What Is the Root of Inflation? II
Last week we raised the question of inflation juxtaposed to the Federal Reserve's decision to raise interest rates. We did so out of the fact that financial reporters and economists seemed to be strikingly at odds over whether or not the American economy is experiencing inflation or whether signs are beginning to emerge that inflation is on the way. We concluded our discussion by raising the question of "What is a dollar?" which we argue is basic to determining whether or not inflation is real or imagined.
We received several thoughtful responses, which we will look at in detail later. But as I read the answers and thought them over I began to realize that a definition of money was basic to the definition of the U.S. Dollar. What is money? Well, money can be defined in terms of the function that it performs for men and women. We identify three such functions.
First, money is a medium of exchange between men and women and nations- it is the means by which human beings trade, just like language is the means by which human beings communicate. Second, money also is a store of value. It has the capacity to represent labor, work, force and power over time. In its capacity as a store of value money allows people to transfer value over time, from one day to the next, from one year to the next. Third, money serves as the unit of account for all transactions. It denominates all trade. In its capacity as a unit of account, money is a measurement that can be applied to all goods and services all forms of capital and labor - anything that human beings exchange. In its capacity as the unit of account money is a definition of value that can be applied to all other things real and potential. In this capacity money is like a yardstick or the metric system - it is a definition of value, a measurement that can subsequently be applied to other items, goods and services.
As you can see all three functions are interconnected and overlap in several areas. We could spend years and thousands of pages in discussion over these overlaps but I raise the three functions in order to demonstrate that the functions of money determine what it is as well as revealing its intrinsic value to all human beings in terms of utility, organization and efficiency.
Most people define money as the medium of exchange between people. This is very true as the medium of exchange is the most obvious function of money. But we think it is important to add that one cannot effectively trade or use money as a medium of exchange unless one is able to know money in its capacity as the unit of account. In other words, you and I cannot effectively use money to exchange goods and services, and labor unless we know the measurement of money. Still, in other words, we can't (with any certainty) really work at a job and get paid in dollars and exchange those dollars for a car, house or Coca-Cola unless we know what a dollar is as the unit of account. When paper is used as money we have to know what that paper is worth, in terms of something else. Why? Because the few inches of paper we exchange for a house and car isn't worth a house or car by itself, according to the primary functions and utility of paper.
For most of the last 6,000 years this wasn't a problem as the world historically used metal as money. When metal is used it is easy to define the unit of account in terms of its weight. So if you were paid for your labor in metal currency you could actually measure the currency according to its weight in order to determine whether you had been cheated by your boss or not. But who wants to carry metal around? Paper is more efficient because it is lighter to carry and easier to write on that metal. But equal weights of paper and metal don't have the same value so when the world used paper as currency, as a medium of exchange, it always, until recently, defined the value of that paper in terms of a weight of metal. Thus the efficiency of paper was combined with the measurement of a metal. That way people could conveniently travel and do trade without being shortchanged.
Today we don't overtly do this. We use fiat currency or paper money and don't define paper in terms of anything else. Paper money now has no sound definition or backing. So on the surface we can't know if the dollars we borrowed from a bank 3 years ago have maintained their value to this day. Some people think we can tell the value of paper money over time, but just try.
What was the price of a soda three years ago? What was the price of a house three years ago? What was the price of a college education three years ago? What was the price of a VCR three years ago? What was the price of a quart of milk three years ago? What was the price of a tank of gas three years ago? If 20 people who live in 20 different states in America were polled on these questions we could very easily get 20 different answers. There are so many variables to consider. Not to mention that we all would have to keep records, beginning three years ago in order to give an accurate answer today.
But if money were defined in terms of something else, the weight of a metal for instance, and that value were maintained, officially, we could wake up knowing what a dollar was, at least in terms of one thing. This would allow us to know if we were making an equal trade with people. It would allow us to know whether the dollars we borrowed 3 years ago are the same, more or less in value than the dollars we are responsible for paying today.
That is the purpose of a unit of account - it is the one key measurement that denominates all transactions. Just like a yardstick measures a car, a football field and a person; a dollar "measures" a soda, haircut and Nintendo. A yard is always 36 inches. It is a definition of two points in space. A dollar is 100 cents and has traditionally been the definition of a weight of a commodity. Space and distance have utility to human beings and the weight and content of a metal have utility to human beings.
Now, the question turns to the supply and demand for money. And it is here where we get into the current debate over what causes an inflation. There are basically four schools of thought on inflation. The Demand school of thought which argues that the demand for money to purchase goods and services is the primary cause of inflation. Then there is the Supply school of thought which argues that the supply or quantity of money is the primary cause of inflation. Then there is the Supply/Demand school of thought which argues that neither the supply of money nor the demand for money, by itself, is the primary cause of inflation; rather this school of thought argues that inflation is determined primarily by the measurement of both the supply and demand for dollars in the marketplace. Then there is the Fourth School which relies upon all three of the previously mentioned schools of thought to varying degrees.
The Demand School primarily measures the size and rate of growth of the economy as well as the prices of various goods and services to determine whether inflation exists. The Supply School primarily measures the quantity of money created and in circulation in order to determine whether inflation exists. The Supply/Demand School primarily views the price of a certain commodity in terms of dollars in order to determine whether inflation exists.
Basic to comparing these four schools of thought are these three general facts : 1) Whoever controls the issuance of currency as well as the banking system determines the supply of money 2) The desire of people to consume and produce determines the demand for money. 3) Fiscal policies/Tax rates affect the demand for money and the amount of money in circulation, among the masses of people, at various times.
Once you have this down we can compare and contrast the four schools and the evidence used to support their claims and arrive at a judgment of who is right and who is wrong when it comes to determining whether inflation exists. Since every experiment has an observed subject we will use the Federal Reserve's recent decision to raise interest rates as our subject. Soon, we will take the four schools of thought and their view of the Federal Reserve's decision to raise interest rates in order to see which school has a superior paradigm with which to measure inflation.
One question to everybody- In what school of thought, as I have outlined them, would you place Alan Greenspan?
Thursday, May 25, 2000