Alasdair Macleod explains the money side of prices, and why government currencies, unbacked by gold, are doomed to collapse. And why gold, which is the sound money chosen by markets throughout history, will retain or increase its purchasing power measured in the goods it buys over the coming years…
From Alasdair Macleod:
Very few people have a full understanding of the relationship between money and goods. This is the relationship that sets prices. Yet, without that understanding, central banks will almost certainly fail in their policy objectives (as they always have done so far), and individuals unaware of gold’s monetary properties will be unable to protect their wealth in monetary and financial conditions that are becoming increasingly unstable.
Money is the link between our production and consumption. As individuals, we maximise the value of our production through specialisation. By making our personal production available to others, we then acquire the goods and services that they can produce better than we can ourselves, and at a far lower cost. This is why classical economists agreed that through the medium of money, we exchange goods for other goods. Money simplifies our exchange of goods immeasurably, by allowing us all to value our production in a common unit, accepted by all buyers and sellers in our own communities and further afield as well. But, and this is important, we only hold as much idle money as we need.
The defining quality of money is to be widely accepted and stable, so that changes in price are reflected solely in the demand for and supply of individual goods. These prices are set by the subjective values placed on them by buyers, because the decision to buy or not to buy and at what price, is always theirs. The producer, who is in business to sell, does not have this option, so prices are not set by the costs of production, as commonly asserted. It is a frequent mistake by politicians of all persuasions and government bureaucrats alike to assume that the cost of production determines prices. They assume if a good cannot be made profitably, the businessman will withhold production. No, if he withholds production, he will go out of business.
It is these incorrect assumptions about costs that are fundamental to the myth that the state as economic agent is superior to free markets. The truth is different. Unless a consumer is forced against his will, he will only buy the products he wants at prices he is prepared to pay. Producers must dance to the consumer’s tune, for in a capitalist society he is king. For this reason, producers strive to cut their costs and improve their products to compete. Assuming sound money, that is money which fulfils the conditions of monetary stability, prices will tend to decline over time, driven by improved production methods, technological progress, and competition for the buyer’s business.
This is confirmed in the real world of commerce, if not in the ethereal sphere of modern macroeconomics. Where it gets more complicated is when one considers the fact that the purchasing power of money, its objective exchange value, is never constant, as we all usually assume. Even sound money varies in its purchasing power, its objective exchange value being never fixed. The reason is that as individuals, our need for monetary liquidity is bound to vary, if not day to day, between pay-checks and between seasons. Each one of us contributes to changes in the overall price relationship between goods and money.
In practice, we tend not to maintain unnecessary cash balances, reserving enough liquidity for our foreseeable needs. This can be in the form of cash, cash balances at the bank, or credit available to draw down. Otherwise, money is either spent or saved to be reinvested productively.
There is an important difference between the money we use today and the sound money of yesteryear. All money not freely convertible at a fixed rate into gold is credit money. Even cash notes and coins are government credit, while customer deposits in the banks are unmistakably credit in both origin and fact. The quantities of government credit-money and bank-credit money can and do vary considerably. Gold as sound money varies less so, due to its inflexible nature.
Gold is continually mined, and the quantity allocated to money also varies as the proportion of the above-ground stocks assigned to other uses fluctuates, such as for jewellery and ornamentation. The dividing line between gold’s use as money and jewellery is itself slender. The human population has increased, particularly over the last two centuries, so there are more people on earth requiring monetary liquidity, and as their living standards improve, their aggregate demand for monetary liquidity is bound to increase as well.
Together, these factors lead to a continuing increase in the purchasing power of gold over time, when it is used as money. Even though today it does not circulate as money, this is still true. It flowed across national boundaries with implications for its local purchasing power, but worldwide, it’s availability was always restricted, though not inflexibly so.
Gold matters, because, excepting silver, it is the only form of money that has survived since individuals discovered the convenience of money over barter. It is also beyond the control of governments, as they cannot issue it without acquiring it first. It is subject to the constraints of its quantity, so that as a medium of credit it cannot be debauched, only defaulted upon. Its relative inflexibility and its soundness are the primary reasons governments do not like monetary gold, and force their preferred alternatives on their citizenry. The vested interest of governments is therefore to discourage, or even ban the use of gold as competing money.
Despite this, individuals numbering over half the world’s population, financially ignorant in the eyes of the West, still understand through experience and instinct that gold retains its role as superior money, compared with government paper and electronic digits in the banks. The educated people, who are the readers searching for an understanding of prices by reading Keynesian and monetarist-inspired journals and papers, are the ones who have lost their monetary compass entirely. This is all of us in the welfare states, educated but ignorant about the theory of money, literate but woefully uninformed about the true relationship between money and goods, believing money is a matter for the state. It is us who do not understand the dangers of fiat money issued by the banking system in increasing quantities.
Understanding the objective exchange value of money
The purchasing power of money in a general sense is regarded as its objective exchange value. The term “exchange value” needs no further explanation. “Objective” means in this context assumed, unquestioned, or taken for granted. Money is the anchor in a transaction, and contrasts with the subjective value placed on goods. As users of money, it is convenient for us to assume there are no price changes from the money side, so that all subjectivity in pricing is reflected in the goods being exchanged for it. When we render financial accounts, this assumption carries through, as it does in law as well. However, we are generally aware that over time, if not during our daily lives, the value of money is far from being an objective constant. This raises the question as to on what grounds we base our value of money.
Logically, we can only know the value of money by referring to our most recent experience of its value, and then incrementally back in time, that we might judge its soundness. This is the reason a resident in Switzerland is likely to have a different appreciation of his francs, compared with a resident in Argentina of his pesos.
Ultimately, this involves an assessment of a money’s value before it became money, which is why people the world over know gold has a value rooted in other uses, in turn based on its physical properties. Paper and digital money have no alternative use-value. To gain credibility, the longer-lived government currencies of today based their integrity on gold or silver, being at one time freely exchangeable into one or other of these monetary metals. This is no longer the case, which from a theoretical standpoint, places government currencies at a continual risk of losing their credibility as money altogether.
Today’s macroeconomic establishment persuades us that this concern must be dismissed, and any economist who questions the validity of fiat currencies as money is condemned as a maverick or simply nuts. This is not an acceptable refutation of the regression theorem described in the paragraphs above, and it is the duty of an economist seeking the truth not to duck this important issue.
No one has come up with a credible alternative explanation to the valuing of money on this regressive basis, partly because not many contemporary economists fully understand the subjective/objective relationship in pricing goods in monetary units, and partly because the implications undermine the whole thrust of monetary policy. This is nakedly evident in Keynes’s General Theory of Employment, Interest and Money, which still serves as today’s vade mecum for much of the economics profession.i
The implications of this lack of sound price theory are indeed important. Without understanding the relationship between money and goods, errors of monetary policy are inevitable. And as those errors become manifest, the personal freedoms we enjoy between us, by exchanging goods at prices mutually agreed, become restricted through increasingly distortive and counterproductive government interventions. Increasing economic suppression is the result, as was demonstrated as the consequences of the soviet repression were finally revealed when the USSR’s command economy collapsed.
If total money and credit in an economy are constant over time, and assuming for a moment that the price-benefits of competition, improved manufacturing techniques and technology are put to one side, the general price level can only remain stable if the general preference for holding money relative to goods also remains constant. Otherwise, a fall in overall preference for holding money will result in a fall in money’s purchasing power, evidenced by a widespread increase in prices. Equally, an overall rise in preference for holding money will result in an increase in money’s purchasing power, evidenced by falling prices.
Money quantities have soared
Since the last financial crisis, there has been a massive expansion in the quantities of most currencies. The following chart shows the expansion of fiat dollars since 2009, which has been far greater than the rate of increase prior to the financial crisis, shown by the dotted line.
The fiat money quantity records the total amount of money both in circulation and in the banking system in the form of cash and ready deposits.ii Some of the increase since 2008 has been in bank reserves held at the Fed ($2,000bn), but this is only a fraction of the $10,000bn increase.
Without resorting to the evidence of questionable government statistics, it is easy to see that this tripling in money quantity in only nine years has not yet led to the expected increase in the general price level. Part of the explanation is that monetary inflation has so far predominantly exaggerated asset prices. But any resident living in financial centres will attest that prices are indeed rising more rapidly than government statisticians admit. Far from being a mystery as to why prices have not yet reflected the rapid expansion of the quantity of money, price rises are indeed on their way, with much of the increases yet to come.
Since the financial crisis, monetary expansion has become the dominant factor in raising the general level of monetary preference. Bank deposits have become swollen as bank credit has been expanded, because it takes time for individuals to readjust their cash balances to their economic needs. Remember, the purpose of money is to act as a bridge between our production and consumption, not as an asset to accumulate.
The readjustment of money preferences back to normality is subject to a combination of factors, including the inflation of asset prices, before it affects prices of goods. The suppression of interest rates continues to generate new deposits by encouraging the expansion of bank credit as well, as the chart above shows. Furthermore, the ownership of all that cash tends to start in a few hands, dispersing into wider ownership over time.
However, the move towards a preference for goods, as people try to reduce their burgeoning cash balances, is never matched by an increase in their availability, leading to imports, trade deficits, currency weakness, and rising prices by that route. This is due to the inflexible rule that we produce to consume, so we cannot consume what we don’t produce, except by importing it. This is the reason trade deficits are a consequence of the expansion of bank credit in the hands of consumers. Indeed, without a ready supply of goods from abroad, domestic prices would rise more rapidly as the balance of monetary preferences readjusts towards normality.
There are, therefore, two routes through which prices can adjust to the change in monetary preferences for any given currency: the foreign exchanges, reflecting trade deficits that increase to supply demand not satisfied by domestic production, and supply from domestically-produced goods and services against a background of supply constraints. When goods are imported, the price rises are often delayed by this roundabout route, and the fact that domestic supply bottlenecks are thereby temporarily alleviated. Otherwise the consequences are the same. Prices rise to accommodate the swing from money preference towards a preference for goods, instead of production being sustainably stimulated.
We must now address the problem on a global basis, because the supply of goods to an individual nation-state expanding the quantity of money relies to a large extent on imports. This cannot be the case when central banks are following the same expansionary policies on a coordinated basis, ignoring, for the purpose of our argument, differentials in savings rates.iii
Imagine a world where money preferences in the hands of consumers everywhere are first pumped up by all central banks and by commercial banks expanding credit, only to subsequently recede towards normality. The shortage of goods as money-preferences recede cannot be satisfied from another planet, so in aggregate, prices everywhere must rise rapidly to absorb the adjustment in relative preferences. We do not need to imagine it, because these are precisely the conditions we now face, thanks to the coordination of monetary policies on a global basis.
The rate at which the general price level rises is broadly set by the rate at which the preference for money deteriorates in favour of a preference for goods. The result is the total money stock relative to the total value of all goods reverts to where it was before the quantity of money expanded, but each monetary unit buys considerably less. If we found it convenient before the monetary expansion to hold a balance of $5,000 in our bank accounts for our liquidity needs, we will now hold $15,000, which will buy the same original quantities of goods at roughly three times the price. Of course, if the ordinary person sees the purchasing power of money deteriorate to a significant degree, he will attempt to reduce his cash balances even more, ultimately collapsing money’s purchasing power entirely. This in common parlance is hyperinflation, and a crack-up boom as people scramble for goods in a rush to dispose of money altogether.
It may be easier to visualise this effect if the validity of objective exchange values for currencies is dispensed with entirely. The evidence then becomes clear. Today, it is missed by nearly all commentary in the financial press, which focuses on the rapid expansion of debt, ignoring the simultaneous increase in the quantity of money. Emphasising debt to the exclusion of its counterpart, deposits, is wholly consistent with a lack of appreciation of the problems concealed by the default assumption about money’s objective exchange value.
Inflation and deflation
The expressions inflation and deflation are too crude for a proper understanding of money and prices, particularly in the context in which they are commonly used. Inflation of prices is associated with improving economic conditions, and deflation with falling prices, taken to be evidence of deteriorating economic conditions. Both assumptions are incorrect, which should become evident from an understanding of the price effects of changes in preferences for holding money relative to goods. Changes in relative preferences are independent from economic performance, which continues regardless, except to the extent it is disrupted by the expansion and contraction of unsound money as described above.
The assumptions of central banks are otherwise, as we have seen. Monetary developments in the US are broadly reflected by similar increases in monetary preferences in other currencies, swollen by credit expansion. Central banks are following common monetary policies under common misconceptions, for the truth is that like Lord Keynes, today’s central bankers have a limited understanding of the price relationship between money and goods. Hence, a common mandate is to target price inflation at a modest rate, typically 2%. Central bankers believe, without foundation, that rising prices stimulate business, when all they stimulate are the statistics.
Bound up in the bankers’ psyche is the objective exchange value of money, so that despite all evidence to the contrary, central bankers believe they can expand the quantity of money without limitation, until official prices edge up towards the inflation target. They fail to understand the consequences of their actions. Like a reservoir full to overflowing, the non-financial community already has a far higher level of financial liquidity than is normal, and the consequences of it being normalised are prices rising beyond anyone’s control.
For the same reasons the establishment has an irrational fear of falling prices, the conditions that are typical of sound money.
The deflationists see a fragile banking system, unable to absorb losses from an economic downturn about which they are continually concerned. They argue that a financial crisis will wipe out bank collateral as asset prices fall, leading to a scramble for cash to cover debt obligations. They say this will lead to a fall in prices, repeating the experience of the 1930s depression.
Central bankers now appear to be more concerned about this outcome. The Fed wants to prepare its balance sheet for the next crisis, the Bank for International Settlements warns us we could be on the brink of a new financial catastrophe, and the Bank of England is ordering banks to boost capital reserves to protect themselves from rising credit risks.
Of course, these concerns are being expressed as an alternative to raising interest rates to slow credit growth. The Bank of England, for example, seeks to retain interest rates at these levels, or at least only slightly higher, while instructing the banks who to lend to and who not to lend to. As usual, the Bank misses the point entirely: price inflation will be driven by the currently high levels of money preference being unwound, not bank policy.
Monetary policy is an inglorious mess. The central banks are positioning themselves to handle the next crisis before the monetary consequences of the last have been unwound.
The outcome is inevitably cyclical. Prices will start rising at a greater rate, and interest rates must rise to keep pace. Unaffordable nominal rates in the near to medium term are a racing certainty. We can assume that a new financial and economic crisis will follow, in which case over-indebted businesses will go bust, asset values crash, and banks will move from insolvency towards bankruptcy, just as the deflationists fear. The response from central banks will unquestionably be to flood the financial system with yet more money to keep the banks alive, and insolvent businesses afloat. Quantitative easing to support asset prices and to fund government spending will have to be reintroduced at a greater level than seen heretofore.
Central banks might succeed in postponing a widespread crisis for a year or two, but the cost will be a new wave of money-creation into a private sector already holding too much money relative to goods. The ability to adsorb this extra money on top of existing liquidity levels is severely limited, and likely to trigger a substantial rise in prices for goods and services with very little time lag, once the initial uncertainty is over.
By way of contrast, sound money, which is physical gold, is not owned in the welfare states in sufficient quantities to provide the day-to-day liquidity required to exchange production under our division of labour. This appears to throw up an arbitrage opportunity between unsound and sound money rarely seen, and certainly never seen before on a global scale, at least not since Roman times.
iSee Chapter 21, The Theory of Prices. Keynes failed to grasp the true subjectivity of prices, becoming confused between the deployment of production resources and a wishy-washy theory of output and employment as a whole. It amounts to an off-road excursion into the long grass, where he leaves his devoted followers stranded to this day.
iiSavings deposits are included in the FMQ total as ready deposits, on the basis that banks will always pay them out on demand, so they cannot be regarded as anything else but cash.
iiiSavings rates matter, because they divert spending from immediate consumption. Thus, China, which has a savings rate approaching 40%, can expand bank credit and maintain a trade surplus.