What is Price?
Before we begin, take a moment to absorb the following ideas:
“Truth - or, more precisely, an accurate understanding of reality - is the essential foundation for any good outcome.”
- Ray Dalio
According to Wittgenstein’s Ruler:
unless you have confidence in a ruler’s reliability, if you use a ruler to measure a table, you may also be using the table to measure the ruler
the less you trust the ruler’s reliability, the more information you are getting about the ruler and less about the table
In any market setting, the most basic function of price is to signal to buyers and sellers how much to buy and how much to sell/produce, respectively. This is because price is derived from the equilibrium at which supply, an objective quality (the truth), intersects demand, a subjective quality driven by behaviour (the perceived truth), thus signaling to all market participants the realities about scarcity (supply) and the perceived value (demand) of a particular asset at one point in time.
Whether it is a tomato, a house or a stock, the most common measure of value for these items is through fiat (paper) currency denoted prices (USD, HKD, AUD, GBP, etc.).
Let’s use a tomato as an example. For the value of the tomato to fully reflect its intervention free real market value, the fiat currency system in which its price is denoted in must also be a reliable, constant, intervention free, market-based system. In other words, the tomato’s market value hinges on the the fiat system's ability to remain a reliable and truthful measure of market value.
Unfortunately, fiat currencies and the truth do not go well together.
To do a simplified assessment of why this is, we must establish the following:
The Central Bank has a monopoly over the issuance of ‘money/loanable funds’ and the policies which affect its supply (monetary policies)
To drastically oversimply things: Debt = loanable funds = Fixed Income = Bonds = IOUs = Credit = ‘Money’ (in its broadest definition)
The Bretton Wood System (1944) - pegged all major world currencies to the USD by pegging the USD to Gold (the gold standard)
Nixon Shock (1971) - President Nixon took the USD off the gold standard
A Quick History on Money
After WW2 the Bretton Woods system established that foreign central banks were entitled to an ounce of gold for every $35 USD they held in their reserves which incentive many foreign nations to peg their currencies to the dollar, thus the USD being deemed ‘as good as gold’. Years later, the US no longer had enough gold reserves to make good on this promise without drastically devaluing the dollar therefore in 1971 Nixon took the dollar off the gold. In other words the dominant global 'reserve' currency is now based entirely on paper (fiat) money without a backing to any scarce asset. To make matters more confusing, major world currencies began adopting a floating exchange rate vs being fixed to one another.
The Top Down Pyramid Scheme
The real assessment begins with the central bank, the authority that controls the issuance of ‘money/loanable funds’ and the monetary policies that affect its supply. Since the establishment of the central banking system, the production of money became ‘centralized’ and its profit privatized through a top-down pyramid scheme whereby each successive layer of banks and institutions lends to the one below it, with the central bank on top, thus profiting from the difference in the interest (the cost of borrowing money) charged.
The fiat currency system gave central banks a method of perpetually privatizing profits from money production without having to suffer any of the consequences since losses are socialized through inflation. As such, there is no disincentives in the fiat currency system since there is near zero cost associated with money production which incentivizes central banks to ‘print money’ into worthlessness while acquiring scarce assets such as gold with these self-annihilating currencies that are on their gradual decline to zero. Said differently, the marginal cost of money production is equal to zero therefore in the very long run, like the fiat currencies of the past, the value of today’s fiat currencies will inevitably converge at its marginal cost of production, zero.
Consequently, there is very little reason to be holding physical cash/fiats due to its inflationary nature caused by the ever-growing influx of supply of ‘money’. Instead, large financial institutions and banks prefer to store their capital in a select combination of asset classes of which sometimes, a significant portion is debt (for example, by adopting the pyramid scheme as shown above). From the QE (quantitative easing) employed since the 08 – 09 financial crisis to the endless rounds of stimulus aid as of late, such monetary phenomena are made possible by central banks directly injecting liquidity (money) into the money/loanable funds market through open market operations therefore governments and institutions can access these funds to distribute to citizens, to invest, to spend etc. Although many things are generally quite confusing in the money market, and perhaps purposely so, one thing can always be guaranteed in the end, that is the nominal supply of ‘money’ has been growing and will continue to do so as long as central banks keep the printing press hot and running whilst governments attempt to solve their sovereign debt crisis to no avail with the issuance of more debt.
The result of this is the inevitable fate of price inflation (hyperinflation) which every sovereign currency of the past and present will eventually have to face, whereby businesses adjust the price of their goods and services to match this ever-growing supply of ‘money’. Had they not, everything will become cheaper and there will be no incentive to conduct business in the free market. Because inflation is the socialized loss generated by the fiat currency system, the loss is actualized through the erosion of your fiat’s purchasing power over time.
Now you may wonder, if the supply of 'money' is constantly growing, how can this system be a reliable measure of value that persists across time and space? Contradicting indeed.
Going back to the supply and demand graph, supply is a numeric based objective quality that serves as the single constancy of truth/objective reality in the price equation. However, when the exact supply of ‘money’ in the fiat currency system is unknown and theoretically infinite and the process in deciding the monetary policies, the supply issuance schedules, the people that get to decide, the criteria used to decide and those who stands to profit from money production are extremely vague, all truth is lost in the very mechanism we use to price and thus value things. At the marginal level, with every additional fiat dollar bill that is injected into circulation, the more it losses its objectivity and the less reliable it becomes as a market price signal. Though, we must acknowledge that the term 'money printing' serves more as an analogy for the many ways 'money' enters our debt driven money markets rather than being a literal depiction of the whole picture.
When the very pricing mechanism for which businesses and individuals use to determine their everyday decisions, financial strategies, investment decisions, etc. fails them, misinformation spreads leading to the misallocation of resources and ultimately the inevitable market booms of bust cycles of which are only becoming more frequent and violent (on both the up and down cycles) for as long as the fiat standard is employed as the mainstream measure of value under the authority of central banks.
As proposed by Wittgenstein’s ruler, the ruler is only as accurate as your confidence is in its reliability. Much alike, the fiat standard is only as reliable of a measure of value as you give it credit for, the less reliable you deem it to be, the less it is telling you about the value of things and the more the ‘things’ are telling you about the value, or lack thereof, of the currency itself.
Considering recent market events, I would like to end with this question:
Are the market fluctuations denoted in fiat currency prices telling us more about the market or rather, is the price/market volatility as of late telling us more about the functioning (or lack thereof) of the centralized money system and its currency's incompetence as being a reliable measure of value (let alone a store of value)?