Tuesday, May 19, 2009

After the Recovery, the Hyperinflation

Former hedge fund manager Andy Kessler does a fine job explaining the basics of money supply and inflation in relation to the recent trillions that have been flowing out of Washington DC. (And, yes, I expect you to be interested.)

Here is how he starts "Putting the Toothpaste Back Into the Tube" (The Weekly Standard, April 27, 2009).

So how is Fed chairman Ben Bernanke going to get all that toothpaste back into the tube? The Fed has been cranking money out like water over Niagara Falls. The monetary base has increased by a trillion dollars in just the last six months. And he's not done, furiously printing dollars (bank credits, really) and buying Treasuries in an attempt to flood the economy with dollars. When will it end? $3 trillion? $4 trillion? And then what? A functioning economy doesn't need all that cash sloshing around. Is runaway inflation our next crisis?

Let's go back to fundamentals for a second. Money is a placeholder of value--the price of a cold Heineken or the value of work already done, a hole dug, a piece of software written, whatever. When things work just right, prices seek the right level and we get a match between that cold beer and the sweat from working for it.

Money supply is how much money is floating around the economy to handle all the transactions. No one quite knows how much money is needed. The classic formula is the output of the economy equals the amount of money times the velocity of money, or how many times the same dollar is spent during the year. You buy the beer, the bartender buys beer nuts, the nut farmer buys a Ford pickup truck, the auto worker buys a cell phone, which you the programmer just finished writing the location-based service code for, so you are out celebrating buying a beer and on and on. Of course, no one really knows what the velocity of money is. If times are tough, you may hold off buying that Heineken for a few months, and when times are good you may party every night.

I like to think of the economy as a giant bucket filled with money (money supply) sloshing around the bucket (velocity). We all hope the bucket is filled to the rim. But, in normal times, the economy grows every year. Population increases, too, so the size of the bucket has to grow to handle the transactions of more people who like to eat and drink. So more money needs to be created to fill the bigger bucket. That's pretty straightforward.

But now the hard part. ...

Read on, then hold onto your seats. Given the way we have chosen to ride out this recession, we could be in for a bumpy landing.

No comments: