Archive for February, 2008

Aussie money supply growth- December 2007 update

Friday, February 29th, 2008

In Australia?s monetary debasement & credit expansion, we showed you a graph of Australia?s (1) money supply growth (base money, M3 and broad money) and (2) the relativity between standard and fiduciary money since July 1959 to October 2007 (see Are we heading for a deflationary type of recession? for the meaning of standard and fiduciary money). The November 2007 update can be found at An update on Australia?s money supply growth. Today, we have an update of the December 2007 figures from the Reserve Bank of Australia (RBA):

  1. Year on year growth of M3 to December 2007 was 22.7%
  2. The standard money to fiduciary money ratio remained unchanged at 3.7%

It looks that up till December 2007, Australia?s monetary policy is still loose, despite the interest rates rise in November 2007. (see What makes monetary policy ?loose? or ?tight??).

A brief history of silver and bimetallism

Wednesday, February 27th, 2008

If you have been with us for a long time, you would know that we cover gold extensively. If you have not already, we suggest that you read our guide, Why should you invest in gold?, before reading the rest of this article. The material for today’s article comes from Professor Murray Rothbard’s book, What Has Government Done to Our Money?.

Today, we will talk about gold’s troublesome sister, silver. As we quoted the late Professor Murray Rothbard in our earlier article, What about silver?,

It is very possible that the market, given free rein, might eventually establish one single metal as money. But in recent centuries, silver stubbornly remained to challenge gold.

Why did silver stubbornly remain in circulation as money? As Professor Murray Rothbard continued,

Silver remained in circulation precisely because it was convenient (for small change, for example).

As we said before in Properties of good money, a commodity has to be sufficiently rare to qualify as money. But it cannot be too rare. Silver, the less rare sister of gold, was useful for smaller transactions because gold was too rare for further smaller sub-divisions.

Hence, in the free market of the past, both gold and silver circulated side-by-side,

The relative supplies of and demands for the two metals will determine the exchange rate between the two, and this rate, like any other price, will continually fluctuate in response to these changing forces. At one time, for example, silver and gold ounces might exchange at 16:1, another time at 15:1, etc.

In that sense, we can see gold and silver as two different ‘currencies’ whose values fluctuated freely against one another according to the free market. But then, the government came in to ‘help’ the market to ‘simplify’ matters by fixing the exchange rate between gold and silver. The fixed gold-silver ratio was known as bimetallism. The next step after bimetallism was to give specific weight of gold (and silver) a national name (e.g. dollar, pound, etc). Once these national names (instead of a specific weight of gold and silver) take root, it eventually became an abstract unit of value of its own, thereby losing its original meaning in terms of a specific weight of gold and silver. Eventually, these abstract units became the national currencies of today.

Bimetallism helped the government to manipulate money. But it introduced its own set of problems. The free market’s exchange rate between gold and silver would always be freely fluctuating, depending on the supply and demand relative to each other at each instance of time. But by fixing the exchange ratio between them, it introduced the situation whereby one will always be artificially undervalued or overvalued relative to each other. When that happens, Gresham’s law will kick in (see Artificially undervalued coins: government interference cripple the free market for an explanation of Gresham’s law), which resulted in the state of affairs that Rothbard described,

Gold then disappears into cash balance, black market, or exports, when silver flows in from abroad and comes out of cash balances to become the only circulating currency in Ruritania [hypothetical country used as an example]. For centuries, all countries struggled with calamitous effects of suddenly alternating metallic currencies. First silver would flow in and gold disappear; then, as the relative market ratios changed, gold would pour in and silver disappear.

Eventually, what happened? As Rothbard continued,

Finally, after weary centuries of bimetallic disruption, governments picked one metal as the standard, generally gold. Silver was relegated to “token coin” status, for small denominations, but not at full weight.

The next question for investors is this: assuming that one day the world will return to the gold standard, will silver regain its free-market status as secondary money? We will explore more on this idea next…

Truth-teller in the news media

Tuesday, February 26th, 2008

In our previous article, Example of vested interest groups undermining the economic interest of others, we expressed our scepticism on the mainstream news media to report in the best economic interest of their readers. But there is at least one journalist who dares to step on the tails of vested interests. In Rents will rise regardless of rates, Ross Gittins wrote that:

We’ve heard it suggested a lot lately that, since many landlords have borrowed to buy the homes they let, any interest rate increase they suffer will be quickly passed on to their tenants.

We’ve heard it suggested, but is it true? No it isn’t. The line that whenever businesses’ costs go up they just pass them on to their customers – known as the cost-plus theory of prices – isn’t economics, it’s just business propaganda.

For a start, ask yourself why, if businesses can pass on their cost increases so easily, they still complain so much about those increases? Why should they care?

In truth, business people know they can’t pass on cost increases so readily, but claim to be able to do it in the hope of eliciting their customers’ support in their efforts to persuade governments to prevent the increases.

Properties of good money

Monday, February 25th, 2008

Previously, in Is gold an investment?, we mentioned that we will talk about silver in the next article. However, we feel that we have to explain one more important point first before we can move on to silver. Please forgive us…

Remember, in A brief history of money and its breakdown- Part 1, we explained how money developed,

At this third stage of monetary development, a highly marketable good will eventually emerge as the most sought-after intermediate good for the purpose of exchange with other goods. This intermediate good functions as money as we know it. Obviously, such an intermediate good must have characteristics of portability, divisibility, durability and sufficiently rare (but not too rare).

Over the course of time, many commodities (e.g. tobacco, cattle, grain, cooper, seashells and tea) at one time or another functioned as money. But eventually, gold and silver became money for most civilisations and societies in history. Obviously, many of the commodities were eliminated from being money. So, the next question to ask is, what makes a commodity ideal to function as money? They are:

Ideal money must be portable. That is, it has to be convenient for you to bring it along to wherever you want. Obviously, cattle fail the portability test and was not the favoured form of money.

Ideally, money should be easily divisible to cater for all types and sizes of transactions. Again, cattle obviously fail the divisibility test.

Physical money should be durable. If not (i.e. can decay), it cannot be a reliable store of value. Tea fails the durability test.

Sufficiently rare
Obviously, money has to be sufficiently rare. If not, you will have to haul a massive quantity of it for transactions. Seashells fail this test. On the other hand, it cannot be too rare. Otherwise, it will be impossible to sub-divide it further for tiny transactions.

Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity. Someone asked whether diamonds is a suitable commodity for money. The answer is no because diamonds are not fungible. Since each diamond is unique, they cannot be substituted or traded easily. Therefore, it cannot be conveniently used for transactions.

Oil cannot function as money because because it is a consumable commodity. Obviously, it is not a good idea to consume your money! It’s pragmatic value is far too great to function as money.

Sorry for web site down

Monday, February 25th, 2008

If you have been trying to access our web site from around 5pm to 10pm, 25 Feb 2008 (AEST), you may find that the web site is down. Sorry for that. We had technical problems.

Is gold an investment?

Saturday, February 23rd, 2008

Remember that we said before in What should be your fundamental reason for accumulating gold?,

If you cannot remember anything else, please remember this: gold is a hedge against loss of confidence in fiat paper currencies.

In other words, gold is the inconvenient torn in the flesh for fiat paper currencies. It has, for centuries (or even millenniums) being chosen by the free market to function as money in most societies (see A brief history of money and its breakdown- Part 1). It was only until recently (in 1971) that the last official monetary role of gold was abolished (see A brief history of money and its breakdown- Part 2). But given the extended historical role of gold, do you think a mere 3½ decades of government decree can really completely erase the perception of its monetary value from the consciousness of humanity? We doubt so. Many ancient governments had tried but none succeeded (see Ancient Chinese fiat paper money).

Therefore, conventional supply and demand analysis cannot be applied for gold because it is not a commodity (see Is gold a commodity?). This is because with its extremely limited industrial use, gold will not be worth that much at all. It is worth so much because its value is largely derived from outside the realm of industrial and pragmatic usage (i.e. monetary value). Similarly, how much industrial and practical value is a piece of crisp US dollar? If there is no pragmatic use for a piece of paper called the US dollar, then why is it in so much demand (e.g. drug dealers use them for transactions)? Therefore, in conventional supply and demand analysis jargon, the monetary value of gold is consigned into a conveniently labelled group called “investment demand.” But in reality, since gold is a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ‘investment.’ Therefore, it has ‘demand’ the same way the US dollar has ‘demand.’

Next, armed with this understanding, we will then talk about gold’s sister, silver, in the next article.

Watch the British government

Thursday, February 21st, 2008

Back in Recipe for hyperinflation, we mentioned that

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.

We should watch the British government too:

Does wage growth cause price inflation?

Wednesday, February 20th, 2008

Today, we saw this newspaper article,

The threat of interest rate rises and calls for wage freezes to curb inflation are falling on deaf ears, with almost half of Australians still wanting a pay rise.

A CareerOne survey found 47 per cent of Australians say they are not paid enough. About 25 per cent of workers think about changing their job every day.

It comes as Prime Minister Kevin Rudd this week called for wage restraint, particularly among executives, to reduce spending. He froze politicians’ wages for 12 months, wanting the Government to lead by example.

First, why are Australians getting to restless about their jobs and discontent with their wage? Is it because of greed? No, we believe the more likely reason is debt (see Aussie household debt not as bad as it seems?). With interest rates rise, mortgage rates rise, rising price inflation, rising food and petrol prices, under-performing stock market, there is little wonder that the debt servicing burdens of Australians are rising. With rising debt servicing burdens, there is little wonder that a rise in pay-cheques will be highly appreciated by debtors.

But is the increase in wages the cause for price inflation?

To answer this question, we will look at this book, What You Should Know About Inflation by Henry Hazlit:

The same chain of causation applies to all the so-called “inflationary pressures”?particularly the so-called “wage price spiral.” If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the “equilibrium level” would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people’s pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply.

As we said before in Cause of inflation: Shanghai bubble case study, the expansion of money and credit is inflation- not rising prices, wages, petrol, food, etc. For more information about inflation, you can read our guide at What is inflation and deflation?.

Does inflation (deflation) benefits the borrower (lender)?

Tuesday, February 19th, 2008

Price inflation is on the uptrend in Australia. As a result, interest rates are going up and the cost of servicing a mortgage loan increases as well. But some people claim that price inflation is good news for the borrower. The logic behind such a claim is that the real value of the debt decreases due to price inflation. Conversely, deflation benefits the lender because the real value of the loan increases due to price deflation.

Is this always true? Of course not!

In what circumstances will price inflation benefit the borrower? When will it be detrimental? To make life easier for you, we will provide you with a highly simplified rule-of-thumb formula that will help you to understand whether price inflation will harm or benefit you as a borrower:

Debt servicing burden = (Debt payment rate – Growth in wage) + Price inflation rate

As you can see, price inflation alone does not reduce your debt burden. Your wage has to grow along with price inflation. But that is assuming that the debt payment rate (e.g. mortgage rate) does not increase.

The worst-case scenario is when your debt payment rate increase along with price inflation, while your wage remains stagnant-in such a situation, you find your mortgage payment and life expenses increasing while your wage remains constant. For Australia, this is the current situation. Mortgage and interest rates are rising, price inflation is increasing, but wages have yet to catch up. No wonder borrowers are finding life harder!

Introduction to the famous Quantity Theory of Money

Monday, February 18th, 2008

Remember, back in Cause of inflation: Shanghai bubble case study, we mentioned about the definition of inflation by the Austrian School of economic thought:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money [and credit], in which the effect is the rise in the general level of prices.

That definition of inflation was based on a very old economic idea, the Quantity Theory of Money, which was revived by Milton Friedman in the form of ‘monetarism.’ This theory has a very famous mathematical equation:


M is the supply of money, V is the velocity of money (i.e. the number of times that the money is used), P is the price level and Y is the level of output by the economy. Assuming that V and Y is constant, then this equation tells us that the price levels in the economy is proportional to the supply of money.

This equation is inherently true because it is just a mathematical relationship. The problem is, it floundered when it comes to the application of economic policy. First, as we said before in our guide, What is inflation and deflation?,

Today, in this modern age of finance, money is far more complicated than what it was used to be (i.e. simple gold and silver). It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.?

The price level is also another troublesome measurement. As we said before in How much can we trust the price indices (e.g. CPI)?, the whole idea of price indices is logically invalid.

Monetarism became popular due to the infamous stagflation of the late 1970s. At one time, central bankers target the quantity of money as a way to deal with the intractable problem of stagflation. As history has shown, monetarism did not work and was discredited. There are subtle differences between monetarism and Austrian School monetary theory. We will not delve deep into it today, as we know it is very boring and abstract unless we can bring it to life with a relevant contemporary application. But we would like to bring to your attention one thing: there is a crucial insight from the Austrian School that is missed by monetarism. Monetary inflation (or ‘printing’ money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ‘printed,’ prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).  This is the key Austrian School insight.