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October 22, 2008

The Physics of Money

Money doesn't count unless it's in motion; that's why governments not only can but also feel that they must create great supplies of the stuff in these deflationary times. The good news is that all this new money isn't inflationary (at the moment); the bad news is that this new money so far isn't breaking the deflationary cycle because it's refusing to move.

A simplistic but not inaccurate view of inflation is that it occurs when too much money is chasing too few goods; deflation, of course, occurs when money is the scarce commodity and other goods – houses, say, or oil – are abundant. So how did we go from inflation to deflation so rapidly? Where did all the money go?

Basically, the money went into various mattresses; it stopped moving.

The definition of money is complex; it's much more than just cash. It's also the debt of governments and even private entities; it's the outstanding balance on your credit cards; it's lots of other stuff. But it only counts when it's in motion. Economists speak of the velocity of money; the number of times it changes hands (turns over) in a year. The effective money supply, the money supply which at any given moment is either too big or too small for the goods available, consists of the absolute money supply MULTIPLIED by the current velocity of money.

This is easier to think about if we pretend that money is just cash. Suppose that the 100 residents of an isolated village have a million dollars of cash in their economy. How much income, then, can each resident have? The answer depends on the velocity of that million dollars. If it turns over only once a year, then the mean income will be $10,000/resident. But, if the money turns over ten times a year, if each resident spends income almost as fast as he or she earns it, the mean income will be $100,000 since each dollar changed hands ten times and got counted as income ten times.

The faster we spend, the more money there is available in the economy. Money we put in our mattresses might as well not exist as far as the economy is concerned even though it may be very important to us. Money we put in the bank is USUALLY as good as spent economically because it gets lent to someone else who spends it. But these aren't usual times; if the bank doesn't relend the money, it might as well be in a mattress.

Banks aren't lending like they used to; we aren't spending like we used to. The velocity of our money supply has slowed to a crawl; that's how we moved from inflation to deflation; the money stopped going around.

Deflation causes (and is caused by) depressions. Governments rightly don't want depressions to happen on their watch, makes the citizens surly. So governments around the world are creating vast supplies of new money to counteract the fact that the money is moving slower. It's debatable (but not in this post) whether the money is being injected into the economies of the world at the right place to get it in motion; but there's no question that lots of new money is being deliberately created to fight deflation. Inflation isn't a concern because deflation is the problem. Governments want prices to stop falling so they're working to cheapen their currencies – backwards of what we're used to since inflation is what we usually worry about.

One danger in this deflation-fighting strategy is that it can lead to hyper-inflation. The absolute money supply is being increased; if it then goes into rapid motion, the effective money supply goes through the roof. Money will go into motion if people are afraid it's going to lose value; in that case they'd rather have goods so they start spending. Some of that is good to break the current deflationary cycle, a lot of spending with a bloated money supply ends up in a situation like Weimar Germany or Zimbabwe.

Aren't you glad you aren't running the Fed.


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