The most difficult thing in economics…is to explain rising prices

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by Alasdair Macleod, GoldMoney:

It is apparent from media commentary that there is considerable misunderstanding over the causes behind rising prices and the consequences for interest rates. There are now signs that the official narrative over these issues is misleading at best.

Those who have protected their wealth by investing in financial assets no longer have the following breeze of falling interest rates. Financial bubbles are now bursting. Understanding the causes and therefore being able to assess the likely losses involved is becoming urgent for anyone committed to financial markets.

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This article explains inflation in its proper context, which is loss of purchasing power for state-issued currencies, so that current conditions are better understood. It dissects the delusions behind monetary policies over both the causes of rising consumer prices and interest rate management.

It concludes that we are beginning to experience the worst of two worlds simultaneously: while the financial bubble collapses, in anticipation of and the response to an accelerated debasement of fiat currencies, prices of everything from commodities to finished goods will soar as a crack-up boom materialises.

The role of money

For the first time in decades inflation fills the headlines. The popular press is full of tales of hardship for the disadvantaged in society. Higher energy costs, higher food costs, rising taxes — they all serve to inflict hardship. In opinion polls politicians are facing the wrath of those who suffer. Financial commentators have not much of a grasp of the situation, reacting religiously to government statistics and many concluding that the condition is stagflation — a condition whereby the economy stagnates while prices rise.

The combination, according to macroeconomists, cannot be adequately explained because it cuts across the relationship between supply and demand: a stagnating economy or a recession represents inadequate demand and inadequate demand leads to falling prices, they say. So how can prices rise in a stagnating economy? This is what students of economics are taught today and the thread of this economic illiteracy runs through everything from monetary policy to discussions over the dinner table.

Until Keynes weaponised it, perhaps economists could agree on one thing, and that is money’s function is as a medium of exchange, whereby we earn it in return for our labour and we spend it to acquire the things we need and desire which we don’t produce for ourselves. This division of labour still applies when we save it. Money is then a credit for our production yet to be spent. The intention is always to spend it or give it to someone else to spend it in the future, such as by lending it, through inheritance, or even paying the government to pass on as welfare.

The concept of money’s purchasing power is simple enough, being what can be obtained in exchange for it. But what amounts to the same thing, the objective exchange value, perhaps needs further elaboration. Simplistically, when we exchange money for goods the exchange is recorded in the price of the goods measured in money, and not the price of money measured in goods. We say that a loaf of bread has a price, not that of the money used to buy it. And the value of a loaf of bread is purely subjective, meaning that the individual considering its purchase places his value on it when considering whether to buy it. While his decision is whether he values the loaf more or less than the money, it is impossible for him to decide unless he assumes that the exchange value of the money is a constant factor enabling him to exchange it for other goods, or even an alternative type of loaf of bread.

But we must take that one step further and explain that despite Keynesian economic use of money as a medium for macroeconomic management, money has no other use than as a medium of exchange. The value we place on a medium of exchange is the anticipated use-value of the things that can be obtained with it. Obviously, this is a subjective factor in the minds of those that use the money, and this use-value of it therefore depends on psychological factors.

Equally and separately from its use-value, its exchange-value is also subjective. In other words, there must be trust that the money in one’s possession will be accepted by others in exchange for goods. By combining both use and exchange values, the possessor of money can then view it objectively when it comes to exchanging it for goods. It allows for the comparison of the values of goods to be made one against the other, with the medium of exchange being regarded as the common, or objective factor in the comparison.

While automatically assuming money’s objective value in transactions, it permits individuals to understand that changes in the purchasing power of money can occur, so long as they continue to accept both its use- and exchange-values. As Ludwig von Mises put it in his The Theory of Money and Credit:

“The central element in the economic problem of money is the objective exchange value of money, popularly called its purchasing power. This is the necessary starting point of all discussion; for it is only in connection with its objective exchange-value that those peculiar properties of money that have differentiated it from commodities are conspicuous.”[i]

As Mises stated, it is only a starting point. But it is from this point that the disinformation starts. When the general level of prices rises, it is commonly referred to as inflation. The word in this context is incorrect. Inflation is something that happens to balloons. In this context it is an increase in the combined quantity of money, currency, and credit, which will tend to increase prices all else being equal.

An increase in the general level of prices reflects the falling purchasing power of money. The purchasing power of money can fall for two reasons, one of which is the dilution of money through an increase in its quantity or the quantity of its substitutes in the forms of currency and credit. But the most important reason for its fall is changes in the anticipated use-value of the things that can be obtained with it. In other words, if a population believes that the purchasing power of money will fall, by altering the preference relationship between monetary liquidity and ownership of goods in favour of goods, the purchasing power of money will indeed fall. So even the idea that rising prices always reflects monetary inflation is incorrect.

Deflation is another linguistic sin. Deflation is something that happens when the air is let out of a balloon, or expectations are not fulfilled. Common parlance amongst economists is that it is falling prices. No —falling prices are the consequence of an increase in money’s purchasing power, which can happen either due to a contraction in the total of money, currency, and credit, or when a population decides that on the margin holding a greater amount of money, currency and credit is preferable to adding to one’s stock of goods.

We must now look in greater depth at the relationship between money and prices.

The economics of sound money differ from fiat money

The economists of the twentieth century based their concepts of money and credit on knowledge gained under the gold standards of Britain, Europe, and America before the First World War, and in important respects have not revised their notions in adapting theory for the purely fiat currency world that has been our lot since the end of Bretton Woods.

Monetarist theory evolved from David Ricardo’s observations in the early nineteenth century, and the debate over money, currency and credit subsequently raged between the currency and banking schools until the Bank Charter Act of 1844. But the consequence of the gold standard was that it imparted an underlying stability of human action over money which allowed for monetarist theory to develop. It allowed economic actors to combine the subjective use- and exchange-values into an objective value for currency as described above. Remove the sheet anchor of true money, and a currency becomes exposed to a breakdown in its objectivity.

Not only have economists in their theoretical deliberations paid insufficient attention to the difference between money with its credible substitutes and an unbacked fiat currency, but most of academia does not understand credit either, as exemplified by incorrect descriptions of the workings of the banking system.[ii]

While the cycle of creation and contraction of bank credit is common to both sound and unsound monetary systems, a gold coin backed system differs materially in its effect on the general level of prices from that based on a purely fiat currency. Secure in the knowledge that it can exchange currency for coin on demand, the public does not generally alter the relationship between its currency preferences and ownership of goods, other than when tempted to do so by credit-driven variations driving interest rate changes. Therefore, through all the ups and downs of bank credit, wholesale prices tended to fall gradually between the official introduction of the British gold sovereign in 1820 and 1897. The general level of wholesale prices fell 17%, driven entirely by industrial and technological progress despite the increase in above-ground gold stocks (see Figure 3 below, of the UK composite price index).

Following 1897, prices began to rise, reflecting the unprecedented increase in gold mine supply, when South African gold output began to affect the purchasing power of money. From 1886 annual world mine output rose from an estimated 157 tonnes to 702 tonnes in 1913, slightly more than doubling recorded above-ground stocks.[iii] Under this influence the general price level increased by nearly 13%. But the fact that this price increase was minor compared with the increase in above-ground gold stocks is justified partly by the expansion of non-monetary gold stocks not entering the reserves of the banking system, partly by a tendency for the British population to increase their savings attracted by wholesale borrowing costs which rose from 2% in 1897 to 3.6% in 1913, and partly due to improvements in production methods.

At the outbreak of the First World War, over 80% of world shipping afloat was built in Britain, a talisman of Britain’s economic success in the global context following the introduction of its gold coin standard in 1820. But that was to be the peak, and following the Great War, we must follow prices set under America’s monetary standards, a gold exchange regime fixed at $20.67 to the ounce. In the post-war slump, US wholesale prices fell by 44%, but then stabilised until 1930. Reflecting a collapse of bank credit, the depression drove prices down to pre-WW1 levels.


Following the dollar’s 40% devaluation in early 1934 to $35 per ounce of gold, prices rose sharply, fuelled by a combination of a ban on domestic gold ownership and an increase in broad money quantities (M3) which had risen 260% by 1947.[i]

Under the 1944 Bretton Woods agreement, foreign central banks were free to exchange dollars for gold, reflected in stability in prices for commodities, energy, and raw materials, which were priced in dollars. Crude oil was priced at $2.57 per barrel in 1950, and by 1968 it had only increased to $3.07. The stability of energy and commodity prices contributed to wholesale prices increasing only gradually over the period, despite the increase in the quantity of money and credit, which from 1947 had grown a further 287%. In effect, there were two standards, a domestic fiat dollar and an intergovernmental bullion-dollar exchange standard.

The empirical evidence is that a pure gold coin standard is associated with gently falling prices over time. Compromises which restrict the ability of economic actors to exchange gold freely for currency remove the strict discipline on the issuer, leading inevitably to a fall in purchasing power. By giving foreigners through their central banks access to a bullion exchange standard, the Bretton Woods agreement preserved a general price stability for commodity and energy inputs. But that was not to last due to the expansion of dollar currency and credit, not just on the domestic front but also to finance wars, notably in Korea and then Vietnam. Further currency expansion was deployed as America established military presences throughout the free world and inevitably this debasing expansion would impose systemic strains between the domestic fiat and foreign bullion standards. This led to the failure of the London gold pool in the late 1960s, and then the ending of the Bretton Woods agreement in August 1971.

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