Sunday, March 09, 2008

Inflation as entropic process

Paper money eventually returns to its intrinsic value ---- zero. Voltaire

A friend recently asked me when is a day or so longer than a few weeks? When the Dude says he'll write again within that time.

Another friend of mine, and all around bright fellow, has, through a few days of debate on the causes of rising prices, inspired me to finally start posting again.

I find it fascinating how different minds think about the same issue. The "bones of contention" in any debate, assuming (and this is a big IF) the issue has been properly defined, reveal the differing underlying beliefs.

After going back and forth on the issue of the necessary causes of rising prices, I saw his underlying assumption: some force, such as might occur if a market was "cornered," a la the Hunt's silver play of a few decades past, must come into play in order for prices to rise. Thus he kept, quite reasonably, under that view, asking for the mechanism that drove prices higher.

Throughout the exchange I found myself at something of a loss for words. It seemed obvious to me that prices should be rising, yet I couldn't explain the basis of my view to an inquiring mind. Finally, having spent a few days pondering why I thought higher prices were so obvious but he didn't, the answer came to me- he was assuming that the unit of account and medium of exchange was of stable value, while I had accepted Voltaire's view, above, as true- paper money, such as the US$, was returning to its intrinsic value, zero.

In my next response to him, I inverted the arrow of causality: The better question to ask is how the price (which is simply the relation of a good/service to a unit of account of minute intrinsic, but some implied value) of any good stays the same over time instead of rising. That seems to me a more difficult question to answer.

That is, in a fiat money system, price stability is a low entropy configuration requiring some enforcement to maintain, inflation, i.e. a shift in a currency's perceived value towards its intrinsic value, is a shift to a configuration of greater entropy.

For those unfamiliar with the concept, entropy can be thought to rise as potential dissipates. A state of higher entropy is, in a sense, more disordered than a state of lower entropy. The second law of thermodynamics states that the world acts spontaneously to minimize potentials- tends to a state of higher entropy. For instance, an ice cube placed on a table at room temperature will melt without being heated or a concentration of gas, perhaps enclosed in a chamber under the same pressure as the surrounding room, will diffuse through the room over time after the chamber is opened.

Voltaire's view, which I share, implies that some ordering force must be applied to maintain the value of paper money. Remove the ordering force and paper money will begin losing value just as the ice cube on the table in your room (assuming you can afford heating oil these days) will begin to melt if heat is not constantly drawn from it.

This line of thought reminded me of my recent read of Greenspan's The Age of Turbulence- particularly his oft expressed sense that a well functioning, efficient economy (however one might define such terms) was a "natural" occurrence, at least in the west, due, as he notes in relating his observations of Russia's shift to Capitalism, to our long standing traditions of valuing private property, etc. An inefficient economy in the US, according to Greenspan, is a result of restrictions or rules which impede the transition to its natural state. Free the markets, and, he avers, things will sort themselves out.

This runs counter to the second law of thermodynamics. Of course, we are not bits of ice or molecules of gas, thus this law should only be assumed to operate on our physical beings (for instance the entropic process by which every ordered biological entity is always tending to death and disintegration, mitigated only temporarily by regular additions of energy (food), water and air).

Yet, it seems to me one can imagine this law operating on cultures as well. As the fall of myriad cultures over history seems to attest, humans, barring organizing forces, (which might be internal, such as simple faith that "the system" is working, or external, such as the imposition of sanctions on certain behaviors, what we call the justice system) are always tending towards the "noble savage." Our current state of, despite the occasional war, and other atrocities, high level cooperation is the "un-natural" or low entropy state, always pregnant with a return to barbarism.

Returning to the topic at hand (I need to force myself to stop digressing, or expressing my natural mental entropy) it seems to me that Central Banking in America at least, has forgotten its primary function by assuming that zero inflation under a fiat money system was a "natural" result. The Fed or Treasury would need to "do something wrong" to ignite inflation.

Au contraire, say I, the natural value of these colored, variously numbered pieces of paper in my pocket is almost nil. The Fed needs to "do something right," i.e. enforce the view that paper money has value, in order to stop inflation from occurring. Acting as if external imbalances never need to be resolved, blocking the mortgage market from clearing, and cutting interest rates ever closer to zero (etc.) don't seem to me to be policies that will stall the now accelerating entropic process of the US$ finding its intrinsic value.

p.s. I'm not arguing that restrictions are necessarily a good thing, the fewer the better, so long as the really important ones, like maintaining a stable unit of account, are enforced.

4 comments:

Fullcarry said...

What the Deflationist miss is that its not necesassary for the supply of money to go up for the unit of account to lose value. All that needs to happen is for people to realize that the supply can conceivably go up. In your parlance once they realize that the natural order is for the entropy to rise they will rush to protect themselves and there will be a run on the money forcing its value back to its natural level.

STS said...

Dude, welcome back.

You're on to something with this post. I look forward to your further development of the theme.

fullcarry,

I'm not sure I agree -- as long as the fiat currency isn't replaceable with something else (the way some national currencies used to be replaced by US dollars in years past) I think the usual law of supply and demand holds.

And the argument for deflation at the moment depends mostly on the way credit is collapsing faster than reflation efforts can take hold. Of course in the early 1930's commodities prices were collapsing. Not quite the same story today ...

Fullcarry said...

STS,

The law of supply and demand is holding. Its the demand for dollars that is falling.

Credit is collapsing. But demand for dollars is collapsing even faster.

Dude said...

STS,

Thanks and yes, I look forward to exploring this theme further.