Exciting stuff! Double posts on your Monday afternoon! Seriously, the site has been slow to develop and now that I have some time I will be looking to get a lot more posts up. Let’s get that started right now…
Recently, you have probably heard from some pretty “smart” people on CNBC or in the New York Times (err… probably Wall Street Journal) voicing concerns about debt and what that will ultimately for one the most discussed economic concepts: inflation. In many ways, inflation is something that you already know and something that most are pretty capable of discussing. What we need to do, though, is think about it a little bit more closely and start to realize why inflation is a pretty important concept. In a quick historical sense, do research on some of the greatest economic collapses of the last few centuries and chances are you are going to read about stratospheric rates of inflation. When one item doubles in price over night it becomes nearly impossible to hold any sort of stability in an economy.
Of course, this sort of hyper-inflation is not quite what will be discussed or expected by economists and political commentators, but it’s a similar idea just in a more restrained sense. This isn’t supposed to be about doomsday messages and the end of the world, but to demonstrate how drastically important money is in our world. Recently, my dad did a great job of creating a metaphor for describing the role of money and inflation in the real world. So, sorry dad, but I am going to steal that story and share it with you.
Firstly, we need to do a little informal history to understand where we are today and why inflation is more of a problem today than it was in the mid-20th century. Nowadays, cash is something that we take for granted. We walk into the grocery store, pick up a bag of chips on the shelf, and pay the cashier whatever the item is marked for. Seems simple. But think a little bit more. What you are actually doing is taking one good and exchanging it for a piece of paper. This transaction takes place because the buyer and selling both agree that the bag of chips is worth X amount and the amount of cash exchanged is also worth X amount. In other words, both parties believe that the piece of paper has value, it’s worth something. The exchange takes place because of a mutual belief in that value. But why couldn’t I buy an HP printer and print some identically looking 20 dollar bills out of printer paper? For one, I actually could. But what would that 20 dollar counterfeit bill be worth? Certainly not 20 dollars. It would be worth whatever a cut-out of a second-hand piece of paper would sell for. That is, it would be worthless. So why is one piece of paper worth a lot and another is worth nothing when, in essence, they are both just pieces of paper?
Why can't I use a horse as currency?
This is where the informal history comes into play. In the early days of civilization, it would be common to have purchases and sales take place on a barter and exchange basis. You have something I want and I will trade you something that you think is of equal value. Essentially, then, exactly the same as what happens today. But without cash (or money/currency), there became what I like to call the horse problem. Imagine that I wanted to buy a rug that some craftsman made but that the only item of value that I owned was a horse. In this scenario, then, the horse acts as my currency. Instead of carrying cash, I now have a horse. Both have value, which is why I transaction can take place. Thus, the horse has value but the derivation of value brings numerous problems. Firstly, it’s not divisible. If the seller of the rug determines it to be worth half a horse, I can’t take a chainsaw to my horse and give the seller half of my horse while, at the same time, expecting my two halves to worth the same as one live horse. In other words, I can only buy something that is worth exactly one horse or else I have to give up my whole horse to get something of lesser value. My horse brings a lot of value as one live horse, but less value as two dead halves. The next problem is of determining that value. Imagine I am trying to sell the horse to a stable owner who wants to run the horse in a race. I may think that the horse will be very fast and very good on the track. However, the stable owner may not view my horse to be not as fast and not as good on the track. The determination of my horse’s value is a bit unknown. That is, I can’t just look at a horse and know it’s value. On the other hand, I can look at a 20 dollar bill and know it’s value instantly. Finally, there is the practical problem: I can’t fit a horse in my pocket and carry it with me. It makes it very impractical to use as a currency.
What this demonstrates are some basic qualities that a currency must hold. It must be easily divisible so that you have multiple transactions of varying values. It must be of easy determined value. It also must be easy to transport. Because of these ideas, early currencies were mainly that of precious stones. The value of a chunk of silver was easy to determine. It was just a matter of weighing the amount and going from there. For that same reason, you could chop a smaller piece off if attempting to exchange for something of small value. Precious stones and metals could also be easily transported compared to a horse.
Cash came about later as transactions became of increasing value. Sure, carrying a lump of gold or silver was much easier than transporting a horse. But having to lug a huge bag of gold still isn’t the most elegant solution. This is where cash and banks started their role. A bank would allow for a customer to store a large collection of gold in their account and the bank would make accurate records of its size and value. Instead of going to the bank and lugging the precious stones or metals to the market, the bank would issue cash to the customer instead. In this context, cash was actually more akin to a check. The cash bill stated that who ever held that piece of paper was entitled to a certain amount of the customers account in gold or silver or what have you. Thus, someone could carry cash around and exchange goods for cash since at the end of that paper trail lied something that you really valued. The seller didn’t value the piece of paper itself, but valued what the piece of paper represented, what the item at the end of the bill was worth.
Clearly, this idea of cash is much more convenient than anything else previously discussed and is why it continues to be the primary method of transactions today. But what’s really important to grasp here is that cash was something more than a piece of paper. The belief of its value was backed by the lump of gold sitting in the bank. It was that mutual belief in the value the item in the back that allowed the transaction. Without that mutual belief in whatever was backing the currency, the bills were worthless since there was nothing in the end of the paper trail holding tangible value.
Now we get to the Monopoly Theory of Money, as I like to call it. Imagine you are playing a game of Monopoly with your friends. You are deep into the game and things are pretty level with everyone holding some valuable properties but no one in a better position than anyone else. So to make things more competitive and interesting, you decide to take your second Monopoly board game (because, of course, you keep two Monopoly sets just in case you lose one…) and dump its Monopoly money equally among the competitors. Now everyone has more money to use on buying properties and the like. Now, let’s say that you try to buy a property from another competitor. Say its value before the money dump was valued at 400 dollars. If I try and buy that property from my competitor after the money dump, I certainly won’t be able to buy it for 400 bucks now. Why? Because the value of that money is relative to what I think it’s worth. Since there is nothing backing that piece of paper and I know that everyone just got the same amount, my competitor will ask for more of my newly-issued money. Before, I would have bought the property for 400 dollars based upon my belief that 400 dollars was an appropriate price given the amount of money available to everyone else. But now that the money supply has increase, that relative value as decreased.
Now, get apply things to a little more real world scenario. Imagine that gold backing that Monopoly money. That is, if I wanted to, I could take my Monopoly money to a bank and the bank would give me a big pile of gold. Assuming the value for gold hasn’t changed, then the value of the money dumped currency hasn’t changed either. 400 Monopoly dollars is still worth the same since the gold backing that paper is still similarly valued. Without that gold backing the currency, the only thing that makes the money valuable is the belief by both parties that the currency is valuable. But if there is no belief? What if we keep dumping more and more sets of Monopoly money into the game? What keeps me from asking 4,000 dollars for a property I would have bought for 400 dollars before the money dumps?
Nothing is the answer.
That is why inflation, in today’s world, is more heavily discussed and of greater concern. As government debt increases and increases (and chooses to print more money and increase the money supply to fund that debt), the greater the chance of buyers and sellers losing faith in the value of that currency. This idea is what is currently known as the the intrinsic theory of value. In 1975, the United States veered away from the Gold Standard (the valuing of the currency based upon the value of gold held in federal reserve banks). As a result, the United States dollar became known as a fiat currency, a currency which is not backed by any physical asset. That is to say that, unlike before, I can not take a US dollar to a Federal Reserve Bank and receive a determined amount of gold based upon the relative value of the currency and gold. Because there isn’t that gold backing the bill, just like in our Monopoly game, the intrinsic value of that currency is nearly nothing; the currency is only worth the value of the paper itself. Without the common belief in value, transactions become nearly impossible in a modern world to coordinate. What is backing the currency is the US government and its assets, whatever they may be. Of course, as debt increases and increases, the value of those assets to the currency holders become less and less. But, of course, with ever increasing amounts of currency being printed, the value of those bills decrease and decreases even more.
Interestingly, an citation-less Wikipedia article claims that as of 2004, given the amount of US currency in circulation and the amount of gold assets held by the US government and Federal Reserve, if a gold standard were to be reinstated, the value of gold would have to be $2800/ounce (or much more than twice its value today before adjusting for price levels). Again, the article does not provide a citation so don’t take this figure to the grave, but know that if a gold standard were to be initiated, the value of gold would skyrocket.
The history and theory of money supply and circulation obviously goes much further. But the basic idea is that transactions take place based upon belief with inflation and debt acting to weaken that belief. For this reason, there are many would recommend that you hold investments in gold. This gold is almost like a reserve currency (or alternative currency). Remember, a currency is just something that easily divisible, easily valued, and easily transported. It does not have to be a piece of paper backed by an asset. It simply has to be an asset of value. Thus, as the belief in the US dollar decreases, the value of a tangible asset increases. It makes for a safe investment since most governments and investors have historically turned to gold when searching for value.
Again, this post isn’t about creating doom and gloom. Rather, it’s about understanding what the pieces of paper in your pocket actually do and what they stand for. Understanding that role can make it very clear what happens when more bills are printed, the value of backed assets decreases, and so on.
