Back to Basics, Pt. 2: It’s all about appearances

In the previous post, I covered the phase-out of the gold standard. During the times when we were using commodity money, a medium of account(MoA) was developed that is valid for both gold and cash. For this to happen, one had to be fixed on the other. Silver was abandoned in the 19th century, and gold was abandoned in 1968 after gold prices rose in the second half of the 20th century. After this point, only the currency remained as MoA.

Why is fiat money worth something? This question actually contains two different questions. First, how do we define the value to society of having a MoA? And second, how can a nominal MoA have value? MoA is a tool for exchange and can also be considered as a store of value to a point. What might an asset with these roles be worth? Its value as a medium of change is probably 1% of GDP, and as a store of value, it is somewhere between 1% and 10% of GDP. So how can we know that? Because MOA traditionally did not pay interest. Therefore, the net value of the interest for which the cash stock is forfeited is the stock itself. And currency stocks tend to be between 1% and 10% of GDP.

Sometimes you hear people say that fiat money is “essentially” worthless. What does this mean? If fiat money loses its role as a MoA, it has no value. However, gold or silver is also important in other fields, and this is not the case for them. 

This situation then reveals a deeper problem: Of course the monetary system is valuable, but this does not explain why an asset is considered a monetary value. We couldn’t learn what valued him from the above questions. There are several theories that may be compatible with each other on this subject:

  1. Unlike t-bills, its nominal price is fixed, which makes it suitable for transactions. Unlike t-bills, they are obtained at favorable nominal values. Private small denomination currency issue may be banned.
  2.  Some kind of social contract/bandwagon effect. This is probably the most common answer you come across: People will take it as money because everyone else will.
  3. Support can be provided in an emergency. For example, let’s say technological change is expected to make cash obsolete by 2049. The public may believe that the government will redeem it for some sort of asset instead of allowing hyperinflation in this situation. This can be thought of as public confidence that the government will not allow hyperinflation.
  4. The government allows individuals to pay taxes with this unit, thus making it official.
  5. The unit is supported by assets on the central bank balance sheet.

In fact, all of these theories may be correct, they are compatible with each other. In the last days of the gold standard, people mostly preferred to use cash and small coins. This situation made people get used to seeing cash as money. If you’re an economist looking to study inflation in 1968, the end of gold as a MoA would seem like a crucial decision to you. However, the public did not care much about this – they were already used to using money as money. Appearances and aesthetics are quite important in economics(as well as politics): if something is used as money, then it is money.

In fact, even just the social contract/bandwagon effect is sufficient from this point forward, but that doesn’t mean that other factors are absent – rather they are hidden in the shadow. If the public had expected that the government would suddenly start hyperinflation tomorrow, the value of the cash would collapse.

This post has been long enough, so I’ll leave it for the next post to study the money quantity theory. In the next post, we will see how and using what tools the central bank can control the value of money(and naturally, NGDP).

Aggregate Demand is not what you think

Scott Sumner has a new piece arguing that supply and aggregate supply are unrelated and misnamed:

The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.

When people think about macroeconomics, they often tend to confuse concepts. Frankly, I think that is the reason for this situation. Just like aggregate supply, aggregate demand is a terrible term for the concept that we use in macroeconomics 101.

If an ordinary person thinks about macro, he will probably see “aggregate demand” and “quantity of goods and services purchased” as the same thing (or at least use these two concepts interchangeably). But there is an important nuance:
Suppose there is no change in AD but AS has declined. We are in a supply crisis(for example, you can call it the Black Death or the Covid-19 pandemic), and even if there is no change in AD, the amount of goods people buy in stores will decrease. However, the important point is that this is a decrease in equilibrium amount, we simply cannot talk about a decrease in AD.

Let’s start with the Black Plague and then come to the present-day. The Black Death caused Europe’s population to decline by 30%. In terms of the curves shifting to the left, the demand for almost every commodity has probably dropped considerably, and of course, supply curves have shifted to the left as well. Therefore, the relative price did not change significantly.

So how could the Black Death have almost no effect on aggregate demand? How do we explain this? There were far fewer people in the world, and the demand for each commodity has dropped dramatically. Shouldn’t the aggregate demand also decline?

At this point, the concepts I mentioned above get mixed up and force you to think wrongly. I do not claim that this is anomalous, the first thing that every person who sees the terms “demand” and “aggregate demand” would involuntarily do in his consciousness would be to encode aggregate demand as “the total quantity of goods purchased.” The term we have created forces us to reason wrongly.

Here’s what really happened: The Black Death or any other epidemic doesn’t have the power to kill money, so the money supply probably didn’t change (I’m talking about commodity money, of course). By lowering the speed it may have shaken AD, but as far as we know, this did not have a serious effect. What we do know is that the Black Death increased prices and quite possibly lowered real GDP. AD curve did not shift left due to Black Death.

And the same is true for the covid-19 recession. Production of supply chains had been significantly disrupted. However, there was not a big decrease in total demand. Instead, prices rose and real GDP fell.

Here’s what happened in both epidemics:

Most people understand what the concept of demand is at the level of individual products. And most people think that aggregate demand is related to the concept of demand at the level of individual products. It isn’t. They are unrelated. Considering ordinary use, the concept of aggregate demand actually has nothing to do with “demand.”

At the micro level “demand” is a kind of real concept, the amount of Samsung Galaxy Note 10 consumers want to buy at various prices. Aggregate demand is nothing like that. When we talk about AD, we are not talking about consumer goods. AD is a nominal concept related to money. Monetary policy determines the AD and only central banks have the tools needed to solve AD-related problems.

The piece in The Economist is quite important at this point:

But whether the understanding of supply shocks forged in the 1970s still applies is unclear. In practice, the distinction between shocks to demand and those to supply is fuzzy. In a paper published in 2013 that revisited the era of stagflation, Alan Blinder of Princeton University and Jeremy Rudd of the Federal Reserve argue that supply alone cannot explain the soaring unemployment of the 1970s. In fact, they say, price increases had demand effects that mattered more. They raised uncertainty, reduced households’ disposable income and eroded the value of their savings.

So what can be done with these terms that make us confuse concepts and reason wrongly? My suggestion is to call it nominal expenditure(s). If we use this term, we will have a much more useful and accurate term for the concept.

The Course of Empire: Banana on the Potomac

“Democracy is the most delicate flower in the world. It is tolerance, compromise, and dialogue that makes it alive.”

What happened in the United States today is only a teaser of the vandalism that will be faced when the general principles that sustain liberal democracies are eroded over time. The Principle of the Rule of Law, tolerance, and values of Open Society- we have seen again how important these principles are.

The United States was built on the values that reflect the pure belief in freedom in its roots. However, these values have started to erode a long time ago and this process, which has accelerated in recent years, has finally reached the stage of a banana republic.

The important thing here is to understand that the problem is not just about Trump. Trump is not a cause, but a result of the circumstances that brought him up.

Perhaps the roots of the problem lie in the founding process of the US. The most fatal mistake of the Founding Fathers was that the system is the product of such bonafide naivety from its founders that it is always based on the assumption that only decent people will be presidents. The real world is not like this, and both our historical experience and the reality we encounter prove that this assumption is not correct.

In fact, if only the Founding Fathers could attach a little more importance to the classical liberals’ views on the government and the nature of power. “Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men…”

But instead, the US system was formed around an elected king. The reason Presidents have such massive authority is that the system is designed for an elected king, not a President. This may seem plausible, perhaps going back to 1776. However, this system should not have continued even for 100 years.

The US system only encourages reach a consensus on the unresolved issues. It encourages problems not to be solved on purpose. This is one of the reasons why, despite the fact that the United States experienced one of the bloodiest civil wars in history 160 years ago, still harbored the internal contradictions that led to that war, which is deepened today.

Look at this:

The truth told by this photo is very clear. Looks like it was taken when the barbarians who plundered Rome 1600 years ago were entering the Flavian Palace. But no, the photo was taken in 2021. Sack of DC, huh?

For a while I’ve been claiming that the US is becoming a banana republic. Does anyone still disagree with my claim?

P.S: Libertarians must stand against Trump even more strongly from today on everywhere and on every single issue:


Back to Basics, Pt. 1: The Long Phase-Out of Gold

In this and the next few posts, I will examine how money determines the price level. It seems quite appropriate to start with the silver standard first. Let’s start by assuming that our unit of account is a pound of silver or “PS” for short.

When defining money, we can use many different criteria such as the medium of account(MoA), the medium of exchange(MoE), or liquid assets. I believe MoA is the most useful definition because we will significantly set aside the distractions that MoE can create and focus more quickly on important issues. Indeed, silver itself is an MoA, and I will use this term from now on.

The value of the MoA(let’s call this “money” hereinafter) is equal to 1/PS. The price level is determined only in the silver market. The modeling of the price level is a microeconomic issue in the long run, whereas the effects of changes in the price level concern the macroeconomy.

In our classic model, when a new silver discovery is made that shifts the silver supply to the right, the value of the silver will decrease and the price level will rise inversely with this. We don’t have a money quantity theory yet; we’ll see this later with the fiat money system(although it should be noted that the theory was ironically invented during the period of the commodity money system).

Ultimately, most countries have passed the gold standard. In the US, the dollar was defined as 1/20.67 ounces of gold until 1933. Governments do not usually operate gold mines, so monetary policy in this system is just one tool and only this tool can affect changes in gold demand. This can be done differently, such as changing the amount of gold associated with the paper dollar using discount credits, changing reserve requirements, or Open Market Operations. Less demand for gold is expansionary and vice versa. Small countries obviously have little influence on the value of gold set in global markets.

If we are under a gold standard, we can speak of a kind of “zero lower bound problem” for gold reserves, which Keynes incorrectly called a liquidity trap. For this reason, tightening the money is easier to do than easing, because the easy money is constrained by the idea that the central bank’s demand for gold cannot fall below zero.

Most people think that this is why the US left the gold standard in 1933. But the US did not really abandon the gold standard in 1933, it just suspended it temporarily. It is difficult to say with certainty what the real problem is: perhaps the FDR could not inflate the Fed as much as it wanted, thus raising the price of gold, putting an end to it. However, the dollar was fixed again in gold in 1934, and this continued until 1968.

It took 34 years for gold to be completely obsolete, and there was a huge increase in the price level during this period. This degree of inflation can be attributed to three factors(the first two are related to FDR’s decisions, and the third is pure coincidence):

  1. Gold is re-fixed from $1/20.67 to $1/35. Even just this increased the prices by 69%.
  2. The FDR made it illegal for Americans to accumulate gold, which reduced the global demand for gold. Next US presidents lowered the gold/currency ratio.
  3. Most of the demand for gold outside of the USA was from countries in Europe. The Great Depression and WWII exerted abnormal pressure on European economies, causing a dramatic decline in European gold demand.

Regardless, in the mid-1960s US policy was so expansionary that the gold standard had to be abandoned. Finally, in 1968, foreigners(other than governments) trading in gold was stopped and the free market price of gold rose above $35. The gold standard took its place in history.

Why did this whole process take 34 years? When we look at it today, we cannot fully grasp how deep the idea of the gold standard was in people’s minds in 1933. Even Keynes was vehemently opposed to a pure fiat currency regime(instead of that, he proposed an adjustable gold currency). Post-WWI hyperinflation was not forgotten, and if you talk about the virtues of fiat money in 1933, any “expert” would show you Weimar Germany. 

In 1968, however, the post-war Keynesian model was dominant, and money and everything connected to it was almost completely pushed to the background – this would continue until the 1970s showed people its importance.

In the next post, we will develop a fiat currency model. This model will also include a price level determined by supply and demand for the MoA(which is now cash), but several important nuances lead to significantly different policy outcomes.