Total Fiat Money (& Credit) Deflation Model – Mish


Mike “Mish” Shedlock (Sitka Pacific), Global Economic Trend Analysis:

I don’t agree with some of his attitudes – for example: “Fiat Money” is backed not by a physical commodity, but by trust – one of the most precious forms of social capital, foundational to all human relationships and behaviour. “My word is my bond” is not backed by a physical commodity, but by trust – that hardly means it’s not worth anything. The fact that the States of Weimar and Zimbabwe betrayed that pooled trust, is symptomatic of a complete bankruptcy (literal and figurative) of trust and the social contract or order in those states. A kind of bizarro mirror-image is Kim Jing Il’s refusal to let his subjects use “fiat” (or any other) money until recently – a totalitarian, sociopathic Scrooge McDuck’s hoarding of all trust and exchange to himself.

I think that money is a measure, a bit like inches – a meter would still be a meter even if that rod in Paris was not there to physically back it. Money is a relative measure of all other goods that operates more like a daily index or telephone exchange that transmits messages. I can see how the system can be rigged and devalued, but don’t see that it’s value needs to derive from only one physical good.

The attraction I see with gold is that it has no counterparty risk: it’s unforgeable and limited, though fungible, so the social value derives from the trust itself derived from gold always being gold, and being limited as is trust, but also being transferable and dividable.

But I think the following is a really clear and succinct summary of what is happening – something absolutely missing from all the talking heads. He puts into relatively rigorous and logical terms that metaphor of the growing pile of money the banks are storing in case they need to plug those growing “black holes” of collapsing credit. It is also a useful way to navigate all the different definitions of inflation and deflation, and their resultingly different conclusions, I think:

Fiat World Mathematical Model

Fm = Fb + MV(Fc)

Fm = Fiat Money Total
Fb = Fiat Monetary Base
Fc = Fiat Credit, the amount of credit on the balances sheets of institutions in excess of Fb

MV(Fc) is the market value Fc

Inflation is an expansion of Fm
Deflation is a contraction of Fm

If only base money was lent out (no fractional reserve lending), MV(Fc) would equal zero. The equation ensures we do not double count credit in Fm.

MV is a function of time preference and credit sentiment (ie. Belief that one can be paid back). As long as that belief was high, banks were willing to lend.

Because (at the moment) Fc (credit) dwarfs Fb (base money), the system can only hold together as long as there is belief credit can be paid back and as long as there are not defaults. Needless to say, the perceived belief that Fc can be paid back is under attack, both by rising defaults, and by sentiment. That is why MV(Fc) is collapsing.

In other words, the mark to market value of credit is contracting faster than base money is rising.

See also:


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