and supply and demand for bananas. Similarly, the price of bananas in apple terms depends upon both supply and demand for bananas and supply and demand for apples.

In this way, the one ratio of exchange (apples for bananas) is determined by the same set of market forces (supply and demand for both goods). It doesn’t matter whether we state the ratio of exchange in apple terms or banana terms. The fact is that the ratio of exchange is determined by two sets of supply and demand: supply and demand for apples, and supply and demand for bananas.

Illustrating Supply and Demand in a Barter Economy

It is easier to understand the notion that price is determined by two sets of supply and demand if we illustrate the general concept and then perform a couple of simple examples. The general principle is illustrated in the slide below.

In simple terms, we can say:

Supply and demand for apples determines the market value of apples;
Supply and demand for bananas determines the market value of bananas;
The price of apples, in banana terms, is the determined by the ratio of the two market values (the market value of apples divided by the market value of bananas);
Therefore, the price of apples, in banana terms, is determined by both supply and demand for apples and supply and demand for bananas;
[While it is not explicitly illustrated above, we can also say that the price of bananas, in apple terms, is determined by the ratio of the two market values (the market value of bananas divided by the market value of apples) and consequently by both supply and demand for apples and supply and demand for bananas.]

All else remaining equal, if the market value of apples V(A) rises, then the price of apples, in banana terms, will rise. Conversely, if the market value of bananas V(B) rises, the price of apples, in banana terms, will fall. (If bananas become more valuable, then you need fewer bananas to acquire the same number of apples).

This concept will become clearer as we explain it by use of example. But before we do, let’s quickly think about how it is possible to represent price as a function of two sets of supply and demand.

The key is the unit of measurement used on the y-axis. More specifically, the diagram above measures market value on the y-axis in “absolute terms”, that is to say, in terms of a “standard” or “invariable” unit of market value.

In nearly every supply and demand diagram, the y-axis unit of measurement is “price”. Price is a relative measure of market value: a price measures the market value of a primary good in terms of the market value of a measurement good.

If it is possible to measure a property on a relative basis, then it is also possible to the measure that same property on an absolute basis: if we can measure the property market value on a relative basis (as a “price”), then we can also measure the property of market value on an absolute basis.

What does it mean to measure something in the “absolute”?

This is a long subject that was addressed in detail in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

In simple terms, a measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement. This begs the question, what is a “standard unit” of measurement?

In order for something to act as a standard unit of measurement it must possess two properties. First, it must possess the property that is being measured. Second, it must be invariable in the property that is being measured. (For example, “inches” are a standard unit for the measurement of length).

In the slide above, we assume that there is a “standard unit” for the measurement of market value. Once we have adopted this standard unit, we can illustrate supply and demand for apples in terms of this standard unit. As the market value of apples rises, the quantity of apples demanded falls and the quantity of apples supplied rises. The “equilibrium market value” of apples, V(A), is determined by the intersection of supply and demand for apples.

Similarly, on the right hand side of our slide, we can illustrate supply and demand for bananas in terms of this standard unit. As the market value of bananas rises, the quantity of bananas demand falls and the quantity of bananas supplied rises. The “equilibrium market value” of bananas, V(B), is determined by the intersection of supply and demand for bananas.

The Price of Apples in Banana Terms

Once we have illustrated supply and demand for both apples and bananas in terms of our standard unit for the measurement of market value, we can assemble a clearer picture regarding how the price of apples in banana terms is determined (or conversely, the price of bananas in apple terms).

We discussed the basic concept of “price” in a couple of recent posts, “The Matrix of Prices in a Barter Economy” and “A New Economic Theory of Price Determination”.

In essence, every “price” is nothing more than a relative measurement of market value. The price of one good (“the primary good”) in terms of another good (“the measurement good”) is determined by the market value of the primary good relative to the market value of the measurement good.

For example, suppose that I told you that one apple was twice as valuable as one banana. Question: what is the price of apples in terms of bananas?

If one apple is twice as valuable as one banana (in a “market value” sense), then someone must offer two bananas to purchase one apple. Therefore, the price of apples, in banana terms, is two bananas.

The price of the primary good (apples) in terms of the measurement good (bananas) is determined by the relative market value of the two goods. In this case, the market value of the primary good (apples) is twice that of the market value of the measurement good (bananas). Therefore, the price of the primary good (apples), in terms of the measurement good (bananas), is two units of the measurement good (bananas).

Mathematically, we can illustrate this as shown in the slide below. If we assume that V(A) is the market value of apples as measured in terms of our “standard unit” of market value, and V(B) is the market value of bananas as measured in terms of that same standard unit, then the price of apples in banana terms, P(A_B), is merely the ratio of V(A) divided by V(B).

Now, let’s return to our earlier supply and demand diagram. Supply and demand for apples determines the market value of apples. Supply and demand for bananas determines the market value of bananas. The price of apples, in banana terms, is simply the ratio of the market value of apples divided by the market value of bananas.

Two Simple Examples

The theory that every price is a function of two sets of supply and demand is more easily explained by way of example. In this final section, let’s consider two scenarios and the impact of each on the price of apples, in banana terms, in our barter economy

Scenario One: what happens to the price of apples, in banana terms, if there is an increase in demand for apples?

If there is an increase in the demand for apples, then the demand curve for apples moves to the right. The market value of apples rises from V(A)₀ to V(A)₁. Furthermore, the price of apples, in banana terms, rises. In simple terms, if apples become more valuable relative to bananas, then the price of apples, in terms of bananas, will rise. (It will require more bananas to purchase the same amount of apples).

In the slide above, supply and demand in the apple market is measured in terms of our standard unit (in terms of “units of economic value” or “EV terms”). However, we can illustrate the market for apples in both “standard unit” terms (in terms of the absolute market value of apples) and in “price” terms (in terms of the relative market value of apples). In this example, we can see that we end up with the same type of result, no matter what unit of measurement we use on the y-axis: the demand curve for apples moves to the right as measured in both absolute and relative market value terms.

So far, so good: but what happens if there is a change in the banana market? How does a change in the banana market impact the price of apples?

Scenario Two: what happens to the price of apples, in banana terms, if there is an increase in demand for bananas?

If there is an increase in the demand for bananas, then the demand curve for bananas moves to the right. The market value of bananas rises from V(B)₀ to V(B)₁. Bananas are, to put it simply, “more valuable”.

Now, what happens to the price of apples where the price of apples is expressed in banana terms?

If there is no change in market value of an apple, V(A) is constant, then the price of apples, in banana terms, must fall. In simple terms, if apples become less valuable relative to bananas, then the price of apples, in terms of bananas, will fall. (It will require fewer bananas to purchase the same amount of apples because bananas are now “more valuable”).

Traditional supply and demand analysis (with “price” on the y-axis) struggles with this scenario. If there is “no change” in the market for apples, then how is possible for the price of apples to fall?

The answer to this question is illustrated below. Although there is no change in the absolute market value of apples, the relative market value of apples falls (the market value of apples relative to the market value of bananas falls). If apple prices are expressed in banana terms, then a rise in the market value of bananas will have the effect of shifting down both the supply curve for apples and the demand curve for apples.

The fact is that while there has been “no change” in the market for apples when measured in terms of a “standard” or “invariable” unit of market value, there has been a significant change in the market for apples when measured in terms of bananas.

One Final Word

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The model we have discussed above applies not only to the determination of barter prices (“good/good prices”), but also applies to the determination of money prices (“good/money prices”) and foreign exchange rates (“money/money prices”).

Consider this point. What happens if instead of using bananas to buy apples in the examples above, we use money. Should the principle be any different? The answer is “no”: a good theory of price determination should be able to describe the determination of any type of price.

The view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money. In turn, the market value of money is the denominator of every money price in the economy. As the market value of money falls, all else remaining equal, the price level rise. This view sits in direct opposition to the traditional Keynesian view that supply and demand for money determines the interest rate.

This theory is covered in more detail in the Price Determination section.

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