The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.
If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....
MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:
You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.
I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.
I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:
But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.
If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.
The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.
I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.
Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.
It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.
Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.
In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.
The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.
In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.
At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.
However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).
Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.
I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.
Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.
As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.
Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.
In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.
As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.
The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.
The only solution to these problems are as follows:
- There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
- The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
- The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.
If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.
They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.
When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.
- Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
- The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.
Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.
Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.
More Green Shoots.....
There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.
In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:
There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:
The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.
It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.
Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.
It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.
It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.
In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.
The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.
This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.
Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.
What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.
Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.
At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.
As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.
Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.
One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.
Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.
However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.
Note 2: A long post, but I hope that it proves to be interesting.