Facebook stock had a good day today (1/30/2014), as it shot up $7.55 based on what was deemed to be a good quarterly earnings report.  Suspicious that all the hype was airy-fairy, I decided to conduct some further investigation of my own.   I began by looking at the two biggies—Twitter and Facebook.  Yahoo Finance reported no P/E for Twitter as of 1/30/2014 as a consequence of the negative “E” in the denominator.  Despite the negative earnings per share, Twitter’s market capitalization was reported as being over $34 billion.  Turning to Facebook, it did have a small but positive “E,” and based on its trailing earnings per share the P/E stood at about 156 with a total market capitalization of around $150 billion.   

 Outlandishly high P/E multiples exist for the lesser known social media stocks as well.  Zynga’s service allows a person to socialize by playing online games with friends.  That doesn’t sound like a business model that would make a fortune, but I guess young people like it.  (When I was in college fun was had by skiing on Friday and having a kegger afterwards.  Now the college gang gets together virtually on Friday night for an evening of raucous online gaming.)   Zynga’s market cap is  $2.9 billion, with no reported P/E as a result of a negative “E”.  LinkedIn has a market cap of about $25 billion, with a lofty P/E of 956.  

 Being one of those aging dinosaurs that rarely use any of the services the social media companies offer, I may not be in the best position to comment on whether such sky-high P/E multiples are reasonable.  A short time ago I visited LinkedIn’s website in an attempt to better understand what LinkedIn does, and why it is so popular with folks.  On the company’s website I read what the LinkedIn service helps you to do: “Connect. Find.  Be found.”  For those of us who don’t want to “connect, find, and be found” it is difficult to comprehend how a company that dishes out such punishment can be worth $25 billion.    

 cloudsIn general, what little income the aforementioned social media companies generate is from advertising.  An old marketing maxim says that “half of a company’s advertising budget is wasted—the problem is nobody knows which half.”  Today Yahoo Finance conducted an online poll asking readers whether Facebook will continue to benefit from increased mobile ads in the future. As of the time when I checked the results, here is how the answers were stacking up:  Of the respondents, 26 percent answered yes, Facebook will continue to benefit from mobile ads.  The remaining 74 percent thought the mobile ads were either ineffective (31 percent), a passing fad (22 percent), or soon to be replaced with a different technology (21 percent).  Obviously, the demise of the social media stocks will occur if advertisers come to the conclusion that they are throwing away a great deal of their shareholders wealth by marketing extensively through mobile ads.

 Another canary in the coal mine for the social media stocks is the language the so-called analysts are now using to talk about the firms’ net income.  Rather than focusing on “earnings per share,” the conversation now often centers on EBITDA per share, or even revenue per share.  Now that’s going way up the income statement in order find a positive number.  Flashback to 1999.

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fish and netFor years I have been expecting a surge in inflation.  After all, how is it possible that the Fed can be creating so much new high-powered money without a jump in prices?  Surely those who are familiar with the quantity theory of money share my puzzlement over the relatively stable Consumer Price Index (CPI). 

In trying to understand the absence of rising prices I have thought a lot about fiat money and the process by which it enters into circulation.  After a lot of searching and racking my brain I think I’ve found the inflation.

Low CPI inflation is in part a consequence of our broken banking system, as detailed in the January 22 blog.  Because banks are reluctant to make loans, the rate of growth in high-powered money has greatly exceeded the growth rate in M-1. 

But despite our broken banking system, M-1 is still growing pretty darn fast.  For the six months ended December 31 M-1 has been growing at an annual rate of 10 percent, which compares to an annual CPI inflation rate of only about 1.5 percent.  So, where is the money going?  Where is the inflation?

 Recall that the CPI measures inflation in the prices of consumer goods—capital goods are not included.  If the price of an existing factory doubles, that doesn’t show up anywhere in the CPI.  Nor do rising stock and bond prices. And that is where the inflation has occurred, as will be described below.

Perhaps it is useful to visualize an island economy where there are two goods, a consumption good (fish) and a capital good (fishing net).  In the absence of fiat money there would arise some equilibrium price of a net in terms of fish—it might be 20 fish per net.  If a net is expected to catch, say, 30 fish during its five-year economic life, an investor might reasonably be willing to give up 20 fish today in exchange for one.  Of course, no rational investor would  be willing to give up 32 fish now in exchange for a net that is only going to harvest 30 fish in the future—in that case the price of capital is simply too high.      

Continuing with the illustration, let’s now suppose that fiat currency and a central bank emerge on the island.  The central bank prints up money at a rate it deems to be appropriate.  In order to get the new money into circulation the island’s central bank needs to buy something—it can buy fish and/or nets.  Obviously, the terms of trade between fish and nets will be affected by the central bank’s decision as to which it buys.  If the central bank is determined to rapidly print new money and introduce it into the economy entirely by purchasing nets, then initially the price of nets (capital goods) will soar relative to fish (consumption goods).  Depending upon how feverishly the central bank is printing the money and buying up nets it becomes entirely possible that the fiat-currency price of a net will be 40 times the fiat currency price of a fish, even when the net is only capable of catching 30 fish over its economic life.   The central bank in this example is not particularly worried about making a smart investment—its only goal is to get money out there, and fast!

Presently the Federal Reserve is introducing new money at a rate of $75 billion per month.  The money enters the economy through open market operations where the Fed purchases government bonds and mortgage backed securities from hedge funds, mutual funds, investment banks and so forth.  Obviously an initial impact may be to enrich the sellers of the securities the Fed is buying up. But more significantly for the economy as a whole the affect is to drive up bond prices well beyond what would otherwise make sense. 

So that’s why bond prices are so high and interest rates are so low. However, the story doesn’t end there.  The Fed’s intrusion into the market with a flood of fiat money has also impacted the stock market.  Of course, the Fed doesn’t print up money to buy common stocks.  So why have stock prices inflated?  I believe this is easily understood when we consider who is selling all those bonds to the Fed.

Large financial institutions, hedge funds, and well-heeled investors who own bonds are rewarded when the Fed prints up new fiat money and buys some of their bonds for ballooned-up prices.  But upon selling their bonds to the Fed the financial institution now finds itself invested in cash—an undesirable investment in a world where cash is being enthusiastically created by the central bank.  Where do large investors then go in search for a better return?   The answer is to stocks, and thus we see inflation appear in stock prices as well. 

Have we reached the point where the price of capital goods exceeds the value of the future earnings the capital will be able to produce?  (Is the fishing net now selling for 40 fish when it is only capable of catching 30 over its useful life?)  Certainly the operation of the central bank the past several years has pushed us in that direction.  To cite one piece of evidence, The Wall Street Journal reported a P/E ratio of 86 for the Russell 2000  as of January 17, 2014 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html). So, this is where all the money is going, and where the inflation has first surfaced.

Ultimately markets converge towards rationality, and the relative prices of consumer goods and capital goods will make sense. This might happen with falling security prices or with rising prices for consumer goods.  With all the new money sloshing around, I’m still expecting the latter.

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A recent glance at U.S. monetary data is astounding.  The money base (that is high-powered currency issued by the Fed and held by individuals and banks) stood, at year’s end, at approximately $3.6 trillion.  The M1 money supply (currency held by the public plus checking accounts – the normal “transactions” of money) by comparison was much smaller, standing at $2.6 trillion.  This strange twist is not new, it has persisted since the 2008 credit collapse and it shows how badly broken our traditional banking system was and how hobbled it remains.  The world has moved on, but apparently our anachronistic money and banking system has not.  When the monetary system is “normal,” M1 is usually much larger than the money base.  That is the case when the banks are lending out all or most of their excess reserves as a growing pyramid of loans, creating new money balances in the process through the expansion of checking accounts.  This is what has traditionally been referred to as the “banking multiplier” portion of the stock of money.   It is this old, nasty characteristic of the “fractional-reserve” banking system that has historically resulted in a large injection of uncertainty and instability into our financial system.  It is the reason that past Federal Reserve chairmen have bemoaned the uncertainty and difficulty of controlling the overall money supply and hitting monetary targets.  It is destabilizing because it joins bank lending and monetary expansion at the hip, resulting in the central bank’s lack of control over the total money supply.  This “fractional reserve” banking characteristic is responsible for a sad history of credit booms and busts, of periods of inflation and deflation.

13106574_mThus a minor and unheralded blessing of our current situation is that the “normal” bank expansion of the money supply is not working now.  Why?  Because private banks are in the aggregate either too scared or too tightly regulated to lend—or both.  They are appear to be huddled down and cautiously accumulating all the excess reserves they can get.  This has been the case now for a number of years as the Fed has been desperately throwing high-powered money at the banking system without much effect on aggregate bank lending, “quantitative easings” 1, 2, 3, and so on.  Be thankful the traditional bank multiplier is not working.  If it was, inflation would now be roaring.   To the observer, the Fed is reminiscent of a peculiarly dull child who is flooding a campfire with more and more gasoline, evidently unaware that the embers are totally dead.  Nonetheless splashing about in gasoline is a dismaying behavior to behold.  Clearly it is fraught with danger, as any small spark could and would trigger a real conflagration with all the puddles of gas lying about.

Yet there is hope even for the very slow-witted.  In the back of the child’s mind there is somewhere the vague realization that more and more gas might not be a good thing.  The Fed has the same realization.  Somewhere in the recesses of their minds even central bankers are uneasily aware that flooding the economy with liquidity can somehow raise the risk of future inflation.  Didn’t they read it somewhere?  Thus, they embark on the “taper.”

Since bank lending has failed the strongest attempts by the Federal Reserve to re-ignite it for a number of years, why don’t we congratulate ourselves and just live without it.  The economy is evidently functioning and lending is occurring through other mechanisms—it is just that private banks and their lending are evidently playing a far reduced role.  A market economy evolves and moves on as new lending mechanisms arise as old ones diminish or fail.   The idea of linking bank lending activity to the growth of the overall money supply was always a crazy, de-stabilizing Ponzi scheme in any case—attractive mainly to bankers.  Good riddance to it.  The Fed should take this opportunity to quietly enact several new years’ resolutions for its one hundred and first year.  First and most importantly, set the bank minimum reserve requirement at 100%.  Given where the money and banking system is right now it would be a moot point with little aggregate effect.  For the future it would help make the monetary system more rational and stable.  For the first time in its history, the Fed would actually have a chance to precisely target and control the supply of money.

What should the central bank do next?  We could think of a couple of suggestions.  Follow a “rule of one.”  What do we mean by that?  To simplify the money supply process that Fed should get out of the role of manipulating monetary policy and simply issue “one” of something.  For example, one dollar (in other words divide all wages, prices, and monetary quantities by approximately 1/H or 1/$3.6trillion).  This could be a monetary policy that is understandable to all and possible to implement.  Even the most intellectually challenged central banker should be able to get their arms around the idea that the size of the U.S. money supply is pegged at just one dollar.  After all, with a fiat money units don’t matter, but keeping the supply stable and predictable does.

After the Fed realized that, with its “rule of one,” it really wasn’t doing anything in terms of monetary policy, it could logically move to the final step.  At that point, the Fed could realize that it had evolved into an unnecessary appendix.  It could give the nation a wonderful present after presiding over 100 years of bad policy and chaos since its creation and simply disband itself.   In a technologically advanced, instantaneous exchange, debit-card economy, it is high-time to move on from fiat money to a private, market based unit of exchange and valuation.  What could or should that be.  It could be something with engineered, hypothetical scarcity, such as Bitcoins.  We would suggest an exchange and valuation good, a money, based upon the real fundamental value of broad index units of productive capital.

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Let us imagine an economy burdened with a nefarious, covert clique of counterfeiters.  This group (perhaps with the letter “G” painted on the back of their shirts) desires to steal real output from the stolid producers of real output.  They accomplish this by sometimes printing fraudulent paper money (one sub-group of them) and sometimes by issuing debt (another subgroup of them) or fraudulent IOUs promising interest and principal payments during the future in return for “borrowing” real output from naïve lenders.  Of course, since they really are producing nothing of value, themselves, they realize it will actually be impossible for them to pay off the debt they have issued and they have no intention of doing so.  However, they don’t want the gravy train of stolen output to actually come to an abrupt end with a default on their debt—it’s too lucrative and too much fun.  What to do?


Saving the day, a bright member of their gang suddenly realizes that the two cliques can actually cooperate to their joint benefit.  They can buy back the debt they issued by printing yet more worthless currency to repurchase it—so long as the public is naive or stupid enough to accept the entire fraudulent, synergistic scheme.  They go so far as to label these actions “open market purchases”.   Of course, these illicit activities actually result in some artificial “market” rate of interest on their dubious bonds.  That peculiar lending rate is just an accidental result of the cumulative behavior of the issuers of the worthless currency and the fraudulent debt.  To think of this rate as some sort of “risk-free” benchmark seems absurd.  After all, it can easily be manipulated by both the thieves supplying the “bonds” as well as the resultant inflation rate of prices in terms of the counterfeit currency. How could anyone be so silly as to think this interest rate was particularly important or meaningful—that it was some sort of meaningful “benchmark”?  Clearly, no one would be so blind as to think of it as some sort of a “risk-free” rate of return.  In fact, if this nefarious clique of counterfeiters and fraudulent borrowers threatened to desist, pack up, and exit our imaginary economy, the remaining honest producers surely should and would applaud. It would be strange if they could be panicked at the clique’s threatened shutdown of operations and wonder how their economy could go on without them.


Now, in comparison, let us consider the economy we actually live in.  But wait… it appears the two economies are not so different.  If you are a skeptic about the real value to our economy of public goods and government services, then you may agree.  We have a central bank that issues worthless currency at whatever level it chooses and usually issues it by the means of buying back previously issued treasury debt.  The combined scheme is used to finance government spending—either purchasing economic output directly or transferring wealth or claims on output from those who voted against the political incumbents to those who voted for them.  That is the traditional spoils system or “public choice theory” of representative democracy.  In so doing, our economy strongly resembles the hypothetical one that we previously imagined.   Surprisingly, many of us consider the peculiar borrowing rate determined by Fed and Treasury collusion and manipulations to be particularly meaningful.  If it’s not, what should we use for a logical “benchmark” rate of return?


We can think of two candidates.  First, if you live in an economy that enjoys an average rate of growth of say 3% from year to year, then expecting such a future return on wealth or savings that you loan to another is not such a farfetched idea.  In fact, it seems reasonable to expect it as a reward for deferring your own consumption for one year.  Another logical benchmark is the rate of return to a piece of productive capital.  After all, if you choose not consume all the output you produce, then you would likely consider “investing” it.   That is, creating a tool that will make you able to produce more output in the future.  The expected average rate of return to an investment in such a tool or piece of productive capital also seems a logical benchmark rate of return.


Let us suppose that the annual average rate of growth of our real economy is some rate, n.  Secondly, let us define the real average rate of return to a piece of productive capital as r(k).  It may or may not surprise you that there is a strong, logical argument, in a transparent economy in which individuals try to maximize their sustained level of prosperity, these that two rates will tend to converge toward or to equal each other.  That is, r(k) = n.    (Forget about a “risk-free” rate of return.  There isn’t one.  In an uncertain world, you won’t find it anywhere—especially not as a promised rate of return of government bonds or bank accounts.)  To see how and why the real return or marginal product of productive capital should converge to the growth rate of the economy, you may want to read our book (Capital as Money).  Alternatively, you can follow the brief argument sketched out below.  It was first made by originally by an economist named James Tobin and is popularly referred to as Tobin;s “Q.”


Suppose we consider a very simple economy where output can be either immediately consumed or invested in order to create capital or an investment good that helps produce more output in the future.  A simple intuitive example is corn—it can either be eaten as current consumption or dried and planted in order to produce more corn in the future.  In this very simple economy, suppose that the price (in terms of whatever monetary good is being used) of a unit of output steered toward consumption is P.  The price of the same unit of output steered toward the creation of future production or capital is P(k).      Further let us suppose that the real natural rate of return or interest in this economy is, in fact, just its average annual growth rate, n.  For simplicity, suppose there is no inflation of the price of consumption goods and that P is therefore expected to be stable.    Then the equilibrium price of a piece of capital will be nothing more or less than the sum of the expected returns to that piece of capital over future periods discounted to a present value using the real interest rate, n, and stated in terms of the price of a typical piece of output.  Thus, in annual periods,




(1)     P(k) =   P*r(k)/(1+n)+P*r(k)/ (1+n)^2 +P*r(k)/ (1+n)^3… +P*r(k)/(1+n)^i…




P(k) = the price of a unit of output used to create a piece of productive capital


P = the price of a unit of output used for current consumption


r(k)= the real marginal product of a piece of output turned into a capital good (in terms of output)—expected to be constant.


n = the real rate of growth of the economy.


A^b means that A is raised to the power of b.


i = refers to the ith period or year.


It turns out that equation (1) can become, without too much ado (using some re-arrangement and the algebra of the sum of an infinite geometric series);




(2)    P(k)/P = r(k)/n




What is the intuition of equation (2)?  It is surprisingly simple (and hopefully a major reason why James Tobin was awarded the Nobel prize in economics). The ratio P(k)/P, or Tobin’s “Q” provides a clear and elegant behavioral explanation of optimal capital investment.  First, suppose that a unit of output turned into a capital good is currently more valuable to the market than the same piece of output turned into a consumption good.  Then P(k) > P or Tobin’s Q >1.  If this condition is true, it is also true that r(k) > n.  In that case, current output will be steered by the marketplace toward the production of more capital goods.  Until what?  Until the marginal product of capital falls, thereby converging to the growth rate of the economy.  At that point of market equilibrium r(k) = n and Q =1.   This is the same result as the “golden-rule” capital intensity of the Solow neoclassical growth model (for further explanation you should read Capital as Money).  On the other hand, if the current market value of a unit of output invested to create a capital good is less than the value of same unit of output consumed as a consumption good, then P(k) < P or Tobin’s Q <1.  Thus, output will naturally be steered away from investment and toward consumption by the marketplace.  Until what?  Until capital becomes scarce enough in production that its marginal product rises to r(k) = n and Q once again is equal to 1.  Thus, a logical, rational market mechanism exists in a free-market economy that tends to drive us toward the optimal market-determined capital-intensity or aggregate level of investment.  Notice this mechanism has nothing at all to do with government or central bank manipulation of interest rates.  In fact, when such distractions exist, all that can be said for them is that they will tend to thwart or confuse the capital market in realizing the optimal level of productive capital creation.  It is this always present decision of all individuals and all economies of whether to consume or invest at the margin that causes us to recommend that units of broad productive capital should, in fact, be our medium of exchange and natural store of value—that capital should be our money.


This beautiful and elegant picture grows cloudier when we introduce sustained fiat money growth and inflation.  We would like to say that fiat money growth is perfectly neutral in exerting real economic effects upon the real return to capital, investment and the capital-intensity of the economy over the long run.    Unfortunately, the design of our ham-handed tax system, either by accident or intention, allows no such benign result.


To see why, consider the following thought experiment.  Suppose you own a stock during a period where its market price exactly doubles.  Unfortunately, during the same period the average price of all other goods, including the consumer price index, exactly doubles as well.  Realizing that your stock price appreciation has just kept pace with general inflation, you conclude that the real capital gain on your stock is precisely zero.  Carefully noting that fact on your tax return when you sell your shares, you report to the IRS that since there was no real capital gain on your shares, you owe no real tax—especially since the government or central bank’s monetary policy was responsible for the sustained rate of inflation in the first place.   Good luck with that completely reasonable argument!  Since capital taxes are typically not indexed to inflation, this is an important reason why a rise in the interest rate, taken alone, should generally exert a negative effect upon the future returns to a stock (growth or value).  Most rises in market interest rates simply reflect a rise in the actual or expected inflation rate.  In terms of equation (1), above, an increase in expected inflation does not net out in the effect on the numerator (P growing at the inflation rate) and the effect on the denominator (the discount rate becoming (n + Inflation rate)) because r(k) is reduced by taxes that are not inflation-neutral falling upon the real rate of return to capital.  In addition, there is nothing neutral about our witches’ brew of asymmetric tax rates. They will generally exert real distorting effects everywhere, including the split between investment and consumption.


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“Hey Ed how’s it going””

“Not so hot Jill, but I guess you can see that for yourself.”

“Sorry,” Jill replied with concern.  “I wasn’t going to mention it but you do look pretty motley Ed.  Seeing you now reminds of the time you got caught in that rockslide a few years ago.  You look pretty hungry too—your ribs are showing.”

“Yeah, Jill, I’m missing a few chunks.”  Ed regarded himself sadly.  “Even the end of my tail is missing and I doubt that will ever grow back.  They worked me over pretty good, I don’t mind saying.”

“What!?  Who worked you over?  What happened Ed?”

“Well, I was trying to catch rabbits at Red Gulch when a group of the Federal Coyote Police caught me before I even got any.  They found I didn’t have a rabbit permit and said they were going to teach me a lesson—I guess they did.  Nowadays it’s illegal for a coyote to catch rabbits without purchasing a rabbit permit first.”

“That’s nonsense Ed.  I catch rabbits the next valley over and I don’t have a permit—and not just any rabbits, mind you, but plump, tender cottontails.  What does a coyote do, if not catch rabbits Ed?  It’s what we’re about—our ‘raison d’etre,’ if you don’t mind my saying so.”

“Don’t worry Jill, the Feds will get around to you soon enough.  Mark my words.”  Ed sadly replied.

“Well why don’t you just get a rabbit permit then?”

“It’s not so simple Jill.  You need rabbits to buy a rabbit permit, but you can catch rabbits without one.  So here I sit, unemployed.”  Ed sighed.

‘Unemployed!  How can a coyote be unemployed?  We either catch rabbits or we starve.  If you’re self-employed, you cannot be unemployed.  It’s that simple—it always has been.  So you’re ‘unemployed’ just like Ned over there.   I haven’t seen him catch a rabbit in ages, but he’s all plump and glossy.”

“Well, Jill, I’m not exactly like Ned.  I don’t have his connections to the government and I don’t have his mind.  Ned gets a weekly allotment of rabbits from the Feds because he’s performing very valuable R&D that benefits all of us coyotes.  Thank goodness for Ned.”

“What’s R&D?”

“Research and Development Jill.  Ned gets ideas that are supposed to help all of us other coyotes be more productive in catching rabbits, even though I’ve never seen him catch a rabbit himself.  It’s important and valuable stuff he supposedly comes up with.  He says we need more coyotes performing government research.  In fact, his thinking time is so important that the government now officially counts as part of our economy’s total production of final goods per year.  That’s what they call Gross Coyote Product or GCP and Ned’s thinking, alone, actually makes our total value of coyote production larger.  I only wish I had his brain.”  Ed sighed again, sadly.

“What!  Are you for real?  This is the biggest crock of you-know-what I’ve ever heard.  It’s a scam Ed.  If Ned’s R&D, or whatever you call it, is so valuable, then let him prove it the old-fashioned way—by catching more rabbits himself.  That’s how new or better ideas should be rewarded.  If there is such a thing as “total coyote production,” it should be measured by summing up how many rabbits we catch in total.  It should not be measured by adding up rabbits and ideas.  What nonsense!”

“You just don’t get it Jill.  Ned told me you’re a barbarian, not a progressive.  It’s very important for the government to be able to measure the size of our total output in order to know what level of coyote services to provide for all our benefit and how many rabbits to tax and borrow from us in order to finance those services.  Ned says we are lucky to have a coyote government working so diligently to protect the general welfare of all of us.  According to Ned, whatever rabbits we give to them, it’s far less than they deserve.”

“And that’s not all, according to Ned, the coyote government has way underestimated the value of our total production or GCP because it has also failed to include qualitative improvements in output.  Products get better over time as new technology or thinking is embedded in them.  Ned says that’s important because a bigger economy means government borrowing and taxation can be increased to provide yet more government services for all of us.  I just wish I could get some.”

Jill was shaking her head incredulously as she listened to this.  “Qualitative improvement?  How can that be?  The only output we coyotes produce that matters is rabbits, and a rabbit is still a rabbit!  What nonsense!  Have you seen any ‘qualitative improvement’ in the rabbits you eat?  I haven’t.”

“I wouldn’t know, Jill.  It has been such a long time since I have eaten a rabbit, I probably wouldn’t be able to tell.”

Jill looked at him sadly.  “Poor Ed.  You really have had a tough time haven’t you?  What have you been eating to survive?”

“Well at night I started sneaking into the organic farm and scarfing down quinoa, radicchio, edame and acai berries.  I guess I’ve gotten pretty brazen because I’m so hungry—Now, I just eat in broad daylight right in front of the humans that run it.  They’re OK.  Since they don’t have guns, they just shout and run around beating pans.  I ignore them.  I don’t need a permit to eat this stuff because the coyote government doesn’t tax or regulate it.  That’s why more coyotes, like me, are becoming vegan.”

Jill looked at him blankly.  “Quinoa, acai berries, vegan…?”  She echoed.

“Yeah, at least I’m getting my anti-oxidants.  Ned says it’s just as well for me because a vegan diet is healthier anyway.  Still, I can’t help noticing he still eats only rabbits, himself.”

“Ned only says that because he’s part of it!  Government services!  Listen to yourself!  What are you talking about Ed?  We’re coyotes!  The main thing we need is to be able to catch and eat rabbits—and not have them taken away from us by other coyotes who are regulating, taxing, controlling or ‘thinking’ for us.  We should eat meat not vegan.  We can rely on ourselves, Ed.  What we need is freedom—not some coyote clique or cabal that has just cleverly positioned itself to steal production from the rest of us.  It’s the same old story wrapped up in new clothing.  Government working hard to serve the ‘public interest’—the ‘greater good’.  What blather!  At rock bottom, a coyote is still either just catching rabbits or stealing them, no matter how elaborate or dressed up the explanation.  Can’t you see that?”

“I don’t know Jill.  I’ll admit all this stuff just my head spinning.  I don’t have Ned’s mind and apparently I don’t have yours either.   The only thing I know for sure is that I’m still hungry.   Sometimes I just wish that I could get away from all these regulations, rabbit licenses, taxation, and measurement of coyote production.  Wasn’t it better in the old days when we just caught rabbits, ate them at our leisure, let the sun warm our backs as we rested with full bellies, and enjoyed life?  It seems like whenever we get too concerned with measuring stuff, especially somebody else’s stuff, bad things happen.”

“That’s better.  Now you’re sounding more like the old Ed.  There’s hope for you yet.”

“Seriously, Jill, is there still some place we could go and live like that? Like we used to?”

“Well, my cousin Toby says that it’s still possible to live like that in Wyoming.”

“Let’s go to Wyoming.”

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StatisticsThis past summer the Bureau of Economic Analysis announced several changes to its approach for calculating GDP.  (See Results of the 2013 Comprehensive Revision of the National Income and Product Accounts, published by the Bureau of Economic Analysis, July 31, 2013). The effect of the changes was to increase GDP by roughly 3 percent compared to what it would have been under the previous GDP accounting rules. 

The observer of our government’s recent shenanigans will not be surprised that the accounting change has the impact of increasing reported GDP.  The purpose here is to explain as clearly as possible the change using a simple numerical example.  By understanding the modification one is able form a judgment as to whether the government’s objective is to truthfully and accurately report economic data, or whether the goal is to simply get a higher number that makes the economy appear healthier.   (On a related note, see my March 15th blog titled “Numbers don’t lie, but liars use numbers.”)

To be as clear as possible, I’d like to begin with a review of what GDP is intended to measure.  GDP is defined in textbooks as the “total value of all final goods and services produced in the economy during a year.” So, let’s begin there. 

Consider an economy that consists of a single farm that produces only corn, and the farmer generates the following revenue stream by selling the corn (the final output) over a three-year period:

Year 1:  $400

Year 2:  $430

Year 3:   $370

There are two ways to calculate GDP, referred to as the “expenditure” approach and the “income” approach.  Properly calculated the two should result in the same GDP.

The expenditure approach involves tabulating the spending on final goods and services.  As it used to be done, using the expenditure approach the GDP for our example is quite simply $400 for Year 1, $430 in Year 2, and $370 in Year 3.  Easy enough.

The income approach to calculate GDP involves summing up wages, rent, interest and profits.  It should give the same answer.

To illustrate the income approach, suppose our farmer paid an employee $100 wages in Year 1. The employee’s job was “research and development.”  That is, the employee was paid $100 in Year 1 to sit around and “think” about how he might increase total output on the farm.  And to keep the example simple, assume the farmer fired the researcher at the end of Year 1 so that no wages were paid in Year 2 or Year 3.

Let’s now calculate GDP for each year using the “income” approach as it used to be done prior to the BEA’s recent high jinx. 


Using the income approach, for Year 1 the GDP is the sum of wages and profits, as calculated below:

Profit to the farmer in Year 1 = $300

Wages paid to the researcher in Year 1 (an expense to the farmer) = $100

Total GDP  in Year 1 = $300 (profit) + $100 (wages)  = $400.

Summing the farmer’s profit and wages to the worker gives the same $400 GDP figure as was obtained using the expenditure approach.

In Year 2 and Year 3 the farmer’s profits were $430 and $370 respectively, as there was no wage expense (recall, the “researcher” was fired at the end of Year 1).  So GDP was $430 in Year 2 and $370 in Year 3.

So far so good.  GDP is the same using either approach.

Now let’s talk about the recent accounting change and again calculate the GDP and using the expenditure and income approach.

First, consider the expenditure approach under the new rules.  Now the $100 paid to the researcher is considered a “final output” and is added to the year’s GDP.  That is, under the new rules GDP in Year 1 consists of the $400 of corn produced AND the $100 paid to the researcher.  Using the expenditure approach, GDP for each year is now as follows:

Year 1:  $400 (corn) + $100 (wages paid to the “researcher,” now dubbed to be output) = $500

Year 2:  $430 (corn)

Year 3:  $370 (corn)

Too bad the farmer didn’t pay the “thinker” to do more research in Year 2 and Year 3 so GDP would have been higher then as well!  By “capitalizing” R&D spending it looks like GDP went up in Year 1, but no more output was really produced.    

Lastly, let’s see how the GDP will be calculated using the “income” approach going forward.  The researcher’s “thinking” has now been capitalized similar to the purchase of an asset such as tractor.  Thus, like a tractor, it will be depreciated over time.  When calculating GDP using the income approach the BEA adds back in depreciation on capital—that is the only way the expenditure and income approach will yield the same answer. 

So, back to the example, suppose Year 1’s R&D spending is expensed using straight-line deprecation in Years 2 and 3. 

Under the new GDP accounting gimmick, in Year 1 the farmer’s profit is $400, not $300.  The reason is simple:  The $100 wages paid to the “researcher” are not recognized as an expense in that year—it is now treated as the purchase of an asset!  So in Year 1 the farmer’s profit is $400.  Added to this are the wages earned by the researcher in the amount of $100, resulting in GDP of $500. Presto!

In Year 2 the farmer’s profit is only $380, as a result of the $50 expense incurred depreciating the capitalized R&D expenditures.  But depreciation is added back on to wages, rent, interest and profit in order to calculate GDP using the income approach.  So, here is Year 2’s GDP:

Year 2 GDP  =  $380 (profits) + $50 (deprecation) = $430.

And, for Year 3,

Year 3 GDP  = $320 (profits) + $50 (depreciation) = $370.

Again, each year we obtain the same GDP whether we use the expenditure approach or the income approach.  By either approach the accounting change makes the GDP higher in Year 1 by precisely the amount of the R&D spending.

My ultimate purpose here was not to provide a review of the expenditure and income approach to GDP accounting.  But it was necessary to do so in order to provide clarity to the recent change that the government made to the GDP accounts.  And the above example cuts to the heart of the matter. 

By treating R&D expenditures as the purchase of capital—treating it like it was a tractor—allows for a higher reported GDP.  In our numerical example, GDP went up in Year 1 by the amount of the R&D expense, with no change in Year 2 and Year 3.  Of course, had our example also had R&D spending in those years, GDP would have been magically higher then as well.

Worse still, under the new GDP accounting, government spending on R&D will count as final output too! 

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We have preferred capital as money (the benchmark of value and the exchange good) because it seems to us the most natural choice.  After all, the central decision of a free market economy faced by every consumer is what to consume and what to invest (or, put differently, whether to consume now or enjoy a greater amount of consumption later).  It is, at the margin, a production or consumption decision that needs to be made efficiently, on average, in order to result in an optimal economy.  Optimality, in our view, is measured by an economy achieving the maximum future growth path of per capita consumption.  It is stark choice that would and should face each individual consumer every time a unit of capital is given up for a pizza.  The opportunity cost of consumption is especially clear to us, if there is no intermediate good involved in this decision.  That is why we believe that units of broad productive capital are the ultimate money—not commodities, not restricted supply-constrained fiat monies (or virtual commodities) such as Bitcoins, and certainly not government-controlled fiat monies.  A unit of productive capital is intrinsically valuable because it will produce a stream of output over the future.  It incurs an opportunity cost to create because current consumption must be given up to create it.

Although the capital invested has real value, the shares that represent its ownership can be diluted by the inflationary issue of company managers.  Examples of companies that have done this are, unfortunately, not hard to find.  Other companies have retired shares to increase their value.  On balance, the historic return performance of the U.S. broad capital market as represented, for example, by the S&P 500 is impressive compared both to the real and nominal growth of the U.S. economy.  This is testimony to the fact that dilution on average has either not been overdone or to the fact of historic underinvestment in productive capital relative to its optimal level, or both.  Creating a greater incentive to correct underinvestment in productive capital so that a greater per capita consumption path can be attained is our major motive for preferring capital as money—the benchmark of value and the medium of exchange.  At the “golden-rule” capital-intensity, the real return to capital will converge to the growth rate of labor plus the growth rate of labor productivity (read Capital as Money for a more detailed explanation).

Finally, there is another beautiful reason for capital to be money.  In an economy that uses capital as its money, let’s suppose you are a lazy or distracted actor.  You choose not to consume all of your income, for example, but you simply cannot be bothered to think much more than that about the allocation decision or you postpone it.  Probably a more common behavior than we care to admit.  In a capital-as-money economy, your decision not to invest, but rather to simply accumulate money balances, results in you becoming, possibly unintentionally, an owner and holder of more capital by default.  In so doing, you raise the price of capital and stimulate the actual investment in new productive capital.  What a wonderful default characteristic that would be in an under-invested real world economy such as ours.  To see why, consider a lazy consumer in our current fiat-money economy.  When they passively accumulate excess income now, it typically will end up as added balances in a bank savings or checking account.  From there, through the magic of fractional-reserve banking, it is likely to be lent out to some new “credit bubble” activity or other dubious if not fraudulent consumption.  It is probably unlikely to actually find its way to actual new investment in productive capital.

As a theoretically stable, strong private money, Bitcoins, in our view is the next best monetary alternative.  With no intrinsic value, its universality, its simplicity, its growing acceptance, and the faith of the market in its fixed supply are powerful attributes.  If the supply is ultimately fixed, then the real value of Bitcoins will steadily increase at the average real growth rate of the economy.  That Bitcoins are actually gaining traction and acceptance in exchange and value is of huge significance.  The fact that their scarcity and hence value is artificially created is ironically, at the same time one of their greatest strengths and a potential weakness.  Costless to produce, its acceptance and value are irrevocably tied to a faith that its supply is inviolate.  Were Bitcoins to be successfully gamed, duplicated or counterfeited, all bets would be off.  At this point, all the proponents of Bitcoins would hasten to assure us that this is a logical impossibility given the technical sophistication of Bitcoin creation and exchange control.  Yet to raise the concern, however unlikely, is necessary to any who have witnessed the history of unlimited cleverness and greed of humans.  Bitcoins can become a superb private money, but there is no magic.  Avoiding abuse of any private money still requires its users to be astute and vigilant.  We are too familiar with the manipulation and abuse of central bank/government supplied currencies.

Some may be surprised that we would rank an artificial, fixed-supply commodity money superior to an actual commodity money such as gold or silver.  After all, these commodities have the attribute that their ultimate supply is limited by nature.  Further, precious metals have historical record of use that compares favorably with that of the Federal Reserve.  The problem of commodity monies lies in the natural supply.  It is determined not just by nature but also by demand and technology.   Playing either no critical role or a lesser role in production, their highest value is often as money and is ultimately dependent upon their relative scarcity to other goods.

In this light, the U.S. economic history of the 19th century is instructive.  Each major gold discovery—California, Rocky Mountain, Alaska, etc.—was coupled with, not surprisingly, a period of gold inflation (see, for example, The Monetary History of the United States, by Friedman and Schwartz).  The brief period during which we flirted with a bi-metallic standard (gold and silver) was even more volatile.  During the recent run-up in the price of gold and silver, much of the addition to the supply of these commodities has been obtained not only by finding new sources, but rather by us now enjoying the technological capability that makes it possible to more intensively re-process previously uneconomic ores or waste.   Thereby, we essentially “re-mine” previously uneconomic finds.  This should come as no surprise.  When the percentage of the Earth made up by gold, silver, or any other natural commodity is considered—its stable supply and therefore its stable value relative to other goods and services is not at all assured.  Remember, technological innovation, itself, is an economic good (it improves human or physical capital)—it is induced by investors seeking a return, it is not accidental.  Speculative cycles in the value of gold relative to other goods and gold “booms” or “busts” real or imaginary is what led many to conclude that a gold-standard economy would be inferior to one that boasted an “intelligently-managed” government/central bank fiat money.  Sadly, we know where that led.

This is why we prefer the alternative of a fixed-supply cyber commodity to a money based upon a real one.  After all, were it to be corrupted, mismanaged or violated in any way, it could simply be rejected and replaced by a superior alternative.  Of course, any of the three private monies—capital, Bitcoins, or commodity—would lie outside the direct control of the government.  With the demise of the regulated, fractional-reserve banking system and a system of direct lending instead (which seems to be already happening) a money based upon any of them would be vastly preferable to the hopeless money and credit morass we find ourselves in.

For those interested in a more detailed exploration of money, banking, capital and some of the topics discussed in this blog, we recommend checking out the link on this webpage to Capital as Money.   At your preference, we are pleased to announce that the book can now be purchased for either dollars or Bitcoins.  It’s the least we can do to enthusiastically encourage the adoption of an exciting, alternative private money.

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Capital as Money argues the need for a new medium of exchange. The book carefully details the numerous economic benefits that will occur when an economy has a system of money that is free from government and central-bank manipulation. Bitcoins offer a welcome substitute to government-created fiat money, and we celebrate the emergence of the new alternative!

At Capital as Money we are committed to the Bitcoin and prefer it over dollars. And, to put our “money where our mouth is”, we are now pricing the e-book in Bitcoins. The price of the book is set at 0.05 BTC, regardless of any day-to-day fluctuations in the BTC/$ exchange rate.

To purchase the e-book with Bitcoins, click on the button shown above and follow the instructions. Upon receiving your Bitcoin payment, we will arrange to have the e-book sent to you as a “gift” from Amazon. The book will be downloaded to your Kindle or alternative e-book device in the normal manner as if you purchased the e-book directly from Amazon yourself.

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We can sadly remember watching with a mixture of helpless horror and fascination the video of those unfortunate individuals who wandered out on the quiet beaches of Southeast Asia before the Indian Ocean Tsunami. What were they thinking? We can only imagine… “What a day, the tide is out so far! I can find all kinds of treasures that never are never usually uncovered by the sea. What surprises await me?” Sadly, for them, there was a big one.

Inflation is analogous. Most of our fellow citizens are pragmatic beachcombers. They are simply not interested in theories or threats of future inflation that has not yet materialized. Most of them do have the time or inclination to listen to lectures on the superiority of Bitcoins, capital or other private alternatives for money. Most do not realized that failed money and banking policy are responsible for the largest U.S. economic collapse since the Great Depression and its disappointingly gradual recovery. Right now inflation is nowhere and interest rates, if one can get a loan, are very low. As long as inflation is a non-event, dollars will do just fine and Bernanke’s Fed will provide plenty of them.

Is the inflation tsunami assured? Well put it this way, quantitative easings 1 through n have pumped an unprecedented amount of intrinsically valueless fiat money into the U.S. economy. That inflation has not already occurred is only due to the fact that the U.S. money, credit and fractional-reserve banking system is still broken. When it finally regains its greed and euphoria, watch out. The only way then to stop the inflation tsunami would be for the central bank to re-absorb high-powered money at exactly the right rate to maintain price stability. Can this be done? Is the Federal Reserve and Bernanke up to the challenge? Let’s just say that if they are, it will be the first time in the 100 year history of the Federal Reserve. Clearly the odds are heavily stacked against avoiding the financial tsunami. It would be a feat akin to stopping the Titanic on a dime.

As if that weren’t enough, the public sector hyenas are already barking and salivating at the near-term prospect of the departure of Bernanke from the Federal Reserve. They have all kinds of grandiose, crack-brained spending agendas that will require the full-force fire hose of fiat money to be turned on to finance them. Incredibly, they think that under Bernanke the Federal Reserve has been too tight! If you thought that the rounds of quantitative easings were over the top, just wait! Over the next year or two the Titanic will not stop on a dime. Instead, it is likely to get a new captain who will order full speed ahead and the lookouts sent to bed. The new Fed Chairman will not be an inflation hawk.

When will our financial beachcombers care? When the purchasing power of the dollars in their accounts or wallets is rapidly being devoured by the fire of large and pervasive price increases—when the inflation tsunami has really struck. Then, interest in private monies—Bitcoins, commodities, and capital—will seriously emerge. Real assets will be one of the few havens of value in an inflation fire. Only when serious inflation strikes, will most individuals be open to and interested in storing their value and managing their trades in a different way. Open to the argument of al alternative private money.

The discerning reader may now object, “But I seem to remember that the stock market or the value of capital did not fare so well during the last major U.S. inflation of the 1970s? Why is capital then a haven for value?” Because, dear reader, the value of capital and the return to it was then and still is denominated in dollars. Moreover the tax burden that fell upon it—capital gains, corporate income tax, etc.—rose with inflation. Therefore capital was clearly not inflation neutral. Given our current tax structure, it still isn’t. However, if capital was money or the benchmark of value of all other goods, then, of course, there would have been no fiat money inflation of the 1970s. Remember, inflation is everywhere and anywhere an outcome of the expansion of a fiat money at a faster rate than the underlying growth rate of the economy, as Milton Friedman has so famously and accurately observed. It is just as accurate to think of inflation as a devaluation of a fiat currency—being printed at too high a rate—as it is to view it as a general rise in prices.

Of course, Bitcoins and other private monies aspiring to be the accepted benchmark of value and medium of exchange would face the same issue as capital, as long as their value was denominated in terms of the prime adversary—dollars. With an ultimately fixed supply, Bitcoins can be expected to appreciate at the nominal growth rate of the economy. When dollar inflation comes, transactions in them would occur at increasingly higher dollar values. Expect the government tax man to come knocking at the door. This will make them non-dollar inflation neutral as well. The cure? Redefine the game of value in terms of Bitcoins or capital instead of dollars. When the monetary value of a Bitcoin or capital is just one, there is no “capital gain” and the problem is solved. Of course, this logical outcome will not come without a serious fight, since the government will then have been stripped of its most fundamental financing power. Its fundamental power to steal. Its tool that has historically allowed monarchs, dictators, entrenched bureaucrats and politicians, and other such thieves to have their cake and eat it too. Governments have traditionally enjoyed the privilege of being monopoly counterfeiters, of printing fiat money with abandon, thereby stealing real output from the rest of us. Then, adding insult to injury, governments could tax the value of our real assets, because they were appreciating in fiat money value, thereby stealing real output from us yet again!

Readers who are interested in further development of the arguments presented here are urged to obtain our recent book, Capital as Money. It can be purchased by means of link to this website. We are so excited and enthusiastic about the recent optimistic traction of an alternative, private currency that we now encourage readers to choose the option of purchasing our book with Bitcoins.

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Stocks or BondsSuppose you think interest rates are going to go up, and you are trying to choose between alternative investments.  Of course, rising rates will reduce bond prices, and so you prudently decide to invest in stocks rather than bonds. 

But, if you expect rising rates, should you choose growth or dividend stocks?  From what I hear on business television, the obvious choice is growth stocks.  Dividend stocks, so the “experts” say, are similar to bonds because they are primarily bought for current income.  And, like a bond, when interest rates rise the dividend-paying stock’s price will decline.  This last part I fully understand.  Ceteris paribus the price of a dividend-paying stock will decline when interest rates go up.   Stock prices reflect the discounted value of expected future cash flows.  When interest rates go up the present value of a given cash flow stream will fall.

But what will happen to the price of growth stocks?  Growth stocks are generally those high-flyers that are not presently paying any dividends because the companies are reinvesting all their cash in new projects whose payoff will occur in the more distant future, if ever. Based on what I hear and read in the media, conventional wisdom is that when compared to dividend stocks, growth stocks prices will be less sensitive to rising rates.  And this is the part I don’t get.

Bond traders are usually pretty good with math.  And they understand that the “duration” of a bond determines how sensitive the bond’s price is to changes in interest rates.  A short-term bond whose duration is only one year will suffer a 1 percent decline in price for every 1 percent rise in rates.  A bond with a longer duration, say 10 years, will go down in price by 10 percent for every 1 percent rise in rates. 

Now, shouldn’t the logic be the same with stocks?  A dividend stock that is paying a known cash flow each and every quarter has a shorter duration than a growth stock that is paying nothing now, but offers the (faint) hope of large cash flows in the distant future.   Using duration as the guide, rising rates should drop the price of the short-duration dividend stock by a lesser amount than the long-duration growth stock; the talking heads have it backwards–in the face of rising rates I’ll bet on the dividend stock that is giving me cash now.

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