5. The role of money
Cash money has two functions. Firstly it helps to match buyers and sellers with their transactions without the need for bartering. Secondly it acts as a store of value in itself. In other words, it is either money in action or money standing still. The former is the only legitimate use of money. As a store of value there are many other better mediums or there should be. Currency is not a store of value in itself as those people who operate overseas found in the latter part of 2008 when the value of the pound dropped by a third. Were money not to act as a store of value then the money supply would do no more than float between transactions in which case the average holding period would be very short and so the velocity at which the money moves around would be high.
Real wealth consists of land resources, productive plant, durable goods and people. Paper wealth comes in many forms but debt is a good example. The profusion of paper wealth constitutes an enormous reservoir of inflation. By contrast, money wealth is often debt including mortgages and pension obligations. The wealth of a nation is not increased just because there is more paper money in circulation. Unfortunately, paper wealth acts as if it is real wealth. As a result in a time of inflation Government debt grows excessively but private debt gallops ahead. If too much money causes inflation, then inflationary prosperity causes too much prosperity. If the prosperity is not based on anything tangible then it is so much waste. When inflation reaches its terminal stage there is failing prosperity, shortness of money, falling stock market, rising taxes, larger Government deficits and yet still more money expansion except that it is accompanied by soaring prices. At that point none of the traditional remedies are effective. Everyone is paying and no one benefits. This will be the outcome of the current recession.
Monetary inflation is the sole cause of price inflation but there are three factors at work - money supply, money velocity and the supply of real values. Only money supply is in the control of government. Monetary inflation is the supply of any quantity of money that does not exactly balance the other two factors. To prevent inflation and to achieve price stability this one variable must be adjusted to offset changes in the other two. Traditionally no one can cause monetary inflation other than the Government. Today the banks can now indirectly create the same effect because of electronic banking.
Theoretically monetary quantity and velocity can move independently to one another but only in theory. Monetary inflation can be purely velocity inflation as easily as it can be quantity inflation. Pure velocity inflation is very volatile. If velocity increases for some psychological reason without money quantity inflation the velocity usually returns to normal as quickly as it departed from it. This is important at the moment because in a recession money moves more slowly than it does at the height of a bubble. This means that suddenly it appears that there is less money in circulation so giving the Government an opportunity to print more. This money will remain hidden until the economy stabilises and then there will be a massive inflationary increase as the speed at which the money circulates returns to normal.
At the beginning of an inflationary cycle velocity declines while money quantity increases. In the middle of the cycle monetary quantity and velocity increase, because people wish to hold their money for less time and to spend it faster as they see its value fall relative to other indices. Property buying in the last ten years almost reached the level of panic buying. At the end of a cycle the velocity rises faster than the money quantity as quantity inflation stops. The reverse happens with traditional deflation. Money quantity and velocity fall together along with prices and prosperity. In a period of deflation people tend to hoard money because it suddenly holds it value. However, there is no way that the British Government will allow the quantity of money in circulation to remain static or to fall.
Stopping inflation just means stopping the increase in the quantity of money. Of course, there is always a small delay as latent inflation works itself out of the system. A more subtle effect of inflation is to devalue the nation's money wealth to the level that its debtors can bear. Money wealth is the mother lode and inflation's principle function is to mine this lode and to use the proceeds to buy prosperity for the general population and to lighten the load on debtors. Most of the inflation in society is caused by the Government printing money or the more modern willingness of banks not to actually print money but to create the illusion that they have money that they do not. Very much the shell game. If the banks can move money around fast enough and never have to prove that it really exists then no one knows what is real and what is not. Move the money fast enough with a computer and the same money can appear to be in different places at the same time. The only difficulty is when the day of reckoning comes.
Published: January 2009