Explaining a new paradigm can be both simple and impossible at the same time. For example, Copernicus taught that the other planets and Sun do not revolve around the Earth. He said that all the planets revolve around the Sun, including Earth. It isn’t hard to say, and it isn’t especially hard to grasp.
Indeed, one of its virtues was making the universe simpler. In the old geocentric model, there is the phenomenon of so-called retrograde motion—the planets appear to stop moving forward in their orbits, and move backwards temporarily. It’s difficult to describe mathematically, and worse, no one could explain the cause.
The hard part of accepting this paradigm shift, was that people had to rethink their entire view of cosmology, theology, and philosophy. In the best case, people take time to grapple with these challenges to their idea of man’s place in the universe. Some never accept the new idea.
Rising Prices Aren’t Intrinsic to the Currency
It is the same with money. The prevailing paradigm—the dollar-centric view—is akin to the Medieval geocentric view. This view is characterized by two premises. One, the dollar is money. And two, the value of money is not defined in terms of gold (which is believed to be just a commodity like oil or wheat). The value of money is defined as the inverse of the general price level. This means: what you can buy is intrinsic to the currency.
We can see this point in action, in almost any article about Venezuela. Nicolás Maduro, their corrupt and inept dictator, has destroyed production of just about everything. And he has rendered it impossible to import or distribute what little they still have. Consumer goods are truly scarce, so of course prices are skyrocketing. But people call this inflation or hyperinflation.
They accept that what you can buy is a property of the currency itself, missing that in Venezuela you can’t buy anything anymore, because of the socialist dictatorship.
Everyone knows that the dollar loses value. The Federal Reserve’s target is to make the dollar lose 2 percent per annum. The dollar goes down, and this is not a bug but a feature.
The Unit of Account
Being money, the dollar is therefore the unit of account. However, this contradicts the fact that the dollar goes down. A unit has to be stable, to be useful to measure anything. So how do people reconcile this contradiction? The dollar is the unit of account, but the dollar is constantly shrinking—i.e. it fails as a unit.
Their answer is to try to measure money in terms of prices. They add up the price of apples, oranges, petrol, rent, etc. And they use this consumer price index to define the value of money. They claim to measure the purchasing power of money. Remember that prices are measured in money. So measuring money in terms of prices is circular reasoning.
Anyways, purchasing power enables them to perform a neat trick. It informs them what the exchange rate of two currencies ought to be, based on so called purchasing power parity (PPP). PPP is the exchange rate at which you could trade your dollar for euros or yuan, and buy the same amount of goods in these currencies as you could with your dollar. We would not recommend trading the FX markets based on this notion.
We wonder if they use the purchasing power of the Yuma, AZ dollar or the midtown Manhattan dollar. The former has five to ten times as much power contained inside of it!
We are joking, but there is a serious point. The price you pay for your coffee and breakfast eggs with sausage is obviously dependent on the value of the currency. But it’s also dependent on a whole lot of nonmonetary factors, such as the cost of getting supplies into a dense city on an island. And of course regulations and compliance, taxes and fees, zoning, labor law, building code, etc. It is less expensive—it costs fewer real resources—to operate a store on East Palo Verde Street than it does on Lexington Avenue.
