Currency Wars_ The Making of the Next Global Crisis - James Rickards [93]
Friedman’s idea was encapsulated in an equation known as the quantity theory of money. The variables are M = money supply, V = velocity of money, P = price level and y = real GDP, expressed as:
MV = Py
This is stated as: money supply (M) times velocity (V) equals nominal GDP, which can be broken into its components of price changes (P) and real growth (y).
Money supply (M) is controlled by the Fed. The Fed increases money supply by purchasing government bonds with printed money and decreases money supply by selling the bonds for money that then disappears. Velocity (V) is just the measure of how quickly money turns over. If someone spends a dollar and the recipient also spends it, that dollar has a velocity of two because it was spent twice. If instead the dollar is put in the bank, that dollar has a velocity of zero because it was not spent at all. On the other side of the equation, nominal GDP growth has its real component (y) and its inflation component (P).
For decades one of the most important questions to flow from this equation was, is there a natural limit to the amount that the real economy can expand before inflation takes over? Real growth in the economy is limited by the amount of labor and the productivity of that labor. Population grows in the United States at about 1.5 percent per year. Productivity increases vary, but 2 percent to 2.5 percent per year is a reasonable estimate. The combination of people and productivity means that the U.S. economy can grow about 3.5 percent to 4.0 percent per year in real terms. That is the upper limit on the long-term growth of real output, or y in the equation.
A monetarist attempting to fine-tune Fed monetary policy would say that if y can grow at only 4 percent, then an ideal policy would be one in which money supply grows at 4 percent, velocity is constant and the price level is constant. This would be a world of near maximum real growth and near zero inflation.
If increasing the money supply in modest increments were all there was to it, Fed monetary policy would be the easiest job in the world. In fact, Milton Friedman once suggested that a properly programmed computer could adjust the money supply with no need for a Federal Reserve. Start with a good estimate of the natural real growth rate for the economy, dial up the money supply by the same target rate and watch the economy grow without inflation. It might need a little tweaking for timing lags and changes in the growth estimate due to productivity, but it is all fairly simple as long as the velocity of money is constant.
But what if velocity is not constant?
It turns out that money velocity is the great joker in the deck, the factor that no one can control, the variable that cannot be fine-tuned. Velocity is psychological: it all depends on how an individual feels about her economic prospects or about how all consumers in the aggregate feel. Velocity cannot be controlled by the Fed’s printing press or advancements in productivity. It is a behavioral phenomenon, and a powerful one.
Think of the economy as a ten-speed bicycle with money supply as the gears, velocity as the brakes and the bicycle rider as the consumer. By shifting gears up or down, the Fed can help the rider accelerate or climb hills. Yet if the rider puts on the brakes hard enough, the bike slows down no matter what gear the bike is in. If the bike is going too fast and the rider puts on the brakes hard, the bike can skid or crash.
In a nutshell, this is the exact dynamic that has characterized the U.S. economy