The True Gold Standard (Second Edition)
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Essentially the same thing happens when excess money bids up the price of financial assets. Financial assets are claims on goods. And the price of a claim should equal the present value of the goods on which it is a claim. Therefore, if excess money bids the price of claims above the price of the underlying goods, that cannot be the end of the story. A process of arbitrage is set in motion, by which claims are sold and goods are purchased, until the value of the two is restored to parity. The only difference is that the money price of both goods will be higher.
As we have seen, the P’s and Q’s in Rueff’s theory refer to all goods and claims exchanged for money. Yet we have no such indexes. So how can LBMC use the excess World Dollar Base to predict things like commodity prices or the consumer price index? The answer is that we can rely on the arbitrage mechanism, which is real and reliable, even though it takes time.
An excess money supply is most often created by central bankers during an economic slowdown or recession, when commodities are selling below their cost of production. The money naturally goes to the financial markets, where there is less excess supply. The first result, therefore, is to bid up the price of claims. But the excess money later finds its way to the commodity markets, when these have sorked off the original excess supply, through the process of arbitrage.
And this appears to be the main reason why, in the real world, it takes commodity “auction” markets more than two years to adjust to a change in the World Dollar Base. Even if the prices of some commodities adjusted immediately, their cost of production would take more time, because that is determined by the price of other goods. In all of our equations, we assumed that the supply of goods is independent of the excess money supply. This is true in the end, but it is not true during the process of absorbing the excess money supply. A change in the supplies of all goods is a necessary part of the adjustment to excess money. It does not happen immediately, but it does occur with great precision.
This brings us to Goldman’s objection to the two-year lag. Two-year lags do not bother Goldman – only some two-year lags. He writes:
“Monetarism, as formulated by economists such as Milton Friedman and Karl Brunner, asserted that two years were necessary for bank reserves to turn into consumer price increases. That assumption was perfectly reasonable; the flaw in the model was not the lag, but the velocity problem, as noted. But in LBMC’s model, the two-year lag has turned into something different and extravagant. LBMC believes that auction prices on futures markets react to changes in liquidity with a two year lag. Nothing like this has been argued in the history of economics; all schools of economics believe that auction markets react almost instantaneously to changes in liquidity” (p. 5, emphasis in original).
Let’s try to envision what this means. A farmer, bringing his fresh vegetables to market one afternoon, promises to deliver them the following morning to the supermarket which is the highest bidder. This is a futures transaction on an auction market. According to Goldman, backed by “all schools of economics,” the price of the vegetables is bid up instantly by an increase in liquidity anywhere in the banking system. However, if a shopper goes into the supermarket to buy the same vegetables the next afternoon, the price reflects liquidity conditions two years earlier – that’s “perfectly reasonable,” Goldman says, because those are consumer price increases. What I want to know is: what should the supermarket do with the vegetables? Sell them at a loss? Or put them in a deep-freeze for two years, until the time is finally ripe to mark up the price?
As we have seen, the reason for the two-year lag is not that excess money disappears into a black hole for two years and then pops up in the commodity market. The general price level is bid up almost immediately, but the initial rise in prices is concentrated in the financial markets. The disparity between the price of claims and the price of goods sets in motion an adjustment due to arbitrage, which takes more than two years, at the end of which all prices will have risen more or less in proportion.
Next installment: Reply to Polyconomics - Part 5
The Rueffian Synthesis