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Thursday, June 12, 2008

Velocity of Money Theory for this Round of Inflation? I Don't Think So

In today's Globe and Mail, Avner Mandelman has a column which you can read here. Avner Mandelman is president and chief investment officer of Giraffe Capital Corp. He is stating that inflation is very under reported in the US right now, then goes on to explain why he thinks that inflation is raising its ugly head again. He states that he believes that it is due to the velocity of money. In previous postings, I have stated that money has to move in order to do work, and if it is not moving (equivalent of being stuffed in a mattress for example) it may as well not exist. Avner thinks that this round of inflation is mainly due to money moving faster than it has in the past. He claims that this faster movement is being caused by technology. Click a mouse and voila, money has moved. While I agree to some extent that yes, money can move faster and thus might contribute to some rise in commodity prices, I feel that this effect is a minor one. Money has been moving a bit faster for quite a few years now, but I don't think anything radical has happened here to explain inflation.

I'll tell you what I think is happening. I think that large pools of offshore US dollars are making their way back into the mainstream US economy. If US dollars are used extensively as a medium of exchange in other areas of the globe, especially areas that don't do a lot of trading with the US itself, then those dollars may as well not exist as far as the US is concerned. US dollars are widely accepted all over the planet and have been used as a major medium of exchange outside the US. For example, El Salvador uses the US dollar as its official currency. Those dollars can flow all over El Salvador as a medium of exchange, and as long as El Salvador doesn't chase US goods or services or bids up commodities (such as oil) that the US is also trying to buy, then those dollars may as well simply not exist as far as the US is concerned. Of course El Salvador does a lot of trade with the US so in reality this example doesn't really apply, I just use it as a hypothetical one to illustrate my point.

So why are these previously isolated dollars now starting to find their way home? Well, in one simple word, the Euro. The Euro is a relatively new currency that is an alternative to the US dollar since it is also being widely accepted worldwide as a medium of exchange. A lot of foreign entities, formerly holding US dollars, are now opting to hold some Euros instead. Those displaced US dollars are now starting to come home to roost. Also remember all the spending on the Iraq war, much of it done in newly "printed" US dollars? Those billions of dollars spent overseas are also finding their way back to the US. This whole thing has been fairly obvious as we watch the US dollar fall with respect to the Euro.

To "somerize" lol, all this, the money supply doesn't have to actually grow to cause inflation, it just has to effectively grow with respect to the particular economy where you are measuring the inflation. Velocity changes just don't cut it, in my opinion anyway.


Anonymous said...

Obviously I'm not an expert on finances, but a friend of mine and I had a discussion on why he thought the Us was in some serious financial trouble. Debt. Now, obviously debt is a common part of any society, and some would argue that debt is actually a fairly healthy financially speaking. However, I think it's pretty fair to say that people are incuring more debt than they ever have, but not necessarily making more money. There's only so much borrowed money one person can have before they're a financial risk, however, even if you are a financial risk you can still get money, lots of it depending on where you're looking. Again, I'm not a financial expert in the least, but couldn't debt also lend itself to the economic hardship the US is facing?

Jim Somerville said...

Yes, debt is certainly a big problem for the US. It ties right into inflation, as much of the US debt has been funded by creating money out of thin air via the Federal Reserve. When you create more money, you make all the existing money worth a little bit less since you are diluting it. This is inflation. They are literally inflating the money supply. This is ok as long as you're not inflating your money faster than your main trading partners are inflating theirs. If you do, then your money falls in value compared to theirs. This has happened with the US dollar against the Euro and Cdn dollar, as well as most of the world's main currencies. The war in Iraq is a big part of this US government debt.

Another part of what the US is going through is the subprime crisis. High risk mortgages were used in investment vehicles where the real risk was hidden. Defaults on mortgages caused defaults on those investments which held the mortgages. Those investments had been used as backing assets for further loans, building a house of cards which is now collapsing. That's also a lot of the US's headaches right now.