A small metal box that belonged to my father very much intrigued me as a child. It contained coin and paper currency from several nations and an assortment of marine shells that were also used as money. One type of shell was about the diameter of a penny and had brownish formations that were offset from the centre, giving it a peculiar eye-like appearance. A few of this type came from island natives near an air base my father was assigned to during World War II.
He gathered all these currencies, coins and shells not just for the accumulation of a few souvenirs, but also because of his perpetual fascination with money. Not in the sense of wealth or riches; it was the philosophical conceptualization of money as a medium of exchange that interested him. Even before I started the first grade he introduced the concept of money to me by explaining how each of the items in the box was used in the place he had acquired it.
I have never been shaken from that earliest association with the abstract nature of money and never quite satisfied either, until now, about what money is and what it is not. Since my father is now deceased, my acquisition of a new personal and philosophical abstraction about money might have no practical application for anyone other than myself. Rather, my purpose in this writing is to explain the reason why expansive monetary policy would temporarily fail to recover a depressed economy. I derived the reason quite accidentally, because understanding how market participants perceive and use money during depressed economic conditions made the discovery almost unavoidable.
The following philosophical abstractions, although not absolutely needed for my arguments, will greatly help the reader understand The Perceived Liquidity Substitution Hypothesis.
All economic exchanges derive ultimately from the creative use of the intellect for producing surpluses of food. The primal individual first internalized this exchange since all elements of personal supply and demand are also internalized. Afterward, the individual learned to exchange his intellectual skills by teaching others, and learned to exchange labour or his surplus food or goods directly with other persons for other required necessities. Food, water and to a lesser degree, shelter and clothing, are vital necessities which must be found, produced or otherwise supplied by the individual for himself, or they must be purchased with money or with bartered credits or obtained by force.
Air is in abundant natural supply, although in modern times its quality consideration is raising the specter of its supply and availability becoming dearer and therefore gaining the status of a utility as water generally has in most industrialized societies. Shelter and clothing in the perfect sense are really conveniences, since mankind has in all its history had the capacity to adapt natural environments to provide shelter and clothing. Mankind is also quite capable of living without shelter or in a form of shelter far different from that used in our current experience.
We therefore can present these concepts drawn in the form of a simple representation:
Life = Food + Air + Water
There are no other absolute requirements that are not already preexisting as inherent commodities which will be defined later. Furthermore, air and water essentially drop out as relative constants because they are utilized in direct proportion to the consumption of food. Thus, Life = Food becomes the identity that demonstrates the absolute and primal requirement of man’s existence.
Money is the coercive or compelling force that ordinarily facilitates cooperative exchanges of labour, goods or services in any combination. Power, in the sense of being a controlling influence, is a greatly dissimilar and more efficient force that is yet a further abstraction of money and drives money’s uncooperative exchanges.
The conventional nominal money used in modern societies is for the most part fiat money, and it exists in its static condition entirely as a derived element of power. Fiat money therefore derives its value from its representation of power, not from some other representational value marked-to-market against other commodities that have real value independent of power. Gold, silver, corn and many other commodities used as money do not require power to have value, either real or monetary. Fiat money must be supported with power in order to have any monetary value. It can have no real intrinsic value beyond the mere pittance of its compositional material cost.
All cooperative exchanges of labour, goods or services directly for other labour, goods or services, in which the totals of all values exchanged are netted to market participants without a physical distribution of conventional nominal money being made to any party, are bartered exchanges. Even though bartered exchanges are usually conducted conceptually in nominal money equivalents, they are conducted without using conventional nominal money as a physical representative intermediary of value.
To be sure, bartered exchanges are very likely the only exchanges in which one or more participants might be correctly led to conceptualize that labour, and not nominal money (merely labour’s surrogate), is the core basis of all economic exchange. Yet much as a multilingual person fluent in several languages might still prefer to think and dream in his parent tongue, it is possible that even direct bartering might occur without any participant to the exchange ever constructing this view of labour. The influence of nominal money, whether it is fiat money or real commodity money, may simply be too great a distraction. However, no complete understanding of money can ever occur without accepting the concept that all money exists as an abstraction of mechanical or intellectual labour.
Only cooperative bartered exchanges can be made exclusive of the element of power, but all uncooperative exchanges, bartered or not, necessarily must involve power. All economic exchanges that utilise fiat money impart to the value of the exchanges some proportional quantity of power that necessarily must be greater than zero. It is commonly assumed that every exchange of fiat money must involve some element of trust. This is an erroneous assumption. Placing trust in real commodity money (even if the commodity is an eye-like marine shell), though it fluctuates in marked-to-market value against other commodities, is rational; placing trust in fiat money is irrational, if only understood subconsciously. Trust is not the power element of fiat money.
Instead, the power element is Monetary Obedience. This obedience exists as the point of equilibrium established between two needs, the very rational need to conduct all economic exchanges that only fiat monetary obedience can facilitate, versus the ordinary human philosophical need to nullify an irrational concept.
When the associated power of the issuing authority of fiat money is high, then monetary obedience tends to be high. If associated power declines slowly, monetary obedience will still tend to remain relatively high. But, if associated power drops low enough, then the need to nullify an irrational concept will increase until it rises from the subconscious to the conscious and begins to cause significant changes in the equilibrium of monetary obedience. The equilibrium can ultimately change sufficiently so that fiat money marginally ceases to exist and all cooperative and uncooperative exchanges shift marginally to barter.
All the power elements of economic exchanges that are not derived from fiat monetary obedience are instead related to the mismatching of price and cost. This is true even when price and cost are politically represented as being matched, and still so if the mismatches are totally innocent and result from the ignorance of any, or every, participant involved. The reason for this is that every element of power involved in economic exchanges causes the imperfect allocation of economic resources, at least in some proportion that, even if expressed infinitesimally, still must necessarily be greater than zero. Every misallocation of economic resources hampers the natural progression of human productivity marginally toward philosophical infinity (to be explained later).
Money and power are component expressions of the same philosophical entity. In this sense the relationship of money to power is analogous to the relationship of matter to energy. The force of money may be stored in any form of what we commonly accept as money currency, whether the currency is intrinsically valuable, such as with gold, silver and other commodities that are used as money, or whether the currency has near zero intrinsic value, as with fiat money.
Money may be stored in bartered credits (with or without notation) established by market participants as they conduct the active evaluations of the relative values of these credits. Bartered credits may result from the exchange of anything of value between market participants; often labour and certainly food and other commodities, although all other commodity values derive ultimately from the value of just one commodity, food.
labour is in all cases the ultimate currency of exchange since the coercive or compelling force of money is executed via labour. Productivity is a natural byproduct of the improving efficiency of labour that is derived from intellectual learning. Therefore labour may exist in either mechanical or intellectual form, but both forms are philosophical expressions of intellect. Requiring the use of intellect is not consumptive and can never reduce pure intellect. Pure intellect is a qualitative infinite; intellectual labour is simply the flowing of intellectual force that can be begun and stopped at will. Intellectual labour is to mechanical labour, in magnitude of relative effect, as power is to money.
Wealth is a qualitative abstraction. It is the status of continuously possessing sufficient coercive or compelling force to cause the execution of marginal labour to satisfy marginal demand. Being rich is the status of possessing great relative quantities of assets denominated in nominal money value. It is necessarily a connotation of wealth, but only in real time present value. Having wealth is, however, not necessarily a connotation of being rich, because the status of having wealth may require very little, if any, nominal money value assets.
An island chieftain several hundred years ago may have been relatively as wealthy as the King of England was at the same time, and yet the chieftain’s wealth may have resided in the command of the labour and services of his subjects and little more, without his possessing riches equal to that of an ordinary London merchant.
Too, average individuals in modern society, without possessing great riches, are yet wealthier in real time present value than ancient kings were in their capacities to cause the execution of marginal labour to satisfy marginal demand, when those capacities are viewed in the present day.
If the reader doubts this, I invite the submission of an example of an ancient king who, though he may have commanded armies and possessed kingdoms and chambers piled high with gold, silver and precious jewels, could have realised the benefit of a heart bypass operation, or could have experienced the convenience of flight or the almost priceless utility of the Internet.
While it is true that each of these services would have had philosophically infinite costs for such a king, because they were obviously unavailable to him, that fact alone does not obviate the present day average individual’s possession of a greater capacity to afford them than the king had in his day. It is because human productivity is not a philosophical arbiter of the availability of goods and services in any specific era, but merely a real arbiter of cost… in real time present value.
Here we discover the reason that misallocation of resources hampers the achievement of philosophical infinity in human productivity. It is because the real objective of all human economic endeavours is the reduction of costs marginally toward zero, even if this objective is only understood subconsciously. Mankind interprets this objective to be the marginal attainment of philosophically infinite riches via profiting from economic exchanges. However, profit is an erroneous philosophical conceptualization because it is necessarily the definition of mismatched value and cannot occur without causing misallocation of resources. Every economic transaction therefore that produces profit must also produce a greater quantity of anti-profit, if only infinitesimally greater. Thus, profit can have no philosophical aggregate net basis for existence.
If the reader doubts this, then pause to consider this illustration. What if you were the sole participant in an economic universe? Perhaps a good way to think of this is as a lone individual living in a wilderness environment, dependent entirely on one’s self for every want and need without human contact. Philosophically he would have the capacity to experience all the aspects of economic exchange available in modern culture, except one. He would have no capacity to conceptualize money and its erroneous philosophical expression, profit, because he would have no opportunity to conduct economic exchange with other individuals.
It is not true that this would make him unable to conduct economic exchanges, because these would indeed be accomplished internally. However, he could only express them as the rational allocations of his time, his mechanical and intellectual labour and the commodity resources available to him. All these he would apply to satisfying internal needs. It is very true that he might realise something analogous to profit, but it would be in the form of a gaining of excess resources extracted from his endeavours and from productivity or even from random effortless good fortune. He only has one way to express these gains; they augment the natural progression toward reducing the costs of goods and services marginally toward zero.
Market participants logically pursue profits because they consciously conceptualize that a gaining of riches would assist their personal attainment of an objective, one that is merely equivalent to what is their real subconsciously expressed objective; they seek to benefit from costs that marginally approach zero.
Infinity in human productivity cannot be achieved until all the power elements of economic exchange are removed, and profit is always a power element. Power can never be completely removed until there are no remaining misallocations of resources that prevent the progressive approach toward infinity in human productivity.
By these discussions I do not mean to imply that profit, in its commonly understood tangible expression, is evil. It is the necessary inducement that capitalism provides for the subconscious attainment of zero cost for goods and services. In an imperfect world, capitalism might be flawed by the observance of its occasional unique failures to allocate resources, yet its failures are lessened by the equitable dynamics of the economic system that drives it. Communism and Socialism fail to a greater extent to allocate resources, because those socioeconomic systems depend largely on benevolent altruism and not on the profit motivations of capitalism, for the subconscious attainment of zero cost for goods and services. It might be said that capitalism occasionally fails because of its lack of heart, but that Communism must necessarily fail because of its ultimate lack of altruism.
All animal, mineral and plant material, whether found on earth or in its seas, whether naturally occurring or requiring collection, cultivation, mining, breeding, husbandry or other operations for gaining the control and possession thereof, are commodities. Commodities are natural storehouses of money and power, although labour and thus intellect are required for obtaining them.
Some commodities exist only as Inherent Commodities and cannot be possessed in the form of a titled asset. Some general examples of these would include: solar energy and the machinations of weather, tides, magnetism, gravity, and many other naturally occurring compounds, powers, functions and forces. All these things have the capacity to facilitate the unassisted production of various commodities that can be owned, titled, stored and exchanged as money. However, having the capacity to produce titled assets does not, in and of itself, constitute a titled asset. For example, solar energy cannot be titled, but it can produce corn, timber, electricity and a geographical presence of enjoyment, and all these can be titled.
Inherent commodities therefore in one sense have infinite value; in another sense they have zero money exchange value. This is because they are preexistent elements of attained infinite productivity in terms of human perception and are therefore both priceless and universally owned. In a similar fashion human productivity, when taken philosophically to infinity, ceases the existence of all money exchange value, because the agent of money’s exchange execution, labour, is therefore obviated. At the point of infinity all non-inherent commodities become inherent commodities. Inherent commodities and pure intellect are the only permanent investments of abstracted wealth.
In this sense, wealth at the point of infinity in human productivity may be thought of as being analogous to electronic capacitance; the coercive or compelling force of money is similar to voltage; labour therefore functions as amperage; and productivity is the element of charge. If a capacitor is charged to peak and has no means of discharge, then amperage will drop to zero. Voltage is then an orphan force (or potential) with neither the means of, nor the need for, execution.
I submit that, though it may be difficult to conceptualize philosophically, very nearly 100% of all aggregate wealth is already vested in pure intellect and inherent commodities. The marginal fractions of wealth that are not yet vested this way represent the entire spectrum of aggregate economic endeavours undertaken by mankind. It is only within this tiny spectrum that the abstraction of money in every sense and form can exist.
All present day economic exchanges are facilitated by the excess production of food where food is converted to money and possibly stored, sometimes for extended periods. While the great majority of our everyday economic exchanges might appear to be unrelated to food, all these transactions result from the exponentiation of accumulated productivity gains over centuries of agricultural improvements.
It is no different if food is hard to find and grow, or easy. Food may occur in abundance in tropical climates without requiring much, if any, cultivation, or it might be easily grown in naturally rich tropical soils. Either way it may have less unit value on a relative basis than food obtained in more harsh environments.
The exponentiation of agricultural productivity happens nonetheless whether food is obtained easily or by great difficulty. What does differ is the relative stimulus that occurs for the development of monetary exchange. If food is hard to obtain there is a higher percentage of an individual’s productive time that is dedicated to obtaining food than that of an individual where food is easy to obtain.
It then becomes more important to secure shelter from harsh weather and storage capacity for the food that is harder to produce, because failures in these endeavours may be fatal to the individual or his family. Greater inventiveness is required to accelerate the productivity needed to sustain a growing population living in harsh environments.
A lesser percentage of the individual’s time is thus available to obtain all the other necessities and conveniences of life, and along with food these are more highly valued and allocated more carefully. Consequently their values are more readily observed for pricing, and more complex methods of exchange are required to mark the values to a common market.
The harder it is to produce food, the more likely it is for the society involved to abstract its monetary exchange in material and tangible items of value, such as commodities. The easier it is to produce food, the more likely the society is to abstract its monetary exchange in sociological terms, such as rank, status or title. In any event, in both these situations the availability of food is the absolute requirement for the establishment of all other forms of monetary exchange.
Distilling Abstractions into Macroeconomic Theory
Modern man’s instinct in a crisis is to return to that primal state in which his existence is defined in terms of food and the labour required obtaining it. As he begins this sometimes torturous and symbolic return, he subconsciously both allocates and adjusts various classifications of liquidity, as he perceives them, and both the allocations and their adjustments are not measurable by econometric studies.
M1, M2 and M3 do not measure perceived liquidity (soon to be defined), and though they are usually directly proportional to what the individual considers it to be, they are never exactly the same and at times differ from it by progressively widening margins.
Conventional econometric measures of the money supply are useful and accurate within certain coefficients of confidence, in nominal terms, but the individual components they are aggregated from are mere abstractions in the minds of market participants as they relate to their possessions of money.
Subjective Liquidity Classification
In economic literature the term “nominal” is almost exclusively used to denote the quantitative measure of an entity (for example: money, prices, interest rates, etc.) which is to be converted to a subsequent real quantity by an examination of the factors acting on the nominal measure over time, or in the real time present via some adjustment process.
It that sense a nominal interest rate of 5% per annum, given an inflation rate of 2% per annum, yields a real interest rate of 3% per annum. Therefore $100 invested for one year would produce a nominal sum of $105 and a real sum of $103 in terms of converted purchasing power (all other factors being ignored).
For the remaining purposes of this paper the word “nominal,” particularly with reference to liquidity, will be used largely in one way and without regard to the traditionally recognised factors that convert various nominal economic sums to real sums quantitatively. My use of the word will generally refer to the real time present value of traditionally measured money values that are subsequently acted upon by only the factor of human perception.
Consequently, nominal liquidity is the sum total value of all traditionally observed monetary equivalents of its measure, and perceived liquidity is then the sum total real value of nominal liquidity after being acted upon by perception and also augmented by other factors. These concepts will be developed in greater detail with the following discussion of Subjective Liquidity Classification.
In order to understand Subjective Liquidity Classification, it will be necessary to first accept these principles; that the value of perceived liquidity is not solely a summation of its coexisting nominal measure, but a measure of the value of the goods and services which perceived liquidity, acting as a coercive or compelling force, modulates the exchange thereof; and that mechanical or intellectual labour is in all cases the core vehicle of perceived liquidity’s execution.
If we are to rupture the conventional understanding of money, then new definitions are in order. Consider the individual; he divides his money into only two components, perceived liquidity and deferred liquidity. His total stock of money, Mt, is thus defined as: Mt = Mpl + Md
Perceived Liquidity is the total value of the entire capacity an individual has for executing transactions in order to obtain goods and services in real time present value. That entire capacity also includes the value of goods and services he may provide for himself or provide to others in exchange for nominal money, for bartered credits or directly for other goods and services.
Deferred liquidity is the total value of everything that would have been classifiable as perceived liquidity, had its value not required some adjustment for subjectively converting it to perceived liquidity. These adjustments are necessary because there is some cost associated with the conversion, or because there is some requirement to mark the value of the deferred liquidity asset to market in real time present value.
It is possibly useful to observe that perceived liquidity is an ultra-liquid resource and deferred liquidity is illiquid, although the individual does not possess any truly illiquid assets because he does not conceptualize them in this way. Every monetary resource is held merely in the form of perceived liquidity, or as deferred liquidity with some associated level of difficulty required for conversion. Moreover, the individual holds these two components categorized subjectively, and though they may resemble econometric measures of the money stock they are not the same.
Perceived liquidity consists of: the perceived value of nominal cash either on hand or immediately receivable; the perceived value of liquid nominal credit balances on deposit at banks or other financial institutions; bartered credits immediately receivable; commodities (including food, precious metals and gem stones) immediately exchangeable or consumable; finished goods immediately exchangeable or useable; and the immediately exchangeable or consumable value of the intellectual or mechanical labour the individual may produce himself. There are no other components of perceived liquidity, since every monetary transaction ever completed either by primal or modern man has resulted from the exchange of one or more of these forms of perceived liquidity, and all economic exchanges occur in terms of perceived liquidity.
Deferred liquidity consists of: nominal money either employed at interest or invested at equity but with barriers to its withdrawal (including for example: common stock, bonds, saving or time deposits, and the cash value of life insurance or annuities); deferred accounts receivable by purpose, anticipation or circumstance (for example: an inheritance, a retirement account, tax credits, deferred compensation or deferred bartered credits); unfinished goods or workman’s materials which would require mark-to-market value adjustments; and assets employed for intended permanent or semi-permanent use via some type of amortization or depreciation (for example: real property, such as land, buildings, mines, ponds, timber, livestock and other similar assets). There are no other broadly defined components of deferred liquidity.
Macroeconomic basis of this critique
In the nearly eight decades since the difficult economic era of the Great Depression, much has occurred to modify, blend and reconcile two differing core macroeconomic theories that each attempted to explain it. The core thesis of each view has not really changed over these years. It is only their relative influence on policy that has changed the dialog and fostered cooperation among those with a more eclectic approach. However, none of the theoretician successors to either discipline have yet fully explained the failure of monetary expansion in a depressed economy, whether occurring in the Great Depression or otherwise.
In my opinion there is a good reason for that. It is because they have failed to conceptualize money as existing in anything more than quantitative and empirical terms. Not that they have somehow overlooked the concept that money is simply the representation of the value of all exchange and not the actual value itself; philosophers and economists have understood this for centuries. It is that theoreticians still unite money only with its fixed quality of representation, not its fully-abstract quality; the fixed quality is often, even usually, predictable, but the fully-abstract quality is far less predictable, and macroeconomics is largely focused on prediction.
Monetarists accept the Classical Theory, that in the equation MV = PQ, where M is the money supply, V is the velocity of monetary exchange, P is the price of goods and services, and Q is the quantity of those goods and services exchanged, that velocity is stable and varies only slightly and with an observed predictable relationship to the money supply. This being so, they assume it becomes essentially a constant, such that they can substitute the quantity 1 (one) for V, leading to the assumption equation M = PQ.
What this means is that Monetarists assume a direct and virtually continuous relationship between the aggregate money supply and nominal Gross Domestic Product (GDP), because the constant, whatever it is, is directly proportional to both the supply of money and the execution of its transactional demand. Thus Monetarists place a great reliance on controlling the money supply with the expectation it will regulate nominal GDP, and they consider that fiscal policy actions of government are unnecessary and may accentuate economic disequilibrium.
John Maynard Keynes, the noted economist of the Great Depression era sought to modify this theory according to his assumption that V is by no means constant but under certain conditions can be volatile. If then MV = PQ can no longer be predictive of nominal GDP, because M has a volatile coefficient that counteracts monetary policy, then simply controlling the money supply is at times ineffectual.
A collapse in demand might therefore not be either preventable or addressable by monetary policy, because some market dynamic eventually resulting in a low interest rate and corresponding severe increase in nominal liquidity preference would block it. This is just when that liquidity ought to be used for capital investment, for hiring workers and conducting the commerce thus needed for economic expansion. Keynesians argue that at these times government has an obligation to use stimulating fiscal policy to increase demand which will return the economy to full employment equilibrium.
I contend that, however variable velocity might or might not become at times, it is not a change in velocity that causes a failure of MV = PQ to be predictive of nominal GDP, but rather a change in the market participant’s evaluation of his own perceived liquidity that is the cause. Assessing nominal liquidity cannot discover the change, even if the nominal market value of investments is included, because the individual observes only two components of money, perceived liquidity and deferred liquidity, previously described, and these components are not measurable by government. Expressing this concept as a hypothesis:
The Perceived Liquidity Substitution Hypothesis
(I) All money in an economy is held in only two forms; (i) perceived liquidity, and (ii) deferred liquidity, and market participants hold these forms subjectively and interchangeably.
(II) Perceived liquidity is always greater than conventionally held nominal liquidity measured at the same time, regardless of economic state.
(III) Perceived liquidity is at the steady state equal to nominal liquidity multiplied times a hypothetical terminal low coefficient of perceived liquidity that is always greater than 1 (one).
(IV) Perceived liquidity is at all times substituted for nominal liquidity transactional demand at a rate of substitution that is always greater than zero, and the rate of substitution varies in direct proportion to variations in the coefficient of perceived liquidity.
(V) Upon an upset to the steady state the coefficient of perceived liquidity will increase to some higher but not unlimited value, and the increase will be proportional to the severity and speed of the upset.
(VI) An increased coefficient of perceived liquidity cannot resume its former steady state value until economic conditions resume the steady state.
Assume an individual market participant in an economic steady state. Suppose he has $25,000 in pocket cash and checking deposits, $50,000 in equity in his house and $50,000 in market value of other investments. According to the hypothesis presented, if we calculate his nominal liquidity to be $25,000, then in the steady state he will consider his perceived liquidity to be $25,000 times some terminal low and stable coefficient of perceived liquidity.
If we arbitrarily assign a value to the coefficient of, say, 1.15, then he considers his perceived liquidity to be $28,750 ($25,000 times 1.15). According to the hypothesis, perceived liquidity can never be equal to or less than nominal liquidity measured at the same time. The reason for this is because the individual can always at least work for his own benefit or work for others in exchange for nominal money or bartered credits payable in goods or services, and there are other ways he may also augment perceived liquidity.
Were the steady state to experience an upset, the hypothesis suggests that the coefficient will increase, so that he will reevaluate his perceived liquidity to be greater than $28,750. Moreover, the coefficient will increase within some finite limitation in direct proportion to the magnitude and speed of the upset. Should the coefficient be defined as having increased to 1.25 in this example, then his newly observed perceived liquidity would rise to $31,250.
It should be immediately obvious therefore that perceived liquidity may increase upon an upset to the steady state, by a larger amount than a corresponding decrease of conventionally measured nominal liquidity occurring at the same time. Whatever amount of nominal liquidity remains after the upset (for example: if this individual spent or lost part of his $25,000), newly observed perceived liquidity will still be larger than nominal liquidity measured at the same time, and larger by the same coefficient that results from the upset.
Suppose in this example that nominal liquidity dropped from $25,000 to $23,000 due to expenditure or loss. Then suppose the severity of the upset worsened and that the resulting coefficient of perceived liquidity increased from 1.25 to 1.40, then the newly observed perceived liquidity will be $23,000 times 1.40, or $32,200.
The entire sequence of examples shows that even though nominal liquidity may decline substantially (in this case by 8%) during the progression of severity of an upset, it is yet possible for perceived liquidity to rise above its initial evaluation. At the steady state this had already exceeded nominal liquidity in this case by 15%, or by $3,750. Moreover, perceived liquidity rose from the initial $28,750 to the subsequently observed $32,200, or by $3,450 (12%), even though nominal liquidity declined by $2,000 at the same time, all as a result of the coefficient rising from the initial steady state observation of 1.15, through 1.25 and upward still as the severity worsened, to 1.40.
Suppose we elect to ignore the hypothesis and the concept of perceived liquidity, and then incorporate a most liberal econometric measure for determining the total aggregate nominal money supply, by including the market value of all investment in the total money of an economy. Then ordinarily and by definition a decline in aggregate investment values (assuming no changes in other nominal measures) causes a decline in the aggregate nominal money supply. Such a decline associated with unemployment and a severe recession would further reinforce Monetarist claims that the decline in the money supply is what causes these outcomes, and that failing to inject monetary liquidity in a timely manner would also result in a failed recovery.
But the hypothesis and its prediction of an increase in perceived liquidity cannot be ignored. Even if an individual suffers a decline in the nominal market value of his investments, it will not necessarily correspond with a simultaneous reduction in his perceived liquidity, because investments are a component of deferred liquidity instead. The value of composite Md can never decrease Mpl, but can only be additive to it by subjective conversion. The only exception would be if and when the market participant decided to subjectively convert a portion of Mpl back to Md, and that mental transaction is not likely to occur until after a stabilisation of the conditions that resulted from the upset.
Consider this illustration. Assume you own an uninsured property in the valley below, perhaps a rental house or commercial property, as you stand on the mountaintop above it among a crowd of bidders for it. A fire is still miles away but is moving very slowly toward it from the far distant end of the valley. At present the probability of your property being consumed might be relatively low and the bid relatively high. As the threat of the fire consuming it increases, the bid will drop. At each lower bid you still have the opportunity to accept the bid, whatever it is, and settle in liquid funds, or you may barter settlement and receive it in another form.
In any event, you might convert one or the other of these values to perceived liquidity even without having to conduct an absolute sales transaction. If you do make the conversion, even if it is only a mental marking-to-market of the property’s perceived value at that time, then not until the risk of fire to your property is eliminated will you elect to reverse the process and again place an assumed deferred liquidity value in it.
This does not mean you will be indifferent to the circumstances of risk to the property, but only that, given you otherwise have sufficient perceived liquidity to transact your current level of demand for goods and services, the decision regarding the property is unrelated to your perceived liquidity. It is the same with all other investments as well.
Market participants will absorb decreasing investment values without them affecting perceived liquidity, until the decrease is just sufficient to reach some value at which subjective conversion will cease. At that point transactional demand will either be at equilibrium with or just marginally more than sated by current levels of perceived liquidity. But any marginal increases in transactional demand from that point will require forced depletion of perceived liquidity because either: 1) – the market participant will have ceased conversion voluntarily and subjectively for reasons known only to himself, or 2) – deferred liquidity values may have already reached zero and conversion would no longer be possible even if desired. When perceived liquidity is finally forced low enough to create critical shortfalls in goods and services, any remaining deferred liquidity conversions will also be forced.
In our example of the fire approaching your property, if perceived liquidity had already otherwise declined too low to support your transactional demand for goods and services (for example; if you and your family are at risk of starvation) without converting the property’s value to perceived liquidity, then you would already have converted it, fire or no fire. If perceived liquidity, incidental to the value of the property, happened to drop to that point now while you are observing the bids, you will accept a bid and convert the property value to perceived liquidity, fire or no fire. If perceived liquidity could not independently drop low enough as you observe the bids, you might or might not accept a bid, but not because of perceived liquidity. You would make the decision for other reasons.
Nothing stated so far indicates that there must be a point reached where deferred liquidity will have necessarily dropped to zero before subjective conversion is halted. Arriving at the point where subjective conversion has ceased does not require a total nominal loss of investments, but a decline in value to a point at which, for whatever reason known only to the market participant, he will no longer use deferred liquidity to subjectively conduct the augmentation of perceived liquidity. His investments in deferred liquidity might drop to zero long before his perceived liquidity drops low enough to force the conversion of any remaining deferred liquidity, should there indeed be any left to convert. Conversely, the market participant may choose to operate on a level of perceived liquidity far below his typical economic station in life, even at a level approaching poverty, and still not augment perceived liquidity with deferred liquidity conversions.
Deferred liquidity might first reach zero and therefore mandate the cessation of subjective conversion, but reaching zero is not an absolute requirement. In the prior example of the uninsured property in the valley, fire may literally be casting hot embers onto its roof, and yet the owner may still prefer to resist accepting any bid, even an illogically high bid, and will continue to hold its asset value continuously as deferred liquidity. He owes nobody an explanation of why. He himself may not even know why.
These observations are very critical to the understanding of why expansive monetary policy will initially fail to recover depressed economies after an upset. It is because not until perceived liquidity is forced low enough, to some hypothetical terminal low, so that market participants will no longer substitute it for what would be the normally observed nominal liquidity requirements for that exact level of demand, market participants will incorporate additional inputs of nominal liquidity extracted from monetary expansion and use them merely as augmenting elements of perceived liquidity. The perfect analogy to this that occurs in chemical and biochemical processes is called buffering, a process in which a desired narrower range of observations (for example: in acidity, alkalinity or enzymatic processes) can be produced than would otherwise result from the input of some reagent (reactant) that is not buffered. In my analogy of course, it is perceived liquidity and its coefficient that are the buffers of nominal liquidity. Consequently, market participants will have no need to use nominal liquidity inputs to pursue economic enterprise. This of course has very real consequences for the economy because the intended effects of monetary expansion will be subverted.
The rate of substitution of nominal liquidity by perceived liquidity may have a practical zero, but it can never reach absolute zero except in a purely philosophical and theoretical realm. However, should the reader be interested in once more pondering that realm with me; a rate of substitution of absolute zero would be reached when human productivity reached infinity, but only because nominal liquidity would cease to have value at that point and its substitution by perceived liquidity would have become permanent. Perceived liquidity would exist then in infinity as the vested totals of abstracted wealth. There are only two permanent components of abstracted wealth; pure intellect and the total of all inherent commodities.
When aggregate demand stabilizes after an upset and begins to increase once more, it will subsequently rise to a level at which perceived liquidity will no longer provide transactional capacity for satisfying the increasing demand. At this point nominal liquidity will resume its modulation of nominal GDP, and the hypothesized coefficient of my illustration will decline and begin to approach its former terminal low steady state value.
Consider this example of how perceived liquidity is used. Assume you are a market participant and want to increase your consumption of tomatoes. If you alone both purchase the same quantity of tomatoes as before and also grow your own tomatoes to meet your increased demand, you will have used a component of perceived liquidity as a substitution for the use of the nominal liquidity needed to purchase the additional tomatoes desired.
Conversely, you may recognise a reduction in the available supply of tomatoes first and then, electing to maintain your consumption level without purchasing more tomatoes at higher prices, you may decide to grow tomatoes. This can partially or completely offset the effect on you personally that the market shortage of tomatoes has caused.
As one extrapolates the tomato illustration into a realisation of the complexity of goods and services that are both supplied and demanded in an economy, it should become clear that market participants have many opportunities to substitute perceived liquidity for nominal liquidity transactions. For example, market participants may; purchase more tomatoes, but produce more clothing for themselves; produce more lawn services for themselves, but purchase more lodging and entertainment; paint their own houses, but purchase more milk. The possibilities for these substitutions are almost endless.
Two functions; (i) the substitution of perceived liquidity for nominal liquidity transactional demand, and (ii) the substitution of one’s own self-produced goods and services for augmenting supply, are collectively very important, because they are the elements that modify nominal liquidity. Sometimes this creates a sudden and substantial excess of perceived liquidity for substitution, severely limiting the capacity for new inputs of nominal liquidity (monetary expansion) to bring about a return to steady state equilibrium.
At these times either perceived liquidity must decline or demand must increase (on some relative basis) until the excess transactional capacity of perceived liquidity is reduced to a point that begins to cause a shortfall in nominal liquidity. At this point the economy will again become responsive to monetary policy. The string will have been transformed into a rod.
The reason for these described phenomena is because in a crisis individuals focus inwardly. They become more resourceful; they will call in bartered credits, consume less, economize, develop and hone skills, and they will labour for themselves rather than hiring labour and paying wages. The many ways this happens all cause a magnifying effect on the perceived value of nominal liquidity. Too, perceived liquidity is also augmented by the addition of elements that, as I have already described, are not measurable by government.
Consider the following illustration. Assume an individual contemplates $20 in nominal fiat currency over two consecutive days. Given both that the time value of money is ignored and that the price and availability of goods and services are identical from one day to the next, then, if asked how he perceived the value of the $20 over the two days in question, how do you suppose he would answer? I suggest he must, by any reasonable application of logic, perceive the values on both days to be exactly the same.
But, let us add another assumption without altering the prior assumptions. Assume that after the first day’s evaluation he learns that he has lost his job or that there has been some other economic tumult in his life or in his consciousness. Now, do you suppose he will still consider the perceived value to be the same over the two days? In my opinion it would be simply an absurdity to think he would. No, he will modify the nominal value of the $20 to some higher perceived value after learning the news. That increased modulation is one of the ways he arrives at an increased coefficient of perceived liquidity.
The other way is that, on both days, he subconsciously perceives that he may substitute intellectual or physical labour in order to augment the transactional nominal liquidity demand of the $20. On both days this causes his perception of the value to be greater than $20, but on the second day he perceives it to be even higher than on the first. Because of that higher perception (due to an economic upset to his personal steady state), his level of perceived liquidity is raised progressively higher in amount than the unchanged nominal sum of $20 could ever indicate.
Consequently, he will view marginal additions of nominal liquidity quite differently than if he had not experienced the phenomenon of an increase in perceived liquidity. The aggregated effect of this phenomenon is what disturbs the capacity of nominal monetary expansion to affect a return to equilibrium. In the enigma of macroeconomics this may be analogous to the singularity observed in theoretical physics.
Any critical reader may at this point assert that the coefficient in question is simply an alternative expression of velocity. My reply is that since, according to classical theory, MV = PQ, and therefore V = PQ/M, that no change in velocity could be demonstrated until an observance of sequential nominal money transactions is recorded, since a change in that ratio expresses a change in the velocity. And so a change in velocity would have to precede the upset to the steady state, if it were to have the same effect on the participant, rather than if the upset preceded the change in velocity, which, given there is a change in velocity after an upset, is the more likely course of cause and effect.
Saying this in one other way; even if velocity is assumed to have modulated a steady state, it could only have done so after an upset had already caused a modulation in perceived liquidity. Frankly, velocity might in this circumstance initially increase in nominally measurable terms after an upset, for a period, although it is likely to eventually decline.
The change in perceived liquidity will obviate central bank actions to expand the money supply, because aggregate perceived liquidity, relative to aggregate nominal liquidity measured at the same time, will have already risen and begun to absorb the nominal money expansion by being substituted for its transactional demand. Its transactional demand thus reduced by substitution, nominal money expansion will produce no corresponding linear modulation of economic output. This is much more critical when the nominal money supply has declined as a consequence of the upset, because that is when the central bank will recognise it and have the greatest intentions for expanding it.
The academic and policy implications of this should be staggeringly obvious. It would be relatively as though I have suggested that the sun rises in the west to suggest this phenomenon; that the element of conventional monetary policy thought to be most needed in a crisis is instead: sterile.
I was simply astounded at this realisation, after having searched all of my life for an understanding of money. It answers questions that grew out of the sharing of abstractions with my father regarding the substance of money; what form money takes, and how it was used during the Great Depression era he grew up in.
Money has three conceptualizations for market participants. Whether they consciously understand them all or not is of little consequence because they are nevertheless bound to obey the principles of each. Macroeconomics has attempted to deal with two of these, money’s tangible and semi-abstract representational concepts, but it has not dealt with the third, its fully-abstract psychological concept.
Monetarists point to a collapse of the nominal money supply during one or more economic recessions after the market crash of 1929 as being the primary cause of the Great Depression, and they further argue that expanding the nominal money supply more rapidly and earlier during this time would have prevented it. It is simply not the case, for the reasons I have given.
Too, Keynes, though he was absolutely correct in my opinion that a collapse of aggregate demand was the cause of the Great Depression, also focused on other elements he contended resulted from it. His arguments concerning those elements (for example, the relationship of interest rates to investments and monetary liquidity preference, and about velocity) have largely been challenged and determined not to be proved, or at best, archaic and in need of clarification or integration.
Keynes was also right that it would require an increase in aggregate demand to bring about a recovery because the economy would not respond to monetary expansion. The rub is that Monetarists can defeat his assertions about liquidity preference, later categorized as a “liquidity trap,” by claiming to observe inconsistencies which refute the phenomenon. And rightly so, because now I have discovered that though there probably is a trap in a severe recession, it is not a high nominal liquidity preference resulting from some low interest rate and the teeter-tottering competition of cash against debt (bonds) that causes the trap, but something else.
The elements of Keynes’ argument are of little consequence to market participants at such times. Rather, they are interested in satisfying a primal instinct for survival, economic and otherwise, even if only subconsciously and marginally expressed. Interest rates and investments and their competing merits are simply ignored.
It is the supply of that coercive or compelling force that they trap and covet, and that trap is real and it sweeps up both nominal and perceived liquidity into an animal with no name recognisable by either Monetarists or Keynesians. In these cases depressed economies will certainly emerge from the doldrums eventually, given a sufficient association of higher aggregate demand and depleted aggregate perceived liquidity, but they will not do so just because they are made to float in a sea of nominal money.
At the occurrence of some negative event that upsets a steady state economy and thus leads to an increase in the coefficient of perceived liquidity, the application of expansive monetary policy by central banks would not create the stimulus thought necessary at the time. It cannot do so because the substitution of excess perceived liquidity for nominal liquidity transactional demand counteracts the intended purpose of the nominal expansion.
Perceived liquidity must then decline, relative to demand, to a level where its substitution for nominal liquidity is no longer sufficient to meet transactional demand. Until such point is reached, monetary expansion can be credited with being no more than a merely coincidental factor in economic recovery. Indeed, nominal monetary expansion may even extend the period of substitution, thus hampering and delaying the desired outcome.
The change in the coefficient of perceived liquidity happens for unexplained reasons that might be discerned in hindsight but not beforehand, unless they could somehow be discovered in the hearts and minds of market participants.
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