Here it is folks. Our current recession and economic crisis neatly wrapped up in 9 easy to understand slides.
It’s kind of hard to summarize 9 slides when they are short already but one equation stands out at the end. This really does make all our economic issues simple to understand…
In other words, m is the amount of money in circulation,
v is the velocity at which it moves,
p is the price set for goods and services,
q stands for the quantity of economic output.
Here is what I see that changed the equation.
Velocity slowed down. I have talked previously about the speed of money in my article “Why Politicians Keep Telling Us to Spend, Spend, Spend!!!”
Once velocity slowed down something had to give on the other side. That something was the price of goods and services.
We are seeing this in the price of stocks and real estate right now, and also in cars and other “big ticket” items that most people buy with credit. We will probably see a fall out effect for many other goods and services too. Everywhere except the most basic commodities that are necessary and where demand does not change much.
And here is where governments and businesses are trying to effect the equation.
Most people don’t care about velocity, they care about price. Higher prices mean higher profits (in most cases), and higher prices also mean less unemployment (in most circumstances). When the pricing structure comes down (because of slack demand) we have a recession. A recession defined, once again, as a two consecutive quarter decrease in GDP.
So once V came down P had to come down to balance the equation.
To bring the equation back up the government could do something. Increase the money supply. If the equation holds true than an increase in the money supply would cause inflation and would cause the prices of goods and services to come up.
What we are seeing are price increases for certain goods and services, and price decreases for other goods and services. Apparently this isn’t such a great strategy.
Businesses for their part have decreased production. They have shut down plants and laid of many workers. As long as the left side of the equation is fixed, a decrease in production should lead to an increase in price. Simple supply and demand, right?
Well there is a problem. The more people they lay off the less money they have to buy the goods and services they produce. The vicious cycle continues. Changing q won’t do much for changing p in this climate.
What are we setting ourselves up for?
Worst case scenario: Confidence is partially or fully restored and the government really does get money flowing again. M is permanently higher and V increases by some unknown amount.
Prices for goods and services soar while businesses will be slow to rehire people. People will struggle to afford things for awhile until businesses decide to hire people again. People will probably buy more basic goods and services on credit than ever before.
Fundamentally, we will have changed the entire system to have it based on credit more than ever. In other words, we will have to face these situations every couple of years, and people will continually see their buying power erode away.
Best case scenario: We stop throwing more and more money into the supply and let velocity level itself out. We let demand arise organically (instead of artificially through price manipulation) and let business satisfy the need by increasing output.
We will all learn how to pay for things that we get now right now instead of in the future. We will all be forced to be more disciplined in our finances. We will all have to strive a little harder to find ways in which we can be productive members of society.
We will probably have a lost decade where economic growth flatlines, but if we accept the fiscal responsibility we all should, we will all be better off in the long run. If we go with the worst case scenario then we will probably have to face a similar situation in the next 10 years.