Stock to Flow Fallacy

Stock-to-Flow historically describes the relationship between capital and income, allowing a future capital level to be estimated from an expected income level. Later this elemental concept was applied to money supply generally.

The ratio of stock to flow is a measure of time. Given a higher ratio, stock will increase more slowly. There is a theory that money with a higher inherent stock-to-flow ratio will suffer less proportional monetary inflation than a money with a lower ratio. The theory holds that the higher ratio implies a “harder” money, defined as inherently more resistant to the effects of monetary inflation.

The theory fails to consider the source of flow rates. It necessarily assumes that the rate of production is simply a property of the substance. But production of anything occurs when the anticipated price makes production profitable. A greater profit potential results in more competition, accelerating supply increase. More people digging for gold increases its flow.

In other words, flow is a function of demand. An anticipated loss results in no production whatsoever. This lack of any flow is not inherent in the substance but a consequence of lack of demand. Given that both supply and demand determine flow, the theory is invalid. This long understood error is not an aspect of the elemental stock-to-flow concept, but a misapplication of it.

Given counterfeit laws, competition to produce state money is restricted, allowing control of supply by the state, independent of market forces. As with other monies, supply and demand are generally unpredictable. A state may “peg” its issue of reserve notes to another money, such as gold. This relation may even hold over many decades. In this case the stock-to-flow ratio would incorrectly indicate a “hardness” comparable to that of gold.

Given that the stock-to-flow of money is the inverted monetary inflation rate, its relationship with monetary inflation is tautological. It does not imply anything about future monetary inflation. It can be used to analyze historical relations, and to calculate future stock based on assumed future flow, but it cannot be used to predict future monetary inflation. Any statement that one speculation will be more profitable than another based on historical stock-to-flow ratios is an error.