Wednesday, June 10, 2009

Simple principles

Greetings good citizen,

The principals themselves are simple, it’s the ‘variants’ that can drive you to distraction.

As oil prices head back to the stratosphere, we are witnessing yet another bizarre, um, exception to the law of supply and demand.

As you (should be) aware, we are literally ‘swimming’ in oil, yet the price continues to rise. Is this ‘magic’? Of course not, what we’re witnessing is the effect ‘speculators’ can have on real prices by bidding on the ‘futures market’.

Being a ‘non-economist’ I can sincerely appreciate when someone that knows what they’re talking about explains these concepts in a straight-forward manner.

[Purloined from Jesse’s Crossroads Café]

Price, Demand and Money Supply as They Relate to Inflation and Deflation

There are three basic inputs to the market price of something:

1. Level of Aggregate Supply
2. Level of Aggregate Demand
3. Relative Value of the Medium of Exchange

Let's consider supply and demand first, since they are the most intuitively obvious.

The market presents an overall demand, and within that demand for individual products in particular.

Supply is the second key component to price. We are not going to go into more detail on it to here, since what we are likely facing now is a decrease in Aggregate Demand.

It can seem a little confusing perhaps. Just keep in mind that if the demand decreases for products overall for whatever reasons, like unemployment, if supply remains available the prices will drop overall with some variance across products because of their inelasticity to change. This is known as the Law of Supply and Demand.

How we do know when Demand is decreasing?

Gross Domestic Product = Consumption + Investment + Government spending + (exports − imports),

or the famous economic equation GDP = C + I + G + (X − M).

Consumption, or Aggregate Demand, is a measurable and key component of our GDP figures.

Given the huge slump in GDP, it should be obvious that we are in a demand driven price deflation on many goods and services.

Now, that covers supply and demand as components of price, but what about money supply?


Notice in the above examples we talk about Price as a value without a label.

Money is a medium of exchange. It is the label which we apply to give a meaning to our economic transactions.

If you are in England, or France, or Argentina, or China, the value label you apply to Price is going to be different.

Money is the predominant medium of exchange that a group of people have agreed to use when engaging in economic transactions.

The source and store of wealth are the 'credits' within the system which one uses to exchange for products. The money is the medium of exchange.

If you work for a living, you are exchanging your time and your talent, which is your source of wealth, for products. The way in which this is labeled and facilitated in the United States is through the US dollar. In Russia and China is it something else completely.

The Value of Money

How do we know how much some unit of money is worth? Try not to think about your domestic currency. Since we use it so often every day, we tend to think of it with a set of assumptions and biases.

Let's use the Chinese yuan. What is the yuan worth to us? What if I offered you a roll of yuan in exchange for a day's work? How would you know if it was a 'fair trade?"

Since there is no fixed standard for money in our world, you would most likely inquire in the markets what you could obtain for those yuan I offered to you in an accessible market.

But what sets the rate at which yuan are exchanged for a given product?

In a free market system, it is a very dynamic system of barter. When you offer something for money, I know how much of my source or store of wealth I must exchange for the yuan to provide for the product offered.

Money is just a placeholder. We hold it because we expect to be able to trade it for something else, which we really desire. You don't eat or wear money; you exchange it for things you wish to eat or wear. [Sadly, he doesn’t touch upon the topic of needing a specific kind of money with which to pay our ‘obligations’ with. Desire has very little to do with the ‘why’ we bust our hump for money.]

If the value of money changes, the price of all the things to which you have been applying that label changes. This is why it is important to distinguish between price changes because of changes in demand, and changes because of money supply. They are different, and require very different responses. [Sadly good citizen, we have just crossed the ‘apples & oranges’ line that makes the fabled ‘cheaper there’ possible.]

Money supply

In a very real sense, there is a relationship between how many goods and services are available, and how much money exists. [Worse, we can attribute many of our woes to our powerlessness to protect our wealth due to our total lack of control over this crucial factor.]

Let's say we are in China. I give you 100 yuan. Tomorrow the Chinese government triples the amount of yuan in the economy by giving each of its citizens ten thousand yuan for essentially doing nothing, for not producing anything more or less.

Do you think the 100 yuan will be worth as much as they were the day before? No, obviously not.

In real economies these changes tend to happen with a time lag, or gradually, between the action and the reaction. This is necessary because people can only adjust their daily habits, their economic transactions, gradually. Otherwise it becomes too stressful, since our daily routines and decisions are based so heavily on habits and assumptions of value and consequences.

But in general, if the supply of money is increasing faster than per capita GDP over a longer term average the money supply is inflating, that is, losing real purchasing power.

Seems simple? Well its a bit more complicated than that unfortunately since these things relate to free markets, and if there is any other thing you need to remember, we do not have free markets, only free to varying degrees.

The logical question at this point is to ask, "What is the money supply?" That is, what is money and what is not?

We dealt with this at some length, and suggest you look at this Money Supply: A Primer in order to gain more knowledge of what is money and money supply.

We would like to note here though, that there is a difference between money supply and credit, between real money and potential money.

If I have 100 Yuan in my pocket, there is a real difference between that money, and my ability to work at some job tomorrow and be paid 100 yuan, or have you repay 100 yuan to me which I gave to you yesterday, or my hopes that I can borrow 100 yuan from some third party.

If you do not understand this, you will not understand money. It is one of the great charades of our time that risk has been so badly distorted out of our calculations. We cannot help but think that some future generation will look at us as though we had all gone barking mad.

The subject becomes even more complicated these days because we are in what is called a fiat regime. Fiat means 'let it be done' as we will it, and we are if anything in a very relativistic age in which we think we can will just about anything.

The major nations of the world get together and attempt to manage the value of their currencies relative to one another, primarily through their finance ministries and central banks.

Countries will interfere in the markets, much more than they will admit, to attempt to maintain certain relationships among currencies of importance to them. Sometimes they are overt about it, as when nations 'peg' one currency to another, and at other times they are more subtle and merely influence other currencies through mass purchases of debt and other forms of persuasion and the molding of perception.

I hope this helps. I don't intend to answer loads of questions on this, particularly from those who immediately start inventing complex examples to try and disprove this. Most of the time the examples betray a bias that person has that defies patience and a stubborn belief that everything is relative. In the longer term it is most assuredly not.

Each will learn at their own pace what is real and what is not. But they will not be able to say that they have not been warned that sometimes appearance is different than reality.

Here are some examples of money supply growth in the US. If you read our Primer you will know that MZM is by far the most important now that M3 is no longer reliably available.

Is money supply growing faster than per capita GDP? Yes, decidedly so. And unless this trend changes significantly we will face a whopping monetary inflation.

Here is a chart that shows the buying of US debt that other countries have been doing through the NY Fed Custodial Accounts for a variety of motivations. Without this absorption of US money supply the value of the dollar would be greatly diminished relative to several other currencies. This is probably not a sustainable relationship but it has had a good long run because it is supported by the US as the world's superpower. [No matter how ‘erroneous’ that assumption may be.]

Other countries are essentially trading their productivity, their per capita GDP, for our excess money supply. This is why monetary inflation is not out of control. Other countries are providing an artificial Demand at non-market prices for their own reasons.

One of the great errors of our generationhas been the gradual and erroneous mispricing of risk in of our calculations, through a variety of bad assumptions and convenient fallacies. The consequences of this are going to be enormous.

I do not see this improving quickly because the manipulation of risk for the benefit of the few, and the transfer of that risk to the public and the rest of the world, has tremendous value to the powerful status quo.

But the day of reckoning and settlement of accounts is coming, and as it approaches it will accelerate and come with a vengeance. For after all,

"Life is a school of probability." Walter Bagehot

School is almost out.

I don’t know if my commentary will clarify or mystify what Jesse is attempting to explain but here it is anyway.

Over the past forty years the US has transformed from being the world’s manufacturing ‘dynamo’ to being the world’s largest ‘shopping mall’. This roughly coincides with our conversion from being a ‘gold based’ economy to a ‘fiat’ economy.

Which is not to say that gold would have prevented the meltdown we recently experienced because the ‘price’ of gold isn’t ‘etched in stone’ either, as we have all witnessed. It was merely ‘easier’ to inflate the money supply than it would have been otherwise.

The most dramatic feature of this ‘conversion process’ has been the enormous drop in domestic business investment. Sure, we’ve put a Starbucks on every corner but these miniature ‘coffee producing’ factories don’t help our domestic economy one wit!

We don’t ‘export’ cups of coffee!

So we spent decades ‘draining’ our domestic productive capacity and replacing it with the ‘service economy’. But that’s only half of the picture.

It’s the other half that caused the headaches. The people that transferred our productive capacity to cheaper (and artificially created) labor pools were raking in all kinds of money that they had no place to put…except the Stock Market!

While claiming to reduce prices, these bastards were actually coining money by pocketing the difference between what it cost to produce products and what they had to pay for labor and benefits.

And this money was building into a huge pool with no place to go.

How else do you explain why companies that never earned a nickel in profit were trading for as much as $500 a share? There was no domestic investment so where else was this money going to go?

In the meantime this lack of investment was steadily ‘pauperizing’ the nation. Weirdly, everything on Wall Street looked decidedly rosy so the average citizen could only wonder why they were being left in the dust as they ‘transitioned’ into their new ‘service economy’ jobs.

Then, naturally, we come to the ‘reserve currency’ issue. The US was the only nation on the planet that could ‘print’ what it owed.

So we arrive at our current fix, where Wall Street used it’s newly found ability to ‘create’ financial instruments from existing debt for ‘fun & profit’.

And the markets surged beyond their ‘Tech Bubble’ highs!

Not due to the 12 trillion-dollar housing market but due to the 655 trillion dollar ‘derivatives’ market. The banks are pretty keen on making the public think this crisis is due to ‘irresponsible borrowers’ rather then crooked bankers.

Like all ‘fiat’ currencies, they eventually go bust because there is no shortage of ‘paper’. There seems to be some sort of irresistible attraction for bankers to keep printing even when such action threatens their host nations with bankruptcy.

Perhaps this is why we are bailing out the banking system rather than making them eat their losses. We still have paper, no problem!
No, the problem rests with those of us that can’t hop down to Kinko’s and run off as much ‘paper’ as we need.

Which is to point out that we have one hell of a criminal mess on our hands good citizen and we haven’t even started to straighten things out!

Um, here’s another ‘feature’ concerning our money supply that no one is paying attention to and that is the ‘pooling’ of money. Theoretically, once debt is repaid, that money ceases to exist…or does it?

Since the very wealthy would be extremely hard pressed to spend all of the money they derive from their multiple income streams, the amount of money seeking ROI (a.ka. ‘interest’) continues to grow while the ability to generate that interest continues to shrink.

So we now have a quadrillion dollars worth of debt seeking to earn more money than the rate of inflation. How do you suppose that is working out in light of the global dearth of investment opportunities?

If we ever needed the ‘next big thing’, now would be a great time for it to appear.

Barring that, we need to develop a mechanism that prevents the pooling of money within the economy. We are where we are today because of our inability to pay the interest on what we owe.

Thanks for letting me inside your head,


P.S. ‘A Simple Plan’ solves this pooling problem.

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