Monthly Archives: March 2015

Government Debt & Inflation

Government debt has a critical role to play in the determination of inflation. More specifically, the market’s assessment of the sustainability of government debt and deficits has a direct impact on the market value of the fiat money issued by that society and, consequently, the rate of change in the price level.

Government has a simple choice when determining how to fund its deficits: issue debt (government debt) or issue equity (base money).

Money (the monetary base) is a long-duration, special-form equity instrument that represents a proportional claim on the long-term output of society.

Once government debt accumulates to a point that the market decides that the debt is unsustainable, the market will begin to discount (i) slower future output growth (deficits must be reigned in), and/or (ii) higher monetary base growth (at the margin, more funding needs to be financed by money creation).

The combined shift in these expectations (lower long-term output growth, higher long-term monetary base growth) puts downward pressure on the market value of money and upward pressure on the price level.

In this situation, a central bank may quickly become impotent in its fight against inflation as it losses control over long-term expectations.

Introduction: Government Debt and Inflation

This week we are going to explore the idea that the accumulation of high levels of government debt can have severe negative consequences. More specifically, we will analyze the relationship between excessive government debt and inflation.

The view of The Money Enigma is that fiscal policy plays a critical role in the determination of the price level. More specifically, a policy of persistent fiscal deficits combined with the accumulation of excessive government debt will, at some point, trigger a downward revision of market expectations regarding the future path of the “real output/base money” ratio. In turn, this shift in expectations may result in a significant fall in the value of money and an outbreak of high inflation.

At the present time, many economists and market participants seem to believe that there is little relationship between government debt and inflation. People point to the current high levels of government debt in Japan and/or the United States as proof that high levels of government debt (relative to GDP) have little to no impact on inflation.

This perspective ignores the historical experience of many less developed countries that have seen a massive collapse in the value of their currency and accompanied hyperinflation driven by fears of fiscal unsustainability. Unfortunately, there seems to be a view that somehow the Western World is “different” and immune to these forces.

Perhaps of greater concern is the fact that most economists believe that there is little to no relationship between government debt and inflation. “Too much government debt” barely rates a mention as a cause of inflation in most economics textbooks.

Feel free not to trust me on this point. Rather, read the following article, titled “Inflation and Debt” written by one of the leading economists of our time, John Cochrane, Professor of Finance at the University of Chicago Booth School of Business.

Professor Cochrane’s article is notable for a couple of reasons. First, it provides a simple, but intellectual, exposition regarding the current thinking on the causes of inflation. Second, it provides a great overview of the shambles that is current mainstream macroeconomic thinking: lots of different models (Keynesianism, Monetarism, Fiscal Theory) none of which work well on a standalone basis and none of which easily integrate with the other models.

For our purposes, the key point made by Professor Cochrane is that Keynesianism, the dominant school of economic thought, sees little role for government debt in the determination of inflation. The view of Keynesianism is that “too much demand” is a primary cause of inflation. Hence, the imperative on central banks to slow down economic activity as the economy approaches full capacity.

To be fair, Keynesianism has been modified to include an “inflation expectations” component, largely due to the failure of the old Keynesian model to explain the stagflation in the 1970s. In this New Keynesian world, government debt can only impact inflation if either (a) fiscal spending leads to an overheated economy, or (b) for some reason, higher levels of government debt lead to higher “inflation expectations”. While the first issue is obvious, the many proponents of Keynesianism have done a poor job of explaining how higher levels of government debt may lead to higher “inflation expectations”.

This week we are going to examine an economic model that can clearly explain how higher levels of government debt can lead to what Keynesians would call “higher inflation expectations”. More specifically, we are going to look at a theory of money that can explain how excessive government debt can lead to a fall in the value of fiat money and a consequent rise in the price level.

The Relationship between the Monetary Base and Government Debt

In order to understand the relationship between inflation and debt, we need to start by thinking about a much more simple relationship: the relationship between the monetary base (“money”) and government debt (“debt”).

The most obvious and well-recognized relationship between money and debt is that they are the two key elements of the “government budget constraint”. The government budget constraint states that the budget deficit in any particular period must equal the sum of the change in the monetary base and the change in government bonds held by the public during that same period.

In other words, the government has only two choices when it considers how to fund a budget deficit: either it can issue debt or it can create money.

This is very similar to the choice faced by a corporation that is trying to finance its operations. A corporation can either issue debt (a fixed claim over future profits) or issue equity (a variable claim over future profits).

The view of The Money Enigma is that we can extend this analogy.

Ultimately, society generates only one primary source of economic value that it can use to finance public spending: real output. When society does not wish to fund public projects by taxing current output, it can create (using the legal structure of government) claims on future output. Just as a corporation can create fixed and variable claims to future cash flows, so society (via government) can create fixed and variable to claims to future output that it can use to finance current deficits.

The fixed (or at least, pseudo-fixed) claim on future output is government debt. The variable claim on future output is money. In this sense, money is the equity of society.

The notion that money is a form of equity instrument and a proportional claim on the future output of society was discussed at length in a recent post titled “Money as the Equity of Society”.

The view of The Money Enigma is that we accept money as payment for our services because we, as a society, recognize that it represents a variable claim over the future output of society. Just as a share of common stock represents a proportional claim over the future cash flows of a corporation, so one unit of the monetary base (e.g., one dollar) represents a proportional claim over the future output of the society that issues that currency.

A government has only two choices when it wants to fund a budget deficit: either it can issue debt (a pseudo-fixed entitlement to the future output of society), or it can issue money (a special-form equity instrument that represents a long-duration, variable entitlement to the future output of society).

While this theory of money may seem complex, it does have one great advantage: it allows us to build a valuation model for money. More specifically, the theory allows us to build a discounted future benefits model for the value of money, just as one might build a discounted future cash flow model for a share of common stock.

Building a valuation model for money is a compelling aspect for this theory because it allows us to think about the impact on various shifts in expectations upon the current value of money. Importantly, a valuation model for money provides us with a framework for thinking about how rising levels of government debt may impact the current value of money.

But before we launch into an analysis of the valuation model for money, let’s think more generally about how rising debt impacts the value of equity.

How Does Rising Government Debt Impact the Value of Money?

The view of The Money Enigma is that once government debt reaches a critical level, market expectations regarding the future path of real output begin to fall and market expectations of the future path of the monetary base begin to rise. These two factors (diminished expectations for long-term output growth and heightened expectations for higher base money growth) combine to negatively undermine the value of money.

Rather than launch into the more technical aspects of how shifting expectations can impact the value of money, let’s return to our simple “money versus common stock” analogy.

Consider a company that is listed on the stock exchange. How does rising corporate debt impact the value of the shares of that company?

It’s not a simple question to answer. Why? Well, it depends on the underlying profitability of the company and how much debt that company already has. For example, if the company is highly profitable with low levels of debt, then taking on a bit more debt may have little or no impact on the stock price. Indeed, a little more debt could enhance the value of the shares if investors believe the money raised will fund highly profitable new projects.

However, what about a situation where the company is already highly indebted? Maybe our company lost money during the recession and had to take on a lot of debt. What would be the impact on the value of the shares of that company if the company announced it was going to take on even more debt?

Clearly, at some point there is a tipping point where equity investors will decide that the company is taking on too much debt and the value of the shares will fall. The fall in the stock price will be accentuated if it also becomes clear that the underlying health of the company is not as strong as believed (the company has been raising debt to cover up its weak cash flow problems).

Now, let’s think about this in the context of a society that can issue debt (government debt) and equity (base money). What is the impact on the value of the equity of society (money) as the outstanding debt of society (government debt) begins to rise?

Again, it depends upon the particular circumstances.

If the economic health of society is strong and the existing debt levels are low (government debt is less than 20% of GDP), then it seems reasonable to believe that an increase in government debt may have little or no impact on the value of the equity of society.

However, if a society already has high levels of public debt (100%+ of GDP) and then seeks to issue even more debt (issue more “fixed” claims against its future output), then this could place significant downward pressure on the value of money.

So, why is this case?

Money is a proportional claim on the future output of society. There are two primary variables that drive the value of money: the expected future output of society and the number of expected claims to that output (the future size of the monetary base).

As the expected growth of future output rises, all else equal, the value of a variable entitlement to that output will rise. Conversely, as the expected growth of the monetary base rises, all else equal, the number of future claims to output rises and the value of each claim falls.

As government debt levels reach a certain tipping point, markets will begin to revise their expectations for both of these key factors.

If the markets decide that the current path of fiscal policy is unsustainable, then there are only two ways in which this can be resolved. Either government deficits are reigned in, leading to lower levels of future real output, or the government will be forced to increase the pace of monetary base growth in order to finance those deficits (remember our government budget constraint from earlier).

Both of these factors will lead to a fall in the value of money.

We can think of the value of money in terms of slices of pie. As government debts rise to a critical point, then one of two things will happen. Either the pie itself will shrink (less output), or the pie will be cut up in to more pieces (more money). Either way, markets begin to anticipate this and the market value of money falls.

In more technical terms, the market value of money (as measured in absolute terms) depends upon the expected future path of the “real output/base money” ratio. Higher government debt can trigger a sharp downward revision in the long-term expected path of the “real output/base money” ratio, leading a sharp fall in the market value of money.

In summary, the value of money depends upon a complex set of long-term expectations regarding the future real output growth and future base money growth. Excessive government debt can lead to a sudden shift in these expectations, a shift that may have a severely negative effect on the value of the fiat money issued by our society.

Excessive Government Debt and Inflation

Finally, we need to close the loop regarding the relationship between government debt and inflation. So far we have concentrated on the relationship between excessive government debt and the market value of money. It has been argued that if government deficits and debts become unsustainable, then the market will begin to anticipate lower levels of future output and higher levels of future base money.

The combination of these two factors will place downward pressure on the value of money. Why? The market value of money will fall because money (each unit of the monetary base) represents a variable entitlement to the future output of society. If there is less expected output in the future, then the value of a claim to that future output will fall. Similarly, if the market anticipates more money will be created, then there are more claims on the future output of society and, all else equal, the value of each claim will fall.

But why does a fall in the value of money lead to higher prices? The answer to this question is simple. 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 rises.

We have already covered this theory in many previous posts, but those that are new to The Money Enigma should read “Every Price is a Function of Two Sets of Supply and Demand”, a post which explains the basics of price determination.

In summary, government debts and deficits do matter. The currently fashionable notion that government debts do not matter to inflation ignores the important role of expectations regarding the long-term path of real output and base money in the determination of the price level.

On a final note, the point that should be of most concern to policy makers is that once these long-term expectations regarding output and base money shift, it may be very difficult to bring them back to more previous levels and therefore difficult to control inflation.

While the current market view is that central banks are omnipotent in their control of the global economy, the fact is that it is almost impossible for a central bank, at least singlehandedly, to control an outbreak of inflation that is created by reckless fiscal policy. The only way to control this type of inflation once it occurs is for fiscal and monetary policy makers to work together. Inevitably, this involves an end of the “good times” as fiscal deficits are reduced, the monetary base is brought under control and interest rates are raised.

The Risk of Hyperinflation in the United States

The risk of an outbreak of high inflation in the United States is rising. We are approaching a critical point where the ability of the US economy to grow while the monetary base is reduced will be tested. If the US economy falters, or if the Fed blinks and fails to reduce the monetary base, then the value of the US Dollar, a proportional claim on the future output of the US economy, could fall sharply and prices could rise significantly.

The market value of money is the denominator of every money price in the economy. The view of The Money Enigma is that the market value of money depends primarily upon the expected long-term growth of real output relative to the expected long-term growth of the monetary base.

Presently, the market expects strong real output growth and a reduction in the monetary base. If these expectations are disappointed, then the market value of money could drop precipitously, triggering a period of high inflation.

Ultimately, the prospects for hyperinflation depend upon the “real health” of the US economy. If the US economy is an innovation machine that grows solidly as the monetary base is reduced, the value of money will be protected. But if the US economy is merely a house of cards supported by cheap debt, then hyperinflation is a real possibility.

Introduction: the rIsk of hyperinflation in the US

The value of the fiat money that we use in our everyday transactions depends on market confidence in the long-term economic prospects of our society. If confidence in the long-term future of a society is strong, then fiat money will generally hold its value well and inflation will remain contained. However, if confidence is suddenly lost, the value of fiat money can quickly collapse leading to what is known as “hyperinflation”.

While the risk of hyperinflation in the United States in the next five years may be small, the risk is rising. A collapse in the value of the major fiat currencies may seem unimaginable to most people, but the risk is material. The key to appreciating this risk is examining how money prices are determined and, just as importantly, understanding how money derives its value.

There are many who will scoff at the notion that the United States could ever experience hyperinflation. The recent run of weak US inflation data, the deflationary experience of Japan and the strength of the US Dollar have combined to create a false sense of security on this issue.

Hyperinflation in the United States may be a “black swan” event, but as discussed by Nassim Taleb and others, “black swan” events seem to be occurring more frequently than predicted by statistical models.

Most people tend to treat “risk” in a binary fashion. Either its significant enough that we need to care, or it is low enough that we just ignore it. Six years ago, the risk of hyperinflation in the United States was definitely in that first camp. But times have changed. This week we will discuss how a number of key economic factors are coming together to create a possible tipping point, a point at which inflation begins to accelerate and becomes very hard to control.

The key point that we will discuss this week is that the price level today depends almost entirely upon expectations of the long-term path of the “base money/real output” ratio.

Right now, the markets are very optimistic in this regard. Most people believe that, over the next 20-30 years, real output in the US will continue to grow at solid rates (2%-3% per year), while the monetary base will decline as the Fed gradually reverses QE before resuming its long-run trend growth (about 6% per year).

However, if these expectations shift even slightly, the value of the US Dollar could fall significantly and the price level could rise dramatically.

For example, if markets begin to appreciate that the historic growth rates of the US over the past 20 years simply can not be achieved over the next 20 years, then this will have a negative impact on the value of the US Dollar and a positive impact on prices (inflation will rise). Moreover, if markets realize that the US economy has become addicted to monetary stimulus and “can’t get off the drug”, then expectations for the long-term path of the monetary base will be revised up leading to what could be the most severe inflationary outbreak in modern US history.

Ultimately, determining the risk of hyperinflation in the United States comes down to a call on the “real health” of the US economy. Is the US economy an innovation machine that will grow solidly as the monetary base is reduced? Or is the US economy merely a house of cards supported by cheap debt?

While readers may be divided on the real health of the US economy, this week we shall explore why the real health of the US economy is the key issue in determining the risk of hyperinflation. More specifically, we shall explore why the price level is so dependent upon expectations of both the long-term future path of the monetary base and real output.

In order to understand this theory, we need to go back to first principles and begin with a simple question, namely “how are prices determined?”

What determines a “money price”?

The view of The Enigma Series is that every price is a relative expression of the market value of the two economic goods being exchanged. The price a good, in money terms, depends upon both the market value of the good and the market value of money. The market value of money is the denominator of every “money price” in the economy. As the market value of money falls, the “money price” of a good, all else equal, will rise.

Every economic transaction involves, at a minimum, an exchange of two items. The “price” of the transaction is simply the ratio of the quantities of the two items exchanged. For example, if the price of bananas is $3, then this means that you must exchange three dollars for one banana.

This ratio of exchange is determined by the relative market value of the two items being exchanged. In our scenario above, one banana is three times more valuable (in a market value sense) than one dollar. Therefore, in order for you to purchase one banana, you must offer three dollars for it.

In order for one good to have a price in terms of another good, both goods must possess the property of “market value”. 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 is rather obvious observation. However, what the more important observation we need to make is that for a good to measure the market value of another good, that first good must itself possess the property of market value.

Let’s put that in terms that most are more familiar with.

In order for money to measure the market value of other goods (in order for “money prices” to exist in our economy), money must possess the property of market value. Furthermore, the “money price” of a good reflects the relative market value of the good in question (the “primary good”) and the market value of money (the “measurement good”).

Let’s think about this in abstract terms for a moment. Why can’t we express the price of all things in “sunshine terms”?

The reason we can’t measure the market value of all goods in sunshine terms is because sunshine does not possess the property of market value. We can’t measure the market value of bananas in sunshine terms because only one of the goods in the exchange (bananas) possesses the property of market value.

The reason we can express the price of goods in terms of money is because money possesses the property 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).

Some readers may ask how this view of price determination reconciles with traditional “supply and demand” theory. The view of The Enigma Series is that every price is a function of two sets of supply and demand. Those interested in this idea should read a recent and very popular post titled “Every Price is a Function of Two Sets of Supply and Demand”.

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.

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, money prices will rise.

The Ratio Theory of the Price Level, presented in the slide below, encapsulates this simple notion.

The key to the Ratio Theory, as with many of the theories discussed in The Enigma Series, is recognizing that the property of market value can be measured, at least theoretically, in absolute terms, that is to say, in terms of an invariable measure of market value. In the slide above, the market value of goods V_G and the market value of money V_M are both measured in terms of a theoretical and invariable measure of market value called “units of economic value”. Those readers who are interested in exploring the measurement of market value in both absolute and relative terms should read The Inflation Enigma.

Let’s return to the key point of discussion: hyperinflation.

The key takeaway from our discussion so far is that every “money price” in the economy depends critically upon the market value of money. Once this principle is appreciated, the key to understanding hyperinflation is an examination of what determines the market value of money, the denominator of the price level.

What determines the “market value of money”?

From a high-level perspective, the view of The Money Enigma is that the market value of a fiat currency depends upon expectations of the long-term economic prospects of the society that has issued that currency.

For example, the purchasing power of the US Dollar at any point in time depends critically upon market confidence in the future economic growth of the United States and the market’s trust that policy makers will manage the government’s balance sheet (government debt and the monetary base) in a prudent manner.

Hyperinflation develops when the market rapidly loses confidence in the long-term economic prospects of a society. Zimbabwe is a great case in point. Once the market begins to realize that underlying economic growth is poor (or worse, a country is going backward) and that the government needs to print more and more money just for the country to standstill from an economic perspective, the value of that currency begins to decline rapidly.

But why is this case? Why is the value of money so sensitive market confidence in the long-term economic prospects of a society?

The reason is that money is a long-duration, special-form equity instrument of society. More specifically, each unit of the monetary base represents a proportional claim on the future economic output of society.

We have discussed this basic thesis in a few posts recently, most notably “Money as the Equity of Society”.

While we will not go into all aspects of the argument in this post, the thesis of The Money Enigma is that money derives its value “contractually”. More specifically, there is an implied-in-fact contractual agreement between society (the issuer of money) and those that hold money (“moneyholders”) that the monetary base represents a claim to the future output of society. Moreover, money represents a proportional (as opposed to fixed) claim that future output.

In this sense, money is very similar to a share of common stock.

Each unit of the monetary base represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a corporation. As the expected future cash flows of a business rise, the share price becomes more valuable. As the expected future shares outstanding rise, the share price becomes less valuable.

Similarly, the value of money depends upon expected future output and the expected future size of the monetary base. As the expected future output of a society rises, the value of a proportional claim to that output (the value of money) will rise. Alternatively, as the expected future monetary base outstanding rises, there are more claims to any given future output and, therefore, the current value of each proportional claim to that output (the current value of money) will fall.

Those readers who are math geeks might be interested in the slide below that illustrates the valuation model for money that is developed in the final paper in The Enigma Series, “The Velocity Enigma”.

In essence, this valuation model is very similar to a valuation model for a share of common stock. The value of money rises as expectations regarding long-term real output growth strengthen (“g” rises). Conversely, the value of money falls if people decide that the monetary base will grow at a faster rate than previously expected (“m” rises).

Could hyperinflation happen in the United States?

Let’s bring the discussion back to the question at hand. Could the value of the US Dollar collapse dramatically at some point over the next 5-10 years?

Many commentators seem to believe that if the US Dollar hasn’t collapsed in value by now, after seven years in which the monetary base has more than quadrupled in size, then it will never happen. This perspective displays a stunning ignorance of the role that long-term expectations play in the determination of the value of money.

The value of money depends upon expectations of the long-term (20-30 year) path of the ratio of “real output/base money”. Although the recent QE program has quadrupled the monetary base, most market participants consider the program to be temporary. Moreover, over the past few years, confidence in the long-term prospects for real output growth in the United States have improved.

Both of these factors have supported the current value of the US Dollar, a long-duration, proportional claim on the output of the United States.

This experience is relatively typical of any country when it first experiments with money printing. Money printing boosts the economy and leads to upward revisions in expectations for long-term growth, a factor that supports the value of money and suppresses the price level. Moreover, the money printing is normally sold as a “temporary” measure: something that will be reversed once the economy is strong enough to support it.

“Temporary” increases in the monetary base should have little or no impact on the predicted path of the long-term monetary base and therefore should have no impact on the value of money and the price level.

In theory, the Fed could increase the monetary base by as little or as much as it likes without impacting the value of the US Dollar, provided that the increase is considered to be “temporary” in nature. Moreover, if the Fed’s actions boost confidence in long-term economic growth, then printing money could lead to a rise in the value of money and deflation!

But there is a catch. Sooner or later (and generally sooner), the “temporary” increase in the monetary base needs to be reversed. And this leads us to the interesting position in which we find ourselves today.

Current market expectations reflect what I regard as an extreme level of optimism regarding the ability of the US economy to grow as the Federal Reserve normalizes (shrinks) the monetary base.

In order for the Federal Reserve to normalize the monetary base, it must sell at least $2 trillion worth of US government fixed income securities. The inevitable impact of this will be higher long-term interest rates and “volatility” in investment markets.

Why is the problematic? Well, the bear case, which I support, is that debt levels in the US are too high and can only be supported by the current regime of low interest rates. To be fair, this is not just a US problem. Over the last thirty years, the entire Western World has taken on enormous private debts. The financial crisis in 2008 saw a brief private sector deleveraging, which has subsequently been reversed, but government debts have risen dramatically in the last 7-8 years.

Can the Federal Reserve reduce the monetary base without leading to a significant and sustained private sector deleveraging and a massive fall in economic output? If it can, then the value of the US Dollar should be preserved and inflation will remain a “non-issue”. However, if it can’t, then at some point markets will realize that the long-term path of the monetary base relative to real output is much higher than expected, leading to a significant decline in the value of money. If that decline in the value of money is significant enough, then the result will be hyperinflation.

Ultimately, this is a call about the “real health” of the US economy. Is the US economy an innovation machine that will grow solidly as the monetary base is reduced? Or is the US economy merely a house of cards supported by cheap debt?

If the first case is right, then inflation should remain contained. But if the bears are right, then hyperinflation is a very real possibility.

A Model for Foreign Exchange Rate Determination

A quick survey of the economic literature on foreign exchange rate determination will demonstrate the lack of success that economics has had in developing useful models. You know things are bad when leading academic articles in the area include titles such as “Exchange Rate Models are Not as Bad as You Think” (Engel, Nelson, West, 2007).

In this article, we shall discuss a new expectations-based model for foreign exchange rate determination. While the development of this model is quite complex, we will only focus on the key aspects of the theory.

It is important to start with the basics because this approach highlights the key problem with existing models of foreign exchange rate determination, namely that they don’t start with the right economic fundamentals. More specifically, current foreign exchange rate models don’t start with a comprehensive theory of price determination, nor do they start with a sensible theory of how money derives its value.

Rather than following the orthodox approach of thinking about what might influence a foreign exchange rate and then creating a model to backfill for this result, let’s begin by thinking about what a foreign exchange rate is and build a model one step at a time.

At the most basic level, a foreign exchange rate is a price. More specifically, a foreign exchange rate is the price of one currency in terms of another currency.

Every price is a ratio of two quantities exchanged. A foreign exchange rate is a ratio of two quantities of different currencies exchanged, for example, 1.2 US Dollars for every 1 Euro.

So, what determines this ratio of exchange? What determines the price of one currency in terms of another?

The immediate challenge faced by mainstream economics is that the current orthodoxy teaches that price is determined by “supply and demand”. So, if a foreign exchange rate is just a price, then shouldn’t it be determined by “supply and demand”? But in the case of an exchange rate, there is an obvious follow up question that needs to be asked: “supply and demand for what?”

Think about the USD/EUR exchange rate? Is this exchange rate determined by supply and demand for US Dollars, or supply and demand for Euros?

Mainstream economics can’t answer this basic question. Indeed, it ties itself in knots because the mainstream view is that supply and demand for money (i.e., supply and demand the US Dollar) determines “the interest rate”. But if the mainstream view is right (supply and demand for money determines the interest rate), then clearly it can’t determine the price of money in terms of another currency. So here is a price that isn’t determined by supply and demand!?

The view of The Money Enigma is that there is a simple answer to the question above. The USD/EUR exchange rate is determined by both supply and demand for US Dollar and supply and demand for Euros.

A foreign exchange rate is a relative expression of the market value of one currency in terms of another. It depends not on the market value of just one currency, but on the market value of both currencies.

In simple terms, the US Dollar per Euro exchange rate (the price of Euros in terms of US Dollars) can rise for one of two reasons: either the market value of the US Dollar falls (you need to offer more US Dollars per Euro because each US Dollar is worth less), or the market value of the Euro rises (again, you need to offer more US Dollar per Euro, but this time because each Euro is worth more).

The diagram below illustrates how every foreign exchange rate is determined by two sets of supply and demand. Supply and demand for the primary currency determines the market value of the primary currency. Supply and demand for the measurement currency determines the market value of the measurement currency. A foreign exchange rate, the price of one primary currency in terms of another measurement currency, is a relative expression (a ratio) of the market value of the two currencies.

The key to this diagram is an understanding how the property of market value, which is possessed by both currencies, can be measured in both absolute and relative terms. A foreign exchange rate is a relative expression of the market value of two currencies. In the diagram above, supply and demand for each currency is plotted in terms of absolute market value, that is to say, in terms of an invariable unit of market value called “units of economic value” and abbreviated as “EV”.

How is a Price Determined?

Before we go further, let’s think about the concepts of “price” and “market value”. Most people believe that “price” and “market value” are synonymous, but price is just one form of measurement of the property of market value.

The view of The Money Enigma is that every price is a relative expression of the market value of two goods. In every transaction, both goods being exchanged possess the property of market value: the “price” of the transaction is a relative expression of the market value of the primary good in terms of the market value of the measurement good.

The property of market value, which is possessed by both goods being exchanged, can be measured in both absolute and relative terms. In our daily life, we measure the market value of all things in relative terms that we recognise as a “price”. But we can, at least theoretically, measure the market value of a good in absolute terms. In other words, we can measure the market value of a good in terms of an invariable measure of the property of market value.

Think about the property of “height”. We can measure height in absolute or relative terms. For example, we can measure the height of a tree in absolute terms, in terms of an invariable measure of height such as “inches” (the tree is 120 inches tall), or we can measure it in relative terms, in terms of some of other object, such as a girl (the tree is three times taller than the girl).

The problem with measuring the height of the tree in “girl terms” is that the height of the girl may change over time (her height is not a constant unit of measurement). While the challenge with relative measurement may not be such a big deal in the case of height (because heights change slowly over time), it is a big deal in the case of “market value” (the market value of a good or currency can change quickly).

The property of market value can be measured in terms of absolute or relative terms. Almost universally, we measure the market value of a good in relative terms (in terms a currency which itself possesses market value that is variable). However, we can, at least theoretically, measure the market value of a good in absolute terms, in terms of a theoretical and invariable unit of measure. The Money Enigma proposes a standard for the measurement of market value, called “units of economic value” or “EV” for short.

Once we this standard for the measurement of market value, we can use this on the y-axis to plot supply and demand for a good in terms of “absolute” market value, rather than “relative” market value (in terms of “price”).

The diagram above illustrates how every price is determined by two sets of supply and demand. Every price is a relative expression of the market value of two goods: the market value of the primary good (good A), relative to the market value of the measurement good (good B).

We can apply this general principle to the determination of “money prices”. The price of a good, in terms of money, is a function of both supply and demand for the good, and supply and demand for money.

Furthermore, we can also extend this general principle to the determination of “foreign exchange rates”, or the price of one form of money (one currency) in terms of another form of money (another currency).

Take another look at the last three diagrams. Taken together, these diagrams represent a universal theory of price determination: a theory of price determination that applies to “good/good” prices (barter prices), “good/money” prices (the standard money-based prices we see in the stores every day) and “money/money” prices (foreign exchange rates).

It is the view of The Money Enigma that the primary reason that economics fails to deliver sensible models for foreign exchange rate determination is because it does not begin with a comprehensive microeconomic theory of price determination, such as that outlined above. It can not be the case that “good/money” prices are determined by one process, “good/good” (barter) prices are determined by another and “money/money” prices (foreign exchange rates) are determined by yet another random process. Either all prices are determined by supply and demand or none are. The view of The Money Enigma is that every price is a relative expression of market value and, therefore, every price is a function of two sets of supply and demand.

While a universal theory of price determination provides a good starting point, it does not provide us with a comprehensive model for foreign exchange rate determination. Recognising that the USD/EUR exchange rate is a function of two sets of supply and demand is a good start, but it doesn’t really help those who want to forecast foreign exchanges rates.

In order to say something really useful about foreign exchange rates we need to answer the question “why does money have value?”

Why Does Money Have Value?

We have already discussed this subject at length in previous posts. A few weeks ago, we discussed this issue in general terms in a post titled “Why Does Money Exist? Why Does Money Have Value?” More recently, we discussed this issue in slightly more complex terms in a post titled “Money as the Equity of Society”.

The view of The Money Enigma is that fiat money derives its value from its status as a financial instrument. Real assets derive their value from their physical properties: financial instruments derive their value from the contractual properties. Fiat money derives its value from an implied-in-fact contract that replaced the explicit contract that previously existed when fiat money was backed by gold.

Money derives its value from this implied-in-fact contract, the implied “Moneyholders’ Agreement”. Money is a liability of society, the ultimate issuer of fiat currency. More specifically, money is a proportional claim on the future output of society.

In the context of foreign exchange rate determination, this idea is interesting because it allows us the opportunity to create a valuation model for money, in much the way one might create a valuation model for a stock

In last week’s post we discussed some of the similarities between money (the monetary base) and shares of common stock. Shares represent a proportional claim on the future residual cash flows of the business that issues them. The monetary base represents a proportional claim on the future output of the society that issues it.

Money shares another common feature with traditional equity instruments: money is a long-duration asset. Just as the value of a share of common stock depends upon expectations of long-term earnings per share growth, so the value of money depends upon expectations of long-term (20 year plus) real output per unit of monetary base growth. The reasons for the long-duration nature of money are discussed at length in The Velocity Enigma, the final presentation in The Enigma Series.

Building a Valuation Model for Money

We can use the theory that money is a long-duration, proportional claim on the output of society (“Proportional Claim Theory”) to build a valuation model for money. In essence, the principle is the same as building any other valuation model: the present value of the financial instrument (one unit of the monetary base) is equal to the discounted future benefits that the marginal possessor of that financial instrument expects to receive from its future use.

Nevertheless, there are several complexities involved in doing building a valuation model for money. First, whereas a valuation model for common stock is expressed in money terms, the valuation model for money is expressed in terms of “units of economic value”, our invariable measure of market value. [Note: you can’t build a valuation model for money that is expressed in money terms, i.e. in terms of itself]. In our model, the present market value of money, as measured in absolute terms, is equal to the discounted future absolute market value of the goods that unit of money is expected to purchase.

Second, building a valuation model for money requires us to build a probability distribution for when the marginal unit of money demanded may be spent. A share of common stock entitles its holder to a stream of future benefits, but a unt of money only entitles its holder to a slice of future benefits (one dollar can only be spent once). In practice, resolving this problem is easier than it sounds because we can leverage the theory of intertemporal equilibrium to create this probability distribution.

A third complexity is that a unit of money can be invested before it is spent: these expected, risk-adjusted investment returns need to be included in our valuation model for money (they form part of the discounted expected future benefit of receiving one unit of money today).

The end result is a valuation model for money called “The Discounted Future Benefits Model for Money”. This model provides us with a framework for thinking about what factors drive the value of a fiat currency.

The equation above states that the market value of money is a function of:

The current levels of real output, q_t
The current level of the monetary base, M_t
The current level of the general value level, V_G,t
The expected long-term growth rate of real output, g
The expected long-term growth rate of the monetary base, m
The expected long-term risk-adjusted nominal return on risk assets, i
The real discount rate applied to future consumption, d

In simple terms, the equation above suggests that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. If expectations about the long-term prospects of the economy become more pessimistic, i.e. slower output growth that is supported by higher base money growth, then the market value of money will fall.

We can put this in a more familiar context. The value of a share of common stock will fall if people believe that a company’s long-term cash flow growth will slow while share issuance will rise. Similarly, the value of money will fall if people believe that a society’s long-term output growth will slow while base money issuance will rise. In this sense, we can think of the monetary base as the “equity of society”.

Finally, we can apply this model to foreign exchange rate determination. As we discussed earlier, a foreign exchange rate is a relative expression of the market value of two currencies. The Discounted Future Benefits Model, developed in The Velocity Enigma, provides us with a model that determines the market value of an individual currency as measured in absolute terms. Therefore, all we need to do to convert this into a model for foreign exchange rate determination, (a model for the market value of a currency as measured in relative terms), is divide this model for one currency (the primary currency) by this same model for another currency (the measurement currency).

In mathematical terms, Price(EUR_USD) = Value(EUR)/Value(USD), as per our earlier two sets of supply and demand diagram (notice the formula in the red box below).

But now, by leveraging the concept that money is the equity of society, we have a model for determining the absolute market value of money that we can use to solve for both Value(EUR) and Value(USD) in the price equation above.

In essence, our new model for foreign exchange rate determination states that a foreign exchange rate depends upon long-term (20 year plus) expectations of relative future output growth, relative monetary base growth and relative expected investment returns in the two respective countries. Current levels of the monetary base and real output also matter, but in the end, changes in these current variables tend to be overwhelmed by expectations of the future path of these variables.

The key aspect to this model is that it forces us to think about what drives the absolute value of a currency. This is an important idea. Nearly all economists start from the perspective of trying to determine what moves the relative value of a currency. This model describes what moves the absolute value of a currency, a notion that can then be easily applied to understanding what might move the relative value of a currency.

…………………………….

On a personal note, I would like to take the opportunity to welcome our first child, James Robert John Heddle, who was born on Wednesday, 11^th March 2015. Jocelyn and I are thrilled and James is doing well. I would ask readers to please bear with me if The Money Enigma weekly updates seem a little less coherent than usual over the next few weeks!

Money as the Equity of Society

The view of The Money Enigma is that fiat money is a special-form equity instrument. More specifically, each unit of the fiat monetary base represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a corporation.

The idea that fiat money is an equity instrument begins with a simple observation: fiat money is a financing tool. Society has three options when it wants to fund public activities: raise taxes, issue debt (government debt) or print money. The monetary base represents a way to fund the public activities that we are not prepared to pay for with current taxes or future taxes (government debt).

We can compare this to the financing options faced by a typical corporation. Most companies face three basic choices when considering the funding of new projects: use existing cash flows, issue debt or issue equity.

The choice of issuing debt or equity for a corporation can be a complicated one, but generally it boils down to one simple issue: does the corporation want to create fixed claims against its future cash flows or variable/proportional claims against its future cash flows?

In the case of a corporation, the equity issued by that corporation has value because it is a proportional claim against the future cash flows of the company. The holder of that equity is party to a shareholders’ agreement that promises equity holders a variable entitlement to the future cash flows of that business.

The view of The Money Enigma is that society faces similar financing choices to those faced by a corporation. Moreover, the fiat money issued by society is, in essence, very similar to a traditional equity instrument issued by a corporation. More specifically, it is the view of The Money Enigma that fiat money has value because it is recognised as a proportional claim against the future output of society.

In order to understand this somewhat complicated idea, it helps to think about the evolution of money. In particular, it helps to step back and think about why fiat money exists in the first place.

Why Does Fiat Money Have Value?

A few weeks ago I published a post titled “Why Does Money Exist? Why Does Money Have Value?” In that post it was argued that fiat money was first introduced by the ancient kings to fund the kingdom when their royal treasury was running low on gold. When the kings couldn’t find enough gold or silver to pay the army, they created IOUs, pieces of paper (or other objects) that represented a direct claim on the gold in the royal treasury and issued these pieces of paper to the soldiers.

This ancient fiat money derived its value contractually. Fiat money was, by definition, not a “real asset”: it didn’t derive its value from its physical properties. Rather, it derived its value from its contractual properties, i.e. it was a “financial instrument”.

Early fiat money was governed by an explicit contract: possession of this ancient fiat money entitled the holder to x ounces of gold or silver from the royal treasury. This form of financial instrument proved incredibly popular both with those who issued them and those who subsequently used them in trade. Indeed, this financial instrument became so popular that it became the predominant medium of exchange in most societies.

Importantly, it allowed societies to cheat: spend a bit more today than they really could afford by issuing more fiat money than they could credibly back with gold reserves. The cost of this “cheating” was debasement of the currency, a process that sometimes occurred in small, gradual increments and sometimes in an outright collapse (for example, in 1933, the value of the US Dollar fell dramatically as the peg moved from $20 per ounce of gold to $33 per ounce of gold overnight).

The point is that this form of public finance became an extremely attractive option to the ancient kings and then, as time passed, to the populace itself. So much so, that at some point in the 20^th century, most developed nations decided to take fiat money to the next step: abandon the gold convertibility feature altogether.

While we take non-asset backed fiat money for granted today, it is worth considering what a radical step the abandonment of the gold convertibility feature represents.

If we go back to the beginning of fiat money, the only reason it had any value, and hence the only reason that it was accepted in exchange, was because it represented an explicit contract between the holder of money and the issuer for the issuer to deliver a certain amount of gold (a “real asset”) on request. Without this explicit promise, the fiat money would have been worth nothing.

Jump forward a few hundred years and we, as a society, decide to abandon this explicit contract. So how is it possible for fiat money to retain any value?

The popular and misguided view taught in the textbooks today is that money retained its value because, by the time the gold convertibility feature was removed, fiat money was accepted as a “medium of exchange”. In other words, fiat money has value because it did have value, even if the entire basis for that value is now defunct.

The view that fiat money has value because it is a medium of exchange is a circular argument and a form of logical fallacy. Why does money have value? Because it is a widely accepted medium of exchange. Why is money a widely accepted medium of exchange? Because it has value.

Incidentally, this circular argument sits at the heart of Keynes’ liquidity preference theory. Keynes begins his thesis on money demand by arguing that people demand money because it is (1) a medium of exchange, and (2) a store of value. But Keynes never addresses the issue of why money is a medium of exchange and a store of value. Money can only act as a medium of exchange and store of value because there is demand for it (it possesses the property of market value). Arguing that the demand for money is derived from these functions creates a circular argument that is never addressed by Keynes.

In short, the textbook view doesn’t resolve this circular argument.

The Money Enigma breaks the circular argument by providing an alternative view on how money derives its value. Rather than deriving its value from its functions, which it can only perform because it has value, money derives its value from its status as a financial instrument.

Money is a financial instrument. This means that money must derive its value contractually, even if that contract is implied. When the explicit contract was rendered null and void (the gold convertibility feature was dropped) another, albeit implied-in-fact contract must have taken its place in order for money to retain any value.

Now we get to the fun part. If money is a financial instrument, then what is the contractual agreement that is in place between the issuer of money (society) and the holders of money (individual members of society)?

What is the Nature of the “Moneyholders’ Agreement”?

Just as a shareholders’ agreement governs the contractual relationship between the issuer of common stock and the holders of that stock, so the implied-in-fact “Moneyholders’ Agreement” governs the contractual relationship between the issuer of money and the holders of money.

Since there is no explicit contract, or at least no explicit contract that is meaningful, unraveling the terms of the Moneyholders’ Agreement involves a degree of speculation. But we can at least apply the framework that is used for traditional financial instruments so that we know the right questions to ask.

Every financial instrument must possess certain characteristics in order for it to have value. First, it must entitle the holder of the instrument to some future economic benefit, a future economic benefit that the issuer has the capacity to offer. Second, it must entitle the holder to either a fixed or variable (proportional) claim against that future economic benefit.

For example, in the case of shares of common stock, each share entitles the holder to a future economic benefit (future cash flows) that the issuer (the issuing company) has, at least in principle, the capacity to offer. Furthermore, it entitles the holder to a proportional claim against that future economic benefit (the proportion of future residual cash flows each share claims varies in proportion to the number of shares issued).

Let’s think about these two characteristics and how they apply to the monetary base.

First, if base money is a financial instrument issued by society, then what future economic benefit can society offer to the holder of money? Let’s put this question another way. What does society have that it can use to pay its bills?

The answer is “economic output”.

If we circle back to the beginning of this post, we noted that society has three ways to pay its bills: taxes, debt or money. Taxes are a claim on current economic output. Government debt represents a claim on future economic output.

If society doesn’t wish to pay for current public expenditures by sacrificing current economic output, then it can issue claims against future economic output. Moreover, just as a corporate entity can issue fixed or variable claims against future cash flows, so society can issue fixed or variable claims against future economic output.

Money, the monetary base, represents a variable or proportional claim against the future economic output of society.

Now, why does this matter? The reason this should matter to economists is because we can use this idea to build a valuation model for the market value of money. In turn, the market value of money is the denominator of every money price in the economy and, therefore, the denominator of the price level.

In theory, we should be able to build an expectations-based discounted future benefits model for money just as we can build a discounted future cash flow model for a share of common stock. But there are some nuances and complications.

Those with a financial analyst background will notice one immediate difference between money and a share of common stock: 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 (you can only spend the dollar once).

This distinction creates an interesting challenge. A valuation model for money must incorporate a probability distribution for the future time at which the marginal unit of money demanded is expected to be spent. It turns out that this issue is easily resolved by the application of intertemporal equilibrium theory.

There are several other complications that are addressed at length in The Velocity Enigma, the third paper in The Enigma Series. For the sake of time, we won’t discuss these now, but those that are interested can read all about it in The Velocity Enigma, the third and final paper in The Enigma Series.

The end result is a valuation for model for money, called “The Discounted Future Benefits Model for Money” that looks very similar to a valuation model for a share of common stock. The equation below is expressed in terms of a “standard unit” or invariable measure of the property of market value. In this sense, the market value of money is measured in absolute terms.

The equation above states that the market value of money is a function of:

The current levels of real output, q_t
The current level of the monetary base, M_t
The current level of the general value level, V_G,t
The expected long-term growth rate of real output, g
The expected long-term growth rate of the monetary base, m
The expected long-term risk-adjusted nominal return on risk assets, i
The real discount rate applied to future consumption, d

In simple terms, the valuation model implies that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. If expectations about the long-term prospects of the economy become more pessimistic, i.e. slower output growth that is supported by higher base money growth, then the market value of money will fall.

Let’s put this in a more familiar context.

The value of a share of common stock will fall if people believe that a company’s long-term cash flow growth will slow while share issuance will rise.

Similarly, the value of money will fall if people believe that a society’s long-term output growth will slow while base money issuance will rise.

In this sense, money is very similar to any other equity instrument. The value of any particular fiat currency is ultimately a bet on the true prosperity of the society that has issued it.

Finally, I will leave you with two more slides. The slides below illustrate the critical end result: an expectations-adjusted quantity theory of money. While the price level does depend to some degree upon current levels of real output and base money, it is expectations of the long-term path of these variables that is critical to the determination of the price level.

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.

Share this:

Share this:

Share this:

Share this:

Share this: