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.