“Two ways. Gradually, then suddenly."
Under gold
in a free market, the theory of the formation of the rate of interest is
straightforward.[1] The rate varies in the narrow range between the floor at
the marginal time preference, and the ceiling at the marginal productivity.
There is no positive feedback loop that causes it to skyrocket (as it did up
until 1981) and subsequently to spiral into the black hole of zero (as it is
doing now). It is stable.
In
irredeemable paper currency, it is much more complicated. In this first part of
a multipart paper presenting my theory, we consider and discuss some of the key
concepts and ideas that are prerequisite to building a theory of interest and
prices. We begin by looking at the quantity theory of money. In our dissection,
we will identify some key concepts that should be part of any economist’s
toolbox.
This theory
proposes a causal relationship between the quantity of money and consumer
prices. It seems intuitive that if the quantity of money[2] is doubled, then
prices will double. I do not think it is hyperbole to say that this premise is
one of the cornerstones of the Monetarist School of economics. It is also
widely accepted among many who identify themselves as adherents of the Austrian
School and who write in critique of the Fed and other central banks today.
The methodology
is invalid, the theory is untrue, and what it has predicted has not come to
pass. I am offering not an apology for the present regime—which is collapsing
under the weight of its debts—but the preamble to the introduction of a new
theory.
Economists, investors,
traders, and speculators want to understand the course of our monetary disease.
As we shall discuss below, the quantity of money in the system is rising, but
consumer prices are not rising proportionally. Central bankers assert this as
proof that their quackery is actually wise currency management.
Everyone
else observing the Fed knows that there is something wrong. However, they often
misplace their focus on consumer prices. Or, they obsess about the price of
gold, which they insist should be rising in lockstep with the money supply. The
fact that the price of gold hasn’t risen in two years must be prima facie proof
that there is a conspiracy to suppress it. Gold would have
risen, except it’s “manipulated”. I have written many articles to debunk
various aspects of the manipulation theory.[3]
The simple
linear theory fails to explain what has already occurred, much less predict
what will happen next. Faced with the fact that some prices are rising slowly
and others have fallen or remained flat, proponents insist, “Well, prices will
explode soon.”
Will the
price of broccoli rise by the same amount as the price of a building in
Manhattan (and the same as a modest home in rural Michigan)? We shall see. In
the meantime, let’s look a little closer at the assumptions underlying this
model.
Professor
Antal Fekete has written that the Quantity Theory of Money (QTM) is false, on
grounds that it is a linear theory and also a scalar theory looking only at one
variable (i.e. quantity) while ignoring others (e.g. the rate of interest and
the rate of change in the rate of interest).[4] I have also written about
other variables (e.g. the change in the burden of a dollar of debt).[5]
It is worth
noting that money does not go out of existence when one person pays
another. The recipient of money in one trade could use it to pay someone
else in another. Proponents of the linear QTM would have to explain why
prices would rise only if the money supply increases. This is not a
trivial question. Prices rise whenever a buyer takes the offer, so no
particular quantity of money is necessary for a given price (or all prices) to
rise to any particular level.
In any
market, buyers and sellers meet, and the end result is the formation of the bid
price and ask price. To a casual observer, it looks like a single “price” has
been set for every good. It is important to make the distinction between bid
and ask, because different forces operate on each.
These
processes and forces are nonlinear. They are also not static, not scalar, not
stateless, and not contiguous.
Nonlinear
First let’s
consider linearity with the simple proposal to increase the tax rate by 2%. It
is convenient to think it will increase government tax revenues by 2%. Art
Laffer made famous a curve[6] that debunked this assumption. He showed that the
maximum tax take is somewhere between 0 and 100% tax rate. The relationship
between tax rate and tax take is not linear.
Another
presumed linear relationship is between the value of a unit of currency and the
quantity of the currency outstanding. If this were truly linear, then the
US dollar would have to be by far the least valuable currency, as it has by far
the greatest quantity. Yet the dollar is one of the most valuable currencies.
“M0” money
supply has roughly tripled from 2007, “M1” has roughly doubled, and even “M2”
has risen by 50%.[7] We don’t want to join the debate about how to measure the
money supply, nor do we want to weigh in on how to measure consumer prices. We
simply need to acknowledge that by no measure have prices tripled, doubled, or
even increased by 50%.[8] It’s worth noting an anomaly: on the Shadowstats
inflation[9] chart, the inflation numbers drop to the negative precisely where
M0 and M1 rise quite sharply.
Consider
another example, the stock price of Bear Stearns. On March 10, 2008 it was $70.
Six days later, it was $2 (it had been $170 a year prior). As Bear collapsed,
market participants went through a non-linear (and discontiguous) transition
from valuing Bear as a going concern to the realization that it was bankrupt.
Dynamic
Some people
today argue that if the government changed the tax code back to what it was in
the 1950’s then the economy would grow as it did in the. This belief flies in
the face of changes that have occurred in the economy in the last 60 years. We
are now in the early stages of a massive Bust, following decades of false Boom.
Another difference was that they still had an extinguisher of debt in the
monetary system back then. I wrote a paper comparing the tax rate during the
false Boom the Bust that follows[10]. The economy is not static.
By
definition and by nature, when a system is in motion then different results
will come from the same input at different times. For example, if a car is on
the highway at cruising speed and the driver steps on the accelerator pedal,
engine power will increase. The result will be acceleration. Later, if the car
is parked with no fuel in the tank, stepping on the pedal will not cause any
increase in power. Opening the throttle position does something important when
the engine is turning at 3000 RPM, and does nothing when the engine is stopped.
Above, we
use the word dynamic as an adjective. There is also a separate but related
meaning as a noun. A dynamic is a system that is not only changing, but in a
process whereby change drives more change. Think of the internal combustion
engine from the car, above. The crankshaft is turning, which forces a piston
upwards, which compresses the fuel and air in the cylinder, which detonates at
the top, forcing the piston downwards again. The self-perpetuating motion of
the engine is a dynamic. This is a very important prerequisite concept for the
theory of interest and prices that we are developing.
Multivariate
It is
seductive to believe that a single variable, for example “money supply”, can be
used to predict the “general price level”. However, it should be obvious that
there are many variables that affect pricing, for example, increasing
productive efficiency. Think about the capital, labor, time, and waste saved by
the use of computers. Is there any price anywhere in the world that has not
been reduced as a consequence? The force acting on a price is not a scalar;
there are multiple forces.
It should be
easy to list some of the factors that go into the price of a commodity such as
copper: labor, oil, truck parts, interest, the price of mineral rights,
government fees, smelting, and of course mining technology. One or more of these
variables could be moving in the opposite direction of the others, and as a
group they could be moving in the opposite direction as the money supply.
Perhaps even
more importantly, the bid on copper is made by the marginal copper consumer
(the one who is most price-sensitive). At the risk of getting ahead of the
discussion slightly, I would like to emphasize that today the price of copper
is set by the marginal bid more than by the marginal ask. The price of copper
has, in fact, been in a falling trend for two years.
Stateful
Modeling the
economy would be much easier if people would respond to the same changes the
same way each time—if they didn’t have memories, balance sheets, or any other
device that changes state as a result of activity. Even Keynesians admit the
existence of human memory (ironically, they call this “animal spirits”[11]),
which makes someone more cautious to walk into a pit a second time after he has
already learned a lesson from breaking his leg. People are not stateless.
Stateless, and
its antonym stateful, is a term from computer software development. It is much
simpler to write and understand code that produces its output exclusively from
its inputs. When there is storage of the current state of the system, and this
state is used to calculate the next state, then the system becomes incalculably
more complex.
In the
economy, a business that carries no debt will respond to a change in the rate
of interest differently from one that is struggling to pay interest every
month. A company which does not have cash flow problems but which has
liabilities greater than its assets would react differently still.
An
individual who has borrowed money to buy a house and then lost the house to
foreclosure will look at house price combined with the rate of interest quite
differently than one who has never had financial problems.
It is
important not to ignore the balance sheet or human memory (especially recent
memory) when predicting an outcome.
Discontiguous
Markets (and
policy outcomes) would be far more predictable, and monetary experiments far
less dangerous, if all variables in the economy moved according to a smooth
curve.
A run on the
bank, as is occurring right now in Cyprus (in slow motion due to capital
controls), is a perfect example of a discontiguous phenomenon. One day, people
believe the banks are fine. The next day there may not be a measurable change
in the quantity of anything, and yet people panic and try to withdraw their
money. If the bank is insolvent, they cannot withdraw their money, it was
already lost.
A common
theme in my economic theories is asymmetry. In the case of a run on the bank,
there is no penalty for being a year early, but one takes total losses if one
is an hour late. This adds desperate urgency to runs on the bank, and desperate
urgency is one simple cause of an abrupt and large change, i.e. discontiguity.
Ernest
Hemingway famously quipped that he went bankrupt, “Two ways. Gradually, then
suddenly.”[12] It’s not a smooth process.
There are
many other examples, for instance a scientific breakthrough may enable a whole
new industry because it reduces the cost of something by 1000 times. This new
industry in turn enables other new activities and highly unpredictable outcomes
occur. As an example, the invention of the transistor eventually led to the
Internet. The Internet makes it possible for advocates of the gold standard to
organize and coordinate their action into a worldwide movement that demands
honest money. The gold standard in this example would be a discontiguous effect
caused by the invention of the transistor.
My goal in
Part I was to introduce these five key concepts. While not writing directly
against the Quantity Theory of Money, I believe that a full grasp of these
concepts and related ideas would be sufficient to debunk it.
[2] We do
not distinguish herein between money (i.e. gold) and credit (i.e. paper)
[3] Full
disclosure: when I am not working for Gold Standard Institute, I am the CEO of
Monetary Metals, which publishes a weekly picture and analysis of the gold
basis. One can see through the conspiracy theories using the basis: http://monetary-metals.com/basisletter/
[9] I don’t
define inflation as rising prices, but as an expansion of counterfeit
credit: Inflation: an
Expansion of Counterfeit Credit
[12] The Sun Also Rises by Ernest Hemingway, 1926
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