ROUBINI : INFLATION IS NOT A PROBLEM / CNBC ( VERY HIGHLY RECOMMENDED READING )

Roubini: 'Inflation Is Not a Problem'


On Tuesday November 16, 2010, 10:28 am EST

Despite a huge program by the Federal Reserve intended to provide monetary stimulus to the economy, Nouriel Roubini doesn't think we need to worry about inflation.


In fact, he argues that people who take the position that the Fed should curtail its easing policies do not really understand inflation.


In the first two parts of my interview with economist Nouriel Roubini we discussed two issues: Why Professor Roubini believes a gold standard is no longer a viable option for modern economies, and second why monetary easing is a necessary evil.


So let's take a deeper look at Roubini's theory of inflation.


Let's begin with what seems to be the principal conclusion of Roubini's argument. Simply put: "Inflation is not the problem."


Why does he believe that to be true?


The key to understanding Roubini's assertion may be best summed up in his own words: "Increasing base money is not inflationary because M0 more than doubled in the last year and a half-since QE1-but velocity has collapsed."


That sentence may seem densely packed with economic theory, but with a little explanation it's fairly straightforward to grasp. It is essentially made up of three interrelated concepts.


First, let's begin by exploring the concept of M0. As you probably recall from your college economics classes, there are several measures of the U.S. money supply. M0 is the most liquid measure of money in the U.S. economy. It represents actual coins and currency notes circulating in the economy, as well as the coins and currency notes stored in bank vaults. M0 is actually quite easy to envision, because it represents the sum of physical money you can actually touch with your hands.


Second, Roubini refers to ' QE1'. This of course is the first round of Quantitative Easing, which the Fed began last year. In March of 2009, in the doldrums of recession, the US Federal Reserve began injecting money into the US economy by purchasing assets other than short-term treasury debt. The goal of these purchases was to expand the US money supply-and thereby stimulate the economy-through 'unconventional monetary policy.' What that means is this: With interest rates very close to zero, the US Federal Reserve no longer had the ability to stimulate economic activity by the traditional means of lowering interest rate targets. Without that option available, the Fed engaged in this 'unconventional policy'-creating new money for its own account, and then buying assets to put that money into circulation. (In a post to his New York Times blog last spring, economist Paul Krugman did an excellent job of explaining the goals-and risks -of quantitative easing.)


The third and final term that requires a bit of explanation is 'velocity'. What Roubini is referring to here is the velocity of money in the U.S. economy. Velocity is perhaps best thought of as the rate at which money changes hands in the economy, although the precise definition is a little more complicated. (Wikipedia, for example, defines the velocity of money as: "The average frequency with which a unit of money is spent in a specific period of time.") But, for the purposes of understanding the broad outlines of Roubini's argument, our definition should suffice.


When you put those three components together, it would seem Dr. Roubini's basic meaning is this: Despite the fact that the United States Federal Reserve has injected well over $1 trillion (and rising) into the U.S. economy-even with all that new money sloshing around-the rate at which money is changing hands has actually dropped.


Without an increase in lending and spending, prices simply are not rising.


Roubini further ties his statement about why quantitative easing has not yet been inflationary into the broader Quantity Theory of Money .


You may recall a related topic from your college economics class called the Equation of Exchange . The simplified version of this equation is the famous MV = PQ. As you may remember, the letters stand for Money Times Velocity equals Price times Quantity.


If we apply what Roubini is saying to the Equation of Exchange, the broad implications seem comprehensible: Despite the fact that there is more money in circulation, that money isn't changing hands fast enough to cause a rise in prices based on the total amount of goods and services being produced.


No economist's academic work can ever be reduced to the summary explanation that a brief and general treatment requires. But with some effort we should be able to understand the broad outline of the ideas they encapsulate.


In the case of the argument put forth by Roubini-namely, that inflation is not currently a significant risk to the U.S. economy-the structure is broadly understandable. We can get our heads around this basic idea: If the Fed creates new money, but the money still isn't moving through the U.S. economy, goods and services don't get purchased, and therefore prices do not rise.