Tag Archives: money

Why Does Money Exist? Why Does Money Have Value?

The use of fiat currency in our modern society is so accepted that many people will go through their whole life without questioning why the dollar in their pocket has value, or for that matter, why it exists at all.

In this article, we shall seek to answer two basic questions. First, why does paper money exist? Second, why do we readily accept paper money in exchange for our goods and services?

Mainstream economics tends to answer both of these questions by referring to the role of money as a “medium of exchange”. In general terms, economists might argue that paper money exists because it forms a valuable role as a medium of exchange (barter economies are inefficient) and paper money has value because it is accepted as a medium of exchange.

While it is true that “money is a medium of exchange”, this is the wrong answer to both of the questions posited above.

The view of The Money Enigma is that fiat money exists because it is a useful financing tool for society. When governments don’t wish to pay their bills by raising more taxes or by issuing more debt, they can simply create money.

Moreover, the reason we accept fiat money in exchange for our goods and services is because, as a society, we recognize that money is a financial instrument. More specifically, fiat money represents a proportional claim on the output of our society. This is the way in which fiat money derives its value and this is the reason that fiat money can perform its functions as a medium of exchange, a store of value and a unit of account.

In simple terms, money is the equity of society. Fiat money exists because it is a useful as a financing tool and it has value because it is a financial instrument (it is a special-form equity instrument of society).

The fact that fiat money is a “medium of exchange” is incidental to its nature. More specifically, fiat money does not derive value from its nature as a medium of exchange. Rather, money can only perform its role as a medium of exchange because it possesses the property of market value, a property that is derived solely from its nature as a financial instrument.

Those that claim that money has value because it is accepted as a medium of exchange are engaging in a circular argument. Why does money have value? It has value because it is widely accepted in exchange. Why is money widely accepted in exchange? It is accepted because it has value.

The problems created by this circular argument are largely ignored by most economists, despite the fact that this circular argument lies at the heart of Keynes’ liquidity preference theory. We will discuss the flaws in liquidity preference theory another time. For now, let’s take some time to explore the two simple questions we started with.

Why does fiat money exist?

The view implied by many textbooks is that fiat money exists because it is a useful medium of exchange. But was creating a medium of exchange the motivation of those who first issued fiat money?

Let’s put that question another way. Do you think that the first kings that issued fiat money did so because they felt that their society needed another “medium of exchange”? Was fiat money just part of a benevolent desire by those rulers to assist commerce? Were these rulers visionaries who saw the long-term benefits to trade of paper money?

The short answer to all three questions is “no”.

Paper money was introduced to pay the bills when the kings ran out of gold.

The kings in our early societies didn’t create paper money because they were worried that gold wasn’t fulfilling its role as an efficient “medium of exchange”. Gold and silver were doing just fine as a medium of exchange. Rather, the issuance of paper money was an act of survival: it offered a mechanism to pay the army when the kingdom was close to running out of gold.

However, there was a trick to this arrangement. In order for this new paper money to be accepted, the king had to convince the people that the money was “as good as gold”. More specifically, the money had to be issued with the explicit agreement that it could be exchanged for a fix amount of gold on request (for example, one ounce per dollar). If people believed that this promise was credible, then the paper money would trade at the same value as its gold equivalent. However, if this promise lacked credibility, then the value of the paper money would soon collapse.

Nevertheless, in most cases, this system worked, at least for a while.

Fiat money was issued because it performed a unique role as a financing tool. If the kingdom couldn’t raise taxes and was reaching the limits of its borrowings, then issuing paper money that was backed by gold was an attractive way of financing public expenses.

The point is that fiat money is a financing tool. Originally, fiat money was issued as a financial instrument that promised the bearer a certain amount of gold or silver. This is why fiat money was accepted and why it was considered by all to possess the property of “market value”.

Over time, most modern societies have abandoned the gold standard. Most fiat money is no longer convertible into gold at request. But this hasn’t changed the reason money is issued. Money is a financing tool that. Money is still issued to pay for public activities that we, as a society, don’t wish to pay for with taxes or with the issuance of government debt.

Once you strip away all the technical language, the activities of our modern central banks are simple. When governments wish to manipulate financial markets (most notably, suppressing the interest rate by purchasing government debt), they have three basic choices to fund their debt purchases: raise taxes, issue debt or print money. Issuing debt and using the proceeds to buy back that debt defeats the purpose of the exercise. Raising taxes to buy government debt is not a popular move and is likely to be counterproductive, particularly when the economy is weak. Therefore, the government, through its monetary policy agency (the central bank), issues money to buy its debt. This action lowers the interest rate and everyone is happy.

Once again, nothing has changed. Fiat money is issued to pay for things (buying debt) that the government doesn’t wish to pay for by raising taxes or issuing debt. Fiat money exists because it is a financing tool “par excellence”.

What has changed over time is the way in which fiat money derives its value and this brings us to our second question.

Why does fiat money have value?

If we go back to our earlier example, the reason that fiat money had value in the days of the gold standard is obvious: money was backed by gold.

Gold is a real asset, which is to say that it derives its value from its physical properties.

Fiat money is not a real asset. Rather, fiat money is a financial instrument, which is to say that it derives its value from its contractual properties.

Paper money has no value in and of itself. However, paper money does represent something. In the case of early fiat money, paper money represented an explicit claim to a certain amount of gold or silver. The holder of paper money was a party to a contract that stated that the holder could exchange that piece of paper for something of more tangible value.

The mystery of paper money is why it continued to possess any value once the explicit gold convertibility feature was dropped. Why did paper money continue to have any worth once the explicit contract was rendered null and void?

Conventional wisdom is that money continued to have value because, by that time, it was accepted as a medium of exchange. The problem is that this creates the circular argument that we alluded to earlier.

Money is only accepted as a medium of exchange because it possesses the property of “market value”. If money did not have any value, then it would not function as a medium of exchange (if money had no value, you wouldn’t accept money from me in exchange for your goods/services).

If that basic fact is established, then we can’t also argue that money has value because it is accepted as a medium of exchange. Either money is a medium of exchange because it has value, or it has value because it is a medium of exchange. It can’t be both.

Therefore, what we need is something to break this circular argument. More specifically, we need a better model for explaining why fiat money possesses the property of “market value” when the explicit gold backing is removed.

As discussed, fiat money is not a real asset: it doesn’t derive value from its physical properties. Therefore, fiat money must be a financial instrument: it must derive its value from some sort of contractual arrangement.

The solution is to imagine that when the gold-convertibility feature was dropped, the explicit contract that governed fiat money was replaced by an implied-in-fact contract. In other words, when the gold-convertibility feature was removed, paper money no longer represented an explicit claim to something of value. But, it did still represent an implied claim to something of value: the output of society.

The view developed by The Enigma Series is that money is the equity of society. More specifically, money is a long-duration, proportional claim on the output of society. Money is an economic liability of society, even though it remains a legal liability of government and is issued by government on society’s behalf (society can not issue claims directly because “society” is not a legal entity).

The explicit contract that governed fiat money (gold-convertibility) was replaced by an implied-in-fact contract. This new contract, which is in essence an agreement between every member of society, states that money is a proportional claim on the output of society.

This is a complicated idea, but we can think of it in simple terms.

In essence, money is a much like a share of common stock. A business can issue common stock and each share becomes a proportional claim on the future cash flow of that business. All else remaining equal, the greater the expected future cash flows of the business, the more valuable each share is. All else remaining equal, the greater the number of shares outstanding, the less valuable each share is.

Money is an economic liability of society. Society, like a business, can issue claims against the future economic benefits it expects to generate, most notably, future economic output.

Society can issue money (print dollar bills) and each unit of money (each dollar) becomes a proportional claim on the future output of that society. All else remaining equal, the greater the expected future output of society, the more valuable each unit of money is (the greater its purchasing power). All else remaining equal, the greater the number of expected units of money on issue, the less valuable each unit of money is.

When a society is doing well and is expected to remain prosperous, the value of its money should be strong (and inflation should be contained). Conversely, if output is expected to collapse and a society is printing more and more money just to make ends meet, then the value of that proportional claim on future output is going to collapse. This second scenario is the recipe for hyperinflation.

Clearly, money is not a typical equity instrument. For example, money is a claim to a slice, not a stream, of future benefits. However, in practice this difference is relatively minor. The Velocity Enigma, the third paper in The Enigma Series, explains how we can create a valuation model for money that looks very similar to a valuation model for a share of common stock. In particular, we can use the notion of intertemporal equilibrium to create a probability distribution for the expected future benefits of money. The resulting valuation model is something that equity traders would find very familiar.

In summary, fiat money exists because it is a financing tool that is too useful for our society to ignore. In order for fiat money to be able to finance spending by our society, it must offer the holder something in return. And it does. Fiat money derives its value from its contractual properties. Early fiat money derived its value from an explicit contractual property: gold-convertibility. Modern-day fiat money derives its value from its implied contractual property: it is a proportional claim on the future output of society.

Author: Gervaise Heddle

Why Is There a Lag Between Money Printing and Inflation?

The experience of the last five years has clearly demonstrated that an expansion in the monetary base doesn’t necessarily lead to an immediate rise in the price level. While the Federal Reserve has increased the monetary base in the United States by roughly five-fold over the past five years, inflation has remained subdued.

However, does this mean that inflation will be contained if the monetary base remains at these high levels? Furthermore, does the experience of the last five years imply that the long-term relationship between money and inflation is dead?

In each case, the answer is “no”.

Many financial market commentators seem to believe that the long-term relationship between base money and the price level is “broken”. Indeed, the prevailing view seems to be that the level of the monetary base is irrelevant to inflation, provided that the economy does not “overheat”.

The view that “money doesn’t matter” flies in the face of what is arguably the strongest empirical relationship in macroeconomics. While economists like to pontificate about the importance of the “output gap” in the determination of inflation, the fact is that the empirical evidence supporting the relationship between the output gap and inflation is weak and statistically tenuous.

John Hussman, a fund manager and economist, discusses the absence of evidence for the output gap/inflation relationship at length in his post “Will the Real Phillips Curve Please Stand Up?” Similarly, Professor John Cochrane discusses the non-existent relationship between the output gap and inflation in his excellent article “Inflation and Debt”.

In contrast, dozens of academic studies have repeatedly demonstrated a strong and statistically important long-term relationship between the monetary base and the price level. While it is a well-recognised fact that the relationship between money and inflation is weak in the short term, the long-term relationship between money and inflation is a core empirical observation described in every serious economics textbook.

If the long-term relationship between money creation and inflation is not broken, then this raises an obvious question: when will inflation in the United States “catch up” with the expansion in the monetary base? However, in order to have any hope at answering that question, we need to answer a more general question.

Why does inflation tend to lag money creation?

In order to understand why inflation tends to lag increases in the monetary base, we need to explore two fundamental concepts:

The price level depends upon the value of money, and
The value of money depends upon confidence.

We will explore each of these ideas in more detail in a moment, but first, let’s explain how these ideas can be used to explain the delay between monetary base expansion and inflation.

The value of money is the denominator of every “money price” in the economy. All else remaining equal, as the market value of money falls, the prices of goods and services, as measured in money terms, will rise.

When a central bank prints more money, it may or may not have an immediate effect on the value of money. The reason for this is that the value of money depends upon a series of long-term expectations regarding the future of the economy and the future of the monetary base (or, more technically, the expected future path of the “real output/base money” ratio).

If markets believe that the increase in the monetary base is “temporary”, then such an increase may have little impact on the value of money. Furthermore, if markets believe that the actions taken by the central bank will increase the long-term growth rate of the economy, then such actions may even lead to an increase in the value of money. In other words, if the central banks actions are perceived to be temporary and these actions boost confidence in the economy, then printing money may have a slightly deflationary effect, at least in the short term.

However, what happens if expectations shift? What happens if markets start to realize that the “temporary” expansion in the monetary base is actually a “permanent” expansion in the monetary base? The value of money will begin to fall and, all else equal, the price level will begin to rise. Such a fall in the value of money can be quickly compounded if, simultaneously, the market becomes more pessimistic about the long-term economic prospects of society.

Currently, investors are very optimistic about the future of the US economy and seem to believe that the Federal Reserve is “on track” to reduce the monetary base over the next 5-10 years. This perception has supported the value of the US Dollar, which in turn, has been one of the major factors suppressing prices in the US.

But what happens if market confidence starts to slip? It is easy to imagine a scenario one year from now, where the US economy begins to weaken and markets start to doubt the ability or willingness of the Federal Reserve to significantly reduce the monetary base. If this does occur, then the value of money (the value of the USD) will begin fall, maybe gradually at first, but then more precipitously. As it does, inflation will begin to rise. While global deflationary forces may continue to put pressure upon the market value of goods/services, a significant decline in the market value of money can easily overwhelm this phenomenon, leading to a significant rise in prices.

Let’s step away from the US for the moment and think about what might happen in a small, less advanced economy that engages in money printing. The act of printing money tends to create an immediate boost in economic activity and an immediate boost in confidence (regardless of how that new money is spent). The simple fact is that as newly created money is flushed through the economy, jobs are created and people feel better about the economy and the world around them. Sometimes, this effect is so powerful that people believe that the economy will continue to grow strongly even as all this extra money is gradually retired at some point in the future. Consequently, the value of money is supported and the inflation is contained.

However, as historical experience has taught us, printing money rarely has any lasting effect on the growth of the economy. After a few years pass, people in our small, less advanced economy begin to realize that growth really isn’t that good (all the old problems remain) and that the economy is only being sustained at its current levels by the sustained creation of money. In other words, the economy has become addicted to the money-printing drug.

Inevitably, this collapse in confidence leads to a collapse in the market value of money. The exchange rate collapses and prices, in local currency terms, surge higher.

Inflation lags money printing because expectations can take a long time to change. The value of a long-duration asset (money) depends upon long-term expectations and it can take many years for changes in long-term expectations to occur.

Does this same principle apply to advanced economies? Absolutely.

The price level depends upon the value of money, and the value of money depends upon long-term expectations. Printing money may not have an immediate impact on the value of money because it does not have an immediate impact on long-term expectations. Rather, it may take several years before the markets begin to lose faith in the grand plans of policy-makers. But when the market does lose faith, the value of money can erode rapidly and prices can rise swiftly, even at time when real economic activity is falling.

For those readers that are interested, let’s briefly explore this argument in more technical terms. We have glossed over two important ideas that deserve further consideration.

The first idea is that the price level depends upon the market value of money.

More specifically, the market value of money is the denominator of every “money price” in the economy: as the market value of money falls, the price level, as measured in money terms, rises.

In order to understand this concept, it helps to think about the determination of prices in a barter economy. Let’s assume we have a two-good economy that produces only apples and bananas. What determines the price of apples in banana terms? Is it the market value of apples as determined by supply and demand for apples, or is it the market value of bananas as determined by supply and demand for bananas?

The answer is “both”. The price of apples in banana terms depends upon the market value of the primary good (apples) and the market value of the measurement good (bananas). All else equal, as the market value of the measurement good (bananas) falls, the price of apples, as measured in banana terms, will rise.

Economics struggles with this concept because it fails to recognize that the property of “market value” can and should be measured in the absolute. Every price is a relative expression of two market values. We can measure the market value of each item being exchange in absolute terms and plot supply and demand for each good in absolute terms. This somewhat abstract concept is explained in great detail in The Inflation Enigma, the second presentation in The Enigma Series.

Just as the price of apples in banana terms depends upon both the market value of apples and the market value of bananas, so the price of apples in money terms depends upon the market value of apples and the market value of money. If the market value of money falls, then the price of apples, in money terms will rise.

We can extend this microeconomic theory of price determination to a macroeconomic level. If the market value of money falls, then, all else remaining equal, the price of all goods and services in the economy will rise. This is the “Ratio Theory of the Price Level” as developed in The Enigma Series.

The second leg of our argument, namely “the value of money depends upon confidence”, requires a much more technical discussion. There isn’t time in this post to cover all the elements of this second leg of the argument. However, we can briefly touch on the key ideas.

The view of The Money Enigma is that money is a special-form equity instrument. Fiat money derives its value from the liability that it represents. More specifically, money is a long-duration, proportional claim on the output of society.

The easiest way to think about this is to compare money to shares in a corporation. A corporation can issue fixed or variable entitlements against the future economic benefits it creates (future cash flows). Similarly, society can issue fixed or variable entitlements against its future output.

Money represents a variable entitlement to the future output of society. If the markets believe that there will be a lot more claims issued in the future, then the value of each of those claims will fall. Conversely, if people believe that economic growth will be stronger in the future, then the value of each of those claims will rise.

Critically, fiat money is a long-duration asset. The value of fiat money depends primarily upon expectations regarding the long-term future growth rate of base money relative to real output.

Changes in the current level of the monetary base are largely irrelevant to the value of money. What really matters are expectations regarding the level of the monetary base in 20-30 years and, similarly, the expected growth in real output over that extended period.

Therefore, in the short term, it is possible to dramatically expand the monetary base with little impact on the value of money. The value of fiat money depends on long-term expectations of the “real output/base money” ratio. If market participants believe that an expansion in the monetary base is only temporary, then it should have little impact on the value of money.

The notion that fiat money represents a proportional claim on the future output of society is discussed at length in The Money Enigma, the first paper in The Enigma Series. Those readers who are interested in a more technical discussion of the long-duration nature of money should read The Velocity Enigma, the final paper in The Enigma Series.

2015: A Happy New Year for Markets, or a #Fedache for Investors?

Once again, we come to that time of year where professional investors count their bonuses, or lick their wounds, and start planning their investment strategy for the New Year. The question on the mind of many is whether 2015 will be a continuation of the liquidity-fueled party of 2014 or whether 2015 will the year that a cruel and unusual hangover begins. Will the Fed take away the booze and what will the world look like when it does?

Let’s begin with a quick review of 2014. The most notable feature of 2014 is that there weren’t many notable features. The US equity market didn’t crash, most government bond portfolios suffered few casualties and even emerging markets were relatively tame (at least by historical standards).

There is a good reason that “not much happened” in investment markets in 2014: a tsunami of newly-created money continued to flood into global securities markets as central banks around the world continued to expand their balance sheets at an unprecedented pace.

Over the past six years, the US Federal Reserve has bought nearly $4 trillion worth of fixed-income securities. It is hard to put such a large number in context, but let’s try.

As at November 2014, there were 147m employed persons in the United States. If we assume that only working people can save money (those not working and the unemployed should, by definition, find it difficult to save money), then the US Federal Reserve’s actions were the equivalent of those 147 million Americans saving and investing an additional $27,210 each in the fixed-income securities markets over the past six years.

How does this compare with the current savings of the average US worker? Well, one newspaper article last year suggested that more than three-fourths of Americans don’t have enough money saved to pay their bills for six months. Is it likely that these Americans could have saved an additional $27,210 over the past six years and invested those savings in the securities markets? And could all of these 147 million Americans have saved this sort of money without causing a severe consumer-driven recession in the US? The easy answer, on both counts, is “no”.

Another way to think about the scale of the Fed’s quantitative easing program is to consider new car sales. Americans buy nearly 16 million new cars each year. According to Kelley Blue Book, the average price of a new vehicle was $32,086 in 2013. If we do the math, then we can say that over the past six years, Americans have spent nearly $3 trillion on new cars ($500 billion annually). Therefore, if Americans were to save the $4 trillion that the Fed has invested in the markets over the past six years, they would have to give up all purchases of new cars during that same period!

The point is that the additional $4 trillion that has been invested in the markets by the US Federal Reserve over the past six years is a “big deal”. The private sector could not have saved and invested this amount of money in this period of time without creating a severe economic recession. Moreover, the Federal Reserve is not the only major central bank that has been using money creation to fund the purchase of government securities.

So, where did this $4 trillion come from? Was it raised in taxation? No. Was it borrowed? No. (Note that borrowing the money would defeat the whole “purpose” of QE.) Rather, this $4 trillion was just “made up”.

As a society, we just decided to “make up” a whole bunch of new savings that we never had and invest them in the financial markets. This may sound like a great scheme, but there is a catch: “nothing in life is free”.

The question that investors should be asking as we enter 2015 is what is the cost of the past actions of the US Federal Reserve? How do we as a society pay for all the extra money that has been created? Moreover, and perhaps more importantly, when do we receive the bill for this grand experimentation in monetary policy?

There are two ways that we can pay for the Fed’s actions: either the Fed unwinds the six-year expansion in the monetary base and the markets crash, or the Fed does not reduce the monetary base and inflation takes off (and the markets crash). There is also a more realistic “middle-way”: the Fed makes a half-hearted attempt to reduce the monetary base, resulting in both a weak economy and higher inflation. Once again, this is a bad environment for most major asset classes.

Let’s consider each of the two major scenarios in turn.

In the first scenario, the Fed would need to sell at least $2-2.5 trillion of fixed-income securities in order to bring the monetary base back to its previous trend path (prior to the 2007/2008 crisis, the monetary base was growing at a roughly 6% annual rate).

If the Fed does reduce the monetary base by $2 trillion, then this will have an immediate and detrimental effect on all asset markets. In effect, the biggest marginal buyer in global asset markets suddenly becomes the biggest marginal seller. Just as many investors underestimated the impact of the Fed’s actions on the way up, so it is likely that most investors underestimate the impact on the markets of the Fed’s actions once those actions go into reverse.

It is worth remembering that this isn’t money that will be recycled through other parts of the economy: the Fed will not be selling bonds and using the proceeds to buy stocks or consumer products. Rather, the proceeds of these sales will simply “disappear” from the economy, just as the money used to make the original purchases magically appeared in the first place.

The second scenario is more interesting because it represents a more realistic path. As the Fed realizes the degree to which its actions have distorted the investment markets, it is unlikely that the Fed will have the courage to “put things right”. Therefore, we need to understand what will happen to the economy if the monetary base is not reduced from it current extended levels.

If the markets realize that the “temporary” expansion of the US monetary base is in fact a “permanent” expansion of the US monetary base, then this will lead to a decline in the market value of the US dollar. This decline may or may not be obvious in foreign exchange cross rates (after all, other nations are on a similar path), but it will become obvious in the general price level. Why? For the simple reason that, all else equal, as the market value of money falls, the price of all goods as expressed in money terms will rise.

The distinction between a “temporary” expansion in the monetary base and a “permanent” expansion in the monetary base is the key to the future of inflation. Quantitative easing was always advertised as a temporary solution to a temporary problem (a “soft patch” in the economy). Naturally, most investors expect that the expansion in the monetary base will be reversed in time. However, if these expectations are not met (i.e., if investors realize that QE was “falsely advertised”), then the market value of money will fall and the price level will rise.

Understanding why expectations are so important is a complicated issue that will be addressed in future posts. The view of The Enigma Series is that money is a long-duration, proportional claim on the output of society. As a consequence, the value of money is highly correlated to expectations of the long-term path of the “real output/base money” ratio.

At the present time, investors are quite optimistic regarding the long-term path of the “real output/base money” ratio. Investors seem to believe that the Fed will be true to its word and reduce the monetary base. Meanwhile, investors expect that this can be achieved with little impact on medium-term economic growth. If this is the case, then the value of a long-duration, proportional claim on the output of society (i.e., money) should be well supported and the rise in “money prices” (i.e., inflation) should be contained.

However, what would happen to the value of a proportional claim on the output of society if people suddenly decided that there would be a lot of more claims outstanding (a permanently higher monetary base) and/or lower growth in real output in the years to come? Clearly, the value of that proportional claim would decline.

The bottom line is that the Fed is approaching the end game. Either it remains true to its word and reduces the monetary base, an action that will lead to significant liquidity pressure on global investment markets, or the markets realize that the Fed has failed to live up to its word and the value of the USD adjusts accordingly.

It seems likely that 2015 will be the year that these issues come to the fore. Fiddling with “interest on reserves” is a distraction that may buy the Fed a little more time, but ultimately the Fed must reduce the US monetary base if it is to avoid putting the reputation and value of the US Dollar at risk.

2015. The party is over. The #Fedache begins.

A Preview of Future Topics

Welcome to themoneyenigma.com, home of The Enigma Series!

In the weeks and months ahead, I will use this blog to discuss many of the practical implications of The Enigma Series and to answer some of the questions that readers may have regarding the theory itself.

The Enigma Series is an expansive work that touches upon many areas of economic theory. As a result, there is an almost endless list of topics that we could discuss. While I believe that there are certain pressing topics that need to be discussed, such as the rising risk of inflation and the unsustainable path of government balance sheets across the Western World.

I would encourage all readers who are interested in this blog to subscribe to our email list. Many of the topics covered on this blog will be covered in greater depth and detail in subscriber-only emails.

So, what can readers expect in the weeks ahead?

Firstly, I think it is important to discuss the very simple notion that printing money and increasing government debt have consequences. At the present moment, these consequences are being obscured by what can only be described as extremely complacent conditions in financial markets. But, market sentiment can change overnight. Such a shift in market sentiment could have a major and dramatic impact upon the market value of money, the denominator of every money price in the economy.

Ultimately, the market value of money is a function of confidence regarding the long-term economic future of society. Most market commentators seem very optimistic regarding the future path of the “real output/base money” ratio: they expect real output to continue to grow steadily as the monetary base declines.

My personal view is that there are two key reasons why the markets will be disappointed in this regard. First, central banks will find it very difficult to reduce the global monetary base from its current extended levels for a wide variety of reasons that we will discuss in later posts. Second, even if central banks do manage to reduce the monetary base for a short period without damaging confidence in the long-term prospects of the economy, the defining economic event of our lifetime still looms large on the horizon: “the Great Debt-for-Equity Swap”.

“The Great-Debt-for-Equity Swap” refers to what I believe is the inevitable acquisition and cancellation of trillions of dollars of government debt by all of the major global central banks. Hope, optimism and a false sense of confidence may obscure this complex issue for a few more years. Nevertheless, markets will begin to discount this event long before it occurs and we will discuss how the models developed in The Enigma Series can be used to think about the possible market implications.

Finally, on a more theoretical note, one of the main purposes of this blog is to help explain the strengths and limitations of existing economic theories and how The Enigma Series can provide a better platform for economic analysis. Concepts such as the “output gap” and the “quantity theory of money” persist in economic teaching because they recognize some important element of “common sense” regarding the way the world works. The problem is that most of these concepts provide an incomplete or partial description of macroeconomic forces. The Enigma Series hopes to provide a platform that can both embrace and temper these traditional concepts.

I hope that you find this blog useful and I look forward to working with all of you over the months ahead.

Gervaise

Share this:

Share this:

Share this:

Share this: