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It should be obvious that I think of monetary
effects in terms of changes in monetary value. We talked earlier about
situations where the "dollar does to $0.50," or "the dollar
goes to $2." It is not too hard to imagine what happens in such
situations. When the "dollar goes to $0.50," then it tends to take
more dollars to buy things, and the opposite is the case for when the
"dollar goes to $2." Note the very clear cause-and-effect
relationship. When the "dollar goes to $0.50," then, over a
period of years, it tends to take more dollars to buy things. We do not
just say that, because certain prices have doubled (for whatever reason),
therefore, the dollar's value has fallen. Wrong wrong
wrong.
It should be baldly obvious that, if a car
costs $20,000, and the Mexican peso is trading for 10/dollar, then the car
would cost about 200,000 pesos. If the peso's value then fell to 50/dollar,
then the car would tend to cost about 1,000,000 pesos, or $20,000. It is
easy, in this situation, to see what happens when the "peso goes to 0.20
pesos." But how about if the dollar and the peso both fall in value by a
factor of five? Then, of course, the peso would still be worth about 1/10th
of a dollar, but the cost of the car would, eventually, tend to move toward
$100,000 and 1,000,000 pesos.
This is a very simple sort of way of looking
at things. However, I must admit, that it took me several years to come to
the conclusion that this is the best way, and that it is a reliable method.
I am trying to make this very clear and
obvious, so that it doesn't take you several years to figure out what can be
understood in about twenty minutes.
There really isn't much to a currency besides
its value. And value can only do three things: go up, go down, or remain
stable. That's the entire universe of options.
See: economics is simple after all.
The value of a currency can be interpreted
as the intersection between supply and demand for the currency. This
interpretation has important implications for currency management, as
adjustment of supply does indeed affect value directly. Thus, the
"interpretation" is something quite close to a fact, or a proven
hypothesis. But I like to keep a thin veil between value, which is a concrete
fact (although not necessarily easy to measure), and the "intersection
of supply and demand," which is more conceptual.
The funny thing is, if you open an economic
textbook, you will probably not find a single paragraph describing what I
just outlined above. You won't find it among any "alternative"
economic interpretations either. I consider the above to be a very old,
"classical" interpretation, but it appears that the 19th
century writers grasped this concept somewhat intuitively. But then, they
didn't grow up in an environment of floating currencies and central bank
manipulation. We don't write books about the sun rising.
What you will find, almost universally, is
some sort of analysis based on the "quantity of money." The concept
of the "quantity of money" is then tortured beyond all recognition
to support whatever point the author is trying to make. The fact of the
matter is, however, that if we restrict the notion of the "quantity of
money" to real money, i.e. base money, instead of forms of credit such
as bank deposits, it's rather hard to come to any conclusions. Not too long
ago, the monetary base in Russia was growing at 60%+ per year, but the
currency was rising. Today, the rate of monetary base expansion in the U.S.
is below 5%, but the dollar's value is dropping.
If you look at economic textbooks, you find
the most absurd hypotheses for what causes inflation: pushed by costs, pulled
by wages, ignited by oil embargoes, resulting from too much employment
(?????), resulting from too much credit, or credit on terms that are too
easy, an excess of "animal spirits" or a "propensity to
consume," government budget deficits, current account deficits,
excessive "demand," high capacity utilization, high stock prices,
the "wealth effect," on and on it goes. Indeed, it is still not an
established verity that "inflation is always and everywhere a monetary
phenomena," a popular phrase from the early 1980s. (If central bankers
understood this, they wouldn't get so burned up by "excessive
employment.")
So, the people who recognize inflation as a
monetary phenomena remain only a subset of economists as a whole. That subset
is divided into two camps: 1) those that believe recessions are caused by
"too little money." 2) those that believe recessions are caused by
"too much money." The first are the Monetarists, who remain in the
majority, who blame the Federal Reserve for causing the Great Depression by
allowing a "decline in M2" during the early 1930s. The second, a
vocal minority, are the so-called Austrians, who blame the Fed for causing
the Great Depression by allowing an "increase in M2" during the
1920s.
Without going into all the gory details, let's
just say that most of the commentary today remains mired in discussions about
the so-called quantity of money, which is defined as whatever the
author likes, and whether it is increasing or decreasing, and the supposed
implications of this increase or decrease.
Just forget about it. It does not matter
whether the so-called "quantity of money" -- no matter how it is
defined, as base money, M2, M3 or whatever -- goes up, down or whatever, by
itself. The only thing that matters, in terms of economic effect, is
whether the value of money changes. Now, if you go through the pain and
suffering of figuring out all the existing monetary explanations, you might
never come across any discussion about changes in the value of money. Let me
show you what I mean. Look at this recent discussion on inflation by a very
bright person who is trying to figure out what's going on. Click here. He concludes:
With the above in mind:
1
Inflation is best described as a net expansion of money supply and
credit.
2
Deflation is logically the opposite, a net contraction of money supply
and credit.
3
Government mandated solutions to problems best left to the free market
is the root cause of money supply expansion.
4
With no enforcement mechanism such as a gold standard to keep things
honest, and with no desire to raise taxes, governments simply approve
programs with no way to fund them. The FED has been all too willing to play
along by printing the money needed for those government programs. To make
matters worse, the fractional reserve lending policies of the FED allows an
even greater expansion of credit on top of the money printed. Eventually
those actions result in a crack-up-boom and debasement of currency.
5
Changes in "Purchasing power" required to buy a basket of
goods and services can not be accurately measured because of the need to
continuously add new products to the basket, because the measurement of
quality improvements on existing products is too subjective, and because it
is impossible to pick a representative and properly weighted basket of goods,
services, and assets in the first place. Furthermore, such measurements are
highly prone to governmental manipulation at private citizen expense. Endless
bickering over the CPI numbers every month should be proof enough of these
allegations.
6
Measurement of equity price fluctuations poses a particularly
difficult problem for those bound and determined to put the cart before the
horse as well as those that think such assets belong in any sort of basket.
7
Price targeting by the FED is doomed to failure because a
representative basket of goods and services can not be created, because
prices can not properly be measured, and because price targeting puts the
cart before the horse.
8
Expansion of money supply (typically to accommodate unfunded
government spending) and expansion of credit (via GSEs, fractional reserve
lending, and other unsecured debt issuance) are two of the biggest problems.
Targeting the outcome (prices) can not possibly be the solution.
9
Ludwig von Mises describes the endgame
brought on by reckless expansion of credit: "There is no means of
avoiding the final collapse of a boom brought about by credit (debt)
expansion. The alternative is only whether the crisis should come sooner as
the result of a voluntary abandonment of further credit (debt) expansion, or
later as a final and total catastrophe of the currency system involved."
10
The FED should have been listening to Mises
all along. Instead they have put their faith in "productivity
miracles", "new paradigms", and their own hubris. Those
actions have accomplished nothing other than delay the eventual day of
reckoning.
Do you see what I mean? Not a word about
changes in the value of money, or the intersection of supply and demand for
money. Endless blah-blah about an "expansion in money supply and
credit," government deficit spending, taxes, "purchasing
power," stock market values, "fractional reserve lending," and
the obligatory final prayer to the Holy Mises.
Given that, thus far in his search, this very talented author has come up
with ten postulates that are all either wrong or irrelevant, can you see why
it can take years to understand these childishly simple concepts?
The funny thing is, this is actually better
than most of what's out there, so the self-proclaimed "Austrians"
at least get credit for that.
I think you can see now why it can be so
difficult to abandon "quantity theory" completely and focus on
currency value. You have to ignore what everyone is talking about, and focus
on what nobody is talking about, and, hardest of all, you have to understand why
this is the right thing to do. I certainly did not invent this value-centric
approach, as it was common in the 19th century, and taught to me
in the late 1990s, just as Robert Mundell taught it
in the early 1970s. It is apparent in Mises'
writings, although it seems that he never quite dragged it out into the open
in the fashion that we are doing here. (Mises died
in 1973, and lived virtually his whole life within the framework of stable,
gold-linked currencies.)
However, I think that even those that are
"value-centric" today still have a whiff of quantity-theory about
them, as they have, in my opinion, a slightly exaggerated concern with the
"quantity of supply and the quantity of demand." For example, they
might say that the decline of the dollar today is caused by "an
oversupply of currency in relation to its demand," which is technically
true, but the fact of the matter is that base money supply growth is quite
low (if Fed statistics are to be believed.) What's actually happening is that
demand is declining, in reaction to Fed mismanagement -- or to put it another
way, the value of the currency is falling, even though the quantity of currency
(base money supply) is generally stable. The Fed is not "running the
printing presses." The same thing happened in the 1970s. Indeed, it is
not quite true to say that "demand is declining," as that is a sort
of interpretation, albeit a "correct" interpretation. Really, what
is happening is there is a repricing, a decline in
value, just as a stock may trade at a dramatically lower value even though
the volume of stock traded is minor compared to the outstanding issue. The
"demand" for the stock may be there in a sense, as for every seller
there's a buyer, but just at a different price.
It's funny that this value-centric approach
should be so obscure, when I guarantee you every Mexican paying 1,000,000
pesos for a car that cost 200,000 pesos a year previous understands it very
well.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street Journal
Asia, the Japan Times, Pravda, and other publications. He has appeared on
financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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