When the facts are against you, you can either change your mind, or switch the argument from facts to theory. The easy-money guys have chosen the latter course.
Recently, a client sent me an article written by economics blogger John Mauldin (see his chart below). Mauldin has written some of the best work arguing that America is far more likely to see deflation than inflation. His argument revolves around the concept of monetary "velocity," that is, the rate of money turnover. If each dollar is spent and re-spent many times over, that is a high velocity. If the money is spent only a very few times, then the velocity is low.
Others are advancing the velocity view. For example, the New York Times's Paul Krugman has dusted off the Keynesian liquidity trap theory in order to convince America that deflation is the more worrisome threat. In Krugman's case, it seems as though politics are in charge, and the economics seem to be there for no more reason than to provide an elaborate justification for more stimulus spending. I have been taught that the best way to uncover truth is to debate against the opposing views in their clearest and best forms: and the clearest and best form of the case for deflation is not Krugman's political polemics but Mauldin's economic theory. Mauldin is a truth-seeker, not a propagandist.
Originally, the strong focus on the velocity of money goes back to John Maynard Keynes, who used it as part of his general effort to overthrow the Victorian classical consensus that a stable supply of money is the source of stable prices. Keynes argued that inflation was as much a matter of the velocity of money as of its supply. Hence, the government had an obligation to manipulate the economy in such a way as to stimulate velocity in order to overcome deflationary recessions. In essence, Keynes said do not worry about debasing the currency, because that is not a likely source of inflation.
It did not take long before the classical camp corrected the record. Financial journalist Henry Hazlitt accurately identified the theoretical problems with this view:
I have said nothing above about the much-discussed "velocity-of-circulation" of money, and its supposed effect on prices. This is because I believe the term "velocity-of-circulation" involves numerous irrelevancies and confusions. Strictly speaking, money does not "circulate"; it is exchanged against goods. A house that frequently changes hands does not "circulate." A man can only spend his monetary income once. Other things remaining equal, "velocity-of-circulation" of money can increase only if the number of times that goods also change hands (say stocks or bonds or speculative commodities) increases correspondingly …
An increase in the "velocity-of-circulation" of money, therefore, does not necessarily mean (other things remaining unchanged) a corresponding or proportionate increase in "the price-level." An increased "velocity-of-circulation" of money is not a cause [emphasis Hazlitt's] of an increase in commodity prices; it is itself a result of changing valuations on the part of buyers and sellers. It is usually a sign merely of an increase in speculative activity. An increased "velocity-of-circulation" of money may even accompany, especially in a crisis at the peak of a boom, a fall in prices of stocks or bonds or commodities.
---The Failure of the ‘New Economics,' by Henry Hazlitt, 1959
