Monthly Archives: March 2016

Fed rate decision, Mining Maven interview

Earlier this week, I spoke to Malcolm Palle at the Mining Maven regarding the Fed’s recent decision to keep interest rates on hold. The view of The Money Enigma is that the Fed is too focused on a Keynesian “output gap” view of the world, i.e. the notion that inflation can only rise if the economy overheats. As discussed in many recent posts, the view of The Money Enigma is that inflation is primarily driven by a sustained decline in the value of money, not by the level of economic activity.

Fiat money is a proportional claim on the future output of society and, therefore, its value is highly leveraged to confidence in the long-term economic outlook. If long-term economic confidence is damaged, then the value of money can decline sharply and inflation can rise sharply, even in an environment of weak aggregate demand.

In the second part of the interview, we discuss a couple of small-cap, UK-listed mining companies that are making great strides to a possible turn in the commodities cycle. Although it is still early days, it seems as though commodities are following the traditional boom/bust cycle, albeit this cycle has been more pronounced on both the upside and the downside!

You can listen to the interview here: http://www.miningmaven.com/mining-blog/miningmaven-podcast-no-14-with-gervaise-heddle-covering-gold-mtr-eua-20160321479/

Growth, Confidence and Inflation

March 14, 2016

While the relationship between economic growth and inflation has been much discussed in the economic literature, there is a much more important economic relationship that is far less frequently discussed: the relationship between economic confidence and inflation.

The view of The Money Enigma is that there is, a best, a tenuous relationship between economic growth and inflation. As discussed in a recent post titled “Does Excess Demand Cause Inflation?” the view of The Money Enigma is that high levels of economic growth may lead to higher rates of inflation in the short term, but that, in the long term and all else remaining equal, strong rates of economic growth tend to suppress inflation.

In contrast, the view of The Money Enigma is that, under a fiat money system, there is a strong, inverse relationship between the level of economic confidence and inflation. More specifically, confidence in the long-term economic future of society is the primary driver of the value of fiat money. As confidence in the long-term future of society falls, the value of fiat money issued by that society declines, and prices, as expressed in fiat money terms, rise.

Interestingly, this relationship between confidence and inflation is flipped entirely on its head under a gold standard. Under a gold standard regime, a significant decline in confidence actually leads to a rise in the value of money and a decline in prices.

This stark difference between confidence and the value of money under the two different monetary regimes can help explain why prices fell so dramatically in the early 1930s and why prices are unlikely to fall again in that fashion while we continue to adhere to a fiat money standard.

In the first section of this article, we will begin by discussing the difference between growth and confidence. In the second section, we will challenge the traditional Keynesian view of growth and inflation by examining the relationship between growth, economic confidence and the value of fiat money. In the final section, we will discuss how the relationship between economic confidence and prices changes under a gold standard and why the Great Depression created a perfect storm for deflation.

Growth and Confidence: Same, Same but Different

There is a view that seems to be implicit in the economic community that “growth” and “confidence” are synonymous. While there is clearly a strong relationship between the two concepts, they are not the same.

More importantly, under a fiat money regime, growth and confidence have completely opposite effects on the price level, at least in the short term.

Before we delve into this somewhat complex idea, let’s be clear on how the two terms are defined for the purposes of this article.

Growth is a measure of economic activity in the present time. More specifically, it measures how the level of economic activity has changed from the recent past to the present time.

In contrast, confidence relates to perceptions regarding future economic growth. For the purposes of this article, confidence relates to perceptions regarding long-term economic growth, i.e. economic growth over the next 20-30 years.

While there is clearly some type of relationship between growth and confidence, (one tends to beget the other), the two don’t necessarily move in tandem. More specifically, economic growth tends to fluctuate quite rapidly in relatively short wave patterns, while confidence tends to move in much longer wave patterns. For example, in the 1970s, US economic activity was quite volatile but the overwhelming trend in confidence regarding the long-term future of the United States was down.

This subtle but important distinction can help us understand why some periods of time are marked by high levels of inflation and others by low levels of inflation even when real economic growth, as compared across those periods, is similar.

Growth, Confidence and Inflation: Challenging the Keynesian View

The traditional view taught by many respected macroeconomists is that an excess of aggregate demand relative to aggregate supply causes inflation. Therefore, according to this school of thought, one of the primary roles of policy makers is to ensure that the economy does not overheat, i.e. the economy does not growth too strongly.

Intuitively, this view of inflation is very appealing. After all, it borrows directly from the traditional microeconomic theory that an increase in demand relative to supply leads to a rise in the price of a good.

However, while it may be an intuitively appealing theory regarding inflation, it is also incredibly naïve. Apart from the fact that the empirical relationship between growth and inflation is, at best, tenuous, the simple fact of the matter is that the theoretical underpinnings of this idea are poor.

From an empirical perspective, there is a strong long-term relationship between prices and output that suggests that economic growth tends to subdue inflation. More specifically, the ratio of real output relative to base money as measured over long periods of time correlates strongly with the price level: all else remaining equal, more output equals lower prices. This is the basic long-term application of the quantity theory of money, a theory that does have strong empirical support over the long-term, as opposed to Keynesian output gap theories.

From a theoretical perspective, the key problem with Keynesian aggregate supply and demand analysis is that it ignores half of the picture. More specifically, it completely ignores how economic growth tends to impact long-term economic confidence, which, in turn, impacts the value of money.

As discussed in a recent post “Weak Micro Foundations, Ugly Macro Houses”, the price level is a relative measurement of the market value of the basket of goods in terms of the market value of money. In mathematical terms, the price level is simply a ratio of two values (see below).

If we accept a role for aggregate supply and demand analysis, then the best case that can be argued by the Keynesians is that the intersection of aggregate supply and demand determines the market value of the basket of goods, as illustrated on the left hand side of the diagram below.

It is absolutely fair to say that, in the short term, an increase in aggregate demand, i.e. stronger levels of economic growth, might lead to a rise in the market value of the basket of goods. All else remaining equal, i.e. the value of money remaining the same, this would also lead to a short-term rise in the price level.

The problem with this analysis is that focuses solely on the left hand side of the framework and completely ignores the role of supply and demand for money in the determination of the price level, i.e. it completely ignores the right hand side of the framework.

So, what might happen to the value of money in the scenario above? Does an increase economic activity tend to lead to a rise or fall in the value of money, as measured in absolute terms?

In order to answer these questions, we first need to understand the relationship between economic confidence and the value of fiat money. The view of The Money Enigma is that the value of a fiat currency, as measured in absolute terms, depends critically upon confidence in the long-term economic future of that society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society (see “Theory of Money” section).

In practical terms, the value of fiat money rises as people become more optimistic about society’s long-term future. Conversely, the value of fiat money tends to decline sharply when people begin to despair about society’s economic future (think about obvious cases of societal collapse and hyperinflation such as Zimbabwe).

Returning to our example, let’s assume that a pickup in economic growth leads to an uptick in long-term economic confidence. According to the theory above, what would we expect to happen to the value of the fiat money issued by that society? The value of money will rise.

As illustrated on the right hand side of the chart below, an uptick in long-term economic confidence leads, in effect, to an increase in demand for money and a rise in the value of money as measured in absolute terms.

What is the net effect on the price level? In essence, the rise in economic confidence subdues any inflationary impact from the near-term increase in economic activity. Moreover, if the uptick in confidence is strong enough, the rise in the value of money will overwhelm the rise in the value of goods and the price level will fall!

Clearly, this conclusion sits completely at odds with the standard Keynesian view of inflation. Keynesian analysis presents an incomplete view of the relationship between growth and inflation because it dismisses the important impact of confidence on the value of money and doesn’t appreciate the role of the value of money in price level determination. Indeed, Keynesian analysis, doesn’t even recognize the “value of money” as a variable (see “The Value of Money: Is Economics Missing a Variable?”)

In our example above, it is important to note that it is not a pick up in growth per se that leads to an increase in the demand for money. Rather, money is a long duration asset and the demand for money, in this scenario, increases because expectations regarding the long-term (20-30 year) path of the real output rise.

Just as an equity security is a claim on long-term future cash flows, so each unit of the monetary base is a claim on the long-term future output of society. All else remaining equal, as people expect a higher level of long-term future growth, the value of money rises.

Recession, Collapsing Confidence and The Value of Money

The view of The Money Enigma is that just as growth doesn’t equal inflation, recession doesn’t equal deflation.

Economists love to cite the Great Depression as evidence that economic weakness produces deflation. Yet, historical evidence suggests that some of the worst episodes of inflation, i.e. hyperinflation, are associated with economies that are collapsing.

The fact is that the deflationary experience of the Great Depression is simply not relevant to price level determination under our current fiat money regime. Moreover, the fact that economists cite the Great Depression as an example of the link between economic activity and deflation illustrates just how poorly constructed current models of price level determination really are.

In order to illustrate this point, let’s first consider why recession will not automatically lead to a deflationary outcome in fiat money regime and the circumstances in which a recession may actually lead to an accelerating rate of inflation.

In a recession, we can safely say that there is a reduction in aggregate demand. This shifts the aggregate demand curve to the left and the value of the basket of goods falls.

However, this is not the end of the story. Just because the value of the basket of goods has fallen does not necessarily mean that the price level falls. Rather, we need to consider what impact a recession will have on the value of money.

Typically, under a fiat money regime, a recession will tend to dent confidence in the long-term economic future of society. The degree to which confidence is damaged will depend on many factors including the depth and duration of the recession and the level of permanent damage that is done to the banking system and other key industries.

If we assume that the damage to long-term economic confidence is minimal, then the impact on the value of money is likely to be subdued. In this scenario, the value of money may fall slightly or not at all and, given the weakness in aggregate demand, prices are likely to fall (the percentage fall in V_G is greater than the percentage fall in V_M).

However, if the recession seriously erodes confidence in the long-term future of society, then the value of money could decline precipitously. In this scenario, prices will rise. Although the value of goods V_G will fall, a serious decline in confidence will lead to a dramatic fall in the value of money V_M and prices, as expressed in money terms, will rise.

In an extreme circumstance, if confidence collapses, then the value of money also collapses and hyperinflation can result. This outcome is rare because most people tend to treat recessions as temporary events. However, if a recession unmasks or creates serious structural problems, then this scenario can occur.

The Great Depression and Deflation

If this theory is correct and a collapse in economic confidence tends to lead to higher, not lower, prices, then why did prices fall in the Great Depression?

The answer to this is simple. During the early part of the Great Depression, the United States adhered to a gold standard. The reaction of prices to a collapse of confidence is completely different under a gold standard to what it is under a fiat money regime.

If the value of money is tied to the value of gold, then we can replace the market for money on the right hand side of our Goods Money Framework with the market for gold. More specifically, it is the reaction in the value of gold to a fall in confidence that determines the outcome for prices.

As you can see from the diagram above, the Great Depression created a perfect storm for deflation. Not only did the value of goods fall, the value of money rose! In terms of our price level equation, our numerator fell and our denominator rose, leading to a massive drop in the price level.

Economists who argue that a repeat of this scenario is possible in the present day completely ignore the right hand side of our model. Under a gold standard, a drop in economic confidence leads to a rise in the value of gold and, therefore, a rise in the value of money. However, under a fiat money regime, a drop in economic confidence leads to a fall in the value of money. It is almost impossible for prices to collapse if the value of money is falling!

In conclusion, the relationship between confidence and inflation is one of the most poorly understood concepts in economics. While economists love to examine the relationship between growth and inflation, it is confidence, not growth, that is the primary determinant of the value of money and inflation.

Inflation, Helicopter Money and Gold

In this week’s interview with MiningMaven, Malcolm Palle and I discuss the recent uptick in core inflation data, the notion of “helicopter money”, and the fundamental challenges facing the major central banks.

Listen to the interview

Weak Micro Foundations, Ugly Macro Houses

March 1, 2016

Macroeconomics is a house built upon shaky foundations.

While most economists assume that the microeconomic foundations of economics are solid, the view of The Money Enigma is that there is a critical piece missing from these foundations that endangers the entire macroeconomic structure that has been built upon them.

Arguably, macroeconomics is more like a block of several different houses, all of which are built on the same shaky foundations. And it is these shaky foundations that can explain why none of the macroeconomic houses ever look “quite right”.

For example, each of the major macroeconomic houses offers alternative theories regarding one of the most important questions in economics: what causes inflation? Keynesians argue that inflation is caused by too much demand; Monetarists argue that inflation is caused by too much money; while fiscal theorists argue that inflation is caused by too much government debt.

Interestingly, none of these macroeconomic theories talk to each other, i.e. they are very difficult to reconcile with one another. Moreover, central bankers, the high priests of economics, seem to be constantly surprised by price level outcomes that were not forecasted by their models.

What is anomalous about this macroeconomic complexity is that, in microeconomics, price determination is presented as a very simple process.

There is almost universal agreement in economics that the price of a good is determined by supply and demand for that good. Yet somehow, at a macroeconomic level, everything becomes much more complicated.

So, why are macroeconomic theories of price level determination so dissimilar from microeconomic theories of price determination? And why is there such a difference between the seeming simplicity of microeconomics and the endless complexity of macroeconomics?

The view of The Money Enigma is that the answer to this question lies not in macroeconomics, but in microeconomics.

Modern macroeconomic theories of price level determination are ugly and confusing because the microeconomic foundations upon which they are built are weak. More specifically, current microeconomic models of price determination present an incomplete view of how prices are determined.

In simple terms, microeconomics has a piece missing. Unfortunately, it is a critical piece, especially when we begin to contemplate how prices are determined at the macroeconomic level.

The Missing Piece in Microeconomics

What is the critical piece that is missing from current microeconomic theories of price determination? Well, in a nutshell, current theories are missing a second set of supply and demand.

The view of The Money Enigma is that every price is determined by not one, but two sets of supply and demand.

In every transaction there are two goods that are exchanged: a primary good and a secondary good. The price of a transaction depends on the relative market value of both the primary good and the secondary good.

The market value of each good is determined by supply and demand for that good. Therefore, every price is determined by two sets of supply and demand: supply and demand for the primary good and supply and demand for the secondary good.

We can apply this concept to the determination of “money prices”. In a money-based transaction, we exchange one good (the primary good) for money (the secondary good). The price of the primary good, in money terms, is a function of both supply and demand for the primary good and supply and demand for money.

Those readers trained in mainstream economics will probably look at the diagram above and say, “That’s not right, supply and demand for money determines the interest rate”. Unfortunately, this Keynesian nonsense, otherwise known as liquidity preference theory, has acted as a cornerstone of economics for nearly 80 years. From a structural perspective, it is a cornerstone that is hopelessly compromised.

The view of The Money Enigma is that supply and demand for money determines the market value of money, not the interest rate. In turn, the market value of money acts as the denominator of every money price in the economy: all else remaining equal, as the market value of money falls, prices as expressed in money terms rise.

In order to understand why this must be the case, it helps to abstract ourselves from our experience of a money-based economy and think about how prices are determined in a barter economy with no money.

Let’s imagine we live in a barter economy with two goods: apples and bananas. What determines the price of apples in banana terms? Traditional economics would say “supply and demand for apples”.

OK, so let’s assume that answer is right and ask another question. What determines the price of bananas in apple terms? Once again, traditional economics would answer “supply and demand for bananas”.

But, this creates a problem. Why? Well, the price of apples in banana terms is simply the reciprocal of the price of bananas in apple terms. For example, if the price of apples is two bananas, then the price of bananas must be half an apple.

Can you see the problem that traditional microeconomics has created? In essence, it is saying that the ratio of exchange (apples for bananas) is determined by supply and demand for apples if the price is measured in banana terms, and by supply and demand for bananas if the price is measured in apple terms.

But clearly, this is logically inconsistent. Why would the market forces that determine price be different simply because of the way the ratio of exchange is being measured!

How do we reconcile this situation? The obvious and logical answer is that the ratio of exchange, apples for bananas, is determined by two sets of supply and demand.

Think about it. What happens to the price of apples if there is a shortage of apples? Clearly, the demand curve for apples shifts to the right and, all else remaining equal, the price of apples rises.

Now, what happens to the price of apples in banana terms if there is an increase in demand for bananas? Intuitively, we know that if bananas become more valuable, then it will require less bananas to acquire each apple, i.e. the price of apples will fall.

This is hard to represent on a standard supply and demand diagram with the price of apples on the y-axis. But it is very easy to represent in the following diagram where market value is measured in absolute terms on the y-axis, i.e. in terms of a “standard unit” for the measurement of market value.

In the diagram immediately above, the demand curve for bananas shifts to the right and the equilibrium market value of bananas V(B) rises. The price of apples must fall as the price of apples is a ratio of the market value of apples V(A) divided by the market value of bananas V(B).

How does this reconcile with traditional supply and demand analysis? Well, using the traditional representation, with price of apples in banana terms of the y-axis, both supply and demand curves for apples, as expressed in banana terms, move lower as bananas become more valuable (see below).

If you are feeling a little confused by all the talk about apples and bananas, the key point is this: the price of one good in terms of another good is determined by market forces for both of the goods. Not just supply and demand for one of the goods, but supply and demand for both!

This basic theory of price determination applies to the determination of any price, including prices as expressed in money terms. Money is a good that possesses the property of value: money must have value in order for prices to be expressed in money terms. Moreover, the value of money is constantly changing, a process that is driven by supply and demand for money (or more specifically, supply and demand for the monetary base). The price of a good, as expressed in money terms, is determined by both supply and demand for the good itself, and supply and demand for money.

If you accept that each price in a barter economy is determined by two sets of supply and demand, then it is very difficult to mount the argument that somehow this basic economic process changes just because of the goods exchanged is now “money”. Money can only act as a medium of exchange because it has value and there must be a simple economic process that determines this value, i.e. supply and demand.

Building a Better Macro House

Once the foundations are solid, it becomes much easier to build a house that is not only more functional and attractive, but one that can incorporate many of the intuitively appealing ideas that offered some aesthetic appeal to the old, poorly constructed macroeconomic houses.

At the most basic level, our new and more comprehensive microeconomic theory allows us to illustrate a simple macroeconomic truth: the price level is a relative expression of the market value of the basket of goods in terms of the market value of money.

If every “money price” in the economy is a relative expression of the value of a good and the value of money, then an index of these prices can be broken down into an index for the market value of all goods (as measured in absolute terms) and the market value of money (again, measured in absolute terms, i.e. in terms of a standard unit for the measurement of market value).

Moreover, the price level itself is a function of two sets of supply and demand: aggregate supply and demand for the basket of goods determines the market value of the basket of goods, and supply and demand for the monetary base determines the market value of money. The price level is then simply the ratio of these two equilibrium market values.

By utilizing this basic macro framework, a framework built on much stronger microeconomic foundations, we can now identify the strengths and weaknesses of each of the existing macroeconomic houses and think about ways in which we could merge, improve and refine their intuitively appealing, but somewhat half-baked, theories regarding the causes of inflation.

Let’s quickly think about the strengths and shortcomings of each of the three major schools of thought (Keynesianism, monetarism and fiscal theory) in the context of the framework just presented.

Keynesianism, at least in most traditional form, focuses nearly entirely on the left hand side of the Goods Money Framework. Indeed, Keynesianism doesn’t even recognize the right side of the framework because it doesn’t recognize the simple, but critical, principle that supply and demand for money determines the market value of money.

In the Keynesian world, supply and demand for goods is the primary driver of inflation. If the economy overheats, then excess demand drivers the market value of goods higher and prices rise. The view of The Money Enigma is that excess demand can lead to temporary fluctuations in the price level, but “too much demand” is not the primary driver of inflation over time (see “Does Excess Demand Cause Inflation?”)

Keynesianism limits the role of money in macroeconomics to the determination of the interest rate. In other words, money can only cause inflation if an excess supply of money drives down the interest rate, triggering a burst of economic activity. In short, Keynesianism sees absolutely no role for the “value of money” in the determination of the price level.

This fundamental oversight is perhaps not surprising if you consider the environment in which Keynes developed his theories. Under the gold standard that existed at the time Keynes was at his “intellectual peak”, the value of money would have been fairly stable. Why? The value of money was stable because it was tied directly to the value of gold! In that world, it is easy to see why Keynes didn’t immediately equate supply and demand for money with the value of money and rather jumped to the obvious, but wrong, conclusion that supply and demand for money determines the interest rate.

In summary, the Keynesian house is a horribly lopsided house because it completely fails to recognize the role of the value of money in the determination of money prices. Any theory of inflation that can’t get its head around the fact that money has value and this value matters to the determination of prices is destined to fail.

This shortcoming also explains why modern day Keynesian theorists have been forced to add so many extensions to the Keynesian house, such as “inflation expectations”, in order to have a model for inflation that has any chance of explaining the dramatic swings in inflation over the past 80 years.

Monetarism is another ugly and frankly rather simplistic looking house that has only survived because of the strong appeal of its most basic tenet: the supply of money matters to price determination.

Unfortunately, monetarism is a theory that has been hijacked by Keynesianism. I have discussed this phenomenon extensively in recent posts including “Saving Monetarism from Friedman and the Keynesians”. In short, monetarists have whole-heartedly swallowed the bad idea at the core of Keynesianism, namely that supply and demand for money determines the interest rate. In effect, this has left monetarism sitting on the edge of road and monetarism has largely become the “lame duck” of macroeconomics.

This is a tragedy because monetarism has some important observations to make about the relationship between money and inflation over time. If monetarism simply recognized the right side of the Goods Money Framework as presented above, then monetarists could engage in some very productive debate regarding the primary determinants of the value of money and, more specifically, how the historic and expected path of the monetary base might impact the value of money.

While the façade of monetarism is aesthetically appealing, monetarism is a house that is not only built on bad microeconomic foundations, but is also built upon one of the structurally comprised cornerstones of the house next door, i.e. Keynes’ liquidity preference theory.

The view of The Money Enigma is that money does play a critical role in the determination of inflation. More specifically, expectations regarding the long-term outlook for monetary base growth relative to real output growth determine the value of money. Moreover, the primary transmission mechanism from money to inflation does not act through the interest rate and aggregate demand channel, i.e. the left side of the Goods Money Framework, but rather through the value of money, i.e. the right side of the Goods Money Framework. [Please see “A New Perspective on the Quantity Theory of Money” for an extensive discussion of the monetary transmission mechanism.]

Finally, we have the smallest house on the block, fiscal theory of the price level. At the heart of fiscal theory is the idea that the level of government debt matters to inflation: if a society accumulates “too much” public debt, then the rate of inflation can accelerate dramatically.

This core tenet of fiscal theory is also intuitively appealing: after all, hyperinflation is, in essence, a form of sovereign default. However, fiscal theory struggles to explain the transmission mechanism from debt to inflation.

The view of The Money Enigma is that government debt does play a critical role in the determination of inflation. More specifically, the perceived sustainability of government debt has a direct impact on expectations regarding the future growth of both the monetary base and real output. In turn, these variables directly impact the value of money.

In essence, as the fiscal situation of a nation becomes more unsustainable, the value of money falls and the price level rises. Those who are interested in this relationship should read the very popular “Government Debt and Inflation” post written in 2015.

In conclusion, while the various macroeconomic schools of thought all contain elements of intuitive appeal, they are all compromised by their weak intellectual foundations. Moreover, it can be argued that it isn’t the macroeconomists themselves that we should be blaming. Rather, it is the bastions of microeconomics, who in a state of sublime hubris, have failed to recognize the very fundamental limitations of their most basic and yet most important theory: the theory of supply and demand.

Author: Gervaise Heddle

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