Why the Value of Paper Money Declines as the Quantity Rises

Not much action yesterday. The Dow fell 12 points. Gold rose $19.

What else do you need to know? Nothing much has changed.

US stocks are up about 6% so far this year. Gold has gone up three times as much.

The Wall Street Journal: “Gold vs. the Fed: the Record is Clear.”

Yeah, the record is clear. The Fed’s money has been losing ground against nature’s money for the last 10 years. Roughly, if you’d stuck with gold you’d have 5 times the purchasing power you got from the US dollar.

That’s pretty clear, isn’t it?

But you could go back and look at the history of every pure paper money. Look at how it did against the yellow stuff. Same story every time. No exceptions. Once you let human beings print “money” at will, they will print a lot of it. And unless they repeal the laws of diminishing returns, marginal utility and supply and demand, the paper money will lose out.

The law of diminishing returns says the more you do something the less good it does you. We’re not sure that’s true of everything… Mae West had a slight twist on the concept. “Too much of a good thing is wonderful,” or something like that. But for almost everything but THAT thing, the more you do it, the less you get out of it. It applies to printing up $100 bills too.

The law of marginal utility is just another way of looking at the same concept. It tells you that when you get more and more of something, each additional unit has less value than the one that came before it. You can see how that works in the case of dessert, for example. The first chocolate pudding tastes great. The 10th one makes you sick. At that point, you’re getting not only diminished marginal utility, you’re getting negative marginal utility – which is what you get from bank credit too, but that’s another story.

We once knew a very rich man. He ran for governor of New York. We asked him why he bothered. He didn’t need to steal from the taxpayers; he already had enough money.

“Yes,” he replied. “But that’s just it. I’ve reached the point where the marginal utility of more money is extremely low. I need to do something else.”

He didn’t win the race.

But the point is, the fed’s gazillionth dollar is going to be worth a whole lot less than its first dollar. The more they print, the more you wish you had gold.

And you know the law of supply and demand already. There is a certain amount of goods and services available. This amount can be increased. But not overnight. It takes time, investment, expertise…and so forth.

By contrast, the feds can increase the supply of dollars almost instantly. It can just add zeros and multiply the supply by 10. These new dollars compete with the old ones for the available goods and services. Pretty soon, prices are rising – fast.

Oh…if it were only that simple. Trouble is, there’s the velocity of money too. When the economy takes a cold shower, the velocity of money slows to a crawl. Then, the feds can add as much new money as they want. It doesn’t necessarily get around the way the old money used to. Everybody holds onto it. The banks just keep it in their vaults. Householders keep it in their wallets and mattresses. Everyone figures he might need it.

When trouble hit in 2007, the banking sector had just $2.3 billion in excess reserves (money they held beyond the legal requirement) – barely enough to buy a drink in a good bar. Now they’re swimming in it. They’re got $976 billion in excess reserves. So how come consumer prices aren’t going wild?

By the way, where’d that money come from? The Fed already gave the economy a BIG dose of paper money. The feds were afraid that the banks were failing. They were right to be afraid. They were wrong to try to do something about it. It would have been much better to let the chips fall where they may…maintain the integrity of the government’s own finances and protect the dollar. There were plenty of sensible, well-funded bankers to pick up the pieces of the broken ones and make something good of them.

And by the way, again. This is not just our opinion. Mexico and Chile went through a similar crisis in the early ’80s. Mexico did what the US would do a quarter century later. It “allowed [its] archaic bankruptcy system to perpetuate the lives of money-losing businesses and allocated credit by government direction,” says Grant’s Interest Rate Observer.

And Chile? It let companies fail and allowed its markets to clear.

And what was the difference in outcome? Chile was back on track a decade later, soon surpassing its pre-crisis growth trendline. Mexico, on the other hand, never fully recovered. It’s still 30% below trend.

Just what you’d expect, in other words.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning