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Money Supply, Inflation, Deflation and Gold

Economics / Money Supply May 05, 2008 - 04:00 PM GMT

By: John_Lee

Economics Best Financial Markets Analysis ArticleMoney serves as a medium of exchange and store of value. Price provides an important clearing mechanism in a society. Here we are going to explore the interesting dynamics between money and price. In a free market, when the quantity of money is fixed, the fact that the price of an apple is $1 and that of a Parker pen is $2 has tremendous implications. It takes knowledge, ingredients  and time to grow an apple while it involves branding, material, and capital to produce a Parker pen.


What the market says here is that the total efforts put into producing the pen are worth twice as much as the efforts of growing the apple. There are thousands of valuations communicated through the market by this simple exchange. Over time, with advances in technology, it takes fewer efforts to produce more goods. The same farm that used to grow 10,000 apples can now grow 20,000 in half the time. While the ratio of exchange between apples and pens might still be 2 to 1, since it also takes less to produce a pen, in a world where the quantity of money is fixed the price of both apples and pens should decrease (i.e. 80 cents for an apple, and $1.60 for a pen).

The decrease in the price level of goods represents an economic advance and an increase in the value of money. As the human race progresses and wealth is being accumulated, shouldn't people be able to buy more with less money? Shouldn't people be rewarded for their savings over time with increased purchasing power of their money? Obviously, the exact opposite is taking place in this world. What's going on?

A picture is worth a thousand words and the chart above is no different. There is 1,500% more
paper money today than there was in 1970.

Oil Price Since 19600

Hey, where did all this money come from? Doesn't more money mean more economic progress?

The huge increase in the paper money supply is from borrowing at all levels from consumers, corporations, and government. Every dollar borrowed is a dollar created out of thin air by the banks. The process is legitimized by “the fractional reserve system”, as the bank literally prints dollars in its computer and writes a check to you upon your loan approval.

To answer the second part of the question - there is no positive correlation between the money supply growth and real economic growth. As we explained, the world can function and advance with a fixed money stock.

What's wrong with more money? It stimulates consumer spending, creates more interest-income for savings and promotes higher housing and stock prices. More of everything is a good thing!

To that argument, I say: What if the Fed through its ingenuity and generosity, doubles everyone's savings account balance? Does that create progress? By the same token, to combat price increases, did Venezuela fix anything fundamentally by issuing a new currency, “Strong Bolivar”, that essentially chops a zero off the old Bolivar? Here are 4 more points to consider:

1. Fairness – Arbitrarily, some are allowed to borrow more than others. Does it make sense for a government to have unlimited borrowing power while it hardly produces anything? And what is so special about a banker in that he can lend to whomever, for however much he wants, with the money that's not even his?

2. Price Distortion – Since new money is not distributed evenly, the prices of various goods and services increase in a cascading fashion, depending on who gets the money first (like a ripple effect). Think of a lottery winner. He is likely to outbid others for the things he wants, thus causing prices of his desired items to go up first. Let us be clear: The random introduction of new money impairs the role of price as a proper clearing mechanism.

3. Bad store of value – With online banking and credit cards, today's money is a great medium of exchange. However, the ever-increasing quantity of paper money makes it a terrible store of
value. Remember: Every time someone borrows, new money is brought into existence, diluting the money you and I have meticulously accumulated. Should a retiree rely on the risky stock market to retain his wealth?

4. Moral Hazards – How is it fair that bankers can borrow billions of dollars to spend and invest? And when banks and companies become too indebted but are too big to fail, they are bailed out. How does that serve as an incentive for those who make cars, sew clothes, and plant trees to save?

When unfairness, price distortion, corruption, and loss of true wealth reach the extreme, the result is a loss of confidence in the paper-money system.

I quote John Keynes from 1919: "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. "

Paul Volker was right when he said in 2000: "Inflation is related to monetary policy. It's related to the issue of money. The issue of money is a governmental responsibility predominantly, and to use that authority in a way that leads to inflation is a system that fools a lot of people, and to keep fooling them you have to do it more and more; [that] is a moral issue. I put myself in that camp. "

And Bill Gates said at Davos world economic forum in January 2005: "I'm short the dollar. The ol' dollar, it's gonna go down. We're in uncharted territory when the world's reserve currency has so much outstanding debt. It is a bit scary."

How do you short the dollar? With ECB printing Euros no slower than the Fed printing dollars, it's clear that gold is the only refuge of savings. Gold has raced from $428 to $850 today since Bill spoke in 2005. Is it too late to join gold? The right price for gold today is a long topic that's best be left for another day. However, judging by how oil rocketed from $10 to $100 within the past decade, gold has not nearly reached its potential.

We manage a gold fund and have written much about gold and currencies at www.goldmau.com I invite you to read up.

John Lee, CFA
johnlee@maucapital.com

http://www.goldmau.com

John Lee is a portfolio manager at Mau Capital Management. He is a CFA charter holder and has degrees in Economics and Engineering from Rice University. He previously studied under Mr. James Turk, a renowned authority on the gold market, and is specialized in investing in junior gold and resource companies. Mr. Lee's articles are frequently cited at major resource websites and a esteemed speaker at several major resource conferences.

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