In Part I (http://keithweinereconomics.com/2013/04/22/theory-of-interest-and-prices-in-paper-currency-part-i-linearity/), we looked at the concepts of nonlinearity, dynamics, multivariate, state, and contiguity. We showed that whatever the relationship may be between prices and the money supply in irredeemable paper currency, it is not a simple matter of rising money supply → rising prices.

Here is a fitting footnote for Part I. I just bought a pair of Levis jeans at Macy's for $45. I remember buying a pair of Levis Jeans in Macy's in 1983 for $50. In 30 years, the price of Levis Jeans has fallen by 10%. By any conventional theory based on the money supply, the price should have risen by several hundreds of dollars.

In this part, we look at some mechanics, the understanding of which is a prerequisite to the theory of interest and prices. To truly understand anything, you have to know what happens in reality step by step. This is even more important in an abstract field like monetary science. We discuss stocks vs. flows, how prices are formed in a market, a broad concept of arbitrage, spreads, and how money comes into and goes out of existence.

Let's drill down into a point I made in passing in Part I.

It is worth noting that money does not go out of existence when one person pays another. The recipient of money in one trade could use it to pay someone else in another. Proponents of the linear QTM[1] would have to explain why prices would rise only if the money supply increases. This is not a trivial question. Prices rise whenever a buyer takes the offer, so no particular quantity of money is necessary for a given price (or all prices) to rise to any particular level.

It is seductive to respond by way of the common analogy of "too much money, chasing too few goods". But, is that an accurate picture of how markets work?

Money supply is a quantity of stocks. One could theoretically add up all of the gold in human inventories, or all of the dollars in the financial system, and come up with a scalar number of ounces or dollars.

How about goods supply? This is a different meaning of the word supply. Unlike in money, the supply of goods means the flows of goods. To discuss copper or wheat, one must measure how much is mined or grown every year. This would be pounds or bushels per year.

Flows of goods cannot be compared in any meaningful way to the stocks of money; pounds per year cannot be compared to ounces. Just like in physics, length cannot be compared to velocity; one cannot compare meters to meters per second. That is not a proper approach to science -- physical or monetary.

This brings us to an important fact. The stock of money is not consumed after a transaction. However, in the normal case, goods are. Other than the monetary commodities of gold and silver, only small inventories are normally kept as a buffer in all other goods. To state this in everyday terms, if Joe buys a loaf of bread from Sally for $1, he will eat the bread (or it will go bad) but Sally has the money until she spends it. If Acme Pipe buys 1000 pounds of copper, it will manufacture it into plumbing and sell the plumbing.

Now let's move on to the mechanism of price discovery. In Part I, I stated:

In any market, buyers and sellers meet, and the end result is the formation of the bid price and ask price.

There is not just one monolithic price, but two prices: the bid, and the ask (also called the "offer"). If you come to market and you must buy, then you have to pay the offer. For example, you own an apartment building and your lease obligates you to provide heat for your tenants. So you go to the heating oil market. If heating oil is bid $99 and offered $101, you must pay $101. Note what happens next. The seller of that oil - assuming you just bought all of his oil - leaves. He has exchanged his oil for your dollars and he goes home. The next seller may ask $102. Now the market is bid $99 and offered $102.

Next, a heating oil distributor comes to market with the day's production. He must sell, because tomorrow he will produce more. What price does he get? Did your purchase push up the price? You did not push up the bid price, and so the new heating oil vendor must take the bid of $99. Now this consumer is sated, he has the oil he wants. The next best bid could be $97.

There is a counterintuitive process here. The bid is formed by the competition of producers who keep selling until the marginal seller does not accept the bid. The ask is formed by the competition of consumers who keep buying until the marginal buyer does not accept the ask. This is a critical idea in Austrian School analysis, so I encourage readers to stop and think this through.

Buyers keep coming to market and taking the offer (thus lifting it) until a point is reached where the next would-be buyer balks. This buyer, the marginal buyer, may make his own bid, above the best bid but below the best offer. At the same time, sellers keep coming to market and taking the bid, until the marginal seller balks. This seller may set his own offer, below the best offer but above the best bid.

There is one other actor, the market maker. The market maker will act to keep a consistent bid-ask spread. If the ask is pushed up, then the market maker will raise his bid. If the bid is pressed down, then he will lower his ask. The market maker is the only one who can buy at the bid and sell at the offer. His profits come from the bid-ask spread, the wider the spread the more his profits. Of course, the next market maker will enter and force the spread to narrow, and so on until the margin al market maker balks and the spread does not narrow any further.

From the mechanics described here, we begin to build a picture of how prices are set where the "rubber meets the road" in the market. If there are more market participants who buy at the offer then the end result is that prices move upwards. If there are more who sell at the bid, then prices move downwards.

This may seem tautological. It is prerequisite material.

We return to my rhetorical question. Why would prices not keep rising in the case of a fixed quantity of money? After all, when Joe buys the loaf of bread from Sally for $1 there is no reason why Sue could not buy it from him for $2 and John couldn't buy it from Sue for $3 and so on.

The observant reader may object on grounds that prices can only go up until people cannot afford the good. Bread cannot be $300 per loaf if no one has $300. This is comparing stocks to flows once again. What matters is not whether the consumer has $300 in stocks, but whether the consumer has $300 in flows. If the velocity of money (flows) rises, then the consumer could have $300 of daily income with which to pay the price of his daily bread.

As we see from the above discussion of price formation, neither the buyer nor the seller has an intrinsic advantage. Both come to market and must accept the market price (ask or bid, respectively). Size does not add any power to the seller. If anything, the seller has a disadvantage in trying to get a price he prefers, compared to the buyer. He has capital tied up in his productive enterprise, and certain fixed costs like payroll that must go on whether he sells or does not sell. Holding inventory does not normally do him any good. With the exceptions of food and energy, buyers can afford to be pickier. They do not face the same problem as sellers; if they go home at the end of the day with money as opposed to goods, this is not always a problem.

Without delving too deeply into this topic, I want to paint with a broad brush stroke. There is no force that guarantees a constant price even if the money supply is fixed. There are many reasons why buyers could lift the offer or sellers could press down the bid. Not only can prices rise with the same stocks of money, but they could also rise with the same flows of goods.

Next, let's introduce the concept of arbitrage. People often use this term in a very narrow sense, to mean buying and selling the same good in different markets to shave off a small spread. For example, IBM stock is offered at $99.99 in London and bid at $100.00 in New York, so the arbitrager could simultaneously buy and sell to pocket a penny. Or, in the gold market, which I write about frequently, one could buy spot gold and sell December gold for a 0.3% annualized spread.

In this paper, I use the word arbitrage to refer to a much broader concept. I won't fully explore it herein, but we need to discuss one relevant aspect.[2] Let's go back to our example of the landlord. What is he doing? He is seeking to make a profit by renting out apartments to tenants. The rent is his gross revenue. How is the rent set? If he needs to rent a unit, he must take the bid.

What are his costs? Broadly, he must buy land, construction materials, construction labor, maintenance labor, heating oil, etc. We will address later that he must pay the rate of interest on the capital.

The landlord must buy these things at the offer. We can look at him as doing an arbitrage between his inputs -- bought at the offer -- and his output product -- sold on the bid. The landlord's spread is Rent(bid) - Inputs(ask).

In this light, what should he be the limit of what he is willing to pay for his inputs? A bit less than the rent he receives, at most.

I give this example to make it clear why we should not think the primary driver of markets is the consumer with a bank account balance as his budget. One might think of a consumer who has a total of $10. Let's suppose he would want to pay $0.01 for a loaf of bread. But if he had $100 total, he would pay $0.10, and so on. This is the siren song of QTM luring one to think that increased stocks of money must lead to higher prices. It is often stated, "if everyone's bank account grew by 10X, then prices will be 10X higher."

Will a middle class consumer buy more food if he has more money?

At any rate, instead of the consumer, we should think of the entrepreneur. He is an arbitrager who will not normally buy inputs unless the bid on his output affords him an acceptable margin above the offer on his inputs. What will cause consumers to raise their bid on his outputs? This is a non-trivial question that will be addressed in a later part of this paper.

Up until now, we have been using the term "money" without regard to the distinction between gold and promises to pay, i.e. between money and credit. It is now necessary to make this distinction to continue the discussion. In the current monetary regime, money (gold) has no official role to play at all, though it assuredly plays a role. My permanent gold backwardation thesis[3] can be summarized as follows: the withdrawal of the gold bid on the dollar will bring about the collapse of the dollar because dollar holders will drive prices up exponentially by using commodities to get gold.

Money (gold), of course, can only come into existence via a slow and inelastic process of mining. Money does not go out of existence (though gold coins can be melted down to produce non-monetary objects). Both of these processes are themselves driven by arbitrage. When the inputs required to mine one ounce of gold cost less than one ounce, the gold miners spring into operation. When the inputs rise above one ounce, they shut down. When jewelry sells for more than the cost of its inputs (principally gold, labor, and perhaps gem stones) then jewelers spring into action. When monetary gold is worth more than jewelry, then it is melted down and returned to monetary form by arbitragers known as "Cash For Gold".

Credit is an entirely different animal.

In Part III, we will discuss credit including an examination of the borrower, the borrower's opportunities, and the borrower's considerations.

[1] Quantity Theory of Money

[2] Those interested can read more about arbitrage in Disequilibrium Analysis of Price Formation by Antal Fekete, January 1, 1999

[3] http://keithweinereconomics.com/2012/03/15/when-gold-backwardation-becomes-permanent/