What’s Inflation Got To Do With Goldilocks & Hamsters?

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  1. All of which ultimately shows up as the “good kind” of demand inflation.
  2. This scenario is called
  3. It has to be just right.
  4. This situation, barring a collapse in confidence in the currency that leads to hyperinflation, is like a hamster sprinting on a hamster wheel.
  5. The hamster can run as fast as it can, but it just won’t go anywhere.
  6. If economic growth is the goal,
  7. What

Originally posted on thepensivenugget.com

Inflation is a much used word that somehow evades all attempts at precise definition.

A commonly used one is provided by Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.

Which is just a long way of saying that inflation is always caused by an increase in the supply of money.

But is it that simple?

The Many Flavors Of Inflation

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Inflation comes in many forms, not least of which are food, asset price, currency value, and goods & services inflation.

Asset inflation is when demand for assets is high, causing people to bid up asset prices.

Currency inflation is when a currency falls in value, causing asset values to rise proportionally.

And finally, goods and services inflation is when demand for goods/services drives up their prices.

Asset price inflation is closely tied to currency value inflation, since asset values are expressed in terms of the domestic currency.

This means that when asset prices increase, they do so relative to the domestic currency. A good example of asset inflation would be the large rise in residential property prices in the US housing market going into 2008.

This appreciation can broadly be attributed to two factors:

1) Asset Price Inflation: The US housing market was in a generational bull market with strong demand for houses for dwelling, investment, and speculative purposes.

2) Currency Value Inflation: The USD was in a bear market going into 2008, with investors preferring to swap their dollars for higher yielding assets; no one really wanted to hold on to dollars. The weak USD meant that assets, when priced in dollars, had higher nominal prices.

Monetary policy has the potential to affect asset and currency inflation, because modern central banks execute their policies by influencing interest rates.

This may affect the cost of financing for assets, and thus their prices, while simultaneously changing the yield on holding the domestic currency, hence demand for it.

What Is “Good” Inflation?

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Goods & Services Inflation works like asset price inflation, except that it pertains to goods and services that are not seen as investments in the way “assets” are.

This is important because if goods and services inflation is broad based and present in both essential and non-essential goods/services, this could* be a result of an economy that is growing robustly.

This is what economists call rising aggregate demand, and is a result of the type of economic growth that central banks are trying to engender through their monetary policies.

It leads to higher disposable income, then higher consumer spending which feeds back into corporate profits and expansion, bringing more people into the labor force in a virtuous cycle.

All of which ultimately shows up as the “good kind” of demand inflation.

“Good” because the virtuous cycle mentioned above is a rising tide that lifts all boats. Incomes across the general population increase, labor force participation is high and unemployment low, and general living standards improve.

In other words, it’s the kind of economy that we all want.

Every instance of “non-standard” monetary policy implemented by central banks over the last decade (last two decades for the Bank of Japan), has been in pursuit of the “good kind” of inflation.

Unfortunately, all it has brought so far is asset and currency inflation, with little in the way of healthy goods and services inflation.

*A collapse in the domestic currency’s value would cause the same kind of broad based inflation, but be really bad for the economy — think Venezuela.

Can Money Run? Introducing Money Velocity

How fast can money run? Fast enough to destroy an economy.

Paradoxically, also slow enough to destroy an economy.

But what exactly is money velocity?

There’s nothing complicated to the fancy term actually, it is simply how quickly money changes hands in an economy.

Imagine You Were A Dollar

Here’s a simple illustration:

Imagine that you’re a dollar in the system. Someone takes you out of their pocket to pay for a can of coke, you end up in someone else’s pocket. This new person takes you out to pay for some bread, again you change hands, but this time you end up spending the night in a piggy bank.

You (or rather, the dollar), changed hands twice in one day.

Next consider a scenario where the dollar changes hands five times a day. This could be as it was used by different people for breakfast, lunch, coffee, dinner, then a beer at a bar. The dollar definitely worked harder here, but it still seems like a pretty manageable day.

Inflation, Deflation, And Goldilocks

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Now imagine the dollar changes hands 100 times in the same day.

In terms of our hypothetical scenario that’s a lot of people buying a lot of meals, all in 24 hours!

This scenario is what happens in hyperinflation, and is a result of incredible fear that the value of the dollar would depreciate by the hour. Anecdotes from the Weimar hyperinflation about bread prices skyrocketing within the span of a single day are a good example of this.

So if someone ever riddles you with, “When is it cheaper to board the bus in the morning than at night?” The answer is: When money velocity is way too high!

Finally, consider a scenario where the dollar only changes hands once a day. Someone takes it out of their pocket to pay for breakfast, after which the dollar sits in a cash register for the rest of the day.

Obviously things aren’t going well here either, because people are not spending.

This scenario is called deflation, where people simply refuse to spend.

Deflation is a very different beast compared to hyperinflation, and is often caused by multiple factors.

These could include economic shocks due to internal or external factors, a currency that is too strong relative to its peers, a currency that is pegged to a currency that is too strong, and/or a lack of meaningful money supply growth.

In general however, deflation can be attributed to a lack of confidence in future economic prospects.

When people are not confident in their ability to find consistent work (as opposed to hourly contractual work), work with meaningful compensation, or for that matter any kind of work, their natural reaction is to slash their spending.

Money then begins to flow through the economy at a slower pace, and prices for various goods and services fall in response to the drop in consumer demand.

If this carries on for long enough, producers can no longer supply their goods/services at a profit and begin to shut up shop, which can perpetuate the deflationary cycle, wreaking economic havoc.

Turns out that money velocity is one of those Goldilocks things; too hot and it burns, too cold and it turns.

It has to be just right.

The Monetary Hamster (And Wheel)

As such, the impact of money on inflation arises from the interplay between money supply and money velocity. One component on its own really isn’t enough to provide the economy with the impetus needed for growth.

Consider a situation where only money supply increases, and money velocity remains low. We know that an increase in money supply is an increase in bank loans (not reserves).

However, if banks are busy making new loans but no one in the broader economy is willing to spend the money created from these loans, nothing really changes.

All that happens is a bunch of newly created loans end up sitting on businesses’ balance sheets accruing interest, waiting to be repaid (and thus destroyed).

Consequently, money velocity must also rise; that is, people in the broader economy must be willing to spend money. Without the impetus of spending, money that is created but doesn’t move around the economy is not inflationary.

On the other extreme is a situation where no money is created but people can’t stop spending money, i.e. money velocity is high.

This situation, barring a collapse in confidence in the currency that leads to hyperinflation, is like a hamster sprinting on a hamster wheel.

The hamster can run as fast as it can, but it just won’t go anywhere.

Likewise, money can run really rapidly, and in doing so create some degree of inflation, but not really enough (again, barring the hyperinflationary scenario).

As long as the banking system is not making new loans, money velocity alone cannot create growth and the “good” inflation that comes with it. Therefore, money supply growth is what gets money velocity off the hamster wheel. Likewise, money velocity is what gets money supply growth off balance sheets and into the economy.

If economic growth is the goal, both must work together.

Of course, when growth in both money supply and money velocity is taken to the extreme, an economy can be driven into a hyperinflationary spiral.

The best and most extreme example of this is of course the Weimar hyperinflation, where indiscriminate government printing led to the population’s loss of faith in, and subsequent refusal to hold onto the currency.

Therefore, some degree of balance is required even when trying to stimulate economic growth by influencing growth in money supply and velocity. This would explain policymakers’, and some mainstream commentators’ concern over the size of the US government’s trillions in fiscal stimulus over the course of the pandemic.

The Hamster Is Not Running Quickly… At All

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Unfortunately for them, not only have they overestimated the efficacy of fiscal stimulus to households, they have also misunderstood the nature of QE (it does not work).

To top it all off, here’s a chart of M1 and M2 velocity in the USA:

M1 Money velocity has been falling pretty much unabated since the Great Financial Crisis (and M2 even longer). That’s 13 years now, with velocity hitting an at least 40 year low post Covid.

Inflation from an overheating economy really shouldn’t be the worry now, should it? Because clearly, from a monetary standpoint, inflation is a non-starter.

Granted, this isn’t comforting for the great number of people who have to pay more for food, fuel, and other necessities, but it does point us in the right direction.

And that’s NOT towards the Fed.

As much as conventional thinking likes to picture the Fed as omnipotent, the Fed can’t really influence or control how much suppliers produce. And they definitely can’t control what happens (or doesn’t happen) in snarled up global supply chains.

In other words, QE has little, if anything to do with our current bout of inflation. It simply doesn’t matter because it doesn’t work.

What does matter however, is the fact that money velocity is so low and prices so high.

That’s a recipe for disaster, a.k.a Stagflation. Which is an article for another day.