The prospects for money

Jun 30, 2016·Alasdair Macleod

In my view, this new bout of turmoil in financial markets is the prelude to the final demise of government currency.

If I’m right, a long-expected collapse in the purchasing power, and of the very concept of fiat currency, will evolve from current events. The purpose of this article is to explain why monetary theory predicts a currency collapse.

The question at the heart of today’s market instability is the validity of fiat currency; that is to say, forms of money issued and sanctioned by individual governments, with no backing other than faith in those governments’ creditworthiness, and the enforcement of its use by law. The risks they impose on all of us will be evidenced one day by both the speed of the fall in each individual fiat money’s purchasing power, and inevitably by their comparison with gold’s more stable purchasing power. Essentially, an awareness of the dangers of unsound money will gradually become evident to every economic actor.

So far, or at least since the days when fiat money was freely exchangeable for gold, central banks have managed to enforce upon us their currencies as money, originally on the basis they were gold substitutes. That pretence was finally dropped in 1971. The purchasing power of fiat currencies has never been seriously challenged since, except in relatively few extreme cases, such as Zimbabwe and Venezuela. Not even the financial crisis eight years ago threatened a collapse in fiat currencies, when banks had to be rescued with unlimited extra quantities of money and credit.

The current crisis has commenced while there are determined efforts to stop the purchasing power of the major currencies from rising, even leading to the deployment of negative interest rates in this quest. None of the central banks’ policies appear to have worked. The increasing purchasing power of the yen, despite all attempts to lessen it, is the clearest example of the abject failure of a central bank to achieve its monetary objectives. The same can be said of the ECB and the euro, a currency even more synthetic than those it replaced. It is clear that the central banks are setting monetary policy more in hope than in a true appreciation of their own hopelessness.

They place an undue emphasis on empirical evidence. That’s why charts and statistics are so important to them and all their epigones. When you don’t understand and cannot explain something, you turn to the so-called evidence. And when very few people actually have a reasonable grasp of what money is about, you can rely on empirical evidence being unchallenged. For monetary policy, this tells us two things: central banks are clueless about monetary theory, and in the event of a second systemic crisis, they will be misguided by their experiences of the last one.

Today’s empirical evidence reflects the bail-out of the global banking system in 2008/09. Neo-classical monetarists were initially worried by the potential for price deflation in the wake of the banking system’s rescue, and so central bankers expanded narrow money by unprecedented quantities to counter credit deflation, real and anticipated. These were intended to be short-term measures, to be replaced with more normal monetary policies as soon as the immediate crisis was over. These short term measures are still in place today eight years later.

The impact on the gold price

After the Lehman shock, which led to a temporary flight into both money and short-term government debt, the purchasing power of currencies relative to that of gold rose, with the gold price falling from $930 to $690. Subsequently, when it became apparent that monetary expansion had succeeded in curbing deflationary forces, this trend reversed, taking the gold price to over $1900. That then changed in September 2011, following concerted central bank intervention to supress the gold price.

The dollar-gold relationship has now turned once again, signalling that the tide of confidence is moving against currencies. The purchasing power of currencies measured against that of gold is now falling. We now have a banking crisis in the making, if the share prices of major banks are any indication. The UK’s decision by referendum to leave the EU points to Europe’s political disintegration. Increasing market volatility tells us that another systemic crisis may well be imminent, and government bonds reflect a continuing flight to safety.

Already, the Bank of England has announced that a further £250bn in monetary support will be made available to the banks, and that additional swap lines have been agreed between the major central banks. We can take this as evidence that the central banks, relying on empirical evidence, are preparing a new round of monetary expansion as the solution to any future crisis, confirmed in their belief that the risk to the credibility of their currencies is unlikely to be a problem.

This is not what gold, when priced in these currencies, is telling us. To understand why and where the central bankers are mistaken, we must consider some fundamental points about how money actually works.

The theory of money and its purchasing power

To prepare our minds for a comprehensive understanding of monetary theory, we must at the outset dispense with any idea that statistical analysis is relevant. It is not, because there are no constants involved. Valid statistics require at least one constant, usually the purchasing power of money. In the whole field of economics, let alone money, there are none. The purchasing power of money is to a large degree independent of its quantity, and depends on a fluctuating acceptance that it is exchangeable for goods. Quack monetarists that believe in the equation of exchange, despite all evidence it does not work, overlook the subjective factors that qualify something as money.

When we set out to understand money, we must acknowledge there are three major influences at work, besides a general acceptance that a particular form of money is exchangeable for goods. There is the subjective value of the goods for which an exchange is considered, there are the fluctuations in the relative quantities of goods and money in the exchange process, and there is the balance of relative desires in the population as a whole to increase or decrease the quantity of money held, relative to goods. All these factors are the unknowable decision of every single economic actor, and fluctuate accordingly.

This self-evident truth continually risks undermining the very function of any particular form of money, which in order to be acceptable to the parties in any transaction must have a commonly accepted value, even though one party will want money more than the other at a given price. This commonly accepted value has been described by the economist, von Mises, as money’s objective exchange value. It is the one thing that parties to a transaction can agree upon. A dollar is a dollar, a euro is a euro, and so on, even though different individuals will want these forms of money more or less than other individuals.

So far, we have addressed only one out of four dimensions of the money problem. A second dimension is that demand for some goods is always greater than demand for other goods, so money’s purchasing power will differ for every good and class of good exchanged for it. It is never sufficient to just assume that, for instance, the price of housing is rising solely due to demand for housing. It also rises because people place a lower value on money than they do on bricks and mortar. On reflection, this truth should be self-evident. But it also holds true for every other good for which any particular form of money is exchanged, and it is too simplistic to assume that changes in price come from the goods side alone.

A third dimension to consider is that the products and quantities of goods and services purchased yesterday will not be the same as the products bought tomorrow. Besides making the point again, that statistics are wholly irrelevant to understanding money, we can also add that what money will be used to buy tomorrow and in what proportions cannot be predicted, beyond perhaps some broad generalisations, such as people will buy food, they will use energy, and they will enjoy some leisure time. Such platitudes are of no practical value to understanding monetary theory, and disqualify the use of price indices and aggregates such as gross domestic product.

The fourth dimension is one of time. The injection of money into an economy will start at a point, typically the banks creating loans, or governments through unfunded spending. Money therefore enters an economy unevenly, benefitting some at the expense of others. This is known as the Cantillon effect, and is universally ignored by the neo-classical economic community.

The problem today

The reader should now have a grasp as to why attempts to discern future purchasing powers for money are futile, and why monetary policies of central banks never succeed, except perhaps by pure chance.

As if the four dimensions cited above were not enough, there is a further problem. Most fiat money is produced not by central banks, as is commonly supposed, but by commercial banks, which lend money into existence. Bank credit is essentially temporary money, and is regularly extinguished in credit cycles. It is the obvious potential for this bank credit to contract which concerns central bankers most. When bank credit contracts, businesses that are over-reliant on debt for their capital requirements, and companies that have borrowed to finance unprofitable production go bankrupt. This is the bust of the credit cycle. In recent decades, the bust has been deferred and deferred and deferred, but hasn’t gone away.

The failure of central bank monetary policies appears to have reached an inflection point. This is what the share prices of systemically-important banks are telling us. This is what the political disintegration of Europe, upon which the new synthetic euro is based, is telling us. This is what the cul-de-sac of permanently zero and negative interest rates are telling us. This is what wildly over-priced government bonds are telling us. This is what the greatest indicator of all, the price of gold is now telling us.

The inflection point, I believe, is the marker for a potentially catastrophic decline in the purchasing power of paper currencies that are unbacked by exchangeable gold. The faith and credit-standing of issuers of paper money, and not the known and suspected inadequacies of commercial finance, is the last rotten pit-prop supporting the system. We can easily see how a new round of monetary expansion designed to save the global banking system from its nemesis will lead, not to a Lehman-style outcome, but to a collapse of paper currencies.

This, apart from the implied forecast for gold in the paragraph before last, is the only truly subjective statement in this article on a truly subjective subject.

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