WHEN ECONOMISTS BECOME THE COURT MAGICIANS — PART 1

The Pharaoh watches as the rods of Aaron and his magicians become snakes. (from here)
The Pharaoh watches as the rods of Aaron and his magicians become snakes. (from here)

Long ago Moses visited Pharaoh and told him God’s command: Let my people go! The Pharaoh disobeyed. So through Moses God brought ten plagues upon Egypt. Even though Pharaoh’s magicians, Jannes and Jambres, could not undo what God had done, they “duplicated” the first plagues God brought upon Egypt, and for some strange reason, Pharaoh took comfort in that.

What is magic, that thing magicians do? More often than not “magic” is just sleight of hand. The magician just fools us into believing he is doing something he is not actually doing. Sometimes, however, even the magician does not know what he doing.

That thing we call the economy is one of the most mysterious things in the world. That is, even though we depend upon it for our food, clothing, and shelter, none of us know exactly how it works. Therefore, when what is going on in the economy concerns us, we consult “experts,” economic magicians, to find out what we should do.

Economic magicians? Does that seem excessively derisive? Then consider these two stories.

Will negative interest rates come to the United States? Probably. Sadly, what economists recommend these days often does not make much sense. Our economy is becoming too contrived, like a house of cards. The problem? Well, let’s begin that discussion by considering a magic trick we call fiat money.

What is ‘Fiat Money’
Fiat money is currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be”. (from here (www.investopedia.com))

Because it is not backed by anything, fiat money has no intrinsic or innate value. That is not to say financial analysts do not have formulas to calculate the intrinsic value of fiat money. Nevertheless, fiat money has no utility of its own.

The value that we get from goods and services is innately apparent from the simple, most basic acts of living. We need food to survive, so food has value. The value for tradeable goods and services is predicated on utility and relative scarcity.

For financial assets, and money is the world’s first financial derivative, there is no direct utility. It does not satisfy any basic demand of survival or continued existence. Therefore, any value attached to financial products does not come from utility. It comes from faith. (from here)

What does Jeffrey Snider, the author of the above, mean by “faith.”

Value itself is nothing more than the outward expression of individual faith. The traditional value of money is really just an outgrowth of its historical reputation, earned through so many actions and consequences. Money may seem to add a level of objectivity into the discussion of value, but that is only because of a more universal “faith” in the transactional price discovery process it allows. (from here)

So why do we believe our money has value? There is actually a little more to it than merely believing fiat money is “real” money. Remember that our government uses its power to define fiat money as legal tender, that is, the government says we can legally use fiat money to pay off our creditors.  That includes the government itself. Don’t we pay our biggest bill, our taxes, with fiat money?

Thus, using its power, the government prints money and creates a demand for it. So it is that even though fiat money has no actual value of its own, the value of fiat money still follows the law of supply and demand.

  • Supply equates to scarcity. How much labor or how many goods and services are required to obtain a certain amount of money?
  • The demand for fiat money depends upon the bills we must pay. What is the amount of money we need to pay off our creditors?

Therefore, to make its fiat money serve as an appropriate means of exchange, our government must regulate both the supply of and the demand for its fiat money. That’s what we will talk about in the next post.

Note: that I don’t claim to have a huge amount of economic expertise.  I am sharing my observations in the hope of promoting a discussion. Hence corrections and comments are welcome. If you want your comments to include what you think of the economic proposals of the presidential candidates, that is okay with me.

17 thoughts on “WHEN ECONOMISTS BECOME THE COURT MAGICIANS — PART 1

  1. The basics of economic theory are well known.

    After all, money behaves according to principles that can be stated in the universal language of mathematics.

    Unfortunately, like science, government, education, the mass media, economics have been taken over by the left.

    And this has led to mass confusion about all things that lead to life, liberty and prosperity.

    In a capitalism economy which actually creates wealth, “fiat money” is absolutely necessary otherwise the economy can only grow as large as the supply of material goods which already exist.

    Fiat money also allows infinite wealth to be created from information which is not materially tangible.

    Consequently, money based on precious metals or a commodity like oil always be finite.

    And this would keep the economy small and everyone but the ruling class, poor.

    Liked by 1 person

  2. @silenceofmind

    Is fiat money a good idea? I have my doubts about that. The theory may make sense, but our ability to implement the theory (the good character required to do so) is doubtful.

    Anyway, money is not an invention of government. If government did not print money, we would find something to use for money. As a practical matter, that is still one of the major uses of gold.

    I just noticed this today. If you look at the Constitution, it does not authorize the government to print paper money.
    http://www.history.com/news/8-things-you-may-not-know-about-american-money

    The founders had had some bad experiences with paper money.

    Fractional reserve banking is inherently unstable. Yet some how or another, the country prospered. There was a central bank, but it nothing like what we have now. Nevertheless, our leaders had to “fix” the banking system. Still, at the time of the Federal Reserve Bank’s creation in 1913, the law provided for notes issued by the bank to be redeemed to the Treasury in gold or “lawful money.” Not exactly fiat money.
    https://en.wikipedia.org/wiki/Federal_Reserve_Note

    It seems that the banking system created under the Federal Reserve Bank was not sufficient to stabilize the banking system. To save it, the government stopped backing its notes with gold.
    https://en.wikipedia.org/wiki/Emergency_Banking_Act

    Of course, giving the spending habits of politicians, that has resulted in continual inflation. So we now have secular stagnation to fix that, but that is for a future post.

    Like

  3. Tom,

    As I explained in my comment, fiat money is necessary for information-driven free market economies.

    Also, if currency isn’t managed or common doing business becomes more difficult than it could or should be.

    Like

  4. Also, politicians don’t get where they are all by themselves.

    The People have been choosing big spending, budget busting politicians for the last 100 years at least.

    Blaming fiat money for people choosing corruption of their own free will isn’t rational.

    Like

    1. @silenceofmind

      Fiat money has its advantages and its disadvantages. However, so do other mediums of exchange. During colonial times, for example, folks use to use the certificates that they got in exchange for their tobacco when they took it to a warehouse for money (=> http://www.encyclopediavirginia.org/Tobacco_in_Colonial_Virginia and http://archive.tobacco.org/History/colonialtobacco.html)

      The advantage of fiat money is that its extremely portable. The problem with fiat money is that our leaders can easily manipulate its value. Easily.

      Whenever we give our leaders more power, there is a risk. Giving our leaders control of fiat money, the power to create purchasing power merely by flicking the switch on a printer, has not worked out well. Yet you say giving our leaders this power is necessary? History suggests otherwise.

      Wealth ultimately is tangible, but ownership of it is not. That can be changed merely with a fiat.

      Like

      1. Be careful … “fiat money” is not the same as “paper money.” It depends upon whether or not the note is redeemable for a fixed amount of a tangible commodity. If true, the paper note is just a convenience for the commodity-backed money, like the certificates that you describe to ease having to carry a hundred-pound bale of tobacco.

        They used to do exactly that. Young husky farmers would go down to the docks with a bale of tobacco under one arm (with a certificate as to its quality) to buy a bride from the ships coming in.

        Fiat money is disconnected (at least de facto) from a commodity backing.

        That story I linked to some time back, The Tale of the Adopted Daughter, has not far into the story a good discussion of setting up a bank on a new frontier planet — backed with wheat. The settlers eventually “nationalize” the bank, and discover that the banker wasn’t keeping the (imported at considerable cost, since they can’t print it locally) paper money in the vault, he was burning it. His explanation is illuminating.

        ===|==============/ Keith DeHavelle

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        1. @Keith

          Did I get the definitions a little mixed up? Well, that is why I asked for comments. I am not a great scientist or engineer. I am only an amateur economist.
          😀

          It has been more than four decades since I read any of Heinlein’s books. I suppose I ought to read them again. I expect I will see things that as a teen I never would have noticed.

          Like

  5. I don’t pretend to know the ins and outs of fiat money and economic theory, but I do know something seems inherently wrong with the financial systems of most of the western world. Everywhere we look, countries both rich and poor are spending way, way, way above incoming revenues.

    What happens when the money runs out? When the exploding entitlement and pension fund chickens come home to roost? A lot of people are going to be left without chairs once this dance finally stops.

    Meanwhile, the top three presidential contenders (Trump, Hillary and Sanders) want nothing to do with entitlement reforms and getting our fiscal house in order. Whistling past the graveyard I believe is the appropriate phrase.

    Liked by 3 people

        1. @Keith

          I will link to your post in the next post in this series. Why? I don’t think most people understand why it is important for the dollar to be the world’s currency. I think most people regard it as a matter of pride, not economic importance. Yet because the dollar is the world’s currency, the dollar is stronger and more stable. Because the dollar is in greater demand as the world’s currency, we can trade more easily with other nations, and we can buy more with our dollars.

          Like

    1. The favorite Republican “fix” for excessive social/welfare spending is growing the economy. Trump is trumpeting that. Meanwhile, the Democrats just refuse to admit the deficit matters. All we have to do is tax the rich. Both “solutions” are fantasies.

      Liked by 1 person

      1. Oh Clinton and Sanders are both living on Fantasy Island alright as is most of the Democratic party these days. Trump’s tax plan is ok but from what I have heard he has not coupled it with broadening the base of payers and getting rid of deduction loopholes which keeps people wedded to the distastrous current system. More importantly he has spoken openly against reforming entitlements, which are the real culprits and will take more than growing the economy to address.

        Sorry, I know this isn’t a Trump post, can’t see to help myself….

        Liked by 1 person

    2. Tricia,

      Exactly!

      Further, any economic system eventually fails if the cash flow out (expenditures) exceeds the cash flow in (income).

      Trying to use the economy to cure moral problems is a hallmark of Marxism.

      That so-called Conservatives resort to Marxist theory is a truly ominous sign of just how well Marxist thinking has polluted the entire body politic.

      Liked by 2 people

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