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Why We're Facing Deflation

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How velocity, money supply, and currency-printing affect the economic environment.

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But that assumes you don't have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which mean M (money supply) would need to grow about 5% a year, even if V were constant. And that's not particularly stimulative, given that we're in recession. And notice in the chart below that M2 hasn't been growing that much lately after shooting up in late 2008 as the Fed flooded the market with liquidity.



Bottom line? Expect money-supply growth well north of what the economy could normally tolerate for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that's most of us) to sit back as Monday-morning quarterback for many years.

But this is important. The Fed's going to continue to print money as long as they aren't confident deflation is no longer a problem. They can't tell us what that number is because they don't know. My guess is if they did tell us, the markets would simply throw up -- especially the bond market -- which would of course, make the situation (from a deflation-fighting point of view) even worse.

Sir, I Have Not Yet Begun to Print

When faced with the possibility of deflation, I can almost hear Bernanke now: "Sir, I have not yet begun to print!"

When will they know when enough is enough? When the velocity of money stops falling. When we see two quarters in a row where the velocity of money is rising, then it's time to start investing in inflation hedges.

Why is the velocity of money slowing down? Notice the significant real rise in velocity from 1990 through about 1997. Growth in M2 was falling during most of that period, yet the economy was growing. That means that velocity had to have been rising faster than normal. Why? It's financial innovation that spurs above-trend growth in velocity. Primarily because of the financial innovations introduced in the early '90s -- like securitizations, CDOs, and so forth -- we saw a significant rise in velocity.

And now we're watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be good things. And in the beginning, they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. The absence of new innovation and the removal of old innovations (even if they were bad innovations, they did help speed things up) are slowing things down. If the money supply hadn't risen significantly to offset that slowdown in velocity, the economy would already be in a much deeper recession.

The Fed has more room to print money than most of us realize, and my bet is we'll find out how much more. At some point, they'll probably print too much.
No positions in stocks mentioned.

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