The scarecrow in Japan was named “deflation” and it motivated an unbelievable money print of Yens that is expected to resolve the 2 decades of stagnating Japan economy. So at the moment BoJ is “fighting” the deflation and the “too strong Yen”.
And these days in Europe we discovered our own scarecrow. It is called “lowflation”. Not exactly as frightenenig as the deflation, but enough frightening to motivate the same counter-measures. So we lived enough to see the German ECB member to speak about quantitative easing, and the Central bank itself to establish the first experiment with… negative interests.
When speaking about “too low inflation” politicians demonstrate their impressive lack of basic economic knowledge. And speaking about low inflation after years of money-print demonstrates the procedure of a ritual suicide. Politicians are just looking at some digits and based on them they are taking dangerous decisions which price will be upon us.
Let’s suppose inflation is really low, and this in not just a statistical manipulation created to excuse the money-print needed for repaying government debts. So if we really do have a low inflation, is this wrong? Is this bad? Is the inflation needed in any case? Obviously and logically – no. Low inflation is a good thing. People know the value of their money, they can plan their lives an accumulate savings.
But let’s hypothetically suppose that too low inflation is a bad thing. So the next question is whether the reason for it is the too small monetary base. So do we have too few money so the inflation is low? The obvious question is NO. After years of low interests, LTROs and QEs, the markets are flooded with cash and the increase in monetary base much exceeds the increase in GDP. So obviously in is not the monetary base the problem.
So why do we have lowflation?
This is the main and more important question.
Under the mathematical economic rules, inflation is dependent on GDP, monetary base and… velocity of money. As it is clear we have no inflation-suppressing factors in GDP and in monetary base, therefore the reason for the lowflation is in the velocity. I.e. money is making fewer moves in economy, smaller turnover, and this leads to lower prices.
So obviously the problem is not where politicians are looking for it. It is not in money. It is in slow economy. And it can not be made better by pumping up the monetary base.
In fact money matter nothing. If we have bad economy, high unemployment, blocked labor markets, uncertainty, it doesn’t matter how much money you will print. The low turnover, measured in real goods and services will remain. Even if you succeed in kicking up the inflation this will only change the prices, and not the real goods and services turnover.
Lowflation is a symptom of a bigger problem, it is not a problem itself. You can not solve the problem by addressing the lowflation.
Let me give you an example. Buyer 1 buys good 1. The seller of good 1 takes the money and buys good 2. The seller of good 2 takes the money and buys good 3. And so on. Let’s suppose we have a chain of 10 buyers-sellers so the 10th seller will have to sell good 1 to buyer 1. When the economy is going well we have one and the same money used 10 times. This is the “velocity”. It means that 10 economic players have received the needed 10 goods and services.
Now let’s suppose the economy goes in crash and this chain collapses. It is reestablished, but with fewer participants. For instance – 7. So now we have 30% lower velocity of money. The money is the same quantity, but the velocity is lower. So now we have not 10, but 7 economic players that have received the needed goods and services.
What will happen if we increase the quantity of money? Will this increase the number of players back to 10? Obviously NO.
So what are these officers in Central banks and Governments doing? Why they are not addressing the missing 3 players, but are addressing the money supply? How will these 3 out-of-game market agents go back in business so the business recovers and supplies 10 goods to 10 players instead 7 for 7? What exactly have here to do the money supply?
Taking wrong decisions leads to wrong results. By money supply increase you can not solve structural economic problems. The small problem here is you waste time and effort on useless attempts for economic restart. The big problem is that you are placing a mine that will explode out of your control. If somehow (based on natural adapting mechanisms) the economy self-restarts and increases the velocity of money, this will lead to uncontrollable inflation due to increased money supply. And once money is printed and sent to the market, it is very difficult to get it back. While the velocity is very easy to increase surprisingly.
So the battle with lowflation will be won. It will bring highflation one day. In older terms called also a galloping or even a hyper inflation.
April 1st 2014