Thursday, April 26, 2012

The value of money - the price level

Nothing I read on the internet is as confusing and simultaneously as all-consuming as discussions on monetary theory and banking. I plan to discuss this at some length later on, but a short one on the most recent discussion - where does the 'value' of fiat money (created out of nothing that exists currently by central banks, governments) come from.

For more involved discussions, you can read Nick Rowe, David Glasner, Mike Sproul (reviving the Real Bills doctrine, which seems to me like a tautology in the general case), the standard neo-classical theory since Hume or any number of chartalists. At the moment, I'm just wondering about the circularity of it all. To give an example, witness this section from a completely unrelated post at the NY Times :

The 1,000 shillings note exchanged for roughly $0.13 when Gen. Muhammad Aideed employed a printing firm to reproduce the note in 1996. As the number of notes in circulation grew, the exchange value fell to just $0.03, which is the cost of producing an additional note. Since the exchange value equals the cost of production, forgers can no longer profit by increasing the supply. Today, the Somali shilling is a commodity money. Its supply is governed by the cost of ink and paper required to produce a note. From Letters.

Now notice the number of questions this seemingly simple paragraph begs. If the value of Somali shillings (as denominated in US dollars - this is crucial) fell so much, why did the cost of forging/ printing a new note (as denominated in US dollars) not fall in lockstep? Notice that the argument applies equivalently to the Somali authorities as to the forgerers - this is the same as saying that the seigniorage power of the Somali government is now zero.

This paragraph makes sense only if one was to assume two things - that the global price (or at least the price relevant for printing the Somali shilling) of ink and paper is fixed or sticky in terms of the US dollar, and that the US dollar is the relevant unit of account for the act of printing Somali money. Which is to say, that the Somali currency has also been dollarized, not just commoditized. The argument wouldn't hold equivalently if all the forgery/ printing were to happen through locally produced paper and ink that were not traded in contracts denominated in dollars.

All this is to say that talking about the value of anything without first defining a unit of account is incoherent (also why I think the real bill doctrine is a tautology). And the unit of account does not need to be the same for all trades - it usually would simply be whatever is the most common/ commonly accepted medium of exchange. And then we're back to square one. This is also why I've never quite understood why the price of coffee or restaurant meals should have shot up in the Weimar hyperinflation, or why there should ever be hyperinflation in a localized system. The story goes that a cup of coffee worth 5000 Marks when ordered would be worth 8000 Marks by the time the bill arrived. If coffee was locally produced (the coffee, not the beans), locally consumed, by local people who on the average would have nothing to do with international markets, why should  the depreciation of the Deutsche Mark in dollar terms affect the local price of coffee denominated in Marks?

It would all make sense if one was to talk in terms of self-fulfilling expectations - the cup of coffee became more expensive because the seller no longer trusted the value of 5000 marks, whatever that is, to be 5000 marks. He now expected it to be 8000 marks, so he hiked the price of coffee and the mark depreciated with respect to coffee. The underlying theory of the price level is that people in general have some 'sticky' expectations of relative prices, some expectation of an absolute unit of account (the local currency, gold, dollar, whatever), and then those prices that  fluctuate with respect to the unit of account may (or may not) take the other prices along with them. All of which is very confusing. 


Ray said...

I followed your comments from Marginal Revolution. Is there any way I could email you?

I ask, because I wanted to get information on London's housing problems and general zoning planning issues. And most importantly I wanted to try and figure out who is talking about this and who is trying to change it.

agriculture investments said...

Very interesting post. Ultimately, something like hyperinflation must be considered as a complete loss of confidence in the currency itself.