Picturing Deflation: Velocity of Money Slows

Posted by urbandigs

Mon Dec 1st, 2008 12:08 PM

A: Where did the money go? The fed is trying to stop a deflationary spiral, but still there are those out there that dismiss we are experiencing deflation. Which begs the questions, WHAT IS DEFLATION? Saying it is the opposite of inflation doesn't really help us because there are different definitions for inflation. I used to view inflation as a general increase in prices and the cost of living. I was wrong. Sure, that is one form of inflation, but it is not the type of inflation that the fed worries about that ultimately would lead to aggressive rate hikes to fight it. Rather, the form of inflation the fed worries about is an expansion of the money supply & credit; that may trickle through to wages. Acknowledging this, we can now come to a simple definition for deflation: a contraction in the money supply & credit, and a correlating drop in the velocity of money. Lets discuss.

What is the velocity of money and why do we care? Well, it kinda means something if we are trying to gauge the strength of an economy. I like the way Brian Bloom describes the Velocity of Money:

This is best understood by thinking about the concept of the Economic Multiplier Effect. Essentially, if I earn $100 and I save (say) $4.50 then I will spend the other $95.50. The person who receives the $95.50 will spend some and save some. In this way, a $100 injected into the economy by the Central Bank grows to become a multiple of the original $100.
So, a $100 that I earn today, will be spent by me to buy earrings for my wife so she doesn't leave me. Then, the store clerk will take that $100, and pay her energy bill. Then, Con Ed will take that $100, and put it towards the salary for one of their employees, and so on and so on. The point is that the same $100 gets circulated throughout the economy. The higher the velocity of money, the stronger the economy as the same fixed unit of money freely flows throughout the system. Think of an economy where a $100 earned, doesn't get spent and therefore doesn't flow back into the economy; clearly that is not a sign of a strong economy right? Well, that is where deflation kicks in. In times of hyperinflation, the velocity of money should surge. In times of deflation, the velocity of money slows. So lets look into this.

If you recall my 'Fisher's Debt-Deflation Theory' discussion, Stage 8 included the "Slower Velocity of Money". You calculate the velocity of money by dividing the total GDP (a measure of the nations output) by the money supply. As I discussed last week, the adjusted monetary base is surging as the fed tries to inflate their way out of this mess. Before we take a look at the charts, we need to understand one thing:
The increase or decrease in the velocity of money has a multiplier effect because this new money OR saved money will either create more new money or contract the multiplier effect. Slowing velocity leads to a negative multiplier effect while rising velocity leads to a positive multiplier effect.
I can't seem to find a chart on the Velocity of Money, but I do see this chart from the St. Louis fed showing us the M1 Multiplier Effect, which shows the effect of money velocity as I just stated above:


Quite a sharp decline in the multiplier effect! This is the result of a slowdown in the velocity of money, consistent with Stage 8 of Fisher's Debt-Deflation theory. As time goes on, it is becoming more clear that we are indeed in a period of debt deflation.

Which leads to where did the money go? Is it in mattresses? Is it being spent? Is it in bank deposits, yet not being lent? Tom Evslin chimes in about 'The Physics of Money' over at Seeking Alpha:
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. 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.
These are unprecedented times and the first time I am experiencing a cycle of debt-deflation in the real world. The fed is conducting massive lending facilities, aggressively cutting funds rate, bailing out insolvent banks/insurance companies, and applying measures not used since the Great Depression. To me, this is an amazing learning experience not to be missed, and I want to see not only the effects of what they are doing on the money supply, etc., but what the end result winds up being so I can position myself appropriately. I will be watching the M1 Money Multiplier and the Adjusted Monetary Base weekly as this story continues to play out.