The debate over what comes next, inflation or deflation, has vexed economists for a couple of years now. Some see the promise of inflation in the vastly expanded money supply after the financial crisis. Others see deflation's shadow looming since that bulging money supply has failed to revive anemic spending levels. We say the outcome is all a matter of confidence, or its lack.
Monetary theory examines the fluid dynamics of money in an economy, analyzing its supply and demand and how it affects things like prices and employment. At a first glance, monetary theory is simple enough. It is basically explained by the following formula: over a given period of time, the value of all economic activity equals the value of the available money multiplied by the number of times that money changes hands.
So far, so good. But dig deeper and it soon becomes apparent that the individual elements of this formula – which defines the so-called quantitative theory of money – are a lot more complicated than they appear. Even the notion of money itself needs more clarity. But perhaps the most elusive concept in the formula relates to the number of times money changes hands over a given period of time. This is what economists call the "velocity of money."
The velocity of money can only be measured indirectly, deduced from the other elements of the formula. Moreover, the forces behind the velocity of money are various and often not well understood. For one thing, they generally belong to those "soft" but no less powerful factors of psychology and human behavior. This is rather frustrating since the velocity of money is an important cog in the mechanism that transforms newly created money into price inflation.
The vagaries surrounding the velocity of money are often simply ignored. The less troublesome approach, which assumes the velocity of money is constant, is usually taken. But the indirect evidence makes it clear that the velocity of money is indeed subject to long-term trends and large fluctuations. It does, in fact, change.
In the aftermath of the financial crisis, a massive drop in the velocity of money could be indirectly but palpably observed in the US and in Europe. This means that impact of the money created by the central banks to restart the various national economies somehow gradually faded. Thus, despite the printing presses running red-hot, there has been no massive upward pressure on prices, no surge in inflation despite the vastly increased money supply.
One explanation for the drop in the velocity of money is certainly the diminishing confidence people and businesses have in the economy. This leads to caution about spending, to hoarding cash instead of using it for private consumption or corporate investments. Obviously, greater confidence in the economy could reverse this economic entropy, which the slowing velocity of money reflects. In parallel, an improving economy would likely see upward price pressures starting to build. This is exactly the scenario the Federal Reserve would like to see unfold.
But confidence in the economy is not the only thing that drives this situation. The confidence people have in money itself, in its basic role as store of value, also influences the velocity of money. The less confident they are in the money they hold, the more quickly they will try to get rid of it. In a phase of hyperinflation, the velocity of money is extremely high since no one wants to hold cash – which loses its value by the hour. They prefer to exchange the cash against virtually anything.
So there is a dark side to an increase in the velocity of money that the Fed would so warmly welcome. If the cause is not renewed confidence in the economic prospects, but instead reflects a loss of confidence in money itself as store of value, we could return to a 1970s-style scenario with low growth, high unemployment and, despite these constraints, mounting price pressure.
Such a resolution would deliver a verdict – both Solomonic and Pyrrhic – on the debate between those who take the fading confidence in the economy as a sign of impending deflation and those who think the waning confidence in money as a store of value augurs that inflation is just around the corner. We are beginning to wonder whether both sides are right. Perhaps the debate's ultimate outcome will deserve that ugly description of a chronically sick economy: stagflation.
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