Tuesday, October 23, 2012

Krugman and Money Bubbles

In a recent NYT piece, Krugman suggests that 'money is only a “social contrivance”. It’s a convention, which works as long as the future is like the past.' He then goes on to say later:

A final thought: the notion that there must be a “fundamental” source for money’s value, although it’s a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy — full stop.
Before reading the rest of the post, you should really read his full discussion, as this post will not make sense without you doing so. For me, the problem is his idea that there is no fundamental source for the value of money. It is wholly fantasy.

Here, for the sake of simplicity, I will treat the following as 'money'; base money (e.g. bits of green paper, and money created by the central bank through open market operations, and debt money (e.g. bonds, bank credit etc.). I know that we could debate the question of differences between these money types, what should be included in money etc. However, my purpose here is specific, and you will (I hope)understand why I characterise money in this way.

For me, the most important thing about money is not about the nature of the money, but about the demands that money might make on the economy. For example, each unit of money is a future demand for x value of product and services in a particular economic unit, typically but not always a country. The interesting thing about money is that it can very broadly be divided into 'now' money, and money in y period of time, or money in y period of time and z now etc. In other words, money units have a temporal dimension. This gives us something of an idea of how money can be seen to be founded in something. This is that the value of money is determined by the demands that might be made on the total value of output in the economic unit.

The important point about this is that, at given moments in time, there is a combination of credit money and base money in any economy. However, at any given moment, there is a total level of output of value in the economy. I use the word value here because what value might be is subjectively derived; for person A, they may value a new television over a Wedgewood tea set, even where the tea set has a higher price. However, regardless of what individuals value, there is a total output, however difficult that might be to measure accurately, but with relative prices making the best proxy that we have for perceptions of value. The point is that, with a given labour force, given technologies, given skill sets, and so forth, there is finite amount of value that can be created in an economy at any given moment.

You will notice here that I am treating an economy as if it is an economic island, which is false. Economies are not islands, and an economy's output is also contingent on the value creation in other economies. For example, if country B makes a product better/more cost effectively (I leave this loose here) than country A, then the country A output of value is questionable unless they do something to match the country B output of value. As such it possible to have potential for output of value that will not be realised, as there is a real world of competition. Therefore, the potential output of value of an economic unit is not its potential, but its potential in relation to other economic units. That potential is continually shifting, dictated by policy, individual and corporate endeavour etc.

The value of money is therefore contingent upon several factors; temporal, quantity, and the potential value of output of the economy which the money represents. For example, the bond market is driven by second guessing the relative influence of these factors, albeit that the second guessing is often crude and misdirected. The key point here is that each monetary unit, given these contingencies, at any given moment in time, represents one x percent of the total value of output in the economy. In other words, money is rooted in the total output of value in the economy, at a given moment in time. There can only be, as an economy is currently structured now, x amount of value of goods/services that can be purchased. I am being simplistic here, as some people simply hold the 'now' money, so that it ceases to be a demand on the economic unit, even though the money exists. In this circumstance, it makes no call on the output of value at that moment. It is another contingency on how money is valued, but by not making a call on the value in the economy now, it allows for a call on value tomorrow. For example, for a bond that has matured, might not be used as money now, but to buy more bonds with a view that this will allow an even greater capture of value in the future.

There are several things that are important when viewing money and value of output in the future. It is quite possible to issue more money now in the expectation that output of value will increase in the future to match the increase in money. Creating a greater supply of money, with the contingency that output of value will match the increase in supply is a risk. If output of value does not increase commensurate to the increase in money, then there is a problem. The value of output per unit of money has diminished. Most damaging of all, is when the demand for the value of output sits outside of the economic unit; if the demand is within the economic, it might represent a transfer, for example the liquidation of a mortgage debt.

However, even then, it is possible that the issuance of too much mortgage 'money' might be inflationary, and problematic. If the mount of money created for mortgages increases faster than the value of the value of the housing stock, this means that there is a specific and narrow price inflation, but also with a wider price inflation in the economy as a whole, as that mortgage money transfers into the economy. It just takes time. The housing bubble was this process in action. The rate of mortgage money creation increased faster than the value of housing stock, and also prompted bubble activity, such as building McMansions as a process of trying to soak up some of this new money creation. This brings me back to the problem of external credit, which is far worse, as it never represents an internal transfer.

The external funding of new money in the economy, such as mortgage debt, is a future external demand on the output of value in the economy. In all cases, it quite literally means that in the future, a demand will be made on the value of output in the economy such that some of that value output will no longer be available within the economic unit. The greater the value of the money created through external debt, the greater the demand on future output of value. This kind of demand can accumulate to the point where the external demands on the total output of value are so large, that an economy has no reasonable chance of servicing the value without having so many goods and services flow out of the economic unit that the actors in the unit will be reduced to penury. This is Greece now.

The curious part of the Greece story is that it is divorced from base money, and the problems are entirely created by creditors realising that the output of the Greek economy is not able to provide the value that they expected, or rather that Greece is unwilling to deliver that value as the loss of that value of output from within the economic unit of Greece is too hard to bear. The external debt of Greece is simply a massive demand on the value of the total output of value of the economic unit called Greece.

The idea that monetary units have no foundation, except in a social construction is simply not true. It is founded in the output of value in the economy for which a particular currency pertains. It may be complex, due to the contingencies that I describe. This is why all debt markets are so complex. However, there is one thing that is certain. If the aggregrate money supply increases faster than the value of output, the value of each unit of money will be diminished. We must also remember that the value of each economic unit is contingent upon the ability of each unit in each area of business, and that the aggregate of the ability will inherently effect the value of money, as this will impact upon the ability to realise potential output of value in an economy. Finally, externally created money is the highest risk, as it will absolutely make a demand on output of value in the future, and that value, if repaid will mean less output of value in the economic unit. Even if the economy does grow in an economic unit, a portion of that growth will no longer be available in the economic unit. The economic unit will have less output of value at the time that the demand is made for the output of value.

The final point is this; expanding money supply without an ability for increases in the output of value destroys the value of money. Borrow and spend is exactly this, and external borrowing is horrendously risky.

Note: This started as a short and quick and 'dirty' post, but did not turn out that way. I hope it all hangs together, and I have avoided some complexity that might have been added due to time constraints, and to keep the ideas as simple as possible. The nature of internally generated debt money is a case in point. Comments, as ever, welcomed. Feel free to be critical and pick holes. I published despite this despite being loose ideas with critiques in mind; I would like to refine these ideas, and critiques (constructive ones) and suggestions will help. In short, I have thrown the ideas 'into the ring' to see how they stand up to critical eyes. Regular readers will know that I have considered money before (sorry, no time to find the link, but it would help in supporting this post), and this is just some further thoughts/evolution/adaptation of the earlier longer and more detailed consideration.


  1. "For me, the most important thing about money is not about the nature of the money, but about the demands that money might make on the economy. For example, each unit of money is a future demand for x value of product and services in a particular economic unit, typically but not always a country."

    Money is also a potential claim on assets - real or financial.

    In fact, a vast amount of spending in any advanced economy is spending on secondary financial asset markets. The more rich you are, the more likely it is your money is spent on financial assets. You hold them to get a return, then you might sell them, and buy more assets for a further return.

    It is a strange analysis of money that ignores asset markets.

  2. "The idea that monetary units have no foundation, except in a social construction is simply not true."

    I don't think academics in this area would be so sharp as to say money is valuable due only to the social construction upon which it is based. However, it does play a significant role given its ability to function only exists due to the inherent underwriting of the state (fiat money), itself a social construction. Mary Mellor has been writing some good material on this in recent times: http://www.irishleftreview.org/2012/08/27/money-social-construct-talk-mary-mellor/

    There is no doubt however that today we are spending way above what we can justify by our economic output. It seems the state guarantee is being pushed to its limit and undermining confidence (e.g. price of gold). As you say so much of our money has been created on the basis that economic production will continue to rise into perpetuity. When you add the type of rehypothecated financial junk that is then multiplying the effect of this where credit is backed simply by more credit ad infinitum, we surely are far removed from the path we need to be on.

    1. Completely agree with what you said in the second paragraph, especially regarding the price of gold. However, keep in mind that Gold has been rising for many years against ALL fiat currencies, not just the Pound. It seems to me a general lack of confidence in fiat currencies, and the realization that we are at the end of a 50 year credit bubble.


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