For those readers who are not au fait with economic theory, presented for your consideration is a simple arithmetic equation: M x V = GDP where M is the money supply, V is the velocity of money or the rate a given supply turns over, and GDP is a nation's nominal gross domestic product. Much in the news lately is the Federal Reserve and Treasury efforts to increase M in various ways including buying up worthless assets of failing financial institutions (the TARP program) and giving taxpayers a $500 tax rebate. President Obama has called on Congress this week to infuse the economy with one trillion more fiat dollars. But as in all mathematical relationships the other variables also affect the result. In the case at hand V, velocity, is causing economists to scratch their heads.According to monetarist guru, Milton Friedman, the money stock decreased by an astounding 31% during the first Great Depression and the turnover of that stock fell by 21%. As a result, the national economy as measured by GDP shrank by approximately 50%. In his seminal work, Monetary History of the United States, Friedman suggested that if the government under Hoover had not allowed the money supply to shrink (by cutting the federal budget and raising taxes), the worse dislocations of the Depression might have been avoided. Federal Reserve Chairman Ben Bernanke, a student of the era, is following the monetarist prescription proposed by Friedman: greatly increasing the money supply, M, to keep the economy from contracting too severely. This policy is not a "slam dunk", since our economy is boldly going where no other has gone before [photo]. Unlike the previous Great Depression there is an enormous pile of bad debt--all kinds of debt, not just mortgages--in our midst and it is clogging up the economic pipes. In analytic terms, V is declining. Another prominent economist, Irving Fisher, studied the effects of debt deflation in 1929-33, and in the smaller depressions of 1837 and 1873. Fisher and other economists* realized the effects of excessive debt can overwhelm economic variables. The deflationary effects of excessive indebtedness can become so pernicious in destroying wealth that fiscal and monetary policy cannot spur economic growth because velocity--the rate at which money is spent--declines. Government, despite enormous outlays of money, is left pushing a wet noodle. The debt level in the US is unprecedented. In the third quarter of 2008 total debt reached 358% of GDP. A lot of debt is bad--improperly loaned or financed. This means the likelihood of repayment is low, so lenders are loath to finance new customers who are already in debt. Some market experts believe that any monetary policy is only as good as its ability to stimulate a new cycle of borrowing and lending. In the forth quarter velocity plummeted, offsetting the increase in money supply. In short, everybody is playing Texas hold 'em.
You may dimly remember your freshman college macro-economics, if only because the textbook was so heavy. But you do seem to recall that if the government prints a lot of money that leads to price inflation which can in the extreme case lead to currency devaluation. Right you are, Ridley! The government is pushing our national balance sheet farther and farther into the red by creating more fiat dollars. So why is the US $ in a bull market against other world currencies? The answer lies in Bretton Woods. The United States, thanks to geography, a technologically advanced military, and a massive industrial base, emerged from the second world conflagration solvent and in tact. In 1971, after Nixon took the country off the gold standard, the US dollar became the world's reserve currency. This means other countries keep their money reserves in dollars. The essence of our age, oil, is internationally traded in dollars. More importantly, no other currency is presently capable of replacing the dollar as the world's reserve currency. So the US can go deep into the red without the ill effects experienced by smaller economies such as Iceland. Some commentators suggest that gold could return as the world's standard if the dollar is too severely devalued. Every central bank in the world carries gold on their balance sheets as a reserve asset. Gold is money, a global currency, that can be freely traded unencumbered by sovereign debt and prior obligations according to Royal Bank of Canada. But the dirty secret is that the price of gold is manipulated by--wait for it--the Federal Reserve which obviously has a supreme interest in maintaining the dollar's privileged position in the world economy. Keep those presses rolling, Rawhide!
*Minsky, Kindleberger, Kondratieff, and Schumpeter[photo credit: AP]