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So if money has become less rare while its utility has barely increased (because its utility – its real usefulness – must be a function of its purchasing power, which in turn is related to genuine economic growth, and this hasn’t risen anything like as much as the money supply) then its value must have fallen. To look at it another way, while the amount of real wealth was rising moderately with genuine industrial output, the amount of money being pumped into the economy was expanding much more rapidly.
There is only so much real wealth in the world at any one time and, however much credit banks might create through leveraged lending, or governments might pump into the banks through quantitative easing (more on this in Chapter 12), it doesn’t add one penny to that stock of real wealth. So all it can do is dilute the value of money, like adding water to wine. Just as the wine will be lower in strength, so will the money, and this must inevitably lead to higher prices.
A quick word about inflation
Inflation is commonly understood these days to mean the rise in prices caused by the devaluation of each monetary unit. It would be more correct to say that rising prices are the result of inflation and that the actual inflation is the growth in the amount of money in the economy relative to real economic activity.
An easy way to understand the relationship between the amount of money in circulation and its value is to go back to the commodity analogy.
Say a bushel of wheat has traded for an ounce of silver for several years – this being the accepted market rate, according to the principle of supply and demand – but then farmers start to grow more wheat so they can exchange it for more silver. The effect will be to cause a shortage of silver, raising its price relative to wheat. Each bushel of wheat will then be worth less, when measured in silver terms.
Now try it the other way – an ounce of silver will buy a bushel of wheat. What happens if more silver is mined and gradually finds its way into people’s pockets, via the local market? The demand for wheat increases because people can buy more. Wheat becomes scarcer so prices rise. Farmers might plant more wheat next season to meet the increased demand, but that’s only possible if they have the land. If they don’t, then the cost of wheat stays higher and you have price inflation.
The same thing applies to money supply: if governments print more money than the economy merits, the price of commodities must rise to compensate for the new demand. The money is devalued. Inflation of the money supply beyond genuine economic growth results in rising prices.
Figure 17
The rise in money supply seen in Figure 17 is mostly due to rising wealth and economic activity, and only partly to inflation (this chart is not inflation adjusted). There should be a close correlation between money supply and GDP – otherwise it must mean a change in demand for money relative to output – but the two don’t actually move together. If, for example, we plot US GDP, unadjusted for inflation, against the broadest measure of money supply, which just happens to be very close to GDP in actual dollar terms, we see a close fit (as in Figure 18).
But we see also that the money supply has been rising more quickly in recent years. At the time of writing, we haven’t seen the full effect of this inflation of the money supply, because most of this newly created money is being held by banks and other financial institutions and hasn’t entered the real economy. The high demand that caused the last boom – demand fuelled by credit – has collapsed since the crash, but the supply side of the economy takes longer to adjust. Weak demand relative to supply keeps prices down.
Figure 18
We have had a trend of falling commodity prices over the last half-century (as shown in Figure 7), due to rising efficiencies on the supply side related to globalization and the increase in market size. Prices recently have been up and down like a rollercoaster, partly due to speculation, but this hasn’t resulted in a big rise in most consumer prices in the long term. However, the trend is turning upwards and is likely to rise more steeply as oil and mining companies, and farmers, demand a fair price – a price that takes account of the falling value of the dollar and of money generally.
This has not affected these primary producers significantly yet, because their costs haven’t risen all that much (the cost of equipment and labor and so on). But at some point there has to be a readjustment. It is inevitable that prices will rise, because although the value of money has fallen, the value of the earth’s natural wealth hasn’t changed – except in so far as resources have become scarcer, which will itself also cause prices to rise.
There might not appear to be any particular law that governs the relationship between the value of natural resources and money – supply and demand is hardly a scientific equation – but there ought to be a general consensus that links the scarcity of resources to the price, which must eventually feed through to the markets.
Figure 19
It’s true that markets aren’t actually all that good at valuing commodities, partly because of the influence of speculation – betting on future prices influences those prices, just as betting on a racehorse changes the odds. There’s a tendency towards a herd instinct that pushes the trend too far upwards, followed by an overreaction when it becomes obvious that prices have risen too much, sending the price too low, much the same as happens with stock markets.
One might suppose that the true value of something like oil, for example, shouldn’t vary greatly, both demand and supply being fairly constant. The former rises and falls with changes in the real economy, but not by all that much relative to the total quantity produced, as shown in Figure 20. Supply is depleted gradually by extraction, and can be temporarily reduced by production problems in a certain region – a war in the Middle East, for example. It can also be boosted by new fields coming into production. But these are not wild variations compared to the overall quantity of oil available from operational fields.
Figure 20
If we look at the oil price over the last half-century, as shown in Figure 21, we see that the price hardly varied until the dollar, and therefore oil, lost its link to gold in 1971, at which point producers began raising prices to compensate for the fall in the dollar’s value. Unrest in the Middle East added to the uncertainty and caused price spikes in 1973 and 1979. Prices fell as production increased in the 1980s and 1990s, then rose sharply in the boom up to 2008, driven by speculation as well as rising demand. So the price is obviously not governed purely by the true value of the product, and in fact might bear little relationship to it.
But ignoring these wild fluctuations, the trend for commodity prices is bound to turn upwards. Global demand will keep increasing as long as the population keeps rising and emerging economies continue to grow, while many commodities are gradually being used up. At the same time, money is more
