Distinguishing Inflation and Deflation From The Growth Or Destruction Of Wealth
(Many of the terms and concepts which I refer to here were introduced in a prior post Message 17885050 For purposes of this post I am going to assume that the reader has first reviewed the prior post)
So I'm then led to ask, well what exactly is money? Can we say that money is properly reflected in the standard monetary aggregates M1, M2, and M3? If so, what economic force would powerfully reduce the amount of this money in circulation?
Money is a claim on wealth. A notional unit of exchange implemented in society as the complexity of their economic interactions makes the use of such an artifact useful. It is something which, were it not for the fact that the society has agreed to recognize it as being a claim on real wealth, has no value at all.
I don’t think that any of the standard monetary aggregates, which are measured by the Federal Reserve, are correct.
As you are aware they are:
M1 - Money that can be spent immediately. Includes cash, checking accounts, and NOW accounts.
M2 - M1 + assets invested for the short term. These assets include money- market accounts and money-market mutual funds.
M3 - M2 + negotiable certificates of deposit.
(This is a link to a publication from the Chicago Fed on money and the monetary aggregates: landru.i-link-2.net
None of the categories actually measure only money. They each include both money and wealth.
Money is a risk free claim on a constant unit of wealth. There is no time value of money. But wealth does have time value. A car today is more valuable than a car tomorrow or next year. In addition there can be no risk of loss of value as a result of economic transactions. When a dollar is deposited in a checking account or money market fund, from the perspective of the depositor, the dollar of money has been used to purchase a dollar’s worth of wealth in the form of invested capital. Depending on the type of capital purchased, the degree of risk may vary considerably. But there are very significant differences between a dollar and even a dollar deposited in a checking account, not to mention money market funds and negotiable certificates of deposit.
What economic force would powerfully reduce the amount of this money in circulation?
There is no economic force reducing the amount of money in circulation. It is wrong to assume that a price reduction in something is attributable to changes in the monetary aggregate because the prices of things are not determined by the monetary aggregate alone. They are primarily determined by supply and demand.
In fact, what people are characterizing as deflation, and believing can be corrected with sufficient increases in the monetary aggregate, is a significant reduction in the demand for most things that is the result of a significant reduction of the wealth in the economy. The essence of what is going on in an economy is people exchanging stuff for other stuff. The artifact of money has been created to facilitate those transactions, but creating more money does not correct the destruction of stuff.
We agree that inflation and deflation are monetary phenomena. The only can occur is an economy that has adopted some form of money. They cannot occur in a barter society. So a test that we can apply to determine if something is inflation or deflation is to attempt to replicate it in a barter economy. If we can, than it is not inflation or deflation.
Well, speaking from my own example, a little over two years ago I had perhaps $80,000 in cash in a variety of cash or chequing accounts. This money came from liquidating capital gains made in the stock market during the course of 1999 and 2000. I presently have a negligible amount in liquid cash parked in cash and chequing accounts (or money market instruments). The reason being largely is that I took this cash and reinvested it in the equities, which have subsequently declined in value so that my total wealth as measured by the value of non-liquid assets has also been reduced, but my liquid assets are very close to zero (for arguments sake).
Let’s put you in a barter economy and see if we can account for the change you describe. In this economy there are five people, you, three farmers, and a carpenter. Two of the farmers grow wheat and one grows vegetables. You are in the seed supply business.
A while back you found out that farmers would give you more of their crop for their seeds at harvest time than they would at planting time. So you established the policy that a pound of seeds would cost a bushel of wheat, or ten pounds of vegetables in the spring, or you would be willing to wait for payment until the harvest, but then you would expect to receive two bushels of wheat or twenty pounds of vegetables.
Two years ago you had many pounds of seeds. The farmers elected to pay you the higher price at harvest time and you sold them your seeds. But come fall while the vegetable farmer paid you as expected, one of the wheat farmers came to you and said that because of poor growing conditions he had a poor crop and could only pay 1 bushel of wheat per pound and he would try to pay you back the rest in future years. The other farmer never came to pay you at all. When you went to his farm you found out that this farmer had found out that he could distill whiskey from your seeds, had never planted them at all, but rather made them into whiskey and, to add insult to injury, he had already consumed all the whiskey so he could not even give you any of that.
Now two years ago, when you had many pounds of seeds you were interested in having the carpenter build you a storage shed for your seeds. In fact you had spoken to the carpenter and he indicated that while he had no need for seeds that he would build you a shed for 100 bushels of wheat. But since you would not have the wheat until harvest time you told the carpenter that you would not be able to undertake the project until then.
Well here it is harvest time and you have a lot less wheat than you expected. Additionally you have a lot less seeds that need to be stored. The carpenter comes to see you and asks if you would like to go ahead with the project. Since you don’t have as great a need, and since you don’t have as much wheat as you expected, you are less in need of the shed and have less wheat available to pay for it. So you tell the carpenter that at this point while you are still willing to have him build you a shed you can only pay him 50 bushels of wheat. He really does not like that deal but since he doesn’t have any other customers he agrees, after you agree that the shed will be a little smaller than you had originally discussed. (But still much bigger than you could have gotten him to agree to build for 50 bushels of wheat when you first talked to him.)
The carpenter builds the shed, you give him the wheat, and he then goes to the vegetable farmer to buy vegetables with half of his wheat. The vegetable farmer already has more vegetables in inventory than expected since neither of the wheat farmers bought what he expected them to. The carpenter tells the vegetable farmer that while he is interested in buying vegetables he does not have as much wheat as he thought he would and works out a deal with the vegetable farmer to buy more vegetables with less wheat.
This is the essence of what happened in you case and in the economy as a whole. Real stuff was wasted or destroyed. This has resulted in an overall reduction in the demand for stuff (remember that demand is not want, but rather the willingness to pay a certain amount for something). As a result people who wish to sell their products must reduce their prices. This is not deflation – this is loss of wealth. Increasing the supply of money is going to do little to resolve that problem in the present.
Further it is going to make things worse than they otherwise might have been in the future. A major determinant of an economies productivity and wealth is its capital base. Capital is created when individuals decide to forgo things now for more later. To the extent that the increase in money supply results in greater uncertainty with regard to the constant value of a dollar, and further lowers the interest that people will get by investing, the amount of new capital formation will be less than otherwise would be the case.
The fact that people are spending less now has much less to do with their willingness to spend or their confidence in the future than it does with the fact that they have less to spend.
Until people can eat money or run their cars with money rather than gas (or for that matter drive money rather than a car) the idea that the central bank can correct the consequences of mal-investment and poor management by increasing the money supply will remain what it is – fantasy and illusion. |
