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April 12, 2010
By Tim
McMahon
Back in
1924, John Maynard Keynes
called gold a barbarous
relic. There is a thought
prevalent these days that
deflation is the new
barbarous relic.
In a speech
in November of
2002, Federal Reserve
chairman Ben Bernanke said,
“I believe that the chance of
significant deflation in the
United States in the foreseeable
future is extremely small… I am
confident that the Fed would
take whatever means necessary to
prevent significant deflation…
the effectiveness of
anti-deflation policy could be
significantly enhanced by
cooperation between the monetary
and fiscal authorities.”
He went on to say,
“the U.S. government has a
technology, called a printing
press (or, today, its electronic
equivalent), that allows it to
produce as many U.S. dollars as
it wishes at essentially no
cost.”
He
also referred to “Milton
Friedman’s famous helicopter
drop of money”
as a figurative method of
fighting deflation, which earned
him the nickname “helicopter
Ben”.
His point
was clear, the illustrious
Chairman of the Federal Reserve
says that deflation is unlikely…
but a mere seven years later the
country slipped into a
deflationary scenario. Of course
just as Bernanke predicted
the Fed pulled out all
the stops cranked up the
printing presses, issued a
trillion dollar “bailout” and
several months later the country
was back in inflationary
territory.
So perhaps Bernanke was
right… deflation was short lived
and simply the result of a
drastic contraction of the money
supply due to fear and rapidly
falling stock prices.
However, if
we look at two other factors you
might see the case for deflation
in a different light.
The first factor is the
velocity of money.
In addition to the actual
quantity of money available,
there is a concept call
“velocity”.
To
understand the “velocity of
money” you can look at a simple
model understood by every small
businessman. In business school
they call it turn-over.
The classic example of a
high turnover business is a
grocery store, especially the
vegetable section.
The average product in a
grocery store sits on the shelf
for a little over a week.
Vegetables and fruits
only last a few days, exotic
packaged foods might last
a couple of weeks but the
average is about 8 days.
This is high turnover.
The entire inventory
sells out and is replaced
approximately 50 times per year.
On the
opposite extreme is a car dealer
or yacht dealer.
Their inventory might
take a year or more to “turn
over”.
So you can see that high
turnover or high velocity
results in more transactions and
more economic activity.
In a larger
macro economic sense, on a
nationwide basis if you divide
the total Gross Domestic Product
(GDP) by the Money Supply (M1)
you get the Velocity of Money.
As we can see from the following
chart the velocity of money
climbed steadily from turn over
of just above six per year in
1994 through a high of just
under 10.5 in 2008.
As the economy heated up
people spent their money faster.
During
times of high inflation and
prosperity people don’t hang on
to their money very long, either
from fear of it’s losing value
or because they feel rich and
think they can spend to their
hearts content. During periods
of recession ( the gray bars on
the chart) the velocity of money
falls as people start saving and
conserving.
There was one break in
the steady ascent during the
2001 recession. It is
interesting to note that even
after the official recession
ended in 2002 it took several
years before the velocity of
money began climbing again.
But now we
see that people have slowed
their purchases as we entered a
longer recession and the money’s
velocity has once again fallen
to about 8.5.
So the first force
contradicting helicopter Ben’s
thesis is the velocity of money.
If people are saving more,
they are borrowing less and
spending less. So all that happens
is that people are paying down
debt and building their
reserves.
This does not “stimulate
the economy”
or
drive up prices, so it
reduces the government’s ability
to impact deflation.
The next
factor working against the
effectiveness of the
government’s fight against
deflation is the money
multiplier.
In a “Fractional Reserve”
system like the one in the U.S.,
banks are required to
keep a certain amount of
reserves
to cover withdrawals, but
it is not 100%, they can loan
out the rest.
For instance, if the reserve
requirement is 10% they can loan
out the other 90%.
So if Bank #1 gets $1000
in deposits it can loan out
$900, which theoretically goes
to bank #2 , which loans out 90%
of $900 or $810 which goes to
bank #3 and so on. This is the
“Money Multiplier”.
But what
happens if one (or all) of the
banks decides it isn’t prudent
to loan out the money and they
prefer to increase their
reserves instead? In that case,
the money multiplier
falls.
In the following chart we
can see that the M1 money
multiplier has actually fallen
steadily from just under 3x in
1990 to 1.5x in 2008 (in
contrast
to the velocity of money
which rose).
But in 2008 the money
multiplier plummeted to under
1x.
What does that mean? Any
kid can tell you, if you
multiply by 1 you get the same
number, no multiplication has
happened.
But if you multiply by
less than one, you end up with
less than you started with!
In other words, every
dollar the government is pumping
into the economy is ending up in
the banks and going nowhere!
It is not increasing the
money supply, it is not
multiplying, it is not creating
inflation.
It is going to boost the
balance sheets of the banks.
In
2002, at about the same time as
Bernanke was making his famous
helicopter speech, Robert
Prechter published a book
entitled “Conquer the Crash” in
which he made this exact
argument.
That when the tide turns
there is nothing the government
can do.
The combined forces of
the velocity of money and the
money multiplier are stronger
than the government’s printing
presses.
For more
info see:
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