Categorized | Economics, Investing, Politics

Decomposing the Inflation Argument

Inflation has long been a contentious topic in the U.S., not really abating at any point since the 1960’s. President Johnson’s “Guns & Butter” policies of the Vietnam war era sparked a good deal of money printing, inflation, and debate. Since then the Federal Reserve, Congress, and every President have gone on spending binges, rampant borrowing, and always increasing money supply. These are the tools of macro-economics, in which central decision authorities nationalize resources to socially engineer what they think will be perpetual prosperity. The results are debatable, but the consequences clear:

The currency component of the money supply has risen roughly 1,400% since America eradicated the gold standard and institutionalized Keynesian policy:

Despite such extreme increases in the currency component of money supply, inflation has remained somewhat in check:

Note that despite peaks and downturns, inflation has not once dipped into negative territory since the Great Depression. Inflation, along with Keynesian policy, has become institutionalized-an aspect of life we have come to expect. There are consequences to perpetual inflation, however: the U.S. dollar has lost 97.8% of its value since the creation of the Federal Reserve:

In 1913-the year of the creation of the Federal Reserve-one ounce of gold could be purchased for $20.67, whereas now it costs $939.2 (spot price, as of 3/8/09). This reality has several negative consequences, particularly with regards to the incentives it imposes on society. Saving and its corresponding fiscal prudence are discouraged under a regime of perpetual inflation. Despite increases in productive capacity, as a society, real wages lag and the middle class suffers decreasing standards of living, particularly when debt-adjustments are factored.

M3, the broadest definition of money supply, has experienced a decreasing rate of growth, sure, but is still growing at about a 10% clip. That is not deflationary.

Still, money supply is not the only determinant of inflation. To garner greater understanding of where we stand we must analyze the quantity theory of money identity:

“M” is the quantity of money, “V” is the velocity of money, “P” is the general price level, and “Q” measures the real value of final expenditures, or output.

Let’s rearrange and note that our variable of interest, “P” can be stated as: P = (M * V) / Q

We know that money supply (M) is increasing rather rapidly. Many experts contend that the velocity of money (V) is contracting, and we all know that economic output (Q) is on the decline. So the question becomes, will M/Q or V be the dominant expression?

My contention is that velocity of money may be suppressed sufficiently to offset growth in M/Q, but can turn on a dime.

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  1. […] * V) / Q. Isolating this relationship, we can make some observations, as I’ve already done in Decomposing the Inflation Argument: In the U.S., […]