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Due to the low velocity of money, deflation is lurking

Concerns about deflation are more appropriate

Inflation or deflation: where are we headed? Photo: inside the metro of Amsterdam

We live in exceptional times. The economy has shrunk considerably as a result of the lockdowns and measures to combat the coronavirus. Governments are trying to save the economy from a total collapse with a large number of stimulus measures. A question that concerns many people is where this will lead to: do we have to deal with inflation or deflation in the coming years? An analysis of the current situation suggests that concerns about deflation are more valid.

Inflation is bad

Inflation and deflation are opposites. With inflation, products become more and more expensive. If your income does not increase proportionately, you can buy less and less with the same money. Anyone who has savings will have to deal with money devaluation. Their purchasing power decreases.

There are also negative consequences internationally. High inflation makes products from a country more expensive abroad, what causes domestic producers to find it difficult to compete with producers from abroad, leading to pricing themselves out of the market. As a result, exports will decline. In addition, imports are increasing because products from abroad are becoming cheaper compared to domestic products. This has negative economic consequences.

Deflation is bad too, maybe worse than inflation

Inflation leads to monetary devaluation, deflation ensures that money is increasingly worth more. This seems good for you at first, because you can buy more and more with the same amount of money. Your purchasing power increases. But once people understand this, they will be tempted to delay their purchases. If a new product is cheaper in a few months than it is now, why buy it now and not in a few months? If many people delay spending, the economy will soon come to a halt. What appears to be beneficial at first glance has disastrous consequences for the economy in the long-term.

There are also negative consequences for those in debt, such as people with a mortgage debt, companies with loans and for governments with a national debt. With inflation income increases, making it easier to pay off debts over time. In deflation income does not increase, while in high deflation income may even fall, making it more difficult to pay off debts. Companies will postpone investments while the housing market comes to a standstill.

There are also some positive consequences (less will be imported and more exported), but the question is whether this can offset the negative domestic consequences of deflation.

While both inflation and deflation are bad, the consensus is that a little bit of inflation is better than high inflation or deflation. Money then keeps moving. The economy does not come to a standstill, and the monetary devaluation is limited. That is why, for example, the European Central Bank has a target of 2% inflation per year.

What awaits us?

In order to assess whether we will have to deal with inflation or deflation in the coming years, the current situation can be examined from different perspectives:

  • theoretical perspective;
  • measured perspective;
  • policy perspective.

Theoretical perspective

From a theoretical economic perspective, there are a number of reasons why inflation arises. The first reason could be higher production costs. For instance, rising wages lead to higher production costs. The same applies to higher commodity prices and higher interest rates. Higher production costs are translated into higher prices.

A second reason for inflation occurs when people spend more money. This can be for several reasons. People can distrust money and spend their money as quickly as possible. But also when people have more money and are willing to buy scarce products.

There is currently no evidence for either reason. Due to the corona crisis, employees prefer job retention rather than higher wages. Commodity prices have fallen dramatically. The oil price, for example, was for a short period of time negative. Interest rates in the US and Europe are still falling every day. Nor is there any evidence that people currently distrust or spend a lot of money. Rising unemployment means that people spend less money and save money for the future.

From this perspective, it can be said that deflation is more likely than inflation.

Measured perspective

Inflation is measured. Although there can be questioned how this is done and whether it is done properly, trends in inflation figures are clearly visible.

Inflation in Europe

  • July 2018: 2.19%
  • July 2019: 1.02%
  • July 2020: 0.39%

The trend is clearly downwards. In May 2020, immediately after the corona lockdowns, inflation was even 0.09% compared to a year earlier (Harmonized Indices of Consumer Prices measured by Eurostat).

Inflation in the US

  • July 2018: 2.95%
  • July 2019: 1.81%
  • July 2020: 0.99%

Although inflation in the US is slightly higher than in Europe, the trend is clearly downward. Inflation was also very low in the US in May 2020: 0.12% (Consumer Price Index measured by U.S. Bureau of Labor Statistics).

Another method to measure inflation is by looking at the velocity of circulation of money. Some people often focus on central bank balance sheets to warn of inflation. Obviously, there is some truth to the central bank’s balance sheet: an explosion of base money will undoubtedly lead to high inflation over time. But only if the velocity of money does not decrease. The velocity of money is a measure of the number of times that money changes hands used to purchase goods or services in a given period of time. And what is exactly happening now? The velocity of money has decreased dramatically. The velocity of money has slowed for years, but as a result of the corona crisis, it has fallen unprecedentedly. Money hardly seems to change hands. Money stays where it is. There is no inflation if money does not move, even if the central bank balance sheets explode.

Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2V, August 31, 2020.

From this perspective, it can be said that deflation is more likely than inflation.

Policy perspective

It has already been noted above that some people who warn against inflation mainly point to the balance sheet of central banks. This reference is shortsighted and does not take the velocity of money into account. From a theoretical perspective as well as from measurements, it appears that deflation is obvious.

Politicians and bankers also know this. They know that without measures deflation is lurking. They are setting up incentives to keep the economy going, to make sure that people and companies keep spending and thus prevent deflation. Central banks are pumping money into the economy at an unprecedented rate to combat deflation, but also to prevent very low inflation. Fed Chair Jerome H. Powell said in a speech on August 27th that “inflation that is persistently too low can pose serious risks to the economy”. Powell is more than clear. He wants to avoid deflation at all costs.

Not only bankers want to make money move, governments are also doing everything they can. Incentives and tax cuts are used to get money moving. Government interests are also high as deflation makes it more difficult to pay public debt and interest, governments prefer inflation.

Fighting deflation seems to be a top priority at the moment. Milton Friedman proposed (and quoted by Ben Bernanke) to scatter money from helicopters if necessary to prevent deflation, a method that has now also been used by paying billions directly to the population.

Conclusion

Although the theory and measurements point to deflation, politicians and bankers are doing everything they can to prevent it. If necessary even through throwing of money from the air, free money for everyone. As long as deflation is contested, high inflation is unlikely. For the moment, the danger of deflation is greater than that of high inflation: taking no action will lead to deflation.

Does this mean that we will never have high inflation in the future? No, that’s not what I’m saying. In the long-term once money starts to move and the velocity of money increase, high inflation can set in. It is then the responsibility of the same politicians and bankers to challenge that. The central bank and politicians can then take measures to combat high inflation.

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