Following the recent election on Tuesday, we have just one word for you: Panic!
This advice stems not only from President Obama’s reelection, but also from the insights of John Embry, the chief investment strategist at Sprott Asset Management. He predicts that 2013 could be “one of the ugliest years on record.”
Embry observes, “I believe we will witness the initial effects of negative money printing in 2013. Up until now, money velocity has been declining because, despite the central banks injecting high-powered money into the market, banks and consumers are struggling to activate the lending mechanism.”
“Banks are hesitant, and consumers are over-leveraged. However, I believe this will push quantitative easing (QE) to more extreme levels. Eventually, holders of bonds and cash will have a collective epiphany that ‘My God, the money is being destroyed. Get me out.’”
“This realization will change the direction of money velocity, leading to rapid inflation.”
The Velocity of Money Revisited
Embry’s warning about a swift increase in money flow aligns with the concerns of critics regarding quantitative easing. If banks start issuing the credit generated by the Federal Reserve, the flow of money into the actual economy could accelerate significantly. Once this process begins, it may be unstoppable.
The velocity of money represents how frequently a single unit of currency is spent within a specific timeframe. For example, if a mechanic purchases $40 in supplies from a storeowner, then the storeowner pays $50 for car repair services from the mechanic later on, followed by the mechanic buying a $10 case of beer from the storeowner, there has been $100 of economic activity, despite only $50 in actual currency being used. Each dollar was spent multiple times, resulting in a money velocity of 2 for the day, contributing $50 in spending to the economy from both individuals.
However, what if the storeowner decides to stash the initial $40 sale in a mattress, and the mechanic doesn’t earn his $50 and skips buying beer? In this scenario, total spending would only amount to $40.
Today, even though the money supply has significantly increased, its velocity remains sluggish—at least for now. Here’s why this is important…
Get Me Out
The federal funds rate hovers near zero, the Federal Reserve’s balance sheet has more than tripled, and the federal government has sustained trillion-dollar budget deficits for four consecutive years. Despite these indicators of financial excess, the money is trickling into the economy slowly, like cold molasses in winter.
In the aftermath of the 2008 financial crisis, banks have focused on strengthening their balance sheets rather than extending loans. Though they have access to cheap credit from the Federal Reserve, they prefer to hoard it, much like stashing it away. What little lending does occur often benefits the government through the purchase of Treasuries.
However, attitudes can shift quickly. John Embry believes a change could occur this year as individuals collectively recognize, “My God, the money is being destroyed. Get me out.”
When this realization hits, the velocity of money is set to surge—along with the prices of goods and services. In the meantime, the potential for inflation grows with every asset purchased by the Fed. Nevertheless, the Fed is facing a point of no return.
If the Fed halts its money creation policies now, a great default would ensue. Conversely, continuing down the path of currency devaluation may delay a default only until the consequences become catastrophic.
Sincerely,
MN Gordon
for Economic Prism