Monthly Archives: August 2015

Can the Fed Catch a Falling Knife?

In a post written three months ago “Has the Fed Created the Conditions for a Market Crash?” we discussed how the Federal Reserve’s program of quantitative easing had set up the perfect conditions for a stock market crash.

Given the recent turmoil in markets, it seems like a good time to think about how the Fed might react if major declines continue across global share markets. What will the Fed do if equity markets decline by 20% or 30% over the next few weeks or months? Moreover, how effective will any actions taken by the Fed be in circumventing these declines?

Historically, major stock market crashes (1929, 1987, 2001) have been preceded by a tightening of monetary conditions. What makes this time different is that the weakness in equity markets has not been preceded by any tightening of monetary policy: interest rates have not been raised and the monetary base has not been reduced.

Indeed, Fed policy over the past six years has been explicitly designed to lower required returns on risk capital, thereby boosting asset prices and, hopefully, real economic activity.

However, if the required rate of return on risk capital rises sharply at a point where Fed policy is still highly accommodative, then does this begin to make Fed policy look impotent? Will the markets lose faith in the Fed’s ability to manipulate desired market outcomes?

In the short term, the Fed should retain effective control over the risk free rate. However, it may be very difficult for the Fed to manage the “risk premium”, or the return that is required over and above the risk-free rate by investors in risk assets.

In the long term, the Fed faces an even greater challenge. The Fed’s likely reaction to a market collapse is either “do nothing” or “do more QE”. However, if the markets begin to believe that the Fed tightening cycle is pushed out “indefinitely”, then this could trigger a sharp acceleration in the rate of inflation. In this worse case scenario, the Fed could lose control over both the risk premium and the risk-free rate.

The view of The Money Enigma is that the markets perceive the current bloated level of the monetary base to be “temporary” and that it is this perception that is primarily responsible for holding inflation in check over the past six years.

A stock market crash is just the type of even that could change the perception that the Fed’s program of monetary base expansion is “temporary” in nature. If the markets suddenly decide the current level of the monetary base represents the “new normal”, then this shift in expectations could drive a decline in the market value of money and a sharp rise in the rate of inflation.

Dear Fed, What Happens Now?

Market events over the past few days have highlighted an interesting dilemma for the Fed. What does the Fed do when a policy explicitly designed to boost the price of risk assets suddenly stops working?

Over the past six years, the Federal Reserve has pursed an ambitious and largely experimental monetary policy called quantitative easing. Quantitative easing is designed to stimulate economic activity by suppressing the required return on risk assets, thereby encouraging new investment and business formation. Indeed, boosting asset prices by artificially forcing down the long-term risk free rate on capital is the “primary transmission mechanism” of quantitative easing.

As discussed in a recent post titled “Has the Fed Created the Conditions for a Market Crash?” the purchase of long-term fixed interest securities by the Fed forces down the required return on capital across all asset classes, thereby boosting the price of risk assets. In effect, quantitative easing creates a waterfall effect as investors are forced out of bonds and into more risky investments such as equities and private equity.

Quantitative easing only “works” from a policy-makers perspective if it boosts asset prices and confidence in the long-term economic outlook.

But, what happens if the markets crash and economic confidence is eroded before the Federal Reserve begins the process of reversing quantitative easing?

In this week’s post, we will think about both the short-term and long-term consequences associated with a significant market correction and the Fed’s likely response to this failure of quantitative easing.

Fed Tactics and Short-Term Outcomes

Can the Fed catch a falling knife? If global equity markets continue to fall over the next few weeks, what can the Fed do to arrest the panic?

In the very short-term, there are several tactics that the Fed could employ in an attempt to calm the markets.

First, the Fed could begin by hinting that any interest rate rise in September would be premature. However, this is already largely priced into markets at the time of writing. Therefore, in order to have any meaningful impact, the Fed will probably need to talk down the near-term prospects for the global economy and express concerns about the recent level of global market volatility. The markets will, probably correctly, read this as code for “no interest rate rise this year”. If this doesn’t work, then the Fed could officially rule out an interest rate rise for the next 6-12 months.

If the declines in the equity markets continue, then the Fed could adopt more aggressive tactics. The Fed could begin to suggest that further rounds of quantitative easing are back on the table. It is likely that this would have some short-term positive impact on markets because so many people got caught on the wrong side of the QE trade the first time.

In an extreme scenario, one where markets are down 25-30% from their peak in a short period of time, the Fed could announce a surprise round of quantitative easing designed to “stabilize global financial markets”.

It seems likely that the Fed will employ some combination of these tactics if market declines continue. However, the problem is that none of these short-term tactics really address the key issue.

While the Fed can control the risk-free rate (at least in the current environment) it is almost impossible for the Fed to control the risk premium that is required over and above the risk-free rate.

Over the past few years, the required risk premium has been compressed as investors have chased yield and become more and more complacent about the ability of the Fed to control market outcomes. However, when the risk premium rises sharply in a short period of time, it is very difficult for policy makers to restore it to its previous level in a timely manner.

If the Fed really wants to stop a dramatic decline in the global equity markets, it must make some attempt at manipulating the required risk premium. But given the current design of quantitative easing, this is almost impossible.

The Fed could attempt to control the required risk premium by using additional rounds of monetary base expansion to buy risk assets. In simple terms, the Fed could print money and use it to buy stocks. But this takes the Fed down an even more experimental and dangerous path.

Alternatively, the Fed could simply engage in further rounds of traditional quantitative easing: expanding the monetary base and using the proceeds to buy long-term government securities.

In the near-term, such a response would, at the margin, have some positive impact on risk assets as the purchase of government securities further compresses the risk-free rate, a core component of the required rate of return for any asset.

However, the marginal benefit from such action may be minimal. The risk-free rate is already near historical lows. Moreover, there is no guarantee that lowering the risk-free rate would also lead to any compression in the required risk premium.

In summary, there are several tactics the Fed could adopt to stabilize markets in the short-term. However, none of these tactics are likely to be able to “fix” the core problem, namely, preventing the normalization of the required risk premium.

Moreover, if the Fed does attempt to “catch the falling knife”, then there is a good chance that the Fed will end up with blood on its hands.

In the next section we will consider the possible long-term consequences should the Fed choose to chase the equity market down the rabbit hole. More specifically, we will examine why the long-term marginal cost of more quantitative easing will almost certainly outweigh any short-term marginal benefit.

Fed Strategy and Long-Term Consequences

Over the past six years, the Federal Reserve has quintupled the US monetary base. This represents an extraordinary acceleration in the rate of growth of the monetary base compared to the historical average of roughly 6% per year. So, why hasn’t this dramatic expansion in base money triggered a sharp rise in the rate of inflation?

The view of The Money Enigma is that the only reason the Fed has been able to get away with this aggressive policy and avoid a sharp acceleration in the rate of inflation is because the market believes that the extraordinary recent expansion in the monetary base is “only temporary”.

Moreover, if an event occurs that changes this perception, i.e. if people begin to believe that the recent expansion in the monetary base is more “permanent” in nature, then the value of money will decline sharply and inflation will accelerate dramatically.

A stock market crash is precisely the type of event that could trigger such a shift in expectations.

A few weeks ago, the consensus view was the Federal Reserve would begin tightening monetary policy “any day now”. Most market commentators were calling for the first interest rate rise in nine years to occur next month. This would mark the beginning of a tightening cycle that, ultimately, would see the Fed significantly reduce the size of the monetary base.

Fast-forward to today and perceptions are already shifting. Not only are markets beginning to contemplate no rate rise this year, but respected economic commentators such as Larry Summers are saying, and I quote, “it is far from clear that the next Fed move will be a tightening” (source: twitter).

While it is a matter of speculation, it is not hard to believe that should the equity markets decline a further 10-20% over the next few weeks, there will be enormous pressure on the Fed to stabilize markets by embarking on a new round of quantitative easing. Moreover, if this outcome does eventuate, then it is not hard to believe that market participants will begin to doubt that the Fed will ever restore the monetary base to its previous pre-QE growth path.

While this may sound like a subtle and rather innocuous shift in expectations, the view of The Money Enigma is that this simple shift in expectations regarding the long-term path of the monetary base could mark the starting point a whole new era in global economic affairs. More specifically, it could mark the end of the “low inflation” era and the beginning of a new “high inflation” era.

So, why do expectations regarding the long-term growth path of the monetary base matter to inflation?

In order to understand this point, we need to cover a lot of theory. Given time constraints, we will only touch on the key points today, but those that are interested might want to read two earlier posts, namely “Does Too Much Money Cause Inflation?” and “Why is there a Lag Between Money Printing and Inflation?”

The first concept that must be appreciated is that price level is highly dependent upon the “value of money”. More specifically, the price is a relative measure of the market value of the basket of goods in terms of the market value of money. In mathematical terms, the price level is a ratio of two variables: the market value of goods (numerator) and the market value of money (denominator).

In simple terms, all else remaining equal, the price level rises as the value of money falls and the price level falls as the value of money rises.

For those who are new to The Money Enigma and are not familiar with the “market value of money” expressed as an independent variable, I suggest that you read last week’s post titled “The Value of Money: Is Economics Missing a Variable?”

The second theoretical issue that must be addressed is the nature of fiat money itself. More specifically, why does fiat money have value and what factors influence that value? In other words, what determines the value of the denominator in our price level equation above?

These are questions that we have discussed at length in many recent posts. Readers can find an in-depth discussion of these issues in the “Theory of Money” section of this website, so let’s just focus on the high level points.

The view of The Money Enigma is that fiat money is a financial instrument and derives its value from an implied-in-fact contract. More specifically, fiat money is an economic liability of society and represents a proportional claim on the future output of society.

In simple terms, the value of the money in your pocket depends on long-term confidence in the future economic prospects of society. If money represents a “proportional claim on future output”, then its value is intimately tied to perceptions regarding the long-term economic prosperity of society.

One of the key implications of this theory of money is that the value of money is critically dependent upon expectations regarding the long-term future path of real output relative to the long-term future path of the monetary base.

Until a few weeks ago, the consensus view was that over the next 20-30 years real output growth would be solid while growth in the monetary base, as measured from current extended levels, would be very low. Indeed, most people would have expected that over the next 10 years, real output would grow while the monetary base would decline. These expectations have played a key role in supporting the value of money and keeping a lid on inflation.

The risk today is that a stock market crash could push both of these expectations in the wrong direction.

A major correction in global equity markets may prompt investors to revisit assumptions regarding the long-term growth of the major Western economies. Moreover, a sharp correction in markets could trigger a massive revision in the way that investors think about the future path of the US monetary base.

If investors decide that the Fed will continue to grow the monetary base over the next ten years, rather than reduce the monetary base, then this could trigger a sudden and violent decline in the market value of money.

As discussed earlier, the market value of money is the denominator in our price level equation. A sharp decline in the market value of money could easily overwhelm any deflationary trends in the goods market, leading to a sudden pick up in the rate of inflation.

In summary, investors who believe that the Fed will come to the rescue and catch the falling knife may be in for a nasty surprise. A new program of monetary base expansion may not only prove to be ineffectual in putting a floor under the market, but could also become counterproductive as it acts as a tipping point for expectations regarding long-term monetary base growth, thereby pushing the economy into a new high-inflation era and badly damaging the credibility of the Federal Reserve.

The Value of Money: Is Economics Missing a Variable?

If money has value and if the value of money is an important factor in the determination of prices in money terms, then why doesn’t economics officially recognise the value of money as a variable in its equations? Moreover, why doesn’t economics clearly explain the role of the “value of money” in the determination of money prices and foreign exchange rates?

If you look for the term “value of money” in an economics textbook, you won’t find very much. Indeed, the standard economics textbook has little to say about the “value of money” and its role in price determination.

The reason for this is simple: economics simply doesn’t recognise “the value of money” as an independent variable.

You might ask, “How is that possible? How can economics overlook a concept that seems so fundamental?” The answer to this question is rather complicated, but it boils down to the following.

In order to isolate the “value of money” as an independent variable, economics needs to measure the property of market value in absolute terms. In order to measure market value in absolute terms, economics must adopt a “standard unit” for the measurement of market value, something which economics has not done.

Almost universally, economics measures the property of “market value” in relative terms. For example, the price of a good, in money terms, is a relative measure of the market value of that good in terms of the market value of money. Similarly, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

In both cases, economics is measuring the market value of a good or goods in terms of the market value of money, i.e. both measurements are relative in nature.

So, how does economics measure the market value of money? The most common way to do this is something called the “purchasing power of money”. The problem is that the “purchasing power of money” is also a relative measure of market value. More specifically, the purchasing power of money measures the market value of money in terms of the market value of the basket of goods. (The purchasing power of money is simply the reciprocal of the price level, itself a relative measure of value).

The problem with measuring the value of money in relative terms is that it does not allow us to isolate the “value of money” as an independent variable.

For example, the purchasing power of money can fall because either (a) the market value of money falls, or (b) the market value of the basket of goods rises. The purchasing power of money does not isolate the value of money as an independent variable: rather, it muddies the waters by mixing the value of money with the value of goods.

The view of The Money Enigma is that economics can only isolate the value of money as an independent variable by measuring the market value of money in absolute terms, that is to say, in terms of a “standard unit” for the measure of market value.

Why does this matter? Well, isolating the “value of money” as an independent variable opens a number of doors. First, it encourages us to think about why money has value and what determines that value. Second, it forces us to think about an explicit role for the value of money in the determination of prices and foreign exchange rates. Finally, and most importantly, it allows us to shed new light on existing economic theories such as the quantity theory of money.

How Do We Measure the “Value of Money”?

In our everyday life, most of us are accustomed to measuring the value of goods and services in money terms. An apple is worth one dollar. A taxi ride across town costs twenty dollars. Indeed, money is so universally accepted as a medium of exchange and unit of account that we almost instinctively measure and compare the value of economic goods in money terms.

Therefore, when somebody asks us, “how do you measure the value of money?” most of us need to pause and think for a moment. After all, how do you measure the value of something that is itself used as the measure of value?

The most common answer to this question goes something like this: if we can measure the value of goods in money terms, then we can measure the value of money in goods terms.

The value of money, in terms of the basket of goods, is known as the “purchasing power of money” and it is a popular method for measuring the value of money.

Another way to measure the value of a currency is to measure it in terms of a different currency. A foreign exchange rate is, in essence, a way of measuring the value of one type of money in terms of another type of money.

The purchasing power of money and foreign exchange rates both represent valid ways of measuring the “value of money”. However, there is a problem with this approach. Both of these measures are relative measures of value.

The purchasing power of money measures the market value of money in terms of the market value of the basket goods. A foreign exchange rate measures the market value of money in terms of the market value of another currency. In both cases, we are measuring the value of money in relative terms and, therefore, both measures are dependent upon not only the value of money, but also the value of the measurement good (the basket of goods or the other currency).

In other words, we have not isolated the “value of money” as an independent or standalone variable. Why this matters is something that we will discuss later, but first let’s consider how we might isolate the value of money as a standalone variable.

The Measurement of Market Value: Absolute versus Relative

If a physical property can be measured in relative terms, then it can also be measured in absolute terms. If we can measure the market value of money in relative terms, then we should also be able to measure the market value of money in absolute terms. Moreover, by measuring the market value of money in absolute terms, we can isolate the value of money as an independent variable.

What does all this mean? Well, let’s start by thinking about the difference between absolute and relative measurement.

Every measurement we ever make is an act of comparison. In this sense, every measurement is relative: we are comparing one thing with another thing. However, by convention, science designates some measurements to be absolute in nature, while others are relative in nature.

The key difference between an absolute versus a relative measurement is the unit of measure being used.

A measurement is considered to be an absolute measurement if it is done using a “standard unit” of measure. The key characteristic of a standard unit of measure is that it is invariable in the property that is being measured.

For example, an inch is a standard unit of length. An inch is invariable in the property of length and can be used to measure length and/or height in absolute terms.

In contrast, a relative measurement is merely the measurement of one object, the primary object, in terms of another, the measurement object. Most importantly, a relative measurement does not require that the second object, the measurement object, is invariable in the property being measured.

For example, if I measured the speed of one car on the road in terms of another car on the road, then that would be a relative measurement of speed (i.e. one car is going twice as fast as the other car). The second car (the measurement car) is not invariable in the property of speed, therefore the measurement can not be considered to be absolute.

In summary, the difference between an absolute measurement and a relative measurement is that an absolute measurement can only be made using a “standard unit” of measurement.

The interesting thing about standard units is that they tend to be theoretical in nature. Standard units don’t occur naturally in the real world: rather, we had to make them up. Feet, inches, pounds and kilograms were all standard units of measure that we created.

And this brings us back to the main point of this article: economics needs to create a standard unit for the measurement of market value.

Every economic good possesses the property of market value. If a good did not possess the property of market value, then we would not exchange it in trade.

In theory, we should be able to measure the market value of a good in both absolute and relative terms.

Almost universally, economics measures market value as a “price”. But price is a relative measure of market value. The price of one good, in terms of another good, is relative measure of the market value of both goods.

However, if economics adopts a standard unit for the measurement of market value, then we can measure the market value of each good in absolute terms (in terms of the standard unit).

Why would we want to do this?

Measuring market value in absolute terms allows us to isolate changes in the market value of one good from changes in the market value of another good. In the most basic terms, it gives us greater insight into what is really driving the change in the price of a good.

Price is a relative measurement of market value. This means that the price of one good (the primary good) in terms of another good (the measurement good) can rise for one of two basic reasons. Either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

By measuring market value in absolute terms, we have a better way of tracking what caused the rise in the price of the good. We can track whether the price rise was caused by (a) the primary good becoming more valuable, or (b) the measurement good becoming less valuable.

This notion becomes particularly important when we discuss the determination of prices in money terms.

At the most fundamental level, the price of a good in money terms measures of the market value of that good in terms of the market value of money.

We can easily express this basic concept in mathematical terms if we measure the market value of the good and money independently, i.e. if we measure the market value of each in terms of a standard unit.

The price of a good in money terms can rise because either (a) the value of the good V(A) rises or (b) the value of money V_M falls. Note that the value of money is the denominator in our price equation: as the value of money falls, the price of the good rises.

The notion that the price of a good depends upon the value of money may seem like a very simple idea, but it is a fundamental concept and one that can only be expressed once the value of money is isolated by measuring it standard unit terms.

The Value of Money: Shedding New Light on Old Ideas

So, what are some of the interesting applications of this concept? What are the tangible benefits of isolating the value of money as an independent variable?

Let’s begin with the basics. The price equation in the slide above begs a couple of obvious question. First, what determines the market value of money? Second, if money has value and if the value of money plays a key role in price determination, then how do we incorporate it into traditional supply and demand analysis?

The traditional microeconomic view is that the price of a good is determined by supply and demand for that good. So, what role does the value of money play?

In order to incorporate the value of money into traditional supply and demand analysis, we need to rethink the unit of measurement that is used on the y-axis of our supply and demand diagrams.

The view of The Money Enigma is that every price is determined by two sets of supply and demand.

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. The market value of a good is determined by supply and demand for that good. The market value of money is determined by supply and demand for money (the monetary base).

Therefore the price of the good in money terms is a function of both supply and demand for the good and supply and demand for money.

The key to illustrating this point is the way that we measure market value on the y-axis. In the slide above, market value is not measured in price terms, but is measured in terms of the standard unit, i.e. market value is measured in absolute, not relative terms.

This representation of price determination described above can be easily reconciled with the traditional representation of supply and demand once it is recognised that traditional supply and demand analysis implicitly assumes that the market value of the measurement good is constant.

For example, let’s take the supply and demand diagram for good A that is on the left hand side of the slide above. If you assume the market value of money V_M is constant and you divide all y-axis values for V(A) by the market value of money V_M, then you end up with the traditional version of the supply and demand representation for good A with the price of good A on the y-axis.

Similarly, we can convert the traditional supply and demand diagram with price on the y-axis into standard unit terms by multiplying all y-axis values by the market value of the measurement good, which, by the way, is already assumed to be constant in traditional supply and demand analysis.

The theory that every price is a function of two sets of supply and demand is discussed at length in a recent post titled “A New Economic Theory of Price Determination” and on the “Price Determination” page of this website.

If you are not an economist and you are wondering why this matters, then I will give you at least one good reason.

According to this theory of price determination, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

If this is correct, then Keynes’ liquidity preference theory, a cornerstone of modern economics, is wrong. This is an idea was discussed in a recent post titled “Supply and Demand for Money: Where Keynes Went Wrong”.

From a more constructive perspective, if the market value of money is the denominator of every money price in the economy, then this has important implications for macroeconomic theories of price level determination.

At the most basic level, we can use this idea to construct what is called “Ratio Theory of the Price Level”.

Ratio Theory states that the price level measures the market value of the basket of goods in terms of the market value of money. Therefore, the price level can be expressed as a ratio of two market values.

Ratio Theory highlights the importance of isolating the “value of money” as a variable. The value of money is the denominator in our price level equation above: as the value of money falls, the price level rises.

Moreover, Ratio Theory provides with a way to shed new light on old theories such as quantity theory of money. For example, does an expansion in the monetary base lead to an increase in prices because (a) it drives higher levels of economic activity and a rise in the value of goods, or (b) does an expansion in the monetary base lead to a decline in the value of money?

The application of Ratio Theory to the quantity theory of money is discussed in a recent post titled “Saving Monetarism from Friedman and the Keynesians”.

What Determines the Value of Money?

Before we conclude, it is worth spending a little more time talking about what determines the market value of money.

As illustrated above, the view of The Money Enigma is that supply and demand for the monetary base determines the market value of money. Technically, it is my opinion that this is a fair and accurate description of how the value of money is determined. However, in practice, this description leaves a lot to be desired.

The reason for this is that the value of money depends primarily upon long-term expectations of key economic variables. It is difficult to capture the complexity of these long-term expectations and their impact on the market value of money in a simple supply and demand diagram.

If you are interested in reading more about why fiat money has value and how the value of fiat money is determined, then I would highly recommend reading “The Evolution of Money: Why Does Fiat Money Has Value?” and “What Factors Influence the Value of Fiat Money?”

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Will Inflation Rise or Fall in the Next Recession?

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

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

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

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

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

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

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

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

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

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

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

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

The Price Level is a Relative Measure of Market Value

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Impact of a Recession on the Market Value of Money

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Will the Rate of Inflation Accelerate in the Next Recession?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

What Determines the Price of Gold?

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

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

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

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

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

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

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

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

Why Does a “Pet Rock” Have Value?

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

Debates about gold tend to be contentious for two reasons.

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

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

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

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

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

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

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

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

Why does this make gold valuable?

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

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

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

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

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

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

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

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

The Competitive Relationship between Gold and Fiat Money

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Does “Paper Money” Have Value?

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

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

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

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

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

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

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

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

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

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

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

This is the point that representative money became fiat money.

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

So, why did paper money maintain any value?

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

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

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

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

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

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

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

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

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

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

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

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

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

The Gold Price and Economic Confidence

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

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

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

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

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

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

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

What does this mean for gold investors today?

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

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

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

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

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

Author: Gervaise Heddle

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