[Winstonm]

There are so many guages of inflation bandied about that I grew tired of hearing everything termed as inflation - and I set out to try to figure out what real, modern inflation was and what was its cause.

I stumbled across a good article that presented the idea that inflation in its original meaning was: a debasement of a currency's value.

The classic example of this would be a gold-backed currency whose government produced twice the currency without a compensating rise in gold reserves. Each unit of currency then could only be exchanged for 1/2 its previous amout - the currency value had been debased by 50%.

Using this as a working definition, I tried to figure out the cause of modern inflation when a debt-based currency is the unit of value.

With that, here is the rest of the story:

Quote

                Modern Inflation:Full-time Musings from a Part-time Mind

The most common of misconceptions is that inflation is a change in the prices of goods and services when such is not the case. Price increases may be caused by inflation, but other economic factors may equally serve to raise price. True inflation is a devaluation - or debasement - of a currency's value.

Miltion Friedman is noted for claiming that "inflation is always a monetary event". However, it is important to understand this claim was made during a time of gold-backed currency, so that increasing the currency supply without a commiserate increase in the gold supply caused each dollar to lose some value - to become debased. That was gold-backed inflation and Friedman was right about gold-backed currency. But he was wrong totally about debt-backed currency.

After 1971, a new paradigm for inflation occured.

Debt-backed currency inflation is caused when asset-currency values exceed the backing of debt. In today's monetary system, inflation is nothing more than an imbalance between assets and liabilities. A close inspection will show this to be true.

Many cry "fowl" about the fiat currency system used in the U.S. The plain fact is the U.S. does not use a fiat currency. The U.S.uses a debt-backed currency. Fiat, on the other hand, means simply "money that enjoys legal tender status derived from a declaratory fiat or an authoritative order of the government" (wikipedia). Fiat currency has no backing other than "decree of the government."

This is a subtle yet important distinction. U.S. currency has a pegged value - that peg is the debt that backs it. Whereas the U.S. prior to 1971 backed the currency by gold, today debt has replaced gold as the backing peg.

Debt has value. It is a promise of future payment as well as a claim against future productivity. Anyone who has purchased a second mortgage deed as an investment understands that debt holds value - in fact debt stores value as future payment. In this, it is not unlike gold. But it has a distinct difference in that debt is easier to "mine" and create than new gold bars - and debt can be un-created through insolveny..

Under pristine conditions, there is a 1:1 relationship between debt and currency, even with fractional-reserve banking. First of all, one has to realize that currency is literally "borrowed into existence". Federal Reserve Chairman Eccles in 1941 spoke to the the House of Reprsentatives and explained, "That is what our money system is. If there were no debts in our money system, there wouldn’t be any money." Of course, he was speaking of a gold-backed currency, but even now the principle is the same - only gold backing has been replaced by debt backing.

When a commercial bank lends money, that loan becomes an asset to the bank and a liability to the borrower - a dollar-for-dollar accountancy of the transaction. Regardless of whether or not the bank is lending 9 times their reserve amounts or 1000 times their reserve amounts the 1:1 ratio is unchanged. (Although minor fluctuations can occur due the accountacy of interest due, this is irrelevant to a dicsussion of the causes of inflation.)

Certainly, lowering interest rates or lowering reserve requirments can expand the currency/debt base, but that action does not cause an alteration in the 1:1 ratio. As long as the interest rates or reserve requirements are responses to market actors, there is no real inflation (although demand can cause prices to rise.). When a central planner lowers rates or alters reserve requirements as a stimulus beyond current market demand, the affect on prices can be dramatic - and can create imbalances if allowed to run unchecked for too long of period of time. However, this is simply an increase in the currency/debt base, again, and does not alter the 1:1 asset/liabilty equation - the currency itself still holds the same value as before, which is 1:1 to debt. The only thing that has changed is price. An imbalance that creates an artificial demand due to too low interest rates is better termed an "overexpansion" than inflation - the overexpansion of debt/currency can lead to higher prices in certain targeted, preferred areas of economic activity. Some term this a bubble - but overexpanionary targeting is closer to actuality.

So if an overexpansion does not devalue the currency - and inflation is currency devaluation - then what is the modern cause of inflation? What lowers the value of currency?

As long as currency and debt maintain their 1:1 relationship, the currency value does not change. The only thing that can cause a reduction in the value of the currency is an alteration of this 1:1 relationship, and this cannot occur within the banking system. The cause of the imbalance must lie outside the banking system.

If actor "A" has $1 billion in capital and borrows $1 billion from a bank, there is no change in the ratio of assets/liabilities. But if actor "A" now uses that $2 billion as collateral to control assets valued at $10 billion from an entity outside the banking system, an imbalance may occur. Actor "A" now has $12 billion in assets supported by only $1 billion in bank debt. If misallocation causes the asset values to rise, an imbalance occurs - for expample, a doubling of price would lead to $24 billion in assets backed by $1 billion of debt., although the cause of the price rise may well be 1:1 pristine banking.

The easiest example might be housing. If actor "A" had invested in housing bonds with an average collateral value of $100,000 per house, each time a subsequent actor "B" purchased a house at a higher price - that action being a 1:1 ratio of say, $200,000 borrowed for the house and $200,000 lent on the house - the action of actor "B" affects the bond value of actor "A". If overall home prices rose to $300,000, then actor "A" would hold bond derivatives that now have 3 times the collateral backing and are thus worth much more - but debt has not grown to match this new value. Whatever the difference, the actions of actors "B" caused a derived increase in value for actor "A", thereby creating an imbalance between debt and assets, perhaps  2:1 or 3:1 or more. In essence, actor "A" is making non-debt backed gains - gains that act like currency - creating more assets/values than there is backing debt.  It is this non-debt backed excess that devalues the currency - more currency than debt - the excess currency is derived gains.  The action is similar to gold-backed currency.  An 2/1 expansion of currency means in a gold-backed standard each dollar can only be traded for $0.50 in gold - a debasement; wherease, in a debt-backed currency, a 2/1 derived expansion of assets/values has the same efffect, meaning each dollar-value can only be exchanged for 1/2 the debt due it.

This is modern inflation - derived excess currency equivalents unsupported by an equivalent debt peg. Simply put, a derived expansion of  values/assets above the corresponding debt backing.

Any comments other than a grumbled "idiot"?

[Winstonm]

Just to get things started, it's only fair to warn posters that my thinking on problem solving is this: do not think inside the box; do not think outside the box; correct thinking is to be the box.

Also, on my deathbed, I've been promised total consciousness, so I have that going for me, too.

[DrTodd13]

So, hypothetically if everyone in the US got a billion dollar loan, you're suggesting that prices would not rise?

[Winstonm]

DrTodd13, on Mar 1 2008, 09:53 PM, said:

So, hypothetically if everyone in the US got a billion dollar loan, you're suggesting that prices would not rise?

No, not at all. What I am saying is the price rise does not equal inflation. Inflation is a debasement of the currency, in my definition.

The dramatic rise in housing prices between 2000-2007 would be an example - a central planner lowered rates and held the rates low for too long, causing a misallocation of resources - some would term this "bubble" but I prefer to call it overexpanionary targeting of resources..

Main thing is it wasn't inflation - this may be a semantic argument, as much as anything - but I see a real difference between currency debasement and overexpansionary targeting of resources - or bubble, if you will.

Edit: On further thought, these may simply both be components of inflation and I am trying to understand only one component - the way money can be debased in a debt-currency system.

[kenberg]

"Many cry "fowl" about the fiat currency system used in the U.S. "
Others cry "chicken" I suppose.

I will try to look more seriously later. At a first glance, my thought is that it might be difficult to adequately define "debasement of currency" if it is to mean something other than what it will buy. Maybe something about how trustworthy it is, which I guess means what it will buy later, or how it will in the future trade against the Euro. I'm thinking that this could develop into a serious problem for us.

[Winstonm]

kenberg, on Mar 1 2008, 11:40 PM, said:

"Many cry "fowl" about the fiat currency system used in the U.S. "
Others cry "chicken" I suppose.

I will try to look more seriously later. At a first glance, my thought is that it might be difficult to adequately define "debasement of currency" if it is to mean something other  than what it will buy. Maybe something about how trustworthy it is, which I guess means what it will buy later, or how it will in the future  trade against the Euro.  I'm thinking that this could develop into a serious problem for us.

Heck, Ken, there is even debate over the meaning of inflation. Mike Shedlock has defined inflation as an expansion of currency and debt, whereas strict monetarists, as I understand it, would only look at currency expansion.

From a dialogue I had with Mike Shedlock, it seems on further thinking that perhaps inflation is not the right word - what I was looking to find was a mechanism that explains currency debasement in a debt-currency system.

Like I said in the piece, a true debasement occurs when money stock is expanded without a compensating increase in the reserve base. If gold is the reserve, then every dollar is worth (x) ounces of gold on demand - but if you double the money stock and keep the total amount of gold constant, then each dollar can only be redeemed for 0.5(x) - the dollar is worth less - its value has been debased.

But with a debt-dollar constant, I had trouble visualizing a method to increase the quantity of dollars without a balancing offset of debt - the end result was the hypothesis proposed.

Whether it is named "inflation" or not is somewhat irrelevant to the discussion - if it furthers discussion, it can be called simply monetary debasement.

P.S. As you say, it is hard to talk about this without discussing buying power - but buying power - or prices - is a result of inflation but not inflation itself. Similarily, a debasement of money will lead to more money in circulation without a rise in produced goods, feeding the issue of "too many dollars chasing too few goods" cause and definition of inflation.

[kenberg]

Whew! In maybe 1957 I took a two quarter sequence Econ I and II, using the text by Samuelson of MIT (Is he any relation to the guy who writes op-ed pieces, do you know?). I understood all of the mathematics and none, or at least very little, of the rest of it. My basis of facts remains very sketchy.

Here is where I am, please correct.

At one time, currency was backed by gold. The price of gold was set by law (something like $37 an ounce I think in the 50s) and in theory, although I think for an individual not actually, you could take your dollar to Fort Knox and trade it in for gold.

Somewhere along the way gold was allowed to trade at market price, and then, in what I think was a separate move in the 1970s, the dollar and gold were completely uncoupled (is there still gold at Fort Knox? I think so, but I don't know. You can see my level of knowledge.).

If I have the current situation correct, dollars now have their value set completely by the market. To the extent that people value dollars over another currency, it is because worldwide investors believe that the US Government will act to keep the dollar high. Exactly what those actions should be are unknown to me, and maybe to the investors, but they trust that the US is run by people who both know what needs doing and will do it. If that confidence disappears, then so does preference for the dollar. Beyond theory, I take it that something like this may be happening.

This is what I might think of as currency debasement. I suspect the term might mean something else as you are using it, but I am unsure as to what. I can't say that I really follow this argument about debt-based currency and how it relates to debasement.

So I'll Google Shedlock, since I don't know who he is.

And my initial response was to point out that I believe you mean "foul" rather than "fowl".

[barmar]

In your article, you say that the value of the debt changes as a result of the housing price changes, since the houses are being used as collateral for the debt. But doesn't this just push the question one step back? Why are housing prices increasing?

[Winstonm]

barmar, on Mar 2 2008, 11:38 AM, said:

In your article, you say that the value of the debt changes as a result of the housing price changes, since the houses are being used as collateral for the debt. But doesn't this just push the question one step back? Why are housing prices increasing?

This hypothesis is a work in progress - I posted it for feedback purposes.

One further thinking, it might be best to describe this phenomenon as "one of the two components of inflation."

By this new definition, inflation would be defined as having two components: 1) an expansion of debt beyond market production/demand and a corresponding rise in velocity, and 2) a debasement of the value of currency.

So the initial claim that only debasement of currency is real inflation can certainly be challenged - heck, I challenge it myself.

But my real interest is to understand a mechanism that debases the currency in a 1:1 debt-currency system.

My conclusion is that derived values cause the occurence - the expansion of debt is what drives the asset value.

Not very clear - but I hope you get my meaning.

[Echognome]

A lot of things in economics are just "definitional". The idea is namely to just try to use a definition that has a practical value to be measured over time. I remember in grad school a professor telling me that if every person paid their spouse to clean the house, GDP would rise. (I did mention that they'd be silly to report it and have to pay taxes.) But such is how we measure things. If we viewed that measurement as silly, then we would either use another measurement or not consider it worth reporting the measurement at all.

Inflation is simply supposed to measure the general level of prices of goods and services. Like just about anything in economics, there are factors affecting inflation on both the demand side and the supply side. The arguments above are pretty much focused only on the supply side.

I don't want to get into all the details about all the possible factors to affect inflation, but I do want to mention one neat thing I learned in grad school. Inflation may not only be a concern for monetary policy, but also for fiscal policy! Think of it this way. Suppose we owe $100 in debt. We pay whatever terms we have to finance that debt. But as inflation increases, the real value of that debt increase. We still owe whatever we have left on that debt, but the equivalent amount of goods and services that the debt is equivalent to has lowered. (Think about how cheap people's mortgages on their home seem if they are 20 years into paying it back rather than their first few years.) So, let's bring that back to fiscal policy. The government is a net debtor of its people. Thus, when inflation increases, the real value of its debt decreases. Therefore, one can think inflation as a tax. It is a tax that no one can avoid! This concept in macroeconomics is called seigniorage (if you wanted to look up the term). It is useful as a tax in countries with large black markets. One of the very few things I remember from macro.

[Winstonm]

Quote

This is what I might think of as currency debasement. I suspect the term might mean something else as you are using it, but I am unsure as to what. I can't say that I really follow this argument about debt-based currency and how it relates to debasement

Ken, thanks for your time and input. This entire subject is simply an exercise (for me) in trying to grasp an incredible complex subject - and I appreciate the help anyone provides in that understanding.

Of course, one of the basic problems is the very definition of "inflation". I think most would consider inflation to be a general rise in prices - so I am willing to go along with that and talk about components within that definition.

It is fairly easy to see how inflation can be driven by debt-expansion, i.e., the Fed's actions to lower offered rates and hold the offered rates low too long - however, even in that scenario there is a pychological aspect that market actors must be willing to accept the risks of borrowing, and velocity must increase before debt-expansion produces price rises.

Debasement, as I am viewing it, is a loss of real value to the currency due to an imbalance between total dollars and the debt backing.

Consider a seashell as money. That seashell can exchanged at the bank for one apple. Some mechanism, though, adds an additional seashell to this mini-economy, but doesn't add a second apple.

Now each seashell can be exchanged for only 1/2 of the apple - the value of the seashell has been debased.

This is my concept of debasement.

[hrothgar]

M*V = P*Y

This basic definition lies at the core of most monetary theory. If you want to make a real claim that debt has a significant impact on prices (or anything else) you probably need to use this equality to frame your arguments.

Personally, I think that you are assuming way too much...

The house bubble and a hot topic because of the recent bubble. However, I think that you're giving it way too much credit (deliberate pun). In my mind, the credit market is a symptom, not a cause...

[Winstonm]

echognome,

Thanks for the help.

As I am sure you can tell from the writing, I have no formal training in economics.
What I must do is read, assess, and then come to conclusions based on an exercise of thought-logic (obviously, my own).

My puzzlement was in trying to grasp how currency supply could outstrip its backing in a deb-currency system.

The phrase "real inflation" is probably too harsh and poorly conceived; however, it does make sense that currency/backing imbalances cause devaluation of the currency itself.

The classic example would be a king who recalled all 100% gold coin and re-issued 50% gold coin with the decree that it retained the same value, while keeping the excess for his own. If this doubling of new coinage owned by the king were then spent into the economy, the excess demand would cause prices to rise.

It is this component of inflation I tried to address - but when the backing is not gold but debt.

[Winstonm]

hrothgar, on Mar 2 2008, 12:50 PM, said:

M*V = P*Y

Richard,

What I am trying to understand is a mechanism that would make M >D when systemic configuration seems to require that M=D, where M is money and D is debt.

Your intellect would be appreciated here - but keep in mind that I am limited and cannot stretch to your level of IQ, so you will have to lower your level of explanations to match my comprehension.

Keep in mind that what I am concerned with is causes - what causes V to rise or fall, for example.

Thanks

[hrothgar]

Winstonm, on Mar 2 2008, 09:17 PM, said:

hrothgar, on Mar 2 2008, 12:50 PM, said:

M*V = P*Y

Richard,

What I am trying to understand is a mechanism that would make M >D when systemic configuration seems to require that M=D, where M is money and D is debt.

Your intellect would be appreciated here - but keep in mind that I am limited and cannot stretch to your level of IQ, so you will have to lower your level of explanations to match my comprehension.

Keep in mind that what I am concerned with is causes - what causes V to rise or fall, for example.

Thanks

Hi Winston

One quick cavaet here: When I was doing my graduate work in Economics I focused o Game Theory, Mechanism Design, and Industrial Organization. I tended to steer wide and clear of Macroeconomics. With this said and done:

1. At the a bare minimum I think that you need to do a better job defining what you mean by debt? Are we talking about consumer debt, government debt or what?

2. Intuitively, I don't know if I accept your central thesis. I don't think that it makes sense to distinguish between debt based currency and fiat currency. In my mind, the crucial demarcation is between fiat currency and currency that is tied to some specific commodity (gold, silver, whatever). If I were to drag debt into the picture, I'd focus on the fact that a fiat currency may very well behave differently if the government is running large debts as opposed to large surpluses. In a similar vein, if we're talking about consumer debt I'd be focusing on the fact that consumer debt is largely outside of the control of the government. When consumers start to rack up large amounts of credit card debt they are increasing the money supply.

3. Its completely unclear whether or not it makes sense to talk about a 1:1 relationship between currency and debt. For example, I don't understand how the interest rate factors in to the whole equation. If I borrow 10 dollars today, I'll typically need to repay the principle plus interest. The higher the interest rate, the more money that I need to replay... Simply put, your idealized 1:1 ratio doesn't seem to measure this relationship.

5. Your model doesn't incorporate any kind of expectations theory. Most contemporary macro models are premised on "rational expectations". http://en.wikipedia....al_expectations

Sorry if this sounds overly critical

[Winstonm]

hrothgar, on Mar 2 2008, 02:50 PM, said:

Winstonm, on Mar 2 2008, 09:17 PM, said:

hrothgar, on Mar 2 2008, 12:50 PM, said:

M*V = P*Y

Richard,

What I am trying to understand is a mechanism that would make M >D when systemic configuration seems to require that M=D, where M is money and D is debt.

Your intellect would be appreciated here - but keep in mind that I am limited and cannot stretch to your level of IQ, so you will have to lower your level of explanations to match my comprehension.

Keep in mind that what I am concerned with is causes - what causes V to rise or fall, for example.

Thanks

Hi Winston

One quick cavaet here: When I was doing my graduate work in Economics I focused o Game Theory, Mechanism Design, and Industrial Organization. I tended to steer wide and clear of Macroeconomics. With this said and done:

1. At the a bare minimum I think that you need to do a better job defining what you mean by debt? Are we talking about consumer debt, government debt or what?

2. Intuitively, I don't know if I accept your central thesis. I don't think that it makes sense to distinguish between debt based currency and fiat currency. In my mind, the crucial demarcation is between fiat currency and currency that is tied to some specific commodity (gold, silver, whatever). If I were to drag debt into the picture, I'd focus on the fact that a fiat currency may very well behave differently if the government is running large debts as opposed to large surpluses. In a similar vein, if we're talking about consumer debt I'd be focusing on the fact that consumer debt is largely outside of the control of the government. When consumers start to rack up large amounts of credit card debt they are increasing the money supply.

3. Its completely unclear whether or not it makes sense to talk about a 1:1 relationship between currency and debt. For example, I don't understand how the interest rate factors in to the whole equation. If I borrow 10 dollars today, I'll typically need to repay the principle plus interest. The higher the interest rate, the more money that I need to replay... Simply put, your idealized 1:1 ratio doesn't seem to measure this relationship.

5. Your model doesn't incorporate any kind of expectations theory. Most contemporary macro models are premised on "rational expectations". http://en.wikipedia....al_expectations

Sorry if this sounds overly critical

No, not at all Richard. I appreciate the imput. I don't mind constructive criticism whatsoever.

If you understand that the whole proposition is from an untrained mind, it might help grasp the flaws, as well - to understand the extremely complex I try to reduce it to a theoretically "pure" concept that I can understand and then work outwards from that core.

In this sense, I eliminate (rightly or wrongly) interest, as I can see how interest is a driver that requires debt expansion to repay (if it is a given that Federal Reserve Chairman Eccles comment (1941) was accurate, that "if there were no debt there would be no money." According to Eccles in front of Congressional committe, money must be "borrowed into existence" (my paraphrase).

That is why I used the 1:1 relationship of debt to currency. Considering public debt, even then the debt is monetized by equal sums, either by investors, foreign monies, or Federal Reserve actions of creating money to buy treauries.

It seems to me that consumer debt also carries this relationship, as a $1000 Visa debt is an asset to the issuing bank but a liability to the borrower - this accountancy of debt/currency is at the heart of my perceived 1:1 ratio.

It also appears that there is a market value to modern currency, i.e., its value comapartive to other currencies, but there is also an intrinsic value, i.e., its percentage of debt.

My thinking (questionable, I know) is this - gold-backed currency can be exchanged at a bank for its proper amount of actual gold - now, debt has replaced gold as the value - therefore today, debt-backed currency can be exchanged at the bank for its proper amount of debt (which it can, as 1 Federal Reserve Note can be exchaged for another of equal value.) But when two people go to the bank to exchage 1 Federal Reserve note each, but the bank only has 1 note to exchage, the customers have to settle for 1/2 a note each - the value of their dollars' intrinsic value has changed (been debased.).

If Eccles was correct that all money must be borrowed into existence, then what mechanism could cause this intrinsic valuation decline in debt-currency?

That was the problem I was trying to solve - my terminology probably sucked by using inflation in the hypothesis.

Regardless, thanks for taking the time to read and comment.

[kenberg]

To get at debt and debasement, let's try a not so remote thought experiment.

The Government agrees to pay me Social Security for the rest of my life, adjusted annually by the CPI. And of course it agrees to do this for many others. Let's suppose, even if you may not agree, that the Government really doesn't have the cash reserves to pay for this. In a sense, the Government has created wealth. I have an expectation, if I believe my Government, that I have a guaranteed income. I can use that guarantee to buy things on credit (I don't, but I could), even if I have no job and no money in the bank. So the promise, in some sense, creates wealth. I have gained wealth and no one else has to pay (yet) a corresponding fee because we are content to go on promises.

Presumably this creates problems.

Taking my assumption, not a terribly irrational one, that the Government may not be able to produce the cash, how does this situation fit into your desription of debt, debasement, inflation, etc? It seems to me that this would be a debasement of something, maybe of currency, in the ordinary meaning of the term debasement. Does it match with your usage?


It may be premature to try for an exact definition of terms, but so far my understanding of the terms is too vague for me to agree or disagree with the argument.

[Winstonm]

Let's try it out, Ken.

With SS we are talking about public debt. So with public debt, there must be a monetization occurence to transform the claim (debt) to currency (the payments).

In this form, the debt and the debt monetization, there is a 1:1 accountancy of the transaction. (x) amount of SS debt and (x) amount of monetization to satisfy the debt.

Now, this monetized debt is used to collateralize additional borrowing - it still wouldn't change the ratio, would it, as the new borrowing has its own 1:1 relationahip. Assuming you bought a plasma t.v. on Visa - the bank providing the Visa credit would show a loan (asset), while you hold a liability (debt).

Under your proposal, the government does create wealth - this is the overexpansion of credit I used in the hypothesis - but it does not violate the accountancy of the asset/liability ratio.

My consternation was in finding the means of expansion of asset without a corresponding offset of liability - what I loosely term the 1:1 relationship (doesn't factor in interest, etc.).

Richard brought up a similar point in seperating between public debt and consumer debt, but in my mind I cannot distinguish a difference to the core concept. The U.S. treasury needs $20 billion this week to function. It sells $20 billion in treasury bonds and bills to satisfy this requirement. It does not receive $40 billion for $20 billion in bonds. The debt/monetization formula remains at 1:1.

My thinking could be skewed and wrong - and that is what I trying to determine with others' help - is this model so flawed as to be ridiculous or does it hold some core value - although not totally accurate.

[kenberg]

So are you saying that the SS promise without adequate funding does debase the currency or that it doesn't? The words are stressing me out. If promising to give money that you don't have doesn't constitute a debasement of something I am going to have trouble going with this.

[matmat]

and there i was thinking this might be another post about the big bang. alas.