The Dark Root Of Deflation

We would like to remind our readers of this formula for the Quantity Theory of Money:


Where M is the total money supply
V is the velocity of money

P is the general price level in a given country
Q is the price deflator

The Austrian view of M is that credit should be included as well as the conventional money supply measurements of M1, M2 etc.

The key to understanding present trends, is though the money supply part of M that central banks control has increased substantially in the past two years, the other part of M, the credit portion, has been shrinking with credit conditions becoming more restrictive.
We can recall all the government programs to date to try to stimulate credit use, but to date they have been unsuccessful and the trend continues to move away from borrowing.

Compounding the issue, V, the velocity of money has nosedived, particularly since the beginning of the recession.

As credit becomes more restrictive, illiquid assets such as housing and other real estate tend to drop in value first since they are typically financed rather than purchased outright from savings. In turn, this affects the perception of the consumer (approx. 70% of the US economy), who reacts by becoming more frugal and begins to save rather than spend discretionary funds. This affects the velocity of money, V. As V drops, with increasing consumer thriftiness, it reinforces an expectation of lower prices (with some exceptions). It is a rare condition to see V drop below 1 in an economy, and a major signal that strong deflationary forces are at work despite the best efforts of central bankers.

Can governments and their central banking partners do anything about V?

They can do very little as it reflects consumer sentiment.
It is possible for them to boost velocity, but the consequences of doing so may have some very nasty side effects.

They could:
a) send every tax payer a large refund to "stimulate" consumption. This very expensive proposition would have rapid negative effects in the bond market compounding the interest payment problem on the national debt.

b) they could, as at least one economist have proposed, put an expiry date on dollars issued or have them lose value after a certain date to force consumers to spend. This too would have unpleasant side effects as consumers would dump all available funds into tangible assets to attempt to preserve value.
This topic was discussed in an earlier blog post here.

 Either of these choices is complete, utter, insanity.

This does not mean that rational thought will prevail in desperate circumstances.

When we consider that Keynesian thought largely permeates the economic world, and that post modern thought is the philosophy that supports Keynesianism, we can conclude that such an irrational act by the G20 and their respective central banks is still in the realm of possibility.

These actions would lead potentially to severe inflation or even hyperinflation.

If, instead, the monetary authorities allow the market to do its work, through deflation and not manipulating interest rates artificially lower, eventually confidence will be restored and the dollar will be saved.  By this I am referring to the dollar as a store of value.

This, unfortunately, is not the present trend.

What the current Fed leadership is doing is attempting to inflate the money supply M, in hope that this will offset both shrinking credit and falling velocity.  This is what Dr. Antal Fekete refers to as "pushing on a string".  It is an ineffective policy.

The other issue with the Fed is the pursuit of ZIRP (zero interest rate policy) as Japan has done for the past 20 years.  Dr. Fekete refers to this as the Black Hole of Zero Interest.  It is his view, and mine, that this policy causes even greater deflation, the process in which wealth self destructs.  This is the current trend, toward a severe deflationary episode, and possible hyperdeflation, where the velocity of money approaches zero.

The only cure for either of these nasty monetary diseases, is to terminate money as debt (the fiat currency system) and restoration of confidence in money as a store of value - a gold standard.