Praxeology of Commodity Repricing.

Zimbabweans must be wondering what comes after trillions since the recent introduction of a 100 billion Zimbabwean Dollar bill. I have been wrestling with the concept of rising prices particularly in commodities and factors of production while simultaneously having the economy in the grips of a Japan-like economic crash combined with stagnation, banking systemic failure and destruction the of the wealth and savings of the middle class. Could it be that prices of factors of production continue to rise when other parts of the economy are in a downward spiral?

Just looking back upon the last six years shows us that asset classes experienced extreme levels of inflation in contrast with official inflation levels remaining very benign. Clearly these economic dichotomies can coexist at the same time. It becomes somewhat more complicated to fixate on one harmful development when its economic counter force is also in play. Can inflation and deflation manifest at the same time? Can commodity prices, such as the oil price, continue to rise when consumption slumps? What impact has the money creation monopoly power of State and is its effect only inflationary?

I will use the technique of constructs to isolate the creation of money activity and to gain understanding of complex economic principles. Ludwig von Mises gives an excellent explanation of praxeology, which can be found by following this link to a recently published article by the Mises institute; The Scope and Method of Catallactics.


© Sarel Oberholster

Here is a simple static construct of a ten unit economy with ten units of money available to buy the oil. Thus one unit of money will buy one barrel of oil (price formation). The next step is to introduce motion into the static construct.

Farmer buys the ten barrels of oil, adds his labour and produces 20 units of grain. Farmer use 10 units of grain to feed himself and his family and sells 10 units of grain to Oil producer for 10 units money. Oil producer feeds himself and his family and uses his labour to produce another 10 barrels of Oil. This is now a perpetual and stable economic construct.


© Sarel Oberholster

Next we introduce a State as another economic participant. We do not give State the power to tax but we grant the power to create money. State uses this power and openly creates ten more units of money. State enters the economy with the new money and competes with the old money for the available ten barrels of oil.

The entry of State as an economic participant with new money has very significant consequences for the stable economic construct. First look at what happens to the static construct of Exhibit 1. We add the new money and observe the effect. We also make the assumption that State consumes the Oil for its own purposes (for example to make war or consuming it as a source of energy). The result is shown in Exhibit 3.


© Sarel Oberholster

The equilibrium in the economy has been disturbed. The presence of twenty units of money competing for the same ten barrels of oil has the effect of changing the price of oil from 1 unit of money to two units of money (100% inflation). State now receives 5 barrels of Oil for its 10 units of money while Farmer receives the other 5 units of Oil.

Who has won and who has lost? State has gained 5 barrels of Oil and walks away an outright winner. Oil producer still received all the money in the economy so perhaps Oil producer is no worse off, but we shall see. Farmer has clearly lost 5 barrels of Oil as Farmer held all the money when half the purchasing power of the total money in the economy was transferred to State through its action of creating 10 units of money. It is only when we assess the impact of State's money creation behaviour on the dynamic but stable economic construct that we see the extent of damage done to this very simple economy. State has managed to acquire the total production surplus in the economic construct through its money creation action.

The construct must remain constant but for the behaviour of State and the consequences thereof. State has created money and vested half the economic product on itself. The new money had competed on an equal footing with the existing money in the economy and has reduced the purchasing power of Farmer by half. Farmer can now only purchase half the production inputs (5 barrels of Oil) needed for his farming production. Farmer can only produce half the grain on half the production inputs. However, Farmer uses this half of his farm product to feed himself and his family and no longer has a surplus product (sellable grain) to sell to Oil producer. Pity Oil producer, holding all the money in the economy yet cannot buy any food. Oil producer will starve. Yet Farmer earns no money to purchase any Oil (production inputs) from Oil producer for the next production cycle and will therefore starve when the next production cycle arrives. See Exhibit 4 hereunder.


© Sarel Oberholster

I can hear the critics saying this is an artificial construct, an over simplification. It may be expressed in simple, easy to understand terms but it is irrefutably the outcome of an isolation of the money creation activity of State. Its purpose is deliberate in its isolation of the activity of State without allowing that activity to hide behind a myriad of other variables ever present in a fully functional economy. It is also intolerable to have a stable in-equilibrium economy but it is in the form of this extract that one can focus on the consequences of State's money creation behaviour. The construct can be expanded to add productivity improvements or any other concept which can alter the economic outcome of the construct. For instance Oil producer may realise that Farmer must have 10 barrels of Oil and increase his labour to produce 15 barrels of Oil, yet the price mechanism will still be out of balance until Oil producer has increased production to 20 barrels of oil. At 15 barrels of Oil State will compete equally for 7.5 barrels of Oil. Only at 20 barrels of Oil will the Oil crisis be over. One can add innovation, capital improvements, State exchanging Oil for grain or any of the variables that vest with the ingenuity of humans to improve their economic circumstances, especially in the face of something as devastating as starvation. A magnitude of potential interventions to fix the imbalances opens up a magnitude of consequences. The fact remains that the impact of State's money creation on the production surplus in the economy can ultimately only be remedied through economic behaviour of Oil producer and Farmer.

Money creation via credit expansion, low interest rates and almost unlimited liquidity provision to banks have unleashed an explosion in competing new money in all economies of the world. The competing new money jumped like a wild fire from one asset class to another as it circled the globe. As expected, it had to reach the units of production of which Oil became a focal point. Oil, a strategic production input, faced supply constraints and could not adjust easily to the demand created by the new money. The result was that Oil in particular had to adjust mainly through price increases to the presence of competing new money. The outcome is similar to Exhibit 3 where the competing new money and the old money had to share the existing production, thus the price continued to increase and will continue to increase until new money stops competing for existing production or production is expanded to accommodate the new money or a combination of the two options. The prices of scarce resources will continue to adjust upwards for as long as new money competes for its acquisition. It is altogether possible for competing new money to overwhelm the effects of falling demand arising from high prices. The impact of State's money creation was also not restricted only to inflating prices.

The effect of rising prices stands apart from the hardships introduced to the economic participants other than State. The prices will rise but the rise may be mitigated through the actions and sacrifices of consumers and producers. Farmer and Oil producer had to share the burden of replacing the production surplus required to restore balance in the economy. Similarly will consumers and producers other than State have to shoulder the burden of restoring that portion of the production surplus lost to the creation of competing new money. That burden translates into bad debts, over extended consumers and weak purchasing power parallel with rising prices in the factors of production (for instance scarce commodities) which, in the case of substantial volumes of competing new money, will wreck the banks in systemic paralyses and destroy corporate profits until the rebalancing process has been completed. Any attempts by State to intervene in a monetary manner to further increase competing new money in the economy will perpetuate the adjustment process. Bail-outs, nationalising banks, easy liquidity access against questionable collateral to all and sundry and re-capitalisation of GSE's (Government Supported Entities) would all qualify as monetary interventions injecting competing new money into the economy.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time." USA FOMC statement" 25 June 2008.

Translates into low interest rates and lots of new money should help growth.

"At the Monetary Policy Meeting held today, the Bank of Japan decided, by a unanimous vote to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will encourage the uncollateralized overnight call rate to remain at around 0.5 percent." 2008 Jul 15, Bank of Japan - Statement on Monetary Policy

Translates into we will provide as much new money as needed to keep our ultra low interest rate at 0.5%.

"To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1).

"Without prejudice to the objective of price stability", the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These include a "high level of employment" and "sustainable and non-inflationary growth". Objective of monetary policy, European Central Bank website http://www.ecb.int/ , Monetary Policy. 28 July 2008.

Translates into we say one thing and do another (See also "Notes" at the end of this essay).

"There had been a positive reaction to the co-ordinated announcement of central bank actions on 11 March, designed to relieve liquidity pressures in money markets. But the funding crisis at Bear Stearns in mid-March, leading to a Federal Reserve supported buy-out of the firm by JPMorgan, had temporarily heightened concerns about counterparty credit risk further. The functioning of money markets remained heavily impaired, with interbank lending still concentrated at very short maturities. Term spreads had risen again and market prices suggested that they were expected to remain higher than normal throughout 2008 and beyond - longer than expected at the start of the year." 23 April 2008, MINUTES OF MONETARY POLICY COMMITTEE MEETING 9 AND 10 APRIL 2008, Bank of England.

" ... co-ordinated announcements of central bank actions ... designed to relieve liquidity pressures in money markets" sure sounds like more competing new money entering the economy. This is Central Banks working together to maximise the new money effect. Do not chase after speculators, greedy hoarders, naked short sellers or stingy producers for they have not the power to alter the reality of competing new money. Watch for new money and follow its progress into repricing commodities upwards to the dismay of interventionists. Only in the absence of competing new money will the rebalancing process complete. If not, start counting towards the still unfamiliar Quadrillion even as asset deflation bites.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
August 2008


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Notes:
1. Latest on Zimbabwe money is that the Central bank has knocked off 10 digits from the currency converting a 10 billion Zimbabwe dollar into 1 Zimbabwe dollar. I suppose they no longer need to worry about quadrillions in the short term.)

2. "Stocks jumped as the European Central Bank, the U.S. Federal Reserve and the Swiss National Bank announced an enhancement of their dollar liquidity-providing operations to ease credit strains that have weighed on the global economy. The central bank actions were intended to ease persistent global financial instability as institutions write down losses from exposure to risky U.S. mortgages." FTSE up as central banks act to boost liquidity - Reuters, July 30 2008.

© Sarel Oberholster - 2008