Are We Headed For Inflation, Deflation, Or Stagnation?

Source: AP Photo/Pablo Martinez Monsivais

With the historic collapse of oil prices and glutted tankers sloshing around off the coast of Los Angeles, some forecasters are predicting deflation as far as they can see. They tend to believe that shocks to supplies cause inflation or deflation in commodities that spreads through the economy like a virus.

Others look to the Fed gorging itself on anything that resembles financial paper and predict hyperinflation like that of Germany a century ago or Zimbabwe recently. Historically, growth in the Fed’s balance sheet signaled a rapidly expanding supply of money that would ignite inflation. So which will it be: inflation, deflation, or stagnation?

The money horror picture show

All is not well with the economy in spite of rising home prices and soaring car sales. The disturbing news comes from money. Losing velocity with money is like losing altitude while flying. It can be hazardous to your health.

Economically, the velocity of money reflects how quickly people spend a new dollar once they get it. Technically, it’s the GDP growth that a rise in the money supply can’t explain. The general idea holds that if people are well off and feeling confident they will spend new dollars quickly and each dollar will change hands many times before the end of the year.

Here is an amusing tale about money velocity that I got from the Adam Smith Institute:

It is the month of August, on the shores of the Black Sea. It is raining and the little town looks totally deserted. It is tough times, everybody is in debt and everybody lives on credit.

A rich tourist comes to town. He enters the only hotel, lays a 100 Euro note on the reception counter and goes to inspect the rooms upstairs in order to pick one.