This was the point of Milton Friedman’s work for which he received the Nobel Prize in economics. Gold can be a noose around the neck of the world economy and make people’s lives less rich and rewarding than they would otherwise be. Think what would have happened to the supply and price of gold if China had to match every increase in national GDP (the Q in the Fisher equation) with an equal increase in gold reserves (the M in the equation) with “V” and “P” remaining constant.

A fractional reserve system is much more flexible and responsive to changes in the world economy. Only one country can possess the reference or reserve currency and that is America at this time. This should require an added measure of fiscal responsibility by national policy makers. But our nation (not just the government, but all of us) have done a poor job managing our expectations and have let greed ruin our economy and banking system.

Now we must pay for our mistakes and regain the world’s confidence that we will act responsibly and regulate our banking system for the benefit of the world economy. We need to expand the monetary supply now to get the planet out of its tail spin (for which we are and will be blamed), and then quickly reduce “M” when the economy gets going again in another 12-24 months, as I said before.

Higher taxes to eliminate our deficits and more responsible and conservative investing and saving by our citizens will then allow us to regain the confidence in our system that has been lost. Public policy can help with this by encouraging more savings (more 401k type incentives) and tax consumption (maybe a national sales tax?) This is where I hope our national policy makers will take us.

The author of the article is not referenced, but he needs to dust off his Econ 101 text book and review the more traditional definition of inflation: “A Rise in the general price level of all goods and services – or equivalently, a decline in the purchasing power of a unit of money”; this from “Contemporary Economics – 4th Edition” by Spencer.

In terms of “demand-pull inflation” the same author says: “demand-pull inflation, takes place when aggregate demand is rising while the available supply of goods is becoming more limited.” This is how we typically think of inflation, with the 1970s as the most contemporary reference. Note that the other non-money aspects of the economy (supply and demand) are not static, but are moving in response to price.

Deflation is just the opposite, where aggregate demand is declining while the available supply of goods is becoming more available. This is certainly the situation in real estate, oil and gas and other commodity resources, labor and much more, today. Inflation and deflation are first and formost determined by supply and demand, not by money supply.

Money supply does make a difference, though, all other things being the same (as Hayek maintains). Money supply should stay in balance with supply and demand, according to Nobel Laureate Milton Friedman, as determined by economic growth. In the monetarist view, there is a simple equation that expains the need for an expanded money supply at this moment in time. From Irving Fisher comes this basic formula:

MV = PQ;

where M = money supply, V = Velocity of money, P = the average price for a unit of goods or services and Q = the quantity of those goods and services.

Right now, we are in a period that due to the collapse of the banking system, V is very nearly low. Banks are unwilling (or unable because of their reserve capital) to loan money. It is by spending and lending that Monetary Velocity is established. We all remember from our Econ 101 class, that for every dollar printed, it may be circulated 10 times per year. This is the Multiplier effect created by Velocity. Recessions are signified by a decrease in veocity and the prescription, according to monetarism, has been to increase money supply.

To balance the equation and avoid contraction of “P”, with “Q” fixed, “M” must be expanded. It is really that simple.

The danger that you and the author of the above piece see, Nirav, is that once “V” gets moving again with an upturn in the economy, then there will be way too much “M” in the economy and “P” will take off like a rocket in response. I agree that is a major danger. And because I do not have total faith my government can get off the gas pedal in time, I am long natural resources and gold, and would be short Treasuries. I am hedging for inflation.

But to avoid the absolute carnage that can be wrought by deflation, contrary to the author’s assertions, we do need a monetary expansion right now, today. We need to keep “P” from falling through the floor with a very low “V”. Lower “P” causes people to wait to make purchases or investments, slowing “V” even more and creating the classic downward spiral of deflation.

The extremely low Treasury interest rates tell us that monetary expansion is not inflationary right now. Otherwise, our foreign debtors would require higher interest rates to offset the risk. The stabilization of the stock market, which is a good proxy for real assets, tells us that the monetary expansion underway is working and is well received by sophisticated investors.

Stay tuned. The next 12-24 months will tell the story.

You should click on the Passive Income category link to see what I’m doing. You might also want to check out the about page – I’ve never claimed I’m going to teach you anything – I’ll just share what I’m doing. I have been buying gold coins. And I suggest you do as well. And I’ve always provided a good justification for it.

But if you’d rather be spoon-fed as to what stocks to buy and how to quickly start a site that pulls in money with no work, I’m afraid you’re on the wrong site. There’s no free lunch.