Saturday, 3 October 2009

Money makes the world go round


Monetary items are money held and items with an underlying monetary nature.

Money is the greatest economic invention of all time. Money did not exist and was not discovered. It was invented over a long period of time. Money is a monetary item which is used as a medium of exchange and serves at the same time as a store of value and as the monetary unit of account for the accounting of economic activity in a country or a monetary region like the Rand Common Monetary Area which includes South Africa, Namibia, Swaziland and Lesotho.

Money is a medium of exchange which is its main function. Without that function it can never be money. Money is the functional currency in an economy, i.e. the currency of the primary economic environment in which an economic entity operates. The historical development of money led it also to be used as the fundamental unit of measure to account the value of economic items. Money is the only universal unit of measure that is not a stable value. All other universal units of measure are fundamentally stable units of measure, e.g. inch, centimetre, ounce, gram, kilogram, pound, etc.

Historically money developed on the mistaken belief by people in general that it is stable – as in fixed – in real economic value in the short to medium term in economies with low cash inflation. Stable in this instance was seen as meaning that money kept its real value intact over the short to medium term in low inflationary economies. Money illusion is still very evident today in most economies in money, monetary items and constant items that are mistakenly considered to be monetary items, for example, trade debtors and trade creditors. There is no money illusion in hyperinflationary economies. People know that hyperinflation destroys the real value of money very quickly.

It is not what it appears to be

When we discuss, write about, talk about or analyze this monetary item described above, we call it money and describe it using the term money with the implicit assumption that this money we are dealing with is stable - as in fixed - in real economic value in our low inflationary economies. We thus assume at the same time that prices are more or less stable in low inflationary economies.

The term stable is normally accepted by the public at large to indicate a permanently fixed situation or position or state or price or value. A stable – as in fixed - price over time would be drawn as a horizontal line on a chart. A slowly increasing price over time would be drawn as a slightly rising line on a chart. A slowly decreasing value over time would be drawn as a slightly declining line on a chart. When we say production of a commodity is stable we accept that the absolute number of items being produced is not fluctuating but is at the same level all the time.

The term stable as used by economists, however, does not mean a fixed price or level, even though that is what the public in general thinks it means. The term stable in economics these days means slowly increasing or slowly decreasing – depending on what it is being applied to. The term price stability as used by economists today does not mean that prices in general stay the same, but that prices in general are rising slowly – which is, as we are all taught, the popular definition of inflation.

The term stable money as used by economists equally does not mean that the real value of national monetary units they are talking about stays the same in the economy – even though that is what the public in general thinks it means. What they mean with stable money is that the real value of a national monetary unit is slowly decreasing over time – which is, as we shall see, a much better – but not yet the best – definition of inflation.

When a central bank governor says that the central bank’s primary task or objective is price stability what she or he means is that the central bank would be fulfilling its primary task, in an economy with low levels of inflation, when prices in general are slowly rising over time (that well known definition of inflation again). The flip side of that statement is that the real value of national monetary units is slowly being destroyed by inflation over time – the best definition of inflation.

A central bank’s primary task being price stability is the same as saying a central bank’s main responsibility is ensuring that inflation is maintained at a very low level. This low level is now generally accepted in first world economies to be up to 2 percent per annum. We know that inflation is always and everywhere the destruction of real value in money and other monetary items over time. We also know that inflation has no effect on the real value of non-monetary items.

The maintenance of price stability thus means that the primary task of a central bank is to limit the destruction of real value in money and other monetary items by inflation to a maximum of 2 percent per annum within an economy or common monetary area. Two percent continuous inflation destroys the following percentages of real value over the time periods indicated:


We also know that accountants unknowingly destroy the real value of constant items never or not fully updated during inflation when they implement the very destructive stable measuring unit assumption as part of the real value destroying traditional Historical Cost Accounting model. Historical Cost accountants thus unknowingly destroy the same percentages stated above in the real value of constant items never updated during continuous “price stability” of 2% inflation per annum in low inflation first world economies.

Kindest regards,

Nicolaas Smith