Picturing Deflation: Velocity of Money Slows
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.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.
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.
Thoughts?
Posted by brenda
Mon Dec 1st, 2008 01:00 PM
What amazes me is that the recent (last 6 or so years) debt creation wasn't more inflationary (obviously, other than real estate prices). Was it all absorbed in real estate and commodities? I doubt it, which leads one to look at such things as education and health care costs, luxuries such as travel.
There were obviously increases in the total numbers of people employed, but no real per capita increase in wages, so it stands to reason that the money created by debt went somewhere else, namely those things I mentioned and to the very wealthy responsible for the debt creation itself.
Posted by AvUWS
Mon Dec 1st, 2008 01:42 PM
Inflation was not the same for everyone over the last 10 years. If you lived in the mid-west your cars still cost 25-35k and your homes did not increase much in price (on a per/sqft, per/room-bathroom basis) and you probably could vacation to many places at a similar price.
On the other hand inflation for the well-to-do (rich!) was in double digits for most of the last decade (as high as 30% I think). In NY, real estate doubled, then doubled again, and in some spots, again. fancy hotels around the world jumped from $150-200 to $400-600 (for basic rooms). Luxury apartments (REAL luxury) started going north of $10 million dollars despite a large increase in supply. Bling of all kinds got really expensive ($2 million Bugatti Veyron? A Maybach starts to look modest in comparison). If you were rich you didn't fly first class anymore, just private jet.
Maybe we are lucky. Maybe a large portion of all that money sloshing about remained in the world of stratospheric money? The trick now is to disentangle the financial institutions we need for a real world from that money without them breaking.
Posted by Brian
Mon Dec 1st, 2008 01:57 PM
I agree with everything your saying, but you dont want the velocity of money to be to slow or to fast. To far to either side is not good.
Posted by faustus
Mon Dec 1st, 2008 02:13 PM
Brenda - the inflation over the past 7 years was monumental, but not across all assets. Our typical idea of inflation is higher food, clothing, car prices. The assets that experienced massive inflation were real estate, commodities and, yes, securities. I would also argue that the rapid increase in P/Es and the fall in yields is definitely an inflationary phenomenon. Assets that didn't experience inflation such as standard consumables were kept down in price largely due to (1) increases in productivity and (2) globalization, i.e., lower labor costs. By the way, the inflation was global to the extent that wages in emerging markets stretched to industrialized levels.
AvUWS has a very good point, which is that this last bout of hyperinflation hit among the relatively wealthy - in other words, the ones who REALLY benefited from easy access to capital. This would mean those closest to the flow of capital (wall street, etc) and those who held assets that saw such major appreciation (investors, shareholders, etc.). Hence the disproportionate impact on places like NYC.
Noah - as you know I have long pointed to the elimination of credit (effectively a reduction in velocity) as a defacto erasure of massive amounts of "money supply" for purposes of our discussions. I think that it is key to focus on velocity. My guess is that when velocity picks up, they will begin tightening, but whether that works or not is the big question.
Also, it's important to note that the TARP will not make its way into the system as loans as long as banks need it to maintain reserve requirements.
Posted by Noah
Mon Dec 1st, 2008 02:29 PM
Faustas - you make some excellent points. Yes, the funds for TARP people think are for loans, they are to recapitalize the banks during this destruction of toxic assets cycle, writedowns, and distressed balance sheets. Its not a standstill of course, but that money is for recapitalizing the surviving banks. Question is, is it enough? Some say no.
Also, if velocity increases and we see it in this multiplier, which asset class would you suspect to benefit the most? Stocks? Oil? Metals?
If anything, I would find that as a sign to get short the long end of the curve. I think that trade lives, but its way too early now.
Posted by RonPaulFan
Mon Dec 1st, 2008 03:05 PM
Noah,
We shouldn't have a central bank at all, and shouldn't have to have any conversations about the "velocity of money."
The only reason we have these discussions is because currently our money is created not as a store of value, but as debt. This is a critical distinction.
One of money's main functions is as a store of value -- I create a product and sell it to you for money, confident that I will be able to redeem that money with another person in the future, and that it will not go down in value between the time you hand it to me and I hand it over to the next person. Note that such money is only created *once the product or service has been delivered*.
Money now is created *as debt* -- you take out a car loan from a bank for $20,000, and the money is created right then and there -- the bank writes the $20K on their books, just like that.
Such as system is a ponzi scheme and cannot go on forever; it reaches its mathematical limits when people simply cannot take on any more debt. America is near or at that point now. Then the system collapses, as many fiat currencies have collapsed before.
I recommend this entertaining cartoon video to explain the difference between our current monetary system (money as debt) and our former and future monetary system (money as store of value, backed by hard assets:
http://www.youtube.com/watch?v=vVkFb26u9g8
Posted by Noah
Mon Dec 1st, 2008 03:19 PM
Its a scary ending to the story RonPaulFan! I know your a MISH fan, have to be.
So, your thoughts on gold? Parabolic in the end of this story? Or, delevered and a fools bet? Or, delevered and then parabolic?
I must admit, I own gold simply because of your comment above and the end of the story.
Posted by RonPaulFan
Mon Dec 1st, 2008 03:58 PM
Hi Noah,
It's a scary story indeed, I don't look forward to it at all. But this movie's been seen a hundred times before, including twice in this country, and fiat always fails. Here's the best essay I've ever seen explaining how and why, in case you or your readers are interested:
http://www.goldensextant.com/LLCPostings4.html
It may sound odd, but I think the most logical way to view monetary history over the past few hundred years is as a cycle of financial and political rulers conditioning a nation to forget about hard money and accept fiat; then it ends poorly and people learn the lesson the hard way. A couple of generations of prosperity pass, and the pro-fiat propaganda begins...and the cycle starts anew.
We're there now! Before Ron Paul's campaign, I'd say less than 1 out of 500 Americans understood the immorality of fiat currency. Now maybe it's one out of 50.
We're still screwed, but at least we're trying to get the message out.
Posted by EV
Mon Dec 1st, 2008 07:20 PM
OK-
So we all agree that the velocity is slowing down and to compensate that Fed will have to increase money supply. I don't understand the next stage of the argument when people start talking about debasing dollar or issues with Fiat currency. If we had gold, how would we increase money supply to fight economic slowdown/deflation?
Japan tried to increase money supply to combat this issue still yen is strong and getting stronger-why?
Posted by JB in NYC
Tue Dec 2nd, 2008 12:08 AM
Looking at the charts posted yesterday (Adjusted Monetary Base) and today (M1 Multiplier Effect) led me to wonder about how, 50-150 years into the future, historians, scientists, philosophers, teachers, economists, political leaders (benevolent and malevolent), etc., will view the post-WWII generation.
I think they'll be harsh - "Those baby boomers sucked out the earth's resources, conjured up an illusory, global financial system and then, just as they approached retirement age, blew it all up via recklessly hyped debt securitization and manipulative, speculative derivative trading."
Greed became a virtue and excessive consumption became an aspirational goal. Our heirs will pay for it and they're not going to like it.
Where will the inflation reckoning hit?
Think $250 oil.
Posted by RonPaulFan
Tue Dec 2nd, 2008 01:27 AM
EV writes:
"I don't understand the next stage of the argument when people start talking about debasing dollar or issues with Fiat currency. If we had gold, how would we increase money supply to fight economic slowdown/deflation?"
With gold (or other hard asset-backed) currency, you would not have a secretive, small group of economists trying to pretend they knew the correct amount of money to allow in the system.
Instead, you would have the same system that allows us to avoid shortages and oversupply of shoes, soft drinks, cars, and lemon meringue pies: the free market. Rise or fall in prices of each of these products signal to entrepreneurs whether there is too much or too little of each, and the entrepreneurs increase or decrease their supply based on these market signals.
Money is a product that arises naturally in the marketplace, like shoes or soft drinks. There is no reason for government to regulate it at all, and when it attempts to do so, you get the same result that happened in the Soviet Union when central planners from Moscow (literally) tried to guess how many shoes a country of 250 million people would need: oversupply or, more often, shortages.
It is only in the ponzi scheme of a fiat currency that money must be immorally and artificially created by a central bank. If customers are allowed to find the best money in the marketplace, the way they are allowed to find the best shoes, cars, and soft drinks, there is no such thing as a "credit crunch," no such thing as inflation, and no such thing as a boom and bust cycle -- and certainly no such thing as the Great Depression.
There is a place for a financial industry, but the current one we have now is parasitical and much too large. Probably 4 out of 5 people currently employed in the financial industry will be engaged in producing products people actually want 10 years from now, post-collapse, instead of shifting paper around, paper that can only "gain value" under the immoral inflationary policies of a central bank.
Bring it on.
Posted by WelcomeDeflation
Sat Dec 6th, 2008 12:53 PM
Deflation is not a threat, like many so called "experts"-charlatans are trying to portray it in the media.
Deflation is good as it makes things more affordable and helps average person on the street who has seen his earnings decrease for decades now. The only people that benefit from CPI increases caused by monetary inflation are the bankers. Because they need people to take on more new debt to keep paying interest on the old debt. Once this pyramid stops growing, the banking cartel is in trouble. They can't make anymore money.
As far as economic growth is concerned it is not at all related to inflation. From 1866 to 1897 USA experienced regular deflation and economy consistently grew at 4%.
Posted by Noah
Sat Dec 6th, 2008 03:25 PM
you know, I agree welcomedeflation. Deflation is pure, it cleanses, it reverts, it normalizes.
Excellent perspective!
Posted by DavidB
Fri Dec 19th, 2008 01:24 AM
@Posted by JB in NYC | December 2, 2008 12:08 AM
I like to say the boomers literally squandered at least 5 generations of wealth. Their grandparents, their parents, theirs, their kids and their grandkids....SO FAR.
The so called enlightened generation is the most selfish generation ever and they're not even finished yet. They're getting to the age where the rest of the population, for the first time in their lives, will have to say no to them. It was tried in the '60's and look what happened.
I'm not looking forward to it. We could be heading for a world class, history shifting temper tantrum
Posted by Youri Carma
Fri Dec 19th, 2008 09:22 PM
Thoughts? You guys don't seem to be willing to adapt to the proposition that in fact both are possible at the same time so deflation and inflation going hand in hand. While the deflation is in fact a good guy,cause it's the markets correction on the too much inflated bubble, not the bad guy and inflation is the name of your enemy!
I hope you guys got your Weimar books in time from the bookstore before they are sold out at Christmas time cause that's the stuff you wonna read. An other booktip is " Dark Mission " from Hoagland (even if it's not truth it's an amazing fantastic story )
Posted by Youri Carma
Fri Dec 19th, 2008 10:01 PM
I had forgotten to add;
Youre completely right about " Slowing velocity leads to a negative multiplier effect while rising velocity leads to a positive multiplier effect" and it's very important too.
Cause if you look ad the Monetary Base you will have to combine this with the money velocity story thus getting the complete picture.
You can understand that a very low velocity combined with large money volume is an explosive powder speaking in terms of hyperinflation.
http://www.urbandigs.com/2008/11/is_ben_printing_money_or_not.html
Posted by Dan
Thu Mar 19th, 2009 01:11 PM
Great analysis. Based on the decrease in the velocity of money, it is obvious to anyone who fully understands the equation MV=PT, that even recent fed actions will not lead to the inflation most are expecting.
Posted by Vikram Gupta
Fri Mar 20th, 2009 07:20 AM
Noah - Thank-you for the great article. One question - why did you use M1 instead of M3? M3 is no longer published by the govt but has been tracked by private institutions to be $15TR.
It does seem like velocity of money is contracting due to consumers and businesses hoarding cash, and because credit is contracting. What do you think of the argument that there will be more velocity depending on who gets the gov't money? i.e. a low wage worker is more likely to spend than save because of barely being able to afford things as it is.
Also, deflation does seem very plausible, however, won't all this printing of money lead to hyper inflation once consumers and business settle down and velocity increases? If we are printing close to $5TR (my estimate), we are devaluing the currency by 25% (assuming velocity returns). Then the Fed's only option is to use combination of increasing interest rates and selling debt, correct?
Lastly, deflation seems increasingly likely to me now for the following reasons. I would love to hear your thoughts
- consumers are scared and hoarding cash. savings rates went from 0.3% to 5% over the last 3-4 months.
- Unemployment is increasing which means decreased spending
- Exports are slowing
- Banks are hoarding cash (and the consumer credit and commercial real estate shoes have yet to drop)
So despite the massive amount of money we are likely to print, it seems like velocity is pulling back dramatically, at least in the near-term. So my conclusions are
- near term deflation
- further reduced corporate profits due to decreasing demand, deflation, declining foreign demand.
- Short the market after the rally we are likely to have in the next few week
thoughts?
Posted by Michael Wolff
Tue Aug 24th, 2010 07:07 AM
The effect of deflation is mainly psychological. In the gasoline and oil industry, I see it every week. When the price of gasoline drops, the dealers stop making purchases, hoping the price continues to drop. When the price of gasoline starts rising, the dealers start making purchases in an attempt to buy before the price goes up. This aspect of our psychology has a profound effect on our economy. It's kind of like "Buying high and selling low." It's backwards, yet is the norm for most people. It's a little fear-based. That is what the Fed is more concerned about. Psychology is what is keeping prices up right now.