Exchange Theory & Inflation

      On the subject of inflation, let's not forget Irving Fisher's (1911) exchange equation PT = MV. This implies that if the velocity of money (V) decreases faster than the supply of money (M) increases, and the real value of transactions (T) remains the same, prices (P) must fall. I chose this possibility as the first scenario to look at because that is actually what has been happening for the last couple of year and is the reason we have experienced deflationary pressure in the economy. This article will further explore the connection between debt paydown and debt liquidation and its relation to price deflation.
      The quantity T, originally denoting Transactions, actually refers to real GDP and has been replaced in modern textbooks by Q. The quantity T, as originally stated, was hard to distinguish from V. For this reason most all contemporary economists use the equation in the form  PQ = MV, which makes it more readily understandable. Velocity refers to how many times the entire money stock is turned over within the total of all transactions. The only way real GDP (Q) can rise when MV increases is that P either falls, remains the same, or increases more slowly than MV. When  MV is falling,  real GDP (Q) can rise only if P falls more than MV. I discussed the above example to familiarize readers with how the exchange equation works. In the following exposition we will assume that Q (real GDP) remains constant for simplicity in illustrating under what conditions and in what  directions price changes occur in the context of the exchange equation PQ = MV.
     Not all types of exchanges of money contribute to V. For instance, money that is used to pay down debt does not add to velocity, even though, as today, it originates from an increase in money supply. Likewise, I believe that money that is used to raise bank reserves to a higher level probably does not increase velocity unless these banks actually do lend more of this newly found money to people or entities who (that) will spend it. Only if velocity remains constant, increases, or at least decreases to less than needed to fall to the reciprocal of (1 + fractional increase) of the money supply, will monetary inflation (increase in the money supply)  result in price inflation. In the last case immediately above an example would be that if M increased to 4/3 of its previous level (if it increased by 1/3), V would have to decline to 3/4 (decline by 1/4) of its value to keep MV at a constant value.  If V declined  by less than 1/4, MV would increase and, on the PQ side of the equation, prices would increase since we are keeping Q constant for easy evaluation. To be sure,  it takes real net purchases, of either a capital or a consumer nature, to increase the velocity of the money.  
     The quote "inflation is always and everywhere a monetary phenomenon"  is the most famous aphorism, referring to increases in money supply, from the late great monetarist, Milton Friedman. That renowned economist might have added  "if it is also accompanied by a constant or increasing velocity of money (or a decrease in V much less than the increase in M)". The large increase in the money supply provided by the Fed has mostly been used either to pay down debt or to raise bank reserves to higher levels, this last being all the more necessary because so many banks were virtually insolvent, if not literally so. The need of banks to increase reserves has resulted largely from their huge loss of capital caused by massive defaults on the debt instruments they held.
     So, at its essence, most of the money created and provided by the Fed has directly or indirectly gone to pay off debt, and thus will not generate an increase in the velocity of money. Thus the widely-predicted surge in inflation does not have to come to pass. This puts in question some of the more extravagant projections for the ultimate price of gold. Perhaps this condition could create a more benevolent environment for stocks over the next several years by keeping the cost of doing business low and allowing consumers to build up real savings that will not be destroyed by inflation. This in turn would  gradually allow consumers to prudently start making more purchases, thus stimulating GDP in the old-fashioned way, i.e. "We earned it and saved it before we spent it".
   Of course, in this kind of deflationary environment, it will continue to be very hard to earn money in the first place. What all this portends is a return to economic fundamentals and the validation of what could be called "the Austrian school of economics". That is, in the end, the dependence on credit expansion and its accompanying "skyscraper of debt" does not serve to construct a solid prosperity that can survive strong financial tremors, but rather a flimsy edifice that collapses when the monetary earth shakes, destroying the lives of many of its inhabitants and leaving its survivors insecure and helpless.