Sunday, December 28, 2008

Money---Supply, Velocity, and Loss of

We all know that the money supply has been increasing, and many have been surprised at the decline in prices that has accompanied the recent "growth" of the money supply. We all know that inflation is a monetary phenomenon, Right? Yes that is right, but lets take a closer look at what is happening with the money supply and the velocity of money. If inflation is a monetary phenomenon and money supply is increasing, why aren't we already seeing inflation? During the time that the money supply has been growing the velocity of money has been declining---at an alarming rate. Why has the velocity declined. Financial innovations---such as those nasty Collateralized Debt Obligations (CDO's) increased the velocity of money. These innovations were "productively" increasing the velocity of money when they were created and when all was well with their value. As the credit crisis evolved--we had to unwind all of the "productivity" that was gained through the use of these "darling turned ugly duckling instruments". This unwind took its toll on the velocity of money and the real damage will be the unseen damage that is yet to come. What unseen damage? The damage that will be done as the velocity of money declines as these instruments are "cleaned up". The decline in velocity caused by the unwind of these instruments has contributed to the false sense of "deflation" that has gotten so much attention from many "talking heads" lately. We know, through both common sense and historical numbers that the velocity of money declines during recessions---sometimes sharply. During a NORMAL economic cycle, the decrease in velocity would be normal as central banks would increase the money supply, get the economy going again and then the velocity would again rise.

This credit crisis was anything but normal---in fact I would argue that we have not seen a normal cycle since the Greenspan era began. So why is this time different? Because we are going to overshoot to the downside of velocity? Does consumer confidence contribute to the velocity? You bet it does. If consumers are afraid they will spend less which have a contraction effect. Now stay with me---I know I sound like I am contradicting myself. You may say, Ok if velocity goes down more than normal this time--SO WHAT? Well the more it goes down, the more we will increase the money supply without seeing the effect of inflation. BUT VELOCITY WILL RETURN TO ITS MEAN. IT WILL NORMALIZE---AND THEN IT WILL BE IMPACTING A MUCH LARGER SUPPLY OF MONEY.

What is worse, we are going to see an unprecedented combination of the concurrently falling dollar and falling velocity. Let me give a simplified example to show why I think this phenomenon is going to cause our markets turmoil in the near future. We know that when the money supply is increased more dollars are chasing finite numbers of goods and hence we have inflation. Assuming the exact same numbers of goods, you can create more money supply and not have inflation if the velocity of money decreases. As a matter of fact, the decrease in velocity is EXACTLY what has caused the recent decline in prices. It is just not that simple. The money supply has increased and as our dollar falls in value, we are going to see demand for our goods and services increase. Right now this is not the case as all we can hear about are layoffs and the next impending manufacturing crisis. But it is going to be the case as our exports increase.

So as we increase our exports, we will increase the velocity of money. Balance sheets of companies will improve and the banks will begin to lend money. And then those CDO's---you know the ones that have been virtually written down to zero on most of the banks balance sheets--might wind up having value again. Say it ain't so--you mean WRITE UPS after all we have heard about since the sub-prime debacle began has been write downs. Yes, it is entirely possible. And what happens at that juncture? Further increase in velocity of money. MORE INFLATION.

We definitely have a false sense that inflation is going to be contained. We don't have inflation right now---but just as fast as we paid the price for living in excess during the past decades--we will pay for the inflation that is to come. During the summer when oil prices were increasing so rapidly, I had an interesting conversation with a friend that owns an oil distributorship and convenience stores. I asked him if he was rolling in the dough with high gas prices and seemingly endless demand. He was so disturbed as he explained that gasoline prices were increasing so fast that by the time he could sell one "load" it was costing him the profits on that load just to put another load in the ground. I see many U.S. corporation getting caught in this trap in the future. Sales might be great, but if you have to keep pumping all or more of your profits in to your next round of inventory, it is very very hard to make a profit.

I bought SRS on Friday as I just can't see anything good in the future for commercial real estate. Retailers are in trouble and rental rates are most certainly going lower---if not going away for many of the commercial real estate companies. At the time of this writing, the futures are down and I expect light volumes through the week and perhaps even into the new year. Gold is up in overseas trade and I expect it to hit $1000 in the very near future.


Anonymous said...

We aren't going to see a pick up in exports. We aren't going to see a pickup in inflation either. And, we aren't going to see a falling dollar. The dollar is in the process of putting in a long term bottom.