Money supply growth – ignore it at your peril

As mentioned in a previous post, the Fed decided in early 2006 to kill the M3 measure of the money supply. It is difficult to measure money and costly however scrapping broad money measures is tantamount to saying that money supply growth doesn’t matter.

The monetarist view of economics says that the Money supply (M) multiplied by the Velocity of money (V) equals the economies total production or Price (P) multiplied by the total number of transactions (T). MV = PT. Milton Friedman first brought monetarism on the map and won a Nobel prize.

If M increases and V is constant then, unless the number of transactions increases by the same rate as the money supply, prices will increase.

What we have seen over the last decade is enormous growth in the money supply. What we are seeing now is money being poured into the system hand over fist to save the banks. More money with the same level of supply will impact inflation unless the velocity of money falls. There are good reasons why the velocity of money may fall – typically it does react to the business cycle.

The major fear that I have is that with all the work being done on the money supply side that this feeds through to inflation and that we move into a recession with inflation rising. All the ingredients are in place for a sever period of stagflation. Note that we already have negative real interest rates – i.e. the interest rate that you receive for your money is less than the inflation rate thereby leading to a real reduction in your money’s spending power.

This morning we heard a call for tax cuts from Nick Clegg the Liberal leader in the UK. This I believe is important but it does not address the economies supply side. Private sector supply will continue to decrease over the coming months and any increase in demand from consumers will lead through to prices. A far better solution would be for the Government to boost the supply in the economy by increasing expenditure on infrastructure projects. This is the classic Keynesian response to the situation.

This solution is not on the cards. Central banks and Governments are knee-jerking into a much more politically palatable short-term fix – pour money into the economy. This will make things worse.

Forget the Maastricht limits on borrowing and plan very significant expenditure on roads, schools and hospitals. Imagine what £500bn would do for the supply side of the economy.

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3 Responses so far »

  1. 1

    Gervas Douglas said,

    Boris Johnston would agree with your capital expenditure on infrastructure solution. However, this exacerbates the significant deficit already present in the UK and certain other countries. European countries are mostly saddled with bloated parasitic state structures – this would be an excellent opportunity to trim them.

  2. 2

    jimlove said,

    Trimming bloated Governments in time of recession is called suicide and would certainly lead to depression. A good opportunity to trim is when times are good.

  3. 3

    Darin Oliver said,

    I think it is clear that the Velocity of money is collapsing in front of everyone. However, as I stated in a previous post, I unclear as to which direction we end up in….inflation, stagflation or deflation…what I do see likely here in the US and probably elsewhere in the world is a transfer of debt from the private sector to the public sector. We created an enormous amount of debt in the world and one way or another, that debt needs either repayment or default – four are three ways to repay, austerity, inflation, default or some combination of these. Default is going on in the consumer and housing sectors in most of the western countries – and those losses are being absorbed through government transfer payments (i.e. debt) which will imply larger taxes, bigger government and more socialization in the future. Repayment is also happening, further depressing banks ability to lend to good credits and finally, we are inflating through monetary policy, but its unclear how this inflation will feed into the economy – its not likely to affect asset or commodity prices – yet…commodity prices might be one wild card.


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