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A Letter to Bulls Part Two: Extending the Olive Branch

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October 14, 2010 – Comments (50)

I'm unsatisfied with my last post: "A Letter to Bulls: Please Stop Cheer Leading Our Destruction."  I feel I could have explained myself better, increased understanding, and avoided much of the confusion that followed.  This follow up will hopefully add clarity, enlarge the issue I am driving at, and help add to the debate (fingers crossed.)  And I have a totally canned and cheeky way to do it.

I'm here with David in Qatar: anarchist, champion bodybuilder, Shakespeare aficionado, and world-class lover, to find out where he comes up with his ridiculous ideas.

DQ: Thanks. Only one of those things is true, sadly.

I was being kind. In your last post you stated that the general price level of the stock market can not rise for decades on end without a rise in the money supply.  Where does this crazy theory come from?

DQ: Believe it or not, I don't make stuff up off the top of my head.  The theory belongs to Fritz Malchup, Austrian-born economist, and it appeared originally in his 1931 first edition of "The Stock Market, Credit, and Capital Formation."  I have been reading the 1940 translation over the past couple of weeks.  As you can tell from the book's timing, it was written shortly after the American stock market crash of 1929.  The book is actually a defense of the stock market from a classical/Austrian School framework.  I didn't do a very good job of explaining Malchup's theory, but it is quite simple.

Ok here's your chance to do it again.

DQ: Let's say you have an economy in Year 1 with a money supply of $1T and a total market cap of all stocks at $10M, and that this relationship is typical allocation of discretionary income for the stock market.  In Year 50, if the money supply has remained at $1T, the total market cap of all stocks will be right around $1M, give or take the small fluctuations that happen from day-to-day.  It is simply not possibly for the total capitalization of the market to continue to increase over that time unless new money is added to the money supply.  It doesn't matter how successful individual companies have been during that time frame.  Without an increase in the money supply, the market would remain flat.  But that doesn't mean the economy's wealth would remain the same.  Wealth is not determined by price level.  It's determined by purchasing power.

So where did you go wrong?

DQ: Where didn't I go wrong?  The worst thing you can do is haphazardly mix terms.  I kept using the words static and stable, sometimes interchangeably, and sometimes with different meanings.  The word stable can mean different things in monetary terms.  You can have stable money, meaning unchanged supply.  Or you can have a stable money, meaning that its supply rises predictably and steadily.  Static can refer to the price level, but not the money supply.  I could go on but I'll stop.

Inflation means two different things, sometimes more than that.  Inflation to me is an excess issue of money (I'm an old-school kind of guy.)  Inflation to others is rising prices. To some its currency devaluation.  

Even the term money is tricky.  Money can mean money in your wallet, bank credit, stocks, gold, IOU's. It all depends who you ask.  I determine that all money currently in our economy is a money substitute and not real money, but that is an extremely controversial stance in mainstream quarters and not likely to be accepted.

So you screwed the pooch.

DQ: Yep, I found out I'm not perfect. Which sucks, because my favorite wrestler growing up was Mr. Perfect, and I know he'd be disappointed in me.

You're as close to perfect as I am to winning American Idol. So what was all this nonsense about dollar devaluation?  Why not just say total market cap can only rise indefinitely if the total money supply increases?

DQ: That was another mistake.  I was trying to integrate understanding of Malchup's theory with the Austrian Business Cycle Theory.  I was trying to warn investors that cheap credit can push the market up, but it just sows the seeds for more destruction.  But I would have been better off sticking to one topic.  

An increase in the money supply is not, by definition, currency devaluation. I think I implied that, and that is a huge fail.  Currency is devalued by an over-issue.  This is nothing new.  Understanding of currency devaluation goes back at least to Nicole Oresme's Treatise on the Alteration of Money.  Long before Oresme, people understood what happened when the King altered the coinage.   

Oresme sounds like a hoot at parties. So what's the connection then?

DQ: In the modern economy, our money originates from the Federal Reserve, not from the market.  If the market determined the money supply, the amount of savings available would be represented by the interest rate.  But with the Fed in charge, interest rates are a false signal.  The Fed artificially lowers interest rates.  If the interest rate is lower than the market interest rate would be, more money is being added to the money supply than the market demands.  This is over-issue currency.  It has to go somewhere.  Nobody puts baby in a corner.  The new money pushes the stock market higher, giving investors the feeling that they are getting wealthier.  But it's not real.  Only the person that cashes out before the bust gains real wealth.

You read Malchup for kicks and make Dirty Dancing references.  You redefine sexy.  So who says there has to be a bust?  We can just print more money.

DQ: The longer the Fed suppresses interest rates, the worse it gets.  Entrepreneurs engaging in higher order stages of production need accurate interest rates. Their projects take longer to complete than lower order stages (finished goods).  They use the interest rate as a signal that savings is available to make their projects worthwhile in the long run.  Low interest = high savings.  High interest rate = low savings.  More and more time consuming projects are taken on because of the low rates.  But the savings isn't really there.  And as time goes by, just a slight rise in interest rates can cause these projects to go bankrupt, leading to a tidal wave of bank defaults. The rest, as they say, is history.

So right now the Fed is trying to re-inflate, crank up the bank credit, lower the rates, and get these entrepreneurs to start taking on new projects.  But the same problem persists.  The interest rate does not reflect reality, and the when the Fed can no longer keep the rate near zero, we will get hit with another wave of bankruptcies, defaults, and finger-pointing.

And the finger should be pointed at the Fed

DQ: Absolutely. The Federal Reserve has moved beyond the point of "maintaining the value of the dollar" - if they ever did that - and is now attempting to manipulate the economy.  This is central planning, not capitalism (at least, not the kind of capitalism I like.)

The rising stock market comes directly from the Fed's monetary manipulations. The more it goes up, the more trouble awaits us.

What if the Fed is right?  And interest rates accurately reflect economic reality? 

What are the chances of the that?  Not even the Fed has the gall to say this is really what interest rates should be.  They say "we need to keep rates low so we can get the economy going."  But remember what I just said.  The low rates send a signal to entrepreneurs that savings is higher than it really is.  It's like deja-vu.

Can't entrepreneurs adjust?  You always make them out to be supermen?

DQ: Certainly they can, and they are.  As of right now, they're not taking the bait, which is frustrating the heck out of the Fed.  And what's the Fed's response?  "How about negative interest rates?"  I'm sorry, but you wave enough crack cocaine in front of a reformed user and he's going to give in. The fact that he knows better becomes irrelevant.

So are stock market bulls really cheerleading our destruction, or is something else going on?

DQ: I admit, that's a little harsh. They're good people trying to make a buck, enjoying one of the games of life.  I wanted to be controversial, hoping that it would reach a wider audience.  But that's a total backfire.  I don't wish any harm on DragonLZ, MegaEurope, rofgile, or any other CAPS members that are excited to see the market rise.  So again, my bad. 

But I hope they understand what is going on here.  Maybe they do, maybe they don't.  

Do you think the market is going up?  What do you base your analysis on?

DQ:  Yes and nothing.  It's a gut feeling.  This doesn't feel right.  People tell me that the market priced in QE2.  I don't think so.  For starters, I'm not sure that's possible, and even if it was nobody knows exactly how big we're talking.  This market is getting a nudge up, and when QE2 hits it is going to start taking off.  It's not like there's less leverage available today than in 2006.  When this rally gets going, we're going to see a lot of the same mistakes made.  That's my gut feeling.  But this isn't scientific or anything.

So why should anyone listen to you? 

DQ:  They shouldn't.  I think an understanding of Austrian Business Cycle Theory provides tremendous explanatory power, more than any economic theory I have come across, but it's a Theory not a Law. As far as stock picking go, I've studied it for over a decade, but I've only had real money to invest for three years.  That makes me a novice because only those three years mean anything.  Studying investing makes you see your mistakes faster, but you still make them.

I always stress that people need to decide for themselves what is right.  We may never agree, but I have no desire to force you to agree.  I would prefer it if you understand my point of view, but that's all I can ask. 

Finally I notice you often have harsh words for mainstream economics. Why is that?

DQ: Simply put, mainstream economic theory is a fraud.  It's not theory at all.  In econ class, I was taught the mechanics of modern day economics and told it was theory, as if modern economies evolved from the learned study of economic scholars.

In fact, the exact opposite is true.  Economies evolved through the mostly-backroom deals of bankers and bureaucrats, with almost no input from economic theory at all.  Take the Bretton Woods agreement as a prime example.  From what economic theory did Bretton Woods take its cue?  Stumped?  You should be.  It was a compromise of two economic plans, neither of which originated from the centuries of economic writing that formed the discipline.  In practice, Bretton Woods operated as you'd expect: a shell game doomed from the start.

Yet, these concoctions and compromises, as nice as they are when they help avert total war, are presented to economic students as the result of intense economic study, only implemented after being sanctified by the deans of the field.  Ha!  Try rubber-stamped ex post facto.

So yeah, I tend to be hard on the establishment's economics, but they bring it upon themselves.

I hope this post helped your understanding.  And again, I apologize for the weakness of my original post. 

David in Qatar 

50 Comments – Post Your Own

#1) On October 14, 2010 at 1:20 AM, whereaminow (34.08) wrote:

In Year 50, if the money supply has remained at $1T, the total market cap of all stocks will be right around $1M

edit: $10M.  Missing a zero. Sorry.  

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#2) On October 14, 2010 at 3:01 AM, sawchain (< 20) wrote:

I totally understand your theory.  However, I think I can poke a hole in it...for academic purposes, if nothing else.

 

First, market cap is the current share price multiplied by the number of outstanding shares.  Secondly, any share price can be driven to an arbitrarily high number by consensus and a single transaction.  If consensus is that AAPL is worth $10,000 per share, and only ONE share is sold at $10,000, Apple's market cap would be through the roof ($9.1 trillion).

The point is that the market cap isn't a real number until the entire company is liquidated, sold, and delisted.  Until that happens, it's a consensus.  It doesn't have to be based in anything real or physical.  It's entirely possible that the market cap today is $200B, but after the company is liquidated and sold we find it was worth only $125B.

After reading your previous post, I did a bit of research.  According to this article, total world market cap was $61 trillion in Oct 2007.  According to Mike Hewitt, total world money supply was $58.9 trillion in Oct 2008.

It is entirely possible that the total world market cap fell to a level below $58.9 trillion.  However, (if you trust these numbers) we're starting to see evidence of the possibility that total market cap can be higher than money supply.  Let's look at another example.

Willshire publishes their Willshire 5000 index that claims to show the market cap of all US equities.  In 2006, it was roughly $13 trillion.  The last official M3 number published by the Federal Reserve at the same time was roughly $9 trillion.  This is another example of total market cap surpassing total money supply.

The implication of this data is supported even more when you consider that:

1) The total market capitalizations account for more that the ENTIRE supply of money.  That means that over 100% of all available money was tied up in the stock market.  That just can't be correct.

2) M3 is the most-inclusive, broadest measure of money supply.

I just don't think the assertion that market capitalization can only reflect available dollars is true. 

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#3) On October 14, 2010 at 8:16 AM, whereaminow (34.08) wrote:

sawchain,

That point was brought up on Part One, but we didn't have exact numbers. Thanks for doing the research.

The problem is that bank credit is used to purchase stocks (it's not necessarily a problem, but it's a problem for our research.)  Central banks are tremendously leveraged, so the total amount of credit available far exceeds the total amount of money in the stock market. 

David in Qatar 

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#4) On October 14, 2010 at 8:36 AM, MegaEurope (23.78) wrote:

David #55: Btw, the money supply decreased slighty from 1879-1896.

Me #59: I know prices fell slightly over that period.  Regarding your claim about the money supply, this would be a great opportunity for you to cite a data source.

David #64: Rothbard's History of Money and Banking in the United States is also a very good book on the subject.

http://mises.org/pdf/Rothbardreaders/Part1.pdf

Rothbard, page 157:

"Just as in the previous period [1873-1879], the money supply grew [in 1879-1897], but not fast enough to overcome the great increases in productictivity and the supply of products. The major difference in the the two periods is that money supply rose more rapidly from 1879 to 1897, by 6 percent per year, compared with the 2.7 percent per year in the earlier era. As a result, prices fell by less, by over 1 percent per annum as contrasted to 3.8 percent. Total bank money, notes,and deposits rose from $2.45 billion to $6.06 billion in this period, a rise of 10.45 percent per annum - surely enough to satisfy all but the most ardent inflationists."

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#5) On October 14, 2010 at 8:42 AM, dbjella (< 20) wrote:

David -

I think this is analogous with the overall cost of healthcare...maybe?  A colleague and I were discussing the rise in costs of healthcare and we came up with lots of reasons including rising demand.

I said that I didn't think that costs could outpace the total dollars of the consumer unless another party brought money to the table.  He looked at me an said "Huh?"  I said, the gov't (rightly or wrongly) is involved in healthcare and through local, state and fed dollars has driven up the total cost.  He said "but, they are trying to lower the costs."  I said I agree they may have altruistic motives, but the overall costs cannot climb without this money.

He said that was impossible and then I backtracked a little because people can always borrow to some extent for healthcare, but only to "some" level.  It would be interesting to find out what the "some" would be. 

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#6) On October 14, 2010 at 9:19 AM, SkepticalOx (99.42) wrote:

sawchain 

First, market cap is the current share price multiplied by the number of outstanding shares.  Secondly, any share price can be driven to an arbitrarily high number by consensus and a single transaction.  If consensus is that AAPL is worth $10,000 per share, and only ONE share is sold at $10,000, Apple's market cap would be through the roof ($9.1 trillion).

I don't understand how you could consider that "consensus". If only one share of AAPL is sold at $10,000, that means only one single buyer and one single seller agreed to that price, not everyone in the market or everyone involved in AAPL. I'm pretty sure if the consensus view on AAPL as a whole was that it was not worth $10,000/share then the next trade will bring it back to normal, so whatever that single trade did was temporary. 

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#7) On October 14, 2010 at 10:02 AM, Valyooo (99.58) wrote:

@SkepticalOx: The only market value of a stock is whatever it just traded for in the market.  Who are you to say what the stock is actually worth?

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#8) On October 14, 2010 at 10:29 AM, whereaminow (34.08) wrote:

I notice people speaking of temporary price movements as if they represent real wealth increases for other people who hold the same asset. That's not the case.  In fact, thinking that way is the characterisitc of a bubble, not a real economy.

The key element here willing and able.  You can have the desire to purchase an asset, but it doesn't matter unless you are able.  The able part is either your money or someone else's money.

Let's say you and your neighbors all bought your houses around the same time for $100K.  8 years down the road, one of your neighbors accepts an offer for $1M. Where does the money for this transaction come from?  The owner got paid.  With real money.

The money comes from bank credit.  It came out of thin air.  (Except in the rare circumstance when the buyer had $1M in cash.)  That's the nature of fractional reserve banking.

So think about this as you ponder the next question, every homeowner in the neighborhood perceives that their home is now worth $1M:

What has to happen for every homeowner to actually sell their home for $1M?

If you said new money must be created, go to the head of the class.

The stock market works the same exact way.  And if you think the market can keep going up and up and up, simply because one person is stupid enough to overpay for a stock, that's not true.  It can only keep going up as people are willing and able to purchase equities.

When bank credit dries up (see the post), the able part of that equation disappears.  Plain and simple. This is why the Fed is now a single point of failure for the entire economy.  Nevermind the genius of having a single point of failure for a complex system. That's the reality.

David in Qatar

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#9) On October 14, 2010 at 11:04 AM, SkepticalOx (99.42) wrote:

Valyooo

Except then using the idea of a last trade is sorta irrelevant to this discussion? Tell that to all the people who held onto the toxic MBS they couldn't sell because there was no market. Whatever price they last traded at was irrelevant when they couldn't even find a buyer at 20 cents to the dollar for the crap. 

I really don't understand why it is so hard to grasp the idea that the total stock market value is constrained by the amount of money that comes in and out of it (and whatever extra credit that's used to buy in it)? 

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#10) On October 14, 2010 at 11:04 AM, SkepticalOx (99.42) wrote:

Valyooo

Except then using the idea of a last trade is sorta irrelevant to this discussion? Tell that to all the people who held onto the toxic MBS they couldn't sell because there was no market. Whatever price they last traded at was irrelevant when they couldn't even find a buyer at 20 cents to the dollar for the crap. 

I really don't understand why it is so hard to grasp the idea that the total stock market value is constrained by the amount of money that comes in and out of it (and whatever extra credit that's used to buy in it)? 

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#11) On October 14, 2010 at 11:14 AM, FleaBagger (29.12) wrote:

So are you saying that, in a world of stable (if that's the right word) money supply, increases in productivity and the real economic value of stocks would be seen as stable (again) stock prices over years of decreasing prices in most or all other asset classes and consumer goods?

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#12) On October 14, 2010 at 11:22 AM, SkepticalOx (99.42) wrote:

[b]David[/b]

This is somewhat puzzling me right now, but is the creation of credit somehow linked to future increase of the money supply? I mean, don't people lend out hoping to get paid back, and if you lend out more than all the money in the world, how the hell does that work? 

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#13) On October 14, 2010 at 11:22 AM, SkepticalOx (99.42) wrote:

David

This is somewhat puzzling me right now, but is the creation of credit somehow linked to future increase of the money supply? I mean, don't people lend out hoping to get paid back, and if you lend out more than all the money in the world, how the hell does that work? 

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#14) On October 14, 2010 at 11:44 AM, whereaminow (34.08) wrote:

FleaBagger,

Actually Malchup takes it a step further and predicts slighly falling aggregate stock market levels over the long term in a society with an unchanged money supply, much in the same way consumer prices act under similar circumstances.

SkepticalOx,

Bank credit is money created out of thin air.  It increases the money supply as soon as it is created (note: there is disagreement about when fractional reserve bank credit becomes money.)  

Some will argue that it cancels out, because the money created as a mortgage loan, for example, is repaid.  Only the interest is new money.  That's simply not true.  The money repaid becomes new reserves which are held against the creation of even more money.

And I can't really explain it any better than saying it's similar in operation to counterfeit.  If you create a new bill illegally and then purchase something with it, you have increased the money supply.  Does it really matter if you hold a 10:1 ratio of new money to 'reserves?'  Or a 20:1 ratio?  If you loan that money out and the money is repaid, does that cancel out the money?  Of course not.  Do you burn it when you got it back?  No, you lend it out again or you make purchases with it.

The mechanics of fractional reserve bank credit work the same way, except that it is legal and respected.  That's another story for another time. But if it is something you really want to study, Huerta's Money, Bank Credit, and Economic Cycles is the best book on the topic.

David in Qatar

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#15) On October 14, 2010 at 2:11 PM, NajdorfSicilian (99.88) wrote:

The Fed most certainly does not determine the market level of interest rates, see Clinton 1994, ad infinitum for more details.

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#16) On October 14, 2010 at 2:20 PM, whereaminow (34.08) wrote:

CryingofLot49,

Is your dispute over wording or meaning?  The Federal Reserve definitely wields tremendous influence over the interest rate and purposefully impacts interest rate movements. I'm not sure anyone would dispute that.  If you don't like the word "set", I'm ok with that.  "Plans the interest rate movement" would be more accurate.

http://beginnersinvest.about.com/od/banking/a/aa062405.htm

The most powerful weapon in the Fed’s arsenal is the ability to influence the direction of interest rates

http://www.money-rates.com/fed.htm

The Federal Reserve is popular on Wall Street for their strong efforts to keep interest rates low, but not everyone agrees with the Fed's mission.

http://en.wikipedia.org/wiki/Federal_Reserve_System

The Purpose of the Fed:

To manage the nation's money supply through monetary policy to achieve the sometimes-conflicting goals of maximum employment stable prices, including:
-
prevention of either inflation or deflation
-
moderate long-term interest rates  (emphasis added)

David in Qatar

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#17) On October 14, 2010 at 4:46 PM, Valyooo (99.58) wrote:

My question is, if all of this money is created "out of thin air" (not agreeing or disagreeing), how is there real, hard, physical "stuff" to be purchased with it?

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#18) On October 14, 2010 at 4:51 PM, Valyooo (99.58) wrote:

Also, do you think there should be no stock market then?

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#19) On October 14, 2010 at 4:53 PM, Valyooo (99.58) wrote:

If so, why are you on caps (serious question, not trying to be rude)

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#20) On October 14, 2010 at 5:07 PM, whereaminow (34.08) wrote:

Valyooo,

My question is, if all of this money is created "out of thin air" (not agreeing or disagreeing), how is there real, hard, physical "stuff" to be purchased with it? 

Because people accepts these bills as payment without questioning where the money came from.  That's neither unusual nor surprising.

Also, do you think there should be no stock market then?

Wow. I honestly didn't see that coming. I don't know how you made the jump there.  The stock market does not require a central planning agency actively manipulating interest rates in order to make people wealthier than the really are.  It worked just fine without the Federal Reserve, and would work fine without it.

I love capitalism (the free market kind, not the crony kind) and investing.  I love what good companies provide for us. 

I hope that answers your question.

David in Qatar

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#21) On October 14, 2010 at 5:14 PM, leohaas (34.54) wrote:

Finally got some time to read this and your previous post. Thanks for giving us something to think about. I wish I had the time for that. I don't, so I am shooting from the hip: isn't all this a longwinded way of saying that fractional reserve banking is a fraud? Or is there more to it, and I don't see it yet?

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#22) On October 14, 2010 at 5:26 PM, whereaminow (34.08) wrote:

leohaas,

isn't all this a longwinded way of saying that fractional reserve banking is a fraud?

LOL, perhaps. That certainly was Murray Rothbard's conclusion. I don't feel that I am in agreement.  It is true that fractional reserve banking originated from fraud (embezzlement would be the better term), but that doesn't necessarily mean your Chase bank mortgage rep is a criminal.

Anyway, I remain unconvinced. I think if you remove legal tender laws as time passed fractional reserve banking would become a very minor part of our economy. 

However the government's dependence on fractional reserve banking (and vice versa) always ends up hurting the people.  It's worth being aware of.  It's worth understanding how that relationship manifests itself, particularly with the stock market.

Thanks for reading. I appreciate it.

David in Qatar

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#23) On October 14, 2010 at 5:29 PM, Valyooo (99.58) wrote:

The stock market does not require a central planning agency actively manipulating interest rates in order to make people wealthier than the really are.  It worked just fine without the Federal Reserve, and would work fine without it.

 That does not match up with what you said a few posts earlier

Actually Malchup takes it a step further and predicts slighly falling aggregate stock market levels over the long term in a society with an unchanged money supply, much in the same way consumer prices act under similar circumstances

So does the stock market fall, or does it make people wealthier?

 

Also, if you are saying that people are willing to accept this non-existant money...then whats the problem?  If people are willing to produce things for "fake" money, then how is the money fake?  It is causing production of goods.

If I owned one chicken, and you owned one dollar, and I was charging one dollar per chicken, and you wanted that chicken, you could pay me a dollar.  If you ran to the printing press, and printed 10 more dollars, I would not magically have 10 more chickens to sell you.  So how does this money work then if its fake?  How are peopel buying real things with fake money?

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#24) On October 14, 2010 at 6:00 PM, whereaminow (34.08) wrote:

Valyooo,

That does not match up with what you said a few posts earlier

Please give specifics.

So does the stock market fall, or does it make people wealthier?

Wealth, in economic terms, is not the price level.  Wealth is purchasing power.  That's a very important difference.  The price level can fall while society's wealth increases.  It can rise while society's wealth decreases.

Also, if you are saying that people are willing to accept this non-existant money...then whats the problem?  If people are willing to produce things for "fake" money, then how is the money fake?  It is causing production of goods.

I have not used the term "non-existant."  

This is a phenomenon known as "false demand."  You would not magically have 10 more chickens.  Let's say you own an electronics store. I have a counterfeiting machine.  I print up $100,000 in phony bills and buy up all your TV's.  In response you order more TV's.  The demand for TV's has now been raised.  The resources used to make TV's have also know been raised, since those supplies must be replenished as well.

But there is not an increased demand for TV's. This is a false demand. 

The result of this false demand is another economic law called the Cantillon Effect.  When new money is created, the people that get to use it first, benefit the most, because they get to use the money at today's price level.  That new money pushes up prices as it works its way through the economy.  People who use the money last (wage earners, savers, people on fixed incomes) suffer the most.  They are in perpetually catch up mode. 

For a detailed discussion on how the policy of inflation works, I recommend this post, which is one of my favorites.

David in Qatar

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#25) On October 14, 2010 at 6:58 PM, MegaEurope (23.78) wrote:

There are 3 types of investing cash flows:

1. Cash flows between investors and public companies: IPOs, secondary offerings, buyouts, dividends, etc.

2. Cash flows between public companies and consumers: Earnings.

3. Cash flows between investors: These day to day transactions determine the price/market cap, but don't actually affect the companies that being traded.

Cash flow 2 is almost always positive (public companies as a whole rarely report a loss.)  Cash flow 1 is usually negative in developed economies (unless the IPO market is hot).

If net cash flow (cash flow 2 - cash flow 1) is positive, stock market prices will appreciate - in real terms, not just inflation adjusted terms.  This is exactly what has happened in the US over the last 2 centuries. 

At some point, perhaps centuries or even millennia in the future, public companies will no longer make more profits than they distribute and prices will stabilize (assuming 0 inflation).  Maybe that has been your point of the last two blogs?  But your timeline is not nearly long enough.

 

PS: Regarding post #4, cat got your tongue?  I thought you would appreciate that I read some Rothbard.

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#26) On October 14, 2010 at 7:12 PM, whereaminow (34.08) wrote:

MegaEurope,

Well, I'll be damned.  I missed your comment.  I was wrong about the money stock in the late 1800's.  I remembering reading that it had fallen, but I guess I was mistaken. I wonder if I made the mistake of confusing falling prices with a falling money supply?  That would be ironic.  I guess I'll look that up to see where I went wrong.  But absolutely, I was wrong about that.

If net cash flow (cash flow 2 - cash flow 1) is positive, stock market prices will appreciate - in real terms, not just inflation adjusted terms.  This is exactly what has happened in the US over the last 2 centuries. 

Do you believe that stock prices would appreciate continuously in a market with an unchanged money supply (not zero inflation, but an actual unchanged money supply)?

Just think about it.  How in the world would that be possible?  Since I can't suitably explain Malchup's theory to you, could you at least explain how the opposite could be true?

David in Qatar

 

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#27) On October 14, 2010 at 7:12 PM, MegaEurope (23.78) wrote:

in real terms, not just inflation adjusted terms

should read: in real terms, not just nominal terms.

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#28) On October 14, 2010 at 7:32 PM, MegaEurope (23.78) wrote:

Do you believe that stock prices would appreciate continuously in a market with an unchanged money supply (not zero inflation, but an actual unchanged money supply)?

Maybe, depending on the exact conditions of your hypothetical.  If population growth rate is 1%, efficiency growth rate is 1%, earnings yield is 7% and investor yield is 4% (composed of dividends, IPOs, etc.), then yes, I would expect prices to appreciate 1% per year (7%-4%-1%-1%).

Like I said, I think the price of public companies will increase continuously for centuries, not forever. This is because public companies have controlled an increasing share of world assets over time, and this trend does not seem to be slowing significantly.

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#29) On October 14, 2010 at 7:39 PM, whereaminow (34.08) wrote:

At 1% per year, prices could not appreciate for centuries.  All of the money in the economy would be in the stock market before the first century was finished.  At that point you would have to sell stock to buy stock, since there would be no other money available.  And we know that we'd never get near that point anyway, as returns in other sectors of the economy would become astronimically high.

David in Qatar

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#30) On October 14, 2010 at 8:03 PM, whereaminow (34.08) wrote:

Let's examine this another way, rather than arguing about whether it would take a short amount of time or really really long time for aggregate stock prices to stop rising.

P = D/S

Price is demand divided by supply.

Unless supply is decreasing, prices in the aggregate can never rise unless demand is increasing.

It is impossible for the profits of all or of the majority of enterprises to rise without an increase in the effective monetary circulation (through the creation of new credit or dishoarding). - Malchup

Notice that he says profits.  The same rule applies.  Aggregate profits can not rise unless demand rises or supply falls (or falls faster).

So aggregate earnings cannot continuously rise.  CF2 cannot continue to be higher than CF1, and stock market prices cannot continue to increase.

David in Qatar

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#31) On October 14, 2010 at 8:11 PM, MegaEurope (23.78) wrote:

Yes, you are right that earnings yield would fall pretty quickly if the earnings/distribution/money demand imbalance was that large.  So in my hypothetical, change the calculation to equal .1% or less over the long term, which will let public companies expand their share of assets for centuries.

(Note that while piddling in these deflationary terms, the real return from stocks has clearly been good.)

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#32) On October 14, 2010 at 8:12 PM, rofgile (99.33) wrote:

Hi David,

 I really do appreciate this and the last blog.  I very much appreciate philosophy and philosophical discussions as well as practical discussions.  This talk about money supply and the limits of the markets is both engaging and interesting to me.

 I believe that you are wrong about the limits to the market.

 I think the markets are really most similar to an unlimited fractional reserve banking system.  In such a manner- it is perhaps true that the money supply increases with the markets but it is not the FED that is doing it.  I will try to explain my thoughts below:

 Imagine that there is only 50 dollars in the world.  The market has 3 stocks only.  There are maybe 10 people in the world.  A very simple world - you could actually simulate this world on a computer.  Imagine that equity prices have a tendency to rise.  Those 50 paper dollars are the ONLY dollars existing.  More cannot be created.  All transactions have to involve some of those 50 paper tokens moving from person A to B.   Those are the rules.

 Person A buys stock 1 from person B for $1.

 Person B can use that $1 to buy another stock from person C (or even person A).  

 Person C can use that $1 to buy another stock from person D (or A, B)..

 Person D can use that $1 to buy another.. etc ad nauseum.

 There now exists $4 market capital of stock in the world from only 1 single dollar.  There are still 50 dollars still total.

 Imagine this continued 100 times?  Now the market capital (from the "last trade price") of all the equities is $100.

---

 Now, here's the thing too- when someone sells stock 1 for $1, all the other people who had bought the stock at $.5 saw their value double (virtually, what'll they get when they sell though?).

 If all the market capital was in 2 shares of a stock valued at $25 a share - and some rich bozo with $40 goes and buys one of the shares for $40 what is the total market capital of the stock market?  It is $80, again above the $50 of real hard cash existing in the world.

 ----

 Again - I reiterate, market indexes do not really mean that much.  Money does not flow into markets, it flows between people.

 -Rof 

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#33) On October 14, 2010 at 8:15 PM, rofgile (99.33) wrote:

I should edit my post-

 Remove the "imagine there are three stocks".

 And remove "imagine there are only 10 people" 

 It should be more like, imagine an infinite number of stock shares exist in the world... 

 -Rof 

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#34) On October 14, 2010 at 8:16 PM, rofgile (99.33) wrote:

One more thought:

 In this world, when there is an initial public offering producing more stock shares people can buy - how is that different than increasing the money supply of the world?

 Just a philosophical thought...

 -Rof 

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#35) On October 14, 2010 at 9:03 PM, starbucks4ever (98.86) wrote:

Hi whereaminow,

That's good understanding of monetarism. However, to play the devil's advocate, I will ask you this question: what happens when shareholders begin to use stocks as a legal tender? Unless you ban margin accounts, you can still have fractional reserve banking in the absence of the Fed, only done by brokerages and their clients. 

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#36) On October 14, 2010 at 9:09 PM, MegaEurope (23.78) wrote:

It is impossible for the profits of all or of the majority of enterprises to rise [infinitely? or just for a short period of time?] without an increase in the effective monetary circulation (through the creation of new credit or dishoarding). - Malchup

Private companies make up the majority of enterprises, right?  I suspect that the reason that the 'real' public market cap and possibly even the 'deflated' public market cap will rise is that the earnings yield may be slightly higher for public companies than for private companies.  (Obviously, many small business owners make great returns - but most of that can be attributed to wages from their hard work, not profits from their capital.)  However, I haven't found any data to prove this.

How else do you explain that so many hundreds of thousands of companies have gone public in the last few centuries?  I think investors are chasing slightly higher returns.  And the flow of capital from the private market to the public market continues all over the world.  It is not a stable equilibrium right now.

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#37) On October 14, 2010 at 9:43 PM, whereaminow (34.08) wrote:

rofgile,

Hey rof!  I'm glad you enjoy the posts!  That's more important than being in agreement.  I think you and I would have a great time working together, shootin' the breeze when the work was done.

In the examples you provided you left out the starting total market cap and the balances that resulted from the transactions.  I can't really imagine an infinite number of stocks, but if you are continually increasing the number of total shares that just dilutes the prices of the individual shares, no?

Money does not flow into markets, it flows between people.

I'm going to think about a better way to explain this.  I will answer in more detail later today, ok?

zloj,

what happens when shareholders begin to use stocks as a legal tender?

That's actually been tried before. John Law convinced the King of France to run this scheme. The result was massive inflation and the Mississippi co. bubble.  Interestingly enough, his partner in crime was Richard Cantillon.  Upon seeing what was happen, he changed his tune and started warning against the dangers of inflation.

Unless you ban margin accounts, you can still have fractional reserve banking in the absence of the Fed, only done by brokerages and their clients. 

That seems true. Allow me to think about that for a bit and I promise to get back to you.

MegaEurope,

I suspect that the reason that the 'real' public market cap and possibly even the 'deflated' public market cap will rise is that the earnings yield may be slightly higher for public companies than for private companies.

I don't know.  I would suspect that this would make the return for investing in or starting new private companies more attractive, removing money from the public company arena. 

How else do you explain that so many hundreds of thousands of companies have gone public in the last few centuries?

It's certainly profitable to do so in the short run. It gives companies more flexibility.  I suppose you know those theories better than I do, but I what I am searching for is whether that is actually true if the money supply remains unchanged and how that would play out in the long run.

David in Qatar

 

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#38) On October 14, 2010 at 9:47 PM, MegaEurope (23.78) wrote:

I suspect that the reason that the 'real' public market cap and possibly even the 'deflated' public market cap

Oops.  I meant the price level of stocks, not the market cap.

I think investors are chasing slightly higher returns.

Maybe this is not the best way to put this.  For the past few centuries, capital has been moving from private enterprises to public enterprises.  I believe this is because the "work-adjusted return" is higher.

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#39) On October 14, 2010 at 10:02 PM, sawchain (< 20) wrote:

So we're operating in a system based on fraud.  How would you feel if someone took out a loan backed by fractional reserve banking, then shorted a stock that you own with that loan as margin?

Similarly, what if a business competitor took out a loan backed by fractional reserve banking to finance new product lines that compete directly with yours?  You're screwed twice by the bank: first when they inflate the price of your goods, and second when they deflate the value of your savings.  Then you're screwed by the competitor who never should've gotten a loan in the first place.

Ha ha.  Even further, what if the competitor defaulted on the loan and your bank wasn't able to honor your deposits?  Wow.  The system is more of a sham than I thought.

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#40) On October 15, 2010 at 12:52 AM, whereaminow (34.08) wrote:

sawchain,

Hmmmm, it's funny that you wrote this.  As I was driving out to breakfast I had these back-and-forth discussions with zloj, rofgile, leohaas, Mega, etc. going in the back of my head.

I started to wonder if there was more to it than I was indicating, that maybe there are deeper issues at play that I'm not bringing to the forefront.  One of those would be control, as in who gets to be in control?  Does the concept of who gets to choose have any impact on economic ideas?  Can you say that an economic system (ad hoc, like most economies, or one grounded in theory) is right or wrong from any moral sense?  And I think your comment indicates that you feel there is something wrong with this current setup.

I can't say that I disagree, although I don't think I would use the same terminology you presented, but I'm not entirely sure that I can say "it's ok, everything that happens in our economy is justified and right."   I'm pretty sure zloj has some of those same feelings I do, but I can't speak about anyone else.

rofgile,

In reference to the example that you took time to craft, I didn't mean to blow you off, but I had to take a break.  I also knew that I wanted to try and expand on that, and I couldn't do it in a quick reply with limited time.  I'll be back here to work on that and hopefully you are still following the post.

David in Qatar 

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#41) On October 15, 2010 at 1:04 AM, Valyooo (99.58) wrote:

I understand the difference between accounting and economic wealth.  But if stocks went over time and the dollar stayed the same, why would I ever buy stocks?

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#42) On October 15, 2010 at 1:35 AM, sawchain (< 20) wrote:

@Valyoo: But if stocks went over time and the dollar stayed the same, why would I ever buy stocks?

 

It's simple.  With a constant money supply and productive companies in the stock market, the price of goods and services deflate.  You're holding stock that maintains its price, while the price of everything else (houses, food, cars, energy) go down.  If you held commodities instead, your wealth would deflate along with everything else.

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#43) On October 15, 2010 at 2:07 AM, whereaminow (34.08) wrote:

But if stocks went over time and the dollar stayed the same, why would I ever buy stocks?

Malchup makes it pretty clear that individual stocks would still rise and fall just as they do now.  So your reasons for buying and selling individual stocks would remain the same.  And since, under these conditions, temporary rises and falls in the aggregate price level could still exist, ETF's like S&P 500 bull index could still be a play every now and then.  

But a rising tide would not lift all boats, since the assertion is that the rising tide (in the long run) is simply new money being added to the money supply.

David in Qatar 

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#44) On October 15, 2010 at 8:28 AM, rofgile (99.33) wrote:

Hi David,

 No problem - I totally understand.  I'm pretty busy with work lately (as in, dying from work) but, this discussion has been interesting to think about, and I couldn't help myself from thinking about it.  Here's another long post (how do they get so long?)

---

 Restating my argument in one sentence: I believe as long as dollars are moving between people, total market capital can exceed total real dollars. 

 This is similar to the idea that when you spend $1 at a grocery store, of that $1, $.5 pays the employee, the employee spends $.5 at the video store, video store can spend $.5 somewhere else.. so that $1 became $2 in a local economy.  (There is a term for this effect, I forget what it is - I am not an economic scientist).

 ---

 Whenever a company launches an IPO they produce more shares of stock that can be sold at $X dollars.

 What if there were two people, Pa and Pb -  and only $2 in the world? Each person has $1.

1) Pa launches an IPO for $1/share and 2 shares.  Pb pays Pa $1 for a share.  World mkt capital is $2 as each share is listed as being worth $1 (total money in world $2).

2) Pb launches an IPO for $2/share and 2 shares.  Pa pays Pb $2 for a share.  World mkt capital is now $2 Pa shares and $4 Pb shares = $6 total mkt capital.  Still only $2 in the world.

--

 This sounds like a shell game.  But, by this example is theoretically possible for total mkt capitalization to exceed all the currency in the world. The above market wouldn't be very liquid, and when Pa and Pb try to sell their shares, the market capitalizations might fall back to what currency is in the world but it could unwind by Pb buying back his share for $2, and Pa buying his share back for $1 - no losses for people or dropping of the mkt capital.  

 The problem is that this looks pretty non-liquid of trading.  But, if you have enough liquidity in the system (and shares prices are a miniscule fraction compared to total money supply) then such a system of currency just moving between people could allow very high market capitalisations regardless of the total market capital compared to total currency.  

 Total market capital is probably limited by a function like this:

 Total market capital <= Total money * velocity of money

---

If you want, you could stop reading now because what I write below (Conclusion) is what'll be quite contestable.  Conclusions in philosophy tend to be where the problems really arise!  

1) 

 Printing shares is similar to printing money - it is a tradable asset of value.  So, while the number of dollars hasn't increased, share increases seem to also increase the monetary system to me.  At some point, couldn't Pa and Pb just trade shares directly without those dollars (and this does happen with mergers)?  I think this all gets to the really deep question of "what is money"?   Money is a unit of debt, saying that you'll exchange a service or good for this IOU to later be replaced by some service/good.  As long as there is a need for more trading tokens (growing populations, huge populations of businesses that suck up currency) increasing money supply should be a GOOD thing, because you just need to have these tokens around to facilitate trade and keep liquidity.  

2) 

That's ultimately why gold standards are trouble - if businesses, populations and GDP never grew maybe we'd be fine with a limited or no currency growth.  But there can be a growing need for more trading tokens (money) just to have enough to facilitate trade.  Starving the system of the necessary tokens for everyone to be able to be trading leads to an artificial pressure to use too few tokens / trade (because there aren't enough) and leads to deflation.

 -Rof 

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#45) On October 15, 2010 at 10:31 AM, Valyooo (99.58) wrote:

"It's simple. With a constant money supply and productive companies in the stock market, the price of goods and services deflate. You're holding stock that maintains its price, while the price of everything else (houses, food, cars, energy) go down. If you held commodities instead, your wealth would deflate along with everything else."

Right, but if they held their value, so does cash, so I would rather stay in cash than stock, if stock goes down. I never said anything about commodities.

And I got you David, individual stock picking all the way

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#46) On October 15, 2010 at 11:16 AM, rfaramir (29.41) wrote:

"Central banks are tremendously leveraged"

 

That's an understatement.  Since the money is not backed by anything, and they can print as much as they want, they are infinitely leveraged.  As soon as we see what they are doing, they are done for.  That's why they fight "Audit the Fed" bills. 

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#47) On October 15, 2010 at 3:27 PM, dragonLZ (99.71) wrote:

whereaminow, I apologize if what I'm about to say was already said by you or somebody else (I have no brain capacity to read posts long as yours and/or 46 comments - but I did read the title):

I'm convinced that 99% of the Bulls cheer higher stock prices because higher stock market means improved economy + better standard of living are on their way (market is forward-looking, blah, blah, blah).

It is not true at all that market goes up because of falling dollar (and our destruction). Just because market has been going up and dollar is going down, you and others started thinking that's the way it is and will always be.

Don't you know stock market likes higher employment numbers, good GDP numbers, good earnings, and all of the other signs of good economy?

In other words, I think your thesis about Bulls cheering our destruction is utterly wrong. Bulls are positive people and are cheering prosperity. They want to be happy, they want things to get better. They cheer signs of BETTER tomorrow.

Falling stock market means troubles are ahead and Bulls don't like it. Bears, however, cheer it because bears make money when economy is shrinking, people are losing jobs, earnings are not existing, etc.

I think you owe an apology to Bulls. Somebody else is cheering our destruction...

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#48) On October 15, 2010 at 7:26 PM, Earendil (< 20) wrote:

“Let's say you have an economy in Year 1 with a money supply of $1T and a total market cap of all stocks at $10M, and that this relationship is typical allocation of discretionary income for the stock market.  In Year 50, if the money supply has remained at $1T, the total market cap of all stocks will be right around $1M, give or take the small fluctuations that happen from day-to-day.  It is simply not possibly for the total capitalization of the market to continue to increase over that time unless new money is added to the money supply.” 

In this case, why would anyone ever buy shares?  (Assume that companies paid no dividends.)  For people (assuming rationality) to buy shares in companies, shares must return more than 0.  Otherwise people would simply store money.  People buy shares because they will be a better store of value than money.  

Over time, shares must be worth more than money on average, or they will be worth nothing (and no money will go into shares).  That is because companies are risky investments, and money (in a fixed money supply economy) is not. 

So, in a fixed money supply economy, either shares must appreciate in value, or money must decline in value, or there will be no shares and no stock market, because why would anyone ever give up money to buy shares? 

Basically, shares in the future must always be worth more (on average) than the money they originally cost to buy.  Otherwise there is no reason to take the risk of financing businesses.

So, either in the fixed money supply economy there will be no capital going in to businesses, and the economy will not grow (quite possible, and one of the main criticisms of the gold standard or other fixed, or semi fixed money supply systems. Possibly exactly what did happen to contribute to the decline of the Roman Empire and the Dark Ages), or more and more of the money supply must attach to the owners of capital (either through capital gains or dividends) and shares (in a 0 dividend scenario) must become in aggregate, more valuable over time.

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#49) On October 16, 2010 at 2:14 PM, whereaminow (34.08) wrote:

rofgile,

Ok, I actually had to print out your comment to read it, it was so long LOL.  But I shouldn't talk, right?  I'm the king of long-winded explanations.  So what's good for the goose is good for the gander. (Is that the saying?)

This is similar to the idea that when you spend $1 at a grocery store, of that $1, $.5 pays the employee, the employee spends $.5 at the video store, video store can spend $.5 somewhere else.. so that $1 became $2 in a local economy.  (There is a term for this effect, I forget what it is - I am not an economic scientist). 

Ok, here's where you are going wrong.  The employee at the grocery store is not creating money when goes to the video store.  What has happened is this:

1. The employee trades x amount of labor to the grocery store owner in return for $0.50.  He then trades that $0.50 to the video store owner for a video.  In essence, he has exchanged his labor for a video.  The $0.50 has not increased.  It's a medium of exchange. 

2.  Same thing now, the video store owner has traded a video for $0.50.  He can then take that $0.50 to buy something else (pay employees, buy security, enlarge his store, etc.)  But the $0.50 is just a medium.

The total money supply has not increased.  The circulating money has merely made exchange easier to accomplish.  The road you are going down is a very tempting fallacy.  It leads to the Broken Window. 

Whenever a company launches an IPO they produce more shares of stock that can be sold at $X dollars.

 What if there were two people, Pa and Pb -  and only $2 in the world? Each person has $1.

1) Pa launches an IPO for $1/share and 2 shares.  Pb pays Pa $1 for a share.  World mkt capital is $2 as each share is listed as being worth $1 (total money in world $2).

2) Pb launches an IPO for $2/share and 2 shares.  Pa pays Pb $2 for a share.  World mkt capital is now $2 Pa shares and $4 Pb shares = $6 total mkt capital.  Still only $2 in the world.

There's something about IPO's that you are neglecting.  They require capital to go public.  So a company that wants to go public must get the capital funding to make the IPO happen.  The funding comes from bank credit.  That's new money.  The money supply has just been increased by $2.  (Some will say it's a money substitute, but for our purposes that's not relevant.) 

So when Pa launches the inital IPO at $1/share for 2 shares, someone must fund Pa with $2 to make that happen.  Pa is hoping that others will bid up the two shares, giving him a windfall allowing him to expand his business.  That money to bid up his shares also must come from somewhere.

Printing shares is similar to printing money - it is a tradable asset of value.  So, while the number of dollars hasn't increased, share increases seem to also increase the monetary system to me.

This would be the case if companies were allowed to print new shares completely independent of any financial backing.  This has been tried before, see John Law.  It's extremely inflationary since there is nothing stopping a company from printing as many as it wants (which is the problem for any unbacked money.)

But as described above, new shares do have a financial backing.  If they don't, it's a share dilution and there is no increase in the amount of currency.

That's ultimately why gold standards are trouble - if businesses, populations and GDP never grew maybe we'd be fine with a limited or no currency growth.  But there can be a growing need for more trading tokens (money) just to have enough to facilitate trade.  Starving the system of the necessary tokens for everyone to be able to be trading leads to an artificial pressure to use too few tokens / trade (because there aren't enough) and leads to deflation.

First, let me assure you that neither I nor Malchup advocate an unchanged money supply.  That would require central planning similar to what we have now.  This was a merely a thought experiment to show why the market moves up over time, and that this phenomenon has absolutely nothing to do with the economy but merely the addition of new money.  It is my view that new money should enter the economy out of a demand for money, and not out of the manipulations of a central planner. 

Second, the gold standard is limited.  That's true.  It's hard to get gold out to satisfy market needs.  But this is why prices fall under a gold standard.  Output is always increasing faster than the money supply can expand.  But there's a benefit there as well.  The government's hands are tied, to some extent.  They can, and will, break their own law eventually, usually to finance some bloodthirsty foreign adventure.

Third, Austrian Economists advocate a gold standard up to a point.  The ponit is when the market, not the government, rejects the gold standard.  Markets reject money all the time.  They embraced then rejected copper.  They will embrace and then reject cigarettes if need be.  They have embraced and rejected paper money.  So it goes.

The advanced Austrian School solution is free market currency.  Let the market participants choose the best money.  Let money arrive at the market the way other goods and services arrive.  Then you don't have to worry about how inelastic the currency appears to be, or whether it can fulfill the needs of market participants.  The market rejects currencies that no longer fulfill its needs and embraces new currencies.

I hope this helps.

David in Qatar

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#50) On October 16, 2010 at 2:25 PM, whereaminow (34.08) wrote:

dragonLZ,

Probably because of my confrontational stance in the first post, you seem to have missed the entire post of this exercise. 

The stock market goes up over the long run because new money is created. 

That's it. No other reason.  It has nothing to do with the health of the economy. Nothing. Nada. Zip. Zilch.

I do not advocate an unchanging money supply.

If you got that impression, sorry.  I could have explained myself better. I failed.

If interest rates are forced down, it is a bad thing!

And it creates a boom. The stock market goes up.  This is bad!  Not good.  Bad.  Very very bad.  I can't say that enough.  Bad.  Very very bad.  It creates malinvestment.  It sows the seeds for its own destruction.  Once it busts, there is nothing, I repeat nothing the government or the banks can do to fix the economy.  They just make it worse.  And while they are making it worse, they create other problems which end up harming competition, capitalism and individual liberty.

The entire Bear/Bull dichotomy is foolish, silly, retarded, etc.

Cheering broad market movements is about the dumbest thing an investor can do.  In the long run, the stock market moves because of the money created or removed from the money supply.  That's it. 

David in Qatar

 

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