The Deleveraging Recession

Debt, Deflation and the Velocity of Money

monetary policies debt qe deflation

19 Dec 2013

QE, The Inflation Scare, and the Velocity of Money

“The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand - a drop in spending so severe that producers must cut prices on a ongoing basis in order to find buyers.”

-Ben Bernanke-

We’re all doomed...right?

We’re all waiting for a disaster, the only question is where it will come from. The EU is on the verge of collapse, Germany appears to be headed for recession, American bureaucrats spend like a bunch of drunken sailors on shore leave, and Japan is fast approaching its tipping point where an aging population and near zero savings prevent them from borrowing money at .8% interest. The world, it would seem, is getting ready to melt down.

Recently the FOMC had again signaled it’s intention to run a third round of quantitative easing. Pulling from the minutes, “Many members judge that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”

Could the FOMC be more vague? Works like “fairly soon”, “substantial”, and “sustainable” are not words that inspire confidence that they intend to use any objective measurement.

And sure enough, not only did the Fed go ahead with another round of QE, they went one step further this time with an open ended commitment to purchase 40 Billion in mortgages a month until the economy rebounds.

For those of us in the U.S., the army of fear peddlers have dawned their full battle regalia to launch an assault on the dollar claiming “an end to the fiat currency”. They speak of massive inflation, even hyperinflation as though the events are certainties. But are they? I’m not so sure.

A report put out by Bloomberg notes U.S. Bank deposits are outpacing loans leaving lenders with no choice but to buy treasuries to try and make some kind of return. This in not due to the banks being unwilling to lend, it’s due to lack of interest on the part of businesses to borrow. Part of it is no doubt due to the fact that U.S. businesses are sitting on large capital reserves but they aren’t using those either. The simple fact is, nobody wants to spend any money.

What makes this time different

There are many things that make this recession different than any we’ve seen in our lifetime but the most notable is that unlike recessions of the recent past, this is a deleveraging recession. Put simply this recession happened because we borrowed too much. Not just the government but the people as well. Many of you may recall the negative savings rate that started in 2005. Americans were mortgaging their future....literally.

So what does all that mean? This month I want to discuss a little about what causes inflation and more importantly deflation. We all want simply answers to what are often very complicated problems. For example, it’s easy to say, “the fed is printing money, therefore we are going to get inflation.” While this may certainly be true it is an extremely elementary way of looking at the complex subject. It is much harder, albeit much more accurate to say, “The fed is printing money but that money is not making its way into the economy. Savings rates are increasing and banks are using the surplus capital to build reserves and shore up balance sheets.

Therefore price pressures normally brought on by printing money have been delayed.”

The velocity of money

The one component that all dollar bears fail to consider is the rate at which money changes hands. This is known as the velocity of money and it is a critical piece of the inflation puzzle. Let me explain.

Inflation is a product of 2 things.

1. The number of dollars in circulation.

2. The rate at which those dollars change hands.

There is a simple equation that illustrates exactly how this works, P=MV where P equals nominal GDP growth (non inflation-adjusted), M stands for the money supply and V of course for velocity. By multiplying the money supply times velocity you get nominal GDP. If you want to know how to calculate V just divide P by M.

If the math makes your head hurt let me clear it up for you. Printing money is only one part of the equation. All those newly printed dollars must make their way into the economy and start changing hands. If the government shows up at your door and hands you a freshly printed hundred dollar bill but instead of spending it you stick it under your mattress or deposit it in the bank that money has no effect on inflation. You must spend that money on a product or service in order for it to have any effect. If dollars stop changing hands it means people are saving instead of buying goods and services. This creates deflationary pressures on the economy as businesses and producers must continue to cut prices in order to sell products.

The government can create a similar effect on the economy if it reduces it’s spending. The greater impact government spending is on total GDP, the greater it’s deflationary impact when government reduces spending. There is a great deal of pressure in America to make massive cuts to government spending in order to reduce deficits. If this actually happened it would cause a massive contraction in the U.S. economy that would most certainly send America into a depression.

Deflation is a very serious issue for an economy. It is so scary in fact that central banks will do virtually anything to keep it from happening. This is what the fed is looking at when making the decision on QE. They must act quickly and decisively when deflationary pressures set in because once they do central banks are limited in their ability to respond. They can try, and are trying, to pump money into the economy thus increasing M in our equation but they cannot force a transaction.

In an inflationary environment they have a lot more options. They can remove money and make it so expensive through interest rate hikes that no one can afford to borrow, and restrict the flow of money to banks thus making them less willing to lend. Paul Volcker did exactly that in the 1980’s raising the federal funds rate to 20% in what was a successful attempt to tamp down double digit inflation.

The big takeaway here is this: we need to see an increase in the velocity of money in addition to Fed printing to get the type of inflation that is being touted. So, how quickly are the dollars changing hands these days?

The chart in Figure 1 outlines money velocity going back to 1900.

monetary policies debt qe deflation velocity of money

As you can see, Velocity peaked in 1997 and has been steadily declining since then. In 2008 it broke below the average of 1.67. The only thing keeping GDP growing at this point is the money supply. But as I said printing is not enough to create an inflationary environment that the gold hawks and dollar bears envision. We need to see those dollars start to change hands.

This type of velocity contraction tends to indicate a real risk of DE-flation not inflation. So, what happens if we get deflation and an entire nation goes on sale?

A Nation on Sale

You’ve seen the ads. The sound of the siren song beckoning us to take action, with the allure of rock bottom prices and never-to-be-seen-again bargains. We all want to believe we’re getting a great deal. Nobody wants to walk away from the purchase of a new car or designer pair of shoes thinking, “Man did I pay way to much.”

The generally held belief is that falling prices are a good thing. When prices go down our dollars buy more. We’re able to live on less and make each dollar stretch just a little farther. But what if an entire nation, every industry, every sector, starting slashing prices? What would that mean for an economy?

For the past 50 years the United States and much of the world have been in a rapid credit expansion. We have put off paying for the desires of today with easy credit and intense desire to keep up with the Jones. Most of us don’t remember a time when you needed first rate credit, a long stable job history and 20% down to buy a house. Most of us have never gone to our good friend Mr. Samuels who owns the local “Main Street Trust” to ask for a car loan. We live in a world of distant creditors and faceless underwriters.

By 2005 the U.S. savings rate had gone negative. That meant the average American had nothing. He or she had mortgaged their house at 120% of it’s value, had thirty thousand dollars in school loans, zero savings, and about ten thousand dollars of credit card debt. Then the financial collapse hit. Americans were forced to take a good hard look at their balance sheets and realized they were on and unsustainable path.

Since that time savings rates have climbed back near 6% and although credit is still easy thanks to our good “friends” at the Fed, banks are having a hard time finding anyone to loan money to.

So why is the Fed so concerned with stimulating the economy? Why can’t we just let nature run its course? If we know Americans are still underwater and paying off mountains of debt why not give them some time to build up some reserves? In a few years the ship will right itself and the economy will return to normal, steady growth. Right?

Technically that’s correct. But the fed is concerned with the real fear that if people stop spending it could send us into a downward spiral that would culminate in massive unemployment, boarded up businesses, decades of stagnant growth, and a generation in poverty.

The Deflationary Cycle

The easiest way to illustrate what I am talking about is with a simple diagram of what I call the deflationary cycle (see Figure 2).

monetary policies debt qe deflation deflationary cycle

The initial spending reduction can come from reduced consumer spending or government spending. The key principal here is the money is leaving the economy. By reducing spending consumers end up saving money or paying down debt. The same is true for a government. The money either goes to debt reduction (don’t laugh) or to a surplus in revenue.

With decreased spending, businesses make fewer sales. It becomes harder to get people in the door. The inventory reserves that were once adequate for market conditions are now to high. This increase in inventories forces businesses to modify their production schedules. Higher inventories means higher costs and in some cases outdated merchandise. To combat high inventories smart companies increase advertising and cut prices. As prices fall competing companies are forced to reduce their prices or modify their sales approach to stay competitive.

While lower prices are great for the consumers who are now getting much better prices on everything they buy, it’s not good for companies. The increased cost for advertising and the decrease in revenue caused by pricing discounts lead to reduced corporate profits. Fewer profits also means lower tax revenue to the government that can reek havoc on local municipal budgets.

As revenues fall companies initially stop hiring. The job market becomes more competitive as job opportunities grow scarce. If the situation deteriorates further companies are forced to lay off workers leading to higher unemployment.

(Side note: This is why Obama’s plan to offer tax breaks to companies who hire new employees is so stupid. If there is no work, why would a company hire a 30,000 dollar a year employee to save 3K on taxes? The only companies this type of program benefit are those that intent to hire anyway. These types of programs are a blatant example of how little the current administration understands about what drives an economy and what’s needed to fix it.)

High unemployment, few job opportunities, increased savings rates, and slow to no GDP growth. Sounds familiar? Now do you see why Bernanke is so nervous? What recourse does he have? In a deflationary market the Fed is limited in its ability to respond. In fact, to spite what he may say, the Fed has very little left in its powder keg in the event things do not improve. If the cycle continues it could lead strait into a national depression and that would mean a decade of poverty and a generation of rebuilding.

A little silver lining

In most cases all this deflation stuff is temporary. Prices fall to a level where consumers feel comfortable spending, profits adjust and things stabilize. We see this every day in many different industries. It’s part of the market cycle.

A problem arises when the deflation becomes widespread across multiple sectors. If things get out of hand deflation becomes an economic spiral of death. And that is why the Fed and the ECB are willing to take on any amount of debt that is necessary. They are literally playing the only card they’ve got left.

Jason Stapleton