August 26, 2016

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

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

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

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

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

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

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

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

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

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

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

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

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

More Debt, More Money, No Problems?

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

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

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

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

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

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

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

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

The Cost of “More” Stimulus

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

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

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

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

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

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

The Fiat Money Enigma

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

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

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

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

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

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

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

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

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

Too Much Money, Too Much Debt

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

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

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

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

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

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

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

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