The Memory Of Money Velocity

June 29, 2014

A recent article we published last week brought up some interesting commentary worthy of expansion. 

Particularly, with regard to money velocity and complexity theory.

Here is a recap of the main points of the article...

If the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.

P = M * V / Q

Where the variables are:

P = Price level
M = Money supply
V = Velocity of money, how many times money turns over in a year
Q = Real GNP

In hyperinflation the money supply is going up, the velocity of money is going up, and the real GNP is going down - all at the same time.  It is a triple whammy that drives prices up really fast.

One of the problems with this equation is that it doesn't measure potential velocity. Nor does it measure the exchange of money that happens in the gray or under the table economy.

Fixation on money velocity serves only in the aftermath. Those who constantly point out this measure as proof that inflation is not alive and well are misguided. Confidence is much like bankruptcy - its loss happens slowly, then all at once.

"Dear Dr. Lewis, 

I read your recent post on about Money Velocity, and totally agree with you the equation is incomplete.

While reading the history of the United States by Milton Friedman and Anna Schwartz, it was evident in examples provided that something was missing.

Other economic publications have done extensive analysis of monetary velocity during hyperinflations, and in a footnote explained that the data had high correlation with the results of a third order linear differential equation.

Nothing more was said after his data crunching.  

Studying engineering, as students we were tasked relentlessly to solve those third order equations and produce state-space diagrams.  

When I saw the footnote expression, it made complete sense.  Third order differential equations describe systems with memories.  That is, what happens next is always dependent on the last state of the system.

For a moment I was puzzled how an inert item like currency could behave as if it had memory.  Didn't take long to see the connection.  The currency reflected the behavior of those spending it, and they are the ones who have the memory.  All conditions for a third order linear differential equation have been satisfied to reinforce what I surmised.

I was invited by a friend studying at the University of Alberta School of Business to give a presentation to his class.  The topic I chose was monetary velocity, but from the point of view it was dependent on memory.  I produced state-space diagrams to show how 3 solutions of the third degree linear differential equation can affect monetary velocity.  Graph presented is attached.

In the "steady state" solution, spending is constant, expectations for future purchasing power is unchanged.  In the "over-damped" solution, money velocity decreases and expectations are that future purchasing power will be greater.  Postponing expenditures makes one richer.  In the "under-damped" state, expectations are for reduced purchasing power and everyone scrambles to buy goods today which they will not be able to afford in the future.  Postponing expenditures makes one poorer.

Today, the Fed through QE is trying to walk the "thin" line between an "over-damped, under-damped" economy.  A slight miscalculation (which will happen) will land the economy in one of the two states."

Indeed, simply introduce a bit of chaos and confusion into an already fragile system and watch what happens.

Suddenly it will become clear what the Warren Buffets are really doing - shedding dollars as fast as they possibly can, while talking down the canary every step of the way.

Our friend and fellow subscriber added the following:

"Many feel that the "solutions" or the "behaviors" cannot be modeled. Or they are too complex.

In his latest book about currency and the coming collapse, James Rickards makes a strong argument against all of the Fed models (useless, out of date) and argues strongly for "complexity theory".

He defines the difference between complicated and complex and seems to suggest the Fed does not understand the difference.

I believe it is also important to define this in the context of fragile versus robust.

Complexity is intrinsic. Something is complex if it involves a lot of [metaphorical] moving parts even when considered as a platonic ideal.

Complication is extrinsic. Something is complicated by external influences, or because of external influences.

Rickards suggests "complexity theory" which he claims to have studied addresses Black Swan and random events.

The real key to modeling is the consideration of risk. Value at risk is the telltale variable, the standard of care for complacency that caused almost “everyone” to be caught by surprise as the last major financial crisis unfolded.  

Dollar Reset Before or After

One take is the coming dollar reset, at least the first one, will take us all by surprise—most assuredly a weekend event.

The ultimate power still held by the central banks is the regulatory ability to shudder the system “for your own good” without notice. 

That scenario would lead to almost immediate chaos. Though one would doubt they've included that in their modeling. 

It can happen at any time.

Some say this is impossible because nothing is in place to supplant the U.S. dollar—as if chaos cannot be a realistic outcome.

And the psychology behind it (the coming reset) is not a candidate for accurate modeling. Very much like "climate change" which, as we all learned in grade school, has been a constant since the formation of planet earth. 


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