Tag Archives: inflation or deflation

The Risk of Inflation in 2016

Is inflation or deflation the greater risk in 2016? Is it possible for inflation in the United States to accelerate in the midst of global economic weakness? And in a world of complex economic cross currents and unpredictable policy actions, how do you even begin to answer these questions?

Most market commentators overly simplify the inflation or deflation debate by making a false assumption, namely that “economic weakness = deflation” and that “economic strength = inflation”. This represents an essentially Keynesian view of the world, a view that dominates the thought process of most central bankers.

But is it really this simple? Will the inflation outcome in 2016 be determined solely by the strength of the US economy? Or is there another factor at play? A factor that is harder to observe and quantify, yet one that could have a much greater impact on the 2016 inflationary outcome than near-term economic conditions?

The view of The Money Enigma is that we can break any analysis of inflation in two parts. First, we need to consider how near-term economic conditions might impact the market value of goods. For example, if the economy deteriorates, then we need to think about how this might negatively impact the value of goods and labor. This is the traditional part of the analysis that is familiar to most commentators.

The second part of the analysis is less orthodox and requires us to consider how expectations regarding the long-term economic prospects of society might shift and how any such shift might impact the market value of money.

A shift in long-term expectations is the critical second factor that is often ignored by market commentators. Long-term economic expectations play a critical role in the determination of the market value of money. More specifically, if people lose faith in the long-term economic prospects of society, then this undermines the value of fiat money issued by that society.

In this week’s post, we will explore what might happen if this second, often silent, factor comes into play in 2016. More specifically, it will be argued that inflation could accelerate markedly in 2016 if long-term confidence is damaged.

Ironically, the global economic weakness that many believe will drive a deflationary outcome in the United States in 2016 could be precisely the factor responsible for triggering a decline in long-term economic confidence and a reacceleration in the rate of inflation.

The Risk of Inflation: A Two-Part Analysis

Any attempt to analyze the risk of inflation assumes, prima facie, that one understands the key drivers of inflation. Unfortunately, economists have been unable to reach consensus regarding the primary causes of inflation.

In very rough terms, there are three competing views regarding the primary cause of inflation. Keynesians believe that inflation is caused by “too much demand” relative to the economic potential of the economy. Monetarists believe that inflation is caused by “too much money” relative to real output. Fiscal Theorists believe that inflation, particularly severe inflation, is caused by “too much government debt” as measured relative to GDP.

Professor John Cochrane in his article “Inflation and Debt” does a much better job than I can of describing these various schools of thought and some of the problems associated with each.

While each school of thought has its own problems, the greater issue from my perspective is that each school of thought speaks a different language. More specifically, the basic price level models used by the various schools of thought don’t really talk to each other. For example, the New Keynesian expectations-augmented Philips Curve doesn’t explicitly include a role for government debt and, quite frankly, has almost completely excluded any explicit role for the size of the monetary base (in the New Keynesian world, money only matters if it impacts the interest rate).

So, in the midst of all this academic confusion, how does one begin to analyze the outlook for inflation?

The view of The Money Enigma is that we can simplify our starting point by recognizing a fundamental truth: the price level is a relative measure of market value. More specifically, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

Mathematically, the price level can be expressed as a ratio of two values. The price level is determined by the ratio of the market value of goods V_G divided by the market value of money V_M. The key to demonstrating this is recognizing that the property of market value can be measured in absolute terms, i.e. in terms of a “standard unit” for the measurement of market value. Both the market value of goods V_G and the market value of money V_M in the equation above are measured in terms of this standard unit. You can read more about this very important concept in “The Measurement of Market Value: Absolute, Relative and Real”.

If the price level is a relative measure of two factors (the market value of goods and the market value of money), then this automatically suggests that any analysis of inflation needs to be conducted in two parts.

First, we need to consider the impact of near-term economic conditions on the market value of goods, the numerator in our price level equation. Second, we need to consider how shifts in long-term expectations might impact the market value of money, the denominator in our price level equation.

As you will see from the analysis that follows, we can use this simple two-part framework (“Ratio Theory of the Price Level”) to incorporate many of the ideas that are promoted by the various schools of economic thought. More specifically, we will explore how aspects of Keynesianism, Monetarism and Fiscal Theory can all be incorporated into a discussion of the outlook for inflation.

On that note, let’s begin our two-part analysis of the outlook for inflation in 2016.

2016 Inflation Outlook, Part One: Will Global Economic Weakness Put Pressure on the Value of Goods & Labor?

There can be no question that, over the past couple of decades, major global deflationary forces that are secular in nature have emerged and that these forces have played a key role in creating the low inflation environment that is currently being experienced in the Western World.

The opening of major European markets at the end of the Cold War, the free market revolution in China and the emergence and mass adoption of the Internet have all contributed to a more competitive world.

Moreover, none of these deflationary forces look set to reverse, at least not in the near-term. Despite political tensions between Russia and the US, it seems very unlikely that the USSR will return. In China, economic bumps all the road have been met with some unorthodox policy, but the fundamental trend towards free markets still seems to be firmly in place. As for the Internet, it is hard to imagine a world without it, despite that the fact that many of us, myself included, began our careers before email existed!

Therefore, it seems relatively safe to assume that we can extrapolate these secular trends forward for at least another decade.

The secular trends may be clear, but what about the impact of cyclical factors? Are we safe to assume that, in the near term, cyclical factors will also add to the deflationary pressures?

This is a more difficult call because it requires us to see ahead into economic conditions in 2016. Will the US economy slow further in 2016? Will China act as an anchor on global economic growth in 2016?

Frankly, many of you will be in a better position than me to answer these questions. Nevertheless, let’s assume, for the sake of argument, that economic weakness spreads further in 2016 and that the US economy slows down markedly. What would we expect the impact to be on the value of goods and labor?

Clearly, any US economic weakness in 2016 would put further downward pressure on the market value of the basket of goods, the numerator in our price level equation.

This part of the analysis is entirely consistent with the Keynesian view. If secular forces continue to drive growth in aggregate supply and these secular forces are met by a cyclical decline in aggregate demand, then we should expect an increase in slack in the economy and downward pressure to build on both the value of goods and labor.

So, is that the end of our analysis? Absolutely not.

Many market commentators (and central bankers) might stop their analysis at this point and conclude with the observation that “if the economy is weak in 2016, then the risk of deflation is greater than the risk of inflation”.

The problem with concluding our analysis at this point is that we have only considered half of the picture. Inflation is not simply a function of economic strength. If it were, then Zimbabwe would have experienced deflation as its economy imploded, not hyperinflation.

So, what is the missing link? Why is it possible for economic decline to be met with an acceleration in inflation? The answer lies in the denominator of our price level equation: the value of money.

2016 Inflation Outlook, Part Two: Will a Decline in Long-Term Economic Confidence Trigger a Sharp Decline in the Value of Money?

In order for money to be accepted in exchange, money must possess the property of market value. In a commercial exchange, you are not going to give me something of value (for example, an apple) unless I give you something of value in return. When I pay for the apple with money, you accept money because you believe that money has value, value that will be recognized the next time you try to use the money I gave you to buy something.

The value of money has a critical role to play in the determination of prices as expressed in money terms. In simple terms, if the apple I try to buy from you is worth twice as much as one dollar, then I will have to give you two dollars to pay for it. If the value of money falls relative to the value of the apple, then I will have to give you more dollars for the apple, i.e. the price of the apple in money terms rises.

We can extrapolate this simple principle to the price level. The price level is a measure of the market value of the basket of goods in terms of the market value of money. In other words, all else remaining equal, if the value of money falls, then the price level rises.

This raises an obvious question: what determines the value of money?

The answer to this question is far from obvious and is something that still eludes the science of economics. Indeed, most economists struggle to even acknowledge the “market value of money” as an independent variable, for reasons that are discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

Nevertheless, by observing the history of various fiat currencies, we can make one sweeping observation regarding the nature of fiat money: fiat money is only as good as the society that issues it.

In more specific terms, the value of fiat money depends upon confidence in the long-term economic prospects of the society that issued it.

If confidence in the future of society is strong, then the value of the currency issued by that society should be well supported. Conversely, if confidence in society’s future deteriorates, then the fiat money issued by that society will decline in value. In an extreme situation, if confidence in the economic functioning of a society collapses, the value of the fiat currency issued by that society will collapse, triggering a period of hyperinflation.

Intuitively, it makes sense that the value of the fiat money issued by our society should be intimately tied expectations regarding the economic future of our society. However, from a theoretical standpoint, explaining why this is the case is a complicated challenge.

The view of The Money Enigma is that the value of fiat money is tied to confidence in the economic future of society because fiat money represents a proportional claim on the future output of society.

Fiat money is a financial instrument: it derives its value from its implied contractual properties. Fiat money is a liability of society and a claim against the future output of society. More specifically, fiat money is a long-duration, special-form equity instrument and represents a proportional claim against the future output of society.

This theory of money, “Proportional Claim Theory”, is discussed at length in the “Theory of Money” section of this website.

From a practical perspective, the primary implication of this theory is that the value of fiat money depends upon market expectations regarding the long-term (30 year+) future path of two key variables: real output and the monetary base.

Currently, the market is optimistic regarding the long-term path of real output relative to the monetary base. Most commentators believe that the Federal Reserve will reduce the monetary base from its current extended levels over the next 10 years and that during that time real output will continue to grow at solid rates.

This combination of optimistic expectations has supported the value of the US dollar and, as a result, has helped keep a lid on prices.

The fact that the Fed has quintupled the monetary base over the past seven years has had little negative impact on the value of money because the market perceives this monetary expansion to be “temporary” in nature.

But what happens if confidence in the long-term economic future of the United States declines and the market begins to believe that the Fed’s program of quantitative easing is more “permanent” in nature? What happens if global events unravel such that the market begins to believe that the Fed won’t or can’t reduce the monetary base?

Let’s continue with the 2016 scenario that we discussed in Part One: the global economy continues to weaken, with several major countries slipping into recession, and economic growth in the United States slows to crawl speed.

This is a scenario that most economists believe will almost certainly produce a deflationary or very low inflation outcome. I agree that such a scenario would put pressure on the market value of the basket of goods. But what might happen to the value of money in such a scenario?

Arguably, a period of global economic weakness in 2016 could become a tipping point for long-term expectations regarding the structural health of the United States.

Think about these factors.

First, as we enter 2016, the Fed will have made little to no progress in reducing the monetary base. Will a global recession encourage the Fed to accelerate a reduction in the monetary base? No. In an extreme scenario, a global economic recession may encourage the Fed to further expand the monetary base.

Second, a slowdown in the rate of growth in the US will not improve the Federal budget deficit nor help to reduce the outstanding debt of the US Government. Rather, a deterioration in near-term economic conditions is likely to fuel concerns about the long-term fiscal sustainability of the United States.

Third, the Fed has spent the last five years searching for “lift off”, the magic point at which the US economic recovery becomes strong and self-sustaining. After seven years of sub-par growth, a slowdown in US economic growth in 2016 might be the straw that breaks the camel’s back: the event that causes the market to lower its long-term expected growth rate for the US economy.

What is the likely outcome of the combination of these three factors: a sharp decline in the value of money.

If the theory of money discussed above is correct and fiat money represents a proportional claim in the future output of society, then a loss of confidence in the long-term economic future of the United States could easily lead to a sharp decline in the value of the US dollar.

2016: The Balance of Probabilities

What is the outlook for inflation in 2016? Our two-part analysis suggests that there could be two conflicting trends at play.

First, it seems reasonable to expect that there will be continuing downward pressure of the market value of the basket of goods, the numerator in our price level equation. All else remaining equal, this would suggest a deflationary environment in 2016.

However, the risk is “all else remaining equal” doesn’t hold in 2016. More specifically, the risk is that global economic malaise, Fed inaction and a general loss of long-term economic confidence triggers a decline the market value of money, the denominator in our price level equation.

The ultimate outcome will depend upon which force is stronger and, perhaps more critically, the timing of how events unfold.

If the economy is weak, but long-term confidence remains strong, then the majority of market commentators may prove to be right: 2016 may be a year in which inflation remains contained. However, if weakness in the economy damages long-term economic confidence, then 2016 could be the year that inflation reaccelerates.

Author: Gervaise Heddle

What Causes Inflation?

Inflation remains one of the great enigmas of modern economics. In this week’s post, we will examine a simple theory of the price level, “Ratio Theory of the Price Level”, and a basic model that can be used for thinking about short-term movements in the price level “The Goods-Money Framework”. We will then use these ideas to examine some of the traditional explanations for inflation.

Despite extensive academic studies and seemingly endless debate, a quick keyword search on “what causes inflation?” will reveal a jungle of different ideas and opinions regarding the true drivers of inflation.

The traditional view, taught at high schools and colleges, is that inflation can be driven by “demand pull” or “cost push” factors. In essence, this is a macroeconomic extension of the basic microeconomic tenet that the price of a good can rise either because there is more demand for that good (“demand pull”) or because there is reduced supply for that good (“cost push”).

The “demand pull/cost push” model represents an “old Keynesian” view of how the world works: if aggregate demand increases, then real output should increase and the price level will rise, particularly if the economy is operating near full capacity.

Mainstream economists recognize that this simple aggregate supply and demand view of the world often fails to predict episodes of high inflation. Therefore, this basic Keynesian model has been fudged by the addition of something called “inflation expectations”. This “New Keynesian” model states that inflation is caused by either (1) too much demand, or (2) expectations of future inflation. The problem with the “inflation expectations” term in the New Keynesian models is that no one seems to have a good sense of what determines “inflation expectations”.

The issue is made more complicated by the fact that most economists recognize that, over the long term, the monetary base plays an important role in the determination of the price level. Even senior central bankers tie themselves in knots trying to explain how to reconcile the New Keynesian model of the world with the simple, empirical fact that money matters. Mervyn King, former Governor of the Bank of England, discusses this problem in his article “No money, no inflation – the role of money in the economy” (2002) in which he concludes that “the absence of money in the standard models which economists use will cause problems in the future”. Frankly, I couldn’t agree more.

If even central bankers can’t reconcile the competing views of what drives inflation, then this suggests that something is wrong with the underlying models. The view of The Money Enigma is that both Keynesian and Monetarist models fail to provide satisfactory models for the determination of the price level because they both start from the wrong fundamentals.

In order to build useful models of the price level, we need to go back and challenge the basics of current microeconomic theory. In particular, we need to develop a more comprehensive answer to the question “how is a price determined?”

It is the view of The Enigma Series that the current presentation of microeconomic price determination, namely the traditional supply and demand chart with price on the y-axis, presents a one-sided and very limited view of the price determination process.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. More specifically, the price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

A few weeks ago, we discussed how prices are determined in a genuine barter economy (an economy in which there is no commonly accepted medium of exchange). We asked the question “what determines the price of apples in banana terms? Is it supply and demand for apples? Or is it supply and demand for bananas?” The answer is both.

Every price is a relative expression of two market values. The market value of apples is determined by supply and demand for apples. The market value of bananas is determined by supply and demand for bananas. The price of apples, in banana terms, is a relative expression (a ratio) of these two market values. Therefore, the price of apples, in banana terms, is a function of two sets of supply and demand (see diagram below).

This principle can be extended to the determination of “money prices”. The price of a good, in money terms, is a relative expression of the market value of the good and the market value of money. For example, if the market value of one apple is three times the market value of one US Dollar, then the price of an apple, in US Dollar terms, is three dollars.

In general terms, the dollar price of an apple can rise for one of two reasons: either the market value of an apple rises (for example, there is a supply shortage), or the market value of the dollar falls.

The diagram below illustrates how the price of apples, in money terms, is determined by two sets of supply and demand: supply and demand for apples, and supply and demand for money. The key in this diagram is the y-axis unit of measurement: a “standard unit” of market value. Instead of using price, a relative measure of market value, on the y-axis, the diagrams above and below use an absolute measure of market value of the y-axis. The standard unit of market value is a theoretical and invariable measure of the property of market value, just as “inches” are an invariable measure of the property of length.

The key point that readers should take away from the above diagram is that every “money price” in our economy is a ratio. More specifically, the price of a good in money terms is a ratio of the market value of the good (the numerator) divided by the market value of money (the denominator).

The Inflation Enigma, the second paper in The Enigma Series, extends this simple microeconomic concept (every price is a relative expression of two market values) to a macroeconomic level. If the market value of money is the denominator of every money price in the economy, then the price level can be stated as a ratio of two market values: the “general value level”, a hypothetical measure of the absolute market value of the basket of goods/services, and the market value of money. This is called the Ratio Theory of the Price Level.

Ratio Theory of the Price Level states that the price level is a function of the value of goods relative to the value of money. If the value of goods rises relative to the value of money, then the price level rises (inflation). If the value of goods falls relative to the value of money, the price level falls (deflation).

We can best illustrate Ratio Theory with a simple macroeconomic framework called “The Goods-Money Framework” (see diagram below). The Goods-Money Framework is broken into a left side and right side. On the left side, aggregate supply and demand for goods/services determines real output (x-axis) and the market value of goods (y-axis), as measured in absolute terms. On the right side, supply and demand for money (the monetary base) determines the market value of money (again, market value is measured in absolute terms).

The price level is a ratio of two macroeconomic equilibrium: the market value of goods, as determined on the left side of the model, divided by the market value of money, as determined on the right side of the model. Now, let’s get back to our original question.

What causes inflation?

The left side of the Goods-Money Framework provides some distinctly Keynesian answers to this question. All else equal, the price level will rise if the market value of goods (the “general value level”) rises. In a stylized sense, this can occur either because the aggregate demand curve shifts to the right (“demand pull”) or because the aggregate supply curve shifts to the left (“cost push”).

The right side of the Goods-Money Framework provides a somewhat more Monetarist perspective on the issue. All else equal, the price level will rise is the market value of money falls. In very simple terms, this can occur either because the supply of money (the monetary base) increases or because the demand for money falls.

In practice, both the left side and right side of the model are both moving at the same time. For example, deflationary forces that are acting on the left side of the model, (for example, “globalization” of the labor force), might be offset by inflationary forces on the right side (for example, aggressive monetary easing), leading to a net result where the price level changes little. [Note: if both the numerator and denominator fall by roughly the same percentage, then there is no change to the ratio itself].

While interpreting the left side of the framework is relatively straightforward, the right side of the framework is extremely complex. The main problem is that “supply and demand” is, in practice, a poor short-term model for the determination of the market value of money.

We know from recent experience that a large increase in the monetary base can have little short-term impact on the market value of money (and hence, little short-term impact on the price level). The reason for this is that money is a proportional claim on the future output of society. More importantly, money is a long-duration asset. The market value of money depends far more upon expectations of future levels of the monetary base than it does on the current levels of the monetary base.

The Velocity Enigma, the final paper in The Enigma Series, develops a valuation model for money that demonstrates that the current market value of money depends upon long-term expectations. More specifically, the current market value of money is highly dependent upon the expected long-term path of the “real output/base money” ratio.

As you can see, there is no simple answer to the question “what causes inflation?”

The traditional Keynesian view provides a very limited perspective on the issue. Importantly, the notion that inflation can only occur if the economy is overheating (the economy can only experience inflation if there is “too much demand”) is nonsense.

The price level depends upon a complex set of expectations. Most notably, the expected long-term path of the “real output/base money” ratio is the key determinant of the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy.

This model provides a sensible explanation for how inflation can occur in a weak economic environment. If aggregate demand is weak, then this will place downward pressure on the market value of goods on the left side of our model. However, if confidence in the economic future of the country falters, then this can easily lead to a decline in the market value of money that overwhelms the fall in the market value of goods. In the context of Ratio Theory, as the denominator (the market value of money) falls more rapidly than the numerator (the market value of goods), the price level rises.

In summary, we can say that, in the short-term, the drivers of the price level are complex. Aggregate demand and supply matter, but expectations of the future path of the “real output/base money” ratio are critical.

While economists may disagree on the short-term drivers of the price level, there is at least a broader consensus on what drives the price level over the long-term: money. More specifically, the ratio of base money to real output is the key driver of the price level as measured from point to point over very long periods of time.

The Enigma Series provides a common sense explanation for this phenomenon.

Money is a special-form equity instrument of society that represents a proportional claim on the future output of society. The value of a proportional claim on the output of society will rise as real output rises and fall as the monetary base increases (i.e. as the number of claims against that output increases).

Therefore, if over a period of many years, the monetary base has grown at a much faster rate than real output (as it has in the United States over the past 80 years), we should expect the market value of money to have fallen significantly and, all else equal, the price level should have risen significantly.

Over long periods of time, it is this ratio of money/output that drives the price level. The question today is how long can the monetary base in the United States can remain at these extended levels without triggering a significant decline in the market value of money and reigniting inflation. Too many commentators who are worried about deflation are, at least implicitly, focused only on the left side of our model above. The key to inflation remains the right side of the model, the market value of money.

A Bubble of Confidence Obscures the Risk of Inflation

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

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

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

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

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

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

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

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

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

Money is a long-duration asset

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

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

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

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

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

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

Money is a proportional claim on the output of society

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

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

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

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

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

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

However, there is a risk.

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

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

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

Inflation or Deflation: A Microeconomic Perspective

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

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

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

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

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

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

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

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

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

What is a price?

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

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

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

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

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

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

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

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

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

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

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

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

The short answer is “no”, but why?

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

And this brings us to our key point: price is a relative expression of market value.

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

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

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

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

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

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

We can extend this microeconomic concept of price determination to a macroeconomic discussion of inflation.

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

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

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

Why Is There a Lag Between Money Printing and Inflation?

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

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

In each case, the answer is “no”.

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

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

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

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

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

Why does inflation tend to lag money creation?

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

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

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

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

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

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

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

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

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

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

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

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

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

Does this same principle apply to advanced economies? Absolutely.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inflation or Deflation: Which is the Greater Risk in 2015?

Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?

The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.

The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.

While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.

The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.

The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.

The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.

We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.

In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “V_G” and the value of money “V_M” (see image below).

Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.

The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?

You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.

But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?

It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.

However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.

So, what is the risk of a sudden collapse in the value of money in 2015?

After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.

Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.

Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.

However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.

Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.

So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.

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