The Physics of Money 34 comments
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Money doesn't count unless it's in motion; that's why governments not only can but also feel that they must create great supplies of the stuff in these deflationary times. The good news is that all this new money isn't inflationary (at the moment); the bad news is that this new money so far isn't breaking the deflationary cycle because it's refusing to move.
A simplistic but not inaccurate view of inflation is that it occurs when too much money is chasing too few goods; deflation, of course, occurs when money is the scarce commodity and other goods – houses, say, or oil – are abundant. So how did we go from inflation to deflation so rapidly? Where did all the money go?
Basically, the money went into various mattresses; it stopped moving.
The definition of money is complex; it's much more than just cash. It's also the debt of governments and even private entities; it's the outstanding balance on your credit cards; it's lots of other stuff. But it only counts when it's in motion. Economists speak of the velocity of money; the number of times it changes hands (turns over) in a year. The effective money supply, the money supply which at any given moment is either too big or too small for the goods available, consists of the absolute money supply MULTIPLIED by the current velocity of money.
This is easier to think about if we pretend that money is just cash. Suppose that the 100 residents of an isolated village have a million dollars of cash in their economy. How much income, then, can each resident have? The answer depends on the velocity of that million dollars. If it turns over only once a year, then the mean income will be $10,000/resident. But, if the money turns over ten times a year, if each resident spends income almost as fast as he or she earns it, the mean income will be $100,000 since each dollar changed hands ten times and got counted as income ten times.
The faster we spend, the more money there is available in the economy. Money we put in our mattresses might as well not exist as far as the economy is concerned even though it may be very important to us. Money we put in the bank is USUALLY as good as spent economically because it gets lent to someone else who spends it. But these aren't usual times; if the bank doesn't relend the money, it might as well be in a mattress.
Banks aren't lending like they used to; we aren't spending like we used to. The velocity of our money supply has slowed to a crawl; that's how we moved from inflation to deflation; the money stopped going around.
Deflation causes (and is caused by) depressions. Governments rightly don't want depressions to happen on their watch, makes the citizens surly. So governments around the world are creating vast supplies of new money to counteract the fact that the money is moving slower. It's debatable (but not in this post) whether the money is being injected into the economies of the world at the right place to get it in motion; but there's no question that lots of new money is being deliberately created to fight deflation. Inflation isn't a concern because deflation is the problem. Governments want prices to stop falling so they're working to cheapen their currencies – backwards of what we're used to since inflation is what we usually worry about.
One danger in this deflation-fighting strategy is that it can lead to hyper-inflation. The absolute money supply is being increased; if it then goes into rapid motion, the effective money supply goes through the roof. Money will go into motion if people are afraid it's going to lose value; in that case they'd rather have goods so they start spending. Some of that is good to break the current deflationary cycle, a lot of spending with a bloated money supply ends up in a situation like Weimar Germany or Zimbabwe.
Aren't you glad you aren't running the Fed?
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This article has 34 comments:
Also, fractional reserve lending causes inflation as loans are made and deflation as loans are repaid and new loans not issued to replace them.
The problem with this current environment is that I don’t see much money in motion lately. How is it getting into the system???
Yes, banks may have unprecedented amounts of liquidity thanks to the Fed and Treasury, but who are they lending it to? They’ve greatly tightened their lending standards for both consumers and businesses and they’re still too scared to lend and fewer entities and individuals now meet their new standards.
Hedge funds are desperately deleveraging and liquidating their portfolios. Customer redemptions are killing them. How many will be gone by this time next year? Most?
Assets prices are in a free-fall, especially in real estate. How many trillions of dollars have now left that particular asset class? How many trillions more will leave it in the next couple of years?
Commodity values have collapsed with no floor yet in sight.
With the economy being caught is several nasty feedback loops, layoffs are accelerating and the consumer has rolled into a fetal position, praying that they will still have a job in the next 12 months. How many cars and houses are they currently buying?
Contrary to popular belief, the Fed doesn’t print bails of $100 bills and toss it out of the windows of helicopters. So I guess I’m asking the hyper-inflation proponents (Jim) and gold bugs, how exactly is inflation going to work itself into the system anytime in the foreseeable future?
Anyone?
estimation of the deleverage, no bottom in sight!
Monetary Supply Rates
Selected Countries: July 2008
M2/M1 M3/M1
US 554% 994%
Brazil 456% 930%
Republic of Korea 117% 721%
Australia 216% 463%
Singapore 442% 453%
Japan 190% 312%
EU 13 198% 234%
UK (EMU Data) 165% 195%
Poland 172% 175%
Switzerland 237% 144%
China & Hong Kong 285% NA
M3: US not official data
Ah, caused by "inflationary expectations" becoming "unhinged"?
Thank you. Please Wade in more often.
This currency was designed specifically to be a means of exchange and *not* a store of value.
So we now are grappling between inflation and deflation without a definite conclusion. However if there is a severe recession it means net result is deflation. Currently we are seeing more deflationary effects than inflation, due to the ongoing recession.
Velocity (measured as GDP/M1) started increasing rapidly in the early 90's. This is consistent with the thesis that increased trade and productivity gains from technology masked the velocity inflation. Consumer goods were getting cheaper, so no inflation was recognized, and "easy money" policies were followed.
Of course, investment assets did inflate.... one at a time. First we had the Internet bubble, then we invested in "safe" investments... houses and Dow stocks for our 401K's. Throw in a commoditiy bubble for good measure.
The deflation occurs when everybody gets on the same side of a given trade, it stops working, and a rush for the exits begins.
The Fed's charge under Humphrey-Hawkins is to maintain price stability and full employment. There's nothing in there about monitoring velocity, leverage, or asset inflation. Greenspan did what the law specified. If he had caused a recession in the 90's, he'd have been widely criticized, but we'd be healthier now. Any reform going forward must redefine the Fed's guidance.
denounce FRB as fast as you can.
Your body won't last and your reps in tatters
So tell the truth
(while it still matters.)
put another way the US is like a guy with a small income that is getting smaller that is spending more and more on his credit card. eventually, he won't be able to find a debt buyer. that's another way we can go inflationary very quickly, because the debt will be printed away. this is even more likely when one considers the argument that bond prices are set to collapse (www.moneyweek.com/inve...).
oil will go from $50 to $200 within 36 months. precious metals are where it's at.
The "multiplier effect" is Economics 101 stuff...
But the important point of your article, that is missed, is the multiplier effect vis-a-vis the derivatives that were floated -- as bad as they were, they still circulated through the economy and multiplied. Maybe tens of trillions in bad debt out there has its root in garbage paper... Too much to save the world's economies from implosion. Maybe a lesson for future generations (maybe Alan Greenspan too...maybe).
All of the Bush-Paulson props won't heal this sick monkey.
I was listening to Bloomberg this afternoon and one of the talking head "analysts" they had on said that it will be important to get consumers out using credit again to get the economy going...
Imagine...
Where do they get these idiots?
So the banks keep their money, refuse to lend and win in the fact that the percent of overall wealth in the US goes to the one who doesn't loose equity. Ergo the rich get richer while the others starve paying the bank's bad loans and the brokerages' derivatives bills.
Bush Jr. and the Republicans should be calling themselves socialist commies, not the democrats about now.
1) How much govt deficit spending is taking place
2) How much exported dollars are returning to this country via purchases of goods and bonds.
3) How well the loans the banks who play with our money do on their investments since fractional reserve banking can quickly expand or contract the effective money supply.
4) How many people at any given time are hoarding money. That is do they prefer dollars are or things such as stocks, TV's, etc...
5) The fluctating supply of foreign currencies,
This list could probably be expanded to a hundred or perhaps thousands of different things. The point is that because of an ever growing array of different forms of financial securities all of which have an effect on the paper supply of money they (The Federal Reserve and governments) can no longer effectively maintain price stability. Perhaps they never really could and just managed to get lucky a few different decades or so.
Now realized beyond all these complexities the major portion of our money supply is actual just dollars multiplied by debt instruments and you realize that to continue to increase the money supply the ability of a nation to take on debt is paramount and you realize that people can only afford so much debt. Personal, county, city, state, Federal debt, and business debts are all huge. A large amount need debt to continue as is while other need none. Banks realize now tht those who need the debt can't be trusted with it and no one else wants to take out loans. This adds to credit freeze also.
My belief is that at some point the government will have to stop creating new debt for dollars and simply turn on the printing press effectively paying down the national debt or spending it on public works projects. They may suceed doing it the traditional way by creating a debt instrument to back up the new dollars but either way they are going to print and print and print until interest rates sink so low everyone will want to borrow the cheap money. When all the factors that now conspire against the supply of money and its velocity reverse course their will be much more M1 supply in circulation. Odds are this will boomerang into hyperinflation.
I did like what one person said the other day. We could see big ticket items requiring debt funding such as cars, houses, etc to see price declines while all the new money goes into necessities like Oreos and PBJ's.
Keep a close watch on the US Dollar, if it starts to collapse it will be one of the first indicators that the shift to inflation is starting.
Other useful indicators will be a rise in gold, drop in treasury prices (i.e. rates/yields will rise), perhaps the fed will start will start humming and hawwing about inflation, and heck maybe even equities will rise, but with the volatility in equities, this one will be difficult to determine.
Again, excellent article!
Debt is not a problem if its a one time thing. However, social programs continue and become larger and larger---Socialized medicine and other social progams will bankrupt the nation and must not be passed.
All gov. spending must only be for a short time and not be made permanent. Even Roosevelt did not intend to make social security permanent. However its almost impossible to remove the gov. tit from the mouth of our people.
Excellent article!
As for all the self-described inflationists and even wackier hyperinflationists, all I can continue to wonder is where they think the nominal buying power will come from. Even if credit loosens to a point even looser than existed before the real estate bubble busted (highly unlikely if not impossible), for their scenario to play out we would have to see, literally, it become standard fare for people to pay for things like rent and discretionary, non-durables almost purely on credit. As in, you pay for your cable TV with your credit card every month, and for some inexplicable reason, you don't mind that it now costs over $1,000/month.
Think it through. Not likely, even in the debt-happy US. Actually, the US has savings rates not too afar from Europe's if you normalize how rent & housing costs are considered in these various equations.
The tragic, ironic, hypocrisy of the hyperinflationist cheer crowd who fantasize about $500 oil and $5000 gold is that they are, in fact, doing a cheerleader rain dance for a bubble to form. While they talk about the evils of bubbles, mostly the credit & real estate bubbles, they are so obviously invested in a different asset class which they hope ever so much will be the next to bubble up. One can't help but wonder if they're anything but a bunch of jealous folks who're pissed they missed out on the real estate mania and now are smirking, thinking those real estate bubble speculators will have to fork over their money to a new breed of oil & gold bubble speculators.
[Un]fortunately for all of us, the free market is stubbornly reasserting itself despite all the distortions and greed. That is being seen as falling money velocity, broader and broader price deflation, and more recently a spike in normalized savings rates & savings behavior in the US consumer.
The only problem with the theory of watching the dollar to gage inflation is that most of the rest of the world is combating the crisis in a similar way to the US (excessive spending). Hence, the dollar could theoretically grow stronger against various currencies (such as the British Pound and the Euro), even while inflation is fairly bad.
VM = ( (CAFE + COCA) * CACA ) / MTR
that was funny constructe lol