A lot has happened in the last 12 months, particularly in response to COVID. Regardless of how you feel about COVID or the measures governments have taken, we are all affected to some degree. A large part of the government response is the changes to fiscal and monetary policies, in other words, stimulus. Specifically, our neighbors south of the border have supplied historic amounts of stimulus, with more on the way.

However, it is our belief, and the belief of many others that more stimulus is not the answer. By continually handing out more and more money, the desired outcome will not be reached. Below we aim to try and explain why that is the case.

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Just less than a year ago we wrote a piece called “Helicopter Money to Increase Short Term Inflation 2020?“. In that post, we looked at why the handouts from the government would create inflation in the wrong part of the economy. We want to echo some of those thoughts and expound upon them.

What Comprises Inflation?

When it comes to money’s effect on inflation, there are two main components: supply of money, and velocity of money.

The supply of money is exactly what it sounds like, the amount of money in circulation. In a sense, money gets its value from scarcity. If there is 100 units of money in circulation and you own 1 unit but now the government increases the money supply to 200 units, your one unit is now worth half of what it once was.  

The velocity of money refers to how fast money is spent. The relationship between these two components becomes complicated rather quickly. If you are interested in a further breakdown, with formulas, Thismatter.com, does a good job of breaking down the components.

In essence, inflation occurs when aggregate demand exceeds aggregate supply. Aggregate demand is influenced by both the supply of money and velocity of money. With extremely low money velocity, it is hard to generate stable, healthy inflation. Inflation is experienced when the supply of money and the velocity of money increase more than real GDP.

If real GDP is higher, than supply and velocity of money can increase without experiencing inflation.

However, there in lies the issue.

Velocity, Supply and GDP

A large part of velocity of money is reliant on consumer confidence. Consumers are only going to spend their hard-earned money if they are confident in the future of the economy. Consumer spending makes up 70% of economic activity. If consumers lose confidence in the economy, consumer spending will start to decrease.

Money supply on the other hand is almost fully dependant on the central banks. To say the least, they have fully utilized their control over money supply in the last year. Over the last 25 years, the money supply in Canada was slowly increasing. See the chart below.

But as you can see, early in 2020 the money supply shot up. It went from around 100,000,000,000 to 417,245,000,000 by November of 2020. That is an increase of more than 300%.  

Based on what we said earlier, if we knew that real GDP was going increase markedly, that large of an increase in money supply might not be a big deal. However, in the midst of COVID, it would be hard to believe that GDP increased. Based on statistics, that is exactly what we have seen.

Current GDP Statistics

According to ceicdata.com, Q1 2020 saw a decline in GDP of .281% year-over-year. Not bad, right? Well, COVID only really started to hit Canada near the end of February. Q2 2020 saw a decrease of 12.499% year-over-year. Q3 was not quite as bad with a decline of 5.162% year-over-year. Q4 data was not available on the site yet.

In the end, according to thismatters.com, inflation = the change in money growth – the change in real GDP. We had historic increases in the money supply with a decline in real GDP. This means we could be on the cusp of higher than desired inflation. That is, if people start spending all the money given to them.

People Are Not Spending Their Money

In November of 2020 we wrote Canadians Increase Their Savings Rate. In that article we talked about how the savings rate of Canadians has increased markedly during COVID. Why is that?

Well one reason, is that people cannot travel or do much of anything. Thus, their discretionary spending has declined. The second, as referenced early is a lack of confidence. Why would you spend your money today on things you do not need, when you don’t know what the economy will look like in the future? Exactly, you would not. Or at least not to the same extent as you would under normal circumstances. That is most likely a large factor in why household savings rates have increased.

If the goal of the stimulus is to propel the economy, to increase general inflation slightly, the extra stimulus may not have that effect. That money is going to be put towards debt, mortgages, missed rent payments and essential items like food. What isn’t spent on those things will most likely be saved or put into some sort of store of value.

Conclusion

In the end the only way that things return to normal is by the economy opening. Once the economy is open and people have the opportunity to spend their money, consumer confidence will slowly return. As Consumer confidence returns, savings rates will digress to a more normal level and inflation might return to “normal” levels.

The balance is tricky now that the money supply has been increased so dramatically. By not opening up the economy, we may also run the risk of altering consumer habits so much that they don’t return to what we previously saw.