The Money Tree

We have seen a lot of craziness in the financial markets recently. A small group of investors, known as the Reddit investors, bid up several low-priced stock prices, squeezing short-sellers. Many people have applauded this activity depicting it as the small guy outsmarting the big guy — in this case, hedge funds. But, there is another side to the story about which no one seems to talk.

What’s happened for these low-priced stocks provides a microcosm for problems faced by the broader market —for commodity products as well as stocks. We must consider another influence about which people seldom talk: monetary expansion.

What influence did the change in the volume of money in the system have on these markets?

To provide some background for that discussion, I will discuss what I referred to as the “money tree.”

The money tree begins with two types of money, for which I have coined the terms “market money” and “non-market money.” I classify these two types of money by how people acquired them.

Market Money

I use the term “market money” to refer to money acquired at some sacrifice to the holder. A person acquires ”market money” by sacrificing (or giving up) something they value or providing a labor service in exchange. (Even borrowed money would have been acquired through sacrifice by someone.)

If the market operated how it ought to, we would only need “market money.” That money would circulate throughout the economy, and the rise and fall of prices would indicate the relative increase and decrease in the relative quantities of goods bought.

But we don’t have only “market money.” We have another form of money, which I have dubbed “non-market money.”

Non-Market Money

I refer to money acquired at no cost or sacrifice to the holder as “non-market money.” “Non-market money” comes in two subcategories:

  • Confiscated money
  • Artificial Money

Confiscated Money

I call any money taken by force from another party (mostly by taxation) “confiscated money.” If you have received any money acquired from taxation, you have received non-market “confiscated money.”

Artificial Money

I referred to money created artificially, with no sacrifice by any party, as “artificial money.” The banking system creates most of our “artificial money.” Banks create “artificial money” by making ledger entries when they buy notes from individuals or businesses or when they buy bonds from the government.

A considerable amount of government spending receives funding by selling bonds to the banking system. Thus, when voters and legislators favor spending programs, they also favor creating “artificial money.”

This process has been going on for a long time, as I will demonstrate with the two charts below.

Monetary Expansion from 1950

The first chart shows the steady growth of “artificial money” from 1950 (as depicted by the blue line). The money supply grew at roughly 7% per annum from 1950 until approximately 2008. After 2008, in response to the real estate crisis, the banking system increased the money supply at an accelerated rate.

(The red and green lines show the levels of actual and required reserves, respectively. The Fed has discontinued reporting these series because they made them meaningless—a subject we may discuss later.)

You can consider all of the money on this chart “artificial money” because efficient markets do not need to expand the money supply.

Monetary Expansion – Last 5 Years

The second chart shows the very same data over the last five years. For the first four years of that period, the money supply grew at a rate above its historical average. Then, in 2020 another dramatic change occurred. To partially compensate for the government’s ill-conceived decisions to close businesses, the government authorized large-scale “stimulus” payments.

Since the government had run out of “confiscated money,” it got the banking system to provide “artificial money” by buying government bonds. This created the crazy growth in the money supply shown in the last 12 months of this chart.

Whether “market” or “non-market,” all money becomes available for spending.

Spending Money

I will now examine money based on how people spend it rather than how they acquire it. I refer to money available for spending as “spending money.”

Money held for spending co-mingles “market money” and “non-market money.” Thus, the spender cannot tell you whether he’s spending “confiscated money” or “artificial money.” All money held for spending can be considered the same.

The sources of money held for spending, however, does influence the quantity of spending money available. The addition of “non-market money” artificially changes the quantity and distribution of “spending money.”

Distorted Preferences

The infusion of “non-market money” into the quantity of “spending money” distorts the preferences of buyers holding “spending money.” Because some portion of the money they hold requires no sacrifice, people will buy things that they would not otherwise consider or would only consider in smaller quantities.

To use a current example, a family that has an extra thousand dollars in their bank account, because of the “coronavirus stimulus,” might acquire a videogame (no matter how inexpensive) that they would not buy if their account was only filled by “market money.”

When you multiply this effect by all the buyers in the market, it can have a tremendous distorting effect on market prices. If buyers buy things they would not otherwise buy, sellers will not discount products they would otherwise discount, thus, causing prices to remain higher than they would without “non-market money.”

So what effect does this have?

Misallocation of Resources

Distorted preferences, caused by the infusion of “non-market money,” distort market prices. Since the effective and efficient allocation of resources in a market economy requires accurate pricing, the co-mingling of “non-market money” in the spending money causes a misallocation of resources.

Conclusion

I have demonstrated how adding “non-market money” to the spending stream distorts pricing mechanisms. Distorted prices then lead to a misallocation of resources.

In my next post, I will use the Reddit investors as an example to show how these distortions and misallocations manifest themselves.


I have added a post that contains a video version of the diagram I used to develop this post: Developing the Money Tree.

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