Money & Inflation

Money & Inflation
Photo by Adam / Unsplash

This was a piece I wrote in the summer of 2021 as I became increasingly concerned about the inflationary nature of the US's fiscal and monetary policies. It explores the empirical relationship between money and inflation. Here's a highlight:

While the 20th Century taught the world the necessity of capitalism and decentralized pricing for capital goods markets, the 21st Century will provide a dramatic lesson on the necessity of sound money and decentralized pricing for capital markets

  1. Introduction
  2. What Makes a Good a Good Money?
  3. Relationship between the Money Supply and the Economy

           a. Short-Term Relationship between Money and Price Levels

           b. Long-Term Relationship between Money and Price Levels

           c. What are prices?

           d. Short-Term Implications of Sound Money and Accurate Prices for Capital     Goods Markets from the Perspective of Individual Consumers and     Corporations

           e. Short-Term Implications of Sound Money and Accurate Prices for     Markets from the Perspective of Individual Consumers and Corporations

           f. Long-Term Implications of Sound Money for Capital Markets from     Perspective of Individual Consumers and Corporations

           g. Implications of Sound Money and Accurate Prices for the Economy as     Whole

4. Conclusion

I. Introduction

“History doesn’t repeat itself, but it does rhyme."

The situation our nation presently finds itself in, though unlike anything that has ever occurred in American history, has occurred repeatedly throughout the histories of other civilizations. It represents a later stage in the big debt cycle that generally coincides an empire’s rise and fall. In his book The Changing World Order, Ray Dalio studies the cyclical nature of the 13 most prominent empires appearing over the last 500 years. He finds that they have all followed a fairly similar and predictable pattern. A driving feature of that cycle is the rise and fall of the integrity of the countries’ money. Dalio uses the following framework to describe the typical pattern that money takes.

The empire is founded with low debt and ‘hard money’. Hard money is described as something for which there are physical limits on the rate at which new supply can grow in comparison to the total amount of the good already in circulation. In other words, it is ‘hard’ because it quite literally cannot be meaningfully increased at the whims of businessmen or politicians. Hard money is in the best long-term interests of the nation because it forces fiscal responsibility and long-term decision making. The most quintessential and, not coincidentally, successful hard money throughout history is rare metals – in particular, gold.

However, carrying around bricks of gold is inconvenient so claims on hard money, or paper money, are introduced for daily transactions. This first severance between the hard money that underpins the monetary system and the money used in the day-to-day transactions does not technically change the nature of money, because the paper money represents a certificate for a fixed amount of the underlying hard currency. It is promise to exchange the paper certificate for a fixed amount of hard money upon request.

Theoretically, these certificates’ hardness is identical to that of the underlying money. However, the word “theoretically” must precede any description of the currency’s hardness at this juncture, because in practice the fixed relationship between the paper money and the underlying hard money has never been maintained by any society for any meaningful amount of time throughout the entirety of human existence.

The moment that the government uses the surgical power of the pen to relegate the hard money to the role of a good that underlies something else, it makes the money used in daily transactions an abstraction of the hard money. This abstraction of money fuels the cognitive dissonance in politician’s minds that feeds their natural desire to unshackled themselves from the harsh confines of fiscal discipline. There are no objective bounds on the amount of paper that can be printed. So, no matter how hard the good that the paper is supposedly linked to is, that link can be discarded in a moment’s notice if the people in power so choose. After all, the link is only ensured by promises made by those very same politicians.

Invariably throughout history, the empire steadily builds up debt, which eventually elevates to levels extending beyond the nation’s capacity to repay in full. Rather than explicitly default on the debt it owes, it achieves the same goal by turning to the printing press. It floods the market with massive amounts of new money, thereby sharply devaluing it and defaulting on its debt without having to publicly admit to doing so. This marks the transition to fiat currency, which is the type of money that every nation employs today.

At this point, the government has finally and completely freed itself from the restraints of responsibility. Debt begins upon an unrelenting march upwards. The monetary authority must accommodate this lack of fiscal discipline by printing ever-increasing sums of money; and, any time the fiscal government’s addiction to debt engenders a financial or economic crisis, the monetary authority must down-shift the money printing process and launch it into hyper-drive. This natural relationship between the monetary and fiscal policymakers develops over decades from an initially casual entanglement to, eventually, a life-or-death relationship necessary for the very survival of the established government.

The bonding process described above can be directly observed in the US. The monetary authority, the Federal Reserve (“Fed”), began as an entirely private organization whose board was comprised by executives of the countries’ most preeminent banks. That is to say, it had no connection to the government. Fast forward one hundred years to today and the US’ fiscal and monetary authorities have perfected the synchrony of their steps in their malignant waltz. Indeed, the agency self-describes itself as being a “government entity.” One example of this is the fact that Janet Yellen went from being the Chairman of the Fed to the Secretary of the Treasury. Apparently, the two jobs are somewhat interchangeable.

The danger of letting this dance continue through to its end is that as the debt rises to unsustainable levels and the monetary authority floods the economy with extraordinary amounts of money, the money and the debt denominated in that money begins to lose its meaning and becoming increasingly worthless. The money loses its meaning when the government constantly creates so much new money that it stops serving its three primary functions: that of a unit of account, a medium of exchange and a store of value. This devaluations of money itself makes the debt denominated in it also worthless.

Understanding complex and abstract ideas that lie in the gray area of a continuum is always made easier when one examines what occurs at the extremes. When the dual policies of ramping up the debt level and the rate of money printing are pursued with passion and an unbridled lack of caution over a short period of time, the conditions for hyperinflation are sown.

Though many examples of hyperinflation exist, the most classic one is the Weimar Republic, which was the name for the German government after the conclusion of World War I. Burdened by the impossible task of simultaneously trying to rebuild its economy from rubble and pay the tabs of the war’s victors, the country inevitably experience the viscous, self-reinforcing cycle that is hyperinflation. As exhibited in the Table 1, the value of the nation’s money infamously plummeted by 17x in just a few years as the percent inflation rates spiked into the hundreds and then into the thousands on a monthly basis.

Table 1 Source: New World Economics

The nation’s citizens unfortunately learned the lesson the hard way that there exists no more effective way to make money meaningless than rapid and extreme inflation. The images below depict the end result of this: kids playing with stacks of cash as if they were Legos, lugging around carts full of cash to make everyday transactions (for instance, a loaf of bread cost 4.6 million marks at one point), and bank notes that read “One Hundred Billion Marks.” The human mind cannot fully comprehend numbers that big, so it surely cannot accurately ascribe the meaning of money at that point.

In an interview with a visitor of Moscow, Vladimir Lenin exquisitely articulated how extreme inflation inadvertently rips apart the very fabrics of capitalist societies. The transcript from the conversation, published in an article for the London Daily Chronicle in 1919, detailed how ‘the high priest of Bolshevism’ had a plan ‘for the annihilation of the power of money in this world.’ The plan was presented in the Chronicle as a series of quotes that allegedly came directly from Lenin himself:

Hundreds of thousands of rouble notes are being issued daily by our treasury. This is done, not in order to fill the coffers of the State with practically worthless paper, but with the deliberate intention of destroying the value of money as a means of payment … The simplest way to exterminate the very spirit of capitalism is therefore to flood the country with notes of a high face-value without financial guarantees of any sort. Already the hundred-rouble note is almost valueless in Russia. Soon even the simplest peasant will realize that it is only a scrap of paper … and the great illusion of the value and power of money, on which the capitalist state is based, will have been destroyed. This is the real reason why our presses are printing rouble bills day and night, without rest.[1]

The visitor was an anonymous source so one can never be certain whether or not this actually came from Lenin’s mouth. What does seem certain, however, is that “the real reason” the Russian presses were tirelessly printing money was not to destroy the very concept of money – that was the inadvertent, yet inevitable consequence of doing so. The real reason was the same one that underpins every instance of the dials of the printing press being nudged, or in this case cranked, upwards: to achieve short-term political objectives. At the time, the Bolsheviks’ objective was to wage political warfare against their challengers, spreading propaganda and otherwise ensuring that their party would remain in power. The proposition that the hyperinflation that wrought the country after the Bolsheviks’ victory was part of their master plan to create a moneyless society was instead an ex-post rationalization of the economic ruin that ensued. It was an attempt to disguise careless and uneducated actions taken to achieve near-sighted and self-empowering political goals as a long-term plan to enlighten the common person and free them from the grips of capitalist money.

Whether or not we notice, American politicians of the past and present have combined to create a situation necessitating large devaluations of our money, the dollar. Now, there is a chasm between “large devaluations” and hyperinflation. This author is not brashly implying that what will unfold will come even remotely close to the decline of the Weimar Republic or of the rouble. The purpose of those two illustrations, as discussed earlier, is to demonstrate the consequences of taking the types of policies seen in the world today to ludicrous extremes. In particular, they are the consequences of instigating and subsequently losing the first World War in the former case and of an endlessly careless, clueless and corrupt government in the latter case. These are the types of extreme conditions necessary to engender the rapid, self-reinforcing downward spiral of hyperinflation.

Though American politicians do possess a knack for showing off their ability to act carelessly and even cluelessly to some extent, they are immeasurably less talented at squandering their citizens’ wealth as the Russians of the early twentieth century. Not only are they aided by the rich historical lessons of the 20th Century, they have access to many of the world’s most preeminent experts at analyzing that history so as to guide the economy to prosperity and avoid engendering such extreme conditions as those necessary for debilitating economic occurrences like hyperinflation.

Though that is not to say that they have mastered the art of following unbiased instruction. The exceedingly short length of American political office relative that of the big debt cycle combined with the hamster wheel of the two-party system ensures some degree of selective listening. Chart 1 displays this propensity for selective hearing coming increasingly to the forefront, especially in the era after the US officially transitioned in 1971 to Dalio’s fifth stage of the money carousel: fiat money. They display the two partners of the waltz – debt and money supply, dancing with fervor and passion increasing at exponential rates.

Chart 1 Source: TreasuryDirect

Admittedly, the graph is more visually stimulating than realistic illustrations of an impending need to carry around wheel barrows of U.S. dollars. They are more meant to provoke an understanding of the lack of restraint that fiat money – the antithesis of hard money – enables from those who control it. How exactly such non-linear growth in money and debt will permeate through the economy over the long-term is studied throughout the course of the essay. After a brief synopsis on what money is and what makes a good money, the essay surveys the academic literature on money’s relationship with the economy and then explores how that relationship manifests itself in Dalio’s framework. This penultimate section provides a more detailed overview of Dalio’s framework, past examples of times it ran its full course and an analysis of the US’ progression through the cycle. It ends with an overview of the present situation we find ourselves in and a recommendation as to how to most smoothly make the inevitable transition into Dalio’s sixth and final stage: the return to hard money.

II.             What Makes a Good a Good Money?

A good’s effectiveness depends on its soundness, a term studied in length over the last few centuries. The formal definition for a currency’s soundness has changed slightly in response to how the last two centuries have unfolded. 19th Century economists like Carl Menger focused their understanding of a money’s soundness on the degree to which it was chosen via free market interactions. The 20th Century witnessed a trend that directly threatened this definition: the coerced centralization of money into the hands of the government. As such, 20th Century economists like Mises, Hayek, Rothbard and Salerno added a nuanced second layer to this definition, emphasizing a money’s capacity to resist government control and thereby promote individual sovereignty. Ludwig von Mises, possibly the most revered of the group, defined sound money in the following excerpt from his book, The Theory of Money and Credit:

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings. The postulate of sound money was first brought up as a response to the princely practice of debasing the coinage. It was later carefully elaborated and perfected in the age which—through the experience of the American continental currency, the paper money of the French Revolution and the British restriction period—had learned what a government can do to a nation’s currency system… Thus, the sound-money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system.[2]

Mises asserts that sound money was developed to protect the individual’s right to the pursuit of freedom and prosperity; and, that it was as central to these ends as the natural social and political human rights laid out in the United States’ Constitution and Bill of Rights. However, these truths are not self-evident today.

Though often powerfully poetic, Austrian economists’ definitions of sound money are rarely dogmatic. They do not provide exact, concrete definitions of the types of attributes a money requires to achieve acceptance via free market interchange or “protection of civil liberties.” The proceeding section of this essay seeks to identify these specifics.

The soundness of money is determined by its capacity to meet the three coincidences of wants: salability across scale, space and time. A good that is salable across scales can be easily subdivided into smaller units or grouped into larger ones, thereby allowing the holder to exchange the currency for goods of any value. Salability across space underscores the ease with which the good can be transported. This has steered natural selection of money towards those with high value relative to its weight. These first two characteristics are rather trivial and could be fulfilled by a large number of goods being considered for use as money, from rocks to Pokémon cards. To meet them, the good simply cannot be found only in preposterously small, large or dense forms.

The final and most important attribute, a money’s salability across time, is reflected by its ability to maintain a certain level of purchasing power throughout time. This necessitates that a constant quantity of the currency could be exchanged for goods or services of fairly constant value. In other words, if one unit of the currency can be exchanged for one apple today, it should be able to be exchanged for an apple tomorrow, the next year, ten years from now, and so on – as long as society does not independently change its views on the fundamental value of apples.

The first and most obvious pre-requisite for a good to hold value into the future is its ability to resist rotting, corrosion and any other type of physical deterioration. This explains why apples, or any other perishable good, are not a good store of value and thus were not selected by free market interactions as the money of choice. Physical integrity is a necessary but far from sufficient determinant of salability across time.

Even if the individual goods remain perfectly physically intact, a dramatic rise in the number of those goods dilutes their value relative to goods they can be exchanged for, ceteris paribus. For example, let us suppose you own the only unit of a currency that can be exchanged for one apple. Suddenly, a second unit of that same currency is created, and, voilà, your purchasing power is cut in half. Even though the physical integrity of the currency you hold has not changed in any way, you can now only buy one half of an apple. Thus, the degree to which the new supply of a money can be meaningfully increased relative that which is already in circulation is the key driver of the money’s salability across time. The new supply that will be created in the coming time period is called the flow. The existing supply already in circulation, called the stock, can be measured as the cumulative production of the good throughout time minus that which was destroyed. The ratio of the stock-to-flow is a reliable measure of a good’s salability across time.

A good’s salability across time is stress tested when a population select it as the good with which they would like base their economy on. When a population chooses to a good as its most liquid store of value and most common medium of exchange (i.e. its currency), they drastically increase the demand for that good. This causes its price to rise according to the laws of supply and demand. The mechanics and reasoning underlying the corresponding shift in supply depends on whether those in control of the money supply operate in a private, competitive market or in a governmental monopoly. With that said, the end result is the same: the supply of money will increase as much or more than the increase in demand.

When responding to demand shocks, private, competitive markets for the production of goods used as money operate according to the exact same forces as the markets for any other type of good – just look at the gold mining industry when the world was on the gold standard. The simultaneous increase in quantity demanded and in consumers’ willingness to pay provides the firm with the potential to reap higher profits by increasing their supply of the good. Moreover, if they do not do so, another firm will enter the market to secure those profits for themselves; and, if the original firm allows easy entry into the market by new firms, it will lose competitive advantage and become increasingly likely to go bankrupt and be relegated to oblivion. Private businesses intuitively understand this process of corporate natural selection – as proven by the very survival of the firm up to that point – and will thus inevitably increase supply of money when presented with such favorable conditions.

While market responses to demand shocks generally play out in the same way, responses to supply shocks in the market for money do not act the same as what occurs in non-monetary market. The difference being that legal tender is the ultimate essential good. Cash money quite literally must be held by every participant of modern economies, because it is the gateway to purchasing everything else, from other essential goods like food and shelter to luxury goods. Therefore, the price elasticity of demand for money is closer to infinitely steep than any other good in existence. In other words, regardless of what the suppliers do to the price, the buyer side of the market will still demand roughly the same amount of money out of sheer necessity.

Producers of money are certainly aware of their monopolistic power over the ultimate essential good. As such, a dramatic increase in the demand curve for money is not required to acquiesce a supply response. Rather, the producers of money will constantly seek to increase the money supply roughly as much as the physical limits constraining their supply allow them to. For, why would they not? Every new unit of cash they produce provides profit directly into their pockets. Their production literally pays for itself; so, when it comes to owning the money supply, money might as well grow on trees.

While the above paragraph explains why private producers will invariably seek to increase the money supply, money does not stay in the private realm forever. As conveyed by the 20th Century Austrian economists and as corroborated by the expanses of history, governments inevitably centralize and nationalize the money supply for the same reason that the private producers so lovingly clung to it: the individual actors are directly incentivized to do so. Just as private producers can gain economic profit by increasing the money supply, so too can gain what they so desire by minting money.

Politicians are ultimately motivated by their desire for re-election – or if their maximum term limit has been reached, then maximizing the likelihood that their party is re-elected. The good news for them is that having monopolistic control over the money supply is one of the most surefire ways to accomplish these goals, because the incentive structure is set up in a logically connected chain that invariably starts with printing money and ends with a higher probability of re-election, and then round again goes the cycle. The incentive chain looks something like this: increasing the supply of money enables the government to extract seigniorage from the population, which increases their budgets, which enables them to spend more on their constituents without taxing them more, which increases their constituents’ happiness and satisfaction levels which, finally, increases the politicians’ likelihood of re-election.

The chain can be broken down into more detail. Each politician is elected by their respective constituents; thus, the politicians’ success depends on their ability to appease that specific group of people. The politicians are thus directly incentivized to take actions that will make their constituents happy during the short period for which they hold office. Rarely are people merrier when they are taxed more and less is spent on them. This, of course, gives those politicians the direct incentive to maintain fiscal deficits. Thus, the incentive structure established by the modern-day political system rewards politicians for having short-term mindsets.

The American political system also ensures that politicians do not face accountability for their fiscal irresponsibility. Each politician holds office for only a glimpse of the overall long-term debt cycle and the cycle of their nation’s prominence. And, each politician inherits a situation resulting from accumulation of decades worth of decisions that were made prior to the current politician’s assumption of office and were thus entirely outside of their control. The current politician should thus not be held responsible for the situation he or she inherited; however, this creates a slippery slope. Similarly, once the term limits of that position force the politician to step down or, worse yet, they do not sufficiently gratify their constituents and are voted out, the decisions made thereafter are once again are entirely subject to the whims of others. Finally, the fact that the following politician was voted in based on their own platform and has their own sets of constituents means that they will likely set out to achieve quite different objectives. This reality is intensified by the threat that the proceeding actor could be a member of the opposing political party, which has the tendency to not just prioritize entirely different aims but also to attempt to actively unravel the progress made by the prior official. Every link in that chain describing the reality of our political system provides the direct incentive to increase debt fund fiscal deficits in order to maximize the short-term gratification of that politician’s constituents.

The only mechanism capable of restraining politicians from acting upon the incentives presented to them is a fixed change in the money supply that is guaranteed to be outside their influence. This forces accountability for fiscal deficits by forcing the politicians to do one of the following: tax their populous more or spend less on their populous’ needs. If they do neither, the politician will eventually be associated with their country declaring national bankruptcy and default outright on its debt. This presents an exceedingly difficult decision and puts the politician in a precarious position.

The ability to control the money supply makes that formerly arduous decision exceedingly easy. The politician can make the impending responsibilities to repay its debt vanish into thin air with the wave of a hand. Increasing the money supply extracts wealth away from their populous without them consenting or often even knowing. At this point the author would like to remind the reader of the purpose of the government according to the Declaration of Independence: “Governments are instituted among men, deriving their just powers from the consent of the governed.”[3] Confiscating the wealth of the governed shrinks the real value of the debt the government owes. Because this implicit default via implicit taxation goes relatively unnoticed by their constituents, the politicians feel free to continue building up debt for the short-term appeasement of their constituents without having to worry about being held directly accountable later on down the line. And, those down the line that do face the difficult decision of how to handle that pile of debt inevitably make that difficult decision an easy one once again.

All of this is to say that while the incentive structures and competitive environments that private and public actors face are quite different, they both ultimately produce the same response over meaningful timeframes: increase the money supply. Indeed, when presented with the power to do so, neither private nor public actors have ever failed to seize the opportunity in the history of mankind.

The question then is to determine the attributes necessary to restrain the producers of money, whether private or public, from dramatically increasing production. To achieve this goal over the long term, it must be capable of limiting both private and public actors, regardless of which one is in control at the moment. This requires physical or otherwise immutable limits on its production and impermeable separation from the influence of the political sector.

The strictness with which the physical bounds on the goods’ production limit the producers from increasing the supply of the good relative to the size of the stocks already in circulation determines the hardness of the money. In other words, hard moneys make it physically impossible for its producers to exercise their natural inclination to dramatically increase its supply in response to more favorable economic conditions. This tends to means that it must be exceedingly costly to produce more of the good. A good with a high stock-to-flow ratio is called a hard money. Whereas, a good with a low stock-to-flow ratio, or easy money, creates what is called the easy money trap: “anything used as a store of value will have its supply increased, and anything whose supply can be easily increased will destroy the wealth of those who used it as a store of value.”[4]

All of the discussion above explains why rare metals won the two-thousand-year-old free market competition for the money of choice. Though some are better at certain things than others, the various rare metals all address the first two salability attributes similarly well. They can all be melted and reformed into any size and have high value for their weight. From there, gold begins to differentiate itself. It is so chemically stable that destroying it is virtually impossible. This enabled its use as a store of value across multiple successive generations. Furthermore, the traits that truly differentiated it were the fact that synthesizing it from other materials is physically impossible and that it can only be produced by extracting it from unrefined ore, which is exceedingly rare on our planet. Together, these ensured that its inter-temporal stock-to-flow ratio was orders of magnitude higher than any other commodity, as seen in Chart 2.

Chart 2 Source: The Bitcoin Standard

This high stock-to-flow ratio put in place the physical bounds necessary to ensure its production could not be dramatically increased, no matter what incentives to do so existed. Indeed, the U.S. Geological Survey reports that the single biggest annual increase in production in U.S. history was around 15% in 1923.[5] This dramatic increase rose the stockpiles by 1.5%. When the exchange of international reserves is included, the largest increase in stockpiles was 2.6% in 1940. Since 1942, the figure has never exceeded 2%. Chart 3 displayed below graphs the growth in and total accumulation of gold stockpiles. The growth in stockpiles has never ventured outside the bounds of 1%-2.6% since 1900. Without the possibility of another 1849 California gold rush and with the perpetually falling levels of untouched ore in the earth’s crust, these bounds are sure to not expand. In fact, since 1950, it appears the bounds have shrunk to around 1.5%-2% and are certain to continue to shrink over time.

Chart 3 Source: The Bitcoin Standard

These physical bounds on its production that ensure its exceedingly high stock-to-flow ratio cannot be diminished also ensures the maintenance of its purchasing power over extraordinary periods of time. In his book, The Golden Constant, Roy Jastram systematically studies gold’s purchasing power over the more than 400-year period from 1560 to 1976. Throughout the entire period it was used as a money – until 1914, it maintained a nearly constant value. Once the world severed from the gold standard following WWI, both its value and volatility have risen sharply.

Chart 4 Source: The Golden Constant

The remarkable steadiness of gold’s purchasing power over the 300 years it was used as currency is juxtaposed to the world’s current easy monies. The purchasing power since the official de-pegging from gold of four of the largest and most stable currencies in use today are displayed in the graph below. They have all lost over 80% of their value in the last 40 years. The dollar has fallen the most precipitously. This is, of course, quite topical as the U.S. has increased its supply of money by 20% this last year alone. Once again, this compares with the largest single year increase in gold stockpile of 2.6%.

Chart 5 Source: The Bitcoin Standard

This last section discussed what sound money and the traits necessary for its existence and preservation. The logical next step is to unravel why exactly having sound money is so important to the societies that use it. But, to understand sound money’s influence on society, one must first understand how money flows through the economy in the first place.

III.           Relationship between the Money Supply and the Economy

Short-Term Relationship between Money and Price Levels

Intuitively, it makes sense that pumping more money into the economy causes prices to rise, all else being equal. This intuition feels flawless, but even rapid and dramatic rises in the monetary base like in 2008 do not always translate into increases in inflation and rarely cause a proportionately dramatic rise in inflation even when it does flow through to it. This is because the phrasing of the first statement in this paragraph was chosen precisely and every portion must be upheld for the intuition to be observed in real-life. First, the money pumped into banks’ reserves or even directly into citizens’ bank accounts like the cash transfers of the stimulus package must be released and propagated throughout the economy. If banks or consumers, and particularly if both, do not deploy their cash reserves, they stay just that – reserves collecting dust in a vault. Secondly, for prices to rise as more money is pumped into the economy, that level of money entering circulation cannot simply be more than the previous level of money in circulation; the rate at which it enters the economy must be more than that of the production of goods and services. In other words, the money growth in circulation cannot just be more than it used to be, it has to be more than the growth rate of real GDP. Increasing the money in circulation relative to the real goods and services the economy produces by definition means that each unit of money can buy fewer real goods and services: voilà, inflation.

In the most basic monetary system without fractional reserve banking, the money supply and inflation should always maintain a near perfect relationship, with the main deviate caused by random noise in the data. Governments may try to obscure the relationship via explicit price controls, but like anything that attempts to mask the true realities of the markets, these are never sustainable and are inevitably transient. The superimposition of fractional reserve banking on this basic monetary system introduces the two ratios mentioned above: the currency-to-deposit and the reserve-to-deposit ratio. These ensure that the base money that the Fed creates is not wholly released into circulation; and, their cyclical nature ensures that the relationship between base money and inflation is far less apparent when viewed strictly over the cycles’ timeframes of 8-10 years. Finally, the recent introduction of the Fed’s interest payments on excess reserves gives added incentive for banks to withhold the release of their reserves into the broader economy for circulation. All of these together cause short-term deviations from the relationship between the monetary base and inflation that tend to cause inflation to grow slower than the monetary base.

In the short-term, numerous factors can sever the relationship. For one, the smaller timeframes one views, the more random noise affects the data. This is true of any data measurement in the real-world. As one zooms in on particular moments, random data points obscure the true, fundamental relationships that become increasingly apparent the broader the perspective one has. Any number of random things can occur over the course of days, weeks or even several years. However, the probability of those same random occurrences happening over timespans of decades or centuries increasingly approaches zero. For trends to span those lengths of time, they are in all statistical likelihood part of a more fundamental relationship.

Secondly, government intervention explicitly intended to obfuscate the relationship between money supply and inflation can suppress inflationary pressures for limited periods of time before reality re-asserts itself. The classic example of such a policy is price controls. In WWII, the British government employed extensive price controls and rationing. This caused the correlation of money supply and inflation to break down temporarily. However, virtual prices – or those at which agents in the economy would have willingly chosen to transact – would have been tracking the movements in the monetary aggregates more closely. Eventually, the fundamental relationship between money supply and inflation combined with the laws of supply and demand caught up and forced the UK government to break the price controls.

The third way that the connection between the monetary base and inflation can be muddled is by the short-term workings of the two ratios representing the incentives to individuals and banks, respectively, of releasing the high-powered money into circulation: the ratio of currency-to-reserves and of deposits-to-reserves. These two ratios naturally rise and fall in accordance with the short-term debt cycles, as discussed prior. This causes base money changes to deviate from inflation rates over the lengths of short-term debt cycles – typically around 8-10 years.

Major, unexpected external events can also cause short-term shocks to the two ratios. For example, the period surrounding World War II exhibits highly unusual monetary behavior. The inflationary pressures of dramatic rises in high-powered money and in the ratio of deposits to reserves were half offset by a decline in the ratio of deposits to currency, for reasons that have still not yet been determined with certainty. The most educated guess is that “increase in currency transactions as a means of avoiding tax, in part, other factors such as increased mobility which rendered currency relatively more useful, and foreign demand for U.S. currency.”[6]

The most lasting way to affect change to the rate at which changes in base money translate into inflation is by permanently altering the incentives above. The strongest example of this occurred around with the Great Recession. In 2006, Congress passed The Financial Services Regulatory Relief Act, granting the Fed the ability to control the incentives for banks to maintain reserves. Specifically, it authorized the Fed to begin paying interest on the reserve balances maintained by depository institutions at Reserve Banks and to autonomously determine the interest rate it pays on those reserves. Changing this rate makes holding money in reserves rather than transmitting it to the rest of the economy more or less attractive.

In a 2012 speech, the Federal Reserve Bank of San Francisco’s CEO detailed how this new mechanism enabled the Fed to inject massive amounts of liquidity into banks during the Great Recession without having those extra reserves be necessarily transmitted to the rest of the economy and thereby creating inflationary pressures. Throughout the recession, the Fed increased the monetary base by 200% in order to conduct widespread open market operations (OMO).[7] By purchasing long-term securities, the Fed’s OMO bolstered demand for those securities, pushing up their prices and thereby pushing down market interest rates. This move sought to simultaneously strengthen major banks’ liquidity and stimulate the economy by lowering interest rates.

This 200% increase in the monetary base did not translate into spikes in inflation because the banks never released their excess reserves into the economy for several reasons. First, the banks were weary of opportunistically lending out their reserves in the second worst financial environment in U.S. history. They aimed to accumulate liquidity to strengthen their runway and maximize their potential for their own corporate survival, not for aggressive expansion. The new possibility of earning interest on their excess reserves allowed them to achieve that liquidity while simultaneously alleviating the opportunity cost of deploying that capital. This caused an unprecedented rise in excess reserves that can be seen in Chart 6.

Chart 6 Source: Federal Reserve Bank of San Francisco

By shrinking the opportunity cost of releasing excess reserves into the economy, the Fed ensured that the vast majority of the increase in the monetary base was concentrated in bank reserves. Before the Fed began paying interest on bank reserves, the opportunity cost for holding non-interest-bearing bank reserves was the nominal short-term interest rate, such as the federal funds rate. Thereafter, it was the difference between that short-term rate and the interest rate that the Fed paid on those reserves, which it could make any figure the Fed desired. During this time period, the Fed ensured that, for banks, reserves were close substitutes for Treasury bills in terms of risk and return. Thus, the Fed’s massive injection of liquidity into banks’ balance sheets effectively amounted to a simple exchange of reserves for Treasury bills. Hence, the 200% increase in monetary base hardly trickled out of the banks’ vaults and caused a disproportionately minor rise in the total money supply in circulation of 28%.[8]

Chart 7 Source: Federal Reserve Bank of San Francisco

Finally, because consumers faced the same terrifying economic conditions as the banks, they protected themselves by hoarding cash in the two avenues common to all bank panics accompanying deep depressions. The populous feared the collapse of their respective banks and thus the safety of their savings in those banks. They sought to convert their deposits into cold, hard cash which caused the currency-to-deposit ratio to plummet. Simultaneously, they held onto the currency they were able to extract instead of spending it and releasing it into the economy once more, which caused velocity to fall. Together, these two factors caused the money multiplier to nosedive, as seen in the graph below.

Chart 8 Source: Federal Reserve Bank of San Francisco 

All in all, during the Great Recession, then 200% increase in the monetary base caused M2 to rise by only 28% over four years because the banks had every incentive to hold onto that cash; and, that rise in M2 hardly caused any change in inflation because the minimal amount that was released by the banks was also hoarded by consumers. Though this provides a newly bestowed potential for the Fed to temporarily sever the relationship between its OMO initiatives and inflation, this tactic could only be effective in such historically tumultuous economic environments. Similarly miserable economic conditions would need to be present for such a stark mismatch between the monetary base and inflation to hold moving forward. This tool can be seen as a healthy and effective way for the Fed to provide banks with necessary liquidity during times of severe crisis without them needing to increasingly offload deposits at a rate proportional to their decline in reserves. Or, the Fed will have to continually pay a high enough interest on reserves to make maintaining massive excess reserves profitable from a risk-return perspective. The SF Banks’ CEO even admits that under normal circumstances, “banks have a strong incentive to put reserves to work by lending them out. If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return.” And that “If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity. Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock. Moreover, if the economy were operating at its potential, then if the banking system held excess reserves, too much “money” would chase too few goods, leading to higher inflation.”

The graphs below explore the effect that the new policy to pay interest on bank reserves under more normal economic circumstances than the Great Recession. The excess reserves peaked in 2015 and then began falling at a rate mirroring that for which it originally skyrocketed upwards following the installment of the policy. COVID-19 halted this precipitous decline before banks could determine for themselves the steady state level of excess reserves they feel comfortable maintaining in normal economic environments. This steady state level is undoubtedly higher than it was prior to the institution of interest payments on excess reserves so long as that interest rate on reserves is above zero. Thus, while the Fed’s new tool will obfuscate the relationship between the monetary base and inflation to some degree that is yet to be determined, the Fed will likely only lean upon this tool in a major way during major financial crises and thus its impact will in all likelihood only become apparent those periods.

Chart 9 Source: Federal Reserve Bank of St. Louis 

This section discussed the ways in which the increases in the monetary base can be restrained from flowing through proportionally to the total money supply in circulation and thence to inflationary pressures in the short-term. The following section explores the long-term relationship

Long-Term Relationship between Money and Price Levels

Though the level of money in circulation and the price level do not necessarily coincide in the short-term, they far more consistently hold in the long-term. Moreover, the relationship between the two becomes more stable the longer time periods one examines. The reason that these conditions are not always held in the short term but tend to hold fairly strongly in the long term is due to the fact that in the long run, things tend to even out. For, over the long run, many of the factors mentioned in the prior section that accounted for the high degree of short-term variance become negligible: random noise in short-term data disappears, the effects of cyclical fluctuations roughly cancel out, and so too do random events. In other words, it is far more likely that all else is indeed equal over the long run than it is at any given instant.

Various academic studies have provided statistical evidence affirming the long-term connection between monetary aggregates and inflation. These studies find a strong, positive correlation that remained stable over long time periods encompassing radically different monetary systems. The relationship also held for countries aside from just the U.S. This suggests that the correlations are originated in the fundamental structure of the economy and do not depend on specific monetary arrangements. One study conveys a corollary from this suggestion: “any deviation between the trend components of inflation and money growth should necessarily be regarded as temporary.”[9] Chart 10 below visually illustrate the correlation between multiple different measurements of money supply and inflation over the long-term for the U.S.

Chart 10 Source: Long-Run Evidence on Money Growth and Inflation

Below is a graph produced by the Federal Reserve Bank of St. Louis that investigates how the strength of the correlation changes over time. The x-axis represents inverted quarterly time horizons. This means that the 0.50 displayed on the right-hand side represents 1/½ = 2 quarters. As one travels leftward, the time horizons get longer. The first vertical bar marks a length of time of two years (1/8 quarters = 0.125), the second bar represents ten years and together they represent the range of lengths of typical short-term debt cycles. Up to this ten-year mark, the strength of the correlation ebbs and flows in an apparently arbitrary manner, with no clear predictive value. However, as one moves further leftward from that ten-year mark denoting the shortest time-span that is seen to exhibit a reliable trend, the graph makes an unmistakable march upwards.[10] The strength of the correlation at 10 years is approximately 0.3, which means that over time spans of 10 years, growth in the money stock accounts for, on average, about 30% of the change in inflation. As one increases the time span being studied beyond 10 years, that figure rises until it reaches 85% over infinite periods of time, denoted by an inverted time horizon of zero. The practical finding of this study is that as one increases the time period of interest from lengths of 10 to 40 years, the growth in inflation accounted for by the growth in the money stock rises from 30% to approximately 75%. Finally, below this graph displays other studies examining this same long-term relationship. They all corroborate the findings of the two studies discussed in more detail above: money and inflation are increasingly positively correlated over long periods of time.

Chart 11 Source: The Quantity Theory of Money
Chart 12 Source: The Variability of Inflation

What are prices?

Now that we understand the relationship between the monetary base and price levels, it is time to ask ourselves: what exactly are prices, what is their purpose and what is the best mechanism to determine prices? Friedrich Hayek, a legendary economist and disciple of von Mises who was quoted earlier, articulates the answers to these questions with exquisite clarity and profundity in his essay, The Use of Knowledge in Society. Hayek explained that the true problem that economics seeks to solve is not the proper allocation of scare resources as is typically understood. The problem is, more precisely, how to allocate those scarce resources when knowledge about their ceaselessly changing use and value are not held in totality by any single individual, but instead dispersed into “bits of incomplete and frequently contradictory knowledge” which all of the individual participants of the system possess to varying degrees.[11]

The three broad approaches to solving the problem are: central planning, in which the whole economic system follows a unified plan; competition amongst individual actors; and, halfway between the two, monopoly, in which planning is delegated to organized industries. The relative efficiency of those different systems depends on the completeness with which they are expected to make use of the existing information. This, in turn, depends on “whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans with those of others.” The answer to this depends on society’s relative effectiveness at the two tasks.

If society can more reliably distribute to the individual market participants the small amount of information necessary for them to make their decisions, then competition amongst individual actors is likely more efficient. On the other hand, if society can more reliably aggregate and simplify all of the relevant information throughout society into a deliverable that is digestible by a small, suitably-chosen collection of experts, then central planning is likely to be superior.[12] Distilling immense amounts of information into sets succinct enough to be fully consumed and comprehended by singular individuals, regardless of the degree of their expertise, requires that the original, raw information be of the scientific nature. That is to say that effective central planning necessitates the dual requirements that all of the relevant information must be readily quantifiable and that knowable, unchanging and fundamental laws govern the area of study. This makes it possible for the original, raw information to seamlessly transition to levels of higher simplicity and then back again without losing any relevant information in the transitions between levels. Under these circumstances, central planning may very well be the optimal structure that society currently has available to it.

Economists and society at large all too easily forget that the study of economics is a social science, not a natural science. Armies of PhD’s, Nobel Laureates and other brilliant minds have relentlessly pursued encapsulating the entirety of the markets into simple datasets composed solely of numbers and statistics. These are then fed into highly sophisticated mathematical models that were created by the world’s mathematicians. All of this quantification provides a false sense of precision and a deluding yet comforting sense that it is working. This effort to make economics mimic physics is compounded by the usage of verbiage like “the Law of…” or “the Rule of…” or “the Theory of…”

Taken together, economics can often feel no different than physics or biology. This assumption that a scientific approach can accurately aggregate all the possible knowledge in the economy appeals to the public’s imagination. Even more importantly, it provides a false sense of precision that feeds into humanity’s natural desire to feel comfort and security. We inherently want to believe the economy that we base our entire lives and the future livelihoods of our family on is a well-oiled machine that runs according to mathematically proven, scientific laws akin to those that govern the celestial bodies and is overseen by stuffy old men in white lab coats like those that deal with such precision as to require microscopes to make their observations. However, time and time again, the laws and rules and theories that supposedly govern the economy have broken down.[13]

The reality is that the economy is nothing more nor nothing less than the sum of all of the transactions made based on subjective estimations of value by the economy’s participants, all of whom are irrational and emotion-driven. The prior statement can be broken into three parts that underscore the impossibility of aggregating and quantifying all of the relevant information in the economy into comprehensible data. First, there is an unknowable amount of relevant information that is for all intents and purposes infinite in scope. Consider the sheer number of people in the economy, the number of different factors they use to make every one of their decisions, the number of different products available to them. No human mind could even truly understand solely the vastness of the amount of information out there, no less comprehend its contents.

Whether the good is used for industrial purposes, an essential good, a luxury good or anything else, the value of something is in the eyes of the beholder – at that moment, in that situation, etc. Those last several phrases of the previous sentence are crucial. For, not only is it impossible to reach an objective conclusion on the value of a good, the parameters that would make that feasible, if it were, are constantly changing for everyone, everywhere, all the time.

Secondly, even if supercomputers had the bandwidth to aggregate and quantify all of the relevant information and humans had the brain power to comprehend it and put in place the proper diagnostic, the information set that can be quantified in any authentic way is only one subset of total information that drives the economy. Most are driven by subconscious thought more than we know it. No rules or dictums orchestrate the economy in the same objective way that Newton’s laws govern the solar system. No microscopes or telescopes exist to measure and quantify the irrational rationale underpinning every thought process in every transaction throughout all of the economy. This relates not only to the impossibility of aggregating all the tradeoffs that individuals make, but also to the fact that these tradeoffs are themselves not objective, fundamental rules of nature. They are entirely subjective. The decisions that individuals make are never perfectly rational and their reasoning impossible to discern from the outside. The following paragraphs will delve into examples that should clarify just how subjective value is.

What is the value of a nail? This intuitively feels like an exceedingly simple and easy question. But, accurately estimating its value is more difficult than intuition would assume, as the answer to the question depends on the answers to a string of other questions. What is the value of the nail to whom? For what use? At what period in time? In what place? In what situation? Moreover, many of these questions have complex interrelations of sub-questions in and of themselves, though they will not be elaborated upon.

Admittedly, this first thought experiment is not terribly daring. Nails’ uses are almost always strictly limited industrial purposes. So, a rough estimation of the nail’s value can generally be agreed upon if the external aggregators know with certainty the answers to the questions like whom will use it, for what, what ultimate revenue or utility do they expect to generate from it, what share of their budget is it, etc.

An exact, empirical and objective value can still not be universally agreed upon even if one assumes that the following answers can be reached with certainty because the nail’s value still depends on several entirely subjective factors, like the person’s confidence in their ability to acquire a nail in the future or to pay a different price if they are able to find one. Additionally, these judgements all also depend on the valuations of every other good in this chain of industrial production. How do the final consumers value the final good? How are consumer habits expected to change in the future? What is the value of a substitute for a nail like a screw? What is the users’ expectation about the future prices of that substitute? What about a hammer, which is the tool necessary to make the nail useful? If the creation of the final product involves borrowing, then how does the creator anticipate real interest rates to change, etc.? So, even in the relatively “objective” world of industrial production, estimations of the good’s value are ultimately just that – summations of guesses regarding the individual actors’ personal preferences, their handlings of the uncertainty of the future and the estimated summation of all the guesses that the individual actors make regarding products inter-related to theirs.

These questions become even more nebulous and personally subjective when one verges away from goods used solely for practical, industrial purposes. The other end of the spectrum can be represented by art, so the second thought experiment will venture there. What is the value of a van Gogh? What about a fake van Gogh? That depends entirely on the reason for the purchase. Are you buying it because its aesthetic enraptures you and uplifts you emotionally? Or, do you desire to acquire it because you see it as an investment and thus expect to sell it at a higher price than you paid?

Assuming the two paintings are indistinguishable from each other to the naked eye, the question then comes down to what is the value of having confidence that the painting’s creator is a particular person, in this case van Gogh as opposed to some nameless artist who mastered creating clones of famous art pieces. One key aspect of that statement is that the highest degree of certainty one can ever truly reach about the pieces’ authenticity is “having confidence.” You can never be completely certain of the original creator, because, no matter what, you must rely upon the trustworthiness and legitimacy of a third-party seller. This trust stems from the fact neither you nor the seller witnessed van Gogh himself paint either of the paintings. Moreover, the seller’s conviction that the painting they are selling to you is not a fake stems from a chain of trust and hear-say that spans around 150 years. The faultiness of this reliance on trusted authorities is no joke. If interested, take a look at the authentication processes for high-value art. Even experts themselves have liquid certainty over some paintings’ legitimacy, with their confidence flowing freely between defiant conviction and patronizing dismissals depending on who is asked. This impossibility of discerning the authenticity of a painting by the color of paints used, its composition, its meaning and other pieces of evidence up for interpretation translates into endless examples of van Gogh’s and da Vinci’s selling for tens or even hundreds of millions of dollars only to later be “confirmed” fake. For instance, the most expensive painting ever sold at $450 million is alleged by many art scholars to be fake, including the director of a group focused on art preservation who says that the authenticity claims were “built on scholarly sand.”

The relevance of the discussion above depends entirely on the buyer’s answers to the initial questions of whether the motivation behind the purchase was driven by a genuine love for the aesthetics of the piece or by an investment thesis. If the former is the case, the premium to be paid for confidence over the piece’s provenance should be relatively trim, because paintings that look identical should deliver similar levels of enjoyment to someone observing it purely for themselves. Whereas, if the latter is the case, then the price to be paid for the painting is perfectly reliant on its authenticity and thus the many-million-dollar premiums mentioned above can be justified.

For a second example related to art, consider how much you would pay for a random child’s artwork – almost definitely nothing. What about your child’s artwork? May be priceless. All of this underscores the impossibility of quantifying the value of art from both the internal perspective of the potential buyer and even more so from the perspective of a central planner trying to determine the value of art externally. If the piece is purchased for emotional value, how do you put a number on that value? If you desire it because you expect to sell it at a higher price than you paid for it, how much higher of a price do you expect to sell it for and in how long and on what assumptions do those assumptions rest upon? The individual making these decisions would not even be able to come up with accurate guesses as to how to quantify all of that information, because art inherently deals with far more subjectivity, emotion and subconsciousness than industrial goods. So, art’s value can vary tremendously according to the beholder’s personal preferences and tastes, their intended use, their assumptions about the world etc.

One final and particularly interesting example is the value of a cigarette, because its value depends so remarkably on the situation surrounding its use – i.e. the who, what, when and where type questions. Casual smokers are willing to pay $7 a pack based on current average market price. Whereas, a heavily addicted person who is currently fiending for one due to the excruciatingly irresistible symptoms of chemical withdrawal may pay relatively exorbitant sums to get their hands on one. On the other end of the spectrum, someone who does not smoke may view cigarettes’ value as being negative! They may contend that smoking a cigarette would make them more unhappiness in the moment than if they had not touched the cigarette; and, moreover, doing so would be more likely to cause long-term health issues, which deteriorating both their physical and financial health. They may even point out that it would also cause negative externalities to the economy as a whole. Thus, to be properly compensated for the negative value they ascribe to the good – a concept that is odd in itself – would thus demand to be paid money to smoke a cigarette, and may even require a significant sum to do so. The last example of someone ascribing extraordinarily different value to a cigarette is an inmate in a prison whose monetary system is based on cigarettes. To them, the cigarette would act purely as money, serving all three of the use cases of money. The cigarette would enable its user to exchange it for productive goods he desired, because those around him that he does business with also accept the cigarette as payment; it would serve as the unit of account in this ecosystem, as everything would be priced in terms of number of cigarettes; and, its relative monetary soundness would enable him to store his wealth across time. In summary, cigarettes may have extremely high value for addicted smokers and inmates using it as money alike, and they may also have mild value for casual smokers and negative value for non-smokers.

All of this is to say that there exists no object on earth that has an objectively determinant value. Everything from nails to cigarettes to van Goghs exhibit any uncanny display of subjectivity, in which the value truly is at the eyes of the beholder at that particular moment. Humans make decisions based on feeling – how the good they consider buying makes them feel, how they feel about the uncertainty of the future, etc. – as much as they employ rational thought. The fact that these feelings that drive the outcomes of transactions are held internally and are not reliably communicated to the public world makes the job of trying to externally quantify the participants’ decision-making process inherently impossible – you cannot measure what you cannot see.

The final point underlying the impossibility of aggregating and quantifying all of the relevant economic information is the fact that the individual participants’ subjective beliefs are born largely out of thought processes that occur at the subconscious level. In other words, the individual participants cannot even fully understand their own feelings or thought processes because their ultimate provenance rests behind the close curtains of the subconscious. If the individual participants cannot fully understand or articulate the reasoning behind their subjective decision-making process, which is in itself inherently unquantifiable and is not communicated to the outside world anyway, then surely external central planners will fare worse at understanding it for them. Thence, there exists no good or service on earth that has an objectively determinant value that can be reached by outside parties.

The discussion above leads to two realizations. First, that central planners are at an inherent disadvantage at orchestrating an economy determined in no small part by subjectivity and internal dialogues that are rooted in the participants’ subconscious. These circumstances could not be further from the pre-requisites laid out above, necessitating that quantifiable objectivity and universal laws must govern the space in order for central planning to be effective. Secondly, it underscores the fact that every individual has some advantage over all others in respect to some good due to their uniquely intimate knowledge of the particular circumstances of that place in that fleeting moment. Moreover, this is the type of knowledge that cannot be entered into statistical figures and thus cannot be readily transmitted to central planners. Hayek continues to explore the impossibility of transmitting this information to central authorities in the excerpt below:

The statistics which such a central authority would have to use would have to be arrived at precisely by abstracting from minor differences between the things, by lumping together, as resources of one kind, items which differ as regards location, quality, and other particulars, in a way which may be very significant for the specific decision. It follows from this that central planning based on statistical information by its nature cannot take direct account of these circumstances of time and place and that the central planner will have to find some way or other in which the decisions depending on them can be left to the “man on the spot.”

He comes to the realization that:

If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them.

However, there still remains the issue of how much information to communicate to the individual actors so that they can properly fit their decision-making into the full breadth of the economic system and its continual change. Which events beyond the actors’ immediate gaze are important to their decisions and what parts of them are necessary to make the decision? The number of external factors that theoretically could play a role into a complete decision is infinite. Thankfully, a satisfactorily accurate decision requires the actor to only know of a small subset of events and need not know why any of them happen. “All that is significant for him is how much more or less difficult to procure they have become compared with other things with which he is also concerned, or how much more or less urgently wanted are the alternative things he produces or uses.” Finally, Hayek concludes that the only solution to this problem of allocating scarce resources when all actors only ascertain a subset of the available information is the following:

constructing and constantly using rates of equivalence (or “values,” or “marginal rates of substitution”), i.e., by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure. In any small change he will have to consider only these quantitative indices (or “values”) in which all the relevant information is concentrated; and, by adjusting the quantities one by one, he can appropriately rearrange his dispositions without having to solve the whole puzzle ab initio or without needing at any stage to survey it at once in all its ramifications.

This exhibits how prices are not merely a mechanism that enables shrewd capitalists to profit; they are the very mechanism through which all of the information throughout all of the economy is transmitted. Every relevant piece of information for an individual actor to make a decision is condescended into a single, easily comprehensible and reliably accurate number. It is the only method humans have devised to successfully and seamlessly orchestrate processes of production as unfathomably complex as the modern global economy.

We now understand how the monetary base is altered under various monetary arrangements, how that flows through to the total money supply in circulation, how that in turn flows through to price levels and finally what price levels conceptually are. It is time to pair this knowledge of the cause-and-effect relationships underlying the monetary system with our understanding that sound money’s purpose is to maintain purchasing power and that of prices is to concisely transmit aggregated information to understand why all great civilizations were built upon those two features.

Short-Term Implications of Sound Money and Accurate Prices for Capital Goods Markets from the Perspective of Individual Consumers and Corporations

The fundamental struggle of the 20th Century was over the very issue spelled out throughout the course of this section: what is the ideal pricing mechanism and by whom shall it be determined. The western world believed firmly in the decentralization of the pricing mechanism for capital goods described above. On the other side of the economic – though not always geographic – spectrum, the eastern world experimented with central planning. The rise of communism and socialism rode on harmoniously orchestrated dreams of utopian equality. The problem with these dreams is not merely that it superimposed a societal structure on top of a deeply flawed understanding of the true nature of humanity that evolved over millions of years of natural selection: selfishness, tribalism, entrepreneurial creativity, and ambition, among other things. The most fundamental issue is that they lacked one crucial ingredient: an efficient pricing mechanism. The complete disposal of the pricing mechanism guaranteed their failure. For, “without a price mechanism emerging on a free market, socialism would fail at economic calculation, most crucially in the allocation of capital goods.”[14] The struggles the citizens of these nations endured for purpose of a political experiment acts as a tragic reminder that “any economic system that tries to dispense with prices will cause the complete breakdown of economic activity and bring a human society back to a primitive state.”[15]

The two paths that nations in the 20th Century followed provided us with a fairly controlled experiment in economic theory: the consequences of central vs. decentralized planning in the markets for capital goods. Nations aligned themselves on either ends of the spectrum, both of which being near the absolute extremes, and let the clock run for decades. A particularly neat economic experiment occurred in Germany following its defeat in WWII. In 1949, the map of the nation was redrawn, dividing it into two separate countries with juxtaposing economic allegiances. The fact that the lines of the map were arbitrarily redrawn makes the experiment as close to a blind, controlled experiment as the macroeconomics in the real-world provides. Prior to that decision, the two nations had been one whole nation with the same demographics and similar landscapes. Following the decision, roughly two-thirds of the country, in terms of both population and land mass, vowed itself to a parliamentary democracy with a social democratic economic system. The other third was to test out Marxist-Leninist socialism. The consequences of this decision could not be more vivid, as seen in the graph below that uses OECD data.

Chart 13 Source: The World Economy

Starting from identical levels of GDP per capita in 1936 and similar levels in 1950, the two nations’ economic outputs abruptly diverged. Twenty years after the redrawing of the nation’s boarders, West Germany’s GDP per capita was double that of its brethren. By the time the two German countries were reunited in 1990, West Germany’s economic output per person was four times that of the eastern side. The consequences of this economic decision are just as drastic when comparing the two nations independently. In the 54 years from 1936 to 1990, West Germany’s GDP grew by 513% and its population by 50%. In comparison, East Germany’s GDP grew by just 10% and its population by 3% over that same more than half of a century timeframe.

This juxtaposition of the economic and demographic realities of the nations that selected more free-market systems as opposed to centralized planning of their capital goods markets is not just true of Germany. Similar comparisons can be made with respect to any two individual nations that choose the two respective paths as well as in aggregate. The countries prescribing to the socialist or communist orthodoxies of capital goods allocation had horrific results across the board.

Though the western world proudly and defiantly adopted the free market approach to capital goods allocation, it simultaneously increasingly allowed their capital goods markets to be tainted by the encroachment of central planning on its most important market: that of capital. Thus, we saw that while the 20th Century witnessed the free-world governments embarking on a violent crusade in the pursuit of global abolishment of central planning of pricing of capital goods, those same governments were ironically happily engulfing their pricing mechanisms of capital into the hands of central planners. Fast forward to today, not a single one of those “free-market” nations have free markets for capital.

Free markets can be broadly defined as those in which buyers and sellers transact freely with one another on terms determined entirely by themselves. Under such conditions, no third parties limit entrance nor exit from the market, interfere with the profitability of specific ventures by installing subsidies or taxes, nor otherwise artificially manipulate the market dynamics. The free-world governments’ capital markets exhibit none of these characteristics.

Though the bulk of the discussion about the impact of this transition to central planning for capital will come in the proceeding section, it necessarily must be introduced here in order to understand how that move tainted the market for capital goods that was otherwise appropriately decentralized in these western economies. These nations’ central banks had the capacity to create purely monetary inflation: in other words, inflation engendered strictly by increases in the monetary base, independent of the natural workings of the free markets that rely on the soundness of that base. This economy-wide inflation dictated by the central planners of the capital markets only confused the efficiency of those countries’ underlying decentralized capital goods markets. It muddled with the accuracy of the pricing mechanism, which is the fundamental process by which information is transmitted to the individual actors of collective economy. Obscuring the quality of that information to the point that it becomes questionable or even deceptive ensures increasingly inefficient allocation of resources the more that those central planners independently caused aggregate inflation. An academic study by Lucas terms this process the monetary misperceptions model. Its core argument is articulated below:

Individuals cannot distinguish (with certainty) shifts in relative prices from changes in the aggregate price level. This uncertainty can lead to resource misallocation, which is corrected only once the true nature of a price change becomes known. Thus, for example, a firm might increase its production in response to an apparent increase in demand for its product as reflected by an increase in the market price. If, however, the producer understood that the price increase merely reflected an increase in the prices of goods and services generally, and not a change in relative prices in favor of the firm’s output, the producer likely would not find it profitable to increase output. Uncertainty about whether the change in one price reflects a shift in relative prices or simply a change in the aggregate price level can thus cause a misallocation of resources.[16]

This articulates the fact that no person can know for certain whether the changes in the relative value of goods – i.e. prices – he sees directly in front of him are due to the proper transmission of the information necessary for him to make the best economic decision or if it were simply the eventual trickling down of unpredicted acceleration of the monetary base by the Fed at some prior point or even if it were the effects of changes in the free markets’ expectations of future Fed action. The actors can only guess if the information they are receiving is fundamentally relevant, a result of independent monetary actions taken in the past, or peoples’ guesses as to what the central planners will do next. Ultimately, in a system applied on the scales and complexity of modern economies, the information that individual actors receive is never a that of a single malt. It is, unfortunately, always an amalgamation of all three, blended and swirled with every layering of the economy – an even more perplexing relay of information than if individual received any single contributor in its purest form.

To make the best guesses possible in the face of the existence of monetary inflation, businesses must divert time and resources away from productive endeavors to analyzing the legitimacy of prices they see in the present moment and forecasting inflation rates in the future. Jobs and entire industries have specialized around this practice of discerning what is real in the economy and what is artificial.

The weakened quality of the information individual actors receive decreases their ability to make not just the best external decision, but also internal ones as well. We return to the worker dealing with nails. He cannot know how much of the increases in the price of nails he sees is caused by purely monetary effects or by fundamental economic shakings of the market for which he deals – like a scarcity in the necessary raw materials. His interpretation of this information is crucial for his internal strategic planning. If it were a fundamental decrease of the supply curve of the most important input to nails, this would have drastic implications for the short- and long-term profitability of his operation. It would force him to consider laying off a portion of his work force to cut labor costs, or abandoning the operation altogether. On the other hand, if it were a purely monetary price change, then the economics of his operation would not have changed at all, as long as he is able to raise prices accordingly.

This last qualification should not be taken lightly. Prices and particularly wages are reasonably sticky, meaning that individual firms change them only infrequently and when necessary for their firm’s survival, for their customers of course do not like paying higher prices for the same product. In the meantime, before the firms change their prices, they incur the difference between the temporarily fixed price their customers pay and the variability in the costs of their inputs. Moreover, once they ultimately do change their prices, they accept any changes in profitability from doing so, like customers disgruntled with the price hike. So, forcing a firm to change prices for any reason other than those which regard the fundamental economics of the firm in relation to the free workings of the market with which it deals forces the firms to incur unnecessary costs.

In summation, monetary inflation impairs the quality of the information that individual actors receive, increasing the uncertainty and deceptiveness of the foundation upon which the actors make every internal and external decision. They incur the costs of that uncertainty immediately by paying prices for inputs different than the true price, and over time, as they reality of that situation now in past is eventually revealed and they must then take retrospective actions to correct their initial decision, by changing their external prices. Of course, the decreased quality of those decisions is in turn compounded as they are propagated through the practically infinite web on interconnections that makes up the aggregated economy. Indeed, as the legendary economist and monetary policy historian Anna Schwartz stated, any feedback rules that involve government manipulation of private sector’s estimations are “doomed to failure.”

Altogether, these last two sections have explained why perfectly decentralized pricing markets are without comparison the most efficient means of estimating the relative value of all the goods in an economy in real-time. Any deviation from this will only serve to cause inefficiencies in every economic transaction at every level of business. This section explored the application of this concept to the markets for capital goods. The following section will explore its relevance in its sibling market: that of capital.

Short-Term Implications of Sound Money and Accurate Prices for Capital Markets from the Perspective of Individual Consumers and Corporations

While, the 20th Century acted as a lesson on the importance of decentralized pricing for capital goods markets, the 21st Century will teach us the importance of sound money and decentralized pricing for capital markets. Monetary inflation obscures financial decision-making in the same way that it impairs operational decision-making: by making it more difficult for individual actors to discern the true rate of return to be expected, and correspondingly, the accurate price to be paid for that return. For, the prices of financial assets are direct analogs to that of capital goods, only phrased using different terminology. This increases inefficiencies in investing, lending and borrowing throughout the economy – in particular, it impairs the decisions of both financial firms and banks alike.

First, the uncertainty and inaccuracy of financial pricing caused by monetary inflation impairs the decisions of individual investment and lending firms alike. It makes it more difficult to delineate what portion of the nominal returns that investors see is driven by real growth in underlying economic profitability or merely due to monetary inflation. Nominal return, which include changes in price levels, is described by the following formula:

Nominal Return = (1 + Real Return) * ( 1 + Inflation Rate) – 1. Hence, mistaking a change in monetary inflation for one of real returns, or vice versa, causes worse investment and lending decisions. Thus, investors and lenders are unable to properly understand the true risk-return profile of their prospective deals. They invest in and lend to actors that do not deserve that capital at that pricing. Eventually, the economic reality catches up, as it cannot be deceived forever. When that happens, it becomes evident that those investments did not produce the real returns that were expected, causing shortfalls to the firm’s investor base; and, those who loaned money to actors who were not sufficiently creditworthy at that price level see the value of their loans collapse as their borrowers default at a rate proportional to the degree to which the monetary inflation was unpredicted. Thus, the presence of uncertainty regarding monetary inflation increases the number of investments and loans that should not have been made, decreasing the windfalls to investors and increasing default rates.

This uncertainty surrounding the presence of monetary inflation also decreases the number of such deals that should have been made, if it had been absent. Because firms acknowledge the presence of uncertainty, they protect themselves by charging an inflation risk premium which is implicitly added onto the cost of capital of all investments and loans. This increases the total cost of capital for all deals and causes deals that should have been made in the premium’s absence to not be made.

The inefficiencies that this monetary inflation causes are amplified the longer the excessive money growth is sustained in a single direction. For instance, the longer that monetary inflation is sustained, the more likely people are to make speculative bets on these trends due to their overconfidence that such excess will continue. This occurs thanks to three of humanity’s cognitive biases that explain the cyclical nature of the markets in the first place: the availability heuristic, herd behavior and the overconfidence effect. The availability heuristics states that when people are making a judgement, they tend to place irrationally heavy weighting on what has been happening in the most recent past. In other words, they are overly confident that what has been happening will continue to do so. Secondly, herd behavior stipulates that people will tend to mimic the actions of others, irrespective of the rationality of those other peoples’ actions. Finally, people are systematically overconfident in their knowledge and ability to predict the future.[17] These three cognitive biases combine to make us overly confident that monetary inflation will continue as it has been and make us overly confident in our ability to outmaneuver our peers. We thus place correspondingly overly confident bets with our money.

Monetary inflation mixed with the three cognitive biases above turn debt cycles into a sort of pyramid scheme based on bets on inflation. The cycle starts in the recovery phase when inflation is low, the economy is performing below its potential and the stock market is generally undervalued. Those who place long bets early in the upward portion of the cycle are ‘proven right’ in a quasi-sensical kind of way, because their confidence depended not just on the fact that the real economic reality was improving but also that others would follow along into believing that the nominal one would continue increasing at that rate indefinitely. As inflation and the economy continue to build, participants make increasingly speculative investments and even borrow to finance those investments, operating according to their overconfidence that inflation will continue well into the future and that they will thus be able to appropriately service their debt. Even as the cycle matures and economic fundamentals begin to underscore the widening the disconnect between the real economic reality and the delusions of the nominal one, people continue gleefully flowing into speculative investments, because they are sure they will not be the last one standing.

Eventually, the unsustainability of that disconnect trickles up to the surface until it is undeniably clear that the disconnect does indeed exist. This ensures that there are always people left standing, duped by their cognitive biases into taking part in the excessive speculation enabled in part by monetary inflation. At this juncture, when the bubble pops, inflation declines abruptly, causing financial distress to those who borrowed under assumptions of continued inflation. Borrower incomes may prove insufficient to fully repay their loans, leading to rising borrower default rates which weakens the equity of those who lent money to the speculative borrowers. Because the lenders to the economy are ultimately banks and other financially systemic institutions, mass borrower defaults can directly threaten financial stability and engender crises if the financial distress is sufficiently endemic.

In addition to being the root lender to an economy filled with increasingly distressed borrowers, the banks’ troubles are further compounded by their reliance on deposits and thus the faith of the public for their funding. The public maintains their deposits in a bank only as long as they are confident the bank is solvent. Any cracks to this confidence can lead individual depositors to retrieve their savings from the banks’ vaults. When depositor loss of confidence occurs in mass, the ensuing bank run can push the bank itself into financial distress and thenceforth into bankruptcy. Such losses of confidence can be triggered by the public’s perception of declines in asset values, disinflation, rising default rates, or other signs of danger ahead. The fact that it is up to the public’s perception underscores the problem of information asymmetry as it relates to bank runs. The public does not have direct insight into the banks’ financial health. They are left to extrapolate what they see in the news with regards to market conditions to their specific bank and make their best guess as to whether or not their savings are safe. This information asymmetry and the resulting guessing game leads to runs on banks that would otherwise be solvent. In times of economic turmoil, banks are thus vulnerable from both sides of their balance sheet: their loans and their deposits.

This section relies upon the definition of sound money detailed above: that its high-to-flow ratio and separation from political influence ensures its maintenance of value across time. Similarly, it assumes that on top of that sound monetary base, one has a fully decentralized price mechanism allowing the free flow of information throughout the economy. These two things allow better allocation of resources and more prudent investment decision-making in the shorter terms, and lengthens the time horizon of participants of such an economy, meaning they save and invest money while taking on less debt.

Note that these two things do not cast away the possibility for inflation. They do, however, ensure that massive, unpredictable changes in inflation do not occur, that they instead have a fairly low upper bound, and that any deviations in inflation from the underlying monetary base growth are instantly transmitted throughout the economy via the pricing mechanism. Moreover, it ensures that inflation is not the cause of monetary control by a central planner, which can ultimately only tend to confuse the workings of the pricing mechanism.

Long-Term Implications of Sound Money for Capital Markets from the Perspective of Individual Consumers and Corporations

Sound money increases the time horizon of those who use it because the certainty that their money will maintain its value across extensive timeframes, no matter what events transpire in the meantime. Moreover, this certainty that the money’s supply will not be radically expanded rests solidly on objective sets of laws that are physically impossible to break, no matter the incentive to do so. This compares to leaving one’s lifetime savings in the hands of a corporation or government, trusting wholeheartedly and faithfully that those institutions will keep the promises they made – or even the promises made by those before them – despite the fact that it is directly in their incentive to take action that is easily within their means to break those promises. No wonder that people using a money whose soundness is based on the unbiased, objective guarantees of nature as opposed to promises made by corporate managers or politicians tend to plan longer into their financial future. In other words, the increased certainty of the financial future allows people to think about and plan for that future more.

The first corollary of the lengthening of people’s time horizons is their likelihood to save far more for their future. The stability of their currency’s purchasing power fills them with the confidence that their savings will predictably maintain a positive real growth rate and they will be able to earn the entirety of their desired real return on their investments. The dual certainties these citizens have that their savings will steadily appreciate at the full rate of their desired real return and that those accumulated savings will not be suddenly squandered away due to decisions made by others explains why societies based on sound moneys have far higher savings rates. Indeed, before the gold standard was officially abandoned in 1971, the average savings rates of the seven largest advanced economies was approximately 13%. Following that final and official severance of their currency from any underlying hard money, these economies saw their citizens’ savings rates plummet. The savings rates of these now fiat-based economies sunk to levels as low as 2-3%, and in some cases even negative savings rates. The U.S. is a perfect example, with its savings rates falling from 12-15% in 1970 to as low as 2.5% in 2005. Since 2015, it has stabilized at around 7%. Though meaningfully higher than the low of 2.5%, 7% is still half of what it was prior to the official decoupling from gold and lower than it had reached at any point prior to that moment. This is plotted in Chart 14.

Chart 14

Saving rates’ and investment rates’ relationship to the hardness of the underlying money can be likened to home development’s relationship to property rights. Lacking guaranteed ownership over the future of their homes, citizens in countries with dismal property rights refuse to invest in their homes because they understand that whatever progress that yields can be confiscated or otherwise neglected. Similarly, lacking guaranteed ownership over the future of their money, citizens in countries with governments instituting easy monetary policies do not invest in their future because they understand that whatever progress that yields can be squandered by their government.

The harder a nation’s currency is, the longer the individual actors using that currency can extend their time horizons. The hardness of the dollar had been steadily deteriorating well before Nixon officially de-pegged it from gold – hence the reason for its de-pegging in the first place. The last time the US or any country for that matter had a truly hard money was 1914, when the global gold standard began to unravel. Though data explicitly detailing saving rates does not extend that far back, there are other ways to estimate it in order to understand how the era of supreme global monetary hardness impacted saving rates. Indeed, the 19th century exhibited the highest number of inventions per capita of any century. Note that to qualify as an invention, it must be an entirely new product or concept. PayPal’s founder, Peter Theil, would describe this phenomenon of creating something entirely new as transitioning from zero to one. Moving from one to many would mark progressive iterations or improvements on those initial inventions. For example, while the yearly iterations on the iPhone are certainly positive improvements, they are incremental. The invention of the phone itself can be traced back to 1875. This period displayed such disproportionate rates of invention in no small part because the potential reward for spending decades researching and developing the technology would not be gnawed at by inflation. That reward would remain steady, because the purchasing power of the currency it would be paid in would remain steady.

By the second side of the same coin, the certainty of the stability in the purchasing power of money encourages limited borrowing. Without the benefit of inflation, debtors are forced to repay their debts in their entirety, with the only alternative being declaring bankruptcy. Hard money thereby enforces cold, hard accountability for those who over-borrow. This concept is articulated well by Dr. Saifedean Ammous in the following piece:

It is first important to understand the distinction between loanable funds and actual capital goods. In a free market economy with sound money, savers have to defer consumption in order to save. Money that is deposited in a bank as savings is money taken away from consumption by people who are delaying the gratification that consumption could give them in order to gain more gratification in the future. The exact amount of savings becomes the exact amount of loanable funds available for producers to borrow. The availability of capital goods is inextricably linked to the reduction of consumption.[18]

This rigidity does not bode terribly well with voters. People do not want to decrease their current consumption in order to save for their future. This is where central banks step in, offering a helping hand to make that fantasy a reality, at least for now. Since inception, the Fed has been wildly successful at obscuring the linkage between the loanable funds available and aggregate savings. Its goal has generally been to spur economic growth, bolster employment rates and increase consumption.

Attempting to make these objectives come true irrespective of the macroeconomic environment can only be achieved via money printing and artificially low interest rates. Businesses exploit these artificially low interest rates by taking on more debt to initiate new projects than they otherwise would. However, this heightened appetite for debt is not financed as it would be in the absence of monetary manipulation; it is not financed by corresponding rises in savings achieved via deferrals of aggregated short-term consumption rates. Instead, in the presence of monetary manipulation, this artificially large debt-load is financed by the Fed creating new pieces of paper or the digital equivalent. There are no free lunches. If the population saves less (which it has been, as seen above), there is less capital available for investors. It is that simple. Printing more paper to make up for the lack of savings does not magically mean that deficiency did not exist in the first place. It means that the population is being non-consensually taxed in a regressive manner and its legal tender devalued to make up for an economic disconnect that the Fed itself created via its monetary manipulation.

Unsound money makes such government meddling with the economic engine possible in the short-term. This artificially cheap financing is actually the primary driver of the short-term debt cycle. At the beginning, producers are deceived by the excess money available. They believe it is truly more capital ready to invest, not a higher quantity of pieces of paper fresh off the printing press. This deludes the producers into the confidence that they will have secured an investment sufficient to allow them to buy all the capital goods they need for their production process. Ammous continues this line of thought with the following excellently articulated explanation of what happens next:

As more and more producers are bidding for fewer capital goods and resources than they expect there to be, the natural outcome is a rise in the price of the capital goods during the production process. This is the point at which the manipulation is exposed, leading to the simultaneous collapse of several capital investments which suddenly become unprofitable at the new capital good prices; these projects are what Mises termed malinvestments — investments that would not have been undertaken without the distortions in the capital market and whose completion is not possible once the misallocations are exposed. The central bank's intervention in the capital market allows for more projects to be undertaken because of the distortion of prices that causes investors to miscalculate, but the central bank's intervention cannot increase the amount of actual capital available. So, these extra projects are not completed and become an unnecessary waste of capital. The suspension of these projects at the same time causes a rise in unemployment across the economy.[19]

The sudden exposure of malinvestments economy-wide did not only cause national unemployment to spike. It also ensured that those who borrowed earlier in the cycle believing that the low interest rates they initially saw were emblematic of strong economic fundamentals instead of simple money printing realize at the cycle’s end that they could no longer afford to service their debt. They come to the unfortunate realization that their investment was one of the many malinvestments. These inappropriately-originated loans become increasingly delinquent. Defaults rise initially in pockets and then spread virally until the defaulted debt too becomes systemic. This is the point of the debt cycle known as the recession. It is the moment when the Fed’s magic trick is exposed for what it truly is: mere sleight of hand.

Sleight of hand is not possible in hard money economies even in theory. To compare apples to apples, let us return to the previous case where interests rates are forced to artificially low levels. In a regime with unbounded, easy money, the shortage in savings is swiftly filled by the Fed’s newly printed money. But, in a regime with hard money that has objective, physical bounds restricting any meaningful money printing, filling the shortage in savings that way is infeasible. It must exist on its own, as it truly is. The remedy to this void in the case of hard money economies is the natural, automatic workings of the free-market economy. The lack of savings is reflected by the dearth of capital available for borrowers, which causes the interest rates to rise. This heightened interest rate in turn decreases demand for borrowing and increases the supply of savings until the two achieve equilibrium.

IV.          Conclusion

This paper sought to understand the relationship between the underlying monetary base and the broader economy. In order to do so, it needed to work out several different intermediate links in the chain. It first investigated the two generalized buckets that the monetary base can fall into: easy money and hard money. The main realization from that study was that the producers of any good used as money that has a malleable supply will invariably take advantage of that fact to their direct benefit, but ultimately not to the long-term benefit of the rest of the economy. This discussion of the workings of the monetary base itself lent the foundation for the understanding of how the monetary base then flows through to price level changes and the rest of the macro economy. This too needed to be broken down into discrete steps to begin to be comprehended. First, it explored the relationship between the money supply and price levels to understand if and how the two are connected. It turns out that, for several reasons, the two do not follow one another step-in-step in the short-term. However, the longer a time horizon one adopts, the clearer the relationship becomes. While the topic of prices was on the mind, the essay delved into considerable detail on what exactly prices are, what purpose they serve and how they relate to the economy as a whole. This fostered an understanding of the crucial importance of an accurate and free-flowing pricing mechanism to solving the fundamental problem of economics: allocating scarce resources efficiently in a world where information is dispersed amongst every actor. This knowledge of what exactly prices are was a pre-requisite for understanding both the short- and long-term implications of sound money and accurate prices. These topics were discussed both from the perspective of the individual person and corporation and were applied to both the capital goods and capital markets.

Understanding how monetary policy and the economy are linked has never been more important to the world’s population than the current day. Monetary policymakers around the world have been relentlessly printing money for a century now. The effects of such near-sighted actions have taken center-stage in the last ten years. Everywhere one looks, the zero-lower-bound has been approached or passed; fiscal debt has piled up to previously unfathomable levels and is being increasingly monetized by increasingly easy monetary policy; three different kinds of quantitative easy have been experimented with, when a decade ago that term had never been used on any meaningful scale; and, throughout all of this, the policymakers have assured their populations the same, heavily-worn slogan: “This Time is Different.”

The U.S.’s leadership assures its populous that this time, it is equipped to ensure that 2008 will never happen again. It even seems to have convinced itself that it can prevent any recession from happening again, so long as it keeps its hand on the throttle of the printing press. It certainly managed to do that. The Fed increased the money supply by 20% last year. Think about that statement for a second. There are now 20% more dollars out there than had existed in the United States’ 245-year history, combined. He insists that the new money created by these securities in combination with the 20% increase in money supply last year should not be of inflationary concern. He insists that the economy has sound fundamentals. In sum, he insists that this time is different.

Unfortunately for the U.S. and global citizenry alike, this time is no different than the last 100 years. The money printing seen around the world today will flow directly into already inflated financial assets, helping the rich get richer while hurting the working class and the poor on a relative basis. The already historical asset bubble will continue to be pumped with air by the policies of the Fed; eventually, the true, underlying economic reality will catch up with that artificially-created “economic boom”; and, sadly enough, the common American will once again pay the bill for the Fed’s short-sighted, ill-formed policies, while the rich collect their capital gains.

However, the author of this essay, hinging upon some hard-to-quantify mix of countless hours of research and hopeful optimism, genuinely believes that some time relatively soon in the future, it will all be different. The reasoning for this hypothesis will be detailed in essays to come. What can be committed to paper at this moment is the following core concept underlying the author’s reasoning: appearance cannot deceive reality forever.

The monetary policy seen today can be traced back to the end of the Great Depression nearly 90 years ago. That launched the start of the long-term debt cycle that typically lasts 80-100 years that we currently find ourselves at the tail-end of. The hallmarks symptoms of being at such a point are the types of headlines that you see in the news daily: insurmountable debt buildup, weak inflation-adjusted economic growth, interest rates perennially stuck at zero percent, etc. These are all the signs that, time and time again throughout human history, have preceded reality resurfacing in such a powerful way so as to force the fundamental restructuring of the global monetary system from the ground up. So, while, the 20th Century taught the world the necessity of capitalism and decentralized pricing for capital goods markets, the 21st Century will provide a dramatic lesson on the necessity of sound money and decentralized pricing for capital markets. In no more than a few decades, this time really will be different.


[1] Butcher, “Debasement and Decline of Rome.”

[2] Mises, “The Theory of Money and Credit”

[3] Thomas Jefferson, et al, “Declaration of Independence.”

[4] Ammous, “The Bitcoin Standard,” 5.

[5] Ibid, 24.

[6] Friedman and Schwartz, “A Monetary History of the United States,” 387.

[7] Williams, “Monetary Policy, Money, and Inflation”


[9] Benati, Luca. “Long-Run Evidence on Money Growth and Inflation,” 2.

[10] This upward march appears to start at approximately the 0.05 mark, denoting 5-year time spans. This observation that money growth becomes an increasingly reliable correlator with inflation at time-spans of five years or longer does not yet have predictive value. For one, at the 5-year mark, this same graph shows the correlation being negative. It does not become positive until around 7-8 years, and does not explain more than 30% of the variance of inflation until year 10. Thus, the strength and trend of correlations over varying time spans is an area requiring further academic study.

[11] Hayek, “The Use of Knowledge in Society,” 2

[12] However, note that even assuming that a suitably-chosen group of experts is theoretically superior at determining the answer to a problem, that only shifts the difficulty of the problem to reliably choosing that “suitably-chosen” group. [13] In fact, the current moment displays the highest rate of dysfunction of those laws in decades if not centuries

[14] Von Mises, Socialism: An Economic and Sociological Analysis, 216

[15] Ammous, 108.

[16] Bordo, “Price Stability and Financial Stability,” 18.

[17] There are extensive studies demonstrating all of these effects. One particularly entertaining example is of our overconfidence bias: 64% of Americans describe themselves as “excellent” or “very good” drivers. Do you? Not only is it impossible by definition for 2/3rd of people to be above average, it is nearly laughable for 2/3rd of people to deem themselves exceptionally far above average. This exuberant self-affirmation can be juxtaposed by peoples’ feelings about others. They judge their friends to be, on average, half as likely as themselves to be “excellent” or “very good” drivers and are similarly pessimistic about peers in their age group, giving those groups ratings of 29% and 22% respectively.

[18] Ammous, 113.

[19] Ibid, 115.


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