Thursday 17 January 2013

When money velocity stabilises, inflation will let rip

A while back, before the trillion-dollar-coin idea that was publicly kited and then smacked down, I too was wondering why, if the government can conjure up money out of thin air and lend it to itself, it can't similarly forgive itself.

Insofar as banks are allowed to get involved brokering the deal, I suppose debt cancellation might deprive them of some of their income stream, but other than inconveniencing a few thousand banking families it wouldn't seem to be a bad scheme. As President Andrew Jackson famously said, "You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! " One longs today for such un-mealy-mouthed leaders.

But this kind of living on debt causes real damage, whether or not it is ultimately extinguished. Because the government is trying to keep things normal in the economy, and spends the borrowed money on salaries and other benefits. This is increasing the stock of cash in the economy.

The reason we don't have high inflation at the moment is that money is changing hands more slowly during the recession - its "velocity" is dropping, and counteracting the boost in the quantity available to spend.

When the velocity stops dropping, inflation will begin properly. (Food and energy prices may be rising at the moment, but there's other factors at work there. Houses, cars and all sorts of other things are trading at a discount still, for ordinary people. Overall, I think we are still experiencing deflation, partially disguised by increased prices for the things rich people buy because they are benefiting from the collapse of the middle class.)

If velocity increases, inflation will roar. Unless government removes money at just the right rate (by taxation, or higher interest rates) - and it will be reluctant to do so because it won't want to be seen to be "killing the recovery". Ordinary savers will be sacrificed for the sake of apparent health in stock and property markets. But the economy will still not have been fundamentally set right, and sooner or later we will need some reset in the currency. In real terms, in the currency of "stuff", the average Western person will be poorer.

And that is why smart, privileged money is pouring into tangible assets. A small fraction of the population will become the "Sultans of stuff".


Charles Hugh Smith thinks the deflation is unstoppable. But there will be an end, however far off it now seems.  I think spotting the turn and moving out of cash fast will be the test for investors.

John Ward opines, "...there is no such thing as a gradual panic. Those ahead of the panic are openly opting for the last place left offering financial long-term and physical short-term safety: top-end property." Not all of us can afford it. It's the small saver who is being hauled to the stone table.

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Mad Numismatist said...

Excellent analysis, velocity is the missing ingredient, and deflation can clearly be seen in M4, while M0, is close to zero. It conjures images of trying to climb from a sand pit. The harder you push, the more sand collapses in. Eventually you will get out, but absolutely exhausted.
There is great passage in Hazlitt’s; economics in one lesson, describing exactly how the rich get a jump on the masses by buying up everything they can lay their hands on. I will post it if I can find it.

Sackerson said...

Thank you, please let me know when you do.

Mad Numismatist said...

Reading it again, it portrays precisely what is occurring:

Page 180 Hazlitt: economics in one lesson.

“....we may clarify the process further by a hypothetical set of figures. Suppose we divide the community arbitrarily into four main groups of producers, A, B, C and D, who get the money-income benefit of the inflation in that order. Then when money incomes of group A have already increased 30 per cent, the prices of the things they purchase have not yet increased at all.

By the time money incomes of group B have increased 20 per cent, prices have still increased an average of only 10 per cent. When money incomes of group C have increased only 10 per cent, however, prices have already gone up 15 per cent.

And when money incomes of group D have not yet increased at all, the average prices they have to pay for the things they buy have gone up 20 per cent.
In other words, the gains of the first groups of producers to benefit by higher prices or wages from the inflation are necessarily at the expense of the losses suffered (as consumers) by the last groups of producers that are able to raise their prices or wages.”

The entire book is available through Von Mises for free here:

Sackerson said...

Thank you, MN, that's a useful link.