Happily for the purpose of writing this post, I had a couple of friends come to dinner recently, and our discussion turned to economics and wealth creation. I say 'happily', as one of the friends is very knowledgeable about economics, meaning that he knows the arguments of many mainstream economists. As we conducted our discussion, it struck me that there is a fundamental problem in such arguments. It is not something that they ever say directly, but an assumption that sits underneath many of their theories and thinking. They actually think that wealth has arisen as a result of macroeconomic tinkering by governments.
As such, I thought I would start this post with a key part of understanding deflation, which is to consider what wealth actually is and how it is created. I will use some rather odd illustrations that I used during the dinner so that, as I explain, at several points it might be useful to imagine you are at the dining table with us.
One of the points which was central to the discussion, is so obvious that it should not need to be said. However, it is a point which is often lost in all of the complexity of economic discussion. The point was this:
If an economy has a total output of 100 units, it does not matter what the number of money units there are in circulation, as this will have absolutely no bearing on the level of wealth in that economy. The economy could have one hundred units of money in circulation, a thousand units, or a million units. It will make not one jot of difference to the wealth of that economy. The output will still be 100, and that output represents wealth.
To explain the point I was making, I took two wine glasses on the table and said that yesterday I, as a unit of labour, produced two such wine glasses every day. These two glasses of output were sufficient for me to live a day to day subsistence lifestyle. I then added a wine glass, and explained that due to various improvements in my ability to make glasses, I was today making three glasses instead of the two yesterday. As such, I have an additional glass which means that I have increased my wealth creation such that I can use that one glass of output for discretionary spending.
Having added the additional wine glass to my output, I suddenly have some choices. I looked around the dinner table, and decided that I would utilise that additional wine glass as a means of exchange for one portion of dessert. I designated one of my friends at the table as a dessert manufacturer. I moved my additional wine glass over the table, and exchanged it for a portion of dessert. I am now one portion of dessert richer, and the dessert manufacturer has one wine glass.
The interesting part of our transaction, however, is not immediately visible in this example. When we increase the output of a good, more of that good is available in the market. Assuming that demand is not increasing through factors such as significant population growth, then the additional supply of glasses has some interesting effects.
Before my output of wine glasses increased, the cost of wine glasses was higher reflecting the greater input of my labour in each wine glass, and the dessert maker would therefore have to pay me one and a half portions of dessert in exchange for a wine glass. Under these circumstances, the dessert maker could not afford to buy the wine glass, and was forced to use a cheap pottery mug to drink his wine. As it is now, the number of wine glasses has increased in relation to demand, my input of labour per glass is lower, such that I am now willing to exchange my additional wine glass for just one portion of dessert. The result of this change in my wine glass output is therefore as follows:
I am one portion of dessert wealthier, and the person who makes the dessert is wealthier because he can now keep a half portion of dessert that he would previously need to have given me. We have both become wealthier. Even as the exchange value of the glasses has decreased, we have both become wealthier.
The curious point in this is that, if the wine glass production had not increased, then the dessert manufacturer would not have wanted to make the exchange at all. He felt that one and a half portions of dessert was too much of a price to pay for a wine glass. My increase in output not only allowed me to increase my wealth by one dessert, but also expanded the market for my output. This is why everyone is wealthier...
If we return to the earlier point about an economy having 100 units of output, in this case I have just increased the output by one. We have 101 units of output. The economy is more wealthy, and it has nothing to do with the number of units of currency in circulation.
Returning to my increase in output of glasses, there is no necessity for me to use this addition of one glass of output to consume a portion of dessert. I can use it for many purposes. Let's imagine that I am supporting a family, and I have ambitions for my children. I want them to go to university. In order for my children to go to university, I will need to save some money to pay for the fees. As such, I forgo the portion of dessert, and decide I will save the additional daily output of wineglasses. According to many economists today, this foregoing of consumption of dessert is a bad thing....the more we consume, the wealthier everyone becomes.
However, (wisely) ignoring these economists, I go ahead and decide that I will save the one wine glass of additional output to pay for my children to go to university. I look around, and conveniently decide that the other person at the dinner table happens to be a bank. I cancelled my deal with the dessert maker, returned his portion of dessert, and passed the wine glass to my friend who is now acting as a bank. Instead of the dessert manufacturer holding the glass, the bank now holds the glass.
Why did I not just keep hold of the additional glass? After all, over the years, I could store up lots of glasses and give them to the children when they reach university age, and they can then use those glasses to exchange for all the things they need. Why did I give it to the bank?
I gave it to the bank because the bank will invest it. In this case, the bank uses the value of the glass as a means to give another producer the ability to do something new, such as increase the sales of wine. At the time I am giving the glass to the bank, one glass of wine can be exchanged for one wine glass (obviously that is the quantity of wine - as you do not keep the wine glass). In order for me to give the glass to the wine seller (a wine bar owner), I ask that the wine seller gives me a tenth of a glass of wine every day for every glass that I provide. The wine seller gets more glasses in which to serve the wine, and I get wine in return. Meanwhile, as a price for putting me and the wine seller together, the bank charges a fee of one twentieth of a glass of wine per day, per wine glass invested. We all get wealthier.
In the case of the wine seller, with more wine glasses available, he can now serve more units of wine to more people and increase output, I am wealthier as I am getting lots of wine, and the banker is wealthier because they used their knowledge to put me and the wine seller together, and they get some wine too. Just as before, the economy has become wealthier. It has nothing to do with the number of units of currency. It has to do with my increased output of wine glasses.
Now at one point, my economically knowledgeable friend suggested that we needed inflation to make people invest money, and that it was necessary to increase the money supply as the economy grows. That was why I gave the example of why I would (without any inflation) still invest my money in the bank. I also explained inflation this way:
I went back to my original choice of using my original wine glass as an exchange for a dessert; exchanging a portion of dessert in exchange for a wine glass. Instead of consuming the dessert myself, however, imagine that I am going to give it as a birthday present. The birthday is not for 6 months, so I take the dessert home and put it in my freezer. Having put it in the freezer, I am rather surprised to find that, every day, a stranger comes into my house, opens the freezer, and takes a small piece of the dessert away with them. As such, every day the dessert gets a little smaller. This is inflation. The stored value of my labour, represented by the dessert, is reducing every day that goes by.
This is one of the keys to understanding the supply of money. Every time there is an increase in the money supply, it is the equivalent of taking a little part of the value of everything from people. Where does that value go. Who is the person who is coming in and taking away a small piece of my dessert every day?
In the case of money, this is the person who makes more units of the money. Whenever they do this, they take a little part of the value of money from the existing money. In the case of the dessert, it represents the stored value of my additional wine glass of production, which is equivalent to saving x units of money. I made an exchange for one unit of dessert, and wanted to give the person having the birthday the equivalent of one wine glass of my labour. However, in a situation of inflation, the same thing happens to money as happens to my portion of dessert. Someone comes and takes a bit of it away every day. Whilst we would not accept a person coming in to our house and taking a piece of our stored value from the dessert, we readily accept them doing the same thing with our money in the bank, or money in our wallets.
In this example there is an illustration of something about wealth and money. Wealth is based upon output, and the structure of the money supply has nothing to do with making wealth, but has something to do with the distribution of wealth. Inflation distributes wealth away from you to the printer of the money. The only way to become wealthier is to produce more 'stuff' and this can be achieved without any manipulation of the money supply. This then raises the question of why there is so much manipulation of the supply of money. Macroeconomics is full of lots of complex models of the supply of money.
For the answer to this, we will leave the dinner table economics behind and turn to Adam Smith, who (as ever) got the picture absolutely right. This is what he has to say about money:
'For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal [gold or silver], which had been originally contained in their coins [...] By means of those operations the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise been requisite.'The cost of this he illustrates with an examination of landed estates, some of which which were awarded rent in money, and some which were awarded rents in corn. The estates with rent fixed in units of corn continued to be wealthy, but the estates with rent fixed in money became poor.
What Smith is explaining is that debasement of money serves only to help the state. Inflation of the money supply today is exactly the same in principle to what Smith was describing, and the same as someone coming in an taking a piece of my dessert.
In modern macroeconomics it appears that many economists are entirely confused about money. They seem to think that money has some mysterious purpose. If we go back to the dinner table economics, we did not need money to get wealthier, we just needed me to increase my daily output. Money has absolutely nothing to do with wealth. Money is, or should be, a unit of exchange that makes transactions more simple, and an abstraction of stored value that everybody accepts. It is the equivalent of the portion of dessert, or the wine glass - it is representation of these objects and the input of labour that created them.
The velocity of money, the number of units in circulation has nothing do with output whatsoever, it has to do with the way the wealth of output is distributed. I can not put this any more clearly than this:
Wealth is created by units of labour A, B and C producing and output of X, Y and Z.
The only difference that money makes in this equation is whether the money system offers incentives or disincentives to those units of labour to produce more or less output, and how the wealth is distributed. That is largely a factor of how much and in what way the value of their labour is expropriated through the scheming of 'princes and sovereign states'.
My knowledgeable friend was suggesting, and has argued that it is that monetary system that has allowed the growth in wealth in the Western world. My point is very clear; it is the increase in total output of labour that is the sole reason for the increase in wealth. All of the fiat money systems, and all of the rest of the apparatus of modern macroeconomics has done is play a part in how that wealth is distributed. From the dinner table economics, we can see that there is no need to create any incentives for people to get on with the useful business of increasing output and investing their increasing wealth to create even more output. The logic of these actions determines that this is what would, in any case, be what would happen.
Now if we return to the economy that has an output of 100 units, and imagine that today we have 100 units of money for that output, we can see where inflation fits in. If we then increase the money supply to 110 units, then we have inflation. The increase in the money supply has no bearing on the output, but simply means that there are more units of money relative to the output. The ten new units of money have been produced, and the value of the new units means that the producer of the new units of money have taken a portion of the value in exchange of the existing money. If you hold one of those units of money, you have just given something to the producer of the new money.
Lets imagine that the units of output also increases to 110, at the same time as the money supply increases to 110 units. Surely this is okay, as we can still buy the same number of units of output with our 1 unit of currency? This might seem reasonable, right up to the point where we start to think about where the increase in output has come from. If we think of the dinner table, it is me that has increased my output of wine glasses, so I have created the wealth. The printer of the new money has not increased output of anything, but they still have ten units more of money. This still means that my unit of money is worth less than it should be. If the additional units of money had not been created I would have been wealthier, but that additional wealth has been transferred to the producer of the new money.
But the producer of the new money has created no output....I have, and it is me that increased the output....but I see no benefits from it.
As an alternative, we can take another scenario, which is that output increases from 100 units to 11o units, but the units of money remain at 100. In this case, as my output increases, I become wealthier. My increase in output directly benefits me. I gain the full benefit of my output (the reality is however, that this is collective, not individual - everyone benefits). This is what many economists fear - deflation.
Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....
Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.
If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.
Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....
The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).
However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.
In short, steady deflation does not stop people from consuming.
This still leaves investment. In the case of investment, an argument might be put forward that, in the event of deflation, you could keep money under your mattress and still see it increase in value. As such, you have a disincentive to invest.
However, if we imagine that we have a situation of deflation, what has changed compared with inflation. In a period of inflation we have to invest our money just to stand still. However, we have many choices. We can put our money into a building society account and get a steady interest rate which will see a small return on our investment. Alternatively, we can put our money in a higher risk investment but risk our investment overall. In all cases we measure our return bearing in mind the rate of inflation. If we see inflation is at 3%, then we will want at least a 3% return, but most of us will want a return greater than inflation.
If we then imagine a deflation rate of 3%, that means that we will gain a 3% return on our money under the mattress. However, if someone offers us an additional 2% return over and above that 3%, we are very likely to be tempted into this. Just as in the case of the investment of the wine glass in the dinner table example, we will see that this can be a very smart thing to do with our savings. The only difference here is that it is not necessary to invest in order to keep your money, and this therefore becomes an issue of morality.
This is the morality argument; if we return to the dinner table economy, I have through my own ingenuity and efforts, ensured that I have achieved enough output to have an additional wine glass every day. This is the value of my own labour, not the labour of anyone else. The question here is, do I own the value of my own labour? What I do with the value of my labour should, as far as possible, be my own. If I choose to risk that value of labour by investing it should be my own decision. Whilst there are good arguments in favour of me making that investment, does that mean I should be compelled to invest it in order to preserve its value? If we think of the person coming into my house and taking away a piece of my dessert every day, such that I will not want to store the value of my labour in such a way, is that morally justified?
I will let you decide on the morality argument. However, what is certain is that there is no reason why deflation should lead to people not wanting to invest their money.
The final argument is that it makes the burden of debt greater. This one is a real puzzle to me. If you have a situation of inflation of 2 % and you want a 5% return, you will charge 7% to achieve this return. If you have deflation of 2%, then you will charge interest of 3%. In both cases the cost to the borrower remains the same. If you move from inflation into deflation, as would be the case now, then you have a problem in that the debt burden would increase. However, if you went from an inflation rate of 10% down to an inflation rate of 2% then the debt burden would also increase. In other words, the burden of debt is nothing to do with inflation of deflation, except for when there is a change.
What if there were a rate of deflation of 10%? The cost of borrowing would then have to go up dramatically for our example, with a 15% rate! However, if we had no increase in the money supply and the output of wealth from the economy was increasing by 10% causing 10% price deflation, I think that nobody would be complaining....everyone would be much, much wealthier...the deflation would later ease back as the supply of credit would reduce, reducing investments which might increase output...the system would balance back towards steady deflation. In other words, deflationary growth in wealth is self-regulatory and will provide a more steady model of growth in wealth.
Quite simply, I just do not believe that ongoing and steady deflation is a bad thing. If anything it is far better than ongoing inflation. Regular readers will know that I have advocated a system of money based upon a fixed specie of commodity (such as a gold standard). However, the more I have thought about this, the less I like the idea as the supply of gold also increases, such that the supply of money increases.
There is a better way, which is to absolutely fix the supply of money, such that it can never be expanded. Instead of inflating the money supply, as an economy expands, the units of currency at the start simply increase in value.
This does pose some practical difficulties, such as a unit of currency increasing in value so much that it becomes difficult to exchange for anything but ever larger items. To illustrate with an extreme example, if there were one thousand units of currency in the year 1066, then each unit of currency today hold nearly enough value to buy a city. The way around this is not to increase the units of currency, but to sub-divide the currency into smaller units. Just as today there are pounds and pence, as the value of a currency increases, it would need to be divided into pounds, pence and 'x'. At no time are any more pounds created, such that the pound is never watered down. Dividing a pound into pence does not devalue the pound, it is the increase in supply of pounds that devalues the pound.
There are many more points that could be made for such a fixed supply of currency (such as international implications), but this post has already gone way beyond my original intent. As such, I will leave it there, and leave you pondering on dinner table economics.
I am still getting more comments on my posts on fractional reserve banking. A brief answer to some of the comments. Yes, I agree that £1 GB is actually an IOU, and that banks also are creating IOUs. As such they are comparable. As you may have noted - throughout the blog I am casting doubts on whether the IOU that underpins the £GB and $US have any greater value as money than the IOUs of banks. In this sense, they are even more comparable than is widely believed.
However, my point about what is money always rests on a single principle, and I have explained this in several examples. Money is what people collectively believe it to be. I think I gave an example that illustrates this. A person who is starving to death will see a bowl of rice as more valuable than an ingot of gold, if he can not exchange the gold for rice. In a situation of starvation (where no food can be purchased from outside with the gold) rice would become a currency. People would exchange houses, land, or anything for the rice. It would become the currency that everybody believed in.
In the example in this post, even the value of the currency that I am proposing would be superseded by a food currency in the starvation situation.
When people were waiting in long lines outside of Northern Rock, they wanted to have their money denominated in £GB, not in bank IOUs. When they did this, they were clearly expressing their view of what money was, and that was not a bank IOU. It was a government IOU. Sadly, their belief in the government IOU is probably about to be tested as well....
The point in all of this is that when policy makers make policy, it seems a wise idea that, when they model the economic world, they have an understanding of money that conforms to the idea of money held by all of the economic actors - a reality which is expressed in the people waiting in line outside Northern Rock.
Note 2: At the dinner (on Saturday), I was explaining to a Chinese friend that her country was now the most powerful in the world, that power had shifted entirely towards China. As if on cue, Hilary Clinton is seen with the begging bowl out in China. Regular readers will know that I have been pointing to the reliance of the US on China for a long time.....
Note 3: Regular readers will also know that I have long been suggesting that the economic crisis has the potential to see the end of the Euro, and this is now the subject of speculation in the press..
A regular commentator 'Lord Sidcup' points out that mainstream commentators are starting to arrive at the same conclusions as my own (a couple of examples above). He asks where I can take the blog as they finally catch up.
It is a good point. I am wondering this myself, as my purpose was always to try to get a message 'out there' to as many people as possible. The blog has moved to the point where many readers (measured in many 1000s) now read each of my posts. As such I have a sense of obligation to offer something useful and that will only be the case if I can offer what I believe to be a better description of 'reality' than others. My philosophical foundation is critical scientific realism, which has helped me in this task so far.
However, if others offer the same analysis as the blog, then it might be time to call it a day. As such, I suspect that this blog may not have much life left in it. In particular, the scene is now set, and I very much doubt that anything will turn back the inevitable course of events. Whilst the exact timing of the denouement is still a matter of some uncertainty, the contradictions I have been discussing for so long must be resolved. A commentary on the detail of events will not offer anything that I have not already covered. Wealth will be still be wealth, and ongoing economic delusions that are the subject of this blog will remain delusions.
The populists, the something must be done politicians, will flail around for solutions, all the while doing more harm. The general populace will still think that everything might be 'fixed', without accepting the reality of what is actually broken. The fundamental problem is that the reality of the underlying problem is something that is hard to accept. This is the idea that we are no longer wealthy enough to live as we have before....unless we accept reform, and very tough reform.
At this stage, I am less and less sure of what I can add, and have had this thought occur to me several times recently. I will give this subject some thought. Comments welcomed.
P.S. Lord Sidcup, I am glad to hear that you read Marx and Adam Smith. Smith, is quite astonishing, and I have long suspected that one of the problems with economics is that all economists are comparing themselves to his ghost.
Note 5: I had a considerable amount of traffic on my posts on QE, and hope that many letters were sent to MPs. My thanks to those who took the trouble. I find it very disturbing that a significant (historic proportions?l) policy might take place under such conditions of opacity. Let's hope somebody pays attention.....