Classical Model

[jueco2005]

Quote from Ed Breen:

Jeuco, thanks for you comments. It does appear that you have read a few books and you know quite a lot. Your explanations are much better than your quips. I agree with much of what you assert. I am well versed in the Austrians, currently reading Schumpeter (Who is not an Austrian) and I am well versed in the Keynesian-Monetarists, the Monetarists and I know most of the important supply siders, the real ones, not the politicians. I understand inflation real well. I get it in three dimensions. That is why I can tell we are not having it now.

I have explained enough of what I think above and we are talking past each other, so I'm not going to explain anymore unless you ask me a question.

I would like to ask you a question. It really surprises me that you do not see inflation happening now.

So far the fed has been pumping new massive amount of money into the system. That is inflation. Sooner or later we will see this new money creating inflation or assent inflation in some places. Look at the volatility of commodities.

It takes time for newly created money to find its way into the system to fully flow. We see inflation when money is created not after it materializes.

Thanks for your time and attention my friend.

 

[Ed Breen]

Jueco, sorry I did not respond sooner; I have been travelling.

You define inflation as the simple increase of base money supply. I am saying that is not a good enough, not a useful definition. In the Freidman sense, and most schools accept Freidnman's monetarism on this point of the Quantity Theory of Money, the increase in base money, beyond the demand for base money, is supposed to cause and increase in the general price index...as it will produce a condition of 'too much money chasing too few goods.' During the period of time since 2008 until now we have dramatically inceased base money in an unprecedented way and yet the promised increase in general prices has not occured.

You admit that it takes time for the flood of base money to enter the 'system' and produce the promised effect. This is analogous to the claim that 'monetary policy works with an undeterminant lag'. The resort to 'undeterminant lag' is the same thing is saying 'I don't know how it works; I don't know when it will work; but if something does happen at any time, I going to take credit for it. You can't really be intellectually honest and claim there is a lag associated with you policy that you cannot explain or predict.

You say the fed is flooding the 'system' with 'money'. I am asking you to think about what the 'system' is and what 'money' is.


So, for me inflation is inflation if it causes prices of all goods and service to rise according to their price elasticitiy, which for me is related to the nature and network of long term contracts in the particuar economy in queston. If base money expands and the general price index does not rise then I cannot say there is inflation just becuae base money increased. Observing that this is what has happened in the past three years has casued me to admit that the The Quantity Theory of Money' as commonly understood, does not work.

The question then becomes why doesn't it work and how does non supply demand driven price increase, true monetary inflation increase, enter the real economy? Here we have to understand what the 'system' is. We have the public aggregate bankinig system that is little understood by academic economist and is really the domain of the finance schools. That is a different, but related system, from the larger economy that includes production, distribution and the transactions in goods and services that financing relates to. I acknowledge that base money has been increased but I notice that it has remained withing the public aggregate banking system and it has not produced the sought for effect in the larger economy generally.

I think the reason for this is that for monetary inflation to manifest as general price increase there has to be a transmissioin mechanism. This transmissim mechanism is private credit expansion. Monetarists assume that the credit expansion occurs simply becuase the base money is increased. In practice that is not what happens. Private credit increases only when micro individual actors demand credit. This demand for credit is not driven by the supply of base money or by the rate of interest (these factors can effect the rate of private credit formation only when private credit is already expanding for other reasons). On the micro level the demand for credit is driven by an entrepreneural view of the future that includes the estimation by an individual actor that his average weighted cost of capital is less than the risk adjusted spread between his estimated net profit after tax. Where the view of the future is negative or uncertain the risk adjustment estimation of the spread is so large that individual actors choose to wait. The decision not to invest is not driven by interest rate or base moeny in the banking system.

Understand that the point of entrepreneural investment is to create or maintain assets ('assets' being the possessive right to a future income stream). So, the decision not to invest in the creation or maintenance of 'assets' is the decission that the futue cash flow or the possesive right to that cash flow is likely to be lower than than the present value of existing capital or cost of debt.

A way to recognize whether inflation or deflation is taking place is to look at aggregate capital flow. In an inflation capital flows out of financial assets and into tangible assets through the expansion of private credit that includes an increase in leverage ratios on collateral assets. In a deflation capital flows out of tangible assets as leverage ratios decline and private credit contracts and into short term reservoirs of liquidity (a.k.a. 'money'). What we have been seeing in the past three years is a flow of capital out of collateral assets and into liquidity. The financial market of the past couple years can be a seen as a global search for 'money'.

I hope this helps you understand how I look at inflation. There is much more I could say about it but I think this is enough for one post on a discussion page. If you have any follow questions please let me know.

 

[jueco2005]

No problem Ed.

Wow you and I really see things very very different. Here are some key economic principles of mine

1- Inflation is creation of money not backed by anything. Money out of thin air.

2- Money is just anything serving as a medium of exchange. All other uses of money are secondary and not important. Medium of exchange is the keyword.

3- Fractional Reserve lending practices is what leads to risks of severe contraction and expansion in the supply of credit. This credit or new money creation takes form of debt. When inflated too much everyone is full of it and unable to get out. The ultimate global bubble is a debt bubble.

4-Central Banks exists with the only purpose to ensure banks existence under Fractional reserve lending.

5-This economic crisis proved that the banking industry failed, it collapsed and is being artificially sustained by new money being created at the expense of us. Remember too big to fail??? All ships can sink.

There has been a massive inflation being created in the last few years by the fed. You can see it in price increases but it is obviously more evident when you look at banks balance sheets and cash reserves all over.

Banks are full of cash, business need credit and interest rates are at record lows. According to mainstream economic thought this is the perfect recipe for a recovery to take place; being accompanying with fiscal spending.

So?? What is preventing it from happening??

The ultimate bubble my friend. Debt every where.

 

[DontMissTheBus]

I'll reply in the quotes with [*] in front - since it's easier than breaking up your points to separate quote blocks.

Quote from jueco2005:


Wow you and I really see things very very different. Here are some key economic principles of mine

1- Inflation is creation of money not backed by anything. Money out of thin air.

* But there can be inflation with money backed by gold or silver. The spanish empire saw quite a bit of this when all the gold from the new world was added to circulation. So it's quite wrong to say inflation is defined as "creation of money not backed by anything"

2- Money is just anything serving as a medium of exchange. All other uses of money are secondary and not important. Medium of exchange is the keyword.

* So money as Store of Value is a secondary characteristics? All the usual services of money are necessary, not sufficient conditions of being money.

3- Fractional Reserve lending practices is what leads to risks of severe contraction and expansion in the supply of credit. This credit or new money creation takes form of debt. When inflated too much everyone is full of it and unable to get out. The ultimate global bubble is a debt bubble.

* On the other hand, a 100% reserve requirement means absolutely no lending, which means worthwhile business ventures can't be financed, which means sluggish economic growth for everyone

4-Central Banks exists with the only purpose to ensure banks existence under Fractional reserve lending.

* This is clearly wrong. Central banks exist also to exact monetary policy, which is almost to 'ensure existence'.

5-This economic crisis proved that the banking industry failed, it collapsed and is being artificially sustained by new money being created at the expense of us. Remember too big to fail??? All ships can sink.

* Okay. But there's been banking/debt crisis since the Roman days. In fact, they are less frequent now than in the 19th century

There has been a massive inflation being created in the last few years by the fed. You can see it in price increases but it is obviously more evident when you look at banks balance sheets and cash reserves all over.

* I think we differ on what "massive inflation" is. Prices of food/gas has gone up (I'll use those instead of CPI-Core, since we all care about food/fuel). But certainly not catastrophically so. You had to bring in 'banks balance sheets' (no, it's not inflation no matter how you define it) to make your point.

Banks are full of cash, business need credit and interest rates are at record lows. According to mainstream economic thought this is the perfect recipe for a recovery to take place; being accompanying with fiscal spending.

* Meanwhile we are seeing a lot of fiscal contraction from austerity, budget cuts, and uncertain regulatory regimes

So?? What is preventing it from happening??

The ultimate bubble my friend. Debt every where.

 

[jueco2005]

Quote from DontMissTheBus:

I'll reply in the quotes with [*] in front - since it's easier than breaking up your points to separate quote blocks.

I disagree with you in every point. We share different ways and understanding about economics.

Thank you anyways for sharing your thoughts

 

[DontMissTheBus]

Clearly. But I like to know why you disagree with my views on the first point, since it appears to me to be one that's really hard to dispute given we have actual historical observations.

Specifically, you claim inflation is a result of money not being backed by anything. I pointed out that this can't be true since money backed by gold and silver are also subject to inflation. Why am I wrong? This is independent of our 'understanding' about economics.

"But there can be inflation with money backed by gold or silver. The spanish empire saw quite a bit of this when all the gold from the new world was added to circulation. So it's quite wrong to say inflation is defined as "creation of money not backed by anything"

Quote from jueco2005:

I disagree with you in every point. We share different ways and understanding about economics.

Thank you anyways for sharing your thoughts

 

[Ed Breen]

Jueco, I offered you a much deeper analysis than what you are giving back. I read your comments as hard money psuedo austrian sloganeering. You don't make any real argument; you simply make unsupported assertions, some of which are obviously false as has been pointed out. It does not appear that you have done a serious examination of these slogans to see how they work in the details, what predictions they can support, how the ideas actually operate in finance.

Take your newly offered definition of inflation as being the creation of money that is not backed by anything. The dollar hasn't been backed by anything since the 1970's and even before that there was inflation...you don't have to go back to Spain's pillage of the Inca's to see that.

But even this is beside the point if you properly understand money. Sure money serves as a medium of exchange and that is important, but that is only one aspect of money. In its most fundamental nature...'money' IS debt, paper money is a form of credit. A dollar bill is the non interest bearing debt of the U.S. government. Look at a dollar bill, see that it says "Federal Reserve Note" right on its face. When the Fed creates these notes it records a 'liability' on its balance sheet. The dollar is but one extreme of a continuum of debt types issued by our Federal Government. You start with non interest bearing dollar bills and you move out the yield curve to 30 year Treasury Bonds. They are all government debt. We use government debt as our medium of exchange. Money is government debt.

It used to be that the government issue of money debt was collateralized with gold or silver. Presently, it is uncollateralized. What some like to call 'fiat money' is simply unsecured promisory note non interest bearing debt issued by the Government.

As interest rates have collapsed the distinction on the yeild curve between dollar reserve notes and treasury bills and notes has been blurred. The yield on 1 month, 2 month, 6 month and even 1 yr Treasuries is now insignicant. All these bills and notes are trading as 'money.' With interest rates so low there is no lost income in holding or carrying gold or some other metal as a store of value that is liquid. The issue has become liquidity in a time of uncertainty and metal, notes bills, even the 10 year Treasury are all being used as 'money', only becuae they are perceived as 'liquid'.

Now, when the dollar is not collateralized, it is backed by the credit worthiness of the U.S. Government. All sovereign money is only as good as the credit worthiness of the Sovereign. Currencies fali when a sovereign can no longer sell its longer term interest bearing debts in the interenational market. The dollar note debt is backed by Treasury debt. The dollar is only valuable becuase we believe that the Treasury will still be able to issue new debt and private actors will buy that debt. In that way the dollar, as debt, is based on the expectation that credit will continue to be available to the sovereign issuer. In that way money at its most fundamental basis is really the expectation that credit will be available.

You go on to complain that banks are full of cash. You need to understand that 'cash' is a liability to a bank....and loans are bank assets. It does Banks no good to have a lot of cash that no one wants to borrow. They have to reserve against cash and it does not count as part of their capital. In fact the amount of cash they are allowed to accept is limited by thier capital. If you want to talk about bank balance sheets you need to get this straight. The issue with bank balance sheets is the form and nature of thier regulatory capital and the quality of thier assets not the cash liabilty.

I explained above why banks are not able to make loans...its about the micro actor's concensus view of the future which is a fiscal context problem, not a problem that can be fixed with monetary minipulations.

When you think about the Quantity Theory of Money, think about is from the point of view that 'money' is credit. Consider that 'money velocity' is really the rate of private credit formation. Consider what has happened to the supply of 'credit' and 'credit formation' since the financial crises of 2008.

You need to think deeper about these issues below your sloganeering if you want to be able to use any of these insights.

 

[jueco2005]

Quote from DontMissTheBus:

Clearly. But I like to know why you disagree with my views on the first point, since it appears to me to be one that's really hard to dispute given we have actual historical observations.

Specifically, you claim inflation is a result of money not being backed by anything. I pointed out that this can't be true since money backed by gold and silver are also subject to inflation. Why am I wrong? This is independent of our 'understanding' about economics.

"But there can be inflation with money backed by gold or silver. The spanish empire saw quite a bit of this when all the gold from the new world was added to circulation. So it's quite wrong to say inflation is defined as "creation of money not backed by anything"

Money is anything used as a medium of exchange. All other uses as I said before are secondary. The best uses of money are those commodities highly acceptable by most players in a society. Gold, silver, tobacco, salt and many other minerals have serve as money for many years in human history without any problem.

The value of such money is therefore a supply and demand one. You mine more gold??? Its value goes down respectively with other commodities. Today’s fiat currency has not substitute. You can only see its value decline or rise with respect to other currencies (fiats as well) and this is not a good indicator of which currency is doing better.

At the end the best forms of money are those who win their place in the market place. You point the case of Spain when they mined the hell out of south America. Sure it is a valid one yet you can see how paper money is different than real money. A rapid increase in either can create inflation but with gold and silver it was different.

Had Spain just printed paper money it would have created just inflation and virtually no benefit from it. But gold and silver being highly demanded all over the world enabled Spain to run a trade deficit and enjoy a higher standard of living. There was an old saying going like this “Spain can’t run without the products of the world and the world can’t run without Spain money”. Regardless of this massive new gold and silver its value was determined in the market place and created much more good. Relatively low inflation when the markets adjusted to its value.

 

[DontMissTheBus]

I think you don't realize that Spain saw cripplingly high inflation when Inca gold came flowing into the monetary system. It's no different from printing fiat money. It was not exactly "Relatively low inflation when the markets adjusted to its value".

Further, I don't think you quite appreciate the utterly aweful deflationary crisis brought on by metal-based currencies that were prevalent up until the 20th century. I think this is a result that your knowledge of economic history extends back perhaps no more than 30 years.

I don't really think you understand the role of money (be it fiat or metal backed) in an economy. As such, you hold on to some very common, but completely inaccurate views that are entirely inconsistent within itself.

Quote from jueco2005:



Had Spain just printed paper money it would have created just inflation and virtually no benefit from it. But gold and silver being highly demanded all over the world enabled Spain to run a trade deficit and enjoy a higher standard of living. There was an old saying going like this “Spain can’t run without the products of the world and the world can’t run without Spain money”. Regardless of this massive new gold and silver its value was determined in the market place and created much more good. Relatively low inflation when the markets adjusted to its value.

 

[jueco2005]

Quote from Ed Breen:

Jueco, I offered you a much deeper analysis than what you are giving back. I read your comments as hard money psuedo austrian sloganeering. You don't make any real argument; you simply make unsupported assertions, some of which are obviously false as has been pointed out. It does not appear that you have done a serious examination of these slogans to see how they work in the details, what predictions they can support, how the ideas actually operate in finance.

Take your newly offered definition of inflation as being the creation of money that is not backed by anything. The dollar hasn't been backed by anything since the 1970's and even before that there was inflation...you don't have to go back to Spain's pillage of the Inca's to see that.

But even this is beside the point if you properly understand money. Sure money serves as a medium of exchange and that is important, but that is only one aspect of money. In its most fundamental nature...'money' IS debt, paper money is a form of credit. A dollar bill is the non interest bearing debt of the U.S. government. Look at a dollar bill, see that it says "Federal Reserve Note" right on its face. When the Fed creates these notes it records a 'liability' on its balance sheet. The dollar is but one extreme of a continuum of debt types issued by our Federal Government. You start with non interest bearing dollar bills and you move out the yield curve to 30 year Treasury Bonds. They are all government debt. We use government debt as our medium of exchange. Money is government debt.

It used to be that the government issue of money debt was collateralized with gold or silver. Presently, it is uncollateralized. What some like to call 'fiat money' is simply unsecured promisory note non interest bearing debt issued by the Government.

As interest rates have collapsed the distinction on the yeild curve between dollar reserve notes and treasury bills and notes has been blurred. The yield on 1 month, 2 month, 6 month and even 1 yr Treasuries is now insignicant. All these bills and notes are trading as 'money.' With interest rates so low there is no lost income in holding or carrying gold or some other metal as a store of value that is liquid. The issue has become liquidity in a time of uncertainty and metal, notes bills, even the 10 year Treasury are all being used as 'money', only becuae they are perceived as 'liquid'.

Now, when the dollar is not collateralized, it is backed by the credit worthiness of the U.S. Government. All sovereign money is only as good as the credit worthiness of the Sovereign. Currencies fali when a sovereign can no longer sell its longer term interest bearing debts in the interenational market. The dollar note debt is backed by Treasury debt. The dollar is only valuable becuase we believe that the Treasury will still be able to issue new debt and private actors will buy that debt. In that way the dollar, as debt, is based on the expectation that credit will continue to be available to the sovereign issuer. In that way money at its most fundamental basis is really the expectation that credit will be available.

You go on to complain that banks are full of cash. You need to understand that 'cash' is a liability to a bank....and loans are bank assets. It does Banks no good to have a lot of cash that no one wants to borrow. They have to reserve against cash and it does not count as part of their capital. In fact the amount of cash they are allowed to accept is limited by thier capital. If you want to talk about bank balance sheets you need to get this straight. The issue with bank balance sheets is the form and nature of thier regulatory capital and the quality of thier assets not the cash liabilty.

I explained above why banks are not able to make loans...its about the micro actor's concensus view of the future which is a fiscal context problem, not a problem that can be fixed with monetary minipulations.

When you think about the Quantity Theory of Money, think about is from the point of view that 'money' is credit. Consider that 'money velocity' is really the rate of private credit formation. Consider what has happened to the supply of 'credit' and 'credit formation' since the financial crises of 2008.

You need to think deeper about these issues below your sloganeering if you want to be able to use any of these insights.

I am sorry to hear about that ed.

My arguments are very real. I just don’t have the time to discuss in detail how the real thing is supposed to work. My apologies.

You properly know how the current money system works I am surprise you did not see anything wrong with it. You are right money is credit fueled by government debt. That is why we are so full of it and this is the ultimate bubble and the crash of this system. Sooner or later all fiats currencies fail, specially those backed only by debt and the ability to pay it.

Money does serve many purposes but its key purpose is medium of exchange. You take that away and you don’t have money anymore. Think hard about it.

Since 1971 the us dollar receives no real backing power. Go check out what has happened to us every since that day.

The quantity theory of money is a fallacy. Its key point is the velocity. The velocity is the supply and demand of money which is still present in a fiat currency. Since money is just a medium of exchange its demand will go up when economic activity increases and vice versa. Its supply is those medium of exchanges available to be used and accepted by the public. This theory is based on weak foundations and will lead you no where.

Your assertions on banks are true although not for the right things. Fractional reserve lending is the key to the banking system. What happened in 2008 was a systemic bank run in the whole banking industry. That’s why it collapsed and that’s why it ate trillions of dollars of newly created money to stay afloat. Without a central bank a fractional reserve lending system can’t work.

So now they got cash or credit available to lend but few customers able to absorb new debt.

You already know our money is just debt. And essentially you use it as long as you can repay it. Well that ability to repay it is very weak. Debt is the reason why we haven’t start to recover yet from this depression and it is the reason why the market for new loans is so weak.

Thanks.