In the last essay in this series we looked at some examples to show how and why our economy came to exist and explain some fundamental principles from a different angle of approach. This essay will use those mechanisms to show how some natural evolutions of our economy are not to the advantage of society. Much as I dislike a negative essay it is important to highlight problems so we know what we are trying to fix.
So far from the previous essay the only method of altering the value of money in society we have explored is by improving the efficiency of labour or production. Many factors were kept constant or removed from consideration in the potato producer example which we shall now look at in turn to asses the resultant changes to the value of money.
It was stated that in the example society their was a fixed total amount of currency which we placed at 10,000,000 money. Currency is simply a reference tool and the actual numbers are only relevant when relative to something else. By using our understanding of equilibriums it should become clear that something in our society that cost 5 money would necessarily cost 10 money if the total amount of money in the society was doubled and all other factors remain constant. The real cost in labour terms to the society in producing the item is unchanged. That cost may be expressed as a percentage of the total labour.
Cost of item in labour = 5
Total cost of all labour in society = 10,000,000
(5/10,0000,000)x100 = 0.00005%
Now, if we double the total amount of money to 20,000,000 while leaving the percentage requirement of labour to produce the item we have
0.00005 x 20,000,000 /100 = 10
The ultimate equilibrium position makes no difference to the economy of a society (in isolation) however the transition from one equilibrium to another equilibrium position will cause some instability in the economy if it is too rapid. The transition period is where the most significant profits and losses are to be made.
Many factors can cause the physical amount of money to change or create a situation which simulates the creation or destruction of money. Minting new currency is the most direct way to increase the total amount of money in a society. It is rare that a government produces significant quantities of money relative to the total amount at any time due to the economic instabilities it can cause, particularly as no society is in isolation like in our potato example!
Population growth will simulate the removal of money from a system. Imagine an identical society to that our previous example but with exactly double of everything except the total amount of money. To produce the item which cost 5 money in the first society requires half the percentage total labour of the society. This is because the labour required to produce the item is the same while the total amount of labour available is doubled.
It therefore takes 0.000025% of the total labour to produce.
0.000025 x 10,000,000 /100 = 2.5 money
By increasing the population but not the total quantity of money the cost of things will fall. The quantity of labour increases with increased population and as money is used to procure labour the cost will be reduced in nominal terms to ensure the relative costs remain the same.
Another way to express this is with supply and demand. As more trades are made in a growing society due to increased total requirements and labour the demand for money to make those trades will increase. We have assumed the supply of money remains the same therefore when trading a good for money the recipient will receive less money. The increased demand for money increases its value as a commodity and so all other goods and services become cheaper or exchange for less money.
So far we have only a minor way to cause inflation which is via the minting of new currency and we have two major means of deflation through improvement and population growth. A very good question to ask at this stage is why, when our societies are clearly improving across the board in production methods and the population continues to grow do we experience inflation of money? It may also be prudent to consider why it is when deflation is the result of improvement that it is generally considered that inflation, or the devaluation of money, is a good thing.
I stated earlier that work or labour added value to something, however when attempting to define labour I did not point out that by adding value to a commodity it would also result in the increased value of money. When a potato is brought to market the value of money will be increased by that amount.
This would suggest that the total value in society was increasing continually however this is not at all the case for when the potato is consumed that value is lost again. Food is produced in similar quantities to the amount consumed and as a result the net effect is nil. No value is gained or lost by society. If something is consumed and not replaced it will become more scarce and command more money to purchase. This increased price is another way to say that the value of money is decreasing. Consumption therefore is a significant contributor to inflation or the devaluation of money. Value is always being added to society while at the same time removed, the net increase or decrease (assuming all other factors constant again) will determine whether deflation or inflation are observed respectively (again, assuming all other factors are constant). The most suitable economic definition of consumption is when something is no longer able to perform its function. Certain things like food are consumed immediately and others have a lifespan which may vary greatly. Services may be said to be consumed at a rate equal to how frequently the same service is required again. The product which lasts longer may be said to be consumed more slowly.
Along similar lines to consumption is an idea already touched on which we called parasitic trades. These are trades which may benefit one party but at a greater total cost to another party than was gained by the first. There are many examples of this but perhaps the easiest one to relate to is that of the slack worker who is present at work and receives pay but who achieves basically nothing. That person is supported by the productive labours of others yet returns little or nothing to them or the society at large. Each individual who produces less “value” than they consume is reducing the total value of society and consequently the value of money used in that society.
Labour is performed to produce or procure stock which is then sold to pay for the labour, the land and the upkeep of any required equipment. In most situations being able to guarantee a wage to labourers and being in possession of necessary equipment is required prior to generating any stock in which to sell. Profits from the stock may be reinvested to enable more efficient generation of stock and/or a greater quantity of stock. This is a slow process if one assumes that only the money generated by the stock may be used in this way. A much faster way to generate a good profit is to borrow money in order to fund the labour and stock. There is a strong positive correlation between the amount of money invested in the production of a given stock and how much return may be expected upon that investment, which is another example of economies of scale. As a result the ability to employ capital in producing stock, and ultimately profit, commands a cost of it's own. This cost is usually represented by the interest paid on a loan. Money not only acts as the profit made from selling stock but also as the stock itself and so money becomes a commodity in it's own right under capitalism.
As a commodity that may be sold for profit, those in command of a sizable sum of money are in a position to profit from the lending of that money alone. People earn returns on their savings or surplus money by giving it to banks and brokers who invest or lend it to others on their behalf. The more one has at their disposal the greater return they can expect from it. Under capitalism there is a general trend of money gravitating towards greater pools of money. The rich get richer is not a conspiracy theory where the rich plot ways to increase their wealth but simply the logical result of a system that allows a reference tool to extend beyond it's design parameters. Money flows like water with wealth acting as the gravity which gives it direction.
When a loan is taken to enable the production of stock the price of that stock when taken to market must incorporate the interest to be paid on the loan. This increased cost on the commodity is a cost that all who purchase the goods must pay in part. The more loans are utilized in industry the more the cost to society at large. Assume that all the potato producers in our example had taken out loans to buy their fields and support themselves prior to their first crop being harvested. We have already asserted that all other industries incorporate the cost of the potato as all persons in our example society consume them. The price of the loan is ultimately born by the society at large in order to benefit the owner of the initial capital against which the loan was issued. Certainly the potato producers had to incorporate the cost of the loan into their business plan however it is not really the producer but the consumer who must bear the cost of this loan. Consumers include the poorest within society where as those with surplus capital do not. The interest paid on loans is a tax upon the whole of society. This tax is not however used for improvement to society such as funding education but an additional income for those with the most already. The end result is a further devaluation of money as the cost of goods and services increases. Loans which demand an interest payment are another cause of inflation.
In certain situations loans can be given where the physical quantity of money does not cover the value of the issued loan. A bank may only have X money invested in it however it may have lent 2X money out. This is deemed acceptable as the invested money is not required by it's owners and the loaned money will be returning over time with interest. Although this may allow a society to fund new industry at a greater rate than it otherwise could it also has the exact same effect as minting new currency. The more money available in society- the more expensive goods become. The price of goods increasing or the value of money decreasing is therefore facilitated not just by the interest paid on loans but also by those loans which are made against a non-existent capital.
It may be unreasonable to describe those in the industry of providing loans and investing money as a parasitic trade on society, as mentioned previously they do provide a unique service which in turn allows for other things to become available to society. Should there become an alternate method by which new industry were funded and capital made available then the transactions made by investors would certainly be counted amongst those trades which are parasitic within society. The labour used on redistributing capital adds no value to any commodity, any value they obtain will be someone else's loss. The finance sector globally is huge, if one is to look down the hundred biggest companies they will have to look pretty far down before they find a company that does not deal in oil or finance. The argument in support of the finance sector is that they are the best able to put capital in the hands of those that will confer the most advantage to society. This is certainly a useful role but allowing it to operate in free market capitalism (or at least a capitalism with few restrictions) will ensure that the industry grows out of proportion to a size unrepresentative of societies need for informed wealth allocation. I would not like to postulate as to what fraction of those involved in finance are needed to function in the best interests of society in an ideal world, but I suspect it is a tiny fraction of what we currently have. The reason that a capitalist asset allocation system will grow out of proportion is due to the natural gravitation of wealth. The finance sector is best place to gain out of this trend as they dictate the terms by which they invest capital. The more capital they have at their disposal the more powerful they become, and thus the more they are able to dictate conditions, which they would sensibly do their own advantage thus furthering growth.
We have previously shown how gaining market share is the main route to the profitability of business and thus one of their main aims. Several factors also work in the favour of larger companies such as the larger an organisation is the better able it is to employ good economies of scale. Larger companies generally have more assets and are able to employ more capital, more cheaply, at their discretion. They also have more leeway in tougher times and will be more able to borrow to cover their costs. Each of these factors will further enable a flow of money towards wealth and help the larger companies to take market share from the smaller ones. In regards the larger companies uses of economies of scale it may be seen as beneficial to society when companies grow, however there are more factors in play than just economies of scale.
Competition was the mechanism by which improvements made within industry are allowed to benefit society at large. The larger the company in terms of market share, the less competition they will have. This means that companies are enabled to control demand to an extent as they control the supply. A company with a monopoly on one kind of product may produce as many as they see fit to do so, the less they produce the higher price they will command. As the price rises less people will purchase the product so the monopoly will attempt to find the optimum balance for maximum profit where margins are high but turnover is still significant. If the margins were to get too high due to very low supply then the turnover will fall enough to reduce overall profitability. Not only can a monopoly control supply to maximise profitability they are also in a position to pocket any returns from improvements made to production as no competition exists to have a price war for market share. Industry without competition does not serve society, nor is it under any pressure to make advances and improvements.
Society is generally wise to avoid allowing any company to gain a monopoly on an industry. There are some cases however where it makes some practical sense to have only one set of infrastructure, such as a rail network as having two sets of lines is likely to be a very inefficient use of labour space and resources. These examples are few enough that they may each be dealt with independently and are outside the scope of this essay series anyway. There are some arguments against letting companies get too close to monopoly level. Minsky claims that the larger a company gets the more it will invest in things that offer no advantage to society such as advertising and executive weekends. This may well be the case but it needs close scrutiny as it is not so clear cut as that. Larger companies are best able to fund and implement new improvements to give one example. The task is therefore to find some approximation of the optimum size (measured in market share) for industries in terms of their efficiency and conferred advantage to society.
Real and Relative Changes of the Value of Money
1. Minting of new currency
2. Improvements to production
3. Population growth
4. Interest paid on loans
5. Loans made against non-existent capital
6. Consumption greater than value adding labour
7. Parasitic trades
We have now covered in a round about way, stopping for various tangents, the most basic principles that effect the change in value of money as listed above and many now return to our question of why inflation may be viewed as a positive effect. By maintaining a society of steady and constant inflation one may be assured that by doing nothing with a large pile of money it will fall in real value. As a result, anyone with capital would be sensible to employ it in some task or investment rather than let it diminish in value over time. By operating with an inflating currency a society is encouraged to save less and spend/use what they have. This in turn assures that all the money within the society is in continual circulation and use. More trades are made, more goods are consumed and produced and so jobs are available to provide for the increased consumption. In a society of deflation people are in a better position to save their money as it will accrue value over time. It would discourage people from frivolous spending creating an environment where people purchased only what they needed rather than until their budget was all used. Inflation creates a demand for consumption which is good for all producers of non-essential goods and services. Inflation also creates a demand for investments as those with a surplus capital that do nothing with it are loosing money continually. If inflation is at 2% a year, a person sitting on a million “money” is losing the equivalent of 20,000 money annually in devaluation. Even though they still have the same amount of money the purchasing power of that money is always getting less. People in this situation will either buy up assets with minimal depreciation or loan money to those wishing to turn a profit in order that they may gain interest on that loan.
Let us take two identical example societies and then impose 2% inflation of currency upon the first and 2% deflation of currency to the second. In both societies there is the same quantity of money and initial value however the flow or number of transactions in the first society will be far greater. A good way to illustrate this is by taking a single coin to represent an average coin of these societies. In the deflating society this coin may well only be involved in a few transactions and change hands these few times while in the inflating society the coin is more like a hot potato where it is rapidly passed from person to person, non wishing to hold it for too long. By having a situation where the same amount of money is used more frequently the result is a strong and booming economy. Investors are encouraged to see the populous spend everything they have at their disposal and the demand for goods and services at their maximum. These conditions will ensure the most immediate profitability to would-be investors and producers. It may initially appear to an external viewer that the society experiencing inflation is more opulent and has greater resources and greater wealth to begin with than the deflating society but this is only the appearance.
The society with 2% inflation may well be attaining greater value faster through increased production but it will also be removing that value again with increased consumption. The consumption in this case drives the production and not the other way round therefore the net increase in value by any measure in the society experiencing inflation cannot exceed the otherwise identical deflating society. It is also worth noting that the society experiencing inflation will consume it's natural resources at a greater rate than the other. This is in part due to the increased consumption but also due to the ‘hot potato’ effect. The inflating society is always under the pressure of having to act immediately otherwise have their money reduce in value where as the deflating society is happy to wait for a better opportunity as waiting only increases their money's value. Where inflation is prevalent the most important factor to consider is time, where deflation is prevailing then efficiency becomes more important than time. As such a deflating currency will help to increase the sustainability of an economy through frugal use of raw materials and longer lasting products however it will lower immediate profitability and stunt the growth of some newer industries. Inflation benefits those who are in a position to reinvest capital (providing they do so and sensibly) where as deflation is to the advantage of the poorest in society. The advantage gained by the poorest under deflation is not however as pronounced as the advantage gained by the capitalists under the same percentage inflation due to the numbers of people affected. A small and slow gain for many verses a more immediate and significant gain for the few are the options.
It is not inflation in itself which is good but rather we live in a society which runs on the energy and urgency injected by inflation. Although there is only a 4% change in effect in my example it is a very significant change in economic terms. If such a change were to occur overnight there would be chaos in the economy, it is indeed always the rapidity and magnitude of an economic change that causes the problems, not the resultant new equilibrium position. Inflation is therefore good as we, as a society are used to it, expect it and are set up to deal with it. Not only would the economy change if we suddenly experienced a period of ongoing deflation but the whole mechanism of society would need to readjust. I would argue that in undertaking any such readjustments to cope with deflation a more sustainable society would result but the slower these adjustments are allowed to take place, the better for all those involved.
So inflation may be regarded in some senses as good simply because that is the economic condition that our present societies are set up to expect. Inflation in and of itself is very difficult to classify as “good” or “bad”, it just is. A more useful way to look at inflation are the merits of its causes. If we take our list of seven factors which affect the value of money we can remove population decline and minting of currency and describe these as neutral effects (the morality and goodness of population growth/decline is entirely outside the scope of this particular argument). Of the remaining five factors it is clear that those which cause inflation are all negative contributors to society. It is not that inflation is bad but that the majority of it’s causes are bad. A society could weed out all negative economic factors and still experience inflation of it’s currency due to the neutral effects.
It is worth noting that both inflation and deflation are positive feedback mechanisms and by that I mean they are self perpetuating. Under an inflating currency the factors which further increase inflation, such as the interest rate on loans, are encouraged. The greater the inflation the greater the more significant the factors that effect it become. We have seen historic examples of countries which experience run away levels of inflation to quite disastrous consequences. Although there are fewer examples we can look to for cases of run away deflation the same self perpetuating conditions arise. The higher the percentage inflation or deflation the greater the rate at which it wishes to increase. As we have asserted, it is not inflation or deflation that are good or bad but rather a rapid change in economic conditions which causes most harm to a society. Inflation rates are kept low and steady in economies that are doing well in the present day. By letting them get to high you run the risk of having them spiral out of control, the same would be true of deflation. The closer your currencies change in value is to zero percent; the less it will encourage further change. This argument implies that inflation and deflation are both bad and that an unchanging value of currency is good or optimal. I would argue against attempting to maintain a steady zero percent level on inflation as it is an impossible task as economies are chaotic systems with too many factors to consider holistically. A margin of error or an acceptable fluctuation is a more sensible aim, for example say -/+ 0.5%. Flipping from inflation to deflation continually will cause problems in the economy due to the different effects they each have. It would be better to ensure you are as low as possible in either, so for example a target rate of 0.5% deflation with an acceptable variance of 0.5% would be acceptable as the possible range (0% - 1%) would never put the economy back into inflation while being as realistically low as possible to avoid positive feedback mechanisms taking over.
The fact that inflation is experienced throughout most of the world is testament to the might of the finance industry in that it must provide a great deal of unproductive labour in the relocation of money. To achieve the required levels of inflation experienced on a global level despite improvements to production and population growth a vast sum of money must be being created. traded and skimmed by the finance sector. All of this trading is not adding value to anything and must require the labours of others to support.
There is one further ramification of inflation I wish to discuss but it requires some understanding of the interactions between two (or more) currencies. We earlier defined money, in part, as a tool to relate variables, in other words it is a relative constant. As soon as you introduce multiple currencies you create a contradiction of sorts as those currencies vary with respect to each other yet only functioning as intended when relatively constant. The result of this contradiction is that trade outside of a single currency will not necessarily reflect real values of commodities as they should when under a free market and using only a single currency.
This is best described with an example so we shall take two identical isolated societies, called X and Y and give them different currencies. We shall then allow trade to occur between these two societies to show the effects of their currencies. To begin with these societies have a currency of equal value, X$ = Y$, the same nominal quantity of either currency will purchase the same amount of labour or goods. As with all examples designed at showing only one economic rule we shall keep all other factors which affect the value of money constant but allow the quantity of goods each country trades with the other to vary.
Country X sells X$10,000 worth of goods produced in country X to country Y annually. Country Y sells Y$20,000 worth of goods produced in country Y to country X annually. This implies that country X has a greater degree of consumption than country Y as they must make use of the extra $10,000 of goods which they purchase. If both countries produce $200,000 worth of goods and services annually then country X consumes $210,000 while country Y only consumes $190,000 each year.
Country X is now running at a trade deficit as it is purchasing a greater value of goods than it is selling. Any currency finding itself, through foreign trade, in an area where it is not a useful currency must find its way back to the country of origin so that it may be useful and retain any value at all. In the course of one year of trading in our example we find that X$20,000 are in country Y and half that amount of Y$ are in country X (this assumes that both countries pay for goods in their own currency which changes nothing that would affect the economic trends but does make understanding easier). Country Y wishes to use the useless X$ to recall the Y$ it used in the foreign trade. The ratio of X$ to Y$ wanting to find their way back to their countries of origin is 2:1 which is a very basic way to understand exchange rates. Based on the trade deficit of these two countries which should have equal real value in currency the value of a Y$ is roughly twice that of the X$ even though in their own countries $10 will buy the same quantity or value of goods. Exchange rates are governed by money entering and leaving a system primarily and only slightly affected by the goings on within that system. Simply put this means that when purchasing from a system from the outside you are able to trade under conditions where values are not equal.
The ramifications of this unbalancing of values is that $Y commands a much greater purchasing power for commodities produced in country X. This is a negative feedback mechanism which ensures that prices tend to normalize towards their real value. As the Y$ is so strong compared to the X$ the imbalance of trade between the nations will swing in the other direction as those in country X get more for their money if buying in country X rather than country Y so they import less than previously and those in country Y begin to find it cheaper to buy from country X rather than the home markets. What began as a trade deficit for country X will become a trade deficit for country Y as country Y’s internal trade begins to purchase from cheaper sources in country Y, this is also true in reverse as country X will look to source things in the home market as country Y is twice the price. It is fortunate that unlike inflation and deflation, which are positive feedback mechanisms, the fluctuation in exchange rates are negative feedback mechanisms and essentially self regulate. If they were not self regulatory then sustained periods would exist where goods could be purchased at a price that is lower that their real value.
The equilibrium condition of our societies X and Y will be one where the exchange rate of their currencies will ensure that whichever currency you choose to buy any goods with you will receive the same level of value. Despite being a negative feedback mechanism tending towards the equilibrium condition it is the whole system that must respond to changes internally and therefore will necessarily have a lag phase. Any such lag phase will allow the most diligent of traders to make some very good profits for a short time. The scale of any such profits would be dependant on the degree to which the equilibrium position was deviated from; the greater the deviation the greater the potential profits. A deviation from the equilibrium position must have been caused by something, in our earlier example the deviation is caused by establishing a trade deficit in country X. In the time it takes their economy to regain an equilibrium holders of $Y will be able to gain advantage from purchasing goods made in country X. Fluctuations either side of an equilibrium position can be harmful to an economy as markets will be intermittent, companies who rely on imports and exports can lose custom or be unable to afford supply. When importing is cheap, exporting must be harder, and the same is true in reverse. Instability in markets caused in this way are as harmful to society as any other economic instability is.
By adding in multiple currencies, not to mention allowing all the factors we kept constant to vary naturally, we create a chaotic system of variations and ever changing equilibrium positions. Trends described in this essay will still be present but they may not be predominant and predictability is all but lost. By using our understanding of the aims and befits of money and trading, and also our knowledge of the causes of economic problems and trends, we are able to suggest potential solutions and improvements to an economic system with societies best interests being the prerogative.
Presently we observe in the global economy a number of the biggest individual economies able to maintain a seemingly continual trade deficit. When one considers the effects of combining an inflating currency with a trade deficit and our understanding of lag phases we are able to see how a deficit may be maintained. A lag phase of time must exist between a currency leaving a country and that currency returning. The rate of inflation over that time of the currency will not be accounted for directly by the exchange rates. The longer the lag phase on currency returning to it’s home country, the greater the inflation (providing it is stable) and finally the greater the total amount of that currency; the larger the trade deficit that country is able to support.
Let us paint a basic example. Country A has 1,000,000 money total and experiences a stable and constant annual rate of inflation of 4%. If we say the average lag phase for money returning to country A is 6 months then it may sustain a trade deficit of up to 20,000 money annually, this figure is 2% of the total money of country A. These figures assume much more than previous examples given in this essay and cannot in reality be calculated as such, most notably that all of country A's money would need to be used to import goods to be able to support the maximum deficit which is not achievable. If we were more reasonable and claimed country A imported goods to the value of 100,000 then it would support 2,000 of that at the expense of other nations. A country with a trade deficit is essentially borrowing value from other countries. If the countries lending value were using the same currency as the country borrowing it there would be no factors like inflation to upset any balances, as such the amount of value returned would be equal to the amount borrowed. As it is however, any value gained by a country with inflating currency will be returned at a reduced rate. Countries exporting goods to other countries with sustained inflation will exchange those goods for a lower value of goods (assuming their rate of inflation is lower) and as a result they will be working to improve things for those other nations. The loss on any transaction is minor, and on small trades is unnoticeable, however when massive economies operate under these conditions the summation of all the tiny gains becomes significant and enable that country to support itself upon the labours of others.
In this essay we have looked at the causes of changes in the value of money, deflations and inflation. This was used to determine how society acts in accordance with the conditions. The effect of capital acting as stock was also discussed which lead us to understand some of the problems in the finance sector and of monopolies. Lastly we looked at how multiple currencies cause can cause instability and periods of unjust (unequal labour values) trading, this idea was advanced by combining it with our understanding of inflation and delay times between equilibria readjustments. This is a critical essay which I shall attempt to justify writing by offering some possible solutions to the problems highlighted here in my final essay in the series - “Solutions”. Given the complexity of our global economy and the lack of any planning given to its evolution it is impressive how few flaws it has. They are more like minor compromises in order that we may gain the monumental benefits of trade, even so, it seems wise to attempt to improve where possible, particularly given the importance of economics in society.
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