Money Isn’t Real
We talk about dollars (or yen, pounds, euros, dinars, or whatever) as if they were real. But money isn’t real, what it stands for is very real though. And in not realizing this, we get ourselves confused about inflation or deflation, and end up making bad decisions as a result. Money is something of a fiction. What is real is what money represents: time, effort, goods, and services that require time and resources to make.
It all started out back in the very old days when I might have had some fish and you might have had some bread. We figured out that I could trade you a fish for a loaf of bread. Then we’d both be better off.
Perhaps some bad weather came in and it took me three times as long to catch the same number of fish as I used to. But it took you the same amount of time to raise the grain and make the bread. The ratio of fish to bread trade would have to change, the value of the fish in relation to the bread went up - the barter price would have to change.
Keeping track of all this became pretty cumbersome when you add the fruit, wine, sheep, chickens, nails, firewood, etc to the mix. It was much easier to make money as an intermediate. Everything can be converted into money by being sold, and you can convert money to anything by buying that thing. Initially we made money out of something pretty permanent that had value of its own like gold or silver. This helped fooled ourselves that the money itself is valuable. But it is what we could buy with the money that is actually valuable. This “value” that we’re talking about here can be measured in various ways. The currently popular way across the economy is the GDP or Gross Domestic Product. In a generic way, economists sometimes call this just “goods and services”.
Eventually though, we figured out that gold or silver weren’t really necessary and using them actually causes some technical problems. Money was really a marker, it represented a certain amount of work or resources, it represented value. And, it was worth what we decided it was worth.
At any one point in time, there’s a fixed supply of money. There used to be at least. Money was printed or stamped out of metal and you only made so much of it. But now money is more electronic than physical and the amount of money is determined by what kind of money you’re counting.
Some kinds of money are more liquid than others: cash for example. But you can spend your credit card balance almost as easily. Then you may have a money market account too. That’s a little harder to spend - the bank has to sell money market securities to make that available so there’s some delay. It’s not as liquid as cash. With all the various financial instruments available today, determining money supply isn’t straightforward. It is like the bottom in a silty lake. The surface of the water is definitely water. The bottom is definitely earth. But there are gradations of increasingly dense mud between the two.
But money supply is difficult to count, it is important and we can’t ignore it. If the amount of money goes up faster than the amount of goods and services in the economy (basically the Gross Domestic Product, the GDP) then more money has to be spread over a relatively smaller total value. The price of a product goes up since that money per unit of the value. This is inflation.
If the money supply goes down faster than the GDP, then less money is spread out over the same amount of value GDP. So prices drop, there’s deflation. We can’t track “value” so we use money and prices instead. But that’s like using a ruler whose length can change unpredictably on you.
For various technical reasons the economy can’t respond evenly. Some prices go up or down faster, some slower. There’s arbitrage between markets, and between products or services that have some equivalence as well. Wages don’t respond evenly either. So, prices may rise faster than you salary for example.
In inflation, debt is rewarded. If you borrow money today, you get to pay it back with cheaper money tomorrow. Interest rates will adjust to correct for that, but in a situation with increasing inflation they won’t correct enough. Deflation is the opposite, debt is punished.
Deflation has a real problem though. We all will tend to wait to buy something or invest in a new project if we know the price will probably drop soon, “I’ll just wait for that sale next week.” If deflation continues, then we might just keep waiting. If enough people do this, then no one is buying and businesses continue to fail or cut back workers which reduces spending, causes more deflation, and so forth. Monetary policy - changing the money supply - doesn’t really solve this problem. The only thing that really addresses it is fiscal policy - the government going into debt and spending money. That builds the economy, generates more tax revenue for the government which can then later - in theory - pay back its loans.
So this deflationary spiral is one reason the stimulus is necessary to boot the economy out of the current Bush depression. It’s also why the Federal Reserve, which is charge of the monetary supply, has tended to favor a small amount of ongoing inflation. Better that than risk deflation.
But this ongoing inflation can distort things. For example you might compare recent house prices with the price your parents paid for a house. Because this yardstick of money has changed with time, the numbers are like comparing apples and oranges. Instead you need to compare “constant dollars” corrected to a given year. Otherwise it’s all fiction. You can use this calculator to compare different year’s dollars.
The CPI (Consumer Price Index) is one measure of inflation and deflation. Over the last five reported months (January data isn’t available yet) the CPI either declined or was zero. This might be the start of a deflationary spiral.