Applied Philosophy

Introduction

In The Magical Jet Engine and Global Monetary Disconnect I wrote about a war in the realm of pure thought between those who see deflation and those who see inflation accruing in the economy. The inflation is proven by many charts that show the increase in the price of gold, oil, metals, food, etc., while deflation is proven by first stating the formal definition of inflation: “net increase in money supply and credit”, then a multitude of charts are given to prove that the sum of credit and money supply is decreasing and thus there exist a deflation.

“Before we can begin any discussion, it is imperative to agree on the meaning of terms. I happen to believe in Austrian economics and the definition I use when I speak of inflation is a net increase in money supply and credit. Deflation is the opposite, a net decrease in money supply and credit. For more on those definitions as well as rationale for discarding seven other definitions, please see Inflation: What the heck is it?“

-Mike Shedlock, Deflation In A Fiat Regime?

This definition is fairly young-twentieth century-so its not some ancient wisdom or holy commands set in stone. Despite its youth it originated in a time wholly different than ours, a time when there was a fixed reserve of gold anchoring the value of fait fiat currency, thus an increase in money supply and credit was the only factor in determining the inflation/deflation question, those innocent days are long gone now.

The gold anchor is long gone. Money supply ran so high for so long that pools of cash, amounting to trillions of dollars, emerged in the world, functioning as a source of money themselves. Credit/debt is so pervasive and widespread it has become impossible to fix its sum at any one moment. Finally the secular change in oil supply, influencing the supply of all manufactured goods, means that factors that could be neglected in the past are now essential (did the Austrian Economic School ever consider a world were industrial production is in secular decline?).

Such a practical definition would be like defining the working day in the wintertime as from sunrise to sunset, then expecting people to work in the summertime for sixteen hours because that’s what the holy definition decreed; or defining adequate clothing in the summer as a cotton jacket and then expecting soldiers to fight in the winter’s cold clothed in cotton jackets because that’s what the sacred definition dictates.

Practical definitions have their uses by they are perishable goods and care should be taken otherwise one will end up with rotting ideas firmly lodged in his brain.

Those who see inflation are in no better position either, lacking a well posed theoretical definition they are unable to analyse the phenomenon or seek its causes and usually end up in confusion: they confuse demand with supply, cost with value, theory with practice, oil with dollar. To help clear the picture I will try here to give an abstract definition of inflation, in the hope of lifting up the level of debate and furthering the discussion.

The Formal Definition

We don’t want a practical definition, which depends on the nature of the money under discussion and the nature of the economy, but rather a theoretical definition based on an abstract concept of money. First we need to define what we mean with money, the most abstract and encompassing definition is the following:

Money: Medium of exchange.

This is the basic abstract fact that makes money what it is; all other attributes (e.g. measure of value) are secondary. The definition is so wide that it covers money with intrinsic value (e.g. gold) and without (e.g. fait fiat currency). This definition covers money in all its forms, thus it includes credit, exchangeable foreign notes, etc.

“Davanzati showed how “barter is a necessary complement of division of labor amongst men and amongst nations”; and how there is easily a “want of coincidence in barter”, which calls for a “medium of exchange”; and this medium must be capable of “subdivision” and be a “store of value”. He remarked “that one single egg was more worth to Count Ugolino in his tower [prison] than all the gold of the world”, but that on the other hand, “ten thousand grains of corn are only worth one of gold in the market”, and that “water, however necessary for life, is worth nothing, because superabundant”. That was of course before International Monetary Fund (IMF) conditionality requiring the poor in the indebted Third World to pay for water through privatization of basic utilities to service foreign debt.”

 -Henry C. K. Liu, Critique of Central Banking

Money is exchanged for value-I leave this concept undefined-in the exchange domain, which is an abstract encompassing concept and can range from the local bazaar to the world of high finance. The fact that money is exchanged for value means that money has a value-this is sometimes called the exchange value to differentiate it from other values, but for our discussion we will just call it ‘value’-we will discuss how this value is determined in the next section.

The value of money is not constant. The value of one unit of money will change over time. We can define for one unit of money a mathematical function that will give the value at a point in time, and we call it: the valuation function v(t).

If we take a unit of money and measure its value at two points in time, t1 and t2, then divide the difference between the values, v1 and v2, on the difference between the time points we get the rate of change of the value of a unit of money.

rate of change = (v2 - v1) / (t2 - t1)
rate of change =  ∆v / ∆t
instantaneous change =  dv / dt

We call the rate of change in the valuation, i.e. the first derivative of the valuation function, the enrichment function. Thus we get the following:

v(t) : the valuation function, or the value of a unit of money at time t.
dv / dt : the enrichment function, or rate of valuation.
d2v / dt2 : rate of enrichment.

For the enrichment function we have three possible conditions:

dv/dt > 0 → enrichment, or deflation.
dv/dt = 0 → steady value.
dv/dt < 0 → negative enrichment, or inflation.

Some points follow naturally from our definition:

• There is inflation at time t if the enrichment function is negative at time t.
• Money undergoes inflation between t1 and t2 if the total change in the valuation function is negative, or the sum of the enrichment function over the same time-line is negative.
• The change of inflation is the second derivative of the valuation function, when it changes its sign the curve of valuation undergoes inflection.
• While price inflation is a positive quantity (increase in the price), monetary inflation is actually a negative quantity (decrease in the value).
• Inflation is wrongly defined for a fixed amount of goods and a variable amount of money; the correct definition is for a fixed amount of money and a variable amount of goods (i.e. value).
• Deflation is considered, wrongly, a bad phenomenon because it increases the burden of debt, this should lead us to reject debt and not deflation, which is really an enrichment of money.

The Value Quotient

As I said above money is exchanged for value and thus has value, but what is the nature of this value? Let us imagine a man with a large amount of North Korean banknotes in the middle of New York, this man has nothing because he can neither exchange his banknotes for value nor exchange them for US banknotes. If the man should go to North Korea then he will be rich because now the banknotes have value.

The value of money is actualised by exchange; outside of exchange the value is potential and not actual. Bankers who treated credit/debt as cash money when it was liquid-when it could be exchanged easily-only to discover that this value disappears when the credit/debt is illiquid are learning this simple idea the hard way.

So to determine the value of money-the value of an exchange medium and not the intrinsic value-we need to look at money at the point of exchange, thus for a certain exchange domain at a certain point in time we define the value quotient as:

Q = Total exchangeable value / Total exchange medium

The totals here are only for the exchange domain and not absolute totality. The quotient could change when either one of the totals change or it could change when both change or it might stay constant when both change in ratio.

A practical example of change: goods held in storage will lead to price increase, which is the idea of monopoly. Another example could be a change in the amount of coined gold circulating in the market causing a change in prices [of course the price is not Q, but the change in price reflects the change of Q].

The value quotient, Q, is an abstract quantity that can’t be determined practically, but just like we have indicators and indices that help us chart the movement of an economy, similarly we can use indicators to determine Q and we take such indicators to be the valuation function v(t).

One way of measuring the value is to compare the amounts of goods that a single unit of money can buy, we can get this by looking at the price of a basket of goods as is done in measuring inflation by governments. We use the Consumer Price Index data from the Federal Reserve Bank of St. Louis; as shown in this graph:

Click to view

We divide by hundred then take the inverse, that will give us the value of a unit of money, then we normalize to the dollar of 1947. The graph of the value of the dollar from 1947 to May 2008 based on this method looks like this:

Click to view

The decline in value (inflation) has slowed down, but there is definitely no deflation (increase in value) since the fifties.

Another measure of dollar value: We measure the value by looking at the price of oil alone. We use crude price from 1860 to 2006 [data from BP's Statistical Review of World Energy 2007; see Reviewing the Review], we take the inverse to obtain the amount per dollar, then normalise to the value of 1972:

Click to view

In 1972 the dollar was taken off the gold standard and its value plunged, inflation was rampant in the seventies. The petrodollar regime stopped the decline of dollar by providing international demand for the dollar. The increase in non-OPEC oil production brought the price to obscene levels in the nineties, lifting up the value of the dollar. This deflation was not realised in practice because of the obscene increase in consumption, resulting in mild overall inflation in the nineties (although gold was deflated to the chagrin and bewilderment of some gold bulls who thought the increase in money supply will lift the price of gold).

If we compare the two methods we might get a better view of the value of the dollar from 1972 to 2006:

Click to view

We see that the CPI method is a sort of smoothing of the oil price method! The fact is the value of the dollar since 1972 is dependent on the oil price. If all other factors are constant than the dollar’s value would be a pure function of oil price, but not only other factors are not constant they are also interdependent.

If people are convinced of Peak Oil-the secular decline in oil production and by extension all manufactured goods-then they must expect a decline in money supply and credit just to keep the value quotient constant. This simple fact was neglected in the “definition” because then there was no natural limit to production, but now there is and should be taken into account.

“Over these last few years, the U.S. economy has experienced what we would call “controlled” inflation. We would say that inflation has ranged somewhere between 5% and 10% depending on one’s consumption of fuel, medical care and collegiate education. Why this has not sparked outrage among the citizenry is twofold. First, bogus government CPI numbers as well as politicians & journalists blaming oil companies have helped distract the public. Second, some of this inflation has found its way (until recently) into stock & housing prices, which the American investor class seems to applaud. As long as your house and 401(k) go up in value, a little inflation here and there is acceptable.”

-T. Stein & S. McIntyre, Riots May Kill Inflation

Historical Outlook

During the nineteenth century the dollar underwent as much inflation as deflation; here is a graph from Wikipedia (we are interested in the change of the red line):

Click to view

Between 1865 and 1900 the dollar experienced deflation (i.e. enrichment), which restored the value lost during the civil war years. The deflation was much longer in duration than the deflation of the Great Depression and more intense, yet the economic might of the US was built during those years:

“The central attribute of US history during the latter part of the 19^th century was rapid economic expansion. Between 1860 and 1900, railroad mileage increased almost seven folds from 300,000 to 1,930,000 miles. Capital investment in manufacturing multiplied ten folds from $1 billion to $10 billion. The population grew from 31 million to 76 million. The portion of urban population rose from 20% to 40%. The number of workers rose from 1.3 million to 5.3 million, yielding a two and a half times increase of capital investment per worker, from $800 to almost $2,000. The annual value of production multiplied seven folds from less than $2 billion, to more than $130 billion. Worker productivity rose 15 times, from $1,540 per worker to $25,000 per worker. Yet annual wages rose only from $297 in 1860 to $384 in 1870, dropped to $345 in 1980 [sic.] and rose to $427 in 1890.”

-Henry C. K. Liu, Legacy of Free Market Capitalism

The last deflation experienced by the dollar was in the 1930′s, during the Great Depression. Since the 1940′s inflation, or negative enrichment, has been persistent and it is taking the dollar to the zero level; anyone who sees deflation in the current conditions does not know what he is talking about, anyone who thinks deflation is a negative phenomenon is completely ignorant of history and its lessons.