Monday, November 1, 2010

Economics: Money Represents Production

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I think this is where it starts to get very interesting. We've covered that currency is just a medium of exchange, so the rules of supply and demand work the same way. Inflating the currency results in higher prices (through the currency's loss of value), and similarly deflating it results in lower prices (through the currency's gain in value). Inflating it too much too quickly will result in hyperinflation and possibly result in its destruction altogether.

Now we'll begin to set the stage for understanding what a "bubble" is (aka "boom and bust"), where it comes from, and how some can spot it but others do not (or at least they refuse to acknowledge it).

Money represents real productivity. For example, if I work at Wal-Mart for 40 hours and get paid $5/hr then I'll get paid $200. That $200 represents a service rendered, real productivity. A more illustrative example would be a baker who bakes a loaf of bread and sells it for $2. That $2 represents one loaf of bread made, and when that baker goes and buys a carton of milk for $2, then we've essentially said that the $2 was merely a place-holder for the exchange of a carton of milk for a loaf of bread.

Very important to understand the concept that money is a physical representation of a good or service. Money in and of itself is a mere placeholder for some rendered good or service, for something of value that's been produced. This is why counterfeiting is illegal, because you suddenly have the power to purchase a good or service but you never created anything of value yourself, you simply created out of thin air the medium of exchange that represents rendered productivity.

Let's show this in a real example. I want a pair of shoes, I go to the shoemaker and he says that he'll make me a pair of shoes for one loaf of bread. I bake the bread, give it to the shoemaker, one week later he brings me a pair of shoes. Society evolves and we're now using a bill of credit to represent my loaf of bread. I go to the bank and hand them my bread, they hand me my bill of credit which is redeemable for 1 loaf of bread. I go to the shoemaker and hand him a credit note saying that he has access to one loaf of bread. He makes the shoes and goes to the bank to redeem his bill of credit for his bread. Society expands, there's now 2 bakers. I bake my regular loaf of bread, take it to the bank and put it on deposit for my bill of credit. The other baker does not make his bread, but instead gets a loan from the bank for a bill of credit and hands it to the shoemaker.

Business is booming for the shoemaker!

He makes 2 pairs of shoes, takes his bills of credit in for redemption but the bank only actually has 1 loaf of bread in reserve. He's been robbed. He's wasted his time and resources making a product that he cannot immediately sell, if he handed it over already then he has nothing in return for it. Yet, on the outset it seemed as though business was picking up! In reality, the bank sent a false signal to the market to ramp up production when in fact there had been no real increase in productivity. It was not immediately apparent, because it takes time for the real resources to be called upon, in our case it took a week for the shoemaker to find out that there weren't 2 loaves of bread. He had a very short boom and bust cycle. (This example tweaked from Thomas Woods' version in his book "Meltdown", I highly recommend it.)

This is why the Federal Reserve, the US central bank, is the root of all the market volatility for the past 100 years (including the Great Depression). As the controller and sole creator of US Dollars, they have the ability (and exercise it quite often) to create as much new money as they desire, however they merely create it out of thin air, that newly created money represents no new productivity from the market place. Thus, upon the new creation of money it sends the signal to the market to ramp up production which ultimately results in a large collapse once the resources are ultimately found to not exist.

After the 2001 Dot-Com bust, the Fed in conjunction with politicians started up the next bubble, the housing market (more on that later) in order to get the economy going again. Now that the housing bubble has popped, the Fed is trying to start its next Boom, but the market may be too taxed. Time will tell, but this Wednesday may be a landmark day, the Fed will officially announce its next batch of inflationary policies, how much, how often, and for how long. The keyword will be "Quantitative Easing", don't let the lingo fool you, it just means inflation, aka "creating money that nobody earned", or as I like to call it, "stealing".
A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

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