We do not hear much about monetarism these days, but perhaps we should. The key idea of monetarism is that the crucial variable in economic life is the money supply. Money occupies a distinctive position in that it is both a medium of exchange and a commodity. Money evolved out of commodities like gold and silver that could serve both functions. Gold is portable and can readily be broken down into smaller bits and so can function as a medium of exchange more conveniently than, say, cowrie shells. The purpose of a medium of exchange is to keep track of credit, of who owes who how much. Modern money has become what we call fiduciary issue. This means that it relies upon faith. The transition from gold to paper money was due to the fact that paper is easier to carry. A piece of paper that says “I owe the bearer such and such an amount of gold” issued by a reliable lender was more convenient than the gold itself. Then it was found that the lender did not, in practice, have to keep that much gold either because the borrowers did not, in practice, all ask for the gold at the same time. So paper gradually replaced metal and nowadays paper is being replaced in a similar way by electronic records. This has now reached the point where some are experimenting with issuing purely electronic currency, most notably the “bitcoin”.
Gold, therefore, was a commodity that functioned as a medium of exchange. In trade, a merchant gives a product to a buyer and the buyer then owes the value of that product. The buyer signifies this debt by transfering to the merchant an equivalent amount of medium of exchange. Let's put this differently. If I own x amount of the medium of exchange, what this actually signifies is that the world owes me x worth of goods. In a modern economy with plenty of opportunities for exchange in the form of shopping centres, I can go and get the goods I am owed more or less whenever I choose. When I get some goods, the amount I am owed goes down and I have less money. If I sell something my credit goes up – I have more money. What most people sell is their labour. Such is the nature of money. It measures what we are owed for our input. A variety of social conventions then determine how much this should be. Although a person may spend many hours looking after their own children the convention generally is that they are not owed anything for doing so, but if they spend that time looking after other people's children in accord with a legal contract then they will gain credit (money) for doing so.
Monetarists then realised that it makes a lot of difference (a) how much credit there is and (b) what happens to the value of the medium of exchange.
If the value of money is falling (inflation) then there is an incentive for me to go and get my goods as soon as possible, because later I will have to give up more of my credit than now to get them. If the value of money is increasing (deflation), then the incentive is opposite. It is better for me to wait. The goods I want will be less expensive next year so I may judge that it is better to do without them for the moment.
Also, each of these conditions is self-reinforcing. If the value of money is increasing and that of goods is therefore falling, there is also an incentive to get rid of goods and exchange them for money. This incentive to sell will itself depress the money value of goods further, which is to say, it will make the growth in the value of money more rapid. If the value of money is falling and goods are getting more expensive, there is an incentive to get rid of money as fast as possible, thus further depressing its value. Left to itself, therefore, without any regulation, there would be a tendency for the money supply to be unstable, suffering from periods of run-away inflation or deflation, either of which undermine money's ability to act as an efficient medium of exchange.
Thus, the basic function of a medium of exchange is to keep track of credit. If I give to another a motar car, the system should ensure that at some later date I am able to receive a motor car's worth of other goods. If, however, the value of the medium of exchange changes in the meantime, this no longer works and I either recveive much more than I deserve or I an cheated out of what I am owed. If these discrepancies become too great, the ordinary member of the public will become disaffected and political trouble will ensue.
Now there is a further twist. Some commodities other than money do act as more or less efficient stores of value. I am calling them stores of value rather than media of exchange because they are generally either not portable enough to act as the latter or they are too rare to be generally recognised in the latter capacity. Gold, since it ceased to be a medium of exchange, has reverted to being a store of value. However, the store of value par excellance is what we call real property, namely land and buildings. Sometimes it may serve me much better to invest my money in real property than to keep it in money form. Real property is a long term money store.
So far, so good. Now let us look at what is happening at the moment. With the opening up of international trade, a process now sometimes called globalisation, some people have become rich. This is not necessarily a bad thing. At various periods in history there have been expansions of trade, particularly in the aftermath of the creation of great empires such as those of the Romans or the Mongols, or in times of exploration and colonisation, and these have often been times of cultural eflorescence broadly beneficial to everybody as well as opportunities for a few to become rich. I am disinclined to see globalisation per se as a problem. It could be a boon to everybody.
However, there is a downside in that the rich tend to store rather than spend their money. If we go back to basics, if one person is owed a fabulous amount, then they are actually owed more than they will ever need and there is, therefore, no point in them claiming it. The rich, therefore, become a money sink. The emergence of a class of super-rich such as has occurred in recent decades, persons vastly more rich than anybody has ever been before, constitutes a sink in the money supply. This means that there is then less money to go round among the rest of the population. With no other intervention this would mean that the value of money would start to rise, a deflationary cycle would set in. Deflation favours those who hold money and therefore favours the already super-rich. The cycle is self-reinforcing and can only get more and more extreme unless there is some other intervention.
In the last decades of the twentieth century this tendency was countered by a different phenomenon which was the growth of credit. Deflation did not set in because there was enough general confidence in the growth of economic activity for people to simply create new measures of credit. There was an explosion of consummer credit mediated by banks who invented new ways of keeping track of who was owed what. Everybody acquired plastic cards that carried the information. People were able to spend money that they did not have. This, in effect, expanded the money supply. So although there was an underlying deflationary tendency already at work, it was disguised by a mechanism that permitted ordinary people to go into the red. For a couple of decades this continued to work. Money, which now included consumer credit, continued to lose value and we seemed to be in an inflationary cycle. This was, however, a bublle that burst and it did so in 2007.
Let us recap. Money is a fiduciary system. It relies on the confidence that people have in it and this confidence depends upon the ability of money to do what it is supposed to do which is provide a fair and accurate record of credit. As long as it does so people will trust it and use it. However, as we have seen, money has an inherent instability and is prone to run away into deflationary or inflationary cycles which do not correct themselves. This means that human intervention is needed to prevent these cycles running to an extreme. Such intervention does not always work. When they run to an inflationary extreme there arises the kind of situation that afflicted the Weimar Republic and has bankrupted various Latin American governments in the past. Sometimes this ends in war. When they run to a deflationary extreme, the kind of revolutionary situation described by Karl Marx is created with such extremes of wealth and poverty that the dispossessed feel they have nothing to lose in slaughtering the better off.
Since 2007 we have tipped over from an inflationary period into a deflationary one. So far the governments of the largest countries have intervened only to the extent of injecting some extra money (quantitative easing) into the system. This has dampened down the deflationary effect. However, the rich are still getting richer, economic activity is still at a very low ebb and the danger of collapse into a wild deflationary cycle is apparent. It is very likely, however, that this will not be allowed to happen.
In fact, we are probably about on the cusp. Japan's new government has decided to go for a reflation of the economy. One should note, in passing, that none of this has anything to do with “left' and “right”. While in Europe it is the left that urges some degree of reflation in Japan it is the right that has done it. There is some tendency for the right to favour deflation because it benefits the rich, but only in the short term. In the long term it provokes revolution and plays into the hands of the extreme left. Nonetheless, while this is not a left-right issue in the normal sense, a great deal does hinge on politics. Policy will determine how long the deflationary trend is allowed to run before we flip once again into inflation and policy will not be only a response to these economic factors. Other matters are always also in play.
To some extent, the situation where there are several major currencies controlled by more or less independent governments works against wisdom in either of the run-away scenarios. Whether it is a period of inflation or deflation, there is what in game theory is called a “Nash equilibrium”, named after the mathematician who identified the phenomenon. A Nash equilibrium is the situation that arises in a game where there will be one winner and many losers where winning requires action but whoever moves first will lose. This type of game is surprisingly common in many fields of human interaction. It results in no party being willing to make the first move even though they know that moving has to happen sometime. I suggest that we are in such a situation.
In a deflationary cycle, in theory, the first country to reflate risks seeing its currency lose value catastrophically. Whether this will actually happen to Japan or whether the Japanese initiative will spark reflation in other areas or policies designed to protect Japan from the raw consequences of its approach remains to be seen. A key player here is America. America is in a delicate position. It's economy is big enough to have an effect on other players and so it could risk reflation. On the other hand if the value of the dollar were to start to fall too precipitately this could also lead to a run away catastrophe since a vast amount of dollars are held overseas, most notably by China. Were these dollars to come out of storage and enter the world currency markets the value of the dollar would drop very rapidly indeed. America might then have to become proectionist in order to prevent its home economy from collapsing and it would certainly lose most of its remaining world role. America would become isolationist.
What about Europe? It appears to me to be the case that insofar as one can talk about the EU as one entity it is playing the long term game aiming to be the last player to reflate and, thereby, take the biggest prize, albeit at the cost of considerable internal tension in the meantime. The deflationary period in Europe favours centralisation and efficiency. These are the things that Europe needs in its present phase of development. To act as a single entity in the political world it has to be more than merely a confederation. Centralisation of control has to be achieved somehow. The population is becoming increasingly reluctant to vote for this so it will be achieved by non-democratic means. An example remarkable for its swiftness and effectiveness has been the implementation of the banking union over the past couple of years. This has created a mechanism for a degree of centralised economic control essential to the European project. The effectiveness with which the central authorities dealt with the Cyprus situation was a first demonstration of the power that has thereby been created. This centralised regulation will force higher levels of efficiency and lower levels of corruption upon those member states that have in the past been least efficient and most corrupt. Europe is getting its house in order. At best this will mean that when the inevitable eventual reflation occurs Europe will be in the optimum condition to take advantage of it and if Europe reflates last it will do so without any of the risks of currency devaluation that the early movers incur. At worst, however, the internal tensions generated by high unemployment, shortage of credit and deflationary pressures will cause the EU to fall apart or become internally dysfunctional before it reaches the point at which it is able to cash in its advantage. This is clearly a game of nerve and risk. Interestingly, a block like Europe with its collective leadership may well fare best in this particular game doing better than countries with aparently more effective, because singular, leadership. The fact that it take the EU longer to make decisions means that they lag behind the trend and in a game where the last player wins this may well be to the EU's advantage.
However the particular politics play out, a phase of reflation starting sometime in the not distant future, and possibly already beginning, is the only alternative to a world scale disaster. The hesitancy with which most countries are approaching this prospect is, however, very understandable. The danger of flipping into out of control inflation is real. Once it becomes apparent that the world as a whole is entering a reflationary phase, the incentives all reverse. Those who have hoarded money for the past six years will have a strong incentive to get rid of it and convert it into other stores of value or to simply enjoy its fruits. The rich will see the prospect of the value of their pile being eroded. All this will lead to a sudden up-swing in the money supply. This could be such as to make the consummer boom of the 80s and 90s seem small by comparison. Basically, the bigger the market the bigger the market fluctuations. Globalism has great advantages but with them come equally great dangers. Unless a degree of international co-operation never seen before occurs, and I doubt that it will occur, rapid inflation is on the way some time soon.
Who will win and who will lose? This is very hard to predict but my best guess is that the EU will come out of it rather well in the end, that America will emerge having lost influence in the world, still a substantial player on the economic scene, if somewhat isolationist compared with its present position, and that Japan will go through a period of considerable cultural change as its dash for growth will make it much more difficult for it to maintain its traditional insularity and self-sufficiency. The outcome for China is perhaps the most obscure. The danger of internal strife is perhaps now higher in China than in any of the other blocks. The authoritarian government holds its legitimacy by dint of its ability to deliver steadily increasing living standards to the majority of the population. If this falters, as it must sooner or later, there is likely to be trouble. If China can achieve a “soft landing” then it may end up normalised into being one major player in the international economic game with continuing overall increases in living standards and gradual democratization of its institutions at home. However, the chances of a rougher ride must be quite high and we have recently seen how the govenrment has tried, fairly successfully, to divert discontent into nationalist fervour, a route that is always tempting for a government in trouble, but one that can bring major unpredictable consequences at home and abroad.
So, in summary, it seems almost certain that in the near future there is going to be a widespread shift from deflationary to inflationary policy internationally; that this is unlikely to happen in an internationally co-ordinated fashion; that this lack of co-ordination will create significant winners and losers so we can expect the present differentials between economic blocks to shift; that there are greater dangers in this change of direction than formerly simply because the process of globablisation creates a bigger pool in which bigger waves can occur. Inflation is coming to a country near you sometime very soon.