Deflation Bubble Update: Debunking The Velocity Of Money Myth
Vancouver, Canada-The markets got off to a bad start Wednesday following the news that some members of the Federal Open Market Committee slipped the word “deflation” into the minutes of its last meeting, in December.
Thus, the media jumped all over the deflation theme. Although there was only one mention of “deflation” in the entire 6,000-plus word release, it prompted headlines like this one from MarketWatch: “FOMC Members Discussed Mounting Risks of Deflation, Depression at Mid-December Meeting.”
The stock markets crumbled. Most commodities fell. And even though the dollar fell, gold prices fell $24 on the Comex in response to all this noise Wednesday, while the gold stocks were among the worst performing sectors on the board. Recovery sentiment halted in its tracks as the deflation trade came back with a vengeance. Of course, I’ve been more cautiously bullish with gold prices approaching the resistance points controlling their intermediate downtrend. But my reasoning is that the reflation trade will win out and drive up both stocks and commodities broadly, at gold’s expense, but only short term.
The bulk of the evidence supports this trade, but it has ebbed a little this week because of the news flow – none of which says anything new about the prospects of “deflation” in the Fisherine sense of a liquidation of debts and contraction in deposits. It was just more of the same drivel about falling prices and the shrinking economy, profits and employment, with commentators dragging in long-discredited concepts like velocity of money, the multiplier or even Japan’s alleged deflation during the ’90s.
Of course, as with any other “bubble” – if I am right to call it that – it implies an extent of irrational exuberance or popular delusion, and then there is the sustainability feature… bubbles simply don’t last.
In the reader comment section in response to the MarketWatch report on the minutes of the FOMC, there were example after example illustrating that people believe deflation is caused by a slowing in the economy; rising unemployment; or falling wages and prices, including asset prices… or that deflation is bad; or saving is bad; or deflation existed throughout the ’30s, despite the Fed’s efforts.
I have already dealt with most of these misunderstandings in past issues. My influence must be waning, because they’re not fading away!
Now let me take this opportunity to emphasize something. I do not mean to seem stubbornly fixed to the inflation paradigm. I’m not, in fact. I worry about the deflation possibility. I am always considering new facts and old premises as part of an analytical check to my evolving outlook. My recent tirade is not against the “possibility” of deflation – which cannot be denied. It is a reaction to the nonsense that underlies the great many bad arguments for deflation, which are either littered with factual errors about history or rely on theoretical concepts that are outdated, obsolete and have been long discredited.
The best argument for deflation, given the current monetary system, is if central banks decide that they want to take liquidity out of the system one day (i.e., run a deliberate deflation policy) or be serious enough about fighting inflation, they might overshoot. But no one is making this case.
Unlike the period 1929-33, central banks today can print “reserves” up. You can see this yourself.
There is nothing much to check this process but the will of the populace or the prudence exercised by politicians. The original deflationist, Irving Fisher, made sure of that. He scared America off the gold standard much like the deflation calls of the day have scared the Fed into ballooning its balance sheet!
Speaking of Fisher, I want to deal with one of the most ancient nonsensical theories about money that underpins the deflation scare today: the “velocity of money,” a concept that Fisher himself resurrected.
According to proponents, an increase in money supply doesn’t necessarily mean that money will lose its purchasing power if the velocity of circulation slows down, which happens if people don’t spend.
David Rosenberg, Merrill Lynch’s chief economist, recently put it this way:
“Money supply will increase, but money velocity will not. We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline.” [Emphasis added.]
And in a segment on CNBC Wednesday discussing the grave threat of deflation, Art Cashin said:
“Even if you walked over and gave somebody a trillion dollars and they either put it in the mattress or just in their pocket, it doesn’t help the economy. You need the velocity of money to move. You gonna give people money, they gotta go out and begin to use it. And we’re seeing some of that worry coming home to roost here in the market today. We saw Intel…” [Emphasis added.]
With people like this, big credentials and all, promoting such ideas, it’s no wonder the deflation scare has teeth, even though it can’t bite through the flesh. Contrast their words with those of former Wall Street Journal reporter and economist Henry Hazlitt, who brought the Austrian School to America:
“Monetary theory would gain immensely if the concept of an independent or causal velocity of circulation were completely abandoned. The valuation approach, and the cash holdings approach, are sufficient to explain the problems involved.”
Hazlitt wrote that in 1968 in an essay in which he demolished the velocity of money notion.
Simply put, the idea “refers to the rate at which money circulates, changes hands or turns over.” It is a very old idea, harking back to the days when the “mechanistic quantity theory” of money predominated. That is, before we understood how individual judgments determined value, this concept of velocity explained variations in the value of money that were out of proportion with the variations in its supply. Under the mechanistic quantity theory, such changes were to be proportional.
Fisher adopted the idea of velocity in his dubious formulation MV=PT (where M is the supply of money, V is its velocity of circulation, P is the general price level and T is the volume of trade).
Both the mechanistic quantity theory and Fisher’s equation have long since been refuted. No credible economist takes either of them seriously. But the idea of the velocity of money has survived, nevertheless, and today it’s a pain in the neck. Hazlitt’s insights were as follows.
First, as far as Fisher’s equation goes, velocity (V) is not an independent variable. It is always exactly equal to the volume of trade T, and is driven by trade, not vice versa – it does not drive trade:
“What we have to deal with, in the so-called circulation of money, is the exchange of money against goods. Therefore, V and T cannot be separated. Insofar as there is a causal relation, it is the volume of trade which determines the velocity of circulation of money, rather than the other way around… the velocity of circulation of money is, so to speak, merely the velocity of circulation of goods and services looked at from the other side. If the volume of trade increases, the velocity of circulation of money, other things being equal, must increase, and vice versa.”
Changes in the velocity of circulation are thus the effect, and not the cause, of changes in the demand for money and/or goods. The concept is a makeshift explanation for the factors affecting the demand for money. For example, if the price level did not change in direct proportion to the money supply, the “Fisherine quantity theorists” would explain it with reference to changes in the velocity of circulation.
Yet the statistic has no more bearing on the value of money (its purchasing power) than the concept of “inventory turnover” has on the price of the individual units of inventory. It cannot cause anything.
Second, as Ludwig von Mises explained, money doesn’t really circulate at all. Nor is it idle. It is always in someone’s possession, but ready to be exchanged (or used). It only spends a fraction of the time changing hands – i.e., without an owner. And when it is exchanged, someone else wants it for the same reason: to keep on hand for future use. It does not simply circulate on its own, as if by some unexplained force, and especially not independent of human judgments of value or expressions of the demand for money, as von Mises pointed out in his famous treatise Human Action:
“The service that money renders does not consist in its turnover. It consists in its being ready in cash holdings for any future use. The main deficiency of the velocity of circulation concept is that it does not start from the actions of individuals, but looks at the problem from the angle of the whole economic system. This concept in itself is a vicious mode of approaching the problem of prices and purchasing power. It is assumed that, other things being equal, prices must change in proportion to the changes occurring in the total supply of money available.”
Third, neither does velocity measure the willingness of people to hold or get rid of their cash, because for everyone who is rendering their cash, someone is taking it, so that at all times, Hazlitt tells us:
“Average individual cash holding must always be the total supply of money outstanding divided by the population… People who are more eager to buy goods, or more eager to get rid of money, will buy faster or sooner. But this will mean that V increases, when it does increase, because the relative value of money is falling or is expected to fall. It will not mean that the value of money is falling, or prices of goods rising, because V has increased… It is the changed valuation by individuals of either goods or money or both that causes the increased velocity of circulation as well as the price rise. The increased velocity of circulation, in other words, is largely a passive factor in the situation.”
He did find, however, that increases in money velocity corresponded with periods of intensifying speculation, whether that speculation was a bullish or bearish extreme. That is, this velocity has no directional significance even as a byproduct – it was just as likely to rise with too much speculation on the bearish side as on the bullish side. Consequently, since it is tied to the volume of speculation and trade, “velocity of circulation cannot fluctuate for long beyond a comparatively narrow range.”
In summary, I am not saying deflation is impossible – only that if the Fed is inflating, we’ll have inflation.
This truth is so simple that it is bewildering to see so many people take the other side of that bet. It is a testament to the effectiveness of the Fed’s propaganda campaign that the deflation argument tends to recruit some of its otherwise potentially most ardent critics.
Keep your eye on the ball, and in the end, you will see that the deflation bogeyman is just that – a myth – used by politicians and central bankers to fear monger the masses into allowing them to inflate.
It has never been anything more.
Irving Fisher was one of its earliest authors, and it was he who lobbied for creation of the Fed, and advised the subsequent abandonment of the gold standard. Certainly, there is no precedent for what the Fed is doing today, but that by itself is no reason to summon the deflation bogeyman.
As for why the reserves the Fed is creating have not been multiplied, the answer is simple: Interest rates are too low! If you fixed the price of oil at 50 cents per barrel, supply would run out quick too.
for The Daily Reckoning
January 14, 2009
Before starting up Gold & Options Trader, Ed comes straight from the North American heart of the gold market – Vancouver’s Howe Street. During the nasty commodity bear market in the ’90s, Ed still guided his clients to gold profits in Argentina Gold and Arequipa, both of which became buyout bait for Barrick. He also founded the “Bugos Gold Stock Index” which included no more than 10 stocks at any time.
Give us Madoff! Give us Madoff!
“Oil rises to $39 on Bernanke comments…”
“Asian stocks rise after Bernanke remarks…”
When they turned out the lights and closed the doors in New York last night, the Dow had lost 25 points and oil had gone down to $37.
But this morning, investors seem to be feeling better about things. What did Bernanke say to bring about the turnaround?
We find the report on the front page of the International Herald Tribune:
“More capital injections and guarantees may become necessary to ensure stability and the normalization of credit markers,” said the main man at the Fed, speaking to an audience at the London School of Economics.
He went on to say that he didn’t necessarily like bailing out Wall Street, but it “appears unavoidable.”
Nothing particularly exciting about that. But then we turn to page 12:
“Bernanke warns that bigger bailouts needed around the world,” is the money headline.
And then, the report gets down to business. The world economy is dangerously ill, says Dr. Bernanke, or words to that effect. We’re going to have to try some experimental drugs to rescue it.
“Beyond buying troubled assets from banks, Bernanke said, another option was to provide asset guarantees under which the government would absorb part of the banks’ losses in exchange for warrants and other forms of compensation. [Of course, if the banks had any means of compensating investors they wouldn’t be in this fix.]…
“Bernanke also expressed support for the idea of creating a so-called bad bank that would allow the government to buy financial assets in exchange for cash or equity.”
Here is where we laughed so hard we thought we might damage our midriff.
Create a ‘bad bank?’ Is he kidding? The world’s full of bad banks already – banks that did just what Bernanke is proposing to do; they bought financial assets, notably mortgage market derivatives, for cash. Now, they turn to the taxpayer, desperate for a handout to keep them from going under.
And the baddest bank of all? Next to the Central Bank of Zimbabwe it’s the U.S. Fed. What’s it doing? It’s buying trash and paying cash. In this way, the mistakes of rich bankers are transferred to the people…via the people’s bank – the Fed. Of course, the people don’t know what’s going on. And they won’t notice either when the Fed eventually unloads these toxic assets – in the dark of night.
We have not checked the gold market this morning. Yesterday, gold held steady at $820 and appeared ready to drop into the $700 range. If gold doesn’t go up this morning investors are not paying attention.
Let’s go back over the fundamentals. The world economy is correcting. The feds are trying to stop it. They tried their Friedmanite monetary stimulation – cutting rates to zero. And they’re sweating like Sisyphus, trying to make Keynes’ fiscal stimulus work too.
Both will fail – for the reasons we explained in these Daily Reckonings. You can’t help an alcoholic by giving him free hooch. And you don’t do a fat man any good by offering him another dessert.
If America’s leaders are going to have any success at all, they have to understand the game they’re playing…and turn to someone for leadership who knows a queen from a one-eyed jack…someone who keeps an ace up his sleeve, just in case. America needs better leadership; not these clueless jokers – Bernanke and Paulson. America is blowing up a bubble in public finance; it needs someone who understands how the public finance system works.
America needs Bernie Madoff. Reports tell us that Madoff has not been arrested. He is at home, apparently watching the news on TV and waiting to hear from the gendarmes.
Why not take advantage of his free time? Why not ask him to do some community service?
*** Colleague Chris Mayer sends us this note about what has already been penned the “Indian Enron”:
“Turns out Satyam Computer cooked its books. (Satyam, ironically, means ‘truth’ in Sanskrit). That $1.1 billion in cash on the balance sheet? Well, it really turned out to be $66 million. Those operating profits of $133 million? Uh…make that $12.6 million.
“When it rains, it pours. Another blow to the already bludgeoned Indian market.
“I visited Satyam in Hyderabad during my trip in India in 2007. Nice campus. Business seemed OK. But I never like those sorts of things for investing. Basically, they provide people on the cheap. I don’t know. It’s my own bias, but I like to own stuff. Where is the copper mine?
“I remember one of the executives complimented my sunglasses. ‘I admire your choice in sunglasses,’ he said to me. ‘Wayfarers. Once you have them, you can never go back to anything else.’ I smiled politely. Mine were knockoffs. Maybe his comment was a red flag of some kind.
“What is disturbing about Satyam is the main perpetrator was the founder of the company. B. Ramalinga Raju founded Satyam in 1987. He had many admirers. And PricewaterhouseCoopers audited the books. How could it miss $1 billion in cash that wasn’t there?
“Unfortunately, there was not much investors could’ve done in this instance. This one fooled everybody. When I was in banking, we put a lot of stock in the character of the borrower. And as an investor, I value a good owner-operator. Satyam is a reminder that there is no bulletproof way to avoid occasionally finding a bad egg.
“Having said that, I wouldn’t let the Satyam affair tarnish the whole Indian market. There are still good opportunities there, as I wrote about in my last letter to my Capital & Crisis subscribers.”
*** In a broad sense, the social welfare economies of all the advanced Western nations are nothing more than Ponzi schemes. Typical is the Social Security system of the United States of America. It survives only as long as there are enough new contributors to cover the promises made to the old ones. As in any Ponzi scheme, the first ones into the system do very well. The very first beneficiaries put in little and got a lot out – depending on how long they lived. But as time goes by, the deal goes bad. Middle-aged people today would be better off with a private pension system…and the young are unlikely to see any benefits at all.
John Law never lived to see America’s system of public finance at work. Nor did Charles Ponzi. But even without a paternity test, each would have recognized it as his own.
Bernie Madoff is still alive as of this writing. He is the world’s reigning champion…title holder in the Ponzi league. Yet, compared to America’s system of public finance, his scheme was penny ante…chickenfeed. Madoff’s swindle cost investors only about $50 billion. America’s dollar swindle will cost them trillions.
The nature of the scheme is most easily understood by looking forward rather than backward. President Obama announced last week that Americans faced “trillion dollar deficits for years to come.” Already, the estimate of the deficit for 2009 was $1.18 trillion. Some experts predict a deficit over $2 trillion. At least one guesses that it will come in over $3 trillion, if not in 2009 then the following year.
These huge deficits do not seem to disturb the sleep of the homeland bound citizens. A trillion-dollar annual deficit, over 5 years, would add about $50,000 to each family’s burden of debt. But some intuition assures Americans that they will never have to pay it. By instinct alone, they know it’s a Ponzi scheme.
The day is long past when Americans could say “we owe it to ourselves.” A large part of U.S. borrowing is taken up foreigners. There is no way these enormous deficits could be financed by domestic savings. The foreigners have to pony up the dough, or the United States will run out of money. They do so in the hope of getting the money back – with interest. But how can the United States pay back the money it borrows? It has no earnings. It has no surpluses. Instead, it must borrow more to service past borrowings. It must depend on bad money to come in so the good money can go back out. It is a scheme John Law would love; Ponzi would be proud of; and Bernie Madoff can operate.
As we write nothing is more remarkable than the credulity and gullibility of the world’s patsies. Bernie Madoff’s oldest friends would come up to him and practically beg him to take their trust funds. People joined his Palm Beach country club just so to get close enough so he could separate them from their money.
And now, investors practically stumble over one another in their eagerness to lend money to world’s biggest debtor. In all the astonishing figures now crossing the big board probably none is more amazing that the current yield on U.S. Treasury paper. At barely over 2% yield on 10-year notes, investors lend money to the feds and ask nothing in return…except their money back.
Of course, every Ponzi scheme must end. And the scheme of U.S. public finance is already reaching its conclusion. As we write, lenders have still not wised up. But they’ve gotten poorer.
Two of today’s headlines from Bloomberg tell the tale:
“China’s exports decline most in a decade…”
“Trade deficit narrows…”
Trenton no longer takes. So Tianjin no longer makes. And Tianjin’s entrepreneurs no longer turn up at the central bank with piles of dollars to exchange for yuan. Which leaves China’s central bank with fewer dollars to buy up U.S. Treasury debt.
The whole system is breaking down. Most likely, it cannot be repaired. But at least Bernie Madoff will know what to do when the end comes.
The Daily Reckoning