A Vocabulary Lesson for Your Money

By Henry Meers Jr.

Today’s headlines are filled with financial crises and the names of the large American institutions involved in them; often as they relate to the Federal Reserve System along with its efforts to ameliorate the situation. The terminology used by the press and commentators bears some scrutiny as a way to better understand what is going on in the banking industry and our economy in general.

The first and most misused word is inflation. It originally meant a fall in the value of money, as the issuer put out more than the marketplace was willing to use. In other words, it is a purely monetary term as Milton Friedman often pointed out. Deflation is the opposite, a rising value of money. Both definitions are reflected in purchasing power, but used to be measured in gold.

Consumer prices confuse the above definitions with commentary suggesting there’s inflation when they rise, and deflation when they fall. In truth, market prices are simply the intersection of supply and demand expressed in money. If you consider Say’s Law, which expresses the idea that one man essentially pays for another’s production with his own, a farmer could barter four cows for a sedan, should the dealer be so inclined; but the usual arrangement is to sell the cows for, say, $20,000 and buy a car with the money. Raising the cows and building the automobile is going to require the same amount of effort and material for considerable periods of time in this case.

Once you plug dollars into the trade, what we call price in everyday usage can change when the value of money does. This is where misunderstandings arise. When the dollar falls 10%, the price of the car is going to rise 10% at some point, so people will say it is more expensive even when it takes the same amount of time and material as before. This is something more and more Americans are becoming aware of as the dollar falls in the foreign exchange markets. An automobile manufactured overseas would be rising in price as fast as the dollar was falling. That may not be reflected in the selling price immediately, as companies try to hold market share, but it is obvious in the dollar’s relationship with the manufacturing country’s currency.

Inflation is controlled by monetary policy, which is usually a nation’s way of dealing with its own money. Fiscal policy, on the other hand, deals with non-monetary actions of government, such as spending and taxation. Over the millennia, a workable balance was struck using precious metals, gold and silver, which could be minted into coins of a specified weight and purity for ease of use.

In the nineteenth century paper money began to come into general use and caused people to examine its relationship to the precious metals they were used to using. It is, after all, far easier to use in commerce. At first, it was essentially a warehouse receipt and evolved from there using convertibility into the metals as a “money-back guarantee”: if you didn’t like the paper money, you could return it to the bank for gold or silver. The key move was really the founding of the Bank of England in 1694, which made the country’s finances transparent as Parliament received its creation as a concession from the king to fund his borrowing. With fiscal policy visible and a private-sector institution with essentially a monopoly on printing money, monetary policy entered the modern age. No sooner had this occurred than the wars against France intensified, culminating in the Napoleonic Wars ending at Waterloo in 1815. The latter were so severe that gold convertibility was suspended until 1821.

In any case, Britain had a better monetary reputation than France. As a result, it could borrow much more on the implied promise of returning to the gold standard. The policies during those wars did send prices much higher, and there was a period of recession as the government returned the price level to its prewar standard.

So, in some ways, things haven’t really changed all that much. The public is still trying to find a way to hang on to what it earns, and the central government has its own requirements. Linking money to an outside reference point, which became gold pretty much universally in the 1870’s, allowed both sides to see what was happening. If the issuer was too loose, people would bring their bills in for gold, and the monetary authority would lose some of its ability to issue money based on gold. That is the easy way to see what monetary and fiscal policy do. Today the Fed has linked the value of the dollar to interest rates, which means it ends up trying to control the economy rather than the value of money.

Henry Meers worked in money management at Merrill Lynch for twenty years. He can be reached at hmeers@worldnet.att.net.

Sponsored Links
Henry Meers Jr.
Author Archive