Monthly Archives: May 2015

Has the Fed Created the Conditions for a Market Crash?

NOT INVESTMENT ADVICE

Has the Federal Reserve inadvertently created the perfect conditions for a stock market crash? Over the past few years, many market commentators have accused the Fed of “blowing bubbles”, i.e. using monetary policy to feed the speculative market environments that enabled both the Nasdaq bubble of 1999-2000 and the US housing bubble of 2006-2007. But has the Fed’s experiment with quantitative easing set up equity markets for a historic fall in the next few years? Will the Fed be held responsible for the next share market crash?

The view of The Money Enigma is that the Federal Reserve has backed itself into a corner, at least in regards to financial market conditions.

If the Federal Reserve makes any concerted attempt to reduce the monetary base, then this will raise the required rate of return on capital across all global markets, triggering a major sell off in both bond and equity markets. Just as quantitative easing drove down the cost of capital (as explicitly desired by Ben Bernanke), so reversing quantity easing will drive up the cost of capital, thereby placing downward pressure on the price of all risk assets.

Conversely, if the Fed does not reduce the monetary base, then high-single digit inflation will return, an event that will create chaos in markets that are priced to achieve very low rates of nominal returns. The view of The Money Enigma is that inflation has been kept in check over the past few years because the increase in the monetary base has been perceived as “temporary”. However, if market participants begin to believe that the US economy is addicted to these higher levels of base money, then confidence in the long-term economic future of the United States will suffer and inflation will return.

The Recipe for a Stock Market Crash

While every commentator will have a slightly different view on the exact mix of conditions that are required for a stock market crash, the basic recipe is fairly straightforward.

As a general rule, in order set up the right environment for a stock market crash, you need to create a situation of extreme overvaluation across a fairly broad range of stocks: certainly not all stocks, but enough to matter.

This is harder than it sounds.

While overvaluation in certain segments of the stock market is a fairly routine occurrence, extreme overvaluation of large portions of the stock market is not. While there is much debate in academic circles about whether “markets are efficient”, there should be no doubt that markets are efficient in the sense that people aren’t stupid. Very few people will intentionally rush out to buy a business for more than it is worth. Therefore, in order to convince lots of people to buy a wide range of businesses for more than they are worth (at least, more than they are worth in retrospect) requires a special set of conditions.

First, you need a strong fundamental catalyst: a new “reality” that forces investors to think differently either about the future prospects of a wide range of businesses, or justifies, at least temporarily, a lower required rate of return on risk assets.

Second, you need to create a set of flawed expectations: a series of new “myths” that allow investors to justify ever-increasing valuations. These myths encourage new investors to buy into the excitement and lull existing investors into a false sense of complacency.

In this sense, the recipe for a stock market crash nearly always involves a mixture of “myth” and “reality”. The recipe for a market crash of historic proportions requires a small dose of reality and a large dose of myth. It is this potent mixture that allows stock market valuations to climb to extremes. Moreover, it is the large helping of “myth” in the mixture that sets up the perfect conditions for a sharp reversal of fortune.

A classic example of this phenomenon is the technology bubble of the late 1990s.

There is no doubt that the technology bubble of 1990s started with a set of important realities: dramatic advancements in semiconductor and computing technology that enabled a corresponding advancement in software and networking technology. These advancements reached a critical tipping point when they enabled the development of the Internet.

The Internet represented an important paradigm shift not just for the technology industry but for the way all businesses operate. Looking back today, some of the early projections about how business would migrate to the Internet were quite conservative. In this sense, the technology bubble of the 1990s was born of an important reality.

While this reality may have set the foundation for the rise in technology stocks, the mania that developed in technology stocks required the invention and propagation of several myths. Basic finance theory was thrown out of the window, as new myths developed regarding how business model success should be measured and how such “success” should be valued. Suddenly, “eyeballs” mattered more than sales and sales mattered more than profits. Moreover, many investors seem to feel that the paradigm shift was so strong that basic business cycles were a thing of the past: demand for networking equipment and IT services would grow at double digit rates every year.

At some point in the year 2000, the myths began to pop. At first it was recognized that a few very silly Internet-based business ideas wouldn’t make it. Then, the realization began to hit that the panic spending on IT would, at some point, begin to subside.

The Nasdaq lost over 80% of its value from peak to trough. All this time, the “reality” never changed: the Internet has dramatically altered the way we all live and do business. But the myths that surrounded the early development of the Internet and began to implode.

Today, global markets are caught up in what I believe is another highly speculative environment. This speculative environment is more insidious than the technology bubble of the late 1990s because it involves far more assets classes: sovereign bonds, corporate bonds, equities, venture capital, private equity, real estate and fiat currencies. In this sense, it makes it much harder to identify the “bubble” because it is harder to see the bubble in any given asset class on a relative basis: it is not clear that stocks are dramatically overvalued compared to bonds or that private equity is any more speculative than venture capital.

However, the view of The Money Enigma is that there is a high level of broad based speculation across all asset classes. This speculative environment has been generated by the actions of the Federal Reserve and the other major central banks. In particular, it has been created by the reality and the myths that surround the now widely adopted program of quantitative easing. The key for investors today is being able to distinguish between the important reality that drove markets higher initially and the myths that are sustaining current speculative conditions.

Quantitative Easing: Distinguishing between Myth and Reality

The current speculative environment in global markets is a function of one reality and two myths regarding the massive expansion of the monetary base otherwise known as quantitative easing.

Let’s begin with the reality: a massive and sudden expansion of the monetary base that is used to buy sovereign bonds will drive down the required rate of return across all risk assets and, all else remaining equal, will drive up the price of those same risk assets.

For those not familiar with how financial markets operate it may seem surprising that buying government bonds will force up the price of equities. After all, what does the price of government bonds have to do with the price of stocks? The answer is “everything”.

There are two ways to think about this: we can think about it in theoretical terms or in more practical terms.

In theoretical terms, the market value of a business is determined by the net present value of future cash flows that investors expect to receive from that business. Note the use of the term “present value”: $100 in ten years is not worth the same as $100 today. Therefore, we need to discount expected future cash flows using a discount rate to covert those future cash flows into their present value equivalent.

While the discount rate that we use to calculate net present value will vary between one business and another, depending upon the nature of that business, the discount rate is always some function of the “risk-free” rate. The “risk-free” rate is the required rate of return from a risk free investment. Theoretically, the calculation of a discount rate for a business always begins with this “risk-free rate” which acts as the foundation rate upon which other discount rates are built.

In our modern society, it is widely accepted (at least at the present moment) that the risk-free rate is best proxied by the interest rate on government bonds. Therefore, if central banks create money and use this money to buy government bonds, then this forces down not only the interest rate on government bonds, but forces down the risk free rate which is used as the baseline for all risk asset valuations.

The valuation of a long-duration risk asset is highly sensitive to the long-term discount rate and, therefore, the risk-free rate. Moreover, the valuation of the stock market is much more sensitive (at least in principle) to the risk-free rate than to near term business conditions. This is an important point that we will return to shortly.

We can also think about this issue from a more practical perspective.

Government bonds, corporate bonds and equities are, at least to some degree, substitutes for each other. They are not perfect substitutes, but they are substitutes.

If the Federal Reserve begins to buy lots of government bonds and forces down the interest rate on government bonds, then this will induce investors who invest in both government and corporate bonds to seek higher yields in corporate bonds. At the margin, the Fed’s “investment” in the government bond market crowds out private investors in the government market. These investors turn to the next best substitute: corporate bonds.

In turn, this forces down the yield of corporate bonds. Those investors who invest across the corporate spectrum (corporate bonds and equities) will now, at the margin, chase the higher expected return in equities, forcing up the price of equities.

In this way, the Fed’s actions create a domino effect across all asset classes: investors shift from government bonds to corporate bonds, corporate bonds to low-risk equities, low-risk equities to high-risk equities, high-risk equities to venture capital.

In more technical terms, the massive expansion of the Federal Reserve’s balance sheet lowers the required cost of capital across all asset classes, stimulating higher prices across the entire spectrum of risk assets.

At the margin, this whole process has had a positive effect on the economy. By lowering the required cost of capital for all investments, more investment activity has been stimulated: the shale oil boom, the biotech boom, the pick up in small business activity are all, in part, a function of a lower cost of capital.

This is the reality of quantitative easing.

Now, let’s discuss the myths.

The market has created two myths regarding quantitative easing that have been absolutely critical in sustaining the positive momentum that the equity markets have enjoyed over the past few years. So, what are these two myths?

Myth #1: If the Federal Reserve begins to reverse quantitative easing (reduces the monetary base), then the underlying strength in the economy at that time will offset any weakness that occurs because of tightening “liquidity conditions”.

Myth #2: If the Federal Reserve does nothing and leaves the monetary base at the current exceptional levels, then there will be no adverse inflationary outcome. More specifically, inflation is caused by “too much demand”, so it doesn’t matter if the Fed leaves the monetary base where it is, as long as the economy doesn’t “overheat”.

The Federal Reserve has done little to discredit either of these myths. The reticence of the Fed to even discuss a significant reduction in the monetary base suggests that the Fed understands that the first myth is a falsehood. The Fed seems desperately keen to invent new reasons for why a “normalization” of monetary policy is not required “at this time”. (Ever notice how the Fed’s “natural rate of unemployment” target keeps getting lowered?) I doubt there is one single member of the FOMC who wants to be on the FOMC the day that a surprise reduction in the monetary base in announced. After all, “you break it, you own it” and who wants to “own” a broken stock market?

More worryingly, the Federal Reserve has done nothing to dispel Myth #2. In regard to this point, it may be that the Fed really believes its own myth. The notion that “money doesn’t matter” and that “inflation is caused by too much demand” is a fashionable idea in mainstream economics. The view of The Money Enigma is that this New Keynesian approach to the issue of inflation is fundamentally flawed and that if the monetary base is allowed to stay at these levels, then inflation will surely accelerate.

We have discussed the relationship between money and inflation at length over the past few months (for example, see “Does Too Much Money Cause Inflation?” or “Why is There a Lag Between Money Printing and Inflation?”) and we will touch on it again in a moment. But before we do, let’s discuss Myth #1.

Myth #1: Stocks Won’t Fall if the Fed Reverses QE

Myth #1 is a favorite of the chattering class on CNBC who don’t understand the fundamentals of equity valuation. In essence, their argument is that when the time comes to reduce the monetary base (by the way, when is that?) the economy will be strong enough that investors will look past the fact that long-term interest rates are rising: rather, investors will focus on strong near-term earnings.

So, here is a simple theoretical question? Is the value of a long-duration asset more sensitive to (a) changes in near term cash flows, or (b) changes in the long-term discount rate?

The answer is (b).

Clearly, the answer depends slightly on definitions (e.g., how do we define “near-term”?) but the principle is simple. The value of a business depends upon the sum of an expected stream of discounted future cash flows. The net present value of a business is only marginally impacted by a 10% change in the expected cash flows that will be produced in the next one or two years.

However, what happens if the discount rate rises by 10%? A rise in the discount rate impacts the present value of all future cash flows, not just the value of future cash flows that are expected this year and next, but the value of cash flows that are expected to be received 10, 20 and even 30 years from now.

If the Federal Reserve reverses quantitative easing, then, all remaining equal, the interest rate on government bonds will rise, the risk-free rate will rise and the required cost of capital for all risk assets will rise. The negative impact this will have on the valuation of risk assets will far outweigh any marginal benefit to near-term earnings from a strong economy.

Discussion regarding “tightening liquidity conditions” miss the point: yes, it won’t help the stock market when bond and equity investors suddenly need to sell a trillion or two in corporate debt and equity in order to buy government bonds from the Fed. But more fundamentally, the issue is one of valuation. As the Fed reverses QE, the required rate of return on capital will rise across the entire spectrum of risk assets and, all else remaining equal, the net present value of stocks will fall.

Myth #2: The Size of the Monetary Base Doesn’t Matter to Inflation

Myth #2 is more pernicious than Myth #1 and, unfortunately, is much harder to debunk. Dissecting and dismantling Myth #2 requires us to revisit the very foundations upon which the science of economics is built. More specifically, we need to fully reexamine (a) how prices are determined, and (b) the nature of money. The Money Enigma is dedicated to both of these topics and we have explored each at length over the past few months. Clearly, we don’t have time to cover all this ground today, but we shall touch on a few core concepts.

Before we do, let’s start with a simple observation: “money isn’t free”.

Government and it agencies, most notably the central bank, are empowered by our society to “create money” (expand the monetary base). In this sense, the central bank can create something of value “out of thin air”. However, this does not mean that creating money has “no cost”.

If there was no fundamental economic cost associated with the creation of money, then there would no constraint on how much money our society creates and no limit to our prosperity: we would simply keep the printing presses rolling until everyone had everything they ever wanted.

So, what is the cost associated with money creation? At the most basic level, the economic cost associated with creating money is a decline in the value of that money and a commensurate rise in the price of all goods as measured in terms of that monetary unit.

Now, this is not a simple process. While the long-term relationship between the “money/output” ratio and the price level is well established, there is no simple or predictable short-term relationship between the size of the monetary base and the value of money.

For example, over the past six years, the Federal Reserve has quintupled the monetary with little to no impact on the value of the US Dollar or consumer prices in the United States.

Many commentators seem to believe that since the expansion of the monetary base in the past six years has not produced high levels of inflation, we are safe to assume that the link between the “money/output” ratio and the price level is “broken”. In other words, many seem to believe that the quantity theory of money, one of the strongest long-term empirical relationships ever demonstrated in economics, is now defunct.

The view of The Money Enigma is that the long-term relationship between money and prices is well and truly alive. Moreover, the longer the Federal Reserve delays a “normalization” of monetary policy, the greater the risk that inflation accelerates.

So, what explains the subdued levels of inflation that we are currently experiencing? Why does inflation lag monetary expansion, in some cases by many years?

In order to understand why the price level doesn’t immediately jump as soon as the Fed prints money, we need to understand a couple of key concepts.

First, we need to understand how the price of a good, in money terms, is determined. The view of The Money Enigma is that every price is a relative expression of market value. The price of a good, in money terms, depends upon (1) the market value of the good, and (2) the market value of money. The price of a good, in money terms, can rise either because (1) the market value of the good rises, or (2) the market value of money falls.

For example, if one apple is three times more valuable than one dollar, then the price of an apple, in dollar terms, is three dollars. This relative value differential can be impacted by a change in either the value of the apple or the value of the dollar. All else remaining equal, if the value of one dollar falls, then one apple will become more valuable relative to one dollar (even if the value of the apple itself has not changed when measured in absolute terms) and the price of one apple, in dollar terms, will rise.

[Economics struggles with this simple concept because economics has not developed a “standard unit” for the measurement of market value and, consequently, doesn’t appreciate the difference between the absolute and relative measurement of market value. This issue is explained at length in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”, a post which I strongly encourage everyone to read.]

We can extend this microeconomic theory of price determination to a macroeconomic theory of price level determination.

The view of The Money Enigma is that the market value of money is the denominator of every money price in the economy and hence is the denominator of the price level. All else remaining equal, as the market value of money falls, the price level rises.

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

This is a complicated subject and one that has been discussed at length in two recent posts: “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, derives its value from its contractual features. More specifically, fiat money is long-duration, special form equity instrument that represents a proportional claim on the future output of society.

Consequently, the value of fiat money is primarily dependent upon expectations regarding the long-term path of both real output and the monetary base. If the market expects long-term real output growth to be strong, then this supports the value of the fiat money issued by that society. Conversely, if the market expects long-term monetary base growth to accelerate, then the value of fiat money will fall.

Now, let’s think about what this theory might mean in the current environment.

The view of The Money Enigma is that an increase in the monetary base that is perceived to be “temporary” will have little to no impact on the value of fiat money. Why? The value of money depends upon expectations of the long-term path of real output relative to the monetary base. A change in the current level of the “real output/monetary base” ratio only impacts the value of money to the degree that it leads to a shift in long-term expectations regarding that ratio. Conversely, an increase in the monetary base that is perceived to be more “permanent” in nature will have a considerable impact on the value of money.

The reason that QE has not triggered a fall in the value of money and a rise in the price level is because the market perceives QE to be a “temporary” phenomenon. Over the past six years, quantitative easing has been routinely represented as an “emergency measure”: an extraordinary policy for an extraordinary time. Almost by definition, emergency measures are temporary actions (we can’t live in a permanent state of emergency).

Despite the many delays in “normalizing” monetary policy, the markets still seem to be convinced that the recent expansion in the monetary base is “temporary” in nature.

The question that no one wants to discuss is what happens if the “temporary” expansion in the monetary base becomes more “permanent” in nature? Moreover, what happens if instead of reducing in the monetary base, the Fed is forced to further expand the monetary base?

The view of The Money Enigma is that either of these scenarios will lead to a loss of confidence in the long-term prospects of the US economy, a fall in the value of money and a significant rise in the price level.

A return to high single digit inflation rates would represent another bad scenario for global stock markets: risk assets that are priced to achieve low nominal rates of return don’t respond well to a sudden acceleration in inflation.

In summary, the Federal Reserve has backed itself into a corner. If it reverses quantitative easing, then risk assets are likely to perform poorly as the required return on capital rises across the entire risk spectrum. However, if the Fed fails to reverse quantitative easing, then inflation will accelerate, a scenario for which global investors are not prepared.

Does “Too Much Money” Cause Inflation?

Does money have any role in the determination of inflation? Does printing too much money cause inflation? And what does it mean to say “too much money”? “Too much” relative to what?

Milton Friedman once famously observed, “Inflation is always and everywhere a monetary phenomenon”. Less well known is his qualification to this statement. Friedman’s full observation was “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (Friedman, “Money Mischief”, page 49)

Friedman’s qualification helps us narrow down our original question to the following, “Does too much money, relative to output, cause inflation?” Alternatively, we could ask, “Does growth in the monetary base that is significantly in excess of growth in real output cause inflation?”

Empirical evidence strongly suggests that, when measured over long periods of time, growth in the monetary base that is significantly in excess of growth in real output does lead to a concomitant rise in the price level. In this sense, Friedman’s observation appears to be correct.

However, over short periods of time, this relationship does not appear to hold. For example, over the past six or seven years, the monetary base of the United States has quadrupled, while real output has grown only modestly: yet the price level has barely moved higher.

So, why is this the case? Why does the quantity theory of money work over long periods of time, but not over short periods of time?

The view of The Money Enigma is that, over short periods of time, the primary driver of inflation is not the change in the current ratio of “base money/real output”, but the change in the expected 20-30 year future ratio of “base money/real output”. In other words, it is not the current level of growth in money relative to output that matters, but rather the expected long-term future growth of money relative to output that matters.

In this sense, it is not “too much money” that causes inflation, but the expectation of “too much money” being created over the next 20 years that matters.

Why might market participants suddenly expect a society to create too much money (relative to output) in the future? There are many possible reasons, but obvious reasons might include war, a secular decline in productivity, economic mismanagement, or just the sudden realization that a country has been living way beyond it means.

Inflation and the value of money

In the academic world, fashions come and go. In the late 1960s and early 1970s, there was much discussion about the role of money in the determination of inflation, a discussion that was led by the great minds of that time including Milton Friedman, Anna Schwartz and Philip Cagan.

Fast forward nearly fifty years, and it is not fashionable to discuss the role of money in the determination of the price level. Indeed, there is a view among many economists (notably, New Keynesian economists) that money is almost irrelevant to the discussion and that the size of the monetary base is only important in so far as it influences interest rates.

This is despite the fact that one of the strongest empirical relationships in economics remains the long-term correlation between the price level and the ratio of base money to real output. As Friedman once put it, inflation “…is and can be produced only by a more rapid increase in the quantity of money than in output.” This sentiment is clearly supported by the long-term data.

So, why is there such a disconnect? Why do academic economists largely dismiss the important role that the money/output ratio has in the determination of inflation?

First, the correlation between the price level and the money/output ratio breaks down in the short term. Although the quantity theory of money is valid over very long periods of time, it doesn’t work over short periods of time. Therefore, most economists feel comfortable ignoring quantity theory in their short-term forecasting of inflation.

Second, mainstream economics does not recognize the important role that the value of money plays in the determination of the price level. According to the orthodox view, the “value of money” has nothing to do with price determination!

Indeed, mainstream economics does not officially recognise the “market value of money” as a variable in any of its equations. Mainstream economics does not recognise the “market value of money” as a relevant economic variable because the view of mainstream (Keynesian) economics is that supply and demand for money determines the interest rate.

The view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money (not the interest rate). In turn, the market value of money is the denominator of every money price in the economy and, therefore, is the denominator of the price level.

This general issue was discussed in a recent post titled “The Interest Rate is Not the Price of Money“. But rather than dwell on Keynesian theory, let’s briefly discuss how prices are determined at both a micro and macro level and then use this to continue with our discussion of the relationship between money and inflation.

What is a “price” and how is a price determined?

Price determination is a subject that we have discussed extensively over the past few months, so I don’t want to dwell on it in this post. We will discuss the basic principles today, but if you want more detail you should read the following posts:

“Every Price is a Function of Two Sets of Supply and Demand” (01/20/15)

“The Measurement of Market Value: Absolute, Relative and Real” (04/21/15)

“A New Economic Theory of Price Determination” (04/28/15)

In simple terms, the view of The Money Enigma is that every price is a relative expression of the market value of two goods.

Consider a simple exchange of two goods. Both goods must possess the property of market value in order for them to be exchanged. The price of the exchange simply measures the market value of one good in terms of another: the market value of a “primary good” in terms of the market value of a “measurement good”.

In our modern money-based economy, the measurement good most commonly used is money. The price of a good, in money terms, simply reflects the market value of the good relative to the market value of money. For example, if the price of a banana is $2, then we can say that the market value of one banana is twice the market value of one dollar.

The key point is that the price of a banana, in money terms, is a relative measure of value: it is determined not just by the market value of the banana (which can rise and fall) but also the market value of money (which can also rise and fall). If the market value of money falls, then, all else remaining equal, the price of the banana in money terms will rise.

In this sense, the market value of money is the denominator of every “money price” in the economy. In mathematical terms, the price of a good, in money terms, is a ratio of the market value of the good divided by the market value of money.

The trick to expressing this in terms of mathematical formula is recognizing that market value can be measured in the absolute. Just as we can measure any physical property in the absolute by using a “standard unit” of measurement for that property, so market value can be measured in the absolute by using a “standard unit” of measurement for market value.

The height of a tree can be measured using a standard unit for the measurement of height, namely “inches”. An “inch” is an invariable measure of the property of height. In economics, we can create an invariable measure of market value: a standard unit” for the measurement of market value that possesses the property of market value and is invariable in this property. Since no good exists that is invariable in market value, we need to create a theoretical measure, called “units of economic value”.

Once we have a standard unit for the measurement of market value, we can measure the market value of both goods being exchanged in terms of this standard unit. In other words, we can measure the market value of both goods in absolute terms.

This raises an obvious question: how is the market value of a good determined? In this respect, we can adapt an old paradigm: the market value of a good is determined by supply and demand for that good. If we plot supply and demand for each good in terms of our standard unit of market value, then we can see that the price of the primary good (good A) in terms of the measurement good (good B) is a function of two sets of supply and demand.

Supply and demand for the primary good (good A) determines the market value of the primary good. Supply and demand for the measurement good (good B) determines the market value of the measurement good. The price of the primary good in terms of the measurement good (the price of A in B terms) is the ratio of the market value of the primary good divided by the market value of the measurement good. This is a universal theory of price determination that we can apply to the determination of barter prices (good/good prices), money prices (good/money prices) and foreign exchange rates (money/money prices).

In a money-based economy, the price of a good, in money terms, is determined by the ratio of the market value of the good divided by the market value of money.

We can extend this microeconomic principle to a macroeconomic description of price level determination. If the market value of money is the denominator of every “money price” in our economy, then the market value of money is the denominator of the price level. (Remember, the price level is nothing more than a hypothetical measure of overall money prices for the set of goods and services that comprise the “basket of goods”.)

Once again, if we measure the overall market value of goods and services in terms of a standard unit of market value and denote this as V_G, and we measure the market value of money in terms of the same standard unit and denote this as V_M, then the price level is simply a ratio of V_G and V_M.

Ratio Theory of the Price Level simply states that the price level depends upon both the overall market value of the basket of goods and services and the market value of money. If the market value of the basket of goods and services is relatively stable over time, then the price level will be primarily determined by the direction of the market value of money. If the market value of money falls significantly over time, then the price level will rise significantly over that same period of time.

The determination of the market value of money

The view of The Money Enigma is that the market value of money is the denominator of every “money price” in the economy: the price of a good, in money terms, depends upon both the market value of the good and the market value of money.

If this theory is correct, then the market value of money plays a critical role in the determination of the price level and inflation. So, what determines the market value of money?

We have already hinted at part of the answer: supply and demand.

If every price is a function of two sets of supply and demand, then every money price must be a function of two sets of supply and demand. More specifically, the price of good A, in money terms, depends upon both supply and demand for good A and supply and demand for money (the monetary base).

As discussed in the introduction, the view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money, not the interest rate. (The interest rate is determined by supply and demand for loanable funds).

While this might be an interesting first step, it really doesn’t tell us much about the factors that influence the value of money. In order to understand the specific factors that determine the market value of money, we need to develop a deeper understanding of what money is.

Over the past two weeks, we have discussed the nature of fiat money at length. In the first post, “The Evolution of Money: Why Does Fiat Money Have Value?” we traced the evolution of money from “commodity money” to “representative money” and finally to “fiat money”.

In that post, it was argued that representative money derives its value from an explicit contract: representative money is just a piece of paper that promises the holder of that piece of paper a real asset (normally, gold or silver) when that piece of paper is presented to its issuer.

When the gold/silver convertibility feature was removed, i.e. when the explicit contract was rendered null and void and the representative money became fiat money, the explicit contract was replaced by an implied-in-fact contract. In this way, fiat money derives its value contractually. Every asset derives its value from its physical properties (it is a real asset) or from its contractual properties (it is a financial instrument). Fiat money is not a real asset. Therefore, fiat money must be a financial instrument that derives its value from its contractual features.

The nature of the implied contract that governs fiat money was explored in a second post, “What Factors Influence the Value of Fiat Money?” While it is difficult to speculate on the exact nature of the implied contract, we can leverage finance theory to guide us in the right direction.

The view of The Money Enigma is that fiat money is a special-form, long-duration equity instrument issued by society. More specifically, fiat money represents a proportional claim on the future output of society.

And this brings us to the crux of the issue: what determines the value of fiat money and, consequently, the level of money prices in the economy?

If money is a proportional claim on the future output of society, then its value depends, at least primarily, upon future expectations of (1) real output, and (2) the size of the monetary base. Moreover, if money is a long-duration asset, then its value depends upon expectations regarding the long-term (20-30 year) path of these two important variables (real output and base money).

If the market suddenly decides that long-term (20 year) real output growth will be higher than previously anticipated, then the value of a proportional claim on that future output should rise (the market value of money should rise). All else remaining equal, the value of money will rise and the price level will fall.

In this example, there has been no change in current levels of real output or the monetary base, yet the price level has fallen. Why? The price level falls because it depends on the market value of money (the market value of money is the denominator of the price as per “Ratio Theory”). In turn, the market value of money depends upon long-term expectations. Current conditions really only matter to the market value of money to the degree that they impact expectations of long-term conditions. This is true of the value of any long-duration asset: current conditions are only important to the value of a long-duration asset in so far as they impact long-term expectations.

Now, let’s consider what happens if the market suddenly decides that the long-term growth rate of the monetary base will be much higher than previously anticipated. If money is a proportional claim on output, then more claims at some future point will mean that every claim is entitled to a smaller proportionate share of output at that future point. If the market decides that the future value of money will be lower, then this will have an immediate negative impact on the current value of money. Why? In simple terms, the market value of money depends upon a chain of future expectations regarding the future value of money.

Admittedly, this is a complicated concept and one that is explored in much greater detail in The Velocity Enigma, the third and final paper of The Enigma Series.

The key point that I wish to highlight is that, if proportional claim theory is correct, then the current market value of money depends upon the expected long-term path of both real output and the monetary base. Furthermore, since the market value of money is the denominator of the price level, the price level itself also depends upon the expected long-term path of both real output and the monetary base.

Bearing this in my mind, let’s return to our original question.

Does “too much money” cause inflation?

There can be little doubt that, over long periods of time (30 years+), growth in the monetary base that is greatly in excess of growth in real output will lead to a rise in the price level. There is strong empirical support for this observation.

This observation sits neatly with the theory that money is a proportional claim on the output of society. Over long periods of time, if the number of claims on output grows at a substantially faster rate than output, then the value of each claim should fall. In other words, if the monetary base grows at a substantially faster rate than output, then the market value of money should fall and the price level should rise (the market value of money is the denominator of the price level).

On the other hand, there is also compelling evidence to indicate that, over short periods of time, a dramatic increase in the monetary base can have little to no impact on the market value of money, even if the increase in the monetary base dwarfs any increase in real output during that same period of time.

This phenomenon has always been harder for economists to explain, but it can be explained by the theory that money is a special-form equity instrument and a long-duration, proportional claim on the future output of society.

If money is a long-duration, proportional claim on output, then the value of money will only be sensitive to changes in current levels of real output and the monetary base to the degree that changes in current levels impact expectations regarding the long-term path of both real output and the monetary base.

We can use a simple analogy from finance: the value of shares. The value of a share of common stock depends on the expected future cash flows that will accrue to the holder of that share. More specifically, a company’s stock price depends little on current earnings or current shares outstanding. Rather, the stock price is determined by expected long-term earnings per share. Therefore, it is the long-term path of both net earnings and shares outstanding that matter to the current value of a share of common stock.

Similarly, money is a long-duration asset and its value is primarily driven by expectations of the long-term real output/base money ratio, not by the current real output/base money ratio.

This has one important implication regarding market perception of monetary policy and its impact on inflation. If the market believes that a sudden rise in the monetary base is only “temporary” (it will be reversed in the next few years), then such an increase in the monetary base should have little to no impact on the value of money and, therefore, little to no impact on the price level.

However, if the market believes that a sudden rise in the monetary base is more “permanent” in nature, then that increase in the monetary base should lead to a fall in the value of money and a rise in the price level.

The view of The Money Enigma is that the dramatic increase in the monetary base in the United States has had little impact on the market value of the US Dollar (and little impact on the price level) because market participants believe that the increase is “temporary” in nature.

In slightly more sophisticated terms, the extraordinary actions of the Fed have not changed the market’s view regarding the long-term (20-30 year) path of the real output/base money ratio. Most market participants remain optimistic that real output will grow at solid rates for he next 30 years, even while the monetary base is reduced or at least capped at current levels. This has put a floor under the value of the US Dollar and a lid on the price level.

However, what happens if market expectations change? What will happen if the market becomes more pessimistic regarding the long-term economic prospects of the United States?

If market participants begin to believe that the Fed is unwilling or unable to reduce the monetary base, then this shift in expectations will begin to put downward pressure on the value of money and upward pressure on the price level. This fall in the value of money will be compounded if the market becomes more pessimistic about the long-term rate of real output growth in the United States. If this were to occur, then a return to double-digit levels of inflation is quite possible.

What Factors Influence the Value of Fiat Money?

Fiat money possesses the property of market value. Fiat money must possess this property in order for it to act as a medium of exchange. But what determines the market value of fiat money? Why does the value of fiat money fluctuate and tend to fall over long periods of time? Moreover, why does the value of a fiat currency sometimes fall sharply in a short period of time?

In last week’s post, we asked the question: “why does fiat money have value?” After all, fiat money is nothing more than a piece of a paper with pictures on it. Why does something with so little intrinsic/physical value have any value at all?

In this week’s post, we will attempt to answer an even more difficult, but related question: “what determines the value of fiat money?” In order to do this, we will discuss the nature of the implied contract that governs fiat money.

As discussed in last week’s post “The Evolution of Money: Why Does Fiat Money Have Value?” the view of The Money Enigma is that fiat money is a financial instrument and derives its value contractually.

All assets are either real assets or financial instruments. Real assets derive their value from their physical properties. In contrast, financial instrument derive their value from their contractual properties.

The first form of money used in most societies was commodity money. This early commodity money was a real asset and derived its value from its physical properties.

Over time, paper money was introduced. Originally, paper money was nothing more than an explicit contract that promised to its holder some weight of commodity money such as gold coin. This “representative money” derived its value from its contractual properties (it was a promise to deliver something of tangible value).

At some point, the explicit contract that governed paper money was rendered null and void. So why did paper money retain any value? The view of The Money Enigma is that the explicit contract governing paper money was replaced by an implied-in-fact contract between the issuer of money (society) and the holders of money.

By exploring the nature of this implied contract, the “Moneyholders’ Agreement”, we can begin to build a better picture of which factors influence the value of money. Furthermore, we use this perspective to think about why the value of fiat money tends to fall over time.

In simple terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. Over long periods of time, an increase in the monetary base relative to real output will reduce the value of the proportional claim and lead to rising prices across the economy. We have seen this pattern exhibited repeatedly across most Western economies over the past fifty years.

Over short periods of time, expectations regarding the future path of the monetary base and real output are critical to the value of money. If people become more optimistic about the growth of future output, then the value of money will rise. Conversely, if people become less optimistic and believe that more money will have to be created to support the same level of future output growth then the value of money will fall and the price level will rise.

The Fiat Money Enigma

“Why does this asset have value?”

In the case of most assets, this isn’t a difficult question to answer. If we choose almost any asset at random, then we can answer this question by applying a simple paradigm: every asset is either a real asset, it derives its value its physical properties, or it is a financial instrument, it derives it value from its contractual features.

For example, land is a real asset that derives its value from its physical properties: its owner can grow crops or build shelters upon it. In contrast, a corporate bond is a financial asset that derives its value from its contractual properties: it entitles its holder to a fixed stream of future cash flows.

This paradigm provides us with a simple way to think about how any asset derives its value. Furthermore, this simple paradigm can be easily applied to early forms of money, namely commodity money and representative money.

Commodity money is a commodity that is used as a medium of exchange. The most obvious example of commodity money is gold. Commodity money is a real asset and derives its value from its physical properties.

Representative money is paper money that represents a claim against the issuer of that paper for a certain amount of a commodity on request. Stated in slightly different terms, possession of representative money makes the holder of that money party to an explicit contract that promises the delivery of a certain amount of a real asset.

The most obvious example of representative money is paper money that issued under a gold standard. In the case of the gold standard, each note issued was an explicit promise by the issuer of that note to deliver a certain amount of gold on request.

From the perspective of our “real versus financial asset” paradigm, representative money is a financial instrument. Representative money is an asset that derives its value from its explicit contractual properties.

The point is that we have one simple paradigm that can be used to explain why an asset, any asset, has value. Furthermore, this paradigm can be usefully applied to early forms of money, both commodity money and representative money.

Now, let’s ask the question: “why does fiat money have value?”

Surely, the best place to start in any attempt to answer this question must the simple “real assets/financial instruments” paradigm? After all, this paradigm seems to explain why almost any asset has value, including all the early forms of money.

Despite the strength and logical simplicity of the paradigm, most economists chose to ignore it in their analysis of fiat money. Rather, economists prefer to treat fiat money as something special, almost magical: an asset that is so unique and enigmatic that it is automatically considered to be an exception to the simple paradigm that applies to every other asset, including the early forms of money that preceded fiat money.

The problem is that by ignoring this paradigm, economists have been forced to venture into unchartered and dangerous intellectual territory. After all, if an asset doesn’t derive its value from its physical properties and it doesn’t derive its value from its contractual properties, then how does it derive its value?

Inevitably, economists have created “solutions” to this problem that seem to make sense at a superficial level, but quickly fall apart once you scratch the surface. One of the best examples of this is Keynes theory of demand for money as espoused in his “General Theory of Employment, Interest and Money”.

If you cut through all the flowery language used by Keynes, his key thesis is that demand for money depends on its usefulness as a medium of exchange and its relative attractiveness as a store of value.

Superficially, this sounds plausible. Money is useful as a medium of exchange and we do use it as a store of value. Therefore, one might be tempted to argue, as Keynes does, that the reason money has value (the reason there is demand for money) is because it performs these functions.

The problem with this argument is that it fails to recognize why money can perform its function in the first place. The only reason money can act as a medium of exchange is because money has value. Similarly, the only reason money can act as a store of value is because money has value!

You can’t build a theory of demand for money based upon its functions: money can only perform its function because there is demand for it! If you rely on the functions of money to generate demand for money (i.e. the functions of money are the mechanism by which money derives its value), then you have created a circular and fallacious argument.

Fortunately, there is a better, albeit much more difficult and intellectually challenging way to think about how money derives it value. Rather than trying to invent some “feel good” solution that falls apart as soon as we scratch the surface, we could try to apply our “real assets/financial instruments” paradigm to fiat money.

Clearly, fiat money is not a real asset. As noted by many, fiat money is often nothing more than a piece of paper with some ink on it. Therefore, it is fair to say that fiat money is not a real asset and does not derive its value from its physical properties.

This leaves us with only one alternative: fiat money is a financial instrument and derives its value from its contractual properties.

The difficult question, a question that very few economists have spent any real time considering, is what is the nature of the contractual agreement governing fiat money? Clearly, the terms of any contract will not be standard or straightforward (if they were, then speculation on this topic would be well advanced). But this shouldn’t deter us from this path: if we can propose a contractual solution that is plausible, then this is far better than trying to create an alternative paradigm to explain how one specific asset (fiat money) derives its value.

Think of it this way. Prima facie, what is the better approach to the answering the question “how does fiat money derive its value?”

Should we:

a). Try to apply an already well-established paradigm that accounts for how assets derives their value, even if that path poses some intellectual challenges in explaining how this particular asset derives its value; or

b). Attempt to create a new paradigm to explain how one, only one, of all the assets that are in existence derives its value in a manner that is completely independent from all other assets?

The view of The Money Enigma is that we need to make a concerted effort to explain fiat money within the context of the existing paradigm. Therefore, this requires us to explore and speculate upon the nature of the implied agreement that governs fiat money and from which fiat money derives its value.

The Implied Moneyholders’ Agreement

Before we speculate on the nature of the contractual agreement that governs fiat money, we need to consider a few important points.

First, it helps to give the agreement a name. For lack of a better term, we will call the contractual agreement that governs fiat money the “Moneyholders’ Agreement”.

Second, we need to be careful with our definition of “money”. For the purposes of this analysis, “money” is defined as comprising solely the monetary base. For reasons that should become clear from the following discussion, the monetary base is unique as a financial instrument. Most of the assets that economists describe as money, most notably bank deposits, are created by contractual arrangements between private parties such as banks and deposit holders. In contrast, the monetary base can only be issued by government (acting on behalf of society): the monetary base, “fiat money” in the purest sense of the term, can not be created by individuals, banks or corporations.

Third, we need to recognise that the agreement that governs fiat money is an implied-in-fact contract, not an explicit contract. What does this mean? It means that there is no explicit written contract that we can read, nor an explicit verbal contract that we can listen to. Rather, the Moneyholders’ Agreement is a contract that is created by a common or mutual understanding, an understanding that can be implied from the behavior of the parties to the contract.

The implied nature of the Moneyholders’ Agreement makes it difficult to speculate on the exact terms of that agreement. But we can try to draw up a sensible term sheet, drawing on insights from the nature of other financial instruments, and then think about how these terms might influence and impact the valuation of money. To the degree that we can use the price level to provide us with some evidence regarding how the valuation of money adjusts in response to various historic events and shifts in future expectations, we can then determine whether the posited terms of the Moneyholders’ Agreement seem realistic.

So, let’s begin trying to dissect the terms of the implied Moneyholders’ Agreement.

The process of creating any financial instrument begins with determining the counterparties to the agreement. Therefore, the first question that we need to ask is in relation to the Moneyholders’ Agreement is who are the counterparties to the contract?

Clearly, one of the parties to the agreement is the “moneyholder”, those people in possession of money. As illustrated in the diagram below, money is an asset to the holder of money. However, in order for a financial instrument to be an asset of one party, it must be a liability of another. So, who is the counterparty? Who is the issuer of money?

The view of The Money Enigma is that, from an economic perspective, society itself is the issuer of the monetary base. From a legal perspective, government is the issuer of the monetary base. However, from an economic perspective, government is an empty shell: it is nothing more than a legal vehicle created by society in order to achieve the economic and social outcomes that society desires. The assets of that vehicle are, in truth, assets that belong to all of us: the bridges, airports and tanks owned by the government are assets of our society. Similarly, the liabilities of that vehicle are, at least from an economic perspective, liabilities of society.

An easier way to think about this issue is in the context of government debt. From a legal perspective, government debt is a liability of the government. However, from an economic perspective, government debt is more aptly considered as a liability of society. More specifically, government debt is a claim against the future output of society.

If you’re not convinced about this, then it is worth thinking about why US government debt attracts such a high credit rating. Investors in US government debt don’t feel safe because it is “backed by the full faith and credit of the US government”. Investors believe that US government debt is a low risk investment because it is backed by the future prospects of the US economy, one of the most stable and diversified economies in the world. Ultimately, it is society, through the political process, that chooses whether to honor this “government” debt, a debt that only has value because it is, in truth, a liability of society and a claim against the future output of society.

The point is that both government debt and the monetary base are liabilities of government in name only: they are, from an economic perspective, liabilities of society itself.

This raises the next obvious question: what does society produce that it can offer to a counterparty of such an agreement? Remember, every financial instrument represents some sort of quid pro quo: you give me something of economic benefit today and I will give you something of economic benefit tomorrow.

So what can our society offer as consideration for the liabilities it creates? The answer is future economic output.

At a high level, the only way our society can pay for public expenditures and projects is by sacrificing economic output. We can pay for public projects with current economic output (raising taxes today), or we can pay for these projects with future economic output. However, in order to pay for projects with future economic output, we need to create a legal vehicle (government) that can act as the issuer of liabilities that represent a claim on future output.

Once again, we need to think about the role of government (a legal entity) and its relationship to society (a non-legal entity). The view of The Money Enigma is that one of the key roles of government is to act as a legal entity that can both hold the assets of society and issue liabilities on behalf of society. (Society can’t hold assets and issue liabilities directly because it is not recognised as a legal entity).

However, in order for government to issue any meaningful liabilities (notably, government debt and money), government must be authorized by society to issue claims against the future economic output of society. This mechanism is illustrated in the diagram below.

As discussed, government debt is an indirect claim on future economic output (government debt represents a claim to future taxes that are, in turn, a claim on future economic output).

In contrast, money (the monetary base) represents a direct claim on future economic output.

In very simple terms, the Moneyholders’ Agreement promises the receiver of money that in return for their output today, they will be able to use the money they receive to claim some portion of the output generated by society in the future.

For example, let’s assume that our society wants to build a new bridge. Rather than fund this bridge by raising taxes today or raising taxes tomorrow (issuing government debt), society decides to simply issue more claims against its output (money). You, as a building contractor, accept this newly printed money, not because of its valuable physical properties, but because it represents a claim against the future output of society.

Frankly, this basic concept is fairly straightforward. The trick is deciphering the exact nature of the claim on future output.

In finance, there are two primary types of contractual entitlement: (1) “fixed” entitlements, and (2) “variable” or “proportional” entitlements.

A corporation can issue liabilities that represent either a fixed or variable entitlement to its future cash flow. A liability that represents a fixed entitlement to future cash flow is known as a financial liability or debt instrument. In contrast, a share of common stock, the most common form of equity instrument, provides its holder with a variable or proportional claim on a stream of future residual cash flows.

The view of The Money Enigma is that society faces similar options when it decides to fund current government expenditures through the issuance of liabilities.

Government debt represents, at least in principle, a fixed entitlement to future economic output. Clearly, this analogy isn’t perfect because government can debase the value of the currency in which the debt is repaid, but at least at a high level, it is a reasonable comparison.

In contrast, money (the monetary base) represents a variable or proportional entitlement to future economic output. In this sense, money is an equity instrument. (Technically, the Moneyholders’ Agreement is an equity instrument and possession of money makes the money holder party to this equity instrument.)

However, if money is an equity instrument, then money must be a special form of equity instrument. Most notably, it doesn’t entitle the holder to a stream of future economic benefits, but rather a slice of future economic benefits. Whereas a share of common stock entitles its holder to a stream of future cash flows, one dollar provides its holder with a proportional claim on output that can be used only once (you can only spend the dollar in your pocket once).

This fact impacts the next unusual feature of money: the proportion of output that one unit of money can claim seems to go up and down often in a manner that bears little or no relation to the number of claims on issue (the size of the monetary base).

We have seen a real-life example of this phenomenon recently. As the monetary base in the United States has increased fourfold, the proportion of US economic output that one dollar claims has not fallen by 75%.

The reason this is the case is because in a state of intertemporal equilibrium, the value of money must discount expectations regarding the long-term path of both real output and the monetary base.

Let’s assume that the Moneyholders’ Agreement states that the “in principle” proportion of output that one unit of the monetary base can claim at a future point in time is the expected “baseline proportion” for that given future period. Furthermore, the baseline proportion at that future point in time shall be determined with reference to the initial baseline proportion at the time the Moneyholders’ Agreement came into effect (the day the fiat currency was launched) adjusted for the increase/decrease in the size of the monetary base since that time.

Now, will the proportion of output that one unit of money can buy today (the “realized proportion”) be equal to the “in principle” proportion of output that the same unit of money should be able to buy today (the current “baseline proportion”)? The answer is “probably not”.

The reason for this is that the value of money today discounts a chain of future expected values.

As mentioned, we can only spend the dollar in our pocket once. Therefore, we need to choose when to spend the marginal dollar in our possession: we could spend it now, in six months, in six years, or in twenty years.

Part of this decision process involves calculating what the value of that dollar in pocket will be over time. For example, if we think the value of the dollar in our pocket is about will significantly over time, then we will prefer to spend it now.

The problem is that if everyone suddenly decides that the value of money will fall significantly at some point in the future, then the value of money will fall today. If everyone decides that the value of money will fall in the future, then more people will attempt to spend money today and fewer people will be willing to accept money in exchange for real goods/services at the going rate.

In economic terms, a state of intertemporal equilibrium is disrupted. The only way to restore intertemporal equilibrium is for the value of money to fall until it reaches the point where people are indifferent about spending the marginal unit of money today, in 6 months or in 20 years.

Expectations of the “Real Output/Monetary Base” Ratio Are Key

Now, let’s bring this back to the terms of the Moneyholders’ Agreement. As discussed, money represents a proportional claim on the future output of society. The Moneyholders’ Agreement allows us to calculate the in principle proportion of output that one unit of money can buy at any point in the future (the baseline proportion at launch of the fiat currency adjusted for any increase or decrease in the monetary base).

If the market suddenly decides that, for much of the next 20 years, output growth will be lower than expected and the monetary base will be higher than expected, then what happens to the current value of a proportional claim on future output?

Clearly, the current value of that claim must fall: there is less future output for each unit of the monetary base to claim and there will be more claims against that future output (the size of the monetary base will be higher than previously anticipated).

Even though there has been no change in current output or current levels of the monetary base, the value of money depends upon a chain of future expectations and, therefore, must reflect expectations regarding the long-term path of real output and the monetary base.

Conversely, the opposite could be true. As we have seen recently in the United States, the monetary base can be increased dramatically, with little or no impact on the value of money, if the increase in the monetary base is perceived to be “temporary”.

Money is a long-duration asset: its value depends upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio. It matters little to the value of money if this ratio falls and is expected to remain low for a few years. What matters is the long-term path of this ratio.

In this sense, the value of fiat money provides us with a gauge of market confidence regarding the expected long-term economic prosperity of the nation that issued it. Presently, global markets remain optimistic about the long-term economic future of the major fiat currency nations (US, Japan, Europe). However, if this confidence is eroded, then the value of those fiat currencies will fall, increasing the risk of a return of high levels of inflation in those nations.

Proportional Claim Theory vs Quantity Theory of Money

Proportional Claim Theory (the theory espoused above) provides us with a useful explanation for why the quantity theory of money works over long periods of time, but not over short periods of time.

If money is a proportional claim on the future output of society, then one would expect that over long periods of time, if the monetary base grows at a rate far in excess of real output, then the value of money would fall significantly and the price level would rise significantly.

However, as discussed above, over short periods of time, changes in the current ratio of “real output/base money” has little impact on the value of money. Money is a long-duration asset. Therefore, in the short-term, fluctuations in the value of money are driven primarily by shifts in expectations regarding the long-term future path of real output and the monetary base. Therefore, over short periods of time, the price level is primarily driven by swings in these future expectations.

This idea can be expressed more clearly by developing a valuation model for fiat money. If we combine Proportional Claim Theory and the notion of intertemporal equilibrium, we can derive a valuation model or “discounted future benefits” model for fiat money.

The valuation model for fiat money suggest that the value of money depends on not just current level of real output and the monetary base (q and M above), but also on expectations regarding the long-term growth rate of real output (g) and the long-term growth rate of the monetary base (m).

Not surprisingly, the value of money is positively correlated to confidence in the economic future of society. If people believe that output growth (g) will be strong and that monetary base growth (m) will be constrained, then this supports the value of money. Conversely, if people become more pessimistic about the growth of output relative to money, then this will undermine the value of money.

If you are interested in reading more about this issue or exploring some of the ideas discussed above, then please download The Velocity Enigma, the third and final paper in The Enigma Series.

The Evolution of Money: Why Does Fiat Money Have Value?

Over the past two thousand year, money, in all its many forms, has played a critical role in the development of human society. Commodity money, money whose value comes from the commodity from which it is made, has a very long history. “Commodity-backed” or “representative” money also has a relatively long history. In contrast, fiat money is an anomaly of economic history, a strange invention of the modern age.

The use of fiat money is so widespread that many of us seldom question why it has value: it just does. But for economists, the question of why non-asset backed money or fiat money has value is fundamental.

Surprisingly, economics struggles to provide a simple answer to the basic question “why does fiat money have value?” Most answers to this question rely, at least to some degree, on the notion that fiat money has value because it is accepted a medium of exchange. But this line of reasoning creates a circular argument: “fiat money has value because it is accepted as a medium of exchange, fiat money is accepted as a medium of exchange because it has value”.

In order to break this pattern of circular logic, we need a new way to think about money. The first step in this process is asking the question “why does any asset have value?”

For example, why does land have value? Why does a government bond have value? The answer in each case is different. Land has value because it is a real asset. In contrast, a government bond has value because it is a financial instrument.

The view of The Money Enigma is that every asset derives its value either from its physical properties or from its contractual properties. Fiat money is not a real asset and can not derive its value from its physical properties. Therefore, fiat money must derive its value contractually.

In order to help us think about this point, we will trace the evolution of money from commodity money to representative money (commodity-backed money) to modern-day fiat money. It will be argued that when the commodity-backed feature of representative money was removed, the explicit contract that governed representative money must have been replaced by an implied-in-fact This new implied-in-fact contract is what gives fiat money its value.

The difficult question for economists is what is the nature of this implied-in-fact contract? This is a difficult question that we will address in more detail next week when we consider the question “what factors influence the value of money?” However, the view of The Money Enigma is that money is a special-form of equity instrument and a proportional claim on the future output of society.

Why does any asset have value?

While there are not many things that can be said with certainty in economics, one thing that can be said with certainty is that “money” remains an enigma. A simple question such as “what is money?” can trigger hours of debate among professional economists. In an attempt to lessen confusion, economists have been forced to invent multiple classifications of money such as “base money” and “broad money”. A myriad of different tests have been created to test whether an asset possesses the quality of “moneyness”. Despite these efforts, the basic of question of “what is money?” is not easily answered.

Perhaps it is not surprising then that the question “why does money have value?” is even more difficult to answer. There is an immediate and instinctive view among most economists that money is something special. It is a unique asset and, at least from a theoretical standpoint, must be treated differently from other assets.

There is no doubt that money, or more specifically, fiat money, is “unique”. After all, fiat money is a relatively recent invention when viewed on the grand scale of economic history. However, maybe money is not quite as “special” as most economists believe.

The view of The Money Enigma is that rather than trying to answer the question “why does money have value?” by treating money as special, we should begin our analysis by treating money as if it is just another asset. More specifically, we should first answer the question “why does any asset have value?” and then, once we have established a sensible answer to that question, see how money fits into that context. While it may be that we can’t find a perfect answer to the question by pursuing this path, at least we will have a sensible framework to begin our analysis with.

So, why does an asset have value? Let’s begin by rephrasing the question: how does an asset derive its value? Fortunately, there is a well-established paradigm in finance that we can use to answer this question.

Assets can only derive their value in two ways: either they derive their value from their physical properties or they derive their value from their contractual properties. Another way of saying this is that an asset either derives its value from it’s the usefulness of its physical properties (for example, land is valuable because it can be used to grow crops) or from the liability that it represents to another party (for example, a bond is valuable because it represents a contractual obligation by the issuer to pay a set of cash flows to the holder of that bond).

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

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

A real asset is an asset that is tangible or physical in nature. More importantly, it is an asset that derives its value from these tangible or physical properties.

A financial instrument is, according to “IAS 32 – Financial Instruments: Presentation”, a “contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”

A financial instrument is, by definition, both an asset and a liability. A financial instrument derives its value as an asset from the liability that it represents to another. In this sense, the value of a financial instrument can be considered to be an artificial creation of a contract entered into by economic agents.

So, where does fiat money fit in this simple paradigm? Does fiat money derive its value from its physical nature or does it derive its value from the liability that it represents to its issuer?

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

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

The Evolution of Money

Money has taken many forms over the centuries. If we loosely define money as a widely accepted medium of exchange, then we can say that there have been thousands of different types of money used globally over the past few thousand years including, but not limited to, cowry shells (used as currency in Africa and China), koko (a unit of rice used in Japan’s feudal system), grain, copper, bronze, gold coins and paper notes.

However, our purpose today is not to discuss all the various forms that money has taken, but rather to discuss how money has evolved from commodity money to the fiat money that we use today.

In nearly every society, the first form of money used was some form of commodity money, money that was, quite literally, a basic commodity that had value in that society. Over time, as commerce became more sophisticated and trade became more widespread, the use of perishable commodities (such as grain and rice) as money became less common. Less-perishable commodities, such as copper, silver and gold became the predominant mediums of trade. The acceptance of these metals accelerated when they were issued in coin form.

All of these forms of commodity money derived their value from their physical properties. Early coins were accepted because the metals they were made of were valuable in and of themselves. If a government started debasing their coins, often by reducing the amount of the metal in the coin, then the value of the coin would fall and prices, as measured in terms of that coin, would rise.

Even in the times of the Roman Empire, the principle that the value of money is the denominator of the price level. As the Romans debased the value of their coins (by cutting down on the metal content of each coin), prices began to rise. “Ratio Theory of the Price Level”, the notion that the value of money is the denominator of the price level, is discussed in a recent post titled “What Causes Inflation?”

The point is that money in ancient societies, commodity money, was a real asset that derived its value from its physical properties.

The problem with commodity money is that it restricts the capability of governments to finance wars and other public expenditures: you can’t pay your armies in gold coin if you run out of gold. This problem led to the invention of the first “representative money”. Rather than paying the armies in gold, the ancient kings and emperors decided to pay soldiers by issuing pieces of paper that were promises to deliver gold on request.

The first paper money was nothing more than a legal contract: an explicit contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king. The value of this paper money was derived solely from its contractual properties.

Many of the major modern currencies we use today were, at one time, asset-backed currencies. The British Pound and the US Dollar, the two currencies that dominated global trade over the last three hundred years, were both gold-backed currencies for many years. For a long time, the value of both these major currencies depended upon the explicit contract that promised holders that they were convertible into gold.

However, there was one key problem with this arrangement: it limited the amount of money that both governments could create.

At some point, it was decided that we should simply drop the gold convertibility feature. In effect, the explicit contract that promised holders this piece of otherwise worthless paper could be exchange for a real asset was rendered null and void.

So, why did these currencies maintain any value at all? After all, when these paper currencies were first issued, the only reason they were accepted in exchange was because they were “as good as gold”.

The popular view is that these paper currencies maintained their value because, after many years, people were accustomed to using them. In the language of an economist, the fiat money maintained its value when the gold convertibility feature was removed because it was already widely accepted as a medium of exchange.

The problem with this argument is that it relies on a circular argument, a form of logical fallacy.

In order for something to act as a medium of exchange it must have value. Benjamin Anderson, in his book “The Value of Money” (1917), states, “the medium of exchange must have value, or else be representative of something which has value. There can be no exchange in the economic sense without a quid pro quo, without value balancing value, at least roughly in the process”.

What does this mean? In simple terms, we are not going to part with something of value (a good or service) unless we receive something of value in return. We will not accept money in exchange unless it possesses the property of market value.

Therefore, money can only serve as a medium of exchange because it has value.

Now, let’s ask the question again “why does money have value?” Can you see the problem? Is it reasonable to argue that money has value because it is a medium of exchange if we also recognize that money serves as a medium of exchange because it has value? No, it isn’t. What we have created is a circular argument.

We can only resolve this circular argument by breaking one of its legs. Notably, we need another way of thinking about how fiat money derives it value. Fiat money must have value in order to act as a medium of exchange, so how does it derive this value?

Why Does Fiat Money Have Value?

As discussed earlier, it is generally recognized that all assets derive their value in one of two ways: real assets derive their value from their physical properties, while financial instrument derive their value from their contractual properties.

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

Most economists haven’t spent much time speculating on the potential nature of the implied contract that money represents. This is unfortunate because such speculation could provide interesting insights into how the value of money is determined.

The view of The Money Enigma is that we can apply at least some elements of traditional finance theory to a theory of money. First, we need to identify the issuer of money. While the legal issuer of base money is the government, the ultimate economic issuer of money is society itself.

Second, we need to think about what it economic benefit is possessed or created by the issuer that could be promised to the holder of money. In the case of society, the obvious economic benefit that could be promised is future economic output. As the slide below illustrates, society can implicitly authorise government to issue claims against the future output of society. Although fiat money (the monetary base) is legally a liability of government, economically it is a liability of society itself and a claim against the most valuable economic benefit society produces: its future output.

Third, we need to consider whether the claim represents a fixed or variable entitlement to that future economic output. The view of The Money Enigma is that money represents a variable or proportional entitlement to the future economic output of society.

In this sense, money is a special form of equity instrument: just as a share of common stock represents a proportional claim on the future cash flow of a business, one unit of base money represents a proportional claim on the future economic output of society.

This theory is explored at length in The Money Enigma and The Velocity Enigma. Those readers looking for a short-form discussion of this idea might care to read a recent post titled “Money as the Equity of Society”.

Next week we will discuss how this theory of money can be used to think about the key factors that influence the value of money.

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