“Inflation is always and everywhere a monetary phenomenon.”

-Milton Friedman

One of the late Milton Friedman’s most memorable and most quoted phrases is summed up in another cliché from the quasi-academic world of dreary science, “too much money chasing too few goods.”

Inflation: Shop NOW

Friedman taught us that money is essentially a good or commodity, and its value is determined by supply and demand. One of the consequences, and not the cause, of inflation is the increase in the price of goods. When we realize that today’s money is likely to buy fewer goods in the future, we stop saving for the future and look for ways to spend it now. By doing so, the unsaved money increases the frantic chase to buy goods now.

Inflation, in other words, occurs when money becomes less valuable relative to the cost of goods. This can happen when:

1. The money supply increases

2. The supply of assets decreases

3. Lower demand for money

4. Demand for other goods increases

The most common cause of inflation is when the money supply increases faster than the supply of other goods and services.

Money has value only as long as people believe that they will be able to exchange their money for goods and services in the future. This belief will last as long as people do not fear future inflation. To avoid inflation, central banks are mandated to maintain price stability. To this end, they must ensure that the money supply does not increase too quickly.

the speed of money

Deflation is the complete opposite of this. Deflation is commonly defined as falling prices, but falling prices are the result of the underlying failure, not the cause. The cause is always and everywhere, to borrow Friedman’s words, a decrease in the money supply. Other studies show that the velocity of money, that is, the money multiplier in the economy, is equally important. When both of these factors are on the wane, a recession or worse is headed our way full speed.

What is ‘The Money Multiplier’?

M3, which is the aggregate of a wide range of bank accounts, has been abandoned by Bernanke’s Fed since 2050, but British and European monetarists still follow. M3 began to contract at an alarming rate last summer, giving about a year’s notice of the direction of the US economy. This year the pace has picked up. The money stock fell from $14.2 trillion to $13.9 trillion in the three months to April, which equates to an annual rate of contraction of 9.6%. Institutional money market fund assets fell at a rate of 37%, the sharpest drop ever. This drop in M3 is unprecedented since the Great Depression.

The Money Multiplier, MM, is of fundamental importance in national monetary policy. In the US, from 1959 to September 2008, banks lent close to the maximum allowed. So the broad money supply was roughly equal to central bank money multiplied by the maximum MM allowed.

During that period, the multiplier was often a factor of 5 times or more. During the great depression and again since 2008, banks accumulated excess reserves, that is, they did not lend money, and the MM decreased significantly. Throughout 2009, lending fell by more than $100 billion, representing a record 10% absolute decline, plummeting to a record 16% annualized rate. It seems that even before this year began, a double-dip recession, or worse, was written on the wall for the second half of 2010.

the road ahead

Recent indications strongly suggest that a resurgence of the recession is on the way now that the temporary effects of cash for junk, first-time homebuyer discounts, etc. have expired. CPI heads south along with consumer confidence.

Money, as a commodity, depends on the consumer’s faith in its value. It seems that the common Joe is more confident in money now than at any time in recent memory. That’s why Joe and Jane Doe are saving their money in significant amounts for the first time in years. During deflation, the relative value of money increases as we realize that today’s cash will buy more tomorrow as prices fall as deflation is spent. Governments look down on ordinary people like us, particularly this elitist socialist government of Obama, while all the while the actions of the people clearly point the way forward: deflation.

Is cash king?

After a period of economic contraction, the overcapacity and overproduction that we see at the beginning of the deflationary period will be eliminated. At some point, whether it’s 5 months, 5 years or 30 years from now, prices will drop so low and the money accumulated will be so great that buying will start again. Then we will probably see inflation kick into gear and rise at an alarming rate, as once again there will be too much money chasing too few goods.

So for investors, “cash is king” isn’t necessarily bad advice to follow right now. For traders, this is not the way to go. In all periods of economic activity, trade occurs and markets exist to facilitate that trade. Generally speaking, asset prices decline. during deflationary periods, so trend following traders would mostly be short sellers. However, from time to time, declining markets give rise to volatile short-covering rallies that can move quickly and unsuspecting correction levels. These offer more opportunities to profit from trade during deflationary periods. Deflationary Times Market Profile, or Auction Market Theory, offer a reliable means of recognizing and understanding market structure and low levels of business location risk.

Straight Ahead: Deflation Renewed?

We can expect a new deflation immediately ahead. The depth and duration of the deflationary spiral could well be of the proportions of the 1930s-EURY depression. During this period, the value of money will increase. Investors having cash ready for the next asset bull market is not a bad thing. Traders, on the other hand, must continue to trade the opportunities in changing asset prices in the markets that facilitate trading.

Trade well and follow the trend, not the so-called “experts”.

larry levin trades the S&P 500 on the Chicago Board of Trade, now known as The CME Group; the largest and most diverse financial exchange in the world. Levin is the founder of Trading Advantage.com, a leading trading education company that specializes in empowering traders to achieve and exceed their financial goals. He appears regularly on CNBC, Fox Business News, and other major media outlets around the world. Contact larry at 888-755-3846 or [email protected]