The Theory of Money, Part 36

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Part 35 here.

This far into reading anything about money, usually the writer tends to start getting lazy and skipping some of the micro-steps to understanding the new information–it’s happened in every book I’ve read about money. I would like to try to avoid doing that.

So let’s start this week by recapping where we are.

Our fictitious society has evolved its monetary situation from direct barter all the way to 0% backed fiat money.

Originally, the government had no control over the money other than through its power to tax. (And, I guess I also had the government coining, although we discussed last week that that wasn’t strictly necessary.)

And now the government has extensive control over the money, especially through deliberately adjusting its value via changing the discount rate and the minimum reserve ratio. The government also affects the value of money when it leverages its money-creating central bank to create new money for it, although this one isn’t used as a means specifically of manipulating the value of money, it’s just an unfortunate side effect.

So what is the government to do with all this power over the value of money? If it has a lever at its disposal that it thinks it can use to help the country, will it not pull that lever from time to time as the situation dictates?

Yes, of course. And when it is manipulating the value of money, remember that it isn’t creating or destroying any Labor Units; it is just diluting or concentrating the same number of stored Labor Units over a larger or smaller pool of money.

I’ve already talked about the effects of monetary expansions and contractions way back in Part 21, and the effects are the same whether it’s the government inducing them or some other cause. But let’s briefly review all those effects:

  1. It causes wealth redistribution as the benefits of a larger money supply (or the downsides of a smaller money supply) accrue primarily to certain groups of people depending on where they are in the chain of effects.
  2. It induces inefficiencies in the market due to pricing uncertainty.
  3. It causes Labor Units to be lost due to the pricing uncertainty and general market uncertainty that leads to investment failures.
  4. It distorts purchasing decisions as people perceive they have more wealth than they really do because prices have not adjusted yet to the new supply of money.

I want to expand a little bit on the second one listed there.

I’ve talked a lot about how deliberately changing prices (“administrative pricing”) interferes with a market working efficiently because now all the information contained in the market-determined price has been lost. Well, I’ve always been referring to administratively setting prices for things one by one. What about when the government deliberately changes the price of everything in one fell swoop by changing the value of money?

If the price of everything were to generally rise or fall at the same time, then maybe the relative price of things remains constant enough that it’s not so bad, and we only deal with the short-term generally too-low or generally too-high prices.

But prices do not rise and fall at the same time, so relative prices are going to be out of whack to some extent as well.

That’s two different effects, and I don’t have any means of quantifying the degree of destructive inefficiencies either of them cause, but I suspect they are not trivial.

So, when taking all these effects of a monetary contraction or expansion into account, I’m convinced that the costs far outweigh any benefits.

To conclude this week, how about we get concrete and discuss a specific example to illustrate some of these effects?

Let’s say there’s a pandemic. Global supply chains are disrupted, companies are closing down, and lots of people are getting laid off. People are not buying as much stuff (except for toilet paper and sanitizer and masks), so there’s a general slump falling on the whole economy.

The government sees this, and they think, “You know what can stimulate an economy? A big infusion of cash! Sure, it will induce all those negative effects that Christensen’s Theory of Money blog posts describe, but until prices adjust people will behave as if they have more money and will therefore start spending money again, which will help the economy. And a healthy economy helps everyone!”

So the government sends everyone below a certain income threshold a big fat stimulus cheque funded by newly created money. And the recipients of these cheques think they are wealthier, so they start spending money accordingly.

Little do they know that inflation will hit them hard enough down the road that it may more than compensate for the extra money they got in that cheque.

So what the government has essentially done is manipulated people into spending money that they otherwise wouldn’t have spent by convincing them in the short term that they’re richer and then taking it away again (through inflation) later on.

And the people have no idea. In fact, when they get the cheque with the President’s name on it, they think he’s such an amazing guy. And then, when inflation hits them later on, they blame the businesses for greedily raising prices so much.

It’s a perfect PR move by the government. They manipulate the people into doing what they want, get thanked for it (and are now seen as proactive and good politicians), and get none of the blame later on when the people realize they have less wealth than they thought and have been spending irresponsibly.

This sounds pretty critical of government, and I guess it is. But how clearly do politicians supporting these policies know that this is what they’re doing? Maybe some or all of them can claim ignorance. But regardless of their intentions, the effect of their policies is the same: they harm us financially. So these efforts by the government to manipulate the money supply to help the economy are yet another example of how 0% backed fiat money gives the government the power to harm us financially. And to do so without almost anyone knowing. Part 37 here.

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