The Theory of Money, Part 23

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This end-of-the-year holiday time is a busy one for most people, including me, so let’s see if I can make this a quick one!

Last week, we saw the banks start using non-cash assets as reserves, which opened up a lot more potential for expanding the number of circulating Goldnotes. Let’s just clean up a few topics related to that this week to make sure everything is settled before we move on to what happens next in the evolution of money in this fictitious society of ours.

First, I want to make sure I was clear about what monetary expansions and contractions do. They have a few effects, and this may not be a complete list. First, they skew purchase decisions by giving the illusion of wealth or poverty (depending on which way the money supply is moving). Second, they increase uncertainty in prices, making long-term contracts more challenging and leading to more investments failing (loss of Labor Units). Third, they cause a transfer of wealth from some people to other people; for example, when there is new money created, the first few people this money passes through get to spend it at pre-inflation prices, and thus they are getting additional wealth transferred to them at the expense of others further down the chain.

Now, related to that second point, let’s talk more about prices to show how destructive monetary expansion and contractions are.

Prices are super important as an indicator of the value of something in the market! Each thing’s price is derived from millions of individual decisions made by all the other participants in the economy. For example, some people decide one thing is too expensive, so they substitute something else for it. Others cannot substitute, so they are willing to pay that fairly high price. Others decide something is cheap, so they’re going to buy more of it or use it for additional purposes, which leads to changes in how much of other things they buy. And so on and so on.

The aggregation of all these millions of individual self-optimizing decisions is what forms the market price of a thing, which is what every other participant in the economy uses to figure out how to further optimize their own situation and needs. This is how things are put to their most effective uses. This is how an economy runs efficiently to generate as many Labor Units as possible and distribute them appropriately according to the value provided by someone.

We’ve seen government systems in the past try to have “experts” set prices for all or most things in an economy, and suddenly the value and efficiency derived from accurate prices became very apparent! They saw how inefficient an economy becomes when you lose the information that market prices provide with all those millions of points of data they contain. Administrative price setting was tried especially in communism experiments, although communism is merely the most widespread and famous effort at that. There are tons of other price setting attempts going on today, including in the United States, and the reasons for administratively setting prices seem compelling when policy makers don’t have a clear understanding of the cost of losing the information that market-generated prices provide.

So, putting all of this together, when we have monetary expansions and contractions, it is ruining the accuracy of the price of EVERY SINGLE THING in the market, which induces a communism-like effect on the efficiency of a market! Sure, this is a temporary situation that lasts only until prices adjust, and, sure, people can at least guess at what the true price of a thing is if all prices are rising generally a similar amount, but there will still be a huge efficiency cost to this change in prices. And this inefficiency cost is incurred each time the rate of inflation or deflation changes, and this inefficiency cost is probably incurred (albeit to a lesser degree) even when inflation or deflation is happening but at a relatively stable rate.

These are the reasons I don’t like inflation and deflation, and in this series we will soon get to how governments induce monetary expansions and contractions (inflation and deflation) in modern monetary policy. Let’s just hope 2023 brings less of that than how much we’ve had since the pandemic started! Part 24 here.

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