My Debt Discussion Continues (Velocity of Money) Important!!!
Chris wrote to me the following comment:
Debt is the biggest issue facing us all.
I found this video on YouTube which really opened my eyes to the importance of getting out of debt: http://www.youtube.com/watch?v=50bWUrKAbwU
I am sure you will be as amazed as I was.
Chris, sorry to disappoint you, but I was not amazed. Not because what he was saying was not true. In fact he is saying the truth, but the fact that he is misleading the truth. What he is saying about getting out of debt and the fractional banking system is not entirely correct because he is missing the rest of the equation.
If you are wondering about missing the rest of the equation, go to Wikipedia and search for Simon Newcomb. What he did in 1855 was quantify an equation on the quantity of money of money. Quite an important equation actually.
His equation was as follows
MV = PQ
This says that the money and its velocity is equal to the prices of their products and their quantity.
You might think, velocity of money, HUH? Velocity of money refers to the term of how often money is cycled. Think of it as how often a dollar bill exchanges hands. If the dollar bill exchanges hands many many times then you have a high velocity, and if not well then you have no velocity.
The velocity of money is the key to any functioning economy and that is what was missed in the great depression. The velocity of money collapsed. But the fact that we do have a velocity is what causing people to have an over-sensitivity to hyper-inflation. Let me explain the equation.
First let’s say you have a money supply of say 100 USD, and let’s say that your current velocity is 1. This means multiplying the money supply with 100, and 1 gets you 100.
Second let’s look at the right side, if the product quantity is 10, then to fulfill the equality of the equation the price of the products will be 10 (10 times 10 equals 100).
With fractional requirements you increase the velocity of money since that same dollar is being recycled more often. So to make the equation balance you need to alter the right side and assuming you have a constant consumption the price would equal 20.
Now assuming you believe it was this easy you would say, “but Christian this is hyper-inflation”, and indeed this is exactly what everybody is talking about. So I don’t argue that the equation is right, and don’t argue that we could have hyper-inflation, but here is where I disagree.
I don’t believe the consumption of goods will remain constant. In fact I believe that the consumption of goods will increase, if you can get other countries to consume. But to get them to consume you need them to spend and soak up the dollars that they need. For that to happen you need traders to move out of currencies and into commodities. And that has happened quite effectively. The result is that those commodity based countries will get the excess currencies and spend them. This in turn will result in jobs for the west because there will be increased trade.
This is why I do believe so long as there is more consumption inflation will have a hard tie since in the west there will be a lack of ability to pay for the higher prices. A sort of buffer against inflation will be created where the west will slow things down.
Now let’s take the opposite approach. Imagine for the moment that you reduce the money supply and the velocity. You know no debt, no nothing. Then to make the equation meet up you would have to reduce the number of products that are consumed or their prices.
And it is at this point a devils circle begins. Since you are forced to reduce quantity or prices you are forced to lay off people, and thus have less consumers, who will consume less. My point is that the equation is a very fine scale that could get tipped either way towards depression or inflation. It is the task of the central bank to control the money supply and velocity.
So I am not arguing for uncontrolled debt. I am arguing for controlled managed debt. Because without debt our world would be very very different. And I don’t think for the better.
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Christian,
In the US, there is a decrease in the total Money(+Credit) Supply. Despite Ben’s attempts at staving off deflation, printing press output has been a pittance in comparison to the amount of credit that has been destroyed.
Furthermore, velocity has also come to a halt with regards to new monies injected into the banks as they have no one to lend to (tighter restrictions + less ppl looking to borrow + defaults continuing when considering the correlation to jobs).
We are tipping towards Depression (despite efforts by Barak and Bernanke). The US central bank (FED) does not have control of the situation.
This ^^^ is the distinction I was looking for in the older post where you bashed Schiff and Taleb but was unable to find it.
Christian,
this is another good point…
China has been loading up on commodities recently. They are also in talks with many other foreign nations about accepting each other’s currency (just another factor in the “USD being dethroned as the world reserve” argument). So I agree that commodity producing nations will begin to see exports rise substantially and as commodities rise, wealth will increase. What I wonder though is where and how is that money going to be spent.
The US is in a deflationary spiral at the moment (see comment #1). Wages will not rise and much more likely fall. As a credit-based economy with a serious trade deficit, we will unfortunately not see our prices decline at the same rate. Factor in the decline of the US dollar as the reserve currency of choice, and the US is going to get squeezed HARD.
The problem I’m having is where to put my money. I’m thinking about just buying commodities on dips for the rest of the year.
Am I missing anything?
Bill I agree with you on basically all points. I guess we are not that far apart
Is the US in a deflationary spiral? Absolutely!!! Will the US fall into a depression? Not likely actually, and you can thank the global economy for that. The global players like GE, and McDonalds will keep things going in America.
How would I invest? I don’t like commodities, not because I don’t commodities but current investing techniques are actually bad. Current commodity ETF’s invest in futures and you are stuck with the future contract rollover issue. Thus you will loose money even if the contract goes up slightly.
My approach has been to focus on global economic players. I bought into Ford, GE, MDR, etc. These are global players that will benefit from the global economy. I as a rule DO NOT invest in any local player regardless of where they are registered (US, Canada or Europe).
I wonder, in the end, if it’s all about power? If I owe you, you have power over me. If you owe me, the reverse.
If you’re a small nation with massive natural resources, and you owe me a lot of money denominated in my currency …
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