Value and Quantity

Value and Quantity

April 30, 2006

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.