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15 - Where Does All the Paper Money Go?

The new money which is created disseminates throughout the economy in two ways: through national product transactions and through capital transactions.

National Product Transactions

This is money spent on current goods and services, such as buying food, a car, or perhaps the services of a carpenter or lawyer. If all of the new money were to feed into national product transactions we would see the price of consumer goods and services rise dramatically. Meanwhile there would be little impact on the values of capital markets.

Capital Transactions

These consist of spending on such things as savings, stocks, bonds, property, land, plant and equipment. You might call this category “Investments”. If all of the new money were to flow into the capital markets, we would see rising asset prices, while experiencing little change in the price of goods and services.

Matching Theory to Experience

From your own experience you will know that we have seen rising prices in both pools over the last few decades. However, the majority of the new money has fed into capital transactions, fostering all manner of asset bubbles.

Consider your own circumstances for a moment: you go to work and earn a salary and with the money you earn you purchase your essentials for the month, plus perhaps some luxuries. If you have any money left over you have two principal options. The first is to purchase additional consumer items. But if you don’t need more food or more shoes (sorry ladies!) it is more likely that you will opt for the second option, which is to save or invest the residual money.

In this way, little of the excess money flows into national product transactions and the goods and services in that pool do not experience price increases which are out-of-the-ordinary. The excess money therefore feeds into the capital markets with the effect of inflating prices there beyond reason and expectation.

Taking recent history as an example, the dawn of this century saw the bubble inflate and burst. Between 1990 and 2000 the S&P500 rose from 350 to 1550 (a rise of 340%) before falling 48% back to 800 in 2003. Over the same period the NASDAQ rose by a staggering 900% before falling 77% from its highs. Next came the turn of the real estate bubble. The ongoing flood of money into banks generated a lending boom which pushed property prices to stratospheric, unjustified heights. The collapse of real estate prices since 2007 has been accompanied by yet another devastating stock market crash and a precipitous fall in the value of commodities.

The Public Reinforce These Bubbles
While the flooding of the capital market reservoirs with freshly printed money substitutes seeds the early stages of asset bubbles, the public reinforces them. Firstly, since the inflation causes a real decrease in the public’s quality of life as their savings and incomes are continuously eroded, people are pushed towards speculation in order to supplement their incomes. This was also a clear observation during the German inflation...

Speculation alone, while adding nothing to Germany's wealth, became one of its largest activities. The fever to join in turning a quick mark infected nearly all classes, and the effort expended in simply buying and selling the paper titles to wealth was enormous. Everyone from the elevator operator up was playing the market.10

"As regards dealing in shares, all classes of the population have for months been speculating with a fine disregard for common-sense. Shares have been freely bought in totally unknown concerns, in some cases with the object of exchanging valueless paper money for what was considered a good security, but generally in the hope of profiting by a rise in the stocks. Shares in respectable concerns which had paid a 20 per cent dividend, say, were pushed higher and higher till the final holders could not expect a return of even 1 per cent, with the result that the improvement of the mark has brought not satisfaction but the very reverse."11

Secondly, the inflation strips people of their sense of value - when money is so easy to come by, we seem to take less care to obtain real value for it. The profits generated during the asset bubbles are for the most part fictitious. No real value or wealth is created, it is simply that the increase in paper money that has pushed up assets prices in general. If the money printing averages a rate of 7% per annum, it is a fact that we would see the stock market and house prices increase by 7% per annum, albeit with some small delay in adjustment. Yet little investigatory work is performed by the public to estimate the appropriate value for the assets they are purchasing. The absence of logical checks on value help the asset bubbles to increase out of all proportion.

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