Dilution vs Supply and Demand

Megan has a somewhat tortured discussion with Matt Steinglass on inflation, whether it should be targeted, etc. As I've mentioned before, I simply cannot understand Macroeconomics as it's taught in school. IS-LM, AS-AD, et al made no sense to me then, and don't make any sense to me now. I have come to suspect, however, that my confusion comes more from the fact that these concepts do not actually make any sense, than they simply lie outside my intellectual abilities. Others may agree.

I think that Megan, Matt (and even Joe Stiglitz, who I found very disappointing in person) would have a better conversation if they separated inflation into two parts: price changes as a consequence of currency dilution (print more dollars, each dollar is worth less, so prices go up) and price changes as a consequence of changes in supply and demand.

I don't think it is interesting or useful to talk about what the net effect of these two dynamics is. Who cares if the net impact of dilution (government printing money) and rising demand is 5%? I want to know 1) how much has the government diluted the currency, and 2) how much has demand risen (or fallen). In fact, netting out these two variables clouds dilution, which is at the very heart of the monetarism that Stiglitz and Matt say is "dead".

I do not understand why inflation is necessary to a healthy economy. Suppose you had a fixed money supply (no dilution) and rising technological productivity which drove lower prices. Would it really be so bad to know you would have to work less in the future because all the clever technologies humans came up with were actually making us all richer and better off? Isn't that how things are meant to work? Instead, we have a dollar which has lost 95% of it's value in three generations, and 40% in just the past 6 years (against the Euro. It's done even worse against oil and gold. And it's a mere 20% down against the Yen). A system that needs such dramatic transfers from savers to debtors on a permanent basis simply seems broken to me.

If people who want to save are fed-up with their money being taken from them and given to debtors, is it any surprise that they are moving out of fiat currency and into something with more tangible value? Cassandra decries this behavior as evil speculation and wants to see commodities no longer be a financial asset class and return to a market that treats them as actual physical goods to be traded between real produces and consumers.

I'm on board with this, and would consider extending this to a whole host of other financial arrangements which now exist as financial assets classes only, not real products to be bought and sold by real produces and consumers. One example would be the 30 year bond, the 20 year bond, the 10 year bond, and heck, even the 5 year bond. What is the real demand for a financial instrument that pays out after 30 years, but not before, and cannot have its term changed through maturity mismatching? Does anybody really believe that the yield on a 30 year treasury bond reflects in any way on what the market expects in the year 2038? How meaningful is the yield curve if everything from year 5 onwards is really just an artificial construct enabled by maturity mismatching, which guarantees bank runs, and destroys any information on what the demand 5 years out really is.

Waldman lays it out very clearly:

Some of us think that some thing's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Right now there is no ETF that is a perfectly hedged basket of major planetary fiat currencies. That leaves us with GLD