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Five Myths and Misconceptions of Modern Economics

December 15, 2015

Myth #1: Supply and Demand Determines the Price of a Good

The first misconception of modern economics is that supply and demand for one good determines the price of a good. The view of the Money Enigma is that the price of one good in terms of a second measurement good is determined by both supply and demand for the first good and supply and demand for the second measurement good.

Consider the following example. Imagine that we live in a barter economy with two goods: apples and bananas. Does the price of apples in banana terms depend on (a) supply and demand for apples, or (b) supply and demand for bananas?

The answer is (c), “both”.

Think about it this way. What would happen to the price of apples in banana terms if there was a sudden shortage of bananas?

All else remaining equal, if there was a sudden shortage of bananas, then bananas would become more valuable. Therefore, it would require fewer bananas to acquire one apple and the price of apples in banana terms would fall. Although there has been “no change” in the market value of apples in an absolute sense, the price of apples falls because the measurement good is now more valuable.

In other words, the price of apples in banana terms depends upon both supply and demand for apples and supply and demand for bananas!

The myth that the price of a good is determined solely by supply and demand for that good has sustained itself for a long period of time because it is based on a half-truth. Supply and demand for a good does determine the market value of that good. But the price of one good, in terms of another, depends upon the market value of both goods being exchanged. What determines the market value of the second good? Another set of supply and demand!

The traditional representation of the supply and demand paradigm, with price on the y-axis, obscures the true nature of price determination. At the most basic level, a “price” is nothing more than a ratio of two quantities exchanged. This ratio of exchange is determined by the relative market value of the two goods being exchanged.

By definition, we can not measure a relative relationship between two goods unless both goods possess the property being measured, i.e. the property of “market value”. Both goods must possess the property of market value and, therefore, there must be two independent market processes at work.

More specifically, supply and demand for the first good determines the market value of the first good. Supply and demand for the second measurement good determines the market value of the measurement good. The price of the first good in terms of the measurement good is a relative expression of the market value of both goods and, therefore, is determined by supply and demand for both goods.

The theory that every price is determined by two sets of supply and demand is explored in many recent posts including “A New Economic Theory of Price Determination” and the popular “Is The Price of Apples Determined by Supply and Demand for Bananas?”

Myth #2: Supply and Demand for Money Determines the Interest Rate

The failure of economics to develop a comprehensive model of microeconomic price determination left the door open for another economic myth to be created. In the early 20^th century, Alfred Marshall described the simple notion that supply and demand for a good determines the price of that good. However, if this is the case, then what does supply and demand for money determine?

This apparent hole in Marshall’s price determination theory was filled by John Maynard Keynes who argued that supply and demand for money determines the interest rate: a misleading and dangerously simplistic idea sits at the heart of modern macroeconomic theory.

This second economic myth has sustained itself for nearly a century because, at least superficially, it seems quite credible. For example, if I ask to borrow money from you, then what is the “price” of that money? One might argue that the price of that “money” is the interest rate that you charge me.

The problem with this example is that it confuses the “price of money” and the “cost of credit”. When someone borrows money from another person, then that act creates a credit instrument and the cost of that credit is the interest rate. We could call the interest rate the “price of credit”, but really it isn’t a price at all. Why? Technically a “price” is a ratio of exchange, i.e. a quantity of one good for a quantity of another.

The “price of money” is a ratio of exchange, not an interest rate. Technically, money doesn’t have just one price. Rather, money has many prices, depending upon which measurement good you are using to measure the value of money. For example, we can measure the price of money in terms of apples, or bananas, or in terms of a basket of goods. In each case, the “price of money” is a ratio of exchange reflecting how many units of a good must be exchanged for each unit of money.

Moreover, the price of money is determined by two sets of supply and demand. For example, the price of money in apple terms is determined by both supply and demand for money (i.e. supply and demand for the monetary base) and supply and demand for apples. Conversely, the price of apples in money terms is determined by both supply and demand for apples and supply and demand for money.

As discussed in the earlier section on price determination, every price is a relative measurement of the market value of two goods. In order for money to be accepted in exchange, it must possess market value. The market value of money is determined by supply and demand for money, or more specifically, supply and demand for the monetary base.

In summary, supply and demand for money determines the market value of money, not the interest rate. The market value of money plays a key role in determining the price of all goods in money terms: all else remaining equal, as the value of money falls, the price of all goods in money terms rises. In contrast, supply and demand for credit (the act of borrowing and lending money) determines the interest rate.

The theory that supply and demand for money determines the market value of money, not the interest rate, is discussed further in “Supply and Demand for Money: Where Keynes Went Wrong”. The notion that money possesses the property of market value and that the value of money plays a role in price determination is discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

Myth #3: Inflation is Caused by “Too Much Demand”

Both of the misconceptions described earlier have led, at least indirectly, to the creation of a third economic myth: inflation is caused by an overheating economy.

The idea that the primary inflationary risk faced by the economy is an excess of aggregate demand is a fundamentally Keynesian view and one that draws primarily on the experience of the Great Depression. In essence, Keynesians believe that if too little demand created deflation in the 1930s, then too much demand must be the primary cause of inflation.

Surprisingly, economists still cling to this notion despite the fact that the empirical evidence for this contention is poor. Anecdotally, some of the strongest economic periods in the last century, for example the 1990s, were characterized by low and falling levels of inflation. In contrast, some of the weakest economic periods, such as the 1970s, were dominated by high levels of inflation.

From a theoretical perspective, the problem for Keynesian economists comes back to misconception #2, namely that supply and demand determines the interest rate. In the Keynesian view, the risk to inflation is that the Fed lowers the interest rate too far and this leads to an overheating economy and prices rise.

In contrast, the view of The Money Enigma is that supply and demand for money determines the market value of money. The real risk associated with creating too much money is that it leads to a fall in the market value of money. As the value of money falls, prices in money terms rise.

Ratio Theory of the Price Level states that the price level is a relative measure of the value of the basket of goods in terms of the value of money. In the short term, it is debatable as to whether it is the numerator or the denominator in the equation above that matters more.

However, if we step back and think about what drives prices higher over long periods of time, it is very hard to imagine how “too much demand” could be the driving force. After all, basic microeconomic theory tells us that “too much demand” today will generally be met by an increase in supply at some point in the near future. Therefore, any rise in the value of the basket of goods, as measured in absolute terms, is likely to be temporary in nature.

Rather, the view of The Money Enigma is that the primary driver of inflation over long periods of time is not “too much demand” but rather a decline in the value of money. If the central banks grows the monetary base at a rate exceeding the growth in real output, then the value of money will decline and prices, as expressed in money terms, will rise.

The relationship between too much demand and inflation is discussed at length in a recent post titled “Does Excess Demand Cause Inflation?” The idea that it is the value of money, not excess demand, that drives inflation over long periods of time is described in another post titled “Why Do Prices Rise Over Time?”

Myth #4: Inflation is Caused by “Too Much Money”

In the last section, it was argued that, over long periods of time, the primary cause of inflation is growth in the monetary base that exceeds growth in real output. However, over short periods of time, the view of The Money Enigma is that inflation is not caused by “too much money” per se, but rather “expectations of too much money”.

This may seem like a subtle distinction, but it is a very important one in practice. For example, it can explain why the quantity theory of money works in the long run, but not in the short run.

The view of The Money Enigma is that money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society. Therefore, the value of money, and consequently the price level, depends primarily upon long-term expectations regarding the future levels of real output and the monetary base.

If people are optimistic about the long-term economic future of society, then they might reasonably expect solid real output growth and restrained levels of growth in the monetary base. This combination of expectations supports the value of money today and keeps a lid on prices as expressed in money terms.

However, if people suddenly become more pessimistic about the long-term future, then they might reasonably expect real output growth to stagnate while monetary base growth keeps climbing. In this scenario, the value of money can decline sharply.

In other words, it is not the amount of money that is created today that drives the value of money, but rather expectations regarding future levels of money creation.

This phenomenon can help to explain why the massive monetary base expansion that has been experienced over the past seven years has not led to a significant decline in the value of money and a commensurate rise in prices. In essence, most market participants still believe that the monetary base expansion by the Fed is “temporary” in nature, i.e. quantitative easing will be reversed eventually. The current risk for markets is that the Fed stalls on the process of monetary policy normalization and fails to reduce the monetary base. In this case, the value of money could decline sharply and inflation could surge.

For those that are interested, the relationship between and inflation is discussed in several posts including “Does Too Much Money Cause Inflation?” and “A New Perspective on the Quantity Theory of Money”.

Myth #5: Government Debt Doesn’t Matter

One of the most popular misconceptions among economists and policy makers today is that the accumulation of government debt has little to no impact on the value of money and inflation. Indeed, the popular view among some noted economists is that higher fiscal deficits are the best solution to any economic slowdown, even at a time when government debt as a percentage of GDP keeps climbing to new post-War highs.

In contrast, the view of The Money Enigma is that the excessive accumulation of government debt has a critical role to play in the determination of the value of money and, consequently, the rate of inflation.

The key to understanding the relationship between government debt and inflation is the notion that money is the equity of society.

In essence, the view of The Money Enigma is that society faces very similar financing options to a typical corporation. When a company needs more funds, it can either issue debt, a fixed claim against its future cash flows, or it can issue equity, a proportional claim against its future cash flows. If a company issues too much debt, then this can begin to have a negative impact of the value of its equity, particularly if the company’s cash flow growth doesn’t match original projections.

Similarly, when a society needs more funds to finance government deficits, it can either issue debt (government debt) or it can issue equity (expand the monetary base). Money, the equity of society, represents a proportional claim against the future output of society.

Just as a corporation can get itself in trouble with debt and devalue its equity, so society can take on “too much debt” which, in turn, leads to a debasement of money. In essence, once it is perceived that a government has issued too much debt, then people begin to expect that (a) output growth will slow in the future, and (b) base money creation will accelerate in the future. This combination of expectations will damage the value of a proportional claim on the future output of society, i.e. it will lead to a fall in the value of money and a rise in prices.

Ultimately, fiat money is only as good as the society that issues it. As a society approaches bankruptcy, the value of the money issued by that society becomes worthless. Nowhere is this concept more evident than in extreme cases of hyperinflation such as occurred in Zimbabwe in the 2000s.

The relationship between government debt and inflation is one of the most complicated subjects discussed by The Money Enigma. Readers who are interested can read more about this topic in “Government Debt and Inflation” and “Does the National Debt Impact the Value of the Dollar?”

Author: Gervaise Heddle

Video Interview with Rethinking the Dollar

This week I was fortunate to have the opportunity to sit down with Mike Manciel, founder of Rethinking the Dollar (www.rethinkingthedollar.com).

We enjoyed a wide ranging discussion about the importance of economic awareness, why money has value and the outlook for the US Dollar.

Can the Gold Price Rise as the Fed Raises Interest Rates?

What is the relationship between the gold price and interest rates? Can the gold price rise in the face of rising nominal interest rates? And is it possible for the next bull market in gold to begin as the Fed normalizes monetary policy in 2016?

The conventional view is that gold prices fall as real interest rates rise. Therefore, most market commentators believe that the gold price will remain under pressure as the Fed raises interest rates in 2016.

In contrast, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed could mark the start of the next bull market in gold.

First, markets are discounting mechanisms. Markets have long-expected the first interest rise by the Fed and, after much delay, it would seem that the moment is finally upon us. Various speculators have taken a negative position on gold in anticipation of the event and these positions may be unwound in the months ahead as gold speculators “sell the rumor and buy the fact”.

Second, the view of the Money Enigma is that the primary driver of the gold price (in USD terms) is confidence in the long-term future of the United States, not the level of real interest rates. More specifically, the gold price tends to peak when people are most pessimistic, and the gold price tends to bottom when people are most optimistic about the long-term economic future of society. Today, most market participants are extremely optimistic about the future of the United States, but this confidence will be challenged as the Fed begins to unwind nine years of highly accommodative monetary policy.

The third and related reason is that the process of policy normalization by the Fed may trigger a sudden rise in the rate of inflation. The view of The Money Enigma is that the value of fiat money is driven by confidence. Fed policy over the past twenty years has enabled a bubble of overconfidence to develop regarding the long-term prospects of the United States. If the Fed begins the process of policy normalization and is forced to stall or defer this process due to unfavorable market and/or economic conditions, then confidence in the United States may be damaged and the markets could be caught off guard by a sudden surge in inflation.

December 8, 2015

Is There a Light at the End of the Bear Tunnel?

Gold has been in a bear market for nearly five years. Since gold peaked in August 2011, the gold price in USD terms has nearly halved.

Interestingly, this collapse in gold and gold equities has occurred during a period in which both fiscal and monetary policy can only be described as highly accommodative.

On the fiscal side, most developed countries, including the United States, continue to record budget deficits and government debt levels as a percentage of GDP continue to climb. On the monetary side, the Federal Reserve has, at least for now, stopped additional rounds of quantitative easing, but globally both Japan and Europe continue to expand the monetary base. Moreover, none of the major central banks have begun to unwind their bloated balance sheets.

Perhaps more surprisingly, gold has just suffered one of its worst bear markets in history before a single major central bank has their benchmark interest rate even once. In most developed countries, short-term interest rates have been stuck at zero for much of the past five years. Yet gold, which supposedly is a beneficiary of a negative real interest rate environment, has been pummelled.

Clearly, all of this creates a concern for gold investors. If the gold price can’t rally in an environment of monetary excess, then how will the gold price manage to climb in an environment where the major central banks are raising interest rates?

While the concern is a legitimate one, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed is likely to mark the end of the current bear market in gold and the start of a period of great economic uncertainty that will ultimately drive gold prices much higher.

The theme “the Fed is going to raise interest rates” has been hanging over the gold price now for at least a couple of years. At the beginning of 2014, many experts were certain that the Fed would raise interest rates by the end of 2014. It didn’t happen. But that didn’t stop investors from unwinding their positions in gold.

As the calendar flipped over into 2015, many experts were once again absolutely positively certain that the Fed would raise interest rates no later than June 2015 or, at the very latest, September 2015. Again, it didn’t happen. But once again, that didn’t stop an accumulation of negative sentiment against gold.

Indeed, one of the key problems for the gold price over the past couple of years is that everybody knew that the Fed would have to do something eventually. The Fed can’t just leave interest rates at zero indefinitely. Moreover, consensus is that easy money is good for gold and, therefore, rising interest rates must be bad for gold.

In this groupthink environment, it is a brave junior trader that decides to go long an asset that is an “obvious loser” on the Fed-tightening theme.

So, why might this change when the Fed does begin to raise interest rates?

Until the Fed actually raises interest rates, the question is largely one of “when” will the Fed raise interest rates? But as the Fed begins the process of tightening, the question will become more about the “pace” of tightening. For example, will the Fed raise interest rates by 25bp at each meeting or only every second meeting?

This may seem like a subtle change, but it’s an important one for investor sentiment. Arguably, it is much easier for the Fed to disappoint the markets on the pace of tightening once the process starts. For example, imagine that the Fed does tighten interest rates three times but then the US economy hits a “soft patch”. Suddenly, the Fed is on the back foot and stalls the tightening process. This stalling of the normalization process could easily create a much more positive trading environment for gold.

However, the real upside for gold comes at a slightly later point. At some stage, the Fed will need to decide what is “normal”, i.e. what is the end point of monetary policy normalization.

While many people don’t appreciate it, current monetary policy settings are exceptionally loose by historical standards. Since the 2008 crisis, the Fed has quintupled the size of the monetary base. The Fed has overtly manipulated markets to ensure that both short-term and long-term interest rates are well below historical norms.

If the Fed is genuine about “normalizing” monetary policy, i.e. if it raises interest rates back to historical norms and cuts the size of the monetary base down to roughly one-quarter of what it is today, then it will be a tough environment for gold.

The problem with this scenario is that is likely to involve a cost to financial markets and the real economy that is too great for Fed officials to bear. Indeed, the view of The Money Enigma is that the Fed will find that the economic and political costs associated with a genuine “normalization” of monetary policy are too high and the Fed will stop well short of this goal.

At the point the markets realize that the Fed will not deliver on its obligation to deliver monetary policy discipline, the price of gold is likely to surge higher. More specifically, the value of the US Dollar and other associated major fiat currencies will be undermined and investors will search for good alternatives to fiat, most notably, gold and silver.

In summary, the first rate rise by the Fed has been hanging over gold for the past three years. As the Fed does begin to raise rates, investors will begin to focus not on the start of the normalization process, but on the end of the process. Starting the process of policy normalization is easy for the Fed. Finishing it will prove much harder.

What Drives Bull and Bear Markets in Gold?

While a shift in investor sentiment may help the gold price in the short-term, the real question for long-term investors in the precious metals space is when will the bear market in gold end and the next bull market begin?

In order to answer this question, we need to establish a theory that can successfully explain what drives the major cycles in the gold price.

Many gold market commentators focus on the relationship between real interest rates and gold. The theory is that as the real rate of return on yielding assets rises, an asset with no yield, i.e. gold, becomes less attractive and, therefore, people will sell gold.

The empirical support for this theory is mixed. While it is true that there have been periods where negative real interest rates have been accompanied by rising gold prices, most notably the 1970s, this same price action is not be observed across all time periods.

From a theoretical perspective, it far from clear that real interest rates are the key driver of gold prices. Intuitively, there is a much better case to be made that the gold bull market in the 1970s had more to do with the declining fortunes of fiat currencies than it did with negative real interest rates per se.

So, if real interest rates are not the primary driver of bull and bear markets in gold, then what does drive the price of gold? This is a subject that was addressed at length in a recent Money Enigma post titled “What Determines the Price of Gold?”

In essence, the view of The Money Enigma is that the gold price is driven by confidence in the long-term economic future of society. As people become more optimistic about the long-term economic future of society, the gold price falls. As people become more pessimistic about the long-term outlook, the gold price rises. In this sense, the gold price can be considered to be a barometer of pessimism regarding the long-term future of the United States.

Why is the price of gold inversely related to confidence in the long-term economic future of society? Well, in simple terms, gold is an anti-fiat asset. When the value of fiat money is stable, gold tends to lose its attractiveness as an alternative form of money. However, when the major fiat currencies come under pressure, gold offers an attractive alternative. In this sense, gold is not a commodity, but rather an anti-fiat currency.

In turn, the value of any fiat currency is primarily determined by expectations regarding the long-term economic future of the society that issues that currency. In simple terms, fiat money is only as good as the society that issues it. In more technical terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. If people become more concerned about the long-term economic prospects of society, then the value of the fiat currency issued by that society declines. In this scenario, an anti-fiat asset such as gold becomes a more attractive alternative.

If we extend this theory to bull and bear market cycles in gold, then we can say that bear markets in gold tend to begin when people are overly pessimistic about the long-term future of society. Conversely, bull markets in gold begin when too many people in the crowd are wearing rose-colored glasses.

Arguably, the markets were quite pessimistic on the long-term economic outlook for the United States in August 2011 when S&P downgraded the credit rating of the US. Perhaps not surprisingly, this low point in confidence marked a peak for gold.

However, the key question for gold investors today is whether markets are too optimistic regarding the long-term future of the United States.

Over the few years, it is likely that any attempts by the Fed to normalize monetary policy will disrupt both financial markets and the real economy. More specifically, low short-term interest rates and quantitative easing have pushed down the required cost of capital for business. As the Fed attempts to unwind these policies, the required cost of capital will rise and this will put enormous pressure on asset prices and reduce the incentive to invest. [See “Has the Fed Created the Conditions for a Market Crash?”]

There is a very real possibility that the Fed’s actions over the next couple of years will pour a bucket of cold water over the markets and that this will lead to a loss of confidence in the long-term economic future of the United States. Such a loss in confidence would lead to a significant rise in the price of gold, even in an environment of rising interest rates.

In summary, the Fed’s actions are likely to hurt confidence and this should lead to a rise in the price of gold. However, even if this theory of gold and economic confidence is wrong, there is still one phenomenon that could surprise markets in 2016 and drive the price of gold to much higher levels: inflation.

The Outlook for Inflation

The consensus view today is that rising real interest rates are negative for gold and, therefore, the gold price will remain under pressure as the Fed raises interest rates.

Even if we accept the theory behind this view, i.e. the relationship between real interest rates and the gold price, the problem with this outlook in practice it assumes that inflation will not accelerate over the course of the next few years. While the Fed is likely to raise nominal interest rates over the next 18 months, there is a real risk that the Fed will find itself behind the curve as the rate of inflation accelerates.

Most market commentators think that the risk of acceleration in the rate of inflation is low because inflation can only be produced by an “overheating” economy and that the Fed will “put on the brakes” well before this occurs. Frankly, this represents a very one-sided and dangerously simplistic view of the price determination process.

What these commentators fail to remember is that the price level depends upon two key factors: the value of goods and the value of money. More specifically, the price level can rise for one of two reasons; either (a) the value of goods rises, i.e. the economy overheats, or (b) the value of money falls.

Most market commentators pay little or no attention to this second factor or what drives it, despite the fact that it is the value of money, not the value of goods, that is the primary driver of inflation over long periods of time. [See “Why Do Prices Rise Over Time?”]

The view of The Money Enigma is that the next few years could represent a turning point for the major fiat currencies.

Long-term confidence in the future of the major Western economies has provided tremendous support to their respective currencies, despite the borderline reckless behavior of both fiscal and monetary policy makers. But as these policy makers attempt to normalize policy, it is likely that the structural cracks in the economic story will begin to appear. As these cracks appear, market faith in the major fiat currencies will be tested, the value of the fiat currencies will decline, and prices, as expressed in fiat money terms, will rise.

A sudden surge in the rate of inflation in 2016 would provide the key catalyst that is required to end the bear market in precious metals and commodities more generally. Unfortunately, it would also lead to a serious decline in equity and bond markets, damage the market’s confidence in the Fed and add further pressure to those struggling to make ends meet.

Interview with MiningMaven

I recently had the privilege to be interviewed by Malcolm Palle who is co-founder of www.miningmaven.co.uk. MiningMaven does an excellent job of covering the small-cap mining space in the UK and Malcolm regularly interviews the leading CEOs in that industry.

During the interview, Malcolm and I discussed one of my recent posts “Confidence Game Creates a Dilemma for the Fed”, the outlook for interest rates and gold prices. You can listen to the whole interview by clicking on the image below.

Should Investors Hope for a Strong or Weak Economy in 2016?

The Money Enigma – December 1, 2015

There is a widely held view among equity investors that the S&P500 can hold its ground and possibly manage small gains in 2016 provided that the US economy continues to recover. While nearly all market strategists recognize that rising interest rates will create a “headwind” for the market in 2016, most of those strategists will argue that the stock market can hold its own provided that the economy remains robust.

The view of The Money Enigma is that this optimistic assessment ignores the fundamental principles of equity valuation. The value of any business is far more sensitive to its required cost of capital than to any near-term earnings potential. Therefore, as the Fed “normalizes” monetary policy and, in effect, raises the required cost of capital for all businesses, the negative impact on stock prices will far outweigh any positive benefit associated with a stronger economy.

Does this mean that equity investors should hope for a weak economy in 2016? It is certainly true that a weak economy in 2016 may delay the process of monetary policy normalization and thereby provide continued support to the global equity markets. However, a weak economy creates its own set of risks.

While many investors will worry about the impact of a weak economy on near-term earnings, the real issue that investors should focus on is how a weaker economy might impact long-term expectations regarding the future economic prosperity of the United States.

There are two reasons that equity investors should worry about how a recession might impact expectations regarding the long-term future of the United States. First, stock valuations are highly sensitive to expectations regarding long-term earnings growth. Second, and less obviously, the inflation rate is highly sensitive to expectations regarding the future of the United States.

If a weaker economy in 2016 damages long-term economic confidence, then this could precipitate a marked fall in the value of the US Dollar and a sudden rise in prices. A sudden surge in the rate of inflation combined with increased uncertainty around long-term earnings growth would spell disaster for the US equity market, particularly given the current state of elevated equity valuations and positive sentiment.

A Strong Economy is Good for Stocks, Right?

Conventional wisdom used to be that a strong economy is good for stocks and a weak economy is bad for stocks. But it seems that times have changed. The equity market treads water on good economic news and surges on bad economic news. So, what type of economy should equity investors hope for in 2016?

In order to answer this question, it helps to go back to fundamentals. More specifically, it helps to think about what makes a business valuable: the sum of its discounted future cash flows.

There are a couple of basic arguments to support the notion that a strong economy is good for stocks. First, a strong economy supports near-term earnings. This factor is particularly important for companies that have been struggling to generate profits and pay down high levels of debt.

Second, a more importantly, a strong economy tends to reinforce and promote optimistic expectations regarding the long-term future of the economy.

While most Wall Street analysts are obsessed by near-term earnings, the fact of the matter is that the stock market’s valuation is, at least theoretically, far more sensitive to expectations regarding its long-term earnings potential than its earnings in the next quarter. At the margin, a strong economy will tend to make investors more optimistic about the long-term earnings potential of the market and provide support to stocks. This rise in long-term confidence tends to be far more important to the market as a whole than any actual improvement in near-term term earnings.

The problem with our analysis so far is that ignores another simple but critical idea: the value of a business is determined by the sum of its discounted future cash flows. While a strong economy may promote confidence regarding future cash flows, we also need to consider how a strong economy may impact the discount rate that is applied to those future cash flows.

In today’s world of hyperactive monetary policy, markets tend to believe that a strong economy is bad for stocks and a weak economy is good for stocks. Why? Well, in simple terms, a strong economy encourages the Fed to tighten monetary policy, thereby raising the risk-free rate and consequently the required cost of capital for all businesses. In contrast, a weak economy encourage speculation that the Fed will maintain the current level of very low long-term interest rates, thereby pegging the long-term cost of capital at a low level.

It should be noted that this wasn’t always the case. Indeed, it is worth thinking about what has changed over the past thirty years.

In simple terms, prior to the current period of Fed hyperactivity that began with the introduction of QE1 in 2008, it can be argued that Fed policy had relatively minimal impact on the real long-term risk free rate and, therefore, a fairly small impact on the long-term cost of risk capital.

Prior to 2008, the Fed focused most of its efforts on controlling short-term interest rates. This manipulation of short-term interest rates did have a significant impact on bank lending activity and it certainly had some impact on the shape of the yield curve, but arguably the Fed’s interference in the long-term interest rate market was fairly minimal.

Why does this matter to equities? It matters because it is the long-term cost of risk capital that drives stock valuations and, one can argue, that prior to 2008, the Fed had very little direct involvement in setting this benchmark.

However, in 2008/2009, the Fed decided that the manipulation of short-term interest rates wasn’t enough. Therefore, the Fed started to explicitly manage long-term interest rates by creating money and buying long-term government securities, a policy known as “quantitative easing”.

Suddenly, the Fed plays a critical role in the determination of stock valuations and, therefore, a critical role in driving stock market direction. Whereas pre-2008 Fed policy was analyzed largely for the impact it would have on future cash flows, i.e. would Fed policy stall the economy, post-2008 we can see that Fed policy has a critical impact on both future cash flows and the long-term interest rate used to discount those future cash flows.

This combination of factors has created much confusion in the equity markets. In particular, it has led to confusion regarding whether a strong economy is good for stocks.

Long-Term Cost of Capital Trumps Near-Term Earnings

As mentioned at the beginning of this week’s article, there is a view among many Wall Street equity market strategists that the equity markets will be OK in 2016 provided that the US economy continues to recover. Their view is that improving earnings will offset any normalization of monetary policy by the Fed in 2016.

The view of The Money Enigma is that this perspective either demonstrates a lack of understanding regarding the key drivers of stock valuations or that these strategists are making rather optimistic assumptions about the path and timing of monetary policy normalization.

The key problem for the US equity market is that the long-term cost of capital used to discount future earnings is far more important than any improvement in near-term earnings. If the Fed begins to normalize monetary policy and the long-term interest rate rises, then this will have a profoundly negative impact on stock valuations.

Moreover, we know from a mathematical perspective that this negative impact will far outweigh any positive impact on valuations from an improvement in near-term earnings associated with a stronger economy. Stocks are long-duration assets and their valuation is far more sensitive to changes in the long-term discount rate than any change in near-term earnings.

Therefore, if a stronger economy does encourage the Fed to normalize monetary policy, then this will have a profoundly negative impact on stock valuations and overwhelm any improvement in near-term earnings.

However, a strong economy isn’t necessarily bad news if the Fed raises short-term interest rates but is careful to keep a lid on long-term interest rates. In other words, if the Fed raises the Fed Funds rate but uses its balance sheet to keep long-term interest rates at current low levels, then the equity market may be able to eek out another year of gains as earnings growth continues and the Fed continues to overly manipulate the long-term cost of risk capital.

For equity investors, this is probably the best near-term outcome. However, this “let’s pretend to normalize policy” path by the Fed does pose long-term risks. As discussed in previous posts including “The Case for Unwinding QE”, the Fed must eventually normalize the size of the monetary base (the Fed balance sheet) or it risks triggering a sharp devaluation in the US Dollar and resurgence in inflation.

In summary, a strong economy in 2016 will probably force the Fed to do something. Whether this action by the Fed will hurt the equity markets will depend on largely how aggressive the Fed is and, more importantly, whether it genuinely begins the normalization process or merely pretends to, i.e. raises short-term interest rates but continues to manipulate long-term interest rates.

Is a Weak Economy is Better for Stocks?

If a strong economy is likely to produce an adverse outcome for stocks, then should equity investors be praying for a weak US economy in 2016?

In the previous section we argued that a strong economy was bad for stocks because the negative impact of a rising cost of capital would overwhelm any positive impact from stronger near-term earnings. Therefore, if we simply reverse the logic, a weak economy should be good for stocks, right? Although there may be a hit to near-term earnings, this weakness will be mostly offset by hopes for a further reduction in the long-term risk free rate, i.e. more QE!

Superficially, this argument is fair. Indeed, it may be the case that this is exactly how events unfold. A weak US economy in 2016 puts the Fed on hold, thereby supporting the equity market at its current lofty valuation level.

The problem with this rather simplistic analysis is that doesn’t consider how a weak economy in 2016 might impact long-term expectations regarding the future of the US economy and the long-term earnings growth potential of corporate America.

While a strong economy in 2016 is unlikely to improve already optimistic expectations regarding the long-term future of the United States, a weak economy in 2016 could damage investor expectations regarding the long-term health of America.

In general, a weak economy should not represent sufficient cause in and of itself for a major rethink by investors regarding the long-term economic prospects of society. But the view of The Money Enigma is that a major recession in 2016 could trigger such a review. Why? Well, if a recession did begin in 2016, then it would be the first time that a recession has begun without any attempt by the Fed to raise interest rates or normalize monetary policy. In other words, investors may begin to feel that the Fed has missed the boat and they may begin to question the underlying structural health of the United States.

If a weak economy in 2016 damage optimism regarding the long-term economic future of the United States, then this could hurt equity prices in two ways.

First, and most obviously, if investors begin to believe that the economy will grow at a slower rate than previously expected over the next 10-20 years, then investors will be forced to lower their expectations regarding the long-term earnings growth rate for the market.

Historically, companies in the S&P 500 have grown their earnings per share at a rate of about 6% per year. However, if investors become more pessimistic about the long-term prospects of the economy, then they may need to lower this expected earnings growth rate, particularly given the current elevated level of corporate profit margins (see John Hussman’s work for more details on this point).

In theory, this lowering of long-term earnings growth expectations will have a much greater negative effect on stock prices than any near-term weakness in earnings that would ordinarily occur in a recession.

The second factor that could have a major negative impact on stock prices is more complex. In essence, the view of The Money Enigma is that the value of fiat money is inversely correlated to optimism regarding the long-term future of society. Therefore, if investor optimism regarding the long-term future of the United States is damaged, then the value of the US Dollar will fall and prices, as expressed in US Dollar terms, will rise.

In other words, a weak economy in 2016 could be the trigger for a sudden increase in the rate of inflation. Such an outcome could be devastating for equity markets that are priced to achieve low nominal expected returns, at least by historical standards. Moreover, a sudden increase in the rate of inflation in 2016 would definitely catch the Fed off guard and hurt the confidence of both bond and equity market investors.

Inflation and Long-Term Expectations

The consensus view among economists is that inflation in the US will only occur if the economy is strong. Moreover, most economists believe that a weak economy poses a greater risk of deflation than inflation. This quintessentially Keynesian view of inflation is terribly flawed and represents one of the great economic myths of our time.

The simple fact of the matter is that historical evidence indicates that episodes of high inflation (10%+ inflation) are more commonly associated with weak economic conditions than strong economic conditions as discussed in a recent post titled “Does Excess Demand Cause Inflation?”

The theoretical foundations for this phenomenon are complex but, in essence, the problem with the traditional Keynesian view of the world is that it only considers one part of the picture. Keynesian economics focuses on the impact of a recession on the market value of goods. But it forgets on key thing: every price is a relative measurement of two values. More specifically, every price in money terms is a relative expression of both the value of goods and the value of money. If a recession triggers a fall in the value of money and if that fall in the value of money is greater than the fall in the value of goods, then prices as expressed in money terms will rise!

The view of The Money Enigma is that the price level is a function of two values: the market value of goods and the market value of money (see “Ratio Theory of the Price Level”). The key to representing the price level in this way is isolating both variables by measuring each in terms of a “standard unit” of market value, an idea is discussed at length in “The Value of Money: Is Economics Missing a Variable?”

While economic weakness will almost certainly have a negative impact on the market value of goods (the numerator in our price level equation above), the view of The Money Enigma is that economic weakness can also impact the value of money (the denominator in our equation).

More specifically, the problem with recessions in fiat money regimes is that they can trigger a sudden collapse in the value of money. Why? Well, in simple terms, fiat money is only as good the society that issues it. More specifically, the value of fiat money is primarily determined by long-term expectations regarding the future economic prosperity of society. If that confidence is suddenly undermined, then the value of money can fall precipitously.

Prolonged economic recessions have a nasty habit of highlighting the key structural weaknesses of an economy. If next year turns out to be a much more difficult year for the US economy, then this could remind investors that the United States faces several long-term structural challenges, most notably its continued reliance on rising government debt and persistent deficits.

If economic weakness in 2016 does trigger a collapse in long-term economic confidence, then the results could be devastating for both the US Dollar and US equity markets. More specifically, a slump in long-term confidence could lead to a sudden jump in the rate of inflation and a decline in long-term earnings growth expectations. This combination would spell disaster for a stock market that is priced for perfection.

In summary, the best hope for equity investors in 2016 is that things continue much as they have done in 2015: the US economy muddles along and the Fed remains on hold. The problem is that the clock is ticking on this “new normal”: the Fed must normalize monetary policy eventually and, as it does, the US economy must demonstrate that it can grow without the Fed acting as life support.

Confidence Game Creates a Dilemma for the Fed

As the December FOMC meeting approaches, the Fed faces a real dilemma. Does the Fed leave interest rates on hold and risk undermining market confidence in the US recovery and the Fed’s own credibility? Or does the Fed start the process of raising interest rates, a move which will put in on a path that could also severely damage economic confidence?

While it may be not clear to markets at this point, the view of The Money Enigma is that the Fed faces what could best be described as the “Bad Debtors’ Dilemma”. In simple terms, if you have borrowed lots of money and can’t really afford to repay it, how do you keep the faith of creditors? Do you wait as long as possible to begin repayments or do start making small repayments now in the hope that things will somehow work out?

The dilemma facing the Federal Reserve is does the Fed push back normalization for as long as possible hoping markets won’t notice, or do they start the process hoping that normalization will not disrupt the economy and damage market confidence?

Over the past ten years, the Fed has engaged in an extraordinary series of unorthodox policy actions, most notably cutting the Fed Funds rate to zero and quintupling the size of the monetary base. The success of this unorthodox policy approach has been underwritten by the notion that the US economy will recover “in time” and that the Fed will normalize monetary policy settings “eventually”.

However, the markets, just like the unfortunate lender to our bad debtor, won’t wait forever. If the Fed waits too long to begin the process of “normalization”, then long-term economic confidence could be damaged.

Alternatively, if the Fed does begin the process of normalization but then starts stalling on further rate rises or, even worse, stops the process of normalization and engages in more quantitative easing, then long-term confidence could be severely damaged. In either scenario, the end result is a poor one for the Fed and the US economy.

The key problem for the Fed is that long-term economic confidence underwrites the value of the US Dollar. If market confidence in the long-term economic future of the United States is damaged, then the value of the US Dollar will fall and this will trigger a marked acceleration in inflation. Any sudden rise in inflation will not only damage the Fed’s credibility but also severely limit its ability to control economic outcomes.

You can listen my interview with the MiningMaven on this article by clicking on link below.

The Bad Debtors’ Dilemma

Let’s imagine that an old friend came to visit you a few years ago and asked to borrow some money. Your friend explained to you that they had hit some tough times and you decided to lend them $3,000.

A few months later, your friend returned. Their situation had not improved and they asked for some more cash. Again, you knew this person well so you felt happy lending them another $3,000. In fact, you were so confident in your friend’s ability to repay the money eventually that you said that they could come to you again if they needed to.

Sure enough, your friend turns up again a few months later and borrows another $4,000 on top of the $6,000 that you had already loaned them. By now the debt is significant, but you feel confident that your friend will repay the debt eventually. In fact, you tell your friend that there is “no rush” to repay the debt.

Now, what happens if your friend struggles to get back on his/her feet?

Your friend knows that, at some point, you are going to want your money back. So, what should your friend do, particularly if your wallet represents their “last resort”?

Should your friend, the bad debtor, keep putting off making any repayment to you, the lender, for as long as possible and hope that you don’t begin suspecting there is a problem? Alternatively, should the bad debtor attempt to keep the lender’s confidence by starting to make a series of small repayments?

For the bad debtor, the problem presents a real dilemma. On one hand, it is tempting to make no repayment and just hope that the lender doesn’t begin to suspect that something is wrong. However, this approach is not sustainable: the lender will get suspicious eventually.

On the other hand, starting to make small repayments, for example $100 per month, can also backfire even if does buy a bit more time. For example, the lender may begin to question why the monthly repayments are so small and why larger repayments are not forthcoming.

More problematically, if the bad debtor suddenly suspends the token $100 per month repayment, then this will definitely raise suspicions. For example, imagine your friend does start repaying you $100 per month for six months but then suddenly asks to reduce the monthly payments to $50 per month. Worse still, imagine how you would feel if your friend stopped the repayments altogether and came back to you asking for more money!

The Fed’s Dilemma

While the analogy may not be perfect, the view of The Money Enigma is that the Fed faces a dilemma similar to that faced by our bad debtor.

In simple terms, the Fed is engaged in a confidence game. The key to winning this game is ensuring that markets believe that the long-term economic future of the United States is sound. So far, the Fed has been very successful in playing this game, helped by the fact that the United States has a tremendous history of economic success. However, the inevitable monetary policy tightening cycle that confronts the Fed will test this market confidence.

In terms of our Bad Debtor analogy, the implementation of ZIRP by the Fed represents the first $3,000 lent to our bad debtor. Markets were happy for the Fed to cut the Fed Funds rate to zero in 2008 because there was a financial crisis and the Fed had a long and successful history of lowering interest rates in a time of crisis.

However, ZIRP was not enough to resolve the crisis. Therefore the Fed quickly came back to markets for the next $3,000, i.e. QE1. Although quantitative easing represented an unorthodox policy approach, market confidence was not damaged because this sudden expansion of the monetary base was viewed as being “temporary” in nature.

Ultimately, the Fed perceived that QE1 was insufficient, so the Fed came back for the next $4,000: QE2 and QE3.

Despite these extraordinary policy measures, the markets have never lost faith in the Fed. The view of the markets has been and remains today that the US economy will continue to do well over time and that this will allow the Fed to “normalize” monetary policy eventually.

The problem is that we are now approaching the point where this confidence will be tested. At some point, the Fed must normalize policy just as the bad debtor must repay the debt.

The challenge for the Fed is figuring out a way to do this that doesn’t damage market confidence. If the Fed is too slow to normalize policy, the markets may begin to lose faith in the Fed. If the Fed is too aggressive in its attempts to normalize policy, then it could easily knock the economy back into recession.

The “middle road” also represents a potential problem for the Fed. For example, let’s imagine that the Fed does raise the Fed Funds rate by 150 basis points over the next 12 months without damaging the economy. Superficially, this would be a great outcome. However, it still leaves a problem. The Fed still needs to reduce the monetary base by at least $2 trillion. In essence, raising short-term rates is only repaying the first $3,000. Ultimately the Fed needs to repay the entire $10,000 to keep the faith of the markets, i.e. it must raise short-term rates and reduce the monetary base to pre-crisis trend levels.

The greater concern is what happens if the Fed begins the normalization process in December but then has to stall this process or reverse it?

For example, what happens to market confidence in the long-term future of the United States if the Fed does raise interest rates to 0.75% and the US economy falls into recession in mid 2016? Alternatively, what happens to confidence if the Fed decides to sell $1 trillion of the bonds on its balance sheet and this triggers a crash in global equity and bond markets? [This second scenario is something that has been discussed in a previous post titled “Has the Fed Created the Conditions for a Market Crash?”]

In many ways, it is easier for the Fed to sit on its hands and do nothing rather than tempt these outcomes, just as it is easier for our bad debtor to avoid showing his/her hand by starting the repayment process. But ultimately, the misadventures of the Fed need to be reversed and this will be the point at which the confidence of the markets will be tested.

Why Does Long-Term Economic Confidence Matter?

Just as our bad debtor needs to maintain the confidence of our lender, so the Fed needs to maintain the confidence of markets. More specifically, the Fed needs to ensure that markets do not lost their faith in the long-term economic future of the United States.

Why does confidence in the future of the economy matter? Well, there are a couple of key reasons.

First, and most obviously, a loss of faith in the future of the United States is bad for business. If markets start to believe that the long-term rate of economic growth in the US will be much lower than previously expected, then capital spending will be slashed, business formation will be delayed and jobs will be lost.

Second, and less obviously, confidence in the long-term economic future of our society is a key determinant of the rate of inflation. In simple terms, high levels of confidence support the value of the dollar and keep a lid on the rate of inflation. Conversely, a sudden decline in long-term confidence could lead to a collapse in the value of the dollar and a sudden rise in prices.

The reasons for this are complicated, but we can use our bad debtor analogy to help explain the point.

Think back to our earlier example. Why does our bad debtor want to keep his/her financial situation a secret? In simple terms, our bad debtor knows that if the lender’s confidence is lost, then the lender will want his/her money back and will not be inclined to lend our debtor any more money.

In more technical terms, we can say that our debtor wants to prevent his/her cost of debt capital from rising. If the lender loses confidence in our debtor, then the lender will probably require a higher rate of interest on existing and future monies lent to that debtor.

The Fed faces a similar challenge, although it is a concept that is poorly understood by most economists. In essence, when the Fed expands the monetary base (“prints money”), it creates claims against the future output of society. In this sense, the monetary base can be considered to be the “equity of society”.

While confidence in the long-term economic future of society remains high, the Fed can issue money without impacting its cost of equity, i.e. without debasing the value of the US Dollar. However, if long-term confidence is lost, then the Fed’s “cost of equity” will rise. In other words, the Fed can continue to issue more dollars, but the value of each dollar is less.

How does a decline in the value of the dollar show up in the real world? Inflation.

All else remaining equal, if every dollar is worth less in absolute terms, then the price of all goods in dollar terms must rise. Every price is a relative measurement of the market value of two items. More specifically, the price of one good, the “primary good”, in terms of another good, the “measurement good”, is a relative measure of the value of the primary good in terms of the measurement good. If the market value of the measurement good falls, then the price of the primary good in measurement good terms will rise.

Therefore, if the value of money falls, then prices as expressed in money terms will rise and the rate of inflation will accelerate.

In summary, the view of The Money Enigma is that the Fed must maintain the confidence of the market just as our debtor must maintain the confidence of the lender. If the Fed loses the confidence of the market, then the Fed’s cost of capital will rise, just as the debtors cost of capital will rise if it loses the faith of its creditors. In practical terms, a rise in the Fed’s “cost of capital” means that the value of the US Dollar will fall, inflation will accelerate and the Fed will largely lose the ability to manage macroeconomic outcomes.

If you are interested in reading more about why the value of fiat money is so heavily dependent upon long-term economic confidence, then I would encourage you to read the following posts. First, I would suggest reading “The Evolution of Money: Why Does Fiat Money Have Value?” which attempts to explain why paper money with no intrinsic worth has any value at all. Second, I would suggest reading the follow on article “What Factors Influence the Value of Fiat Money?” If you are interested in the notion that the monetary base is, in essence, an equity instrument and proportional claim in the future output of society, then I would encourage you to read an older post “Money as the Equity of Society”.

Does Excess Demand Cause Inflation?

The view of most economists is that the key driver of inflation is the strength of the economy. If monetary policy is too accommodative, then it can create too much demand and the economy can “overheat”, leading to higher rates of inflation. Conversely, if the economy weakens, then deflation, not inflation, becomes the key risk.

This quintessentially Keynesian view of the world has been drummed into the minds of market participants by a succession of Fed officials, nearly all of whom have argued that the key role of the Fed is too ensure that the temperature of the economy remains “just right”, i.e. not too hot and not too cold.

But does the strength of the economy really matter to inflation? Is “too much demand” the primary cause of inflation? And is it a given that a weak economy must result in deflation?

The view of The Money Enigma is that excess demand is not the primary cause of inflation. Rather, the primary cause of rising prices over time is a fall in the value of money. While swings in the economic cycle may somewhat abate or accentuate an inflationary trend, the underlying trend is always determined by the value of money, not the value of goods.

When Did “Too Much Demand” Create Inflation?

If you listened only to Fed officials, then you might quickly come to the view that the rate of inflation is primarily a function of the strength of the economy: a strong economy produces higher levels of inflation and a weak economy produces low levels of inflation or even deflation. This is the prevailing view that is implicit in the thought process of most talking heads on CNBC and that appears in nearly every debate regarding the outlook for inflation.

However, the historical evidence for this proposition is thin.

While there have been numerous academic studies conducted on this issue, I’d like to encourage readers to step back from a moment and consider this question for themselves: “When did too much demand create inflation?”

What specific periods of history can you point to, either in the United States or any other country, where high levels of inflation have clearly been created by too much aggregate demand?

There are two ways you can approach this question. Either you can look at periods of high inflation and try to make some judgment about whether there was “too much demand” at the time, or you can look at periods of economic strength and see what happened to inflation during those periods.

While everyone will have a slightly different interpretation of history, the view of The Money Enigma is that it is very difficult to find any clear correlation between economic strength and inflation.

At the most basic level, it is well known that episodes of high levels of inflation, i.e. hyperinflation, have most commonly been associated with very weak economic conditions.

For example, one could hardly claim that hyperinflation in Zimbabwe in the 1990-2010 period was caused by “too much demand”! Similarly, one could hardly claim that prices are rising in Venezuela because Venezuela is the poster child of economic success!

Putting the issue of hyperinflation to one side, it is still very difficult to find clear anecdotal examples where economic strength created to inflation.

For example, the late 1990s was one of the strongest economic periods in US history. During the late 1990s, unemployment was low, consumer spending was high and capital spending, particular on technology, was off the charts.

So, what happened to inflation in the US during the late 1990s? It fell. Inflation fell from 3% in 1995 to sub 2% by 1997-98 and only staged a recovery back to the 3% rate in the last part of 1999 when the participation rate jumped to a record high. In this example, a stronger economy actually seemed to lead to a low inflationary trend, with a small cyclical bump in inflation right at the point that the economy was blowing steam.

Conversely, we can think of the stagflation in the 1970s. In the 1970s, inflation rose from a 5% annual rate and peak at nearly 15%. This peak in the rate of inflation in 1979-1980 was not marked by “good economic times” but rather an economy operating at stall speed.

Clearly, this type of anecdotal evidence does not supply us with a scientific analysis of the issue. However, many academic studies of this issue have been undertaken and the results are, at best, inconclusive.

In technical terms, the notion that “too much demand creates inflation” is known as the Phillips Curve. The Phillips Curve is a core part of New Keynesian thought and the current economic orthodoxy practiced by the major central banks. In essence, the Phillips Curve states that there is an inverse relationship between the rate of unemployment and the rate of inflation. Stated simply, as the economy approaches full employment, wages and prices must rise.

John Hussman, fund manager and economist, provides an excellent critique of the Phillips Curve and the empirical evidence supporting it in his post “Will the Real Phillips Curve Please Stand Up?”

In simple terms, Hussman’s point is that if there is a strong inverse correlation between unemployment and inflation, then that should show up on a chart plotting unemployment against inflation. It doesn’t. Economists have tried to prove the relationship by adjusting the models, but even then the relationship between unemployment and inflation remains elusive.

One Price, Two Values

If the notion that “excess demand causes inflation” is not supported by empirical evidence, then why do so many economists cling to the idea? Why do market commentators persist with the fable that a “strong economy” equals inflation and a “weak economy” equals deflation?

Part of the reason for the persistence of this myth is that it is easy to communicate. Most people understand the basic microeconomic concept that, all else remaining equal, more demand for a good leads to a higher price for that good. Therefore, it is easy for people to extrapolate this idea from one good to many: if there is more demand for all goods, then the price of all goods should rise.

The problem is that, at a macroeconomic level, the forces of price determination are far more complex than this and one simply can’t carry-forward the set of microeconomic assumptions that are associated with basic supply and demand analysis.

At a more fundamental level, the problem with the basic supply and demand analysis described above and presented in most economics textbooks is that provides a partial, one-sided and incomplete view of the microeconomic price determination process.

The view of The Money Enigma is that every price is a relative measurement of the market value of two goods. For example, the price of apples in terms of money is a relative expression of both the market value of apples and the market value of money. The price of apples in money terms can rise for one of two reasons: either (a) the market value of apples rises or (b) the market value of money falls.

Most people believe that “price” and “market value” are synonymous, i.e. they mean the same thing. The view of The Money Enigma is that they are very different. “Market value” is a property possessed by economic goods. “Price”, on the other hand, is merely one method of measuring this property. More specifically, price is a relative measurement of the property of market value: a price measures the market value of one good in terms of another good.

In mathematical terms, we can say that the price of a good is a ratio of two market values, where each of those market values are measured in “absolute terms”, i.e. in terms of a “standard unit” of measurement. [The measurement of market value is a complicated but important topic and I would highly encourage you to read a recent post on this issue titled “The Measurement of Market Value: Absolute, Relative and Real”.]

If this basic theory is correct, then it suggests that every price is determined by not one, but two sets of supply and demand. Supply and demand for apples determines the market value of apples. Supply and demand for money (the monetary base) determines the market value of money. The price of apples in money terms is determined by the ratio of these two market values.

Now, why is this microeconomic theory relevant to our discussion regarding the relationship between excess demand and inflation? Well, this microeconomic theory of price determination can be extended to a macroeconomic theory of price level determination.

If every price is a relative measurement of the market value, then the price level itself is also a relative measurement of market value. More specifically, the price level measures the market value of the basket of goods in terms of the market value of money. In this sense, the price level can be considered to be a ratio of two market values. [See “Ratio Theory of the Price Level” for a more detailed discussion].

Ratio Theory implies that the price level can rise for one of two reasons. Either (a) the market value of the basket of goods rises, or (b) the market value of money falls. In other words, either the numerator in the equation above rises or the denominator falls.

The problem with most commentary regarding the outlook for inflation is that it implicitly focuses only on the numerator in our price level equation.

Shifts in aggregate demand and supply for goods and services can certainly impact the market value of these goods and services. Moreover, an economy that is “overheating” may well experience a temporary rise in the market value of goods.

However, while these are important factors in near-term price level determination, the view of The Money Enigma is that they are primarily cyclical factors and do not explain changes in the inflationary trend. For example, “too much demand” can’t explain why the inflationary trend rose in the 1970s, or why it fell in the 1990s, or why Zimbabwe experienced hyperinflation in the 2000s.

The Value of Money and Inflation

If changes in the numerator, the “market value of basket of goods”, can not explain major shifts in the underlying inflationary trend, then clearly there is only one other factor that can explain these shifts: the denominator in our equation, the “market value of money”.

The view of The Money Enigma is that excess demand is not the primary driver of the long-term trend in inflation. Rather, the primary driver of rising prices as measured over long periods of time is a fall in the value of money.

In terms of our price level equation, swings in the economic cycle will impact the value of goods (the numerator in our equation) and this may somewhat abate or accentuate an inflationary trend. However, the underlying trend is always determined by changes in the value of money (the denominator in our equation).

The “value of money” is a concept that most economists struggle with. The reasons for this are complex and are discussed in a recent post “The Value of Money: Is Economics Missing a Variable?”

In essence, the problem relates to one of measurement. The “value of money” is generally measured in relative terms: for example, the “purchasing power of money” measures the value of money in terms of the value of goods (it is, after all, simply the reciprocal of the price level). However, in order to isolate the “value of money” as its own independent variable, one must measure the value of money in absolute terms, i.e. in terms of a “standard unit” for the measurement of market value.

If this all sounds a bit too technical, then think of it this way. The money in your pocket has value. If it didn’t you wouldn’t accept it in exchange and others wouldn’t accept in exchange. The value of money goes up and down. Moreover, it goes and down independently of the value of other goods, such as apples, and it does up and down independently of the value of the basket of goods.

If the value of money declines significantly over a period of time, then, all else remaining equal, the price of other goods in money terms will rise. Why? Well, if each unit of money becomes less valuable, then people will ask for more units of money for each apple sold or each hour worked.

The view of The Money Enigma is that major shifts in the price level and the inflationary trend are driven by changes in the value of money and the rate of depreciation of the value money respectively.

For example, the price level in the United States has risen roughly tenfold since the 1950s. Does it seem more likely that this tenfold increase in prices has been driven by (a) an excess of aggregate demand for most of the last fifty years, or (b) a decline in the value of the US Dollar due to growth in the monetary base that has dramatically exceeded real output growth?

Frankly, (a) is implausible. The US economy has experienced many periods of slack and weakness over that time that could have easily unwound any temporary inflationary pressures due to “too much demand”. In contrast, (b) is entirely plausible, particularly if one believes that money is a claim on the output of society and that the value of money depends primarily upon the growth of real output relative to the monetary base.

In summary, the view of The Money Enigma is that excess demand can, at least temporarily, lead to an acceleration of inflation. However, in most cases, the impact is likely to be short-lived and is largely irrelevant to the underlying inflationary trend that should concern policymakers.

The primary driver of the core inflationary trend is not excess demand, but rather the decline in the value of money that results when policymakers grow the monetary base at a rate that exceeds the growth in real output.

Will the Velocity of Money Increase in 2016?

Over the past eight years, the velocity of money has collapsed. Since its peak in 2007, the velocity of narrow money seems to have fallen off a sheer vertical cliff, as illustrated in the chart below. However, over the past year or so, there are early signs that the velocity of money has stabilized, albeit at exceptionally low levels.

Does this stabilization mark a turning point for the velocity of money? Has the velocity of money reached its nadir? And what factors might drive the velocity of money higher in 2016 and beyond?

The view of The Money Enigma is that the velocity of money has probably reached its low point. More specifically, there are three possible factors that could drive the velocity of money higher in 2016.

First, the US economy could reaccelerate, requiring a higher turnover of money to facilitate the extra transactions in the economy.

Second, the Federal Reserve could begin to reduce the monetary base. All else remaining equal, if there is less money in the system, then the money that remains needs to turn over more often to “get the job” done, i.e. to facilitate the same monetary value of economic transactions.

Third, the value of money could decline. All else remaining equal, if each unit of money (each dollar) becomes “less valuable” in an absolute sense, then each unit of money must change hands more times in order to complete the same “absolute value” of economic transactions.

The view of The Money Enigma is that the velocity of money is close to its nadir. Why? Well, either the Fed will significantly reduce the monetary base, leading to an almost mathematically certain rise in the velocity of narrow money, or the Fed’s inaction will cause a significant decline in the value of money and a concomitant rise in the velocity of money.

The relationship between the velocity of money and the “value of money” is poorly articulated by mainstream economics. In order to fully explain this idea, we will discuss a new model for the velocity of money and focus on the relationship between each of the three factors described above and the velocity of money. More specifically, we will explore the critical relationship between the value of money and the velocity of money.

A Brief Overview

Since 2007, the velocity of narrow money has collapsed. The chart immediately below illustrates how the velocity of M1 has fallen sharply over the past eight years.

In the last 12 months, the velocity of money seems to have stabilized at exceptionally low levels, levels that have not been seen since the early-mid 1970s. Interestingly, the chart above does seem to suggest that the velocity of money tends to fluctuate within a wide band. Indeed, many economists still believe that the velocity of money tends to “revert to the mean” over long periods of time. So, will the velocity of money begin to revert to the mean in 2016? And if it does, what are the implications for inflation?

In order to understand what might drive the velocity of money higher in 2016 and beyond, we need to do two things.

First, we need to derive a model of the velocity of money that is “useful”, not just a rearrangement of the famous equation of exchange. The view of The Money Enigma is that a useful model for the velocity of money must incorporate an explicit role for the “value of money”.

Second, we need to review the experience on the last eight years in terms of this model. In this week’s post, it will be argued that the reason the velocity of money declined so sharply over the past eight years is because the massive expansion in the monetary base did not trigger a concomitant fall in the value of money.

Once we complete these two steps, then we will apply our model to the outlook for 2016. The view of The Money Enigma is that there are, as always, three key factors that could drive the velocity of money higher. But, in practice, only one or two of these factors are likely to drive a sharp rise in the velocity of money over the next few years.

A Model for the Velocity of Money

In this section, we are going to explore how the model for the velocity of money below is derived and, more importantly, what it means.

There are two key terms in the model above that will be unfamiliar to new readers. The first is the “market value of the basket of goods”, denoted “V_G”. The second is the “market value of money”, denoted “V_M”. In both cases, the property of market value is measured in terms of a “standard unit”. I shall explain what this means in a moment.

At a high level, the model for the velocity of money above suggests that the value of money, “V_M”, plays a critical role in the determination of the velocity of money. All else remaining, as the value of money falls, the velocity of money rises.

The view of The Money Enigma is that the standard equation for the velocity of money (v=pq/M) is not a useful predictive or explanatory model. Simply rearranging the equation of exchange to put the velocity of money on the left hand side and nominal output divided by money supply on the right hand side tells us very little about what actually drives the velocity of money.

More specifically, if a model for the velocity of money is to be useful at explaining why the velocity of money can rise and fall so sharply, then it must incorporate an explicit role for “the variable that economics forgot”, the “value of money”.

However, in order to incorporate the value of money in our model for the velocity of money we must first isolate the value of money as an independent variable.

Isolating the value of money as an independent or “standalone” variable is something that mainstream economics has consistently failed to achieve. The reasons for this are complex and are discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

In essence, the problem relates to how economics measures the property of “market value” or what others might refer to as “value in exchange”. In order to isolate the value of money as an independent variable, we must measure the market value of money in absolute terms, not relative terms. Moreover, we can only measure this property in absolute terms if we adopt a “standard unit” for the measurement of market value.

While most people think of “market value” and “price” as synonymous, the view of The Money Enigma is that “market value” and “price” are not the same thing. Rather, price is merely one method of measuring the property of market value.

Market value is a property that all economic goods possess. For example, an apple has market value and, in order to acquire an apple from you, I must offer you something valuable in exchange. The market value of that apple will fluctuate, completely independent of changes in the market value of any other good.

The price of a good is a relative measure of the market value of one good in terms of the market value of another. For example, if an apple is twice as valuable than a banana, then the price of apples in banana terms is two bananas. Moreover, the price of apples in banana terms can rise for one of two reasons: either, (a) apples become more valuable, or (b) bananas become less valuable.

The point is that “market value” is a property and “price” is a relative measure of this property. This observation leads us to our next question: if market value can be measured in relative terms, then can it be measured in absolute terms?

The simple answer is “yes”. However, in order to measure any property in absolute terms, one must adopt a “standard unit” for the measurement of that property. A “standard unit of measurement” is a theoretical unit of measure that is invariable in the property being measured. While no good is invariable in the property of market value, we can create a theoretical good that is invariable in that property and use this as our standard unit.

Now, how does all this relate to the “value of money”?

Typically, economics measure the “value of money” in relative terms. Most commonly, the value of money is measured in terms of the value of the basket of goods. This is known as the “purchasing power of money” and is simply the inverse of the price level.

The problem with measuring the value of money in this way is that it doesn’t allow us to isolate the value of money as an independent variable. For example, if the purchasing power of money falls, then we don’t whether it was because (a) the value of money fell, or (b) the value of the basket of goods rose.

However, if we adopt a standard unit for the measurement of market value, then, at least theoretically, we can isolate the value of money and the value of the basket of goods as two separate variables and analyze them separately.

Moreover, we can extend our observation that “every price is a relative expression of market value” to the price level. If every price is a relative measure of market value, then the price level is also a relative measure of market value. More specifically, the price level is a relative measure of the value of the basket of goods in terms of the value of money.

Mathematically, we can express the price level as a ratio of two values, an idea that was discussed at length in a recent post titled “Ratio Theory of the Price Level”. In simple terms, if we denote the market value of the basket of goods as measured in terms of the standard unit as “V_G” and we denote the market value of money as measured in terms of the standard unit as “V_M”, then the price level is simply the first term divided by the second term.

What does Ratio Theory imply? In simple terms, Ratio Theory states that the price level can rise for one of two reasons: either (a) the value of the basket of goods rises, or (b) the value of money falls.

Now, let’s return to our discussion of the velocity of money. How can Ratio Theory help us understand the possible drivers of the velocity of money?

The great advantage of Ratio Theory, in regards to this discussion, is that it allows us to substitute out the price level “p” in the equation of exchange and replace it with the two variables described above.

Suddenly, we have a new model for the velocity of money that can provide us with some useful and rather intuitive insights into what really drives the velocity of money. More specifically, we have a model for the velocity of money that contemplates an explicit role for the “value of money”: all else remaining equal, as the value of money falls, the velocity of money rises.

Now, let’s take this model for the velocity of money and think about what has happened over the past eight years.

Why Has the Velocity of Money Collapsed?

Let’s take our new model for the velocity of money and think about why the velocity of money may have collapsed over the past eight years.

From a theoretical perspective, there are four variables that could drive a decline in velocity. However, in practice, the two variables in the numerator tend to be relatively stable. Rather, most of the major variations in the velocity of money occur because of changes in the two variables in the denominator.

The view of The Money Enigma is that the value of the basket of goods VG and real output q are both relatively stable macroeconomic variables in principle and, over the past eight years, are unlikely to have contributed to the major decline in velocity.

Over the past eight years, real output has increased, albeit marginally, and this growth in real output has not contributed to the decline in velocity. It is possible that the value of goods, as measured in absolute terms, has declined slightly over the past eight years driven by globalization and excess supply, particularly in commodities. However, it is unlikely that a decline in the market value of goods can explain the steep drop in the velocity of money that we have seen over the past eight years.

Therefore, we need to focus on the two variables in the denominator of our model. Clearly, the large increase in the monetary base could easily explain the decline in the velocity of money. All else remaining equal, as more money is injected into the system, each unit of money needs to change hands fewer times in order to complete the same value of transaction.

But what about the second variable: the value of money? Could a rise in the value of money explain the decline in velocity?

Frankly, this seems very unlikely. Rather, it is much more likely that the value of money was relatively stable over the past eight years, a phenomenon that was reflected in the relative stability of the price level over that same period.

It is worth remembering that when the Fed first introduced quantitative easing, there were many market commentators who argued that such an expansion of the monetary base would lead to a rise in inflation. However, in practice, this didn’t occur. Rather, the price level remained relatively stable and the velocity of money collapsed. So, what happened? Why didn’t prices rise sharply when the Fed expanded the monetary base and why did the velocity of money collapse?

There is a simple answer to this question: the expansion of the monetary base didn’t trigger a collapse in the value of money. With no collapse in the value of money there was no rise in prices and, as the monetary base expanded, the velocity of money had to fall.

If the value of money had fallen, then prices would have risen and the velocity of money may have remained relatively stable. But this didn’t happen. Indeed, without a decline in the value of money over the past eight years, every injection of new money led to a further decline in the velocity of money.

The Outlook for the Velocity of Money

While predictions regarding major economic variables are notoriously unreliable, attempting to forecast the velocity of money is particularly difficult because of the wide range of factors involved. Nevertheless, let’s take another look at our model and think about what might happen to the velocity of money in 2016 and beyond.

The first factor that could drive an increase in the velocity of money in 2016 is a reacceleration in broader economic activity (higher V_G and q). Frankly, this seems unlikely given the bias of the Fed towards tightening monetary policy, but it is possible. However, even if the US economy does accelerate in 2016, the magnitude of the shift in our numerator is unlikely to lead to a significant rise in the velocity of money.

The second factor that could drive an increase in the velocity of money in 2016 is a major reduction in the monetary base by the Federal Reserve. Once again, this seems unlikely. Even if we accept the consensus forecast that the Fed will raise short-term interest rates in 2016, any major reduction in the monetary base is unlikely given the current planning of the Fed.

If there is a major rise in the velocity of money in 2016, then it is most likely to be caused by the third and final factor: a significant decline in the value of money.

All else remaining equal, a rapid and marked decline in the value of money would have two effects. First, the price level would rise: as money becomes less valuable in absolute terms, the basket of goods becomes “more valuable” in relative terms. Second, a decline in the value of money, all else remaining equal, must lead to an increase in the velocity of money. Why? Well, thinking in absolute terms, if money becomes less valuable, then each unit of money must change hands more times to complete the same total value of economic transactions.

The obvious question that needs to be asked is why would the value of money suddenly decline in 2016? After all, the value of money has been relatively stable for the past eight years despite a fivefold increase in the monetary base.

The view of The Money Enigma is that most major fiat currencies have held their value relatively well over the past eight years because most market participants view the current experiment with quantitative easing as “temporary” in nature. In other words, most people believe that quantitative easing will be reversed in due course and that the balance sheets of the central banks will be restored to more normal levels.

The concern that has been expressed here many times is that the “temporary” flirtation with monetary base expansion will turn into a more “permanent” exercise. At the point the markets realize this is the case, the value of the major fiat currencies could decline significantly leading to a rapid rise in inflation in those countries and, all else equal, a surge in the velocity of money.

Those readers who are interested in exploring this issue further might like to read “Monetary Base Expansion: The Seven Stages of Addiction”, “The Case for Unwinding QE” and “What Factors Influence the Value of Fiat Money”.

In summary, the view of The Money Enigma is that the velocity of money has probably reached its nadir. If the Fed surprises the market and does significantly reduce the monetary base, then it is almost a mathematical certainty that the velocity of money will increase. In contrast, if the Fed fails to reduce the monetary base over the course of the next few years, then the value of money is likely to decline sharply leading to both a rise in the rate of inflation and an increase in the velocity of money.

Does the National Debt Impact the Value of the Dollar?

What is the relationship between a nation’s public debt and the value of the fiat currency issued by that nation? Historical evidence would suggest that high levels of government debt can trigger a sudden collapse in the value of fiat money. However, government debt levels have risen rapidly in many developed nations over the past twenty years with seemingly little impact on the value of those currencies.

So, what is the relationship between the national debt of the United States and the value of the US Dollar and how much debt is “too much”?

The view of The Money Enigma is that national debt plays a critical, but complex, role in determining the value of the dollar. More specifically, it is not “national debt” per se, but rather the market’s perception of the nation’s overall “fiscal sustainability” that directly impacts the market value of the fiat currency issued by that nation.

Why does “fiscal sustainability” matter to the value of fiat money? In simple terms, the government has only two choices when it decides how to fund its deficits: it can issue debt or it can expand the monetary base.

At the point that the market decides that the fiscal path of the nation is unsustainable and that the ability of the government to issue more debt will become increasingly restricted, the market will begin to discount the likely eventuality that both (a) real output growth will slow as taxes are raised and spending is cut, and (b) monetary base growth will accelerate as deficits need to be financed, at least partially, by more money creation.

This combined shift in expectations, lower output growth plus higher monetary base growth, puts downward pressure on the value of the dollar and upward pressure on the price level.

Why does the value of money depend upon expectations regarding the long-term future of real output and the monetary base? The value of money is sensitive to these expectations because fiat money is a financial instrument that derives it value from an implied social contract. More specifically, fiat money represents a proportional claim on the future output of society.

How Much Debt is “Too Much”?

The question “how much government debt is too much?” is an important one both for economists and policy makers. Not surprisingly, many attempts have been made to quantify the threshold at which government debt becomes dangerous.

However, attempting to provide this type of quantitative assessment is much more difficult than it first may appear. For example, Carmen Reinhart and Kenneth Rogoff in their book “This Time is Different” (2009) conducted an expansive empirical analysis of this issue covering sixty-six countries over nearly eight centuries. Their results were unable to uncover any “magic number” that can be used a threshold. Rather, the results of their work suggest that the threshold is highly variable and depends on a number of factors including the nature of the debt, the stage of the nation’s economic development and the nation’s history of default.

The issue is further complicated by the fact that, over the past twenty years, most major Western nations have accumulated levels of national debt that are exceedingly high by historical standards. Indeed, any attempt to have a sensible discussion regarding national debt is inevitability high-jacked by those that point to Japan’s record debt to GDP ratio (Japan’s national debt represents roughly 300% of its GDP) as evidence that there is no limit as to how much national debt and advanced economy can carry.

The view of The Money Enigma is that rather than focusing on quantitative thresholds, a more productive approach may involve taking a step back to think about national debt in the broad context of “fiscal sustainability” and the impact of perceived fiscal sustainability on expectations regarding the long-term economic prospects of society.

In this regard, it is helpful to put aside the specific issue of “how much government debt is too much?” and attempt to answer the more general question “how much debt is too much?”

Clearly, there is no simple answer to this question. From a corporate perspective, a sustainable level of debt will depend upon many factors including variability of cash flows, earnings growth expectations and, ultimately, some type of qualitative assessment regarding the strength of the business franchise itself.

The key point is that it is not the level of debt per se that matters, but rather perceptions regarding the sustainability of that debt. If the market suddenly decides that a given level of debt is no longer sustainable, then that is the point that the cost of both debt and equity capital can rise dramatically.

It is worth noting that, in practice, this tipping point in expectations is seldom triggered by a new issuance of debt. Rather, this tipping point most commonly occurs because of sudden change in perceptions reading the economic future of the issuing corporation.

Similarly, at a national level, the question is one of market perception regarding whether projected levels of national debt are sustainable. As the results of Reinhart and Rogoff’s work suggests, every country will differ in this regard. A national debt load that is dangerous for a commodity-focused developing nation with a history of default could represent a perfectly sustainable burden for a developed nation with a diverse and stable economy.

Moreover, as corporate experience would suggest, it is unlikely that any increase in national debt from say 100% to 120% of GDP is, in and of itself, likely to tip the balance of expectations from “sustainable” to “unsustainable”. Rather, it is more likely that a sudden loss in confidence regarding the sustainability of the US fiscal path will be triggered by other economic events such as the outbreak of war or a sudden and severe recession.

Whatever the cause of this sudden shift in perceptions, a loss of confidence in the fiscal sustainability of a nation should have dire consequences for the ability of that nation to finance its deficits. All else remaining equal, the cost of debt financing, i.e. the interest rate on government debt, will rise significantly.

Frankly, this much should be obvious. What is less obvious is how this sudden shift in perceptions impacts the value of fiat money.

The view of The Money Enigma is that fiat money is, in essence, the equity of society. Fiat money is a form of equity finance for a nation just as shares of common stock are a form of equity finance for a corporation.

If there is a sudden loss in confidence regarding the fiscal sustainability of a nation, then this impacts both the cost of debt, i.e. the interest rate on government debt, and the cost of equity, i.e. the value at which new money can be issued.

More specifically, if the market suddenly decides that the fiscal path of a nation is no longer sustainable, then the value of the fiat currency issued by that nation will decline. Moreover, this decline in the value of fiat money will be reflected in both foreign exchange rates and the domestic price level.

What Determines the Value of the Dollar?

In order to understand why the market’s assessment of fiscal sustainability matters to the value of money, we need to step back and think about what factors determine the value of fiat money and, more fundamentally, why fiat money has any value at all.

The question “why does fiat money have value?” is one that we have discussed in several recent posts including “Why Does Money Exist? Why Does Money Have Value?” and “The Evolution of Money: Why Does Fiat Money Have Value?”

At the most basic level, the view of The Money Enigma is that assets can only derive their value in two ways. Every asset is either a real asset or a financial instrument. Real assets derive their value from the physical properties. In contrast, financial instruments derive their value from the contractual properties. Moreover, a financial instrument is only an asset to one party because it represents a liability to another party.

Fiat money is a financial instrument. More specifically, fiat money derives its value from an implied contract, or “social contract”, that exists between the holders of money and the issuer of money. In essence, fiat money only has value to us because we recognize that, from an economic perspective, it is a liability of society.

The Money Enigma takes this concept further by thinking about the exact nature of the liability that fiat money represents (see “Theory of Money” section).

The view of The Money Enigma is that fiat money represents a claim on the future output of society. More specifically, fiat money represents a variable entitlement or “proportional claim” on the future output of society, much as a share of common stock represents a proportional claim on the future cash flows of a business.

The key practical implication of this theory of money is that the value of fiat money is positively correlated to expectations regarding the rate of long-term real output growth, and negatively correlated to expectations regarding the rate of long-term growth in the monetary base.

In simple terms, we can think of each dollar in our pocket as representing a slice of a cake made of “future output”. There are two reasons for why each slice of cake might shrink.

First, the cake itself could shrink, i.e. the market might suddenly decide that future output growth will not be as strong as previously expected. If this happens, then the value of a proportional claim on future output will be worth less and the value of fiat money falls.

Second, the cake may be cut up into more slices, i.e. people might suddenly decide that the monetary base will be a lot higher in the future. If this happens, then there are more claims against future output, hence every claim is worth less and the value of fiat money falls.

If both of these expectations move sharply in the wrong direction (i.e. less output, more money), then the value of fiat money can collapse quite suddenly. In an extreme scenario, a sudden collapse in the value of money can result in hyperinflation, i.e. the point at which the value of money has fallen so sharply that you almost can’t give the stuff away.

Why Do Perceptions of Fiscal Sustainability Matter to the Value of Money?

Let’s return to our original question and think about the relationship between fiscal sustainability and the value of fiat money. More specifically, what happens to the key set of expectations that determine the value of money in the event that the market suddenly decides that the current fiscal path is unsustainable?

If it suddenly becomes clear that the nation is on an unsustainable fiscal path, then one of the first things that will happen is that the market will begin to put pressure on policy makers to reduce future fiscal deficits. In other words, people will begin to expect that the government will have to cut spending and/or raise taxes.

In this event, what will happen to expectations regarding the long-term rate of economic growth? Most economists would argue that, in this event, people would expect economic growth to slow, particularly if government spending on key infrastructure projects was constrained.

As discussed, expectations regarding the long-term growth rate of real output are a key factor in determining the value of money. If money is a proportional claim on future output, then any event that reduces expectations for future output growth should have a negative impact on the current value of money.

Now, let’s consider to what happen to the other key input factor. How would a fiscal crisis impact expectations regarding the outlook for the monetary base?

Ultimately, every government has only two choices when it decides how to fund its deficits: it can issue debt or it can expand the monetary base.

In modern times, it is rare for governments, particularly those in developed nations, to engage in outright monetization of deficits, i.e. printing money to pay the bills. However, it is very common for central banks to “assist” fiscal policy makers in difficult times, even if such assistance is not explicitly acknowledged as such, by expanding the monetary base and using this newly created money to buy government bonds, thereby lowering the interest rate on government debt and artificially creating a more favourable capital raising environment for the government of the day.

Therefore, while the market may not expect a fiscal crisis to result in outright monetization of deficits, it certainly could impact the market’s expectations regarding the willingness and likelihood of central banks to engage in the aggressive expansion of the monetary base.

Moreover, in an environment, such as the one that exists today, where central banks have already engaged in aggressive monetary base expansion, a fiscal crisis could have a significant impact on the market’s expectations regarding whether the recent expansion in the monetary base is “temporary” or more “permanent” in nature.

If the fiscal crisis tips expectations such that the market believes that the monetary base ten or twenty years from now will be a lot a higher than previously expected, then this should have an immediate and negative impact on the value of money today.

In summary, the view of The Money Enigma is that fiat money is only as good as the society that issues it. A fiscal crisis can severely damage long-term confidence in the future economic prospects of society and, thereby, have a profoundly negative impact of the value of the fiat money issued by that society.

Why is Money Accepted as a Medium of Exchange?

A widely accepted medium of exchange is critical to the efficient economic functioning of any society. Money, in all of its forms, has performed this role for thousands of year. Indeed, acting as a medium of exchange is, without doubt, the most important of money’s “three functions” and, for many, defines what is money and what is not.

However, while economics textbook overflow with discussions regarding the role of money as a medium of exchange and the importance of that role, most textbooks are mute on much more important topic: “Why is money accepted as a medium of exchange?”

There is little controversy around the fact that money is useful as a medium of exchange, a store of value and unit of account. However, merely making this simple observation doesn’t expand our understanding of why money is able to perform these vital functions.

In this week’s post, we will attempt to explain why money can perform its functions and, more specifically, why it is accepted as a medium of exchange. In order to do this, it is important that we go back in history and think about why early money, “commodity money”, was able to perform these roles. Once this exercise is completed, we can think about how money has evolved and why it is still able to perform these functions today.

The view of The Money Enigma is that in order for any item to act as a medium of exchange, that item must be “valuable”. More specifically, it must possess the property of “market value” or what Adam Smith might have called “value in exchange”.

In the context of an ancient economy, it is relatively easy to understand why “commodity money”, such as gold and silver, had value and was, therefore, accepted as a medium of exchange. The much harder question, and a question that economics generally fails to provide sensible answers for, is why does the money that we use today, i.e. “fiat money” or “paper money”, possess value.

Avoiding the Difficult Question

If you open a typical economics textbook and flip to the section about “money”, you will find a whole list of standard questions about money accompanied by a familiar list of answers. Near the top of this list of questions you will find the question “What are the functions of money?”

Economists feel very comfortable answering this question because all of us have some have first-hand experience with the “functions of money”. All of us have some familiarity with money’s role as a medium of exchange, a store of value and a unit of account.

Economists also feel very comfortable talking about why these roles are important. For example, money allows us to avoid the inefficiencies created by a pure barter system.

So far, so good. The problem is that these are easy questions: questions that require a basic modicum of common sense to answer, not a PhD in economics.

The much more difficult question, a question that is avoided by most introductory economics textbooks, is “why can money perform its function?” More specifically, why is money accepted as a medium of exchange, why is money able to function as a unit of account and why is money a store of value?

If you think that I am being unfair, try a quick Google search on “what are the functions of money?” No doubt you will find thousands of responses returned. Now, do a Google search on the phrase “why can money perform its functions?” or the phrase “why is money accepted as a medium of exchange?” Good luck finding a clear answer to these questions that doesn’t just repeat what the functions of money are.

The view of The Money Enigma is that there is little point discussing what are the functions of money if you can’t explain why money can perform those functions. The “why” is a much more difficult question than the “what”, but the “why” is a question that is fundamental to the science of economics.

Avoiding the Temptation of Circular Logic

It is very easy when answering the question “why is money accepted as a medium of exchange?” to inadvertently fall into a logical fallacy.

At the most basic level, most people recognise that in order for money to perform its functions, money must have value.

For example, you would not accept money from me in exchange for your goods or services unless you believe it is valuable. If I offered you Monopoly dollars for your services, you would refuse my offer. Why? You would refuse because Monopoly dollars have no value (except in the context of the game itself). On the other hand, if I offered you US Dollars, you would probably be more than happy to accept them because they are recognized as something “of value”.

In more technical terms, we can say that an economic good can only act as a medium of exchange if it possesses the property of “market value”. Money is only accepted in exchange because it has value. In the words of Adam Smith, we might say that money can only perform its role as a medium of exchange if it has “value in exchange”.

Again, so far, so good. The problem comes when we ask the next obvious question, “why does money have value?” More specifically, why does fiat money, paper money with no “intrinsic” worth, have value?

One of the more common answers to this question is “money has value because it is widely accepted as a medium of exchange”.

Now, can you see the problem with this answer? We have just argued that money is accepted as a medium of exchange because it has value. Therefore, we can’t also argue that money has value because it is accepted as a medium of exchange. One of these answers can be right, but they can’t both be right. Maintaining that both of these answers are right creates a circular argument, a form of logical fallacy.

Where does that leave us? Well, we need to pick one answer that we believe must be correct and then find another solution for the second question.

The view of The Money Enigma is that our answer to the first question is correct: money can only act as a medium of exchange, unit of account and store of value because money has value. Therefore, the question for which we need a new answer is “why does money have value?”

A sensible answer this question needs to achieve two objectives. First, it needs to avoid invoking money’s role as a medium of exchange to explain why money has value. Second, it should provide us with a model that can explain why money has had value in all the various forms that it has taken over time.

Bearing this second point in mind, let’s consider how money evolved over time and why money, in its earliest forms, had value and was able to act as a medium of exchange.

Commodity Money as a Medium of Exchange

It is not hard to imagine how in early barter-based societies, one particular commodity, such as grain or cattle, emerged as the favorite among traders of goods. Indeed, historical records indicate that these basic commodities were used as money as early as 9,000 BC.

It seems likely that, in early societies, goods that were widely used by most people, could be stored for a reasonable period of time and that weren’t prone to wild fluctuations in their value would have become favored as “trading goods” within and between small communities.

All of these basic goods derived their “value in exchange” from their natural or physical properties. Grains and cattle could be eaten, while other materials such as copper and silver could be used to make tools or household equipment.

In modern-day parlance, all of these items had value because they were “real assets”, i.e. they derived their value from their physical properties. Similarly, each of these early forms of “commodity money” had value because they were real assets.

Over time, precious metals emerged as the most popular form of commodity money. There are many reasons for this, but the primary reason for their popularity was the relative invariability in the stock of these commodities. Gold is rare, it’s hard to find and it doesn’t get consumed. Therefore, its stock is relatively constant over time. Why would this make it attractive as a medium of exchange? Well, in simple terms, gold would have acted as constant in a sea of economic variables. While other commodities were subject to vast fluctuations in stock due to natural variations in supply and disease, a trader knew that there was not going to be a lot more nor a lot less gold available in the world one year from now than there was today. (Those who would like to read more about this subject should read an earlier post titled “What Determines the Price of Gold?”)

Whatever the reasons, gold and silver became the preferred forms of commodity money and remained so for many centuries. Importantly, both gold and silver are real assets that derive their value from their natural or physical properties.

Paper Money and the “Real Asset/Financial Instrument” Paradigm

Whether it is cattle or grain or gold, it is easy to understand why something that derives an intrinsic value from its physical properties should be accepted as a medium of exchange. What is more difficult to comprehend is why “paper money”, money that is literally made of paper of little intrinsic worth, should have value.

However, it is easier to understand why paper money has value if we think about the evolution of money over time.

The first form of paper money, “representative money”, was nothing more than contract, written on a piece of paper, that promised some amount of gold or silver coin on request. Issuing these pieces of paper allowed the early kings and emperors to pay for wars and major public works without emptying the royal treasury of all its gold.

In effect, representative money was an early form of “creative financing”: it allowed the rulers and governments of the day to stretch their spending beyond the limits of what would have otherwise been imposed on them if they had to rely solely on using gold and/or silver to pay the workers and soldiers.

Interestingly, the issuers of this paper money didn’t need to have gold in the vault for every piece of paper that they issued. Rather, they just need to make sure that they had just enough that the promised of “gold on request” remained credible.

The reason that I mention the term “creative financing” is not to imply that paper money is somehow of poorer quality than commodity money. Rather, it is to highlight the point that the real function of paper money is to act as a financing tool. The early kings and emperors didn’t create paper money because their societies needed a new or better medium of exchange: gold and silver were doing just fine in that regard. Paper money was created to finance the expenditures of these early rules.

The fact that paper money was invented primarily as a financing tool should give us a big clue regarding why paper money has value. If paper money was created as a financing tool, then, by definition, it is a “financial instrument”.

Financial instruments are interesting because they derive their value in a completely different manner to real assets. As discussed earlier, real assets derive their value from their intrinsic or physical properties. In contrast, financial instruments derive little or no value from their physical properties. Rather, financial instruments derive their value from their contractual properties.

Every financial instrument is both an asset and a liability. By creating a liability against itself, the issuer of the financial instrument creates an asset for another party. In other words, a financial instrument is only valuable to the holder of that instrument because it creates a contractual obligation upon its issuer to deliver something of value.

Now, let’s think about this in the context of representative money.

Clearly, representative money, the first form of paper money, was a financial instrument. Representative money is, quite literally, a written contract that creates an obligation upon its issuer, normally the royal treasury, to deliver a certain amount of gold or silver on request.

Early paper money only had value because it represented an explicit contractual obligation between its issuer and the holder of that money. Paper money was an asset to its holder, because it was a liability to its issuer.

The key point is that the “real asset/financial instrument” paradigm allows us to explain why commodity money had value and was accepted as a medium of exchange and why representative money, the earliest form of paper money, had value and was accepted as a medium of exchange.

Fiat Money as a Financial Instrument

Given how easily both commodity money and representative money fit within the “real asset/financial instrument” paradigm, you would think that economists would have spent much time and effort attempting to extend this paradigm to fiat money.

Unfortunately, you would be wrong.

As soon as “fiat money” enters the room, most economists rush to throw out this basic and important paradigm regarding how assets derive their value. Rather, they spend enormous time and energy trying to invent an entirely new paradigm, a paradigm that can explain why one asset, “fiat money”, is so unique that it must derive its value in a completely different way from every other asset ever known.

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, derives its value from its contractual properties.

In simple terms, when the gold standard was abandoned and the explicit contract that previously governed representative money was rendered null and void, it was replaced by a new implied-in-fact contract. This new implied contract, or what some might term a “social contract”, is what gives fiat money its value.

While it may be difficult to determine the exact nature of the implied contract that fiat money represents, the view of The Money Enigma is that, prima facie, this represents a far more productive line of theoretical enquiry than trying to create a new entirely paradigm solely to explain how one asset, an asset of relatively recent invention, derives its value.

Moreover, if we can unravel the terms of the implied-in-fact contract that governs fiat money, then not only will we have a sensible answer for why fiat money has value and, therefore, can act as a medium of exchange, but we will also have a better understanding regarding what determines the value of fiat money, i.e. what factors cause the value of fiat money to rise and fall.

So, what are the terms of the implied fiat money agreement?

Those who are regular readers of The Money Enigma will know that we have dedicated a significant amount of time to this issue in recent posts including “A New Theory of Fiat Money”, “What Factors Influence the Value of Money?” and an earlier post titled “Money as the Equity of Society” that reviews the parallels between fiat money and shares of common stock.

However, in simple terms, the view of The Money Enigma is that fiat money is a liability of society and represents a proportional claim on the future output of society. In other words, fiat money has value because we recognize it as a claim against our collective future output.

The amount of output that any unit of money can claim at a given time depends on a complicated set of factors, but the term “proportional” implies that it varies in proportion to the long-term expected size of the outstanding monetary base. All else remaining equal, the greater the expected size of the monetary base, the less valuable each unit of money is today. Conversely, the greater the expected growth in future real output, the more valuable each unit of money is today.

In summary, money, in all of its forms, can only perform its role as medium of exchange if it possesses the property of “market value” or “value in exchange”. The view of The Money Enigma is that assets can only derive their value from their physical properties (“real assets”) or their contractual properties (“financial instruments”).

Commodity money, the earliest form of money, derived its value from its physical or intrinsic properties. In contrast, paper money, whether it be asset-backed or fiat, derives its value from its contractual properties. Fiat money derives its value in exchange from its implied contractual properties and it this recognized value that allows fiat money to perform its primary role as a medium of exchange.

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