02 February 2010

On Monetary Inflation and M3

From a chatboard frequented on the occasional break from the kitchen.

Q. A Question for the Inflationists

"The government no longer tracks M3 because of its expense to generate (yeah, right) but private groups still do and it has basically fallen since the stock market entered its bear market a couple of years back. So by definition, do we have inflation or deflation? Gold driven to new highs could be more about gold fever than real inflation."

I usually try to avoid conversations that start this way, with a label and a challenge, since it generally implies an exchange of what are more like religious beliefs, from the opposing 'isms.' As an monetary agnostic, I am usually in the middle of two groups with ardently held beliefs, and a range of impassioned arguments, good and bad. But knowing the person who asked it, I think it is a sincere question, and so here is my answer, for what it is worth.

Within a relatively pure fiat currency system the conditions of inflation and deflation, and the broad range in between, are largely the result policy and fiscal decisions, constrained for the most part only by the acceptability of the bond and the dollar and the tolerance of the people.

Regarding M3, it is the eurodollar component that is primarily missing, and Williams and my friend Bart estimate it. I have discussed the difficulty of that and their specific methods with them. I estimate the eurodollar s well, from the BIS and TIC reports, for another reason. It is my measure of dollar demand from overseas, the sole cause of the last dollar rally that was sustained, the eurodollar short squeeze. But one can look at MZM or M2 and see the same trends essentially. Money Supply: A Primer

Money supply alone is not the sufficient to measure monetary inflation or deflation. That is like asking if someone is overweight, if they weigh XX pounds, without specifying their height. Are they four feet or six feet tall? One meter or two meters? It obviously matters.

The measure of monetary inflation is by definition money supply in relation to something else. If nothing else, to population growth or decline, one might imagine, even if one cannot measure economic vitality, or stagnation. As an aside, it is a curious fact of history that the Plagues decimated the people of Europe, but hard wealth and the land remained. So the survivors were richer per capita, helping to create the relief and ebullience that sparked the Renaissance.

Money supply is relative to demand, and potential money supply to potential demand. Even though money supply may not be growing, demand may be contracting faster than it is not growing. If one looks at GDP, and the Velocity of Money which is nothing more than GDP divided by some nominal measure of defined money, domestic demand is slack. And from non-domestic sources, demand for the dollar reserve currency is weaker than in years past.

But there is a funny thing about potential money supply. It can grow quietly in assets, stored in investments and other less repositories of value, and then spring into action relatively more quickly, when wealth is converted to money, the medium of exchange.

Money as the medium of exchange, the note of zero duration, is a very imperfect store of wealth, when real short term rates of return are negative. So the market does not value it, except perhaps for the daily needs, diminished, and a safe haven from unknown risk, and a refuge from bonds of longer duration whose returns may be even worse.

Monetary inflation is deceptively simple, and immensely more complicated than the average person can allow, and the pundit will admit.

Credit is not money. Debt is not money. They are methods of creation of money, of financing the money used in an enterprise.

Money is the exchange, wealth in action, the others potential for transactions. Money bridges the gap between stores of supply and stores of wealth. Money moves, and goods and wealth are exchanged, and then stored again. Money supply is a snapshot of a dynamic process.

Credit/debt destruction are the preoccupation for the deflationary camp. Yes, they are important sources for the creation of money, over which the central bank exercises a remarkable degree of control, despite their occasional and highly disingenuous denials. As credit is destroyed, by writeoffs for example, potential sources of money are negated. But the real question is, what other mechanism for the creation of money remain, perhaps methods that have not been recently used, because they did not need to be used.

One very fine example of this is the method by which the Bernanke Fed expanded its monetary base, to a degree not seen since 1933. The monetary base is high powered money, because it is supposed to represent a pure financial asset, zero risk. Certainly more leveragable than a collaterized debt obligations. The Fed's balance sheet, and the Treasury's ability to issue sovereign debt based on that balance sheet, are the sorcerer's stone. Touch even the most toxic assets with them, as most recently seen in the case of AIG and Goldman Sachs, and they are now worth 100 cents on the dollar.

Debt/credit are one means of financing the enterprise. There is also equity. But a wise person will look at the organically generated flows of wealth in valuing the shares. Are you consuming more than you are creating? What are the future prospects for this flow of wealth? If there is no prospect of net positive wealth creation, then you are living on borrowed time, in a castle of sand, no matter how good the accounting tricks you are using to hide it from the shareholders.

One might look an an unconnected car battery and say, 'oh look it is benign.' But grab hold of each of its terminals with your bare hands while grounded, and see what happens then. And gold is in part measuring that potential, for the Fed and the monetary base and a resurgent economy to generate monetary expansion. There are lags of years involved in the process.

And this is the nature of Bernanke's challenge. He must at some point allow the economy greater access to his excess monetary reserves, and the swollen monetary base, but try to prevent the dollar and the bond from igniting. And gold is where the prudent seek at least a partial refuge while the central bankers conduct their experiments.

Is gold a bubble? It is said to be so by those who wish you to extend your willing hands, and grasp the poles of their mad experiment, without reserve, to help them measure the effect. And, of course, by those who merely to stand by and watch, and plan for their own per capita increase in wealth if you are subsequently reduced to toast.

"The conscious and intelligent manipulation of the organized habits and opinions of the masses is an important element in democratic society. Those who manipulate this unseen mechanism of society constitute an invisible government which is the true ruling power of our country." Edward Bernays, Propaganda, P.37
It's about confidence, isn't it? And perception, and custom, as in habit. The acceptability of the dollar and the bond by the world is the limiting factor on the ability of the Fed and Treasury to create money, managing its supply, by whatever means direct and indirect, by action or allowance, in a fiat currency.