This post is an excerpt from a recent TSI commentary.

Every central bank in the world, including the US Federal Reserve, now wants a weaker US$, which proves that central banks can be overwhelmed by market forces even when they are united in their goals.

Central banks outside the US want a weaker US$ due to the long-term consequences of the actions that they themselves took many years ago to strengthen the US$. To put it another way, they now want to strengthen their own currencies against the US$ because their economies are suffering from the inevitable ill-effects of the currency-depreciation policies implemented at an earlier time. As discussed in the past, currency depreciation/devaluation is always counter-productive because it “engages all the hidden forces of economic law on the side of destruction, and it does so in a manner that not one man in a million will be able to diagnose.” It is still a very popular policy, though, because at a superficial level — the level at which most economists and all central bankers operate — it seems practical.

Unfortunately for the central banks that are now trying to prop-up their currencies relative to the US$, a central bank’s ability to weaken its currency is much greater than its ability to bring about currency strength. The reason is that weakening a currency can usually be achieved by increasing its supply, and if there is one thing that central banks are good at it’s creating money out of nothing. Actually, creating money out of nothing, and, in the process, engaging all the hidden forces of economic law on the side of destruction, is the ONLY thing they are good at.

The problem they are now facing is that once confidence in the currency has been lost, bringing about currency strength or at least a semblance of stability will generally require either a very long period of politically-unpopular monetary prudence or a deflationary depression. There is no quick-and-easy way to obtain the desired result.

The crux of the matter is that there is very little that central banks outside the US can now do in the short-term to stop the US$ from rising. The best they can do is to NOT inflate. Other than that, they should simply avoid the temptation to ‘do something’ and instead just wait for the current trends to exhaust themselves.

The US central bank also wants a weaker US$. This is because the senior members of the Fed operate at the same superficial level as their counterparts throughout the world. They see the direct, short-term positives that a weaker currency would bring to some parts of the economy, but are incapable of seeing the broader, longer-term and indirect negatives.

The difference is that the Fed actually has the power to create short-term weakness in the US$. It could, for example, surprise the world by not hiking its targeted interest rate in December. That would knock the Dollar Index down by at least a couple of points. To build on the decline it could then start emphasising the sluggishness of US industrial production and dropping hints that another QE program is coming.

Doing so would, however, be a reckless course of action even by Keynesian standards. The US dollar’s upward trend would be over, but at the cost of a total loss of credibility on the part of the Fed and breathtaking instability in the financial markets.

Once lost, confidence is difficult for a central bank to regain. The Fed is therefore now backed into a corner where for the sake of appearances it will have to take small steps in the direction of tighter monetary policy, even though it would prefer a weaker US$.

A modern economy typically involves millions of individuals making decisions about consumption, production and investment based on a myriad of personal preferences. It should be obvious that such a ‘system’ could never be properly described by any mathematical equation, let alone a simple one-line equation. And yet, many economists and other commentators on economics-related matters base their analyses on simple equations.

One of the most popular of these simple equations is also one of the most misleading. I’m referring to the following GDP formula:

GDP = C + I + G + X – Z, where C is consumer expenditure, I is investment, G is government expenditure, X is exports, and Z is imports.

This equation has numerous problems, beginning with the fact that GDP, itself, is a fatally-flawed measure of economic performance in that it treats a dollar of counter-productive spending as if it were just as good as a dollar of productive spending. In essence, it measures activity without considering whether the activity adds to or subtracts from total wealth. But rather than dealing with all of this equation’s problems, I’ll zoom in on its implication that an economy can be boosted via an increase in government spending (G). This implication is not only wrong, it’s dangerous.

Government spending involves taking (stealing or borrowing) money that would have been used by the private sector and then directing the money towards politically-motivated, as opposed to economically-motivated, uses.

Even if we put aside the most basic problems with the GDP concept and the above equation, there’s no good reason to believe that an increase in G will lead to an increase in GDP. This is because C, I and G are not independent variables. In particular, since the government obtains all of its resources from the private sector it is reasonable to expect that an increase in G would lead to an offsetting reduction in C+I. Furthermore, this reasonable expectation is supported by historical data, which reveal a long-term inverse correlation between government-spending growth and GDP growth.

Moving on, another of the most popular of the economics profession’s simple equations is also misleading. I’m referring to the famous equation of exchange, which can be expressed as M*V = P*Q where M is the money supply, V is the velocity of money, Q is the total quantity of transactions in the economy and P is the average price per transaction.

There are numerous problems with this equation, starting with the fact that it says nothing other than the total monetary value of all transactions in the economy equals the total monetary value of all transactions in the economy. In other words, it’s a tautology. As such, it provides no useful information.

In this tautological equation, V (velocity) is nothing more than a fudge factor that makes one side equal to the other side. V doesn’t exist outside of this equation, meaning that it has no relationship to the real world.

In the real world there is money supply and there is money demand. There is no “money velocity”. It makes no more sense to talk about the velocity of money than it does to talk about the velocity of gold or the velocity of bonds or the velocity of bananas or the velocity of houses.

Some of the people who talk about “money velocity” as if it were a genuine economic driver probably mean “money demand”, in which case they should say “money demand”. Money demand is certainly both real and important, but it can’t be calculated via a simple equation.

For more on the Equation of Exchange and the irrelevance of Money Velocity, please refer to my June-2015 blog post on the topic.

In conclusion, when a piece of analysis treats equations such as the ones mentioned above as if they were realistic models of how the economy works, at a superficial level it can make the analysis seem more scientific. However, it actually makes the analysis less scientific.

Using mathematical models that don’t reflect reality is part of why the economics profession has such a dismal track record and is generally held in low regard.

The US$ oil price and the Canadian Dollar (C$) have tracked each other closely over the past 2 years. When divergences have happened they have always been eliminated within a couple of months, usually by the oil market falling into line with the currency market.

In a 25th May blog post I wrote that an interesting divergence had developed over the preceding few weeks between these markets, with the C$ having turned downward at the beginning of May and the oil price having continued to rise. This suggested that either the currency market was wrong or the oil market was wrong. As I stated at the time, my money was on the oil market being wrong. In other words, I expected the divergence to be eliminated via a decline in the oil price.

The oil price was $49 at the time. Over the ensuing two weeks it moved a little higher (to $51) and then dropped by 20% within the space of two months. The result was that by early-August the gap between the oil price and the C$ had been fully closed.

The oil price and the C$ then traded in line with each other for about 6 weeks before another divergence began to develop. Again it was the oil market showing more strength than was justified by the currency market, and by early-October it was again likely that there would be a gap-closing decline in the oil price.

As expected, there was a significant decline in the oil price from mid-October through to early-November. However, the following chart shows that the gap was only partially eliminated and that a rebound in the oil price over the past 1-2 weeks has potentially set the stage for another significant gap-closing move.

I won’t be surprised if the oil price trades a bit higher within the coming two weeks, but my guess is that it will drop to the $30s within the coming three months.

The prices of US government debt securities have been falling since early-July and plunged over the past two weeks. This prompts the question: Where did all the money that came out of the bond market go?

It’s a trick question, because not a single dollar has left the bond market. The reason is that for every sale there has been an exactly offsetting purchase. For example, if Bill sells $100M of T-Bonds, then $100M of cash gets transferred from the account of the buyer (let’s call him Fred) to Bill’s account. After the transaction, Bill has $100M more cash and $100M less bonds while Fred has $100M less cash and $100M more bonds. There has been no net flow of money out of or into the bond market.

In general terms, no money ever goes into or out of any market. A market, after all, is just a place where people go to trade. A market can grow or shrink, but it is not an entity that receives or disgorges money. Furthermore, every transaction in a market involves an increase in demand and an exactly offsetting decrease in demand. For example, in the case of the hypothetical bond traders mentioned above, the transaction involved an increase in the demand for bonds on the part of Fred and an exactly offsetting decrease in the demand for bonds on the part of Bill. Or, looking at it from a different angle, it involved an increase in the demand for money on the part of Bill and an exactly offsetting decrease in the demand for money on the part of Fred.

Related to the fact that no money ever goes into or out of any market is the fact that apart from a relatively small physical float, all of the money in the economy is always in the banking system*. It just gets shuffled around between the accounts of buyers and sellers. This, by the way, is why the “cash on the sidelines” argument that is regularly made to support a bullish stock market forecast is nonsense. In effect, all of the money in the economy is always on the sidelines.

Why, then, do market prices rise and fall?

Market prices rise and fall because one side (the buyers or the sellers) become more eager than the other side. If buyers are generally more eager than sellers then the price will rise by the amount required to encourage enough new sellers and/or discourage enough buyers so that a balance is established, whereas if sellers are generally more eager than buyers then the price will fall by the amount required to encourage enough new buyers and/or discourage enough sellers to establish a balance.

That’s why it sometimes happens that the prices of ‘everything’ (equities, bonds, gold, commodities) trend upward or downward together. One price doesn’t have to go down in order for another price to go up, and prices in one market going down will never be the direct cause of prices in another market going up. Although it is certainly the case that rising/falling prices in one market can alter the motivations of buyers and sellers in another market. The price of gold, for example, is determined mostly by what’s happening to prices in the bond, currency and stock markets.

Clearly, then, US government bond prices have fallen simply because, on average, bond sellers over the past few months have been more eager/motivated than bond buyers, not because any money has come out of the bond market. The reason for the change in motivation is a good topic for a separate post.

*If governments and banks get their way, at some point in the not-too-distant future there will be no physical float and 100% of the money supply will be in the banking system.