Posts Tagged ‘Song Dynasty’

Understanding the big picture in the inflation-deflation debate

Sunday, August 24th, 2008

Right now, there are just too much confusion over the inflation-deflation debate. In fact, this debate is so polarising that many of our readers are thoroughly confused and bewildered by the many millions of conflicting reports, chatter and opinions on the blogs, forums and media. As one of our readers said in Will deflation win?,

I’m getting more and more conflict signals from bases put forward by those who argue for inflation and those who argue for deflation.

So, which will win? Inflation or deflation? Today, we will attempt again to explain the big picture so that you can understand what is going on. As we said before in Failure to understand Black Swan leads to fallacious thinking,

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

First, let’s take a brief look at the history of money at A brief history of money and its breakdown- Part 1. As that article explained, humanity started off with bartering, which was highly inefficient. Eventually, for whatever reason, the free market chose gold and silver as money. It is interesting to note that gold and silver was the coincidental choice across almost every ancient civilization. In any case, regardless of your view on gold, the point is that in most of the 6000 years worth history of human civilization, money always existed in the form of a physical commodity. That is not to say that monetary inflation cannot happen- ancient Rome debased their own silver coins by diluting the silver with some other less precious metals.

If you think about it, it was un-intuitive for money not to be in the form of a commodity. In one of the movies about Marco Polo, it showed a scene whereby Marco Polo was astonished to see his Chinese slave exchanging goods for pieces of paper:

He ask, “What are you doing??!!!?”

His slave replied, “I am buying something.”

“But money is gold and silver! How can a piece of paper be money?!?!”

If you lived back then, it was obvious why money should not be pieces of paper backed by nothing. Firstly, such money is vulnerable to forgery. Secondly, it can be re-produced at almost no cost. Thirdly, as we said before in Recipe for hyperinflation, the integrity of such money depends on the integrity of the authority that issues it:

To illustrate this point further, imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Basically, it WAS obvious why paper money, especially the ones backed by nothing but ‘confidence’ and made legal tender by government decree, is not a good form money. Such money is called “fiat money.” The free market, if left to its own devices, will never favour it. But that did not stop ancient governments from dabbling with fiat money. The ancient Chinese was probably the first to try that (see Ancient Chinese fiat paper money) and failed. Today, the entire world is back to using fiat money again (see A brief history of money and its breakdown- Part 2). History shows that there were many attempts to make fiat money work and all of them failed. In other words, excluding the current one, the failure rate of fiat money is 100%.

To make fiat money work even for a time, some kinds of rules or ‘mechanism’ are needed to maintain its integrity (if it can really be achieved indefinitely). As we said before in Recipe for hyperinflation,

Therefore, some kinds of ?rules? are necessary to fetter and curb such vast power. Without these ?rules,? it is impossible to maintain the integrity of money. If money loses its integrity, the financial system and economy will break down and we will be reduced to primitive bartering.

That is why an independent central bank is part of this complex system of ‘mechanism’ (see Why should central banks be independent from the government?).

What are the ‘mechanisms’ that are used?

  1. Commodity backing– Technically, if a paper money is backed by a commodity (i.e. the paper can be redeemed for a commodity), it is not a fiat money. Today’s fiat money was originally warehouse receipts for gold. If too much warehouse receipts are issued than there are gold in the vault, then the issuer has essentially committed fraud and runs the risk of legal/economic repercussions.
  2. Self-expiry– In ancient China, during the Song Dynasty, paper money had a limited life-span, after which it would become no longer be legal tender. As this article from Financial Sense explained,

    The S’ung dynasty was the first to issue true paper money in 1023, and it did so at first cautiously, issuing small amounts, used in a limited area, and good for a specific time period. The notes would be redeemed after three year’s service, to be replaced by new notes for a 3% service charge, a neat way for the government to make money.

    The abuses started immediately. Though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

    The idea is that at any one time, certain amount of self-expiry money will be retired from circulation and thus, ‘protect’ the integrity of the money. Today, if you look at Zimbabwe’s currency, you will find an expiry date on it.

  3. Credit-system– This is the system used in today’s money (see Are we heading for a deflationary type of recession?). The basic idea is that money is created in the context of credit, which must be returned plus interest.

So, the world’s fiat money system works under the ‘mechanism’ of credit. Because money has to be returned, it acts, in theory, as a check against abuse and rampant monetary inflation. But as we all know from the sub-prime crisis and credit crunch, it got abused to the extreme in practice.

The fact that the global financial system is facing acute deflation threat shows that this credit-system ‘mechanism’ is working to protect the integrity of fiat money! From that perspective, we can see why the US dollar is appreciating in the context of deflation. But at the same time, if the integrity of money is to be protected, then all these years of credit abuse will come home to roost in a colossal economic pain for the masses.

The issue is, do the masses want to avoid great financial pain or does it want to maintain the integrity of fiat money? Reality dictates that it can only choose one but not both. If they choose the former, the only way to do that will be to repeal the credit-system ‘mechanism,’ which will mean the loss of integrity for the current fiat monetary system. Such loss of integirty will manifest itself in the form of hyperinflation.

In summary, whether you believe the end game is deflation or inflation will depend on your faith in human nature.

Have we escaped from the dangers of inflation?

Sunday, February 25th, 2007

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system. The growth of money supply of major economies is estimated around or above 10% per annum, with China having the dubious ?honour? of being near the top at 18% (see Why is China printing so much money?). The top ?honour? goes to Russia, with their M2 money supply rising a whopping 48.8% from the beginning of 2006 to beginning of 2007 (see the figures at the Russia Central Bank web site here).

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Let us tell you a ?secret:? do you know that Zimbabwe?s stock market is now booming too? Do you know why? The reason is not because Zimbabwe is getting richer, but because its currency is becoming worthless with hyperinflation (see Zimbabwe: Living with hyperinflation). As we said back in October last year in Divergent sentiment, ?you can make the Dow Jones climb as high as you want as long as you print enough money.? That is what is happening in Zimbabwe.

As we said before in Example of inevitable effect of monetary inflation, we are very sure that as all these liquidity work its way to the rest of the real economy, it will only be a matter of time before price inflation will show its ugly head. Yet we are simply amazed with Wall Street?s obliviousness to this danger and Ben Bernanke?s incredibly sugar-coated words in his recent economic report to Congress. Can we rely on the Chinese to forever keep the price of importable things down to save us from inflation? We very much doubt so?they have their own inflation problem to handle (see Cause of inflation: Shanghai bubble case study).

The root of the hell of price inflation is fiat currency. Make no mistake about this: in all of human history since the beginning of time, there has never been a time when fiat currencies did not become worthless eventually. For example, the ancient Chinese, during the Song Dynasty (960-1279), had tried it before, even using self-expiring fiat money in an attempt to prevent inflation. The Mongols? use of fiat money to fund their occupation of China was eventually ended by the subsequent Ming Dynasty (1368-1644). Today?s current fiat money experiment only began in 1971 (see A brief history of money and its breakdown- Part 2). How much longer can it last? We do not know but we hazard a guess that it is very much possible for us to see that day in our lifetime.

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.