Debt, Velocity of Money & Ethics

September 19, 2008

The idea that the US Government can “bail out” those whose financial failure seems likely to trigger an implosion of the derivatives market needs to be seen in light of two factors:

  • Debt. Historically, as debt levels have grown, this  has given rise to inflation.
  • Velocity of money. Historically, this has either supported the central bank policy of monetary inflation; or negated it depending on whether it is speeding up or slowing down

Let's try to keep this as simple as possible:

Debt

Table 1: US Public Debt

September 17th 2007

September 16th 2008

$ Change

% Change

$9,000.5 billion

$9,639,8 Billion

$639.3

7.1%

Daily increment in public debt = $639.3/265 = $1.75 billion

Now let's look at the $85 billion AIG bailout.

Q: Where's this$85 billion going to come from?

A: Whether it's printed or whether is borrowed from offshore, more Treasury Bonds need to be issued. Public Debt will rise.

The more bailouts occur, the faster will US Public Debt grow.

The issue with the derivatives market is what is known as “counterparty risk”. If one party on one side of the transaction goes insolvent, the fact that the other party on the other side has a balanced book becomes irrelevant. Suddenly the “balanced book” is no longer balanced - because of the bad debt that manifested.

If the size of the bad debt is greater than the total equity of the party which thought it had a balanced book; then that party will go insolvent.

The end result will be that the whole $500 trillion industry will be in danger of collapse (some say it is as high as a quadrillion dollars).

Velocity of Money

This is best understood by thinking about the concept of the Economic Multiplier Effect. Essentially, if I earn $100 and I save (say) $4.50 then I will spend the other $95.50. The person who receives the $95.50 will spend some and save some. In this way, a $100 injected into the economy by the Central Bank grows to become a multiple of the original $100.

Let's look at 12 cycles of spending, assuming that the Savings Rate is 4.5% across the board and assuming that one cycle of spending occurs in one month:

Table 2

Multiplier effect of $100, assuming 12 cycles of spending and assuming each cycle takes one month to complete. (Savings of 4.5%)

         Savings Rate:

4.50%

 

 

Income

Save

Spend

Jan-07

 $ 100.00

 $    4.50

 $   95.50

Feb-07

 $   95.50

 $    4.30

 $   91.20

Mar-07

 $   91.20

 $    4.10

 $   87.10

Apr-07

 $   87.10

 $    3.92

 $   83.18

May-07

 $   83.18

 $    3.74

 $   79.44

Jun-07

 $   79.44

 $    3.57

 $   75.86

Jul-07

 $   75.86

 $    3.41

 $   72.45

Aug-07

 $   72.45

 $    3.26

 $   69.19

Sep-07

 $   69.19

 $    3.11

 $   66.07

Oct-07

 $   66.07

 $    2.97

 $   63.10

Nov-07

 $   63.10

 $    2.84

 $   60.26

Dec-07

 $   60.26

 $    2.71

 $   57.55

 

 $ 943.35

 

 

In one year, an injection of $100 by the Reserve Bank will give rise to an increase in economic activity of $943.35

Now let's assume that people become more cautious in their outlook, and they save (say) 10%. Of course, they will have to forego certain discretionary purchases.

Table 2

Multiplier effect of $100, assuming 12 cycles of spending and assuming each cycle takes one month to complete. (Savings of 10%)

         Savings Rate:

10.00%

 

 

Income

Save

Spend

Jan-07

 $ 100.00

 $   10.00

 $   90.00

Feb-07

 $   90.00

 $    9.00

 $   81.00

Mar-07

 $   81.00

 $    8.10

 $   72.90

Apr-07

 $   72.90

 $    7.29

 $   65.61

May-07

 $   65.61

 $    6.56

 $   59.05

Jun-07

 $   59.05

 $    5.90

 $   53.14

Jul-07

 $   53.14

 $    5.31

 $   47.83

Aug-07

 $   47.83

 $    4.78

 $   43.05

Sep-07

 $   43.05

 $    4.30

 $   38.74

Oct-07

 $   38.74

 $    3.87

 $   34.87

Nov-07

 $   34.87

 $    3.49

 $   31.38

Dec-07

 $   31.38

 $    3.14

 $   28.24

 

 $ 717.57

 

 

It can be seen that incremental economic growth falls from $943.45 to $717.57.

The Central Bank doesn't like slowing growth, so it shoots from the hip and raises the money supply. Question: How much additional cash does it have to inject to get the incremental amount to equal $943.45?

Answer, as can be seen from Table 3 below:  $131.48

Table 3

Multiplier effect of $131.48, assuming 12 cycles of spending and assuming each cycle takes one month to complete. (Savings of 10%)

         Savings Rate:

10.00%

 

 

Income

Save

Spend

Jan-07

 $ 131.48

 $   13.15

 $ 118.33

Feb-07

 $ 118.33

 $   11.83

 $ 106.50

Mar-07

 $ 106.50

 $   10.65

 $   95.85

Apr-07

 $   95.85

 $    9.58

 $   86.26

May-07

 $   86.26

 $    8.63

 $   77.64

Jun-07

 $   77.64

 $    7.76

 $   69.87

Jul-07

 $   69.87

 $    6.99

 $   62.89

Aug-07

 $   62.89

 $    6.29

 $   56.60

Sep-07

 $   56.60

 $    5.66

 $   50.94

Oct-07

 $   50.94

 $    5.09

 $   45.84

Nov-07

 $   45.84

 $    4.58

 $   41.26

Dec-07

 $   41.26

 $    4.13

 $   37.13

 

 $ 943.45

 

 

But, the impact of this is that the money supply injection of $100 grew by 31.48%. Of course this does not translate into a growth of 31.48% of the total money supply, but it does serve to demonstrate that any attempt by the Central Banks to preserve the illusion of growth will result in an accelerating money supply - and an accelerating rate of price inflation.

Oh, yes. And an accelerating rate of Public Debt.

Now, eventually, one or a combination of three things happens:

  1. Price inflation outstrips income growth and people cannot afford to continue to buy the same quantity of goods. They SLOW DOWN in their rate of consumption and they buy fewer goods and services in any one period. This will be represented by a reduction in the velocity of money.

  2. The rate of price inflation runs out of control as the Central Bank continues to try to fight economic slowdown by printing money

  3. Lenders to the Federal Government throw in the towel and say “no more”.

If one monitors the media, most commentators are focussing on 2 and 3 above.

Let's look at 1. above. Let's assume that consumers begin to buy less frequently and do with fewer goods and services. Let's assume that the velocity of money causes the cycle to slow from one month to two months.

Table 4

Same as Table 3, but velocity of money slows

         Savings Rate:

10.00%

 

 

Income

Save

Spend

Jan-07

 $ 131.48

 $   13.15

 $ 118.33

Mar-07

 $ 118.33

 $   11.83

 $ 106.50

May-07

 $ 106.50

 $   10.65

 $   95.85

Jul-07

 $   95.85

 $    9.58

 $   86.26

Sep-07

 $   86.26

 $    8.63

 $   77.64

Nov-07

 $   77.64

 $    7.76

 $   69.87

Jan-08

 $   69.87

 $    6.99

 $   62.89

 

 $ 685.93

 $   68.59

 $ 617.33

Clearly, if the rate of economic growth slows from $943.45 in 12 months to $685.93 in 13 months, then the combination of accelerating inflation and slowing economic activity is going to lead to an implosion in the debt mountain. People/organisations/governments will not have sufficient money coming in to service their debts and they will begin to go insolvent.

It therefore becomes apparent that the concept is flawed - that the US Federal Government will be able to “print its way out of its problems”.  Ultimately, this will give rise to a reduction in the velocity of money and a reduction in economic activity.

The question arises as to whether gold is an insurance policy against all this.

The short answer is: “it depends”.

It depends on whether the economic infrastructure remains intact.

If the economic infrastructure remains intact then, for a short while, gold can become a medium of exchange because it will hold its value relative to other products and services.  It will never fully replace fiat currency across the planet because there is not enough gold to go around. This implies that the price of gold would have to rise to several thousands of dollars per ounce - which would put it outside the reach of most ordinary people who would need some for of currency to buy bread and milk. So, when all is said and done, gold represents a temporary, stop-gap solution.

At the end of the day, moral integrity trumps any system of economic exchange that humans can devise. Without it, the system will crumble. If the economic infrastructure crumbles, then gold will be about as useful as a box of safety matches under water. At the end of the day, the core issue is “integrity”. Trust either exists or its doesn't.

Conclusion

With the world's largest economy - accounting for around 24% of total income across the planet - now staring into the abyss, the virtues of selfish behaviour are less appealing than they once seemed to be. There is a need to place limits on selfishness. There is a need to create boundaries which delimit the acceptability of selfish behaviour. Private Enterprise has its virtues and it also its limitations. Clearly, those boundaries must be drawn at or before the point at which selfish behaviour has the capacity to threaten all of society.

In 1792 the U.S. Congress adopted a bimetallic standard (gold and silver) for the new nation's currency - with gold valued at $19.30 per troy ounce