January 5, 2010

Ex Nihilo - Money for nothing

The federal government is currently following a policy of Quantitative Easing in order to combat the current economic crisis, which isn't over. The problem with this approach - printing money - is that there is no way to make money out of nothing.

Milton Friedman explained it in his book Freedom To Choose, let me start by attempting the same.

The difference between money and wealth is actually pretty simple. In order to create wealth, value must be added to an existing product/condition/situation. For example, let's say I found some clay and you want it to build a hut (this example puts us back in time a couple of thousand years). I could sell you my clay for (pardon the anachronism) for $10. There is wealth because I own a tangible good. There is money because someone has created a proxy for wealth in paper representation of that wealth (so that you don't have to pay me a goat for my clay - I don't need a goat).

Let's further assume there is only $10 in circulation because that's all the government of the day had printed. You, through shrewd business dealings have managed to get it all. Good work.

There are two scenarios to consider. Firstly let's assume I have discovered the technology of brickmaking. If I take my clay and turn it into 1500 bricks, I have added value to the situation. What I intend to sell is no longer worth $10, it's worth $30 because of my work that has created a way to make better huts and the commodity to do it with. I could sell you $10 worth of bricks and keep the rest to build my own hut as well. That is assuming there was enough. If not, someone else, even perhaps requiring to revert to bartering, could get the rest by paying me in wool.

Wealth was created by new value - bricks - being added to the existing circumstance. In fact the value isn't even really the bricks - it's really better, stronger, safer homes that result from bricks being invented, made, and made available.

The other circumstance is a little different.  Let's say the there is only one brick.  You have $10.  You could offer me $10 for the brick (assuming it was worth it).  But if someone (the government) printed another $20 and you managed to get all of it through their poorly designed stimulus program grant, the additional money does not make you wealthier. What you have done in effect is diluted the value of each dollar.  Instead of each dollar buying 1/10th of a brick, each dollar now only buys 1/30th of a brick.  Why?  There is still only one brick.  Dollars aren't wealth.  What they can buy (what has been produced or value-added) is the real wealth.  The dollars are still only a proxy. 

The resulting dilution of the value of each dollar is effectively inflation.  Each 1/10th of the brick is now worth $3 instead of $1.  Therefore by printing money, you are not creating wealth, you are creating inflation.  That is unless the money printed is backed by a real asset (e.g. gold).  But money today isn't.

In today's world that means that the money being spent by the government has been seriously diluted and inflation is inevitable.  How bad it will be isn't really known.  How soon it will grip the economy isn't really known.  What is known is that the inflation will come.  And what is more important is the basic lessons that aren't being applied in Washington now:

Just like you can't spend yourself out of debt, or spend yourself rich, you also can't print money to make yourself rich - it's not real wealth, just more paper.

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