Money And Prices Are A Dynamic System

By Keith Weiner – Re-Blogged From Gold Eagle

The basic idea behind the Quantity Theory of Money could be stated as: too much money supply is chasing too little goods supply, so prices rise. We have debunked this from several angles. For example, we can use a technique that every first year student in physics is expected to know. Dimensional analysis looks at the units on both sides of an equation.

Money supply is a quantity, a stocks, i.e. dollars or tons in the gold standard. Goods supply is a quantity per year, a flows, i.e. tons / year. You cannot compare tons to tons / year. The attempt is meaningless.

We have noted that if a bank sells a Treasury bond, it is not going to spend the cash on a big bender in Vegas. And we discussed the fact that a dollar is not consumed in the transaction, unlike the hamburger for which it is exchanged. At any given quantity of dollars, that dollar which bought the burger could be used again and again, at an accelerating pace, to buy more and more goods, driving prices up to infinity. We would add that when a burger—or anything—is bought, we cannot just assume that the price will go up. We need to know if the buyer took the seller’s offer price, or if the seller took the buyer’s bid price.

The Meaning, Nature, and Consequences of Leverage

Today, we want to look at the quantity of dollars in a different way. We would like to show in clearer concepts, why rising quantity does not necessarily mean rising prices. We will begin by stating our thesis.

An increase in the quantity of dollars is an increase in leverage.

In an irredeemable currency, an increase in debt goes along with an increase in the quantity of what people miscall money. The relationship is not one-to-one, and is affected by many variables including reserves required by regulation. But there is a positive correlation—and a causal relationship.

This tells us exactly nothing about what will happen to prices. If businesses borrow to increase their rate of buying of commodities and to increase their buffer of work-in-progress in between each stage of the manufacturing process, then prices will rise. Not because the quantity of dollars increased, but because the rate of buying increased to feed commodity hoarding at a faster pace. This describes the economy after WWII through 1981, but especially the 1970’s.

If businesses borrow to increase their capacity to produce, then the prices of their products will fall (though government-mandated useless ingredients might increase at close to a matching rate). This describes the economy since 1981.

Net Present Value

OK, businesses increased their leverage, and hence debt. So what happens next? It depends on the direction of interest rates. To see why, let’s revisit the concept of Net Present Value (NPV). When a business incurs debt, it must make payments. Typically those payments stretch out over years or a decade or more.

Each of those payments has a present value, which is the face value discounted for the amount of time. It is discounted by the market rate of interest. If the interest rate is 10%, then a $500 payment due one year from today, has a present value of $500 less the 10% discount, or $450. NPV is the sum of the present value all future payments.

The higher the interest rate, the lower the NPV. And the lower the interest rate, the higher the NPV. At 0% interest, NPV is just the sum of the face values of the payments (thus, a perpetuity has an infinite NPV).

Rising Interest Rates

So if a business increases its debt and then interest rises, then its burden of debt falls. That’s because once the debt is incurred, the payment does not change but the discount increases. A greater discount on future payments equals a lower present value.

If a business borrowed in the 1970’s, it borrowed to finance a warehouse full of commodities. The NPV of its debt dropped, while the market price of its finished goods was increasing. This business is sitting pretty, breathing easy, cake walking, tricking its hat, doubling its eagle, and generally enjoying every cliché coined to describe when things are going well, and one need not worry or expend too much effort. It was a lazy business environment.

In this case, the business will bid up the price of its raw materials happily, knowing that by the time it brings its products to market, the prices will have risen even further. Cash was trash, and commodities in the warehouse were good as gold (not quite).

Falling Interest Rates

But that is not the world we live in, today. Since 1981, we have had a falling interest rate. Which means a rising NPV of debt. The business debtor does not have a warehouse full of commodities that are going up. It has an asset such as factory or restaurant that produces goods, but it has little pricing power. Prices are soft, and margins are compressing.

It has a tough row to hoe, a hard slog, a Sisyphean task, or use whatever expression you like.

If it can run leaner, reducing its inventory to have on hand the stuff it will need just in the nick of time, it will do so, to free up the cash.

It is reluctantly buying its inputs, always seeking ways to do more with less. It is aggressively selling its finished products, which pushed down the bid price.

In this environment, inventory is crap (sorry) no business wants to carry, much less big buffers of raw materials. This stuff is depreciating, falling, and a burden to finance. Cash is king (though definitely not gold).

The above discussion is not based on quantity analysis. We will have more to say about this, but our method is based on looking at the economy as being many pieces in motion. We seek to understand the dynamics of the system. And we consider multiple different processes, asking which is moving faster than the others, and which is changing its rate more than the others.


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