Tuesday, August 25, 2015

Is Money a Commodity?

One of the most critical issues in Economics is whether money is a commodity. All the major schools of Economics: classical, Keynesian, Austrian and Behavioral agree money is a commodity. Why? Economists observed governments issuing new or additional currency that caused a devaluation of the currency already in circulation.  Another example they looked at was common commodities and observed price movements. It didn't matter if the commodity under the spotlight was gold, silver, oil, corn, sugar, wheat or cotton they all seemed to act the same way when the quantity in the market moved up and down. Looking at the history of money economists found a parallel. When governments increased the supply of money the value of other money seemed to decrease. Money seemed to perform just like cotton. The larger the cotton harvest the less valuable. So economists concluded, if it walks like a duck it must be a duck. Money was declared a commodity.

To simplify the economic logic of money as a commodity you must believe the value of money fluctuates just like the value of apples, the classic example of a commodity. Both act like they may be influenced by the forces of supply and demand. The more apples (Supply) on a store's shelves it is necessary to drop the price (increasing Demand) to encourage a higher rate of purchase. One of the great fears of private economists during the Financial Crisis of 2008 was a fear of inflation from the Fed's strategy of injecting two trillion dollars into the economy. Fortunately, that fear was not realized.

This experience from the Financial Crisis was counter to the money as commodity theory, but few people took notice. Maybe, money is not a commodity. Let's look at money in the marketplace to see the parallels with apples. Clearly, money is not a fruit. Money does not grow on trees. Money is not harvested by farmers. Money is not sold on grocery store shelves. Money is not seasonal. Money is not perishable. Money doesn't taste good or provide a nutritious snack. Does this deductive track lead anywhere? It is interesting, but leads only to a baffling syllogism. Money is called a commodity, but money does not share features with other commodities, therefore money is not a commodity. The question about what money is remains unanswered.

Let's delve into that question. Money seems as mysterious as an alien from outer space. If we encountered a space alien how would describe what we saw? First, we would describe what it is similar to "about the size of a dog, but walking upright and carrying a rifle like object in its four hands." We can make a description of money, "Two and a half inches by eight, made of paper, printed on both sides with a picture of a politician on one side and a building on the other." The description tells us nothing about what it is used for or how it works in the economy. It seems like part one might be a description, but part two needs to be an explanation of the role it plays in the economy. I can see some of you wiggling in your chairs to tell me money is a 'a medium of exchange.' I bet you can even explain how the barter system needed a reservoir of value if a seller did not want to make a product for product exchange, and that prompted the creation of money. True, but money is more. Money can be thought of as an equality of value. What? Money represents value. The value of the chicken you traded or the work you did in the field.

Money is a value equivalency. If I do 'x' you will give me six of those green bills. Done. It is not a commodity that will change value, or age and spoil. It is money, a marker of value usually earned through the accomplishment of work. Why is that important? It creates a connection between work and money. So money can not be circulated unless there is a work product to anchor its value.

Think about this for a moment since it radically alters conventional Economics. This concept is the basis of my textbook, Rule of Money.

Sunday, August 23, 2015

Do low interest rates stimulate economic growth?

Starting in the mid 1990's Japan pursued a low interest rate policy. Unfortunately, the reason the Central Bank lowered rates did not have the intended result. Japan's finance ministers wanted to induce economic growth. Instead the economy faltered. Why? Don't lower interest rates reduce the cost of borrowing for companies? Of course, but unless the companies need to borrow, low interest rates have no effect. Often low interest rates are imposed in times of economic stress. Many companies are unwilling to borrow in such perilous times. Consider the effect of a stagnant economy on Japanese business. In Japan the size of corporate debt went from 147% of GDP in 1990 to 99% in 2011 (Mariko Oi for BBC News, Tokyo, 17-09-2012). One should conclude low interest rates actually reduced corporate borrowing by 50%.

Although Keynesian Economics argues low interest rates are the cure for economic malaise, the facts indicate the opposite. Why? Keynesian Economics is built on the assumption of interest rates driving the economy. The fact is other economic conditions weigh heavier on markets than interest rates. What are these economic conditions? First, it is the confidence in the future of economic management, i.e., the government's ability to manage the economy. Keynesians take this as a given, but business people see it quite differently. Low interest rates are a perfect example. Keynesians see low interest rates as an inducement to business to expand. Business people see low interest rates as an indication of a stagnant economy. Governments see a stagnant economy as an opportunity to utilize Keynesian debt strategy to spark a recovery.  A government supported by an economic theory that lauds their economic prowess is a strong inducement for government to increase their borrowing and the national debt. Unfortunately such a strategy did not work during the Great Depression or the Great Recession. It did solidify the business sector's opinion that the economy was in a downward spiral. In the same article noted above Mariko points out public sector borrowing went from 59% of GDP in 1990 to 226% in 2011.

Even if governments behave themselves and do not increase debt, low interest rates are not good for the economy except in the short term. The short term being a couple of years to induce capital purchases put off because of the weak economic situation.  I would argue it is never good for the government to try and manipulate the market. But there are other reasons besides my opinion. Low interest rates encourage marginal loans. The group of business ideas that work with a 1% interest rate is not the same quality as those that work at 5%. In addition, the origination revenue banks obtain from low quality loans and 1% interest is marginal at best. A healthy banking sector is fundamental for a vibrant economy. Banks play an essential role in taking the new money creation allowed by a central bank and finding places to invest it. If banks buy notes from the Treasury of a country to earn interest no new business is created that can grow. The interest banks earn in the feedback loop and new business creation expands the economy. It is tax paying job creating business that expands the economy; not money creation by the government. A strong economy can not exist supported on a thin feedback loop. The thinnest possible loop is a low interest government bond.