Expert Commentary

The Collapse in Money Velocity and the Coming Deflation

The global economy has stopped and money is not being spent. This is a giant deflationary force.

The true definition of inflation is an expansion in the total supply of money and credit in an economy. The flipside of that is deflation, which is a contraction in the total supply of money and credit in an economy. Thanks to the intended policy of governments to classify deflation in a negative light in order for them to continually expand debt and print money, in doing so expanding the size of government in an economy, we have been conditioned to think of deflation as falling consumer prices. But that is just one element.

In the eighteenth century, John Stuart Mill expanded on David Hume's ideas and stated the "equation of exchange." Irving Fisher developed it further and it is the bedrock of the Quantity Theory of Money. The equation of exchange is:

MV=PQ

M stands for money. V is the velocity of money (the rate at which money is changing hands.) P is the general price level and Q stands for the quantity of goods and services produced.

What it means is that an economy's performance, as defined by its price-adjusted output (P x Q), is determined by the amount of money in the economy and the rate at which that money is circulated (M x V). It used to be assumed, using economists totally unrealistic "ceteris paribus" (all other things being equal) condition, that V was constant. As the first chart below shows, it is not.

The world is currently in a situation where V is collapsing thanks to the intentional shutdown of economies. Therefore, if central banks did nothing with M, there would be a catastrophic contraction in the economy (PQ). That is why the Fed and others are printing money out of thin air at an eye-popping, incredible rate. They know V is collapsing so they are trying to offset it. Many people believe that this historic money-printing by central banks will lead to higher consumer prices (P). But they forget about V. On a blog from 2014, the Federal Reserve Bank of St. Louis stated, "If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation."

The second chart below shows what happened to the velocity of money after the 1929 crash. When data for V is updated for this current period, we expect to see a similar decline. The question, of course, is will this large decline in the velocity of money persist? That is related to the psychology of deflation and is the subject of an upcoming column. Stay tuned to stay ahead of the coming deflation.

200324 - MG

200324 - MG2