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What is Money?

Posted by Steve Markowitz on August 14, 2014

For some years conservative economists have voiced opinions that the easy money policies of the Federal Reserve and the increasing deficit spending by the United States will damage the economy. As the years pass and without clear connection between these policies and their costs or consequences, these calls have begun to sound more like the girl that cried wolf. However, unless one believes in perpetual motion or alchemy, there must be costs to policies that in essence print money.

Forbes Editor-in-Chief Steve Forbes has said of money:

Money is simply a tool that measures value, like a ruler measures length and a clock measures time. Just as changing the number of inches in a foot will not increase the building of houses or anything else, lowering the value of money will not create more wealth. The only way we will ever get a real recovery is through a return to trustworthy, sound money. And the best way to achieve that is with a gold standard: a dollar linked to gold.

While reasonable people can argue as to the merits of again linking the dollar to gold, it is hard to argue with Forbes’ common –sense definition of money being a measuring tool. Fiat currencies, those not tied to a commodity other than the printing press, are a promise that the currency will be worth something of value in the future for trade or commerce. It does not take a PhD in economics to realize that if the total amount of goods, services and demand remain constant while the money supply increases, that the value of money will decrease.

As a simplistic example, in an economy for which the only goods and services offered and that there is demand for is corn. In this example there are 100 bushels of corn produced each year and demand remains constant at 100 bushels annually. Finally, the total currency available to this society is $100. Under this scenario, the price of corn will be $100 divided by 100 bushels or one dollar bushel. If these assumptions remain unchanged, except the aggregate money supply increasing to $150, the price will increase to $1.50 per bushel, $150 divided by 100 bushels. This is an inflation rate of 50% for the year caused by the natural bid up of prices that will occur, the result of excess currency chasing limited supply.

So far the federal deficit and Fed’s easy money policies have not resulted in significant inflation. This is due to extraordinary economic events including: 1) outsourcing that has lowered the cost of labor to the developed world, 2) excessive production capacity due to significant increases, mainly in China, and 3) historically low cost of financing that has offset spending increases by the government and lowered various costs to private industry. However, none of these items are sustainable, which when the tide turns, has the potential to lead to significant inflation with little warning.

Few economists are currently predicting significant inflation in the near-term. However, significant economic changes are rarely predicted in advance by mainstream economists. We need look no further than their track record of not predicting the 2008 economic meltdown or the problems that the subprime mortgage market would cause the economy.

Bubbles and other non-sustainable economic events generally continue much longer than reasonable logic predicts. This reality leads to a hockey stick type trajectory towards the end of bubbles. Therefore, the best economists can do is to predict a low rate of inflation until inflation kicks in. Yikes and hold on!

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6 Responses to “What is Money?”

  1. There is little inflation because money was taken out of the economy when the U.S. residential housing market crashed. Trillions of losses were incurred by financial institutions that made mortgage loans to unqualified buyers. Now image going to the bank and borrowing $100 to buy corn but the bank says the price of corn keeps going up so I will lend you $200 to buy corn. The price of corn crashes to $50.00, the borrower gives the corn back to the bank. The bank just lost $150.00, the Fed prints money and loans it to the bank so depositors don’t lose their life savings.

    • Your comments add a bit more substance to my simplistic example. Now I will tried add to it.

      There is currently an advertisement running on TV with a retired US Adm. informing veterans that they have earned the right to get a government-backed mortgage for a house with no money down. That is a ticket to financial disaster for veterans and benefits the housing industry and the lenders, not the veteran. So the world turns

  2. What happens if you go to the bank to borrow $100 to buy corn. The banker says here is $200 because the price of corn is always going up. Everyone borrows money and the price of corn goes up. However, when the price falls to $50, the borrower walks away and the banker just lost money that belonged to savers. The Fed comes in and prints money to save the bank from going under.
    No inflation because money was distroyed. (U.S. housing market)

  3. It is my belief that the Fed has no choice but to continue printing money. Their irresponsible policies since the meltdown has made equity markets worldwide and other major portions of our economy addicted to this elixir. Pulling the plug on the dope will cause significant pain in many parts of society. While I personally believe this is necessary to correct the economic imbalances, I also understand it is politically unpalatable. No politician has ever gotten elected (or reelected) by offering painful solutions. No lobbyists pays to lower the income potential for their industry.

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