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Why Does Fiat Money Become Worthless?

Fiat money has a long history of losing value. Generally, this process is gradual and prices rise slowly over long periods of time. However, sometimes a particular fiat currency becomes almost worthless overnight and prices soar in terms of that currency.

But what drives the loss of all value in a currency? And what are the necessary conditions for fiat money to become worthless?

In this week’s article, we explore this issue by analogy. More specifically, we examine why certain stocks, under certain conditions, tend to lose most of their value very quickly. We then apply these ideas to the analysis of fiat money.

While some may argue that equities and fiat currencies are not comparable, the view of The Money Enigma is that their behavior can and should be compared side by side because they are, in fact, very similar financial instruments.

More specifically, fiat money, just like a share of common stock, represents a proportional claim on some future economic benefit.

Equities represent a proportional claim on future residual cash flows: the value of an equity (share of common stock) varies according to expectations of future cash flow and expectations regarding the number of shares outstanding, i.e. the number of shares that will have a claim against that cash flow.

In contrast fiat money represents a variable claim on the future output: the value of fiat money varies according to expectations of future output and expectations regarding the size of the monetary base, i.e. the number of monetary units that will act as a claim against that future output.

The value of a stock collapses when the outlook for cash flow plunges and expectations for share issuance soar. Similarly, the value of fiat currency collapses when the outlook for economic activity plunges and expectations for monetary base expansion soar.

Lessons in Resource Stock Investing

If you spend a decade investing in resource stocks, then you are almost bound to learn some painful lessons.

In the right set of circumstances, resource stocks, particularly those in the exploration space, represent a path to quick riches. Those in the industry who have made great discoveries have made many a fortune. Moreover, many investors, who have had the insight and courage to buy resource stocks at the right point in the cycle, have also made a killing.

However, the fact is that the resources sector is also a risky place to invest and many have lost significant sums in the pursuit of great returns. From 2012 to the end of 2015, many resource stocks lost 90% or more of their value as demand for China dried up and the sector fell out of fashion.

As a general rule (and this is a “general rule” and therefore should be considered as any investors reading as a vast overgeneralization), a resource stock does well when expectations regarding future cash flow generation improve and expectations regarding future share dilution begin to moderate.

Conversely, a resource stock does poorly when expectations regarding future cash flow generation deteriorate and expectations regarding the level of future share issuance begin to rise.

In general, it is the combination of deteriorating fundamental prospects for the deposits or mines that the company owns plus the issuance of large numbers of new shares that quickly erodes the share price. In the worst case scenario, a period of heavy dilution of existing shareholders can drive a resource stock down 90% or more, i.e. the share becomes almost worthless.

Clearly, the two phenomena are related. An erosion of confidence in the long-term fundamental prospects of the company wipe out other sources of potential finance and the company is forced to issue shares at lower prices just to raise enough cash to keep the lights on. If confidence remains low for an extended period of time, then the company will be forced to keep issuing shares at lower and lower prices.

The Value of Fiat Money and Long-Term Economic Confidence

Resource stock investing is interesting from an economic perspective because it may provide us with a perspective on why fiat currencies become worthless. Why? Well, the view of The Money Enigma is that fiat money is a financial instrument (it derives its value from its implied contractual properties) and fiat money, like stocks, represents a proportional claim on a future set of economic benefits.

Most economists don’t think of money in these terms, but most economists don’t offer a sensible theory regarding (a) why does fiat money have value, and (b) what determines that value over time.

If you ask most economists why the paper money in your pocket has value, they will give you some waffle along the lines that paper money has value because it is accepted in exchange. The problem with this line of reasoning is that it creates a circular argument: Why is money accepted in exchange? Because it has value. Why does money have value? Because it is accepted in exchange.

The fact is that every asset derives its value in only one of two ways. Either it is a real asset, i.e. it derives it value from it physical properties, or it is a financial instrument, i.e. it derives its value from its contractual properties.

This paradigm applies to every asset we know: bonds, equities, commodities, real estate etc. And yet, when it comes to fiat money, economists like to side step this fundamental paradigm and try to invent new theories regarding how one particular asset derives its value!

Prima facie, economists should attempt to answer the question “why does fiat money have value?” using the paradigm described above. After all, it works for the first forms of money: commodity money (money that is literally a commodity such as gold and silver) and representative money (money that is backed by a commodity, i.e. early paper money that was exchangeable into gold on request). Commodity money is a real asset and derives its value from its real properties. Representative money is a financial instrument and derives its value from its contractual properties.

The question that economics fails to answer is why did paper money continue to have value when the explicit contract that governed representative money (the asset conversion feature) was rendered null and void.

The view of The Money Enigma is that when the asset-backed feature of paper money was removed, the explicit contract that governed paper money was replaced by an implied contract. In essence, money became a proportional claim on the future output of society. Therefore, its value now depended on two key factors: (a) the long-term expected future output of society and (b) the long-term expected number of units of money to be issued (more specifically, the long-term expected path of the monetary base).

Complicated? Yes. Hence, we use the analogy with resource stocks.

Stocks represent a proportional claim on a set of long-term future cash flows. They are a “proportional claim” because each stock only claims a certain proportion of those future cash flows. The proportion that each stock claims depends on the number of shares outstanding today and the number of shares outstanding in all future periods. (Note: people are trained to think about this in static terms and only use shares outstanding today… but this is incorrect. The value of a share today depends upon not only shares outstanding today but expectations of shares outstanding in all future periods).

Similarly, my view is that fiat money represents a proportional claim on a long-term set of future economic benefits, namely the economic output of society. Fiat money is a proportional claim because the proportion of output that each unit of money claims depends on the size of the monetary base today and the size of the monetary base in all future periods.

A more nuanced, but important point, is that fiat money shares another characteristic of equities: fiat money is a long-duration asset. What does this mean? It means that the value of fiat money depends on long-term (30-40 year) expectations regarding the outlook for both economic output and the monetary base.

Why Might a Fiat Currency Become Worthless?

So, why might a fiat currency lose most of its value over a relatively short period of time?

Let’s think about it in terms of our earlier discussion. We noted that a resource stock tends to lose most of its value when confidence regarding its future prospects greatly diminishes. More specifically, it is the combination of deteriorating expectations regarding future cash flow generation plus the expectation that many more shares will be issued that leads to a collapse in the value of the stock.

Let’s apply this to fiat money. If fiat money is also a proportional claim on some future benefit, then it stands to reason that fiat money would lose most of its value under similar circumstances.

More specifically, fiat money will lose most of its value if (a) expectations regarding the long-term future output of society markedly deteriorate, and (b) expectations shift such that people expect a much greater issuance of money over the next couple of decades.

What sort of circumstances might create this? Well, war would be one. If war breaks out and people believe that it will last a long time, drive a marked collapse in the long-term outlook for real GDP and force the government to print money to survive, then one would reasonably expect the value of the fiat money of that society to collapse (and prices to soar in terms of that currency!)

Lessons for Today?

The big question for investors today is whether we are on the verge of a shift in expectations that could lead to a collapse in the value of the major fiat currencies.

At least part of the stage for such a shift in expectations has been set. Government debt levels have soared which could limit future financing options for the major governments. Moreover, the monetary base in most major Western countries has also soared.

Yet, the value of the major fiat currencies has, to date, held up relatively well. Why? Well, probably because the other key part of the equation is missing: expectations regarding long-term economic growth have not collapsed. Rather, it seems that most people remain quite optimistic regarding the long-term economic growth of Western society, despite the fact that, over the past ten years, it has taken a massive deterioration in the balance sheet of Western society just to eke out a small amount of real economic growth.

The bottom line is that we will just have to wait and see. If the market is right, and economic growth continues strongly over the next ten years, then it is likely that the major fiat currencies will maintain their value. But, if confidence in the long-term future of Western society is lost, then it is almost a certainty that the value of the major currencies will erode quickly leading to a sustained period of severe inflation across the Western World.

The Cost of “More”

August 26, 2016

I am both proud and slightly embarrassed to admit that one of the first words of my sixteen-month old son is “more”.

My son has started to use a few other basic words, but there is no doubt that the word he uses most frequently is “more”. If you want more food, you point and say “more”. If you want to play with a yellow duck in the bath, you point and say “more”. If your dumb parents don’t understand, you might add in a few nods of the head at the same time to help build consensus around the issue.

To be honest, I share the same happiness that any parent feels when you first to begin to open the lines of verbal communication with your child and, while we hope to expand his vocabulary, for now the word “more” is music to our ears.

On the flipside, I find the frequent use of the word “more” by adults to be rather unsettling, particularly as it relates to the ridiculous expectations that our society has placed on government and policy makers more generally.

It seems that we have become a society where the economic status quo is never enough and where “more” is regard as a basic entitlement of civilized society.

We need “more jobs”, “more schools”, “more nurses”, “more teachers”, “more roads”, “more trade”, “more growth”, “more innovation”… and somehow, despite the fact that all this “more” is expected to be delivered by central authority, we expect “more freedom”.

Let’s be frank… How often do you hear the word “less” used in conversations regarding any related to government?

“The Fed should do less”… not a phrase you hear very often on CNBC.

What about “the Government should spend less on hospitals and/or schools and/or welfare”: again, not a phrase one hears very often. Or try this one, “politicians should take less action”: have you ever heard that phrase?

As a parent, we try to teach our children that they can’t always have “more”. Yet as a society, we seem to be failing to comprehend this simple lesson.

The problem is that “more” nearly always has a cost associated with it.

If we indulge our children and let them have “more” chocolate cake, then there is often a short-term cost associated with this, namely, a sick child. At an extreme, if the pattern of behavior is repeated, then there can be more serious long-term costs associated with this indulgence, for example, diabetes and obesity.

This much is obvious. Unfortunately, what is less obvious is the economic cost of ‘”more” when applied at a societal level.

More Debt, More Money, No Problems?

There are a number of commentators and supposedly serious policy makers who seem to believe that the answer to any economic problem is “more”.

Job growth isn’t strong enough? We need more monetary stimulus. Productivity growth isn’t strong enough? The government needs to spend more on innovation. The real economy isn’t growing fast enough? Better pull out the big guns: more fiscal stimulus and more monetary stimulus is required!

The Keynesian-inspired view of these commentators seems to be that the answer to every problem is more action by the fiscal and monetary authorities. Yet seldom do we hear any of these same commentators talk about the cost of “more”.

In business, there is always a focus on clearly estimating and measuring the return on capital on any particular investment project, i.e. how much profit is created by an incremental dollar of investment.

In contrast, in political circles, it seems that we start with an argument that we must have “more {insert latest demand here}” without any genuine discussion about the required rate of return on stimulus.

Part of the reason for this is that while the required rate of return on an investment project can be quantified fairly easily, it is difficult for policy makers to comprehend the required rate of return on stimulus because the actual cost, particularly the long-term cost, associated with stimulus programs is very poorly understood by their key economic advisers.

Politicians tend to assume that the required rate of return hurdle is stimulus is fairly low. In other words, politicians almost invariably assume that if stimulus fixes a short-term economic problem, then it has more than justified itself. But this is entirely erroneous because although the key objective of stimulus may be to fix a short-term problem, it is not enough for stimulus to just fix a short-term problem, it must also compensate for its long-term cost.

Every stimulus, almost by its very nature, involves the creation of either more government or more money (an expansion of the monetary base). Many politicians and commentators seem to view more debt and more money as costless. But both come with very real costs, even if those costs are not felt in the short term.

The Cost of “More” Stimulus

Over the past decade, benign economic outcomes in most of the world’s major Western economies seem to have induced an extraordinary degree of complacency regarding the rapid expansion of government debt during this period. Similarly, the quintupling of the US monetary base over the past decade has led to the widely held that view that the size of the monetary base doesn’t really matter and is almost irrelevant to economic outcomes.

It seems that while a lot more debt and money may not lead the desired outcome of policy makers, i.e. high levels of economic growth, it also doesn’t create any economic “problems”.

Unfortunately, the experience of the last decade has boosted the credibility of Keynesians and hurt the credibility of Monetarists just at the time when policy makers need a strong reminder of the long-term risks associated with both soaring government debt and rapid monetary expansion.

Ultimately, the cost of “too much debt” and “too much money” are one and the same: a decline the value of the fiat currency issued by that society and a rapid rise in the rate of inflation.

The fact that we haven’t experienced this phenomenon in the past decade does not somehow negate the fact that this always the long-term cost associated with the long-term overuse of fiscal and monetary stimulus.

In order to understand why this is the case, one needs to consider why fiat money has value and what factors determine the value of that fiat money.

The Fiat Money Enigma

Every dollar of fiat money that you carry in your wallet must possess the property of “market value”. In simple terms, each dollar must have some value or it would not be accepted in exchange.

The question that still plagues economics is why does fiat money have value?

Economists have offered plenty of illogical and circular answers to this question, such as “fiat money has value because it is accepted in exchange”. This contention immediately creates a circular and invalid argument: fiat money has value because it is accepted in exchange, fiat money is accepted in exchange because it has value.

A sensible theory of money must propose another method by which fiat money derives its value.

Fortunately, there is a simple framework that can be applied: real assets vs financial instruments. Assets either derive their value from their physical properties (real assets) or they derive their value from their contractual properties (financial instruments). There is no “third way” here: an asset is either one or the other.

The view of The Money Enigma is that fiat money derives it value from its implied contractual properties. In essence, every dollar in your pocket represents a contract between you (the holder of money) and society (the ultimate issuer of money). More specifically, each dollar represents a proportional claim against the future output of society.

Financial instruments that represent a proportional claim to something are, in fact, quite common. For example, shares represent a proportional claim against the future residual cash flows of a company. So why couldn’t fiat money represent a proportional claim against the future output of society?

Frankly, this model fits neatly with the observed behavior of the value of fiat money.

If the economic prospects of a society suddenly deteriorate rapidly (for example, due to war), then the value of fiat money issued by that society tends to decline rapidly and prices, as expressed in terms of that currency, rise sharply.

Too Much Money, Too Much Debt

So, how might a marked increase in government debt and the monetary base impact the value of fiat money?

If the “Proportional Claim Theory” of fiat money is right, then an accumulation of debt accompanied by an expansion of the monetary base could impact expectations regarding the long-term economic prosperity of society.

If the market begins to believe that a society’s future will involve a much slower rate of real economic growth accompanied by a much higher rate of monetary base growth, then this should negatively impact the value of the money issued by that society and should, at the margin, lead to an increase in prices expressed in terms of that monetary unit.

You may well ask, why hasn’t this happened so far? Debts have ballooned and the monetary base has exploded yet the major Western currencies have apparently lost little of their value.

The view of The Money Enigma is that fiat money is a long-duration asset (“Is Money a Short-Duration or Long-Duration Asset?”). This means that the value of fiat money, at any particular point in time, depends on very long-term expectations (30 years+) regarding the economic future of society.

So far, we have “dogged the bullet”, because most people remain optimistic regarding the long-term economic outlook for Western society, or at the very least, they remain very complacent in this regard.

While this combination of complacency and optimism reign, fiat money can sustain its value. But the combination of “too much debt” and “too much money” creates the perfect recipe for a sudden loss in economic confidence and a collapse in the value of money.

In conclusion, the next time you find yourself wanting “more” from government and the central banks, you may want to step back and consider the long-term cost of “more” and whether the cost of your indulgence is really something you want your children to bear.

The Fed’s Long Road to Rehab

June 7, 2016

“My name is The Market and I am still a Fedaholic.”

You don’t break your drug addiction by driving around and around the rehab center drinking a bottle of whiskey and popping pills.

Similarly, you don’t break an addiction to easy money by constantly stalling any interest rate rises and failing to make any reduction in the monetary base.

However much the Fed would like you to believe that it has put the markets on the road to easy money rehab, the fact is that the Fed is scared of what will happen to financial markets and the real economy if it actually sends the markets to easy money rehab and forces them to stay there.

As argued in a post earlier this year, “The Markets Go to Rehab”, the markets have become addicted to a dangerous cocktail of “easy money” drugs. While the markets have enjoyed an easy money binge over the past ten years, breaking the habit will be a very unpleasant experience. Moreover, if the Fed doesn’t wean the markets off the easy money drug, then the long-term economic consequences will be dire.

Back in the first quarter of this year, it looked as though the Fed might actually try to cut off the drugs. There was a genuine expectation of a series of rate rises over the course of 2016, even if those rate rises were engineered by the disingenuous policy instrument that is “interest on reserves”.

However, as we near the half way mark for the year, it seems increasingly clear that the Fed has no appetite for genuine “normalization” of monetary policy.

Consider the evidence so far. We are now six months into this current cycle of tightening monetary policy. How many times has the Fed raised interest rates in this cycle? Once.

In six months, we have only seen one 0.25% interest rate increase by the Fed. In previous tightening cycles, one would have reasonably expected three or four increase in the short-term interest rate by now.

To repeat, we have seen only one rate rise in six months. It begs the question: is the Fed serious about tightening monetary policy? Or does the Fed just want to pretend that it is tightening policy?

To be fair, short-term interest rates are not the only way we can measure Fed activity. The other key monetary policy setting that we need to consider is the size of the monetary base.

Over the past eight years, the monetary base of the United States has quintupled. This rate of growth in the monetary base is far in excess of the historical norm. Any genuine attempt to tighten monetary policy settings in the United States must include a significant reduction (30-50%) in the size of the monetary base.

How is the Fed doing on this second benchmark? Not so well.

As you can see from the chart above, the Fed has barely touched the monetary base. Indeed, the US monetary base continues to hover at dangerously elevated levels.

The lack of Fed action on both interest rates and the monetary base raises a couple of question. Is the Fed genuinely attempting to tighten monetary policy, or is the Fed merely pretending to tighten to monetary policy? And why would the Fed pretend to tighten monetary policy?

The Great Pretender

Why is the Fed trying to be seen to take action while its takes no action?

We can break this question into two parts. First, why doesn’t the Fed want to tighten monetary policy? Second, why does the Fed want the world to believe that it will tighten monetary policy in the near future?

The first part is easy to answer. The markets are addicted to easy money: take away the easy money and the party is over.

Nowhere is this relationship better illustrated than a chart of the US monetary base plotted against the S&P 500.

While Fed officials may have trouble with some concepts, we know that all the members of the FOMC can understand charts and correlation. We can be fairly certain that the extraordinary correlation between the US monetary base and the global equity markets has not escaped their attention.

Now ask yourself: if you were a Fed official today, would you want to the one that pushes for a reduction in the monetary base? Do you want to be the Fed official that goes down in history as the one who crashed the stock market? Probably not…

While one can understand why the Fed doesn’t want to tighten monetary policy, the more important question is why does the Fed want to appear to be tightening monetary policy? This is an important because the answer to this question highlights the vulnerability of the Fed and the tremendous risks associated with current monetary policy settings.

The view of The Money Enigma is that while the Fed doesn’t actually want to tighten monetary policy, it must keep threatening to tighten monetary policy in order to retain its credibility and, ultimately, to protect the value of the US Dollar. If the Fed doesn’t continue to jawbone the markets regarding imminent rate hikes, then the US Dollar might collapse and the rate of inflation will soar.

One can think of it in terms of our previous analogy.

The markets know that they are addicted to drugs (easy money), an addiction that has been enabled by the Fed over many years. However, the markets believe that this is just a temporary problem, i.e. they can break the habit at some point.

As long as the Fed keeps promising to send the markets to rehab but doesn’t actually send them, then the markets can continue to believe that the addiction is just a short-term problem that will be fixed one day.

However, if the day comes where either (a) the Fed genuinely cuts of the drugs, or (b) stops promising cut off the drugs because the markets are “beyond hope”, then the markets will realize that their addiction problem is in fact a permanent one.

It’s one thing to be an addict who believes you can be redeemed: it’s another to be an addict that knows that all hope is lost.

If the markets begin to realize that the aggressive monetary policy settings of the past ten years are to become a more permanent feature of the economic landscape, then the value of the fiat money issued by the United States could drop sharply. Why? Well, in simple terms, fiat money only has value because it represents a claim against the future output of society. More specifically, it represents a proportional claim against future output, i.e. the more money that is created, the less value it has. [See “Theory of Money” section for a in-depth discussion of this concept.]

Over the past ten years, the Fed has been able to dramatically expand the monetary base with little consequence on the value of money. It has been able to do this because the markets believed that this expansion was a short-term phenomenon. However, if the markets suddenly realize that the expansion of the monetary base is a long-term phenomenon required to support the markets easy money addiction, then the value of money will quickly erode and prices, as expressed in money terms, will surge higher.

In conclusion, the Fed is taking the long road to rehab. It doesn’t want to check the markets into easy money rehab, but it must appear to be doing so. Ultimately, the Fed is playing a dangerous confidence game, and one it is sure to lose.

The Benefits and Costs of Monetary Excess

May 10, 2016

Every day, every one of us makes numerous cost-benefit calculations that impact the way we live our life. We might not sit down with pen and paper or an excel spreadsheet to make these calculations: many of our decisions are based on intuition and gut feel. Nevertheless, nearly all our decisions involve weighing the benefits of a particular action against the cost.

In general, most of us are very good at this. Indeed, one might argue that human beings are perfect or near-perfect cost-benefit analysis machines. The process of evolution has created a biological system (the human being) that is fundamentally attuned to making quick and accurate decisions regarding its own self-interest.

However, while the process of evolution may have endowed us with the ability to make good individual decisions, it doesn’t seem to have endowed us with the ability to make good collective decisions. This problem is becoming more and more apparent as our societies becomes larger and as the barriers between our societies begin to erode.

Moreover, we are very poor at making collective decisions in matters where the benefits are clear and short-term in nature, while the costs are ambiguous and long-term in nature.

Nowhere is this more evident than the policy-behavior of the major Western democracies over the past twenty years.

Over the past twenty years, voters and policy-makers in the major Western democracies have consistently opted for short-term economic gain rather than genuine austerity and real structural reform, even if that short-term gain is almost certain to involve much greater long-term costs.

Government debt levels as a percentage of GDP have risen in every major Western democracy to levels rarely seen except in a time of major war. The chart below illustrates how government debt levels in the United States are back to the peak post-WWII, an extraordinary outcome when one considers the massive government spending that was required to win WWII.

Modern-day Keynesians will argue that government spending in a time of recession is critical to ensure a timely economic recovery. While this may or may not be true, there is a flipside to this Keynesian coin: government can not perpetually run massive government deficits. If society wants to spend in the bad times, then society must save in the good times.

Apparently, there have been few “good times” in the last thirty years. Most Western governments have run almost perpetual and significant budget deficits over that time, the one exception being the United States that actually managed to run a budget surplus in four of the past thirty years (during the epic technology-fueled boom of the late 1990s).

The fact that governments have run almost perpetual budget deficits over the past thirty years suggests that rather than there being few actual “good times” over the past thirty years, our definition of “good times”, at least from an economic perspective, is flawed.

In truth, most of us recognize that economic conditions during most of our lifetime haven’t been that bad, at least relative to the economic conditions that our grandparents and other older generations had to endure. So this raises the obvious question of what is really going on? Why do we keep pulling in the benefits and pushing out the costs?

The view of The Money Enigma is that while each of us are generally good at making cost-benefit decisions that relate to our own individual circumstances, we as society are particularly bad at conducting good cost-benefit analysis when it comes to major economic decisions. This is particularly the case when the benefits are clear and the costs are uncertain.

In the case of fiscal policy, it is not that difficult for the ordinary person to get their head around why there must be some limit on government spending. Most adults have to balance their own budget and recognize the broad principle that government should do the same. Nevertheless, there are still many “serious” economists today who argue that one shouldn’t worry about government debt or deficits, a phenomenon that has no doubt contributed to Western societies profligate fiscal behaviour.

However, in the case of monetary policy, it is very difficult for the ordinary person to understand the long-term costs associated with excessive and prolonged monetary stimulus. This lack of monetary education shouldn’t be surprising: most economists are themselves totally befuddled when it comes to this point. Indeed, the view of The Money Enigma is that modern economics fails to provide a sensible model of the process from “too much money” to “rising prices”.

If people can’t understand the costs of monetary policy, then it is impossible to have a sensible debate about the limits of policy. Given the extraordinary monetary excess of the past ten years, it is worth stepping through the cost associated with such excess and how that cost comes to be realized in a practical sense.

Before we discuss the costs, we shall also briefly discuss the benefits of easy monetary policy. Hopefully, readers will conclude, as I do, that the short-term benefits of such policy are not worth the severe long-term costs.

Quantitative Easing: The Cost-Benefit Analysis

In order to analyze the benefits and costs of highly accommodative monetary policy, it is helpful to define exactly what aspect of this policy we are focused on. In this case, we will focus on the benefits and costs of quantitative easing.

In essence, quantitative easing involves the central bank creating money (expanding the monetary base) and using this newly created money to purchase predominantly long-term, fixed-income government securities.

Why would a central bank do this? Well, creating money and using it in this way achieves something that is difficult to do with conventional monetary policy. Conventional monetary policy operates by manipulating the short-term interest rates. By manipulating the short-term interest rate, the central bank can influence the level of lending by banks. However, conventional monetary policy is limited in the sense that it has limited impact on long-term interest rates.

When the Fed ran out conventional monetary policy options in the financial crisis of 2008, it decided to adopt unorthodox measures. Most notably, it decided to begin manipulating the long-term interest rate by creating money and using it to purchase long-term government securities, a process also known as “quantitative easing”.

The benefit of artificially lowering the long-term interest rate is that it has a profound impact on the allocation of capital across the economy and, therefore, a marked impact on economic activity. More specifically, by artificially lowering the interest rate on long-term government debt, the Fed, in effect, artificially lowers the long-term required rate of return on risk capital.

In simple terms, QE forces investors to accept a lower rate of return on their capital and/or to take on more risk. As the Fed buys more low-risk government debt, investors must look elsewhere to achieve returns: government bond investors shift towards corporate bonds, corporate bond investors shift towards equities, and so on. At the margin, private investors are forced to take more risk for less return.

One “benefit” of this policy is that it encourages higher levels of speculation, i.e. asset prices rise and there is a “wealth effect” across the economy. Another way of saying this is that the rich get richer and spend more, at least theoretically.

The second and more profound benefit is that lowering the cost of risk capital does encourage new business formation and the expansion of existing businesses. In other words, this unorthodox form of monetary policy does, at least in the short term, allow more small businesses to start up and does lead to the creation of more jobs.

In summary, the net benefit of QE is that those with assets get richer and, at the margin, more jobs are created for everyone else. This may not be an ideal social outcome, but it does represent a real economic benefit for most in the short term.

However, QE does come with an economic cost. Unfortunately, the cost is policy-path dependent and, therefore, is not simple to assess. More specifically, the exact nature and timing of the cost depends upon whether the unconventional monetary policy is temporary or permanent in nature.

If the QE experiment is temporary, i.e. if the monetary base is quickly reduced after a short period of expansion, then the primary cost of QE is the impact on financial markets and economic activity that occurs when the long-term cost of risk capital rises.

Just as reducing the cost of capital leads to a rise in asset prices and an increased level of business investment, an increase in the cost of capital (as a result of unwinding QE) should predicate a fall in asset prices and a general decline in business investment and new business formation. As the cost of capital rises, asset prices fall and jobs are lost.

Clearly, none of this sounds much fun. So what is the other alternative? Well, policy makers could decide to leave the monetary base at historically high levels. In other words, this unorthodox and very aggressive monetary base expansion could become more permanent in nature.

While the Fed has generally argued that QE was always a temporary phenomenon, it is increasingly unclear when or if the Fed will reduce the monetary base. At the time of writing, the Fed has barely touched the short-end of the interest rate curve, let alone made any real effort to reduce the monetary base and raise long-term interest rates.

So, why not leave the monetary base at the current exceptionally high levels? Why not avoid the costs associated with reversing QE? Why can’t our society live with a higher level of base money, just as we seem to be living with a higher level of government debt?

The simple answer to this question is that, in the long run, growth in the monetary base that significantly exceeds growth in real output will lead to inflation. Unfortunately, while this there is significant historical evidence for this concept, the simple answer to our question doesn’t explain why this is the case.

Why Does Money Matter?

In order to understand why the amount of money created by the central bank matters, we need to step back and begin with two basic concepts: (1) money has value, and (2) as the value of money falls, the price level rises.

The money in your pocket possesses the property of market value. If it didn’t, then you wouldn’t accept it in exchange for your services and others wouldn’t accept money from you in exchange for their goods and services.

Moreover, the value of money is critical in determining the price of any good as expressed in money terms. For example, if a banana is twice as valuable as one dollar, then what is the price of bananas in dollar terms? Clearly, it is two dollars.

This price is a relative relation: it expresses the market value of the banana relative to the market value of the dollar. Importantly, this relative relationship can change for one of two reasons: either, the value of the banana can change, or the value of the dollar can change. For example, if the value of the banana is constant (in absolute terms) but the value of the dollar falls by 50%, then suddenly each banana is now four times more valuable than each dollar and the price of bananas in dollar terms is four.

Anyway, the key point is that the value of money is a key input into all prices as expressed in money terms. Moreover, if the value of money falls, then prices will rise.

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

The view of The Money Enigma is that money is governed by a social or implied contract. This contract, if it were to be written out, would state that each unit of the monetary base represents a proportional claim on the future output of society.

In essence, money is the equity of our society. Just as our society can issue fixed claims against future output (government debt), so it can issue variable claims against future output (the monetary base).

What determines the size of the variable entitlement to real output that each unit of money represents? The view of The Money Enigma is that the variable entitlement is determined by expectations regarding the long-term size of the monetary base.

In other words, if people believe that long-term monetary base growth will be restrained, then this supports the current value of money. In contrast, if people believe that the central bank has become reckless and long-term monetary base growth will not be tightly controlled, then this can lead to a sudden and severe decline in the value of money.

If this theory is correct, then expectations regarding whether QE is a temporary or more permanent phenomenon matter. If the market is correct and QE will be reversed in due course, then there is little reason for the value of money to decline sharply and for inflation to accelerate.

However, if the market suddenly begins to doubt the Fed’s intentions and starts to assume that QE is more permanent in nature, then the value of money could decline quickly and sharply, leading to a sudden acceleration in inflation.

Today, the Fed is trying to have its cake and eat it too. The Fed is trying to enjoy all the benefits of QE, while avoiding all the costs. The Fed can pull off this magic trick as long as it continues to convince the markets that QE will be reversed in the “near future”. However, if the markets begin to doubt the Fed’s sincerity in this regard, then the value of money could decline sharply. In this scenario, the Fed could find that things quickly spin out of control.

The Perfect Storm: The Interview

Earlier this week, I spoke with Malcolm Palle at the Mining Maven about a recent Money Enigma article titled “The Perfect Storm for Inflation?”

Listen to the full interview

The view of The Money Enigma is that we could be on the cusp of a rare event that is created when two significant economic forces meet at the same time. More specifically, the combination of a turn in the commodity cycle and weakness in the major fiat currencies could create the perfect storm that triggers a surge in the rate of inflation.

I hope you that enjoy the interview!

The Perfect Storm for Inflation?

April 10, 2016

“Perfect storm: a particularly violent event arising from a rare combination of adverse circumstances.”

Over the last twenty years, most investors have become accustomed to a low inflation world. In the 1980s, and even the first part of 1990s, many investors worried about a return to the high levels of inflation that were experienced in the United States in the 1970s. But those fears were never realized and, as we sit here today, many investors are more worried about deflation than inflation.

But is it possible that we are sitting in the eye of a storm? Is it possible that circumstances are conspiring to create a perfect inflationary storm? And, from a theoretical perspective, what might the lead up to the “perfect inflationary storm” look like?

In this week’s article, we are going to adopt the role of economic meteorologists. The view of The Money Enigma is that one can not predict inflation simply by looking at recent trends in the data, just as one can not predict rain by simply looking out the window. Rather, we need to think about the structural events that are required to create a perfect storm. What are the relatively rare circumstances that, when combined, could create a sudden and violent acceleration in the rate of inflation?

Two Storms Approach

The view of The Money Enigma is that we may be on the verge of a rare event: a moment when two powerful storms meet to create a perfect storm.

From an inflationary perspective, the perfect storm requires two key events to occur simultaneously: a sharp rise in the value of goods, and a sharp fall in the value of money.

The value of goods is approaching a potential inflection point, driven by a lack of investment in new commodity supply over the past few years. While many bemoan the future of commodity demand, the simple fact is that there has been a collapse in capital and exploration spending, particularly in vital commodities such as oil.

Conversely, the value of money is poised for a significant decline. The value of fiat money, particularly the US Dollar, has been well supported over the past ten years, despite the reckless actions of both fiscal and monetary policy makers, but this support could erode quickly if the market begins to doubt the sincerity of policy makers efforts to normalize policy settings.

If the value of goods were to suddenly spike, driven by a tightening of supply, at the same time as a dramatic fall of money were to occur, then this could create a violent surge in the rate of inflation.

But before we dig into too much detail regarding the two approaching storms, let’s take a few moments to discuss a simple question: what drives prices higher?

At the most fundamental level a price is nothing more than a ratio of two quantities exchanged: a quantity of one good for a quantity of another. This ratio of exchange, or the “price” of the trade, is determined by the relative market value of the two goods being exchanged. For example, if a banana is twice as valuable as an apple, then the price of banana in apple terms is “two apples”.

Similarly, the price level is nothing more than a relative measure of the market value of the basket of goods in terms of the market value of money. By measuring market in absolute terms (i.e. in terms of a standard unit for the measurement of market value), we can express the price level as a ratio of two values, as demonstrated in the diagram level. (See “Ratio Theory of the Price Level” and “The Measurement of Market Value: Absolute, Relative and Real” for an extensive discussion of this idea).

What “Ratio Theory” says, in simple terms, is that the price level can rise for one of two basic reasons: either (a) the basket of goods becomes “more valuable”, or (b) money becomes “less valuable”.

Moreover, if the basket of goods becomes “more valuable” at exactly the same time money becomes much “less valuable”, then prices will surge higher. In essence, this is the recipe for the perfect inflationary storm.

If one accepts this basic theory of price level determination, then there are only two questions that need to be answered. First, what could drive a sudden and sharp rise in the value of goods over the next few years? Second, what could drive a dramatic fall in the value of fiat money over that same time period?

Commodities: Demand AND Supply

The basket of goods, by its very nature, contains a large number of goods and these goods are subject to a wide array of market forces. It is impossible to analyze every individual element of the basket of goods. However, it is possible to isolate and discuss a key input into the basket of goods: commodities.

Over the past five years, many market commentators have laboriously discussed the slowing of economic growth in China and the impact of this trend on demand for commodities. While this weakness in demand from China is clearly a big issue, it is also an issue that is well understood by the energy and mining industries.

Not surprisingly, there has been a dramatic supply response.

Visually, the most stunning collapse in spending has occurred in the US oil industry. The chart below (source: Baker Hughes, Business Insider) demonstrates how quickly and dramatically, oil-drilling activity in the United States has collapsed. This collapse in activity will lead to lower US oil production volumes in the short-to-medium term, particularly given the high production decline rates experienced by non-traditional (shale) oil fields.

In the mining industry, the supply response has been slightly less dramatic, but nonetheless is still remarkable. While the decline in capital expenditure by the global mining industry at a headline level may not seem that dramatic, the decline in spending is remarkable if you dig into the numbers a little. The chart below (source: CSFB) demonstrates that while maintenance capital spending has remained steady, expansion capital spending has been slashed by nearly two thirds since 2012 and is expected to decline further in 2016.

Moreover, both the energy and mining industries face the same basic problem: major discoveries are becoming less frequent, the quality of discoveries is falling and, consequently, capital intensity is rising. For example, copper head ore grades have declined sharply over the past twenty years, and this is a phenomenon shared by most major industrial metals.

The key point is that while demand for commodities may be tepid at present, there has been a strong supply response, one that threatens to lead to a sudden rise in commodity prices at some point in the near future. A sudden rise in the value of commodities, particularly crude oil, could trigger input price inflation across a wide range of industries, thereby leading to a marked increase in the value of the basket of goods, the numerator in our price level equation.

The Value of Money: Policy Expectations Meet Reality

While a significant rise in the value of goods may trigger higher prices, the view of The Money Enigma is that the key risk to the inflationary outlook is a sudden and violent decline in the value of the major fiat currencies.

Over the past ten years, the major fiat currencies have largely maintained their value based on the (erroneous) belief that the current cycle of extraordinary monetary policy would be “normalized in due course”. But just in the last few months, it seems that markets have begun to doubt the notion that policy will be normalized in the next few years.

The view of The Money Enigma remains that if the markets lose faith in the Fed’s commitment to normalization, then it is highly likely that the US Dollar, and other major fiat currencies, will experience a significant loss in value. If this loss in the value of money occurs at the same time as a squeeze in commodities in experienced, then a repeat of 1970s-style stagflation is a real possibility.

Why will the value of money fall if the Fed fails to normalize policy? Well, this is a question that we have discussed many times over the past six months. In essence, the answer is this: the value of fiat money at any point in time is primarily determined by expectations regarding the long-term expected growth of real output relative to the long-term expected path of the monetary base.

Fiat money is a financial instrument and represents a proportional claim on the future output of society. In some ways, fiat money is very similar to a share of common stock. Each share of common stock represents a long-term proportional claim on the future cash flows of a business. Similarly, each unit of the monetary base represents a long-term proportional claim on the future output of society.

The value of a share of common stock depends upon (a) the expected path of future cash flows, and (b) the expected issuance of equity that is required to support that growth in cash flows. More cash, higher stock prices: more shares out, lower stock price.

The value of fiat money depends upon (a) the expected path of future real output, and (b) the expected issuance of money by the central bank (the expected path of the monetary base). More output, the higher the value of fiat money: the more money that is issued, the lower the value of each unit of money.

Currently, the market exists in a strange fairytale state. Despite the incredible growth in the global monetary base over the past ten years and despite the very poor real output growth this has engendered, the market still believes that at some point, the major central banks will “normalize” policy, i.e. raises interest rates and reduce the size of the global monetary base back towards previous pre-QE levels.

However, if the markets realize that normalization has, in effect, become an impossible goal for the Fed, then confidence in the major currencies will quickly erode.

As discussed in “The Markets Go to Rehab”, the view of The Money Enigma is that the markets are addicted to monetary base expansion and the Fed, despite its best intentions, doesn’t have the intellectual or political strength to wean the markets from this powerful drug.

In conclusion, it is possible that the conditions have been created for a perfect inflationary storm. Most investors are very complacent regarding the risk of inflation and have dismissed the early signs that inflation could be rearing its ugly head. However, should a sudden collapse in faith in central banks occur at the same time as the commodities cycle begins to turn, then the unthinkable could happen and inflation could sharply accelerate.

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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