Three Functions Of Money

When pondering our current economic dilemma, perhaps it is wise to consider what the role and function of money is about.

Money is useful under three conditions:
1. It is a store of value
2. It is a unit of accounting
3. It can be used for the exchange of goods and services

A fiat currency is vulnerable to devaluation because of the temptation to print money and inflate the money supply.
We have Venezuela as a recent example of this phenomenon. Venezuela devalues
While there are conditions when printing money has a negligible effect on value - such as when deflationary forces are reducing the amount of credit available, it is possible to a government to increase the money supply to such a large extent that inflation in prices results.
When this happens, money is no longer a store of value, as inflation erodes the purchasing power.  It is also no longer a unit of accounting, as larger numbers are required on each bill over relatively short periods of time.

So we can see that inflation, and particularly severe inflation, destroys the function of money by violating conditions #1 & 2.

In a deflationary envirnoment, we see the opposite effects.  The currency becomes an excellent store of value, still functions as a unit of accounting and can be used to buy goods & services.  Deflation rewards savers, and thus an equilibrium is gradually restores to all markets as the deleveraging process is completed.  The recovery is then built upon savings rather than debt.
This assumes that a deflationary scenario is allowed to run its course without undue monetary interference by government.
The danger we are presently facing is that, like Japan, our government will not allow economic nature to run its course.  If we see extreme QE developing, thereby boosting the money supply by enormous amounts, or, if we see the velocity of money tampered with, as we explored in the earlier post The Economist Has No Clothes, we run the risk of severe inflation developing.

With these two scenarios existing as possibilities, my investment portfolio has been adjusted accordingly moving to very defensive positions and focusing on tangibles.  2010 Year Of Preparation


Which would you rather own?