It’s fashionable these days to be worried about deflation. And why not? Price levels are generally falling (with some awkward exceptions, like gold) and the economy is showing few if any signs of heating up. Me? I confess to being a bit worried about deflation – it’s a very bad thing, and price levels are more or less flat. But deep down I am more anxious about – inflation.
If worrying about inflation in today’s environment seems strange, consider this: Over the last two years the US monetary base has more than doubled. That’s right, the amount of money sloshing around out there – under mattresses, in banks, whatever – is more than twice what it was just two years ago.
And yet, prices are steady. And the politicians call for more monetary expansion. What is going on?
Well, when the monetary base goes up, and prices don’t, there is only one variable that tells the tale. The velocity of money: that is, the number of times the average dollar in the economy changes hands over the course of a year. The only way (in a free economy, and discounting productivity growth) for prices to stay put when the monetary base sky rockets is for the velocity of money to plummet.
Since the late unpleasantness in the financial markets, the velocity of money has declined substantially. And policymakers have responded accordingly, by putting new money into the system in an attempt to keep enough money changing hands between consumers and producers to keep the economy from contracting/deflating; indeed to try and goad it into a growth mode. And, frankly, I am not sure what else they should do. Still, by letting the monetary base explode, they have planted the seeds of the next great inflationary period.
When will that be? Well, while the timing is uncertain, the event – inflation – is as certain as death and taxes. Inflation will spike as soon as the velocity of money bounces back to historical norms. And the faster the return, i.e., the quicker the rebound when it happens, the bigger and faster the spike in prices will be.
So, whether you want the Fed to do more monetary easing – that is, to grow the monetary base more and faster – or you want the Fed to slow or stop the growth in the monetary base sooner rather than later, you should be glad you’re not the one on the hot seat. Because if you turn off the monetary spigot too fast and/or too soon, and the velocity of money stays low, there will indeed – there has to be – deflation. But if you keep the spigot open even a little too long, and/or the velocity of money snaps back to historic levels sooner or faster than expected (and no one has any good idea of when and how fast that will happen) you will find yourself with a potentially catastrophic bout of inflation. If you were Ben Bernanke, you probably couldn’t sleep at night….. Which is why I am glad I am not Ben Bernanke.