06/19/09 Toronto, Ontario On February 17, 2000, then Federal Reserve Board Chairman, Alan Greenspan, was answering a question from Congressman Ron Paul during a House of Representatives Committee on Financial Services hearing, when the following exchange took place.
Mr. Greenspan: “Let me suggest to you that the monetary aggregates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts.
“The problem we have is not that money is unimportant, but how we define it. By definition, all prices are indeed the ratio of exchange of a good for money. And what we seek is what that is. Our problem is, we used M1 at one point as the proxy for money, and it turned out to be very difficult as an indicator of any financial state. We then went to M2 and had a similar problem. We have never done it with M3 per se, because it largely reflects the extent of the expansion of the banking industry, and when, in effect, banks expand, in and of itself it doesn’t tell you terribly much about what the real money is.
“So our problem is not that we do not believe in sound money; we do. We very much believe that if you have a debased currency that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the standard we employ is whether it gives us a good forward indicator of the direction of finance and the economy. Regrettably none of those that we have been able to develop, including MZM, have done that. That does not mean that we think that money is irrelevant; it means that we think that our measures of money have been inadequate and as a consequence of that we, as I have mentioned previously, have downgraded the use of the monetary aggregates for monetary policy purposes until we are able to find a more stable proxy for what we believe is the underlying money in the economy.”
Dr. Paul: “So it is hard to manage something you can’t define.”
Mr. Greenspan: “It is not possible to manage something you cannot define.”
Here we have possibly the most influential and powerful banker in the world, who is in charge of managing the most widely used money in the world – the U.S. dollar – telling us not only that he doesn’t know what money is, or how to measure how much of it there is, but admitting that it’s impossible to manage the money supply precisely because they have not yet figured out what it is or how to measure how much of it there is.
For something we use every day and that is an integral part of our lives, it is remarkable how little we know about money.
When the money supply increases (inflation) money loses value (prices rise). Because the money supply is almost always increasing (inflation), and therefore decreasing the value of money, it means that our standard of living is eroded over time if our income is fixed, or not rising as fast as the inflation rate (the rate of increase in the money supply). Yet there is no credible measure of the inflation rate. I have been searching for an answer to the actual inflation rate for more than a decade and there was none that I felt was accurate enough, so I had to design my own.
Actual Money Supply (AMS) is a tool that I created to measure the money supply in the United States and therefore the actual monetary inflation rate. The chart below is always the most recent one I have and is updated as data becomes available.
Because the monthly, year-over-year data depicted in the chart is so volatile I added a rolling 12-month average of the Actual Inflation Rate to the chart. The rolling 12-month average inflation rate is itself still quite volatile, but much less so than the actual monthly data.
It is interesting to note that the average rolling 12-month inflation rate averages 8.25% for the past 15 months. To put that in context, the average inflation rate from 1970 to 1979 was 8.32%. We are, absolutely, in a highly inflationary environment. Deflation is not only unlikely given the structure of the US banking system, but nowhere to be seen in the data either.
Demand destruction has had a severe impact on the prices of many goods and services, but that should not be confused with deflation. Inflation and deflation are monetary phenomena and the recent decline in prices has only lead to confusion and further obfuscation of what is really going on.
Monetary inflation is currently mitigating the price declines we are witnessing, meaning those prices that are declining would have declined much more were it not for the inflation, and will eventually cause prices to start rising again. Our greatest concern should not be with the current falling prices of goods and services, but with the rate at which they will rise in the future vis-à-vis our capital and income. I suspect there are very few people out there whose income and investments are keeping up with the inflation rate, which means their wealth is eroding in real terms.
I have also been aggregating and calculating similar money supply and inflation data for Canada and found that the Canadian dollar’s inflation rates for 2007 and 2008 were much higher than the inflation rates of US dollar. However, the average inflation rates for 2009 thus far are exactly the opposite. Canada’s inflation rate is falling while that of the US is remaining steady above 8%.
Year US CAD
2007 7.93% 9.55%
2008 8.31% 10.23%
2009 8.48% 6.89%
For those interested in gold, my fair value of gold for 2008 was $763 an ounce. Using the average of 2008 and 2009’s inflation rates for the U.S. dollar, and gold’s inflation rate for 2008, I come up with an approximate average value for gold of $815 for 2009. Please note that this is an estimate of the average value for the year, and not a year-end estimate.
Clearly the gold price is well above $815 an ounce, and has been so for quite some time. The macro economic environment has probably never been so obviously in favor of gold and it is my belief that the market has already priced much of this into the gold price. While I fully recognize gold’s lure at these times, and the probability that the gold price could still increase quite substantially, I remain cautious about gold. Recall that investors who bought gold when it was grossly over-priced during 1979 and 1980 and then forgot to sell, suffered severe losses.
I would personally prefer gold to sell down to around $800 an ounce, where I know it represents good value, than buy gold at over-valued prices and hope that it keeps going up.
Regards,
Paul van Eeden
for The Daily Reckoning
Paul van Eeden
Paul van Eeden is president of private holding and investment company Cranberry Capital Inc., and is well known for his work on the relationship between the price of gold and currency markets. Originally from South Africa, and having been intimately involved in the financing and evaluation of resource companies, he has an insider's understanding of mineral exploration. Van Eeden is a frequent speaker at investment conferences and a regular guest on radio and television.
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The fair value doesn’t seem to price in any possible currency events, or other shocks to the system. Lets say one has 0 gold, isn’t it risky waiting for gold to hit 800 in this environment? Wouldn’t it be better to at least buy some now? Very good read by the way. Thank you.
The Fed tries to define the value of money, and others try to define the value of gold. The real reason everyone is having such a hard time is because they haven’t defined what ‘value’ is first. Value is based upon ‘future usefulness to people’. In other words, you not only have to have some commodity that is useful in itself, but you have to have people that are able to make use of it. If everyone has plenty of gold, but no food to eat, then the gold is worthless. If there is plenty of food, but it makes us sick…..(cue Monsanto tapes).
Money in the present has value because it is useful in the future for exchange. If there isn’t a future infrastructure (no cheap oil to run the System of systems), then it doesn’t matter what you make money out of, it will still end up being worthless because there won’t be anyone who needs it (those who are still alive will have established barter systems locally).
We might as well institute a sales tax of 50% or more right now to stop people from buying stuff they don’t need and kill the thrashing economy before it kills the planet.
possibly one of the best inflation articles for at least its thoughtfulness….however if money is difficult to define – about which i disagree – price inflation is even more difficult to define – or more preceisely to measure….in fact it is IMPOSSIBLE to measure price inflation….and it is equally impossible to measure the relationship between monetary inflation and price inflation…..the reason for the impossibilities is that the goods and services purchased with said money are not constant…..it will never do to talk about hedonics and a host of other factors attempting to adjust for product change….furthermore, discussion of inflation is crippled beyond repair with the notion of measuring it in dollar prices…..the USD IS NOT MONEY – IT IS ONLY A MEDIUM OF EXCHANGE. 99.9% of most folks will not get that or the implications thereof…..
it is also impossible to isolate the monetary contribution to price changes.
it would be interesting to tell your readers what exactly is in ams…..
the other factor making impossible talk about the relationship between dollar inflation and price inflation is the presence of credit which serves as a proxy for money or buying power.
at least your observation of continued inflationary forces corresponds closely with mine.
it is good to see others struggling with the notions of monetary inflation, price inflation, buying power, and currency debasement however we are still in the dark ages of having a good model to describe these foreces and their interactions. linear mathematics is inadequate just as the quantity theory of money is voodoo economics….
Good discussions, but how to make more money will ever remain the thoughts of every living human. Everyday.
Silly. The first thing you need to know about money….is that “he holds the gold makes the rules”. Being the largest debtor in history means that our creditors “make the rules”. THEY DETERMINE THE PRICE OF THE DOLLAR AND THUS HOW MANY ARE REQUIRED FOR GOLD. To even compare gold in a currency with only a few months to live is pretty funny. If you’re concerned about exchanging gold for dollars in the future than you don’t get it. The dollar is done…gold will be implemented in the new SDR’s at the IMF and the dollar will be reputiated immediately at the expense of this quasi-gold-back currency. Not decline 20%….but to ZERO.
This is “the” best most accurate article I have read concerning the inflation/deflation debate! When you have an equation with two moving variables it becomes more difficult to solve. Holding one variable constant, you can determine the solution if the other variable moves. If we were on a true gold standard (disregarding new gold mined and added to the mix), you would see prices fall due to market conditions of reduced demand. If market conditions (supply and demand) were constant and you inflate the money supply, you would see prices rise due to a lot more money chasing the same goods and services. I suspect we are feeling the effects of inflation but we can’t see the effects until the market conditions re-gain their balance and I am not betting the Fed (based on historical results) can stop the multi-variable locomotive.
“multi-variable locomotive.” Good discription for runaway train.