Tuesday, October 15, 2013

Money Supply - when and how QE becomes dangerous

To understand how money supply becomes dangerous, let us begin with our equation which is now modified as follows:

Just to reiterate, here:
M = Money supply
V = Velocity of Money
MA = Original money supply
VA = Velocity of the money supply
MB = Money supply added during QE
VB = Velocity of this expanded money supply
P = Price of good (product or service) "i"
Qi = Quantity of good (product or service) "i" sold
n = Total number of goods
M*V = Money Momentum
PI = Purchase Intensity

Makings of a recession or slowdowns
Before a slowdown we have MB equal to zero as there is no QE. When a slowdown strikes Qi reduces drastically. To compensate the reduction of Qi, central bank injects MB. In the ideal case the velocity VB should be positive and commensurate with MB (the quantum of additional money supply). Now as we discussed the exact mechanics of QE were designed to keep VB low so that injection of money does not cause runaway inflation.

To adjust to excess money supply, the purchase of some items increases. If such items are assets, then we have the hoarding vs. building problem we spoke about. The exact response of the economy depends on the mechanics of QE. However, either ways it plants the seeds for future problems.

When does QE turn bad
When the economy does finally recover, the right side of the equation starts gaining traction. To compensate, the two components on the left, VA and VB have to adjust (assuming no further QE is added). Now the nature of velocity is such that increments in micro-V (velocity at individual level) are more step-changes rather than smooth analogue. Therefore even when the Velocity in the equation is smoother than the micro-V, it increases quite drastically. The pace of increase of the velocity is remarkably higher than pace at which fundamental growth can take place - i.e. growth in "n"or "Q". The excess therefore spills over to "P" or the price leading to inflation. At such moment, there is required to be a mechanism to absorb excess liquidity. But then a precise mop does not exist that can mop at the right places. The result is that there is inflation in certain goods while others are relatively stable.

The argument the inflationists are making is two-fold - first that the increase in V post revival will be far too drastic to allow for commensurate growth in "n" or "Q" to temper the price rise and secondly the central banks will not be able to mop up the rest. In fact, Bernanke's QE strategy created the VA-VB split to allow for quick withdrawal i.e. the second kind of problem. However, this design kept VB low increasing the quantum stimulus required. In other words, Bernanke's design increases the first type of problem.

Lastly, higher the quantum of QE the more difficult it is to mop it up. Which means the economy will absorb it relatively quickly and this absorption will result into a high-inflation scenario.

The correlated bad effects
The US economy being the global leader and dollar being global reserve currency, there are correlated bad effects to deal with. When inflation gains traction, there is change in the value of holdings of other countries in US (dollar reserves which were necessary for currency management). If the change in value is substantial then there will be a possibility of renewed currency wars.

If the inflation increases beyond control then there is a risk of currency losing its function as carrier of information (of value). This triggers a wider crisis globally.

In Sum - Can we prevent bad after-effects of QE
We can but in all probability we won't looking at current politics. Avoiding the bad side-effects requires integrated monetary-fiscal approach. There is not much room for political compromise as most of the activities are almost imperative. We need the US politicians to be lot more saner than they actually are. But is it expecting too much? I don't know.

Note: This post is derived from my book Subverting Capitalism and Democracy. You can read the book at the link below.